COVID-19 investor wrap: likely outcomes and market insights
Pendal portfolio specialist Chris Adams presents a wrap of COVID-19 market observations, likely scenarios and portfolio positioning insights from the Pendal team
WE ARE now seeing the market price in economic disruption caused by government efforts to contain the coronavirus spread and “flatten the curve”.
We’ve seen from China, South Korea and Singapore that economic lockdowns can be successful in limiting the increase in infection rates.
Such actions reduce mortality rates by ensuring healthcare systems are not overwhelmed — and appear to have brought the virus spread under control in those countries.
But the question for investors is: how much structural damage is done to the economy as a result of measures to halt the virus’s spread.
There are two parts to this question:
1. How long will the economic disruption last?
2. How successfully can monetary and fiscal measures compensate?
Uncertainty about these questions is reflected in the extreme volatility of equity markets of the last two weeks.
There is stress emerging in credit markets. Constant dialogue with our Bonds, Income and Defensive Strategies team, led by Vimal Gor, has helped us maintain a relevant and granular view of this issue.
Spiking credit spreads reflect the fear that this period of economic disruption will result in widespread business closures.
However unlike the GFC or previous crises, this episode is not the “fault” of irresponsible behaviour in a particular industry.
The stress is caused by understandable government actions to prioritise the health outcome over the economic outcome.
This notion is reinforced by the view that the health system has not been adequately prepared to deal with a pandemic. This means governments should be more inclined to back-stop industries under stress.
This contrasts with previous crises where governments were less willing to intervene in troubled industries, citing the “moral hazard” of irresponsible activity.
As a result we are likely to see governments go to unusual lengths to put a firewall between the economic disruption they are causing now and the potential structural consequences that could result.
Industry-based interest free loans, tax holidays, debt guarantees — and central bank purchases of commercial paper and even equities — are all on the table.
The goal is to reduce the risk of widespread business closure and unemployment.
That said, the possible impact on businesses and the broader economy should not be understated.
Businesses are likely to shut down and some will go bankrupt. There are likely to be redundancies and workers on unpaid leave which will have knock-on effects on consumer demand.
While industries such as travel, energy, some retail and hospitality are feeling the first-order effects, few industries will resist some level of impact from policy measures.
That might be impact on financial companies via lower interest rates, impact on the infrastructure names via reduced traffic rates or potentially lower subscriber growth for some of the WAAAX names.
Some companies and industries will be less sensitive to social distancing measures, or may even see some benefit. Telecommunications, for example, or supermarkets while hoarding goes on. However these are relatively few.
The key factor is the market’s confidence that government measures will prove sufficient to underpin vulnerable sectors and see them through the worst of the economic disruption.
Pendal is fortunate to have a team with deep experience that has weathered several episodes of this nature.
Each crisis has its own characteristics but the challenge is the same: protect capital as much as we can and position ourselves to take advantage of the opportunities.
It is important to acknowledge that we do not know the outcome.
We are experts in analysing companies — not in virology. We have no special insight here that gives us an edge in determining the likely outcome for the spread of COVID-19 and social distancing measures to combat it.
What we do is provide a framework in how to think about probabilities, position the portfolio to perform in the most likely outcome, and make sure we are hedged against the less likely — but still possible — scenarios.
The outlook here will be determined by the virus spread and the success of measures to combat it.
We group the potential outcomes as follows:
1) Worst case: A widespread global pandemic, provoking a sustained global recession, zero rates, unconventional policy responses and further material falls (>20%) in the equity market. We think this is a lower probability outcome, particularly given the moves made in recent days to contain the virus.
2) Rolling outbreaks globally: Short-term economic downturns of 2-4% followed by quick recovery. Policy responses include zero rates and targeted fiscal stimulus. This scenario could see further markets falls — potentially of up to 10% or so — with a bounce-back by year’s end.
3) Milder outbreak: Containment measures and the northern hemisphere Spring curtail the spread. This could see a short-term slowdown, with rate cuts and limited fiscal stimulus. The market may already have seen its lows if this is the case, with a good chance of a 10-20% bounce.
4) A quick resolution: A medical breakthrough could see economic acceleration, a reversal in rate cuts, bonds falling sharply and a 20% or more rally in equities. Like the negative extreme, we see this as a low probability outcome.
Portfolio framework is important
Experience has taught us it’s important to focus on what you can control.
We cannot control the outcome of this health issue. We cannot control the market’s reaction. But we can control the framework we think best positions the portfolio.
And we can control our view on which are the best companies to hold within each of the framework categories.
The portfolio’s framework in this environment is designed to weather the more likely outcomes — scenarios two and three — and to take advantage of the buying opportunities that emerge.
We also need to be mindful of protecting the portfolio in the case of one of the more extreme scenarios playing out.
In this context, here’s how we consider the portfolio’s structure:
1) Recession insurance: We want stocks with the potential to hold up well if economic conditions deteriorate. We have some gold exposure — and also hold positions in bond-sensitives that should do well if sentiment worsens.
In terms of the traditional defensives it is important to be selective. We want to hold A-REITs backed by good assets with low gearing, avoiding those with a high exposure to consumer discretionaries.
In infrastructure, it is important to recognise that traditional correlations to bond yields may be swamped by fundamental factors — for example, Sydney Airport is likely to see a hit from travel restrictions, while we also need to be mindful of a material fall in commuter traffic for the toll roads.
2) Quality defensives: Companies that combine strong balance sheets, good management and low sensitivity to the near-term economic dislocation, with relatively limited impacts on revenue.
3) Beneficiaries of fiscal stimulus: While central banks have already moved to cut rates, governments are also increasingly expected to inject stimulus to help companies and the economy bridge the expected slowdown.
The iron ore price has held up reasonably well, helped by weather-related supply disruption in Australia and Brazil and a gradual increase in confidence that China has brought the situation under control.
We think the iron ore miners would benefit from stimulus in China, while we also see housing as a natural area for governments to inject stimulus, with James Hardie a likely beneficiary.
4) Franchise winners: These are good businesses that may see a near-term hit but are well positioned in terms of balance sheets and competitive position to withstand a slow-down. They look attractively valued on a two-to-three-year view.
5) Resolution insurance: There are several stocks we expect to surge quickly on any sign of slowing infection rates or a medical breakthrough. Qantas is our key position here.
6) Areas to remain cautious: If this was just a short-term hit to demand then the sharp drop in the oil price might make energy look more interesting. But the break between Russia and OPEC on production cuts over the weekend has complicated the issue.
If we are entering a grab for share — with some signs that Russia is looking to put pressure on the US shale industry — then the risks here are elevated relative to other commodities.
We also remain cautious on the banks. Dividend yields remain attractive, but additional rate cuts just bring further margin pressure to bear.
A stimulus package could also include some measures to allow struggling businesses to defer interest payments — although there is speculation such a measure may include the quid pro quo of cheap funding for the banks.
How we’re positioning
Within this context, as we stand today, we have a skew to the defensives and recession insurance and beneficiaries of stimulus.
We are being opportunistic around the franchise winners. We are broadly neutral in terms of those companies that we consider resolution insurance.
Given uncertainty about the duration of economic disruption, we need to understand how the first, second and third-order effects of an extended disruption would impact companies.
The size of our team means we are doing this for every stock under our coverage, which includes every stock in the ASX 100, plus a material portion of the Small Ords.
The goal is to identify vulnerabilities that the markets not thinking of now, but which may emerge if the situation deteriorates.
We are modelling companies on the basis of what we think would happen to revenues and earnings if the disruption lasted three months, six months, nine months or longer.
What does that mean for revenues, for working capital, for balance sheets and debt covenants? This has been the key focus this week.
It provides concrete insight which then feeds into our framework — helping select the very best stocks to fit each bucket and help the portfolio perform in an uncertain environment.
Markets are now starting to price in the risk of a material downturn in earnings and recession.
It is worth mentioning that equity market volatility has probably been exacerbated by people hedging credit market exposures. Credit ETFs have created an expectation of liquidity that has not been the case now we are in a period of stress.
We are seeing signs that equities are being used to hedge illiquid credit positions in some instances, contributing to volatility.
The influence of ETFs and passive investing is clearly apparent in the indiscriminate nature of the market sell-off.
This has been exacerbated by the effect of risk parity strategies and other systematic approaches needing to de-risk.
The market’s sell-off is rational, but indiscriminate selling has led to outcomes which are irrational — such as the poor performance of traditional hedges such as gold.
We are mindful of heightened near-term uncertainties and second-order effects.
But when stocks with limited or even positive sensitivity to near-term economic environment are sold off to the degree we have seen, there is no doubt there is mis-pricing and opportunities for active managers.
At this point the market has been hit by a valuation de-rating.
Several companies have withdrawn earnings guidance, though we are yet to see widespread earnings downgrades.
These will come. But it’s only once companies and investors start to understand the duration of economic disruption and the softening effect of policy that we will start to gain a sense of the full market effect.
Key factors to watch
Key factors to watch here include the rate at which infections spread and when they peak, as well as the scale and focus of fiscal and monetary policy measures.
We’re likely to face further volatility until we have a handle on how long the economic dislocation will extend — and until we gain confidence that government actions will underpin the economy during this period.
At that point, we expect investors will start to recognise the undoubted value that is emerging in parts of the markets on a three-to-five-year view.
In this environment active portfolio construction and risk management is crucial.
The ability to weigh risks, recognise the opportunities as mis-pricing surges, and provide a clear and disciplined framework to account for an uncertain range of possible outcomes has paid dividends thus far.
We believe will continue to do so as the current crisis unfolds and the path to recovery becomes clear.
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