Coronavirus: the views from our investors - update
Alex Tedder, Head and CIO of Global and US Equities:
“While Covid-19 has had a material effect on economic fundamentals – alongside the humanitarian impact – it has been a catalyst for a rapid market re-set following an unprecedented bull market too. This reflects legitimate concerns, present prior to the crisis, about the growth outlook and the sustainability of profits (particularly in the US). In 2019, the market return was mainly generated by a significant re-rating rather than by earnings growth.
“Elevated volatility is not unusual during geopolitical disruption and will undoubtedly continue. More relevant, however, are the underlying drivers of equity returns and the outlook for the likely trajectory of the recovery. For the time being, market moves reflect the fear of the unknown as well as the deterioration in the economic environment and growth expectations. Unprecedented monetary and fiscal stimulus is thus being brought to bear to support economic activity.
“If the impact of the virus can be ‘successfully’ managed, or is less profound than the more extreme scenarios, global equity markets could see a sharp recovery in the latter half of 2020. If not, we will likely see a different path of market recovery. The disruptive effects from the virus are likely to be pronounced and it will take considerable time for business and consumer confidence to recover. Some sectors will be more affected than others. Industries which are close to the consumer and/or are relatively undisrupted by supply-chain issues (for example, consumer staples) may see a relatively rapid return to normalised growth. However, industries with long capex cycles and lead times (such as aerospace) are likely to experience a significant hit to revenues and a sharply negative impact on earnings. This will be exacerbated where there is substantial operating and financial leverage, as is already visible with airlines and cruise operators.
“Overall, we think that an L-shaped recovery – a steep decline in economic activity and a slow recovery – is a realistic probability.
“Even in our most optimistic scenario, we expect sentiment to deteriorate in the coming weeks, as virus numbers continue to rise. We believe we are close to a level where we could add risk, but we first need to see data showing that the virus is starting to slow and its economic impacts can be modelled with greater confidence. In conjunction with our Data Insights team, we are monitoring such data points. In light of the very significant falls in the valuation of cyclicals most notably, we are looking at certain names in the industrial and consumer discretionary areas, from a risk-adjusted return perspective. However, prudence remains central to the decisions we take.”
Toby Hudson, Head of Asia ex Japan Equities:
“The recent acceleration in Covid-19 case numbers in Europe and North America has undermined earlier confidence in China’s apparently effective control of their outbreak. This risks plunging much of the broader global economy into a recession as governments move to ‘lock down’ their populations to limit transmission. The duration of this economic shock and the impact on corporate profitability is very hard to predict today, but as the spread of cases eventually slows, and markets gain more confidence in governments’ responses, we would expect to see a sharp rebound in equity markets.
“New cases in China have fallen and industrial capacity is almost back to pre-crisis levels. We would expect a gradual pick-up in domestic consumption as day-to-day life is slowly normalised. With China taking the pain of its lock-down first, it is slightly ahead of the curve. However, the recovery is likely to remain patchy as some segments of the domestic economy will take longer to normalise. There are risks of a secondary spike in infections if the lock-down is eased too quickly.
"The export sectors face a demand shock as Western countries lock down, hitting employment, income and investment spending if the downturn lasts for more than a few months. Given the fragility of the recovery in China, we would expect more stimulus, with increased spending in areas like infrastructure and measures to support household incomes and private consumption.
“Given the lack of visibility on the global spread of Covid-19, companies are providing little concrete guidance on their outlook for 2020. In our interaction with management teams, we have sought to understand what measures they have been taking to deal with the crisis and how well-placed they are to ride out the downturn, operationally and financially. For many companies this year’s earnings are likely to be something of a write-off. Markets will be willing to look through this crisis so long as there is scope for a more ‘normalised’ level of profitability over the medium term.
“In terms of strategy, with China possessing such a large, diverse domestic market that in many cases can be relatively insulated, this has been the first area that we have been adding to, especially our preferred consumer names at more attractive levels. Given the longer-term supportive trends for technology demand, we have become increasingly positive towards this area. Much of the optimism around 5G roll-out in 2020 has gone and, with expectations and valuations more realistic, we see scope for upside over the medium term.
“Valuations in SE Asia have been hit very hard in the recent sell-off, with headline multiples approaching past crisis lows. However, there is very heavy exposure of these equity markets to banks and energy stocks. With interest rates being cut to support growth, and credit risks increasing as GDP growth slows, bank earnings and return on equity (ROE) are likely to be under pressure structurally as well as cyclically, while the outlook for oil prices remains unpredictable given geopolitics. Share prices for the smaller number of better quality domestic consumer names have now started to correct as well, but valuations are not yet compelling.”
Johanna Kyrklund, Group CIO and Global Head of Multi-asset Investments:
“In these turbulent times I thought it would be useful to outline some of the factors we are monitoring.
Firstly, valuations. We entered this episode with very expensive valuations in the market and the good news is that some of the “froth” has been taken off. Certainly, at the stock level, we are starting to see opportunities.
“At the market level we are starting to price in negative earnings growth, which is a necessary adjustment given the significant demand shock we are seeing as a result of the virus. We think we are two-thirds of the way there in terms of the valuation adjustment.
“Secondly, we are looking at the response from governments. The cuts from the central banks are helpful in terms of allowing the markets to function well. But we really need to see a strong fiscal response to support individuals and businesses through this crisis.
“Finally, we are monitoring the infection rates of the coronavirus. If we were to see a peak in the infection rates in Italy that would be welcome news, because it would suggest that the measures taken by Italy are effective. Also, more visibility on the outbreak in the US would help us more accurately price this crisis.
“Having seen some very significant falls in the market, we expect more of a two-way action in the coming weeks. Rising and falling as markets weigh on the one hand the economic consequences of the containment measures and on the other hand governments’ responses.
“So, we’ll probably see a little bit more volatility, but we are starting to see some opportunities emerge at the stock level.”
Sue Noffke, Head of UK Equities:
“These events are certainly very concerning for all the individuals and businesses being badly affected by coronavirus. However, from the perspective of markets, they underline the importance of taking a long-term investment approach and resisting knee-jerk reactions. The coronavirus pandemic has caused the fastest decline in financial markets on record as efforts to deal with the virus hits economic activity indiscriminately, everywhere, all at the same time. Understandably, this is unnerving investors.
“I have experienced several market corrections in my investment career of over 30 years. While this is indeed one of the most challenging situations seen yet, investors can take comfort from the resulting response by global policymakers. Governments and authorities have learnt lessons from prior situations, particularly the global financial crisis, and have been quick to offer significant support for people, economies and the financial system. There will be a recession with hits to economic activity, profitability, dividend income, company failures and employment as companies struggle. However, I believe that authorities will do “whatever it takes”.
“This support may take a while to gain traction, but history shows us that financial markets typically move to discount a fall in earnings and bottom before seeing evidence of economic recovery. It is reassuring that markets have, on the whole, recovered well following abrupt market corrections in the past. In such volatile times we remain patient, disciplined, long-term investors seeking out mispriced opportunities. Our investment process has served our clients well over several past crises and we continue to prioritise financial strength, robust and sustainable business models and to take a long term view.”
Martin Skanberg, Fund Manager:
“Europe has become the epicentre of the coronavirus crisis, with Italy particularly affected. But already, we are witnessing a similar situation in Spain, France and Germany. Countries are implementing containment initiatives such as closing restaurants, schools and cancelling sports events. Across Europe, workers are being encouraged not to leave their homes if they have any virus or flu symptoms. Markets have been quick to price in the likelihood of this leading to a recession not only in Europe but other regions globally.
“In Europe, many governments have been quick to initiate credit and wage support programmes to moderate the severe decline in near-term economic input, and to help smaller, more exposed businesses cope with such a difficult environment. We are dealing not only with the health emergency, but also the collapse in crude oil leading to bankruptcies and global credit tightening (hoarding credit as well foods and staples).
"In addition, central banks globally are doing as much as possible to provide support for markets.
"The impact on end-consumer demand and businesses is impossible to judge with any degree of accuracy. This is compounded by the lack of firm understanding in the scientific community about the ultimate nature of Covid-19: how exactly does it spread, how long will it last, will it return once social isolation measures are eased, how long will it take to find an effective treatment or vaccine? Most companies will be affected to varying degrees and we have to assume our more cyclically-exposed businesses will see significant dents to their top lines in 2020. Indeed, no one in the market can have any kind of confidence about an earnings or cash flow number for this calendar year.
“While 2020 corporate earnings are up in the air at this stage, it is crucial that my analysts and I engage with our companies and think about their medium-term trajectory and potential. Constant engagement and dialogue with the senior management and board members of our businesses is a central foundation of our investment process. Meeting CEOs and CFOs time and again, measuring what they say against what they deliver and discussing in detail all aspects of their business gives us conviction.”
Nick Kirrage, Co-Head Global Value Team:
“The news flow is moving fast, and each day seems to be taking us further into the unknown. With panic taking over the market, fundamentals in many cases are being ignored. The market reaction so far has been to hit value stocks in the commodity and financial sectors. Yet, within these groups, investors who do their homework can find some of the best capitalised businesses in the world today. Coupled with their low valuations, this makes these companies among the least risky prospects for those willing to take a longer-term view of, say, five years.
"There is huge uncertainty about what companies’ earnings for 2020 will look like. That’s why it is vital to look through a whole business and economic cycle, peak to trough, and consider taking advantage of market short-termism when shares are offered to us cheaply.”
Quantitative Equity Products (QEP)
Justin Abercrombie, Head of Quantitative Equity Products:
“The rapid response from governments in terms of fiscal stimulus and co-ordinated monetary easing by global central banks has so far failed to support sentiment in equity markets. There has also been little evidence of a rotation away from the prior market ‘darlings’, despite them being an obvious source of liquidity.
“As we would expect, the quality exposure that runs through our portfolios has been a considerable support. Stocks with superior financial strength (particularly robust balance sheets), greater stability in their earnings and robust governance standards have clearly outperformed. We increased our focus on financial strength during 2019, most notably by avoiding selected stocks with weaker fundamentals, and focusing on high quality and reasonably-priced areas such as pharmaceuticals in Europe and the US. We have also been very selective within resources and financials, balancing cheap valuations with less robust quality characteristics.
“We have remained focused on identifying opportunities in stocks which we regard as “quality on sale”, particularly in areas such as technology and consumer staples.
“Looking ahead, we expect heightened levels of market volatility to persist. This has put to an end the “buy-on-the-dips” mentality which previously dominated. Our process works well in zigzag markets as it provides us with the opportunity to take advantage when we believe that prices have overreacted. We are looking for capitulation in the US market, driven predominantly by a correction in the large cap multi-year outperformers. While there are a number of attractive companies in the US, the opportunities in the rest of world remain more compelling in terms of offering a better balance of both value and quality.”
Philippe Lespinard, Co-Head of Fixed Income:
“Government bonds have been sold at the same time as riskier assets, partly because central bank reserves are held predominantly in government bonds. With many preparing large liquidity support lines, they have had to liquidate bond holdings to realise the cash. Meanwhile, consumption is falling fast, adding a demand shock due to the shutdown of Chinese factories. If we think about retailers, most only keep three months’ worth of operating cash flow on hand.
“There is a large amount of fiscal spending in the pipeline and more direct, micro level measures to support companies, such as government loan guarantees, which allow companies to run big overdrafts. Ultimately some of these overdrafts may have to be forgiven. These losses will go on to government balance sheets resulting in a large increase in national debt in many countries. The increase in government yields is also a reflection of this.
“Cutting rates now achieves little other than providing liquidity to banks, which they already have plenty of. Banks are in good shape: well capitalised, good asset quality, less leverage and large liquidity coverage. We think a risk of a solvency issue in the financials’ sector appears unlikely. Companies have started to call in credit lines, Boeing for instance has just drawn on $14 billion from its banks. This raises the prospect of a big drain on bank liquidity, but that’s why central banks will provide support. It’s more likely we see an issue with asset quality. There are $1.4 trillion of leveraged loans globally, mostly to private equity-sponsored companies. Some of these are highly levered, so any slowdown or stoppage in those businesses is damaging to credit quality.
“We think disruption will last three-to-six months, after which we could start to see recovery. If that happens, you could argue the market does indeed appear broadly cheap now. But it is important to be selective and cautious. Especially if the recession lasts longer, then it will not matter how cheap some companies’ bonds are now, because they will ultimately be zero. For others recovery rates will be very low.
“As we get more clarity on the extent of government support, we will be able to gain a better idea of where the greatest risks lie and where the best opportunities are. Default rates are going much higher and there will be downgrades from investment grade to high yield. Some companies will take the right actions to strengthen balance sheets, others will need to restructure. On a two-year view there are certainly opportunities, but it is difficult to say here and now that there is unequivocal value.”
Michelle Russell-Dowe, Head of Securitised Credit:
“Markets recently went from “sell what you can, not what you should” to just “sell”. We have seen even the most liquid markets, such as agency MBS freeze up. The Fed has now agreed to unlimited QE, or “QE infinity” as it applies to buying US treasuries, agency MBS and agency CMBS. All of this necessary to attempt to stem the rapid declines in markets that were stronger, fundamentally, going into this volatility, such as mortgages and the wealthier consumer. Mortgage REITs, in particular, with leverage and margin calls have created liquidation risks in the agency MBS and the non-agency MBS markets. Some of the mortgage REITs have been forced sellers, creating some eye popping price declines across sub-sectors of mortgage land. European MBS and ABS markets are thin and offer little transparency. CLOs and CMBS are being priced much more conservatively given the dire statistics on the virus and the economy.
What is the market thinking?
"People will no longer shop at malls, go to movies, vacation in hotels or work in offices. Borrowers will not pay their mortgages or their rent. Many businesses will fail. The commercial real estate market will crash. Each one of these has been in the headlines and is obviously at the most severe end of interpretation, and indicative of the concern markets are beginning to price.
"However, in this market we have seen opportunities where it remains possible to have conviction, in high quality, strong structural protection and government support, like AAA rated prime credit card ABS issued by tier 1 banks, or in AAA rated prime auto ABS, at near 300 bps of spread over swaps, With support from the Term Asset-Backed Securities Loan Facility (TALF) in new issues, this seems a simple and safe play while uncertainty reigns. ABS, MBS, CMBS and CLO markets are diverse many ways: in borrowers, in assets and in sector exposure. As more economic information is gathered, these markets, many of which have been characterised by lower leverage and better underwriting, will offer clear, attractive opportunities.
"The US ABS, MBS, and CMBS markets are diverse, large and fairly visible. This time around we are in a different part of the housing cycle than in 2008-2009, and with pricing & liquidity feeling just as bad, it does pave the wave for opportunity when additional clarity allows for real study. Until that time, there are still ABS that trade on spread and not price, that remain a safer haven.
"Leverage has always seemed to be the problem when exogenous events or economic weakness occurs and so being in lower leverage areas seems more important than ever. Choosing good and bad will be difficult until the economic impact on these leveraged borrowers is better understood - so while prices look attractive, the recoveries on defaults are important to understand. While the dislocations across fixed income are different and profound, they should allows us to differentiate and create opportunities."
Emerging market debt (absolute return)
Abdallah Guezour, Head of Emerging Market Debt, Absolute Return and Commodities:
“The global economy appears to be experiencing a sudden halt. The current unexpected dislocations, triggered by the rapid spread of the coronavirus, started at a time when both developed and emerging market (EM) credit markets were broadly overvalued and over-owned, most government bond yields at record lows, monetary policies already ultra-easy and the US business cycle becoming overextended.
"In this context, the re-pricing in global financial assets experienced this month has been disorderly but the multiplication of aggressive policy actions are now starting to provide some support to asset prices. The recent sudden deterioration of liquidity in usually liquid rates and currency markets, and the disappointing performance during the March panic of “traditional hedges” such as long-dated US Treasuries, is making the current crisis for policymakers and investors more difficult to manage than the global financial crisis.
"Now that emerging market bonds and currencies have experienced a substantial re-pricing, and with high cash balances (and cash proxies), the focus is now to identify the potential catalysts for us to start to reinvest. We have established a number of preconditions that we would like to see met to provide us with some degree of confidence in the outlook for EM debt and currency markets.
These key preconditions are:
- evidence of volatility subsiding with normal market functioning resuming;
- valuations reaching more attractive levels across the board in EM debt - this is already the case for selected EM bonds and currencies that are experiencing a ‘bear market overshoot’;
- signs of abating outflows from EM debt mutual funds and ETFs - we believe that there are still significant positions in the process of being liquidated;
- more policy focus in EM and, globally, around exchange rates stability - in this regard, the announcement last week by the US Federal Reserve of an increase in its foreign exchange swap lines with other central banks was encouraging.
Asian fixed income
Roy Diao, Head of Asian Fixed Income:
“Global markets are tracking with volatility levels not seen since 2008. The escalation of Covid-19 into a pandemic and Saudi-Russia oil price war happening at the same time, mean the global economies are getting hit on both sides which dampens demand at the worst time ever.
"There has been substantial re-pricing in securities and liquidity has become one the biggest concerns. Although Asian credit is resilient compared to the US and the other EM due to its lower exposure to commodities, it is not immune to the recent rounds of sales as investors might, at times, trade more on sentiment rather than fundamentals during market dislocations like this. The credit spread of the JPMorgan Asian Credit Index has widened by over 170 basis points since mid-February, and the credit spread of its High Yield sub index has widened by over 430 basis points.
“Despite the market volatility, we do not expect the systemic risks in the banking system that we saw in the 2008 global financial crisis. The financial sector today is on a much stronger footing than before with more robust balance sheet and capital ratios. While default rates in Asia would undoubtedly increase considering the difficult business environments, and given the funding gaps of those corporates with weaker liquidity positions, we do not expect a widespread default in a scale anywhere close to what we saw in 2008. That said, as there is still high uncertainty on the duration and severity of Covid-19 and how long the oil price war will persist, investors should be prepared for a period of weakness and volatility in the medium term.
“We expect the Asian central banks to maintain an accommodative stance and step up their efforts on fiscal policy front to support economies. On Asian local rates, we overweight high quality duration from countries such as Singapore and Korea given investors’ demand for safety assets and expectation of monetary easing. With the expectation that the US dollar is likely to stay strong for some time given risk-averse sentiment and US dollar scarcity, we believe that Asian currencies, such as the Singapore dollar, the Malaysian ringgit, the Thai baht and the New Taiwan dollar, will continue to face depreciation pressure.
“As for Asian credit, we have been reducing overall credit market exposure (i.e. “beta) and upgrading credit quality to ensure that our investments can ride through the market turmoil. It is also paramount to have sufficient liquidity. That said, as the market sometimes gets ahead of itself during dislocations, it is of equal importance to remain nimble and be ready to shift gears, capturing the opportunities with attractive valuations when they arise. Therefore, we favour corporate credits with an attractive risk/reward profile that are both fundamentally cheap and have the ability to navigate the credit cycle. We would also continue to focus on bottom-up selection in order to avoid those names with ‘fallen angel’ risk or potentially downgrade pressure to a CCC credit rating.
US multi-sector fixed income
Andy Chorlton, Head of US Multi-Sector Fixed Income:
“Over the last couple of weeks, financial markets and society in general have had to contend with a daily re-calibration of expectations as authorities face up to the severity of Covid-19 and the policy response to the new reality we face. The fundamental outlook for the coming months is clearly going be difficult. However, as the UK showed at the end of last week, there is now a determination to do as much as possible to address the challenge with monetary, fiscal and containment measures all implemented in ways we have not seen before.
“Liquidity is as bad as any of us have seen, with the economic shock further exacerbated by the fact that many traders are now working from home. To be asked to make prices in a very difficult market while isolated from their teams is a challenge they have not faced before. For us, the clue to the fact that we are dealing with a liquidity squeeze – not just an economic crisis – is the poor price action in what we think of as more rates products than credit products. For example, municipals or agency mortgages - both of which had a very difficult week.
“The US Multi-Sector team continues to be positioned fairly defensively with only a small increase in credit risk over the last week. We have taken advantage of some significant discounts in a surprisingly well-functioning new issue market in the US. Looking forward to the next week or two, our aim is to balance two conflicting objectives. We want to maintain a solid allocation to liquid assets, i.e. government securities whilst also slowly adding risk in the more defensive sectors as valuations cheapen. We feel there will be ample opportunity as this develops to move into the more fundamentally affected sectors, and go down the credit curve so for now are focusing on more defensive issuers and sectors for our incremental risk.”
Nils Rode, Chief Investment Officer, Schroder Adveq:
“For existing private equity investments, the impact varies mainly by region and industry, the specific business model of a company and its financing situation. While several private equity portfolio companies are likely be affected negatively, at least temporarily - and some could be affected more severely - many investments are well positioned to go through this situation without any permanent impairment. A few companies might even be able to benefit from the situation (for example, companies working on potential treatments).
“For new private equity investments, the outlook additionally depends on the type of investment:
- For primary investments, the economic impact of the novel coronavirus can lead to more favourable entry valuations over time. Furthermore, primary fund investments benefit from time diversification during the typical investment period of 2-4 years.
- For secondary investments, economic and financial market turbulences can create buying opportunities. So, in case of extended turbulences, the current coronavirus situation could result in such buying opportunities.
- As new direct/co-investments could potentially experience some type of short-term impact, we expect investors and fund managers to slow down their investment pace for direct/co-investments. Direct/co-investments can potentially benefit from more favourable entry valuations, but high selectivity will be paramount.
“Private equity is generally well positioned for surprising shocks such as the one created by the coronavirus. Private equity funds are well capitalised with locked-in capital that can either be deployed for new investments when opportunities arise, or that can be used to support existing portfolio companies if and when necessary.
“Additionally, the long investment time horizon of private equity funds provides the industry with a high level of flexibility with regard to exit timing, which means that private equity managers and their investors can keep a calm mind even in turbulent times.”
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