March 16, 2020-Global Equities Plunge into Bear Market as the WHO Declares Coronavirus a Pandemic. Is the Bad News Priced In?
Crude Oil Plummets as a Price War Breaks Out Between Saudi Arabia and Russia.What’s Next for the Energy Market?
Aon Announces Friendly Acquisition of Rival Willis Towers Watson in $30 Billion Deal. Is the Market Panic Affecting M&A?
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Transcript:
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian Klymochko: All right. Welcome, ladies and gents, to episode 58 of The Absolute Return Podcast. I am your host Julian Klymochko.
Michael Kesslering: And I’m Mike Kesslering.
Julian Klymochko: Today is Friday the 13, March 13, 2020.
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- Wild days in the markets this week. With global equities plunge into bear market as THE WHO declared the coronavirus a pandemic. But we ask is the bad news already priced in?
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- Crude oil plummets as the price war breaks out between Saudi Arabia and Russia. What is next for the energy market?
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- Lastly, we wanted to chat about Aon friendly acquisition of rival, Willis Towers Watson and the 30 billion dollar insurance deal. Is the M&A or is the market panic affecting the M&A market?
THE WHO Declared the Coronavirus a Pandemic
Julian Klymochko: The most important thing we wanted to chat about this week is just the massive volatility in equity markets. We had just huge, huge moves up and down, mostly down this week, but Friday the 13th did have a plus 10 percent update on the Dow. Well, we had major equities and indices with S&P 500, MSCI All Country World Index and the TSX composite. They all fell into bear market territory, meaning a greater than a minus 20 percent decline, really all based off coronavirus panic, that is the story here. It keeps getting worse and worse. THE WHO declared the outbreak a pandemic. Major markets in Europe were down over 30 percent. In Canada, the TSX down over 30 percent. I believe the S&P 500 was down as much as 27 percent, really at airlines, energy and cruise companies leading the market downward, as the travel industry was the hardest hit from a virus-led global slowdown. Governments implementing and companies implementing no travel policies. What caused the really big draw down, especially on Thursday, Black Thursday? Some investors were disappointed that President Trump did not clearly articulate details of a stimulus package.
Also, concern of a lack of coordination between governments and central banks. We obviously had that Federal Reserve emergency rate cut last week. We saw the Bank of Canada come through an emergency 50 basis point cut this week. And we did see Trump coming back at a speech today implementing basically a state of emergency. The market really like that, you had 10 percent gain in the S&P 500. You saw Canadian government announcing new stimulus measures, TSX up 10 percent today.
We have some price action on specific sectors: airlines, many of them down 20 to 30 percent, Cruise lines down north of 30 percent. Talking about Black Thursday, which in Canada was the largest stock market decline in 80 years. The TSX went down over 12 percent on Black Thursday. So not since May of 1940, the month when Germany invaded France during World War 2. As Canadian stock market seeing a greater loss on a percentage basis than we did on Thursday. Black Thursday also brought a big decline in US markets, down 10 percent. And this already occurred after a 10 percent drop on Monday, bringing many equity indices globally down north of 30 percent. Also, the Canadian dollar tumbling massive moves in various asset classes. Talk about gold, you had big decline in gold with all sorts of volatility in it. Even cryptocurrency, like a bitcoin. It is allegedly supposed to be uncorrelated, but it basically got cut in half over the couple of weeks. What are your thoughts on these crazy American moves?
Michael Kesslering: Yeah. Crazy market moves, indeed, in terms of the actual moves today. You know, as you had mentioned, gaining back about 90 percent of the previous day’s historic fall, but really not bringing back on a weekly basis, you know, still down substantially. In addition, you had the Canadian banks, which really all across Canada in terms of retail, investors have a very heavy exposure to Canadian banks and their dividend growth as Canada’s well known for being huge fans of income investing. There is huge exposure to retail investors; in addition, they just make up a massive portion of the TSX.
They were down eleven point seven percent over the week on average, which is pretty crazy moves for a somewhat stable industry, as you had mentioned, the Bank of Canada with their emergency rate cut. One interesting tidbit from the press conference was Poloz mentioning that he doesn’t really like the idea of negative rates, but that really won’t be his decision as he’ll be stepping down in a couple of months. So we’ll see if his successor has the same view on negative rates. If this continues, I think there is a high probability that you approach the zero bound as well RBC came out today saying that they expect the Canadian economy to fall into a technical recession later this year, which would be two straight quarters of decline. They are expecting Q2 to be down 2.5 percent.
Julian Klymochko: In terms of GDP growth, two quarters of GDP growth.
Michael Kesslering: Yes. Yes. Yes. In terms of that, these estimates are pretty difficult to make at this point in time as the Coronavirus is something that really is somewhat difficult to model in terms the impacts to the economy. They’re just modelling the actual virus itself and how it spreads throughout society. Then there is modelling the second and third derivative impacts to society. As well, I guess just recently this is within the last couple of hours is Trump has now declared a national emergency. So with that, he announced some measures to address the shortage of testing kits, as well as waiving student loan, providing a tax holiday for student loans, earn interest holiday sorry on student loan debt, as well as purchasing large quantities of oil for the Strategic Oil Reserve in the US. The most interesting, what I find most interesting is setting up drive through virus testing in Wal-Mart and Target parking lots, which that would be a really great development. It is something that we saw in South Korea a couple of weeks ago. So that would be great to see, not only in the US, but really it would be great seeing Canada as well as we wait for fiscal stimulus measures north of the U.S. border.
Julian Klymochko: Right. Right. What investors are really wondering here is the bad news priced in? And there is one thing I want to talk about specifically, just the notion of liquidity, and the crazy thing is that I read a stat that 99 percent of the year to date drawdown in equity markets was caused by moves outside of market hours. This is occurring in the futures markets and futures market that are famously illiquid. Anyone can basically go in there and push it down, push it up.
I believe that is largely driving sentiment and what happens the rest of the trading session. There has been this massive decline in liquidity, and basically every asset class largely in the futures market, but you are seeing in equities, ETF, treasury market even, and it’s really just being blamed on extreme price moves. Whereas back in the day, you would have bank proprietary traders, bank market makers able to take positions, which would dampen volatility, but these days there are no more bank prop desks. The so-called Volcker Rule eliminated them, so you don’t really have human market makers that are able to take on large sizes. Therefore, all we have are high frequency traders that provide liquidity. However, in times of stress, in times of high volatility, they disappear. What you have is a big air pocket where you want to sell a stock. Well, there you go, market bid is down 20 percent to get your field. That is a major consideration to take into account of what is causing this absolute mayhem. Clearly, people are scared. Sentiment is awful, and it is really more of a psychological issue at this point where no one wants to step up and provide that liquidity. And we’re seeing it in the daily American moves down 10 percent yesterday, up 10 percent on the market like these moves are nearly unheard of outside of a few days in the global financial crisis, we’re talking about a VIX or volatility index of nearly 80.
Now, that is incredibly high. Typically, it is between 13 and 16, and we hit seventy 75 yesterday, a level that has only been exceeded three days in history. Those days and occurred in October and November 2008, so that gives you a sense of what is happening here. In my opinion, all this news is kind of priced in already. We had over 30 percent declines in many major markets, equity markets globally. If you think about the long term effects of Coronavirus, I think it will be a quarterly thing, not an annual thing. You think, you know, how will this affect earnings five years out? Unlikely to have any effect, and unlikely that anyone will really remember. The other thing to realize is we are now seeing the unveiling of these massive fiscal stimulus measures, which will do nothing but great things for equities. I encourage investors to not be scared, to realize this is a perhaps once in a decade buying opportunity. Once we resolve this Coronavirus issue, you have rock bottom rates, massive monetary stimulus combined with massive fiscal stimulus I mean. What is that positive for? Well, it is certainly not positive for cash and it is likely incredibly positive for equities. I think, stay long. The other thing worthwhile considerably…
Michael Kesslering: Absolutely.
Crude oil plummets as the price war breaks out between Saudi Arabia and Russia
Julian Klymochko: Is the price action and oil. I mean, we basically over last weekend had an unveiling of a price war between Saudi Arabia and Russia. Basically Saudi Arabia went after Russia and North American producers as well. They announced an aggressive oil production increase to punish Russia for not agreeing to an oil production cut to counterbalance to reduce demand from this coronavirus panic. Russia, they are really reluctant to participate in joint production cuts, believing that they are actually subsidizing the U.S. shale industry, which they’re trying not to do. Ultimately, Saudi Arabia announced a massive increase up to twelve point three million barrels per day.
So that’s 2.5 million barrels per day more than it was producing. It is even greater than their maximum sustained capacity, which goes to show you they are actually selling crude from storage to absolutely flood the market, drive prices down to rock bottom levels, really to hurt rivals such as Russia, hurt U.S. shale companies in the process as well, and really fighting for market share here. It is just a shock and awe strategy from Saudi Arabia. One of the biggest down days in oil every Monday morning. WTI dropped from forty-one to thirty. Brent the international benchmark dropped from forty five to thirty one. Just incredible moves combined with all the equity moves and coronavirus panic, it is really just a very unique time. What are your thoughts on Saudi Arabia’s moves in the oil market?
Michael Kesslering: Yeah, I remember on last Sunday, it was mid-afternoon that I came across some of this info. As I was doing some of my reading preparing for the next week. The world was already a little bit “uptight” on the Corona virus. Then you had this to compound things where, really, it just was not great timing for equity investors, especially Canadian equity investors that are quite leveraged to the energy sector. Looking at the TSX Energy Index, it was down 36.5 percent on the week. That is including…
Julian Klymochko: The year to date.
Michael Kesslering: Absolutely. It has been an absolute carnage in the energy sector this week. As you kind of mentioned, it isn’t wrong like that, Russia is somewhat subsidizing U.S. shale in effect by having these production constraints, that isn’t incorrect, but really this was kind of North American producers being hit with a ricochet shot, being caught in the middle between Saudi Arabia and Russia. As you had mentioned, this really is not something that the Saudis can sustain over a long period of time. But I guess if they were going for kind of maximum effect, I guess in that regard the right time to do it for them if they were trying to have the biggest impact that they could have. But really moving forward, I don’t believe this will be really even talked about a year from now, but the effects may still be ongoing for the next couple of months.
Julian Klymochko: Yeah, this one is a really tough one to call. It is like you have MBS, who runs Saudi Arabia, Mohammed bin Salman, and he’s been kind of a wildcard in terms of what his goals are and what he’s looking to accomplish. Clearly, this is just a kamikaze strategy on his behalf. There are basically a number of potential outcomes. Russia can realize their mistake and come back to the table with the hope of coming to a production cut agreement and getting the oil market back to balance, or this could be a multi-year price war where they both battle for market share and combine with U.S. shale producers who are certainly struggling. But it could be a multi-year scenario in which you had rock bottom oil prices, it is a real tough one. I just wanted to touch on some numbers, which really give you a sense of how massive this supply gap will be in the oil market. Analysts are predicting that global oil inventories will expand by nearly 1.4 billion barrels over the next year and a half. This is enough oil to fill 88000 Olympic swimming pools, which would stretch from New York to San Francisco if lined up in a row, so horrible, horrible news. If you are an oil and gas producer in North America, they’re just getting absolutely punished as you indicated, many their stocks down 30 to 50 percent on Monday in one day to see a large cap oil producer and see their stock cut in half is certainly quite the shocking thing to see.
U.S. DXY Index getting absolutely crushed, year to day down more than 60 percent. However, there is one beneficiary, ship owners. So why does it positive for ship owners? It is because traders can buy cheap oil today; lock in a higher price by selling it at a future date and storing that oil on a ship. What happened was the cost of chartering vessels used to transport crude. It surged as the oil price tanked with the Baltic Dirty Tanker Index up 38 percent this week. That just gives you a sense of the beneficiaries being ship owners and the positive economics to them.
M&A
Julian Klymochko: Lastly, on the podcast, we wanted to touch on one more subject that the notion of M&A within this bear market caused by coronavirus, many people ask. Are people going to cease mergers and acquisitions? Is that market going to go completely silent? Well, clearly not. With a massive deal announced this week with Aon buying rival Willis Towers Watson by nearly 30 billion dollars. This was an all share deal at a one-point 0 8-exchange ratio, represented a 16 percent premium to Willis Towers Watson’s unaffected price. And this was a deal that almost occurred last year when these two parties unveiled merger talks. Then Aon walk away the day after the media reported on it. So clearly, this is a strategic move that they have been thinking about over many years, they previously tried to get a deal together. Aon stock has outperformed since then, so perhaps that is one reason why they came back to the table.
But it’s clearly showing business as usual in the M&A space for the most part. Clearly, some parties will be stepping back specifically in terms of the cyclicality. It is important to note that private equity firms in terms of leveraged buyouts; those tend to slow down dramatically during a recession just because the availability of credit comes down dramatically. And that really causes private equity firms to step back from the market, so they are not countercyclical at all.
Commenting more on this Aon-Willis Watson deal. It is actually the largest insurance deal ever, and this is occurring in a bear market and supposed recession. This pro forma entity would be valued at 80 billion dollars. That will make it the new market leader larger than Marsh & McLennan. The current merger yield, it is trading roughly six point five percent annualized with implied 50 percent odds of success. Obviously, when you have a deal this big with major anti-competitive implications, it is going to face some antitrust risks, so that is what the market is pricing in here.
Price action on announcement. Aon shares dropped 16 percent. Willis, shares fell 8 percent, but who knows if that is related to the deal specifically. It was announced on Monday, which was a massive down day in the market. That could have something to do with it as well. What are your thoughts on this absolutely massive M&A transaction? Largest insurance deal in history to happen in the midst of a bear market, no doubt.
Michael Kesslering: Yeah, the timing certainly was interesting but as you had mentioned, like I mean, the companies had been talking likely over a year and specifically on this transaction, they would have been working with their bankers over a number of months. This is not something that especially when it is a shared deal, they are not as concerned with the short-term market timing, as you had mentioned, in your discussion of private equity leveraged buyouts in a bear market, there is no financing risk in this scenario; but will be interesting to watch.
Another thing that has happened this week in the M&A space has been the Cincinnati Bell bidding war with Macquarie, you know, even going so far as producing an overbid in a historically bad week for the markets. So that is another indication of some of these transactions being, you know, a lot more long term focused as opposed to just looking at one particular week. One other thing I did want to touch on was just M&A spreads in general. Which definitely have blown out over the last week. When really since this downturn started, if you look at February 21, when this downturn kind of began the last Friday as of the close then, the implied yield for our merger universe was about five point six percent and a 92 percent probability of closing for the deals in the merger universe that is in the U.S. As of today now, the implied yield on that universe is sixteen point nine percent with a seventy-five percent probability of close. That is actually after narrowing a bit with the peak being unsurprisingly on Thursday where it peaked out over 18 percent. Looking at the yield at 69 percent probability, of course, which when you’re looking at that right now, mergers for the what the market is telling you is that there’s a twenty five percent chance that the current deals would break, which would be really historic levels. What are your thoughts on the current merger ARB universe, Julian?
Julian Klymochko: Yeah, a number of things. Number one, ton of panic and fear in the market as indicated by the VIX at seventy five. It is just showing that people are scared and that is shown to yields not just in merger arbitrage. You are seeing it basically in every asset class, municipal bonds, leverage loans, junk bonds, a spread widening dramatically, credit spreads widening, so merger arbitrage is no different. Clearly, the other thing is liquidity, as we talked about. There is not a lot of liquidity in these markets. This is what is causing these massive price moves combined with all the panic, you have, perhaps hedge funds, de-grossing trying to wind down their books a little bit just so they don’t have so much exposure and volatility in their returns.
You saw some funds are hurting and looking to dial back risk and that is leading to widening of deal spreads. Clearly, the widest M&A spreads since I have seen since 2008, once in a decade, opportunity set as of yesterday, 18 percent average annualized in our merger universe, which is pretty exceptional opportunity set. It really goes to show you that you can be opportunistic here and allocate to some of these M&A trades and really make pretty exceptional money. If you believe that all of this will blow over and deals will still get done. You are seeing it this week at Cincinnati Bell and Macquarie, that deal got announced, the Aon and Willis Towers Watson.
As long as these are strategic deals with a long-term rationale for these companies to get together, that is really something you should be focusing on. Don’t focus on the tape, Don’t focus on the fear and panic and other investors. What they are talking about on Twitter, what you see in the newspaper, just be concerned and careful about deals that require a lot of financing or highly cyclical. You are definitely seeing increasing risks on those, but highly strategic ones that are lower risk in nature, perhaps no financing issues, etc. Those are the ones to really focus on here, and you can find tremendous returns in the market and again for many markets, I mean, stocks is significantly cheaper than they were three weeks ago. As for many other asset classes, just goes to show you that, you know, no asset class is an island. They are all somewhat interrelated when you have a big crisis such as this. Any other thoughts on this deal? Are we ready to wrap it up?
Michael Kesslering: I guess not specific to this deal, but just in general, you know, many, much of the discussion today was on the market sell off as well as the Saudi price, Saudi-Russia price war in oil. Then some of the fear that is actually spreading in to the merger spreads. Speaking from my experience, so this is probably the most that I have been watching the tape over any week in in my investing career. What it really comes down to is it is tempting to watch the tape and be emotional about each up and down tick, but what this really has shown is the importance of just having a process and sticking to that process. As you know, the world is becoming very irrational in times like these. And it becomes even more important than ever to keep a level head on your shoulders and not react too much with the market, I think is something to take away from this week, which really has been a historic week.
Julian Klymochko: Yeah, that is something to consider and advise to investors. I think one of the worst things you can do psychologically and one of the worst waste of your time is to continuously monitor and check on security prices during each day, especially if you have a long term timeframe, if you’re buying interest in businesses that you plan on owning 10, 20, 30 years.
What does it matter if it uptick or downtick 10 percent in one day? And just wasting your time watching that, all it does is really cause mistakes.
People get spooked and panic sell at exactly the wrong time and you never know when the bottom is in. I tell you, the exact wrong time is in a bear market when stocks are down 30 percent more often than not. Well, pretty much nearly every time. That is the time you should be buying aggressively. If we think back to 2008, that was really a once in a decade or perhaps generational buying opportunity. I think we are seeing something similar here. If you look at private equity investors, how many of them are freaking out? Well, none, because they are not paying attention to the price moves because there is ownership, there is securities, their investments don’t get mark to market on a microsecond by microsecond basis. Take that approach to investments, have a long-term asset allocation framework.If it makes sense to rebalance, then rebalance. Be opportunistic and try to be smart about it. Don’t panic, don’t make any rash decisions that’s going to throw you off your long term asset allocation framework. That is really a bear market game plan and how you view things really with a result of he best financial decisions that you can make.
Nonetheless, that wraps it up for today’s podcast, Episode 58. If you want to check out more episodes, you can listen to them at absolutereturnpodcast.com. I implore you to follow us on Twitter. My handle is @JulianKlymochko, K-L-Y-M-O-C-H-K-Oand Mike, what is your handle?
Michael Kesslering: My name is @M_kesslering
Julian Klymochko: I just wanted to comment on this whole Coronavirus, how it affects people from a human perspective, obviously it is a big deal if people get sick and we are trying to prevent that. One thing that we are doing implementing work from home systems at Accelerate.
Hence, apologies for the low quality of this podcast. I am recording it; just buy a laptop and Zoom. We are not in our current podcast studio, unfortunately. This one may be a bit lower quality. However, we felt it was important to update investors. Provide our insights and advice in a key time in the market such as right now. I believe investors want to hear what we have to say and we follow these things 70/80 hours a week. Many investors have full time jobs, they may not be able to pay attention to this stuff, but we are following the stuff. We are analysing it for and we are providing our views with the goal of helping investors, not just investing their money, but providing value added advice as well.
With that said, we wish you the best of luck. Certainly wild times in the market. We will see what next week’s markets bring for us. Until then, wish you the best of luck in your investing and we will chat soon, cheers.
Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.
