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Market update: From bad to worse

Updated: Apr 2, 2020

The oil market has tanked 21% in one day

The situation might quickly deteriorate if it is not resolved soon

We explain the current market dynamics and risks

On March 2 we wrote a letter to give you an update on market movements and how we are positioned to best deal with it. The situation is fast moving. New cases are emerging on a daily basis and, most worrying, is the fact that tens of countries have hundreds of new virus cases. Below we report the case increases from a week ago. The left table is from a week ago, the right table is from today.

2nd of March 2020 9th of March 2020

China, where it all started did not move much. However, South Korea has more than doubled its cases. Italy experienced a 7X increases in a week. And most worryingly, now plenty of countries have widespread infections. For example USA 8X increase, France 11X, Germany and Spain 13X, and so on. Some countries were not even in the left column and now have plenty (e.g. Switzerland, UK). This makes it very hard to control at this stage. Countries such as China and Italy initiated quarantines areas on millions of people, and this is clearly a negative on the economy, nationally as well as globally. However, as we have mentioned in our previous letter:

These situations by themselves, are not terribly dangerous. However, markets are driven by emotions.

At this point, emotions run wild. The VIX, also called fear index, suddenly skyrocketed. We are not in panic mode like during the financial crisis, but current levels were last seen in 2011/2012 during the European debt crisis.

VIX Index from 1990 to 2020

Hence, we still believe that the virus by itself will not cause extreme damage. What is more worrying is what’s happening around it:

- Population panic

- Supply chain issues

These two issues should have a short term effect, until they don’t. People in certain countries are starting to worry and, in cases such as Italy, quarantining large chunks of the population (in Italy we are talking about 17 millions, or 1/3 of the population), will obviously have a detrimental effect on economic consumption and supply chains. China is starting to recover, but the situation is broadening around the world with hard to predict circumstances. A short term impact may soon turn into a long term crisis with bankruptcies and unemployment which can also be self-fulfilling.

The virus should be contained within a few months (although no one knows). Yet, what’s happening next is starting to be seriously worrisome:

1) Credit deterioration

2) Oil market

3) Central bank interventions

In our previous letter we wrote:

Another sector that is being impacted is Oil and Gas. Oil prices are already down and a lot of companies are overleveraged. Hence, a long period of subdued demand might be dangerous. For example, two days ago Barrons reported that the iShares iBoxx $ High Yield Bond ETF (HYG) had its biggest single day of withdrawals on record on Wednesday, losing $1.6 billion.

The situation we discussed above is materializing at an unprecedented speed. Below we discuss the situation in each of those segments of the market:

Credit deterioration

Years of loose monetary policies and low interest rates have allowed companies, even those with poor credit prospects, to raise unlimited funding. Low or negative interest rates in “safe” bonds pushed many investors, including pension funds and pensioners, to increase their risk profile to obtain any yield. Clearly, these situations created market imbalances that are being corrected like there is no tomorrow. Unfortunately, when everyone rushes to the door, the situation doesn’t end up positively.

The pictures below shows the investment grade spread widening. First, the yield on the 10 year US Treasuries are diving, to reach the lowest level in US history.

At the same time, the spread between treasuries and investment grade bonds (riskier bonds) is widening rapidly. This means that markets are buying safe bonds and selling riskier bonds, a so called “flight to safety”. This also means that companies bloated with debt will have more difficulties to refinance and, if they do so, they will have to pay higher interest rates. All this makes risks of bankruptcy more severe. This reinforces what we discussed last week:

We are only looking at companies with low leverage.

Another market with risks is the government bonds market. The European central bank has basically bought all bonds available. However, the Italian situation doesn't look good.

Italy was a weak country and with its very high leverage and uncertain political situation is at risk. Its banks might struggle to cope with a prolonged market downturn.

Oil market

All of a sudden, we have the second piece of the puzzle. Over the last week OPEC+ (OPEC plus Russia) did not manage to agree on production cuts. This means that oil produced will be more abundant than the oil needed by a slowing economy. A production cut would have balanced demand and offer, sustaining oil prices. Since they did not agree, overnight, Saudi Arabia decided to flood the market with oil in a retaliation against Russia. This created panic in the oil market with oil prices plummeting 21%. Last week we said that "we will avoid Oil and Gas" so we are not exposed to this industry.

From the beginning of the year oil price declined from $73 to $32 per barrel, a whopping 56% in less than 3 months. The graph above shows the long term trend of oil prices, inflation adjusted. Current prices are not far from historical lows.

The energy market was in trouble before this, now it is in serious trouble.

As we mentioned in our previous letter, oil and gas was already a troubled industry before this price decline. Here you can see that already in 2018, when the average oil price was $65, the industry struggled to pay its debts. It had an interest coverage ratio of 0.99, meaning that its earnings barely covered the interests on its debts. Its current ratio was 1.10 meaning that it only had $1.10 in short term assets to pay $1 in short liabilities, not exactly a margin of safety. In 2019, the Dallas Fed reported breakeven prices that oil companies need to profitably drill new wells.

The average cost is around $50, quite significantly above the current oil price of $32. Hence, not only oil companies were struggling to pay higher debts when oil price was much higher, they need a much higher price than today to drill new wells profitably.

As the WSJ reports, North American oil and gas companies face a wall of debt refinancing over the next 4 years for a total of $86 billions. Bankruptcies already started in 2019. The WSJ writes: some companies are struggling to meet their obligations as oil prices hover below $60 a barrel. Now we are at half that level. Hence, we are looking at an industry flushed with debt, that struggles to pay its interest payments, that are likely to increase in the future. In sum, more problems in the oil and gas industry will emerge.

Central bank interventions

Central banks are worried. The US central bank, in an emergency meeting, lowered its rates by 0.5%. I expect a similar move this week or at the next meeting (March 17-18th). The EU central bank might lower rates from its -0.5%.

We will soon have even lower rates all around the world. If the situation worsens, central banks will run out of options very quickly.

The next move can only be quantitative easing, meaning buying up assets to inject cash in the system. This can be coupled with government deficits. However, as I reported last week, we are already stretched on both fronts (the U.S. is running a deficit of $1.1 trillion or 4.8% of GDP). This means that we don’t know where this will lead.

The major worry is, again, inflation.


We expect today’s markets to go down by 5% (or more). The short-term situation doesn’t look rosy, especially if the virus and the oil markets continue to disrupt the world for more than a few weeks. Our portfolio has not changed compared to last week, we are slowly adding to some positions (e.g. Danone, Skechers) and we are ready to take advantage of what unfolds, still keeping our hedges (PUT options and gold) in place. We are looking for companies with:

(a) long term sustainable businesses;

(b) low leverage;

(c) good management;

(d) with positive free cash flow;

(e) at fair prices.

We are cautious but ready to take advantage of any market panic. Stay tuned.

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