As the coronavirus pandemic wreaks havoc on global economies, Giles Parkinson assesses the impact across equity markets and the longer-term implications for investors.
5 minute read
The COVID-19 crisis has affected all asset classes; global equities have not been spared. As of April 17, the MSCI All Countries World Index was down 17 per cent from its peak in mid-February and uncertainty continues to cloud the outlook.
In the long-run, equity market returns are dependent on realised and expected earnings, which are closely tied to economic growth. Aviva Investors expects global activity to decline between eight and 14 per cent in the first half of 2020, compared to where it would otherwise have been. This would be the deepest decline in activity in the post-war period.1
In the short-run, markets are driven by sentiment, which could remain suppressed until lockdowns ease and growth rebounds. But the damage has not been evenly spread, and some sectors are proving more resilient. Market dislocations have opened up opportunities for discerning investors who are able to take a longer-term view.
In this Q&A, global equities fund manager Giles Parkinson discusses the impact of the crisis across industries, how investors can best position their portfolios amid the fallout, and the implications for the asset class in the long run.
Which sectors have been hit hardest so far?
The stock market is doing a pretty good job of distinguishing stronger companies from weaker peers and deciding which industries will see their revenues and profits impacted by this recession. No two recessions are alike, and in this downturn travel and leisure stocks – airlines, hotels, casinos, cruise liners, and events – have performed exceptionally badly. Then there’s the overlay of the oil market. In addition to the glut of shale oil supply coming into the crisis, the oil market now has a demand problem, as less travel means less energy consumption.
The stock market is starting to look at the implications for supply chains
The stock market is also starting to look at the implications for supply chains. While restaurants are obvious targets, their suppliers have also been hit: Lamb Weston, which supplies potatoes to McDonald’s and other fast food chains, and Kerry Group, which makes flavours and ingredients, are among those that have suffered.
Which sectors have proven more resilient?
Tech companies have outperformed – not so much chip manufacturers, but rather cloud software businesses with ostensibly recurring revenues. The extent to which their revenues will ultimately be impacted by lower corporate budgets remains to be seen.
Consumer staples have also been resilient in general, but there are nuances. Some pockets that usually perform well in a downturn have been affected by the specific characteristics of the COVID-19 lockdown. Yes, people are bulk-buying packaged food and demand for tobacco remains strong, but alcohol consumption has been disrupted by the shuttering of the “on-trade” pubs and bars. Even so, I don’t expect their brand positioning to be affected and consumption will ultimately bounce back.
Investors need to look at the dynamics of each sector
Investors need to look at the dynamics of each sector. For example, in healthcare, pharmaceuticals companies have performed well, as you’d expect. But demand for medical devices is down, because health systems are postponing elective surgeries such as hip and knee replacements as they prioritise treatments for coronavirus patients.
Should investors be looking at the state of corporate balance sheets to determine whether companies will make it through the downturn?
It’s too late for that. You can tell how a stock has performed over the last two months by answering two questions: The first is, “what has happened to the company’s daily revenues during the lockdown?” The second is, “what is its balance sheet like?” If a company has a lot of debt – especially debt with covenants attached – and its revenues have fallen to near zero, then its equity will have performed extremely poorly.
Some companies’ profits are likely to undergo a V-shaped decline, which would trigger debt covenants and force them to raise equity
The stock market currently implies that while this might be quite a short, sharp recession, some companies’ profits are likely to undergo a V-shaped decline, which would trigger debt covenants and force them to raise equity. Even without the asymmetry of triggering covenants, debt magnifies outcomes. Some regulated utilities such as UK water stocks, despite being defensive businesses, have fallen with the market during the selloff because the high level of debt in their capital structure makes their equities more sensitive to small changes in the overall value of the enterprise.
The crisis is showing up equity investors who can only read income statements. You need to be able to read a balance sheet in order to determine the strength of a company at times like this.
Governments are making big interventions in the economy and private firms are throwing themselves into public service. Could that be a lasting trend, and what could be the implications for markets?
Some pundits have drawn the analogy with the Second World War, when companies were ordered to manufacture equipment for the military, for example. I don’t necessarily agree with that, although it’s good to see companies doing the right thing, like General Motors making ventilators or LVMH manufacturing hand sanitiser. As for government intervention, the measures seem mostly rational in that the bulk of the policies announced so far are designed to help employees as they are furloughed or made redundant, which is where the most acute pain is being felt.
Whenever there is a whiff of a recession, central banks are quick to implement quantitative easing
There is a larger question here as to whether governments and central bankers are too quick to bail out capitalism. The credit crunch of 2008-‘09 required intervention, as it was a balance sheet recession and the financial system was breaking down. But in doing so, policymakers crossed a Rubicon, and now, whenever there is a whiff of a recession, central banks are quick to implement quantitative easing. If these kinds of measures were costless, we’d have been doing them since the beginning of time. The projections of government deficits coming out of this recession are a concern over the longer term because the implications are unknown.
There is a renewed focus on corporate governance and behaviour during the crisis. Are you monitoring this, given the reputational risk for companies that are seen to be behaving irresponsibly at this time?
Yes. Quantitative factors tend to get dropped into a Bloomberg spreadsheet and quickly become arbitraged away; judging qualitative measures, like corporate behaviour, is more difficult and therefore more rewarding for assessing value.
During the last financial crisis some companies emerged stronger relative to their competitors because they adapted quickly amid the turmoil
Some company executives have pledged to take a salary cut during the crisis, and that’s an interesting trend. Others have extended support to their customers and suppliers. The effects of this may last beyond the pandemic. We saw during the last financial crisis that some companies emerged stronger relative to their competitors because they adapted quickly amid the turmoil, continued to innovate and maintain customer relationships, grew market share, and expanded their competitive advantages.
How about other longer-term implications of the pandemic?
Predicting longer-term thematic shifts is notoriously difficult. I find that an easier approach is often to invert the question and ask, “what’s not going to change?” I think you can answer this question with greater confidence and build a stronger investment thesis around the answers.
One thing that is not going to change, for example, is the demise of physical cash and cheques relative to electronic payments such as debit and credit cards. That has long been the direction of travel. Regulatory authorities prefer electronic payments as they are easier to monitor, and the rise of e-commerce at the expense of bricks and mortar is another contributing factor. This is not going to change due to COVID-19; indeed, you could argue the trend is only going to accelerate during the pandemic.
The shift to electronic payments looks to be a trend that will continue long after the pandemic subsides
Shops are not accepting cash because of the coronavirus contamination issue, and people locked down at home need to set up online payment methods to continue to buy goods and services. I’ve heard numerous anecdotal stories of elderly parents who have finally signed up for online banking during the lockdown. When COVID-19 disappears, they will still have that banking app on their phones and a new habit ingrained in their daily lives. The shift to electronic payments looks to be a trend that will continue long after the pandemic subsides.
Finally, has this crisis caused you to think differently about anything: risks, opportunities or even your investment philosophy?
Markets don’t repeat, but they do rhyme. This downturn has been a reminder that each recession has its own particular flavour: 2015-‘16 was about China and commodities; 2011-‘13 the euro zone; 2008-‘09 about US housing and the financial system.
COVID-19 is affecting some industries, particularly travel and leisure, severely. Who plans for months of zero revenues? Yet here we are. This means that, while assessing how a company performed in recent business cycles is always informative, there is always the possibility this time is different. Some “defensives” will prove to have been less resilient than in past cycles.
It ain’t what you don’t know that gets you into trouble, it’s what you know for sure but just ain’t so
This sell-off demonstrates the truth in a statement sometimes attributed to Mark Twain: “It ain’t what you don’t know that gets you into trouble, it’s what you know for sure but just ain’t so.” Investors have to find ways of dealing with uncertainty. A little more diversification – without diluting into ignorance – can be helpful to protect oneself against “unknown unknowns”.