The D Word
You thought I was going to say “Depression”, didn’t you? While we do see that specific “D” word being thrown around with increasing abandon, our focus in this piece is another D word that is a major culprit behind recent market stress. I am referring to the natural market process of Deleveraging. My hope is that a brief review of the structural mechanics that cause deleveragings may help frame recent market dislocations as well as future investment opportunities.
You may recall the old quip “the market takes the stairs up, and the elevator down,” insinuating that bear markets tend to be quick and painful relative to the elongated growth wave of the market cycle. Bear markets are often attributed to panic-driven selling, but the truth is less psychological and more mechanical. The rapidity with which bear markets play out is a by-product of forced deleveraging amongst market participants.
Leverage, debt or gearing as our British friends call it, comes in many forms. It may seem trivial during placid market environments but our modern economy is built on a foundation of credit/debt. In fact, what people often associate as money is actually credit, which takes the form of borrowings or debt. Businesses leverage themselves through long-term liabilities and often rely on short-term funding to maintain operations. Investors leverage themselves by borrowing short-term to invest in higher returning assets to earn a spread; affectionately referred to as a carry trade. Individuals utilize leverage by effectively borrowing from their future selves to make otherwise unaffordable purchases such as homes or autos.
So, leverage is pretty much everywhere thanks to our fractional-reserve banking system. In truth, it is this availability of credit/debt and vibrant capital markets that enable prosperity, and an ever-increasing standard of living.
However, the leverage sword is said to cut both ways. In fact, leverage has the mathematical feature of always going against you; meaning that when asset values appreciate, equity appreciates relative to the debt, and thus “leverage” goes down. The opposite of this is true as well, meaning that declining asset prices can rapidly increase the leverage profile of a borrower to precarious levels. In this scenario, even previously conservative borrowers can find themselves grossly overleveraged and forced to sell assets in order to raise cash.
When the credit cycle turns, be it from natural causes or exogenous shocks (such as COVID-19), the availability of leverage is reduced and the cost of credit increases significantly. This tightening of credit markets typically coincides initially with a decrease in asset prices as the market discounts uncertainty and reduced future cash flows. The combination of declining asset prices and reduced credit availability forces many market participants to sell assets or de-lever. As you might imagine, the act of widespread selling of financial assets leads to ever lower collateral values, further decreasing the creditworthiness of borrowers. If the deleveraging shock is severe enough, this dynamic can quickly become a self-reinforcing vicious cycle whereby selling pressure depresses asset values leading to ever more selling.
This phenomenon has major macroeconomic implications as well. When foreign entities with US dollar borrowings are forced to de-lever, the world sees a massive spike in the demand for dollars needed to repay dollar denominated debts. This results in an ever stronger US dollar, and further tightening in dollar liquidity, which has its own set of self-reinforcing negative side effects. Sadly, this dollar squeeze often hurts the least robust developing economies the hardest.
Unfortunately, we have been in the clutches of a deleveraging resulting from the severe demand destruction of COVID-19. Some market segments are further along in their deleveraging process than others with the deciding factor typically being the liquidity of the underlying asset and the willingness of lenders to lend against that asset as collateral. The Fed and policymakers are doing everything in their power to soften the blow, but there will be severe pain felt by debt-laden market participants; be they corporates with over-leveraged balance sheets or investment vehicles reliant on leverage to generate adequate returns (REITs, BDCs and potentially Hedge Funds and Buyout Funds).
Market uncertainty remains exceptionally high, but the conditions that produce bargain investments are certainly materializing. There will undeniably be instances of distress in the near term, however. When the forced selling subsides and the discounted view of the future is most dour, generational investment opportunities will be present.
We have no way of knowing when this deleveraging process will be exhausted or where the market bottom may be, but we can focus on the variables within our control. Specifically, we can continue to systematically seek investments with strong fundamentals and attractive valuations. We can continue to utilize active managers where appropriate to capitalize on pockets of market inefficiencies. We can continue to lean on the benefits of diversification across asset classes with fundamentally different economic return drivers, including intentionally uncorrelated alternative investments. We can do our best to remove emotions from the equation and to methodically execute the psychologically difficult portfolio actions such as rebalancing, even when it is uncomfortable.
The structural forces of a deleveraging should remind us that in times of peak uncertainty and stress, the best response is to remain unemotional, objective and systematic when evaluating investment decisions.
The above commentary represents the opinions of the author as of 4.8.20 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.