COVID-19 hit equity markets around the world swiftly and sharply. Equities, as is often the case in crises, have been characterised by exceptionally high levels of volatility, as increased weightings in illiquid assets have forced many investors to liquidate where they can rather than where is most logical. Recent years have been characterised by complacency on inflation and increased financial leverage by companies seeking to boost their earnings and distributions. Massive fiscal stimulation may challenge inflation complacency in the future, whilst financial dislocation is seeing share price moves correlate highly with balance sheet strength.
While the natural instinct is to look to our most recent example of equity market disruption – the Global Financial Crisis (GFC) – we analyse why the response to COVID-19 is likely required to be different.
How is this different to the GFC?
Here are four of the most significant ways in which the COVID-19 impact differs from the GFC:
- Economic threat. Unlike the GFC, where economic impact was triggered by financial events and cured through monetary and liquidity responses, COVID-19 and the response to it are material impacts to the widespread economy. Large scale unemployment and significant financial stress for businesses seem likely, at least for the duration of the lockdown period. The financial system and investment markets are responding to these threats.
- Reliant on government response. The response to COVID-19 will largely be in the hands of the government and will require significant fiscal measures. Given the central bank response since the GFC has been consistent monetary easing and asset purchases to buoy asset prices, there is little ability to address this shock through debt servicing costs.
- Wide-spread impact. The short-term financial impact will be significant for the majority of businesses, across almost all sectors of the economy – both in Australia and globally.
Uncertain duration. While optimistic projections envisage a bounce back in a period of months, more pessimistic projections expect COVID-19’s impact to last more than a year as future waves of infection hit populations.
Figure 1 highlights the severity of the indicative impact on Chinese manufacturing (measured by the Purchasing Manager’s Index) with obvious similarities to the quantum experienced in the GFC. Indications suggest China has coped extremely well in containing the impact, and supply chains appear to be recovering relatively quickly. In Australia, where manufacturing is less important, travel, tourism, entertainment and discretionary spending of all types are all likely to see a severe and sustained impact to revenue and earnings. The increased exposure of western economies to consumption and services looks to be a disadvantage versus manufacturing exposure.
Figure 1: Global Purchasing Manager’s Index
Government response and financial system stability
Banks are under pressure to provide leniency to customers on mortgage and business interest costs. However, this leniency is complicated by asset markets – particularly real estate, which has been significantly supported through interest rates and supportive policy. We are wary of the potential for reduced debt servicing capability for consumers and households coinciding with already artificially supported house prices. Signs of pressure on real estate prices could quickly impact banks’ appetites for leniency to consumers, considering explicit government support has historically come at a significant cost to shareholders.
On the issue of government support more broadly, the Australian government has significant scope to increase borrowing levels to assist affected businesses. However, revenue losses for some large companies – such as Qantas – are likely to be substantial. Even over a short timeframe, the impact will be extremely difficult to manage and we believe the government’s financial response will need to be vastly more significant than originally anticipated.
While the initial equity market response to COVID-19 has seen volatility in almost all sectors, we are already seeing how some businesses are more affected than others. As the crisis continues to unfold, we can see opportunities for active investment management to make a difference in how investors’ portfolios can recover – and potentially even benefit – from changing valuations and stock price movements. Here’s a summary of how the various sectors have responded as at 25 March 2020.
The majority of resources businesses have exceptionally strong balance sheets and proven capability in dealing with fluctuating price cycles and volatile revenue streams. To date, the effect on iron ore pricing has been mild. While prices for some commodities, such as alumina, aluminium and copper are more depressed, nearly all are still in relatively strong financial positions. We believe most resource stocks are now attractively priced and offer strong long-term return prospects.
Figure 2: Key price moves – Resources sector
While many energy stocks have experienced sharp declines, this has more to do with the collapse of co-operation between Middle Eastern and Russian producers and resulting decimation of oil prices than COVID-19. However, as the supply of oil rises and demand falls (due to the slowdown of airlines and logistics companies) this could create a disastrous operating environment for energy businesses. Debt levels are also an issue for some producers. It seems likely that energy businesses will have a tough road ahead until conditions stabilise – which could potentially be a couple of years.
Figure 3: Key price moves – Energy sector
Banks are highly-geared entities that are exposed to the broader economy. The immediate impact from COVID-19 is the lower spread from investing in short-term securities and an inability to reduce deposit rates further given already low levels. Reductions in borrowing costs will significantly pressure margins. A longer-term issue is the likely rise of bad debts and its impact on bank capital. The good news is that all Australian banks have materially boosted their capital levels since the GFC and are among the best capitalised banks in the world. Furthermore, if there is a prolonged market disruption, the government is likely to step in to provide support. Bank stocks (with the exception of CBA) are currently very cheap. However, for now we remain cautious on the sector due to its sensitivity to bad debts, high correlation to economic risks and high absolute weight in the equity market.
Figure 4: Key price moves – Bank sector
Unsurprisingly, airline, tourism, casino and gaming stocks have been amongst the hardest hit by COVID-19. Given capacity reductions, high fixed costs and minimal short-term revenue, solvency issues will be significant for these industries. At the other end of the spectrum, supermarkets are experiencing an increase in earnings – however we feel this is transitory and should not materially impact valuation.
Figure 5: Key price moves – Industrials/Consumer sector
Most healthcare stocks have benefited from balance sheet strength with minimal financial leverage, and relatively unaffected revenue streams. However, businesses that are driven by elective surgery will experience deferred revenue as hospital capacity is reserved for essential care. We see little reason for significant positive or negative impact to sustainable earnings for Healthcare businesses, resulting in minimal impact to valuations.
Figure 6: Key price moves – Healthcare sector
|Fisher & Paykel Healthcare||+29.7%|
High levels of disruption to operations, particularly for shopping centres combined with high levels of debt, have proven a toxic cocktail. Whilst this positioning will potentially leave REITs hostage to banks and their propensity to refinance debt, many property stocks are now offering attractive returns should the disruption prove temporary and cashflows recover to levels close to pre-crisis levels.
Figure 7: Key price moves – Property sector
What does this mean for investors?
While there have been sharp market falls across almost all sectors, this could present opportunities to buy businesses at more attractive prices. Here are some examples of how we are positioning our equity portfolios:
- We are favouring resource stocks, and industrial and consumer staple stocks with defensive revenue and earnings streams, that we believe are well-placed to weather the volatility.
- We are looking to selectively add risk in businesses where valuations have become more attractive and we expect businesses will rebound strongly post short-term challenges.
- We continue to avoid businesses in sectors such as healthcare where already aggressive valuations have become even more aggressive relative to an overall equity market level which is materially lower.
- We remain cautious on bank positioning given the likelihood of increasing bad debts and the limited ability of monetary policy to provide support.
- We have added smaller positions in energy stocks where valuations have been savaged, albeit cautiously.
Published by, Martin Conlon, Head of Australian Equities, Schroders