InvestmentEurope is providing ongoing coverage of responses from the fund industry to developments linked to the spread of Coronavirus.
10/3 1045 UMT - Don't blame Covid-19 for poor cashflow
Robert Almeida, global investment strategist at MFS, has commented:
"Investor apprehension over the coronavirus outbreak peaked during the last week of February. As a result, assets de-rated while sovereign bonds, despite many carrying negative yields, re-rated. During the volatile week and throughout the following weekend, there was a surplus of market opinion and prognostication about what would come next, ranging from lowered economic and profit estimates to calls for central bank stimulus and a coordinated fiscal response from world leaders. I, unfortunately, lack the clairvoyance that others seemingly possess in forecasting these events. I can, however, offer our perspective on the situation, rooted in corporate fundamentals and derived from our global research platform.
"Before the market drawdown began, US equity valuations, on a simple price-to-earnings basis, neared the top quintile historically. Similarly, global investment-grade and high-yield corporate bond spreads, on a yield-to-worst basis, were in the top quartile. It was the same across multiple richly priced asset classes. I would characterize these as above average, if not high, valuations.
"While valuation is a critical component of successful investing, it's only part of the calculus. Investing is allocating capital to a company or institution in exchange for a return stream commensurate with the risk taken. In other words, investors must weigh the quality and probability of the cash flow stream that the business or project promises to generate against the potential for an undesirable outcome.
"As I have argued, while every capital cycle is unique, cycles follow consistent patterns. As a cycle matures and confidence grows, the supply of investment opportunities is at some point unable to meet the demand from return-hungry investors. At that point, on balance, investors overestimate market liquidity, underestimate risk and overpay for cash flows.
"We can debate whether pre-selloff valuations levels in mid-February were excessive. But valuation is more of an art than a science. It reflects what someone is willing to pay, and everyone's framework is different. More important, our perspective has been that the quality of cash flows investors have been receiving in exchange for the use of capital has been below average. Our equity and credit analysts have been concerned by the decreasing durability of cash flows globally (margin, profits and EBITDA, for example) given that much of this cycle's apparent profit strength has been generated by cost cutting, balance sheet financialization and working capital enhancements. More businesses have been employing creative accounting, and fewer have been driving margin and cash flows via normal business operations, such as selling more widgets or raising prices.
"Our view has been that investors should shift their approach to portfolio construction from one that does not discriminate to one that is selective, specifically, by seeking to avoid companies whose deteriorating earnings quality can no longer be hidden. We think there will be scarcity value for the stocks and bonds of companies that are able to deliver consistent cash flows. Those are the securities we want to own.
"I don't know how central bankers or politicians will react to Covid-19, lowered economic projections and other looming headwinds. But can any action by policymakers improve what we believe is the below-average-quality cash flow being generated by the run-of-the-mill asset today?
"The markets are blaming the recent shift in market sentiment on the coronavirus. But is that the whole story? Or has the virus outbreak revealed to all what we've been pointing out for some time: that investors have been paying an above-average price for below-average return potential? Asked another way, did the market underappreciate the risks companies were taking until they were tested by adverse conditions? We believe it did."
10/3 1040 UMT - Oil & Coronavirus woes
François Rimeu, head of Multi Asset & senior strategist at La Française AM, has commented:
"At the time of writing, the price of oil is down -18% since Friday's close and following the decision of Saudi Arabia to start an oil-price war. In terms of demand / supply chock, this is maybe the worst configuration for the oil market since the 1930s. The IEA said that there is already a surplus of about 3.6 million barrels a day and we estimate this oversupply could rise to more than 5 million barrels a day during the second quarter.
Consequences:
- Very negative for shale oil producers in the US; we estimate their breakeven price to be between $45 and $50. The December 2020 future is currently trading at $37, meaning that most producers will not be able to survive should the price remain close to those levels. Consequently, this is also very negative for US high Yield with US High Yield Energy companies representing around 12% of the segment.
- Very negative for break-even inflation expectations obviously.
- Very positive for G7 bonds: This is one of the main reasons of the sudden drop is G7 rates today.
Over the medium-term, we can also see some positive effects, especially for European countries importing most of their oil consumption."
10/3 1040 UMT - What's in store for UK Equities?
Laura Foll, UK equities portfolio manager at Janus Henderson Investors, has commented:
"There are now two concerns for global equity markets - a potential global epidemic causing a simultaneous demand and supply shock, and an oil price supply shock. This is causing heightened volatility in share prices as the market attempts to quantify multiple moving parts - does a company have supply chain exposure (either theirs or third party) in China and/or Northern Italy that is being disrupted? Will demand be severely impacted (for example is it a travel and leisure company? Is it substantially reliant on tourist demand)? Does it have any material exposure to oil & gas (either in its own operations, or if it is a financial company, does it have any material lending exposure to oil & gas)? All of these questions are complex and the market's response for now is sell first, work out the reality later."
Possibility of a demand-led recovery in UK equities?
"We do not know how long the impact of the Covid-19 coronavirus will last, or how widespread it will become geographically. Nor do we know how long the oil price will stay at these levels. However, monetary policy is already very loose, fiscal policy may be about to become looser (the UK Budget is just around the corner at the time of writing) and we now have a very low oil price. All of these factors put together could, when the virus is seen to be easing, result in a substantial demand-led recovery. This could come at a time when many industrial companies, because of the fall in manufacturing activity last year, have already had to substantially reduce costs. Therefore the drop through from sales to earnings when a demand recovery happens could be substantial. Corporate debt levels across the majority of companies in our portfolios have remained conservative - lessons have been learned since the Global Financial Crisis and many management teams have continued to be cautious of taking on too much debt. Capital spending has been kept low and the focus has been on cash generation."
"Our response is to do little in the current volatility, but to add in small size to those companies that we know well, have been following for a long time, and where we think the share price reaction looks extreme (recognising that there may well be earnings downgrades but we are investing on a multi-year view)."
Sustainability of dividends via diversification
"From the perspective of managing income funds, the other question in the coming weeks will be around the sustainability of dividends. We think the best approach in this environment is to diversity among income payers. There will naturally be questions about the sustainability of dividends within oil & gas companies (Royal Dutch Shell and BP, for example). However, there are companies that may benefit in this type of event such as pharmaceuticals, utilities and non-life insurers. Across all of the portfolios that we manage we are materially less reliant than the benchmark (the FTSE All-Share Index) on the dividends of major oil & gas companies. This may prove beneficial against dividend cuts in this uncertain environment. Within all of the investment trusts we also have revenue reserves that could be used to smooth dividends in this type of ‘rainy day' event."
10/3 1020 UMT - Coronavirus, market conditions, and long-term opportunities
Rob Arnott, chairman, and Chris Brightman, CIO at Research Affiliates have commented via video. To view it visit: https://www.researchaffiliates.com/en_us/insights/coronavirus-market-conditions-and-long-term-opportunities.html?evar36=eml_coronavirus-video-hero-cta&_cldee=am9uYXRoYW4uYm95ZEBvZG1wdWJsaXNoaW5nLmNvbQ%3d%3d&recipientid=contact-144204da0079e61196c9005056bc3cff-729c5226aedb480da2acd9e8c5e4c096&esid=26defa01-6662-ea11-80e9-870ad18a4adf
