March 2020

Investment Commentary

 

Since the publication of our last newsletter three months ago, the world in which we live has fundamentally changed.  At Glen Eagle, these changes have made us pause and think about how our firm’s mission statement of Faith, Family, Firm® is relevant in this environment.  We have all been challenged to keep faith with one another and trust that good will come out of this difficult time.  It has also given us the gift of connecting, even if virtually, with family and friends who may need us now.  And lastly, as a firm we have witnessed the fastest 30% drop in the stock market in American history, the quarantining of a majority of the 360 million Americans, a historic rise in unemployment, and an economic stimulus package passed by Congress that will spend more than twice the amount of money that was spent during the Great Recession.   

Needless to say, in times like these it is often most helpful to take a step back to understand how we arrived here, and how we, as investors, should interact with the investment landscape in order to achieve our long-term financial goals.

Covid-19 (Coronavirus):  The first catalyst for the market's precipitous drop was the rising cases of Covid-19 globally.  Given the fact that the majority of us are now working from home, within this quarantine environment, it is not necessary to add significantly more commentary regarding the virus.  Instead we think it is valuable to focus on how the virus is impacting certain areas of the investment landscape:

  • Small Caps:  This recession will be defined in many ways by the enormous impact it will have on small companies.  Unlike larger companies (such as those in the S&P 500), many small companies do not have enough cash flow to come out of this crisis unscathed.  This is particularly alarming since small businesses in the United States employ over half of the workforce and are responsible for around 65% of new jobs.  Until we have more clarity on how long this crisis will last, we would avoid small caps.
  • Airline Companies: The airline industry was on the verge of collapse before the federal government agreed to a bailout plan.  To put this extreme situation in context, today every airline company combined is worth less than 1/3 the value of Disney.  Some investors believe that this offers an opportunity to buy their stock since they are “cheap.”  We disagree.  The airline industry will ultimately recover, but we believe that the virus is likely to fundamentally change travel in this country, in particular, business travel.  There may be a time to buy these stocks, but we do not believe it will be in the near term.
  • Banks: Unlike the Great Recession of 2008, the largest banks in the U.S. are not at risk of failing.  That being said, the banking business model has become significantly less profitable during the last three months.  For example, in response to the slowing economy the Federal Reserve reduced interest rates to near 0%.  This means that banks can no longer earn money on the savings accounts that individuals hold with them.  Additionally, as companies become more cash constrained, they are drawing as much money as possible on their credit lines.  These credit lines are loans that the banks had previously promised to provide the companies to help them meet their short-term cash needs. Unfortunately, companies are now pulling the maximum amount out of their credit lines, all at the same time, which is taking capital away from the banks who would otherwise use it to grow their revenue by investing the funds or providing new loans to other companies.

 

Oil Prices: The second catalyst that led to the drop in the stock market was the rapid drop in oil prices.  As countries like China and the United States struggled with rising Covid-19 cases, their economies began to slow, which reduced the global demand for oil.  In response to the falling oil prices, Saudi Arabia called an emergency meeting with other large oil producing countries (OPEC) and non-OPEC members, such as Russia.  The goal was to gain approval from the group to jointly decrease their production in an attempt to increase prices again.  Unfortunately, Russia refused the suggested decrease.  In response, Saudi Arabia reversed course and actually increased their oil production, flooding the market with supply.  The price of oil dropped by roughly 30% overnight.  Saudi Arabia's response reflects two of their goals: 1) to force Russia to come back to the negotiation table and 2) to bankrupt American shale oil producers.  In 2018, the United States overtook both Russia and Saudi Arabia as the largest crude oil producer thanks to the growth in fracking.  The Crown Prince of Saudi Arabia is now hoping to use this geopolitical conflict with Russia as an opportunity to simultaneously cripple American producers, driving many into bankruptcy.

  • Oil Companies:  Many analysts expect Saudi Arabia and Russia to come to an agreement over the coming weeks in response to pressure from President Trump.  Although this would help some companies, we believe the industry as a whole will continue to struggle.  The fundamental problem is that global demand for oil will continue to be muted until the coronavirus is completely contained and economic activity resumes.   This is reflected in the fact that prior to Saudi Arabia's unprecedented moves, some major oil companies had already been forced to use debt to meet their dividend payments.   
  • High Yield Bonds:  These are bonds issued by companies that are less stable and therefore have a higher risk of defaulting on their debt.  To compensate investors for this risk, however, the bonds pay high yields.  Since oil and energy companies currently are the largest issuers of high yield bonds, we would continue avoiding these investments as well until the oil industry stabilizes.
  • Emerging Markets:  As tourism came to a stand-still as a result of Coronavirus-fears, many emerging market countries, such as Costa Rica, began to struggle.  With the drop in oil prices this struggle expanded and was felt by other countries such as Nigeria, which still has an oil-dependent economy.  Additionally, many of these countries lack the healthcare infrastructure to effectively combat the Coronavirus.  As a result, we expect the virus to have far more detrimental and longer-lasting effect on these countries.

 

As discussed above, there are clearly many areas of the investment world that are less attractive now than they were three months ago.  However, the opposite is also true.  For example, large American companies that have large amounts of cash on their balance sheets should perform well over the next few years as the economy recovers.  This is particularly true if we look at companies that have business models that can thrive in both the quarantine environment as well as the world when we return to normality.  One only needs to think of the growth in online commerce or cloud-computing businesses to understand the likely continued growth  of such business models.  Many of these well-positioned companies, which had previously been over-priced, are now trading at a discount and can prove attractive for long-term investors.

A final note: As we reflect on the past few months, it is hard not to feel as if we, as a society, have been waging a battle on two fronts: one in healthcare and the other in the economy.  Needless to say, both are inflicting significant personal and financial costs and it is both easy and completely reasonable to look at everything that is happening around us and feel a sense of disconnectedness.  Yet, in the worst of times is often when we as a society come together.  There are stories of people volunteering on the healthcare front lines, people checking in on others in new and novel ways that do not violate social distancing standards, and people reconnecting via phone or Skype with friends and relatives they have not seen in a long time.  As we work through this health care crisis, the Glen Eagle Team is available by phone or video to connect with you.  Please stay safe and healthy.

 

Disclosure: This commentary is furnished for the use of Glen Eagle Advisors, LLC, Glen Eagle Wealth, LLC and their clients. It does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific objectives, financial situation or particular needs of any specific person. Investors reading this commentary should consult with their Glen Eagle representative regarding the appropriateness of investing in any securities or adapting any investment strategies discussed or recommended in this commentary.