The Canary in the Capital Markets’ Coal Mine: Protecting Long-Term Strategy
Why this matters to long-term companies…
The public equity markets are experiencing a meaningful amount of volatility. The impact of short-term volatility has the potential to significantly impact long-term strategy. Market activity over the past four days has shown something unprecedented. We want you to be both informed and prepared. You have an opportunity to incorporate this into your strategic planning and make your company more resilient.
Effective long-term strategy relies on access to capital and the cost of that capital. Market volatility directly impacts a company’s ability to access capital, as well as the associated costs. This dynamic applies to both public and private companies. If the public market is stressed and the IPO market closes, history shows that there is a spillover effect on the private market. Preparation can prevent you from being forced into short-term decision making.
The following market intelligence newsletter will provide you with context and data driven market insights that should support, and possibly help you double-down on, your long-term strategy.
Tail Wagging…
It is easy to search for, and find, a technical definition of volatility. For these purposes, we will focus on the S&P 500 Volatility Index, or the “VIX.” Think of the VIX as a number revealing broad market sentiment about risk in the equity markets. When the VIX trades above 30 the equity market is signaling dislocation.
Dislocation occurs when many investors engage in “flight to quality” trading. They flock to large cap, profitable companies and sell, often with little price sensitivity, growth stocks. You may also witness large blocks of forced selling in the equity markets purely to create liquidity to protect fixed-income portfolios that, as you will see later, have become illiquid.
Some describe the VIX as a measure of fear in the equity markets. Below is a table that simplifies how to read the VIX and defines equity market dislocation, in the traditional sense:
As of May 9, 2022, the VIX reads at 34.75. While this indicates an equity market dislocation, the equity markets are largely short-term and fickle. Since the beginning of 2022, the VIX has closed in dislocation territory 23 times and not for more than 11 consecutive trading days.
By contrast, at the beginning of the pandemic, the VIX closed in equity dislocation territory for 50 consecutive trading days (February 27, 2020 — May 7, 2020). During the 2008/2009 Great Recession, the VIX closed in dislocation territory for 170 consecutive trading days (September 15, 2008 — May 18, 2009).
Why are some periods of equity market dislocation fleeting, while others are sustained? The duration of equity dislocation matters much more than its episodic occurrence. We actually have data explaining this dynamic — and it does not originate in the equity markets.
The size of the credit market is multiple times larger than the equity market. Global credit is the dog and the equity market is the tail. Watch the dog.
It’s the dog that wags the tail…
The global credit markets are vast and complex. We could share a laundry list of credit statistics related to federal reserve policy, auto-loans, mortgages, fixed-income derivatives, bond defaults and the yield-curve, etc. — but we’re not going to do that.
Similar to the VIX, there is a leading indicator in the credit markets that distills credit sentiment into one metric. It is the rate that measures the solvency and perceived risk of global systemically important banks.
There are only 30 globally systemic banks and they effectively control global credit and money supply. Today, this leading indicator is called Ameribor (Ameribor’s predecessor was called the TED Spread).
Ameribor is expressed in basis points. One basis point is one hundredth of one percent and 100 basis points (100 bps) is equal to one percent (1.00%). Credit dislocation occurs when Ameribor trades above 60bps for more than 10 to 15 trading days.
Dislocation means that these globally systemic banks cannot fully assess one another’s balance sheet risk. As a result, liquidity (money supply) may freeze up. The table below simplifies how to read Ameribor and its concordant market conditions.
Simply put, the data show that when Ameribor signals credit dislocation for more than 10–15 trading days, that equity market dislocation will be sustained. The length of this dislocation is largely dependent on both economic conditions (economic growth, unemployment, inflation, etc.) and artificial economic stimulus (interest rate policy, quantitative easing, etc.).
Ameribor is a unique metric. It is driven by the activity of globally systemic banks. These banks share significant balance sheet risk (syndicated loans, etc.) and carry massive counterparty risks (interest rate hedges, derivative contracts, etc.).
These banks are in regular dialogue with one another, the federal reserve bank (the “Fed”) and other banking regulators. It is a metric that behaves more rationally than the VIX.
Historically, the credit markets signal a sustained equity market dislocation and recovery. Today, we are at the beginning of a potentially unprecedented market dynamic — the credit and equity markets dislocated on the same day, May 5, 2022.
As of the writing of this newsletter, we are just five days in. History will help us put some shape around how this all works…
The Gordon Gecko Era (Black Monday)…
On October 19, 1987, the equity markets dislocated. This event is commonly referred to as “Black Monday.” This period of time witnessed a mortgage market meltdown (thrift scandal), conflict in the middle-east, high oil prices and high overall interest rates.
Approximately one year prior to Black Monday, the credit markets dislocated and foreshadowed a sustained period of overall dislocation. On September 8, 1986 the credit market dislocated and it took over a year for the equity markets to reflect a commensurate level of risk.
The Big Short Era (The Great Recession)…
On September 15, 2008, Lehman Brothers filed for bankruptcy. Similar to the Black Monday event, this period also experienced a mortgage crisis, high oil prices, middle-east conflict and high overall interest rates.
Approximately one year prior to Lehman’s bankruptcy the credit markets dislocated and foreshadowed a sustained period of overall dislocation. Credit dislocation began on August 9, 2007 when two Bear Stearns hedge funds, with significant mortgage related exposure, were sued. Much like the Black Monday event, it took over a year for the equity markets to reflect a commensurate level of risk.
The Economic Lockdown (The COVID-19 Pandemic)…
The COVID-19 pandemic occurred amidst a strong economy with low inflation, interest rates, unemployment, and oil prices. This is very different from Black Monday and the Great Recession. To stop the spread of COVID-19, the US government put the economy into a self-imposed recession.
To prevent a persistent recession, the federal reserve “supercharged” all the lessons learned from the 2008/2009 Great Recession. This new version of “Quantitative Easing” expanded the pool of eligible assets to be purchased by the Fed. The goal was to bolster global systemically important banks and ensure global credit liquidity by purchasing longer-term securities to increase money supply and to encourage lending (credit).
In addition to record levels of congressional stimulus, the Fed injected over $3T of liquidity directly into the credit markets. The Fed bought CMBS (commercial mortgage backed securities), RMBS (residential mortgage backed securities), Treasuries, and even credit ETFs in order to drastically reduce balance sheet risk for global banks. This swift and aggressive action artificially supported liquidity in the credit markets.
While the dislocation characteristics of the Black Monday and Great Recession events were eerily similar, the Pandemic event was unique. The Pandemic event seemingly sets the stage for where we are today.
In early 2020, the global economic shutdown triggered a near simultaneous dislocation of the credit and equity markets. The federal reserve took comfort from a low inflation environment and aggressively cut rates to zero followed by substantial purchases of troubled assets from banks. Their approach contained credit dislocation to just 31 trading days amid a global economic shutdown.
The Uncharted Waters of 2022 (A Potential Perfect Storm)…
To say market conditions of 2022 are unique, is an understatement. It may be that we are witnessing that part of the road where the proverbial can of 2020 was kicked.
The markets are still dealing with the aftershocks of the pandemic, the Federal Reserve has a balance sheet bloated with troubled assets, Russia invaded Ukraine, NATO nations imposed significant economic sanctions on Russia, gas and commodity prices are soaring, inflation is accelerating faster than it has in over 40 years and the Fed raised interest rates, twice.
This convergence of events now leaves us in fairly uncharted territory and it must be closely monitored.
Are there worms inside this can that’s been kicked?
Historically, when credit meanders above dislocation thresholds (as it did with Brexit), it subsides. It is also interesting to note that when the equity market dislocates (VIX trades above 30), it will swiftly recede as long as credit remains stable (below 60 bps).
The recent May 5, 2022 credit dislocation is similar to the Black Monday, Great Recession and Pandemic events. It was significant and sharp. Since we are experiencing record acceleration of inflation and the Fed has fewer tools at their disposal, this sharp move is concerning. We are only five days in. If these conditions persist for another 10 trading days we may be in for a long and sustained period of dislocation.
The public equity market will gyrate. However, the credit market is far more deliberate. During March 2020, credit began to stabilize prior to any public announcement of Fed stimulus. While it is possible for that to happen under current market conditions, the Fed would have to weigh the inflationary risks of additional global banking stimulus (reversing recent rate hikes and quantitative easing through troubled asset purchases).
Doubling Down on Long-Term Strategy…
Historical precedent and data suggest that this is a time to shore up your balance sheet, adjust expectations regarding capital raising terms (this is not Q421), and align with long-term investors and advisors that will support you through challenging environments. We advise companies to run analyses on a few, more aggressive, timelines for financing.
- If you’re a private company planning on a Q322, Q422, or Q123 capital infusion, consider what steps you need to take to accelerate timing.
- If you are a public company, consider making necessary preparations that allow you to take advantage of open market windows between now and the end of the year, if applicable.
We believe this is the time to double-down on a long-term strategy and focus on your key stakeholders. The impact you can make on all of your stakeholders during times of great uncertainty will generate significant momentum once we transition to a constructive capital markets environment.
A healthy balance sheet supports resilience. It can withstand broad market stress and, in a downturn, allow long-term companies to:
- Retain critical talent by being a safe-haven, with a strong balance sheet,
- Opportunistically attract and upgrade strong, and possibly displaced, talent,
- Acquire attractively priced assets and/or make strategic acquisitions,
- Deploy growth capital to increase market share and serve the market as short-term, less prepared, companies weather a downturn,
- Maintain/Improve ESG ratings since balance sheet strength is correlated with higher ESG ratings,
- Manage and plan for dynamics related to any outstanding convertible debt,
Get better educated about credit and debt market alternatives, like revolvers:
- Revolvers might be an attractive way to provide an “on-demand” pool of capital since you draw on the facility on an “as needed” basis,
- You do pay for undrawn funds but the cost is far less onerous than raising debt at high rates or equity at significant discounts.
The experience of LTSE’s capital markets advisory group, driven by more than $160B of transactions completed, teaches us that most companies (public and private) have balance sheets that are not as resilient as they think. We stand ready to support our customers with perspectives on the impact this may have on both public and private financing conditions, structures, and terms.
