Wondering how to value markets right now? Here our head of Multi-Asset Michael Blayney gives a quick overview using three key charts.
Watch this short video recorded at Michael’s home office, or read the transcript below.
TRANSCRIPT
Hi, I’m Michael Blayney, Head of Multi-Asset at Pendal Group.
We’ve seen some very large falls in equity markets followed by a modest but sharp recovery. We’ve also seen very low cash rates and bond yields. The obvious question for investors is: “Where to now for portfolios?”
While it’s natural to want to bail out after seeing large losses, we know that ultimately crises do pass — and for a long-term investor, valuations are one of the key determinants of long-term returns.
So we’ve got a few charts today looking at valuations.
On the first of these (below), we look at a measure of smoothed earnings relative to prices. We then compare this to the subsequent five-year return that was achieved historically when these price-to-earnings ratios or PEs were at these levels.
We’ve done this incorporating data from the US, UK, Japan, Germany, and Australia.
What we observe from the chart is that when markets are very expensive, on average subsequent returns tend to be quite poor.
Indeed, you can see from the chart that when PE ratios started at a level of 30 or more, subsequent five-year returns on average were negative.
Conversely, low PE ratios have tended to correspond to strong subsequent returns.
In particular, when markets have been very depressed at PE ratios of 10 or less, subsequent returns have averaged almost 15% per annum.
At present, major markets are generally in the 10 to 20 range, with Australia, UK, Japan and Germany toward the lower end of the range — around 13 — and the US towards the upper end of the range.
On the second chart (below), we’ve shown our proprietary valuation indicators for equities. This is expressed as a Z score.
The best way to interpret it is that anything above 1 is quite cheap, anything above 1.5 is very cheap, and anything of -1 or worse is expensive or getting quite expensive.
Evaluation indicators incorporate a wide range of measures including through-the-cycle earnings, relativities to corporate bonds and forward-looking measures such as price-to-forward earnings.
We know brokers have started to cut forward earnings, but the level at which these cuts have occurred is nowhere near enough as yet. And we expect further revisions down to forward earnings.
As such, it would be logical to apply a haircut to these valuation measures.
However, even applying a sensible haircut to the valuation measures that come from our model, Australian equities still look reasonable valued and markets across Asia still look very cheap as does the UK and Germany.
In the US, the S&P 500 was extremely expensive coming into this bear market. We see on the quantitative measures of value, it’s now showing as being close to fair.
But we do need to factor in that earnings will almost certainly be revised down further and that US corporations have been buying back shares and increasing leverage significantly over the last decade.
As a result, we’d still be quite cautious on US large caps.
At the same time, real assets have fallen significantly in this market correction.
Many REITs globally now trade discounts to net asset value. Locally the A-REIT index trades at around a 25% discount to book value.
For a long-term, patient investor, this represents a very attractive entry point.
Turning to corporate bonds in our third chart, here we show the spread on US investment-grade corporate bonds spread through essentially the exit yield that you get for lending to a corporation rather than lending to a government (and taking on a degree of default and a liquidity risk).
Now, we note that even allowing for default rates in past deep recessions, these current spreads well and truly more than compensate investors for the risk that they’re taking on.
The final thing is that in this downturn, while at times government bonds and equities have sold off together, for the most part government bonds have continued to play their role and have been diversifying to equity market risk.
While it’s impossible to pick the exact bottoming markets, we do know that through market cycles a process of rebalancing to a long-term strategic asset allocation is one of the best ways to improve returns and reduce risk — with the natural benefit of a buy-low and sell-high approach.
So if investors do nothing else, rebalancing — ie selling some government bonds and topping up equity holdings in a strategic way — is a very sensible and prudent thing to do.
For investors who are able to tolerate a little bit more risk, there are some bargains to be had particularly REITs and Asian equities — and we’ve been buyers of those.
Overall, the key things now are not to panic, stay the course, and of course stay safe.
Thank you.
Regnan’s head of advisory, Susheela Peres da Costa
INVESTORS may think they invest in companies and markets. But they’re really investing in economies and societies.
It’s not until we experience a crisis like COVID-19 that this becomes clear.
When beverage producers start making hand sanitiser and car manufacturers start making hospital ventilators, it becomes clear there is limited value thinking about companies in isolation from their social context. When even the most blue-chip of companies have found themselves needing society’s generosity, the social contract becomes apparent.
As we recover, the community will expect businesses to meet their end of this bargain.
Susheela Peres da Costa, head of advisory at responsible investment and stewardship leader Regnan, makes these observations in the latest edition of Responsible Investor.
The article, COVID-19 shows universal owners need active ownership to safeguard social assets and advocate for principled political economy, can be found here.
Social assets such as population health, intellectual investment, cohesive communities and strong, trustworthy institutions are the foundations on which economies grow and markets flourish, Ms Peres da Costa says.
“If Environmental, Social and Governance (ESG) is about seeing the forest and the trees, COVID-19 shows how both depend on strong roots in solid ground.
“These foundations are all but invisible in better times. For this reason, they are easily undermined when we are inattentive to their maintenance.
“But widely-diversified investors are exposed to social assets and the performance of the economy, and need better metrics that enable them to monitor their strength and resilience through good times as well as bad.
“The interests of individual market actors can be in tension with the healthy whole.
“Investors also need ways to ensure those roots are not undermined for a one-off windfall. It is important to empower decision-makers who can prioritise social assets and thus the economy when faced with competing interests of market actors.”
Regnan is a leading provider of ESG research, engagement and advisory services.
Here is Crispin Murray’s weekly insight into Australian equities, reported by portfolio specialist Chris Adams. Crispin is Pendal’s Head of Equities.
LAST WEEK’S +4.7% gain in the ASX 300 reflected a more positive mood.
On one hand, there are signs the pace of COVID-19 case growth is decelerating globally. On the other, we continue to see a meaningful policy response to help economies cope.
Australia is doing a better job than many countries in containing the spread — and the fiscal support from the government is massive.
There is a possible scenario where Australia serves as something of a relative safe haven, with less investment uncertainty, in the near term.
Investor sentiment has improved but we remain wary of an ongoing flow of data which can deliver sharp sticker-shocks. US employment data, for example, has generally been coming in worse than expected.
We are not convinced yet that the market fully appreciates some of the second and third-order impacts on other parts of the economy not directly touched by the containment measures.
We will also see substantial capital calls likely in coming weeks, which will absorb liquidity and hold sentiment in check.
While the market is acting more rationally than was the case in the initial stages of the crisis, we think the current saw-tooth sideways pattern with high volatility could persist for the moment.
Infection rates
While the overall number of coronavirus infections is staggering, there are some positive signs emerging on infection rates.
Europe looks like it is flattening. Even the numbers coming through in New York are not as bad as some models predicted. This suggests measures to contain the virus are having some effect.
It demonstrates governments have the ability to exert some degree of control over the rate at which the virus spreads, depending on the measures they implement.
This is particularly so in Australia, where the daily percentage increases in new cases has fallen from more than 20% (NSW) in the third week of March to below 5%.
Authorities have had success identifying clusters and acting to contain them. The most recent data gives confidence that the Australian health system will cope with the virus.
It also lends authorities a greater degree of control over how and when containment measures are rolled back. This could mean structural damage to the economy may not be as bad as some fear.
It’s still unclear whether the government is going for a suppression strategy — which would lead to measures continuing through June — or whether a persistent low level of new cases would lead to an earlier roll-back of measures. It is interesting to note that Singapore reinstated some containment measures as case numbers began to pick up again.
Policy response
The federal government’s JobKeeper program is a material positive — and a larger response than many expected at this point.
Analysis suggests governments will need to spend 10% to 15% of GDP to adequately mitigate the economic effect of containment. This package equates to 6.5% of GDP which, in conjunction with previous measures, takes Australia’s total fiscal response above 10% of GDP.
It is important to remember the economic impact will still be very negative.
At this point the technical unemployment rate could still reach 10% — though without JobKeeper it could have been closer to 15%.
There is also the question of how the economy looks once we start to roll back measures. For example, it’s possible the hospitality industry has to keep some form of social distancing in place even when it re-opens – effectively allowing fewer patrons.
The six-month timeframe for JobKeeper still presents a risk factor for the economy if some industries take longer to normalise than others – which is likely to be the case.
Nevertheless, this package helps reduce the worst-case scenario in terms of unemployment and structural damage to the economy, better positioning it for a rebound.
It also signals the government’s intent to do whatever it takes.
Market observations
The JobKeeper announcement was the most significant development for Australian equities last week and helped underpin the market.
Lower correlations within the market suggest investors are allocating capital more rationally, as opposed to the “sell everything” mentality of a few weeks ago.
We are starting to see capital calls coming through. While the hardest hit companies are tapping markets early given more immediate stress, there are also signs of less-affected companies going early in order to get capital at reasonable prices.
They are reasoning that discounts may need to be larger if they wait longer. The market’s bounce and improvement in sentiment has also helped on the capital front.
There has been better support for some stressed companies than might otherwise have been the case, eg Webjet (WEB) -0.7%.
We expect a steady flow of cash calls will absorb some liquidity and have a limiting effect on any near-term market gains.
It is also important that companies are realistic in the amount of capital they are raising. They will want to be one-and-done. The market will be unforgiving to companies that come back twice.
Management will have to think through some of the more extreme outcomes. Auckland Airport, for example, raised enough capital to support liquidity to the end of 2021. On this basis they are expecting a scaled return in domestic traffic while international flights are disrupted for more than 20 months.
Brent crude oil rallied +35% last week on speculation of a deal between the US, Russia and Saudis to limit production. Thus far, nothing has emerged beyond a few Tweets.
Energy stocks rallied, but we believe the scale of the demand shock on sentiment will continue to overwhelm the likely supply side response. Any reprieve here may be short lived.
It is still too early to get a handle on the likely effect on corporate earnings. Most estimates range between 30-50%, with a bounce-back towards the end of the year.
While many are focusing on the near-term hit, we are also considering what the pace of recovery will look like. A company that sees a 30% fall in earnings – and then a 20% rebound – is still worse off than they were before the crisis.
It may not be until 2022 that we see some normalisation in earnings. It is too early to make this call, but it will have a material impact on valuations and must be assessed company by company.
Outlook
In terms of our list of four areas to watch which can help stabilise the market:
1) Medical breakthrough: Nothing tangible here yet. Testing results from a number of interesting initiatives is due in the next couple of weeks.
2) Policy response: Last week’s developments provide much better clarity and the scale of JobSeeker has helped reassure the market. However there is still a great deal of uncertainty over the degree to which it will soften the economic effect.
3) Oil stabilising: Some sort of deal looks more likely, but will still need to contend with hit to demand.
4) Confidence that health systems can cope with the flow of cases: There are signs of growing confidence here – particularly in Australia.
Pendal MicroCap Opportunities Fund
Important Updates
Pendal MicroCap Opportunities Fund (APIR: RFA0061AU, ARSN 118 585 354)
Effective 7 April 2020, the Pendal MicroCap Opportunities Fund (Fund)’s buy-sell spread will decrease from 1.86% (with 0.93% payable on application and 0.93% payable on withdrawal) to 1.60% (with 0.80% payable on application and 0.80% payable on withdrawal).
The buy-sell spread is an additional cost to you and is generally incurred whenever you invest in the Fund. The buy-sell spread is retained by the Fund (it is not a fee paid to us) and represents a contribution to the transaction costs incurred by the Fund such as brokerage and stamp duty, when the Fund is purchasing and selling assets. The buy-sell spread also reflects the market impact of buying and selling the underlying securities in the market. Importantly, the buy-sell spread helps to ensure different unit holders are being treated fairly by attributing the costs of trading securities to those unit holders who are buying and selling units in the Fund.
The Fund’s buy-sell spread increased on 26 March 2020 from 0.70% (with 0.35% payable on application and 0.35% payable on withdrawal) due to higher trading costs for ASX listed micro capitalisation equities as a result of COVID-19. The reduction in the Fund’s buy-sell spread reflects an improvement in trading conditions.
Pendal will continue to monitor market conditions and review and update the buy-sell spread regularly as required. You should therefore review the current buy-sell spread information before making a decision to invest or withdraw from a Fund.
Please refer to our website www.pendalgroup.com and click ‘Products’ for the latest buy-sell spread for each Fund.
Here is a weekly COVID-19 investor overview covering virus spread, economic impact and market insights from Pendal Head of Bond, Income and Defensive Strategies, Vimal Gor.
Watch this short video recorded at Vimal’s home office, or read the transcript below.
TRANSCRIPT
Here I am for our regular weekly COVID outlook.
On COVID-19, it’s quite clear that the curves are flattening everywhere.
Though obviously the US isn’t flattening nearly as much as everyone else. That’s because the extent of the lockdowns they’ve done have been so much smaller — and we’re still effectively hitting peak period in the US.
For the next week or so we can expect the numbers to increase in the US. But then alongside the rest of the world, we can expect them to start tailing off — and there’s already talk of people coming back to work.
The whole narrative is shifting now. Because the economic data has been so bad, as I mentioned last week, the whole focus now is on how quickly we can get people back to work and how quickly economies can get back to normal.
Focus has shifted from trying to stop the transmission of the virus — because we know it’s already beginning to tail off and we can see the curves flattening everywhere — to getting everyone back to work.
Trump recently said he doesn’t want the cure to be worse than the disease.
So as soon as we can open up the economies the better. And that’s happening because the economic data coming out are so atrociously bad. As I sit here today, the S&P is now down less than 20% from its all time high. You need to put that in perspective of economic data that’s going to be the worst since the Great Depression.
We’ve got this big disconnect that’s happening between asset prices and the underlying economic data.
The reason for that is the liquidity that’s flooding through the system. I talked about this last week.
The key issue is — this is liquidity. It’s not solving the solvency issue and that’s going to be an issue that’s addressed over the coming weeks and quarters and years.
So let’s just do a quick run through the asset classes before I sign off for the long Easter weekend.
Firstly, as you know, I love bonds. I love bonds pretty much everywhere apart from peripheral bonds in Europe and some of the Asian economies.
But generally I like bonds and I think the bond yields are going to zero across the world — so you can be a happy holder and make very good capital returns out of them over the coming period.
In terms of FX, I think the only call you need to make is about the US dollar. We know there’s still a dollar shortage out there, but the Fed and central banks around the world are doing everything to alleviate that shortage.
So I don’t think you can have a strong view on the dollar now until the balance comes out or one or the other side.
On commodities, I think all commodities apart from precious metals are coming down.
I think that’s a big disinflationary impact for the entire world and we’ll see that and feel it either the next quarters and years.
In terms of credit, I think there’s a bifurcation. You can happily own the stuff that’s high grade, and hopefully that the Fed’s buying as well, which is effectively investment-grade credit high up.
I don’t think you want to be in low-grade investment grade credit or the stuff the Fed is deliberately keeping away from, which is high yield.
So I think you need to be very careful about your credit exposure. You can safely own some sectors, but certainly keep away from others.
That’s it for this week. I’ll see you next week.
Promising health data is underpinning stronger investor sentiment in the wake of COVID-19. Here’s the latest Aussie equities outlook from Pendal’s head of equities Crispin Murray, reported by portfolio specialist Chris Adams.
MANY now believe we have seen a peak in COVID-19 infection rates.
At the very least, the scenario of an uncontrolled global pandemic now appears to be off the table. In Australia, case growth continues to slow substantially and debate has shifted to the best exit strategy from containment measures.
Encouraging data on the health front is under-pinning stronger investor sentiment.
Last week the S&P/ASX 300 gained +6.4% — its best performance since the crisis began. By Friday the index had bounced +21% off its lows and was down -18.7% for the year to date.
The week saw significant developments on the policy front, with a remarkable support program unveiled by the Fed. The oil producers also agreed to try to constrain supply and support prices.
Capital raisings have thus far been well supported.
Infection rates
Total global new cases of the coronavirus have been decelerating and the outcome in New York has not been as bad as many had feared.
While this is undoubtedly positive, we still face uncertainty over a potential second wave of infections as restrictions lift.
Both Singapore and Japan have shown signs of this. There are perhaps some idiosyncratic factors at play here. Japan had a very low level of testing, which suggests that perhaps the spread wasn’t as well controlled as previously thought. In Singapore a return of foreign workers may have had an effect.
There have been some secondary breakouts in China – notably in Harbin – but they tend to be in areas where perhaps there has been some cross-border spread.
This all has implications for Australia.
With the initial spread now seemingly well under control, the question becomes whether the government pursues a strategy of elimination, suppression or mitigation.
Elimination
• Involves keeping containment measures in place until there are no new untraced cases for a period of time. Domestic activity can then return to normal, while international borders remain locked, with constant testing in place to ensure no new outbreaks.
• In contrast to other strategies, the downside is initial containment measures remain in place for longer. The upside is the domestic economy can regain a normalised level faster once the restrictions come off.
• This is a more viable option in Australian and NZ than in other countries, given the geography.
Suppression
• Similar to elimination, but with a tolerance of ongoing cases and continued widespread testing to trace and quickly contain new outbreaks.
• The upside is initial restrictions come off sooner, but the risk of ongoing disruption and potential for periodic reinstatement of measures.
• This is the approach taken in China and South Korea.
Mitigation
• Effectively looks to build herd immunity by allowing parts of the population to get infected while attempting to manage the rate of infection and shield vulnerable community members.
• This has the soonest end to initial restrictions, but an even greater risk of ongoing disruption and potential for further lockdowns and disruption. There are likely to be ongoing restrictions in terms of social density – eg the number of people allowed on planes, in bars and cinemas.
• This is the approach effectively taken by Europe – given the difficulties in controlling borders – and in the US.
In term of a vaccine, the initial Remdesivir trial showed some signs of success, but was inconclusive given the limited scale (53 patients over 28 days) and uncontrolled data set.
The results of larger, more specific trials are due in late April and May.
Policy response
The Fed’s US$2.3 trillion program – leveraged from the US$454 billion granted by Congress – signifies a material departure from its usual stance towards risk.
It aims to provide the liquidity to underpin funding markets for the following areas:
1) Small-to-medium enterprises: There is $600 billion targeted at supporting lending to small businesses. This is in conjunction with banks, which will assess the borrower, but will only take 5% of the risk, with the Fed assuming the remaining 95%. The loans are for four years, with no interest in the first year. Available to firms with up to 10,000 employees and US$2.5 billion in revenue.
2) The municipal bond (muni) market: A number of US states, large counties and cities were facing the threat of insolvency; $550 billion of the package provides funding, with no credit rating threshold.
3) Investment grade credit program: Expanded to $750 billion. The major change here is that it applies to companies that were investment grade on March 22, so it covers subsequently downgraded “fallen angels” such as Ford and resolves the funding issues they faced.
4) Indirect support to orphan assets: The Fed has expanded what it can buy to include some sub-investment grade bonds, certain high-yield ETFs and parts of the commercial mortgage-backed securities (CMBS) and collateralised loan obligation (CLO) markets.
This effectively underwrites these asset classes, helps ensure companies can access funding and reduces the risk of wide scale bankruptcy. In doing so, the Fed is buying assets and assuming risks it has never previously taken on.
The only area of conservatism is that they have persisted with charging premium rates for access to the borrowing. The Fed’s balance sheet has expanded by a third in the space of one month.
The Fed has also signalled that if this is not deemed sufficient, there will be more. The unprecedented liquidity injection has seen a rapid response in asset prices. Investment grade credit indices have almost recouped all their losses since the health crisis began.
The key risk to all this is if the underlying economy fails to recover, leaving some asset markets mis-priced due to the wave of liquidity. Nevertheless, it is hard to overstate the importance of this move in terms of underpinning confidence in funding and the fundamentals in some key asset markets.
Oil
The key players have cobbled together a deal to address oversupply in the oil market, with a headline agreement to reduce daily production by 9.7 million barrels per day.
The reality is closer to an 8.6 million barrel cut, which won’t come into force until May. This leaves several more week of gross overproduction and inventory build.
Historical observation suggests there will be patchy compliance with the agreement. The issue is that oil demand looks to be down by close to 30 million barrels per day – and global storage could be full by May. The deal may provide some short-term relief, but we remain wary of the sector’s outlook.
Markets
History suggests markets bottom when there is a sense that the bottom for the economy is in sight. However it’s more complicated this time with unprecedented stimulus and liquidity, which has seen markets rebound.
This could either signal optimism over a far quicker recovery from the pandemic than first thought — or that the market is getting far ahead of itself.
We may now be entering the fourth phase of the crisis.
Phase 1: Coronavirus concerns limited to China and the effect on supply chains
Phase 2: The realisation that this is a global crisis – peak fear and uncertainty over the rate at which the virus spreads and the ability of governments to respond.
Phase 3: Upside surprise in terms of the policy response.
Phase 4: A dawning appreciation of the scale of uncertainties we still face: how long do measures stay in place, how are they rolled back, what is the economic impact and how does that affect company earnings. This is a bit of a waiting game. We think it could present challenges for the market as some of the numbers become apparent. Though the liquidity response helps offset some of the pressure.
Pendal head of equities Crispin Murray presents a COVID-19 market update and shares how he’s assessing which companies will emerge in a strong position after the recovery.
Watch this short video recorded at Crispin’s home office, or read the transcript below.
TRANSCRIPT
Hello everyone , it’s Crispin from Pendal Group with an update on our thoughts on the market.
We’ve been speaking about this being a phase of maximum uncertainty — a combination of lack of clarity on the scale and degree of the health crisis and the uncertainty around the size and the speed of the policy response.
Today I’m going to speak to how we see these issues evolving and I’m going to break it down into four components.
1. Health
First is on the health side. We’ve seen countries like Italy plateauing in terms of new cases but at very high levels and no real signs of these levels letting up. Equally we’ve seen in the US an acceleration of cases as testing has been rolled out.
We’re getting a sense of the true scale of the virus spread and a clear warning of the consequences of not imposing enough restrictions on activity.
In Australia there have been some early positive signs that measures are helping contain the case numbers. Also importantly the severity of case so far have remained relatively low.
Clearly this can change quickly, but it does have important implications both for the health outcomes and also the duration and the depth of the economic downturn required to manage the flow of cases through the health system.
2. Policy
On the policy front we have seen good progress in many countries, notably the US with a government program equivalent to around 10% of GDP.
In Australia we had the government announce their wage support program, which in combination with the already-announced measures, takes the overall response to over 10% of GDP.
These are sizeable programs beyond anything we’ve seen in decades.
They’re critical, not so much for softening the near-term economic blow — that’s going to be difficult because people just can’t engage in economic activity. But they will enable a longer-term pathway to recovery.
Burden business people with too much debt and that will choke any recovery. So this is a necessary investment by the government in human capital.
The wage subsidy is important as it may help contain an even larger uplift in unemployment. Already, we believe this is likely to spike through 10% and potentially up to 15%.
It is also worth highlighting the actions of central banks notably in the US, which are putting in place measures to normalise funding markets. These are critical for businesses to stay solvent and retain labour.
So we should have some greater confidence that the declarations policy makers around the world have made to do whatever it takes is being fired up. This reduces some of the uncertainty and risks in the market.
3. The markets
Greater clarity on policy, combined with the end of the initial liquidation phase,as various funds cut risk and de-gear, has helped stabilise the market in the near term.
The reason we are not yet seeing more meaningful market recovery is due to the growing recognition of the scale of the downturn — in the second quarter with estimates anywhere from down 10% to 30% depending on how long these high level of restrictions remain.
Earnings implications will also be larger. Again, it’s almost impossible to predict right now, but certainly numbers of between 30% and 50% down are possible.
It is important to put some perspective on this because I think we need to think of 2020 as one large collective writedown by corporate Australia.
The focus from an investment point of view is:
– Whether the companies firstly have the capital or the liquidity to ride it out
– Can they avoid being too heavily diluted through capital raisings?
– Whether their businesses will recover relatively quickly or will they be constrained by the potential ongoing limits to activity.
– And finally, are they able to materially reduce their long term costs, for what will be a lower level of activity?
Capital raisings
We should expect a lot of capital raisings.
We’ll need to be selective on these. Focus on the key issues, the type of industry, it’s structure, the company’s market position, quality of the management.
When a company does raise capital, you need to make sure they are telling you the full story.
Are they clearly raising enough money to get them through at least 12 months of weak activity? The market will not be forgiving for companies that have to come back for more capital calls.
Dividends
The other issue I want to flag is the risk to dividends. I think this is material and potentially larger than the market expects.
It may only be the next dividend or perhaps the next couple, but preserving liquidity and capital will be the priorities for a lot of companies and particularly for those industries which are also benefitting from government programs.
4. Companies
Our focus is not to try and make that heroic call on which way the economy and the market goes, but to take a long-term perspective, and build a portfolio that identifies the best companies that meet four objectives.
Either they’re providing protection in a recession; they’re leveraged to policy; they’re good businesses facing short-term challenges but coming through that and being stronger; or they’re companies that will give you protection if we get a very quick solution to this health crisis.
Company example – Amcor
Amcor provides packaging for health, food and personal products. These are all essential items people need where demand is holding up, they are a dominant player in their industry, a lowest-cost supplier and have very good free cashflow.
If things do end up proving to be worse for longer, this is a company that will prove very defensive in the portfolio.
Company example – Nine Entertainment
Yes, Nine is more leveraged to the economic cycle. Yes, it will be impacted by the drop in advertising and the loss of the NRL. But it also benefits from improved subscription to the Stan service. They’ve also been very proactive and announced cost savings of over $200 million.
On top of this, they have a good balance sheet. They are the strongest player in their industry and will be very well placed any recovery.
We expect them to perform particularly well if we see policy is seen to be working.
Final thoughts
We are in an environment where there is still a lot of uncertainty — but also given the drop in the market there is opportunity.
It’s important as investors to stay disciplined. To have a clear plan of actions, stick to fundamental principles and identify those companies where risks are being overly priced into their valuation panel.
Pendal has a team of 17 people in Australian equities. While they may not be able to go out and physically meet with the companies right now, we are engaging in an intense daily program of contact with these companies.
We’ve spoken to well over 100 different companies — some multiple times — to ensure we’re getting as much information, as much insight to enable us to make the right investment decisions and position our portfolios in the best possible way.
With that, I would like to thank you again for your time today.
Crispin Murray
Head of Equities, Pendal Group
Here, Pendal fund manager Tim Hext gives an overview of the Reserve Bank’s COVID-19 actions and the outlook on bonds.
Watch this short video recorded at Tim’s home office, or read the transcript below.
TRANSCRIPT
Greetings to everyone wherever you’re watching, I hope you’re safe and well.
My name’s Tim Hext and I’m a fund manager in the Bond, Income and Defensive Strategy team at Pendal Group.
I’m going to give you a quick update on what we’re seeing in markets at these crisis times and offer a few views about where we’re going from here.
As you all know, this is first and foremost a health crisis which has now become an economic crisis. Until the health crisis is fixed, the economic crisis will continue.
It’s unlike any other economic crisis we’ve seen before. The usual way we get into situations like this economically is through a collapse in demand or a collapse in supply as saw in the ’70s.
What that means is the standard textbook way of looking at things — and the way economists gravitate at a time like this — is kind of irrelevant.
The only question to ask at this point in time is: “when is the health crisis officially fixed so things can resume and therefore alleviate the economic crisis?”
It really doesn’t help to talking about “is there going to be a recession or depression?” It’s something we’ve never seen before and it’s something we just don’t have in our textbooks.
It’s kind of — to frame a new word from hibernation and recession — a “hiber-cession”. It’s something where collapse in supply and demand happens at the same time.
So the consequences medium-to-longer-term are going to be very different to what we’ve seen coming out of other crises.
Markets
So getting onto markets and our portfolio. The market’s clearly had a lot of liquidity stress early on in March.
We saw quite large redemptions out of various bond funds, either moving on, re-balancing back into equities or in some cases just needing to cash up for various reasons.
So bonds were quite stressed, but the Reserve Bank was reasonably quick to get in there and fix that problem. It learned from the GFC that the first thing you have to do is flush the market with liquidity.
We’ve seen billions upon billions of dollars put into the banking system. The banking system now in fact has too much cash — $60 billion a day is going back to the Reserve Bank because they don’t have a use for it.
So there’s plenty of cash in the system and through various means that has started to trickle out.
So government bonds, for example — as you probably saw, the RBA is now doing Quantitative Easing, trying to keep three-year bonds around 25 basis points.
So far they bought around $24 billion of bonds and that number’s going up every day. So huge amounts of bond-buying that puts cash back into the system as well.
What we’ve seen is the Reserve Bank of Australia (RBA) really leave a lot of money around. Banks now have access to term funding. The Australian Office of Financial Management for example, is now buying mortgage-backed securities.
We haven’t seen anything in the corporate bond space yet — that may be yet coming to provide some help there. So our funds have managed to maintain reasonable levels of liquidity.
We’ve gone as we always have. We are at the defensive end of the fixed income universe. We tend to run higher levels of liquidity anyway and it’s put us in good stead to meet any needs during the crisis.
So the Reserve Bank has fixed that problem. Of course the economic problems and the credit problems in the system are going to require a lot more work. And as I said, we’ll see a lot more I think in the weeks ahead from that.
Medium-term outlook
But what does it mean for us medium term? Well, the macro in a sense has now become the micro.
You’ve got to look at everything on an industry-by-industry basis in terms of who can come out of this the quickest.
Certain industries are obviously sailing through. There are others who are shutting down, but in a sense can restart quite quickly and are likely to see demand return.
But there’s also some for whom the world has changed, where the cyclical will no doubt become part of the structural.
We look heavily towards our equities team for advice on those sorts of areas. We’re going to be keeping a very close eye on that because the value opportunities are going to be incredible going forward.
Obviously like everyone, we hope antiviral drugs start to come out in the next month or two to take the tail risk out of the health crisis.
Reduce the number of hospitalisations required and then you can start to reduce the shutdown. People will then still get COVID-19 but in a sense it will just be like a bad flu season. And if you start to reach that point, the economy can start to get back into some sort of shape anyway.
Although it will be a slow process.
Hopefully of course by the end of the year we’ll have a vaccine which removes this problem going forward.
But we do remain optimistic that although the darkest days are probably yet to come — particularly internationally — Australia does seem to be flattening the curve. We’ve got to look six-to-12 months ahead.
What does it mean for bonds?
Well the Reserve Bank is anchoring cash rates at 25 basis points. They’ll be there for at least a couple of years.
They’ve told us they’re anchoring the three-year right there as well.
Bond funds and bonds generally are going to be fairly well supported, but the attention will turn at some point for longer bonds into the medium-to-longer term inflation outlook.
As mentioned, I’ll come back to that at another time, so stay safe.
Stay well, show some of peace and love to those around you and we’ll speak to you again soon.
Thank you.
Here is a weekly COVID-19 investor overview covering virus spread, economic impact and market insights from Pendal Head of Bond, Income and Defensive Strategies, Vimal Gor.
Watch this short video recorded at Vimal’s home office, or read the transcript below.
TRANSCRIPT
I’m here to do the third of our coronavirus outlooks. I’ll stick to the same format I’ve used for the last couple of weeks.
We’ll talk briefly about the virus, about the economic impact and then what’s happening in markets.
Virus outlook
So firstly on the virus, it’s very clear now that the lockdowns are having a material impact.
If you look at the countries that have done them in full force — Australia, New Zealand, and most of Europe — you can see the numbers tailing off quite materially.
Unfortunately the US has been very slow to implement lockdowns — only about a fifth of the country is in lockdown right now — and they’re not taking it that seriously. Therefore the US numbers are strong and continuing to increase pretty much on that incremental pace. At some point the US has to introduce more formal lockdowns to try and get on top of this thing.
The second thing to note about the virus is we begin to see lots and lots of news reports about new vaccines or tests and things coming through.
That’s great news because we’ve got the best minds in the world working on this. And all working on this for the same outcome, so I can’t help but hope that there’s some major breakthrough that we’re going to get soon that will enable us to come out of lockdown or even to beat the pandemic totally.
Economic impact
Moving on to economics, make no mistake, the numbers are absolutely terrible. Every bit of data we see is far surpassing on the downside expectations and the range is so large.
To give you an example, the Q2 range economists have for GDP is somewhere between -9% at the most bullish and -45% at the most bearish — and the Fed still looking for a decent bounce-back later this year.
The thing I worry about the most is, that we get this big draw-down in GDP, but actually we don’t get the bounce-back. And therefore we start getting numbers for the calendar year worse than -4%, -5% and somewhere about -5% to -10% which would be really problematic.
But alongside the data getting weaker, what we have seen is continued response from the authorities. Central banks, especially the Fed, are doing new packages virtually on a daily basis.
As I mentioned in last week’s chat, they’re actually backstopping the entire economy now. It’s just not about the Fed being the lender of last resort to the banking system. It’s about the Fed being the lender of last resort to the entire economy.
Here’s an example to give you an idea about the size of the measures that have been enacted by the US both on the monetary and fiscal side. If you’re a small company employing less than 500 people, the packages that are currently out will effectively cover your rent, wages and utilities for a two-month period.
Effectively what they’re trying to do is put the economies into hibernation, so when we’re through the pandemic we can bounce back.
The other thing we’re seeing out of central banks, and again led by the Fed, is this desire to deal with the burgeoning money market problems. We can see that US front-end LIBOR (London InterBank Offered Rate) are quite high and that’s about credit risk in the system and the Fed is flooding the system with liquidity. They’re doing it the front-end of the US dollar curve, plus they’re doing swap lines across the world trying to force dollars into the system and to deal with this problem they’ve got in the front-end.
And right now it looks to be working. It looks like we’re beginning to see the turn in FRA-OIS and US dollar LIBOR rates and this can be only beneficial to the broader economic system, which up until now has been starved of US dollars.
Market outlook
And now on to markets. It’s funny because I don’t really view bonds with less than a five-year maturity as interest rate duration instruments anymore.
I believe they’re s purely a function of what’s happening in central banks and Quantitative Easing (QE) programs and therefore you can just hold them as you know there’ll be moving towards zero over the medium term.
I also believe that’s what’s happening in the back-end of the curves now. When you look at US 10-years around 70 basis points, they still offer significant value to me because you know, the QE packages the Fed is conducting plus the large flow we’re seeing out of the Japanese market –Japanese investors into overseas markets — will continue to push your bond yields lower.
So even though we’ve seen a material bond rally over the last few months, I still think there’s more in this rally as all global bond yields converge around zero.
So hopefully that’s given you an understanding of how we’re viewing this environment across the pandemic, the economics and the market.
I’ll see you next week. Thank you.
Here Pendal head of equities Crispin Murray presents a weekly COVID-19 outlook for investors. Reported by portfolio specialist Chris Adams.
THE Australian equity market ended last week up very slightly (+0.6%), but took a wild path to get there.
We suspect this “saw tooth” pattern of anxiety and relief is likely to persist for a few weeks.
However we have noticed the market has moved from the indiscriminate “liquidation” phase, to an environment where lower correlations within the market suggest it is more rational.
The key risks now are around 1) the size of the earnings impact on individual companies, 2) the impact on dividends and 3) the scale of capital raisings:
1. Earnings
We think talk of the impact of further containment measures — which seemed to spook the market on Friday — is a largely moot point. Most large retailers are effectively already shutting down and cutting staff.
The economic data will be awful over the next few weeks and we are effectively on the path to 15% near-term unemployment.
The earnings effect is hard to dimension yet, but at an index level it could be in the order of 25% to 30%.
It is important to differentiate between companies that will be able to bounce back relatively quickly and those that may continue to be impacted long after other parts of the economy have normalised.
International travel restriction are likely to remain in place longer than domestic social distancing measures, for example, which has implications for the travel and casino stocks.
2. Dividends
Given the scale of policy support and relief measures being provided by banks, there’s an expectation dividends are likely to be cut and capital conserved in this half.
Again it is important to distinguish between companies where the dividend proceeds may just be deferred to the next half, as opposed to extinguished.
3. Capital
We learned a few things last week when Cochlear (COH, +5.1%) went out early, raising about $880 million in a well-supported placement.
The cash is required to ensure the company can rise out of a period in which elective surgeries are deferred. It will also help meet USD damage payments as a result of a patent dispute ruling made last week.
It was interesting to note the placement was entirely taken by existing shareholders — the amount was increased from an initial $800 million on the back of demand.
At current market levels the COH experience demonstrates there is plenty of support for companies that are well placed on a medium-term view.
It also shows investors need to think carefully about which registers they want to be on, given that only existing shareholders had the chance to buy the discounted stock.
Infection rates
We have previously mentioned the importance of monitoring the global spread of the virus as an indicator of how long containment measures will persist. This informs the economic impact and the speed of a rebound.
Italy looks like it has plateaued in terms of new daily cases — although the plateau is lasting longer than it did in China and Korea.
The US is accelerating but an increase in testing is a key factor here. The US outlook is for at least a couple of weeks of further exponential growth.
In Australia the number of new daily cases is falling. This may reflect the fact that local authorities were quicker to move on containment than those in Europe. But the lagged effect of the pre-shutdown period may come through in the next week.
The next three weeks are critical. Once we get through that period, social distancing measures will have started to kick in. The severity of cases is also important to watch.
So far Australia is seeing far fewer serious cases than other countries. This determines the ultimate load on the hospital system. Most models are indicating a peak for Australia around April 15 to 20.
Policy response
We continue to see unprecedented developments on the policy front. The US support package is far larger — and agreement was far swifter — than anything seen in the GFC. It currently equates to 10% of GDP. Germany’s package is also in the 10% region.
But we believe more will need to be done.
Australia’s initial package of 5% of DGP will need to be doubled — or even close to tripled.
There are questions over how quickly funds can flow to where they are needed. But as a statement of intent the policy response is important. It demonstrates governments are willing to do “whatever it takes” — regardless of longer-term debt consequences — to limit the extreme downside of economic damage.
Liquidity injections by the Fed also seem to have repaired some of the plumbing issues in corporate funding markets, which are showing some signs of stabilisation.
Oil
The oil sector remains ugly. There is excess oil production in the order of 10 million barrels per day. This is keeping the oil price low — Brent ended last week down -7% at US$25.76 a barrel. But if oil storage runs out of capacity it could push even lower.
There are signs the US may be pushing for some sort of deal with the Saudis. This demands attention. We saw in 2016 how quickly the sector can rebound from oversold levels. But at this point near-term outlook remains grim for oil.
Outlook
In terms of the near-term outlook four key factors could help stabilise the market:
1. Medical breakthrough: Nothing tangible here yet. Testing results from a number of interesting initiatives is due in the next couple of weeks.
2. Policy response: Efforts thus far have helped put a floor under how low GDP goes, but we expect more to be done. Australia’s package equates to 5% of GDP. We expect it will ultimately need to be 10% to 15%.
There may be a hiatus this week given the scale of last week’s response. However we are expecting something specific around private hospitals to ensure they retain enough revenue to maintain capacity to support the public system.
3. Oil stabilising: At this point there are rumours of a possible US-Saudi seal, but nothing tangible.
4. Confidence that health systems can cope with the flow of cases: At this point still too early to call.
Final Thoughts
In this environment we expect last week’s saw tooth pattern to continue.
The market is now becoming more rational, which is good for active managers.
Coupled with a view on which capital raisings are best supported — and which are likely to require early positioning — it is an environment driving abundant opportunity.
One new area of debate to watch is discussion of how long a society can tolerate lock down — and what is the structural damage caused.
GDP declines in China in Q1 are estimated to be 30-40% (quarterly annualised). Similar numbers are possible for Europe and the US.
The scale of unemployment and business closures will take years to unwind.
The question is: how do you manage this?
This debate will continue, but it is worth noting banks are likely to shoulder a larger burden than other sectors. This could ultimately see the sector with more utility-like returns than has been the case in past years.