Unimaginable levels of central bank support have created an upbeat haze that obscures a host of struggling companies, says Garraway's Head of Multi-Asset Mark Harris in an article for Trustnet.
Optimism is a potent emotion and it seems to be in abundant supply.
The speed of the rebound in several global stock markets, particularly in the US, has been nearly as remarkable as the precipitous fall into bear market territory just months ago.
This potentially premature sense of relief has been aided no end by the roughly $10 trillion of fiscal stimulus pumped into the system by central banks globally.
But should investors feel as buoyed as they do by the ultra-sized life jacket they have been thrown by the Federal Reserve, European Central Bank and others?
Or should they see it as simply delaying the inevitable fate of a not insignificant proportion of companies – that of the proverbial sinking ship?
Is the price right?
One of the trickiest things that investors are having to navigate right now is valuation.
With the prices of some stocks doubling even as earnings continue to falter, establishing a company’s worth is more difficult than ever.
The large-scale intervention by central banks may mean liquidity is flowing but it doesn’t necessarily follow that businesses are solvent. Incorrectly conflating the two means investors may not be able to see the zombie companies right in front of them because they are shrouded by a haze of optimism.
Legendary investor Stanley Druckenmiller, known for founding Duquesne Capital, was recently quoted as saying the risk-reward calculation for equities is the worst he has seen in his career.
He added that the notion that the Federal Reserve can solve all ills is simply not true.
Essentially, his point was that the Fed can keep credit flowing but it can’t force economic demand or turn bad loans into good credits.
This means that fund managers have an even harder task than normal in identifying companies that they genuinely believe can emerge from this crisis stronger and whose valuation is pricing in realistic prospects.
Some stocks have undeniably prospered throughout the coronavirus crisis, fuelled by trends that existed prior to Covid-19 but that have been accelerated by it.
The likes of cloud computing service providers, food retailers, healthcare, and technology firms have all witnessed a genuine increase in demand for their services.
Some may have borrowed growth from the future, but there’s a rising consensus that the uptick in something like cloud storage will not simply revert to pre-coronavirus levels on the other side of this pandemic.
But these companies, often large and American, have cash on their balance sheets and are still producing positive earnings.
Others, however, including some that have raised money through rights issues and equity placings, or even through debt, are pricing in plenty of hope and expectation.
This is where it becomes tricky because a fair chunk of these valuations are taking quite a lot for granted in terms of a vibrant economic recovery, potentially before the economic crisis has truly begun.
Beware the zombies
The coordinated response from central banks was undeniably required as it is helping to bridge the gap when the global economy was forced into hibernation. It has saved it from imploding.
But government furlough schemes will not last forever and at some stage soon, companies will have to resume all their liabilities again, whilst many have cashflow severely impaired. At this stage the issue of longer-term solvency will really focus investors minds.
The potential for further rises in unemployment to become long term cannot be ignored, and the high chances of workers opting to increase the amount they save versus what they spend could also hamper demand.
Although not necessarily my base case, if jobs are lost and/or wages fall, this could create a Japanese-style deflationary spiral where consumers simply delay purchases based on the presumption everything will be ‘cheaper tomorrow’.
If deflation does establish itself, the global economy could be in a position where bond yields remain near zero, yet real yields are positive because of falling prices.
This would be a dreadful combination and make it more expensive at all levels to secure financing, at a time when input costs could be rising due to the more stringent measures needed to monitor supply chains and distribution networks.
If some of the poorer outcomes prevail, which will be extremely difficult to predict with any level of accuracy, the haze of optimism could dissipate and the zombie corporations will emerge.