Viva! Stocks staged a late day rally after weak economic data and mounting virus deaths gave way to an energy-driven rally as US crude producers are finally getting it. A new war of words is brewing between the US and China and traders are watching closely… nervously.
N O T E W O R T H Y
Watch the road! Yesterday’s news stream began with an announcement that US clothing retailer J. Crew would be filing for bankruptcy as a result of the Coronavirus. OK, whether you shop or have shopped there, you surely know it as a mainstay in just about every mega mall and higher-end strip mall. We know what that means for owners of the company, which was taken private in a leveraged buyout in 2011, but it goes farther than that. Leveraged buyout means that there is debt involved and it is precisely that debt load combined with weak sales resulting from the pandemic crisis that put the company in a tough place. Weaker sales means less cash flow. Less cash flow means less cash available to make payments to lenders. If you can’t pay lenders you are in default and if you can’t cut a friendly deal with them then your only option is bankruptcy in which you either liquidate or work out a court-supervised deal with lenders. Now, to be clear, J. Crew is not like an average company from a financial standpoint as the stock is privately held and its debt is held by large investors. I chose to highlight the company to illustrate just how sensitive some companies might be to changes in a business climate, which is only enhanced by a high debt burden. Putting aside the now-obvious fact that retail has taken an abnormally large hit in a very abnormal climate, the real message here is that a company’s level of indebtedness is a big factor in its health, for almost every sector and in all business climates, even normal ones. The US has enjoyed low interest rates for an unprecedented long period in the wake of the financial crisis. Low interest rates meant that companies could borrow more for less. Companies, being rational, did just that, amounting to around $6.6 trillion dollars by the end of 2019. Not only is the large number itself notable, but also the rate at which it has been expanding. After the 2001 recession, corporate debt levels remained fairly flat until 2006 when it began to accelerate right into the financial crisis. One would expect that the recession would tamp down the growth debt levels but in fact it is quite the opposite. With a pullback in revenues and new stock issuance on hold, companies were forced to turn to credit markets to raise capital, and near zero interest rates made it easier for companies to borrow more. The rapid acceleration of corporate debt continued unabated through last year. That all means that, by historical standards, companies were already carrying a lot of debt coming into 2020. Enter the unexpected Coronavirus, which shut down and impacted virtually all corners of the economy. The economic numbers are just beginning to reflect the realities of the economic pause as we get releases that are hitting “lowest on record” milestones. Just yesterday, new orders for manufactured goods, Factory Orders, showed a monthly decline of -10.3%, marking its largest drop on record. We are now just past the midpoint of first quarter earnings season and the results are not surprisingly weak with at least a portion of the first quarter being affected by the nationwide pause. The current quarter’s results are expected to be far worse and those results won’t be out until July. Still, many economists now expect a slow but sure recovery in the final two quarters of the year as the nation gets back to business and new therapies for the virus start to come online. For longer term investors, this means looking at 2021 and writing off the current year as an anomaly. I have written quite a bit about how a company’s stock reflects its future returns. That future includes not only these next few quarters, expected to be bad, but also the many years ahead, which will be better. With that we can take some comfort that healthy companies will someday return to their normal growth trajectories. One thing that some may be overlooking is that company balance sheets are not going to look the same once things get back to normal. Companies are aggressively tapping the credit markets to raise the cash necessary to keep their businesses moving forward during the crisis. That means that many companies will almost certainly emerge with more debt. In that case, even if sales get back to where they were at the end of 2019, earnings, and even more importantly, cash flows will suffer under an increased amount of debt service, making them more vulnerable to future bumps in the road. Mind the debt.
THE MARKETS
Stocks started the session in the red as tensions are heating up between the US and China while weak numbers reflect the economies realities of the pandemic. Later in the session a rally in crude oil and the energy sector led the market higher, brought on by hopes that US producers are going to cut supply. The S&P500 climbed by +0.42%, the Dow Jones Industrial Average advanced by +0.11%, the Russell 2000 traded up by +0.28, and the NASDAQ Composite Index jumped by +1.23%. Bonds pulled back and 10-year treasury yields climbed by +2 basis points to 0.65%.
NXT UP
- Markit Services PMI (April) is expected to come in at 27.0 in line with prior estimates.
- ISM Non-Manufacturing Index (April) may have fallen to 37.9 from 52.5 according to consensus estimates.
- Chicago Fed President Charles Evans, Atlanta Fed President Raphael Bostic, and St. Louis Fed Head James Bullard will all speak today.
- This morning Alaska Air, Regeneron Pharmaceuticals, Aramark, Marathon Petroleum, Nustar Energy, Mallinckrodt, and TransDigm Group beat estimates while Ares Capital, Newmont Corp, Us Foods, Dominion Energy, and Martin Marietta missed. After the bell, we will hear from Mattel, Virgin Galactic, Pinterest, Prudential, Walt Disney Corp, DaVita inc, Devon Energy, Activision Blizzard, Electronic Arts, and Beyond Meat will release their results.