US policymakers, both fiscal and monetary, have been very supportive in mitigating the consequences of the economic shutdown as the world battles COVID-19. The Federal Reserve has virtual carte blanche for asset purchases. Congress’s CAREs Act, which represents 10 per cent of annual domestic GDP, targets income replacement for both individuals and small businesses. Congress has also pledged to do more if it becomes necessary.
Lawmakers’ willingness to write checks at will reminds us of “helicopter money,” a term linked to former Fed Chairman Ben Bernanke during the 2008 financial crisis, who said policymakers could litter currency from helicopters, if need be, to stimulate growth. Recently, however, Washington rhetoric has changed.
As of this week, we’re hearing a growing chorus among pundits and former Fed officials that low-quality, highly leveraged businesses should not be bailed out, arguing that these businesses made a conscious decision to load up their balance sheets with debt in an effort to boost their return on equity. Such risky behavior by business decisionmakers who understood the risks should not be rewarded.
An economic concept, moral hazard, states that firms and individuals will take inappropriate risk if they believe they would be bailed out of their mistakes. The alternative to creating a moral hazard is, simply, to let corporations fail, forcing their lenders and shareholders take the fall when they risk too much and allowing stronger firms buy up the wreckage. This policy shift appears to be gaining traction in Washington, prompting equity investors to view their portfolios like bond investors would, deciding which stocks will survive the maelstrom and which may not. Over the last month, the relative return within the US small cap sector, as represented by the Russell 2000, was dominated by companies’ balance sheet quality. Companies with strong balance sheets and adequate cash have outpaced their highly leveraged counterparts by more than 38 percentage points over the last month through April 1. The S&P 500 followed a similar trend, although the balance sheet quality differential was smaller.
This means the COVID-19 investment response places a premium on individual security selection, particularly in an environment where policymakers could be loath to reward moral hazard. We suggest investors shift out of passively managed equity strategies, particularly among small caps and emerging markets, and consider allocating to actively managed strategies comprising portfolio companies with strong balance sheets. A similar argument can be made for corporate high-yield bond strategies. While the Federal Reserve stands ready to purchase investment-grade bonds and mortgage-backed securities, they have not indicated an intention to make similar purchases of high-yield corporate bonds. As a reminder, equity investing is a long-term pursuit, requiring a multi-year time horizon. While the near-term challenges are daunting, Cresset believes an investment in a diversified portfolio of quality companies has a high probability of standing the test of time.