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.

Here’s the latest weekly COVID-19 investor wrap 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’ll cover these weekly updates in three ways.

Firstly, we’re going to cover off on the virus pandemic. Secondly we’re going to look at the economic changes as they impact in the economies. And thirdly, we can look at the market response to those changes, the central bank and government action.

So firstly on the pandemic, it’s quite clear that the lockdown is having an effect.

Where people are doing a proper lockdown you can see the curves flattening off quite dramatically. And that’s exactly what we need to see because that’s what pushes the number of beds in the healthcare systems back, decreases the demand for ventilators and means that potentially we can weather the storm.

The problem is a number of countries are not locking down, most notably the US, and you can see that actually their numbers are the worst of any economy in the world right now.

As I mentioned last week, there’s a choice that governments need to make and that’s about crushing the economy or letting lives go.

And ultimately what you have to do is crush the economy because then you’re saving lives. And that’s obviously what a government’s mandate is.

But you question what the US is doing now because they’re not moving to full lockdown. I think they’ve got a fifth of the population in lockdown and Trump is talking about actually rolling some of that back in the next few weeks.

Well, that’s exactly the wrong situation because you can see their numbers are getting materially worse.

The economic data we’re seeing are absolutely terrible. And that’s across the globe. We could be looking at unemployment rates at 25% up to 50% in some economies. We could see GDP falling 25 to 50% in Q2 or Q3.

Everyone’s expecting strong bounce-backs in the latter half of the year. But I really get worried about what happens if we don’t see those bounce-backs.

And actually what we see is an L shape recovery or a very, very drawn out slow recovery, which is in contrast to the strong bounce that everyone else is expecting.

Impact of government actions

So since last week’s video, we’ve seen numerous actions by the authorities.

We saw increased quantitative easing by the US Government and we saw massive quantitative easing coming out of the RBNZ in New Zealand.

We’ve also seen the huge fiscal packages coming out in the US which — depending on whichever market report you’re reading — could be somewhere between $2 trillion and $4 trillion.

There’s a massive degree in leverage that can be employed, so it’s very difficult to actually get a handle, but we know they’re trying to backstop a number of businesses from going under.

That’s really what these packages are aiming to do. They’re trying to stop small businesses going down.

Because the problem is, most of the economy — well over 50% of the economy in the US and well over 50% of job openings in the US — are small companies. They’re companies employing less than 50 people.

So if that sector dies out, which it’s very clearly at risk of doing, when we get on top of the pandemic and the fiscal pulse begins to move the economy, you’ll have no impact because there’s nothing left to stimulate.

So the focus of governments very clearly across the world is to try and support the small business sector. So when the bounce-back has the ability to happen, it actually is able to be seen in the economic data.

We have this clear policy by central banks to drive bond yields across the world to zero, and to hold them there. And you can expect they’re not going to be hiking rates for many, many years.

That’s why if you’re able to buy US 2-years around 30 basis points, that pretty much looks a very good deal. Because you know they’re going to trade to virtually zero and just stay there forever. So that’s 30 basis points you’re going to make there.

You can be long Aussie threes because you know the RBA’s backstopping you at 25 basis points.

So if you buy at any level above that, it’s a good trade, and arguably they’ll trade through that 25 basis points level and then ultimately curves will pancake across the world and all bond yields will be heading to zero.

So we’ve got that by central banks. But then on the other side we’ve got this massive fiscal policy that’s coming out across the world. They’re trying to backstop the economy by supporting the smaller companies and making sure that we can bounce back.

That’s the key thing to be aware of here.

Market reaction

So now let’s move over to markets and see how markets are taking these changes.

Well firstly we’ve seen a very strong rally in bond yields. Obviously on the first part of this down move in equities, we saw bond yields rally massively.

We saw 10-year treasuries on or about just under 40 basis points. They backed up to 115. They’ve rallied since then quite materially. And right now 10-year treasuries are at 78 basis points.

They should head towards zero sometime over the next six months to year as well.

So again, being long bonds is a key way we’re positioning in these markets.

Obviously we saw the US packages trying to support investment grade credit, and they’re flooding the system with liquidity. They’re supporting investment grade credit out to four years effectively — not loan forgiveness, but loan holidays, these kind of things.

I just want to be quite clear here. They’ve bought the market time, but there’s a big difference between impact in solvency, and impact in liquidity.

It’s quite clear that the liquidity issues that were very, very prevalent in the market have been largely dealt with by the packages the Fed’s done.

But all the Fed’s done is address the liquidity issues, they haven’t addressed the solvency issues which encumber a number of these companies.

And the reason they have solvency issues is they massively geared up their balance sheet over the last few years.

So we’ve seen this bounce in investment grade credit. High yield has bounced in sympathy with it, but still looks like it could sell off, and Emerging Markets still looks a little bit worrisome to us.

So we’re still sitting more on the nervous side. We’re defensively positioned here.

We do acknowledge the fact that the markets are oversold and with the amount of ammunition that’s being thrown at them by governments and central banks, there is a high likelihood we get a bit of a bounce.

Certainly into month’s end, as a large scale, rebalancing is going to happen.

But the three-to-six month view, we’re still nervous about the valuation of risk assets and we like being long bonds here.

THE world rightly remains focused on reducing the awful human toll of the COVID-19 outbreak.

But as investors we know the crisis will pass. We also know our decisions in this type of environment are critical.

In every crisis there are opportunities. But sorting genuinely good value from assets that have simply fallen in price is the key.

The equity market falls in recent weeks, extreme volatility in almost all financial markets and uncertainty about the future path of the COVID-19 virus and global economy certainly provides the crisis.

Identifying the opportunities depends on the investor’s risk appetite and time horizon.

But if you are investing for the long term – which is at least five years – and take a disciplined approach to handling your money, opportunities are appearing.

Equity markets around the world have fallen by between 20 per cent and 30 per cent in recent weeks.

Potential buying opportunities

Notwithstanding the fact that volatility in markets is likely to remain, there are some specific equity markets that we view as potential buying opportunities.

They are the ones that were relatively cheap going into the crisis and where there’s evidence that their home country is doing a reasonable job of flattening the COVID-19 curve.

We like some of the Asian equity markets. Japan is looking extremely cheap. Unlike US corporations, their Japanese counterparts were actually reducing debt levels coming into this crisis.

Korea and Hong Kong are also good value. These Asian markets look quite attractive for investors who look through the short-term volatility and respect long-term valuations.

Of course it won’t always be smooth sailing. No country is going to be insulated from the global economic downturn.

Real estate

Real estate investment trusts (REITs) have not shown as many defensive qualities as in a typical down-market over the past month.

The price index of A-REITs and global REITs have fallen back to levels seen in mid-to-late 2008.

Some A-REITs are relatively high-yielding and contain good quality assets. When we get through this economic crisis investors will be looking for yields better than those based on a 0.25 per cent cash rate.

Assets like REITs are going to become much more attractive again. For long-term investors, REITS will provide yield and give exposure to real assets.

Infrastructure

Listed infrastructure assets also typically show defensive qualities, but this hasn’t been the case in recent times.

Assets within the category are not homogenous. Airports have naturally been hit hard and so have some listed energy infrastructure assets.

Within infrastructure, we have invested in private-public partnerships (PPPs). They have experienced massive volatility which doesn’t make much sense particularly when some of them house essential services such as hospitals and have governments as counterparties.

In addition, we are taking advantage of better valuations to build exposure to renewable energy.

In the fixed income market, investment-grade bonds are an attractive asset class. Credit spreads — the difference between sovereign and corporate debt — are at 324 basis points.

Source: Bloomberg; Bloomberg Barclays US Agg Corporate Avg OAS

In essence, that means you can buy an investment-grade corporate bond and get 3.24 percentage points higher yield than a government bond.

Through history, including during world wars, actual default rates on investment-grade bonds are low. The current large credit spread provides an attractive opportunity for investors.

The last time spreads were at this level was during the global financial crisis.

But the investor needs to have a five-year time horizon and should not be looking for immediate returns. And of course, there are some lower-rated corporate bonds, such as those from energy companies, that are riskier than others.

There has been indiscriminate selling in many asset classes. It may reflect leveraged investors needing to get out of assets.

In such an environment, if you are active and nimble, it’s a very good market environment to invest in as long as you have the right long-term horizon.

Pendal MicroCap Opportunities Fund

Important Updates

Pendal MicroCap Opportunities Fund (APIR: RFA0061AU, ARSN 118 585 354)

Effective 26 March 2020, the Pendal MicroCap Opportunities Fund (Fund)’s buy-sell spread will increase from 0.70% (with 0.35% payable on application and 0.35% payable on withdrawal) to 1.86% (with 0.93% payable on application and 0.93% 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. 

Due to the impacts of COVID-19, investment markets have experienced substantial increases in volatility. For ASX listed micro capitalisation equities, this has resulted in higher trading costs.

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.

THE spread of COVID-19 is exacting a great humanitarian and economic toll across the globe.

At times of heightened uncertainty there is an even greater need for patient, active and transparent investment management to help clients navigate this challenging situation.

A key component of this investment process is stewardship, in particular engagement with investee companies.

An active engagement program is an important way to identify investment opportunities as well as manage risks.

Fundamental to this is a long-term focus – beyond the rapid velocity of market moves such as those now occurring in response to COVID-19.

At this time we want to continue holding companies to account while preserving value in a manner that is constructive and focused on the most material issues.

Often these include environmental, social or governance (ESG) matters.

Last year Pendal fully-acquired specialist ESG research, engagement and advisory team Regnan, to enhance our responsible investment and stewardship practices.

The wide-ranging social and financial challenges associated with COVID-19 highlight a number of important ESG topics which will continue to form part of our investment and stewardship practices in the coming weeks.

Here, Regnan experts share their view on how this crisis is impacting existing and emerging ESG issues:

What we’re looking out for

The COVID-19 crisis is unique because its implications are truly economy and society-wide.

Government, business and not-for-profits all experienced financial stress during the Global Financial Crises — but the current COVID-19 risks are more widespread.

This outbreak brings multiple challenges such as business continuity planning, workforce planning and supply chain disruption.

These are all aspects we are researching and raising with companies where we have concerns.

The current crisis is stress-testing these policies, procedures and overall governance, including with respect to ESG.

Here are some of the key areas to watch during the COVID-19 crisis:

Board function

Right now company directors need capacity – particularly in maintaining critical business services such as delivery of health care and medical supplies and non-discretionary consumer goods.

The economy-wide implications of the COVID-19 crisis elevate risks for most sectors, posing unique challenges for corporate leadership.

This will test individual directors to respond in ways that address immediate business challenges and longer-term strategy.

These are the types of circumstances Regnan has long considered a risk for companies with over-committed boards.

It may give further weight to the case for companies to mandate fewer board roles.

Management decision-making

How quickly and appropriately companies respond to the crisis will provide insight into company decision-making processes.

We watch for the companies that get on the front foot and mitigate business risks and those that fail to act quickly with necessary actions. This includes the less obvious interdependency risks.

Brand protection

Customer-centric strategies may come under strain as companies face competing pressures.

It is not clear how much any brand value created by a company’s response will translate into future loyalty.

But it is likely any major mishandlings will create reputational risk.

For example, the extent to which banks relax loan repayments for stressed businesses may have longer-term consequences for future business relationships, particularly in the Small and Medium Enterprise segment.

Unsurprisingly this is an area where we have already seen an industry-wide response, given the reputational strains already faced.

Supply chain

The temporary shutdown of supply routes, significant illness among employees, or pressures placed by panic buying will stretch supply chain management for a range of businesses.

Without careful business continuity planning this can elevate ESG risks.

For example, businesses may need to switch to lesser-known suppliers or sub-contractors that have not been through the adequate screening processes.

This raises the risk of lower-quality goods or failure to meet modern slavery or environmental performance standards.

Together with the recent Australian bushfires, the COVID-19 crisis provides lessons for longer-term issues we know are likely to bring supply chain disruption, such as physical disruption from extreme climate change events, either locally or offshore.

Will this make us do things differently?

There has been some discussion on whether the changed behaviours we are seeing with air travel and videoconferencing will lead to a change in practices once the situation passes.

Most of our meetings with company directors have been easily moved to the virtual world for example.

This will partly depend on how long the situation continues and the experience of users during this time.

In the meantime, it will be interesting to see how smoothly large corporates can continue with business-as-usual.

What’s next

Regnan will continue to factor these and other developments into our analysis during this unique time.

We will incorporate these into our company engagement program where material and we will continue to provide further updates on our observations and activities.

As history shows, crises are often associated with new regulation and technological responses along with changes in business and consumer behaviour.

Some of these changes are temporary (eg implementing working-from-home policies or re-tooling production lines to manufacture respirators and masks) while others may be more relevant to ongoing business practices (eg team-orientated communication tools or infrastructure solutions that provide care for elderly members of society – especially in countries with older demographics).

The combination of wide-ranging and rapid change with high uncertainty creates significant challenges – but also investment opportunities.

A disciplined, long-term investment approach focused on anticipating change is key to identifying these investment opportunities and delivering strong risk-adjusted performance.

Pendal’s investment teams have deep experience and insights formed over many market cycles.

Together with Regnan’s ESG analytical capabilities and engagement expertise, we feel confident in continuing to meet client needs despite these uncertain times.

We look forward to providing updates to our clients as this situation progresses.

In the meantime, please do not hesitate to get in touch with your Pendal account manager or learn more about Regnan here.

Investors with well-diversified, well-designed portfolios should stay the course amid the COVID-19 volatility, says Pendal Head of Multi-Asset Michael Blayney.

Michael explains why in this short video. Or read the transcript below.

Transcript

I’m going to provide you here with a brief update on our views on portfolio construction and current market conditions in light of the COVID-19 related volatility we are experiencing.

The first point is it’s always important to maintain a diversified portfolio and there’s multiple ways in which people can diversify their portfolios at a basic level.

It’s having both equities and bonds — but also within equities it’s having a blend of Australian and global equities.

Even though they might move together on a day-to day basis, over an investment time horizon of a balanced investor — which would be five years or more — they can provide substantially different returns over those longer-term time horizons.

In addition, it helps in a portfolio to have some alternative assets and also some foreign currency exposure.

The foreign currency exposure is usually achieved by holding a reasonable proportion of the global equities on an unhedged basis.

In the first part of the recent market correction that we have had, we saw that bonds provided nice diversification to equities with yields falling at the same time that equity markets were falling, resulting in capital gains for government bonds.

In the most recent leg of the market sell-off, we have, however, seen bonds and equities providing negative returns at the same time.

Now the key thing about portfolio diversifiers is they don’t necessarily always diversify in every market condition, so it’s important to have more of them.

And that’s why, for example, foreign currency has been extremely valuable — because the Australian dollar has continued to depreciate and this has helped to cushion the portfolio.

In addition, alternative assets can provide a degree of portfolio diversification as well.

We’ve seen mixed performance from alternative assets in the large selloff that we’ve had. However, even when negative returns have been achieved by the alternative assets, they have generally been better than equities.

So if you put together a portfolio of equities, bonds, alternatives and some foreign currency, that has smoothed the path of returns — even if they’re still negative for an investor.

Spreads on corporate bonds

We also note that in the current environment spreads on corporate bonds — which are essentially the excess yield that a corporate needs to pay to borrow in excess of the government — have widened quite a lot.

We now have spreads in investment-grade bonds, if you look at the US corporate index, of approximately 285 basis points. High-yield spreads also widened considerably.

If we look at the long history of investment-grade bonds, even through world wars, depressions, recessions and financial crises, default rates on investment-grade bonds tend to be very, very low.

So the spread that you get on investment-grade bonds is largely compensating you for what your liquidity is.

That’s a big part of the reason why spreads have blown out so much now.

While we may see some defaults come through, particularly in the energy and leisure sectors, the current buffer on offer on investment-grade bonds well and truly compensates for even an adverse default cycle.

If we were to, however, look at high-yield bonds, the default cycles there can be significantly worse.

And if we see significant defaults on energy, which represents a reasonable proportion of the high yield market, then the current spreads on offer might not be sufficient to compensate for that.

So we’d prefer investment-grade exposure in this environment.

Long-term valuations

While earnings and dividends will take a hit, the current market reaction has exceeded where we believe the impact on long-term valuations should be.

We think it’s probably about about double that impact.

Of course coming into this some markets were very expensive, for example the US. Whereas a lot of the Asian markets were already actually reasonably undervalued.

So some of those markets do represent extremely good value in the current market environment.

In addition, once the crisis eases somewhat and investors start to look around for ways in which they can generate returns on their assets, a quarter of a per cent official cash rate would most likely not be a particularly attractive return.

Even though we are likely to see dividends get cut on shares, the dividend yield on shares is likely to be significantly better than that very low cash rate.

Yields on corporate bonds — in particular investment-grade given those blowouts and spreads — are also likely to become attractive to investers again.

As a result, we believe that in this environment investors should stay diversified, increase exposure where appropriate to particular circumstances of a portfolio, and very much stay the course and do not panic.

We know that while it’s impossible for anyone to predict the exact bottom of a share market, if people do bail out after very large falls, that tends to be quite destructive to long-term wealth.

We know it’s far better to stay the course with a well-diversified and well-designed investment strategy.