Market Review Q1 20: Changing of the Guard

The first quarter was one for the record books. The fastest drawdown on record was immediately followed by the steepest recovery since the Great Depression. The wild swings sent investors' heads spinning and were all the more unsettling because they came with virtually no warning.

This turbulence didn’t just come out of nowhere, however. The seeds were set in an environment excessively permissive of debt that provided a remarkably fragile foundation for market advances. Investors who appreciate this will have a much greater chance of successfully navigating the bumpy road ahead. Investors who don't will struggle to preserve what they have.

To be sure, the proximate cause of the turmoil in the first quarter was the spread of the coronavirus and the public policy measures implemented to contain it. To focus on this, however, is to miss the more important structural condition of excess leverage. Jim Grant assessed plainly in his April 3, 2020 letter: "the volume of credit came to exceed the country’s legitimate demand for credit."

For investors keeping score at home, excessive debt was also a huge problem in the 2008 financial crisis. Unfortunately, very little changed since then. Household debt declined somewhat, but corporate and sovereign debt exploded. There never was a "beautiful" deleveraging.

Kiril Sokoloff captured the landscape in an interview with Real Vision dated March 27, 2020:

"There is a huge amount of leverage in the system, because everyone was trying to squeeze out a profit or getting some return. The pressure to generate profits was massive, and you had to use leverage to do it."

Debt apologists claim that low rates make debt affordable. While this is technically true, it is also disingenuous. The reason is that affordability is context specific. If that context covers only a very narrow set of potential conditions, then it is unlikely to be representative over longer investment horizons.

Debt is affordable if payments are low relative to income but is not affordable if income falls dramatically and/or there are no reserves to cover the payments when income falls short. This is the underlying problem that the coronavirus has exposed: Almost overnight, debt levels for many companies (and individuals and countries) have transformed from being affordable to being unaffordable.