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Which will remain in 12 months' time - the Covid-19 pandemic or the effects of the stimulus?

Asia Analytica
Asia Analytica4/17/2020 06:30 AM GMT+08  • 8 min read
Which will remain in 12 months' time - the Covid-19 pandemic or the effects of the stimulus?
Historically, analysts have never been very good at revising down earnings estimates, especially during crises. Worse, the current health crisis has no precedence for guidance.
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(Apr 17): Global stock markets appear to have stabilised somewhat from the Covid-19 pandemic-induced freefall, from late February to the better part of March. The Dow Jones Industrial Average fell more than 38% from its peak on Feb 12, ending the longest bull market in US history. Since the lows on March 23, however, the closely watched bellwether index has rebounded smartly and quickly, gaining 29%. The broader Standard & Poor’s 500 index charted a similar course.

The question on every investor’s mind must now be, “Have markets seen the worst, or is this a dead cat bounce boosted by short covering?”

The rebound was driven, in part, by encouraging statistics on a slowing in the number of new cases in some of the worst-hit countries such as Italy and the US state of New York — raising hopes that the pandemic is nearing its peak.

Investors were also reassured that governments and central banks are willing to do whatever it takes to protect economies and support financial markets. Case in point: On April 9, the US Federal Reserve authorised the injection of an additional US$2.3 trillion ($3.3 trillion) into supporting small businesses and local governments, even expanding its asset purchases to include non-investment grade bonds — the latest in a slew of measures to backstop the economy.

On the other hand, we suspect that markets have yet to fully comprehend the magnitude of the impact on corporate earnings.

There is no question that earnings results for the next two to three quarters will be very ugly — uglier than prevailing market consensus forecasts. And the actual earnings results could shock the market into fresh waves of selling.

According to the latest data compiled by data provider, FactSet, earnings for S&P 500 companies are set to fall 8.5% this year. That appears far too optimistic. It is quite likely that most analysts have yet to revise their earnings forecast simply because they do not know how to. Companies themselves are offering little new guidance after pulling their previous estimates.

The managements of McDonald’s Corp and Starbucks Corp did offer some clues. McDonald’s said global same-store sales fell 22.2% y-o-y in March, whereas Starbucks forecast a steep 47% drop in earnings for the quarter ended March 2020. And that is not its worst quarter yet. The company warned that the financial hit from the coronavirus pandemic would extend into the third quarter of 2020.

Historically, analysts have never been very good at revising down earnings estimates, especially during crises. Worse, the current health crisis has no precedence for guidance.

There is no clarity on when the outbreak will peak globally nor an accurate timeframe for the phased reopening of economies, the extent of the impact on the global supply chain and the pace of jobs recovery.

Critically, no one knows how safely businesses can restart, and whether it will trigger a second or third wave of infections that would require another lockdown. Neither is there much visibility on how long it will be before consumers feel confident enough to return to their pre-outbreak daily lives and for businesses to resume investments.

As difficult as it is to forecast the level of revenue/sales, it would be even harder to estimate profits. The latter is further complicated by operating and financial leverages as well as cost-savings measures, all of which will differ from company to company.

In short, given the magnitude of prevailing uncertainties, any earnings and growth forecast for 2020/21 is a mirage. This makes any asset allocation decision — whether in terms of country, sector or stock — based on the usual valuation metrics a fool’s errand.

For instance, forward price-to-earnings ratios — which is the current share price divided by estimated earnings per share — would probably be as accurate as throwing a dart blindfolded. Other valuation metrics such as comparing the PER to estimated growth, discounted cash flows and dividend yields are similarly problematic. They are all derived from earnings forecasts.

Risk premiums (discount rates) are distorted by the rush to safety. US Treasury yields are near record lows while credit

spread for the rest of the world, and especially emerging markets, are sharply higher despite low interest rates. For example, bond yields for emerging-market banks and corporates have surged.

Even historical dividend payments are no guide for forward dividends, especially if cash flows come under extreme strain. Companies should, rightly — and some have already announced they will — cut dividends to conserve cash.

And comparing current valuations against historical ranges or betting on reversion to mean — when the operating and financial environments have been completely upended — would be like comparing apples and oranges.

Investors are probably better off simply looking beyond 2020/21 and using the normalised historical earnings and growth as a base to make their investing decisions. One must, however, also take into account any longer-term impact — from the Covid-19 pandemic — on the underlying business models. For instance, some enforced behavioural changes are likely to persist after the outbreak, such as e-commerce, digital payments and virtual banking, remote working and migration to cloud. We wrote about this subject in our article two weeks back.

PERs will probably remain elevated as earnings are revised downwards over the coming weeks and months — because markets are, by nature, forward-looking. That said, the odds are that we should brace for more short-term price gyrations.

Judging from recent developments, including in Japan and Singapore, the outbreak and some degree of restricted movement could drag on for far longer than we had previously anticipated.

It really is impossible to predict shortterm market movements, and more so when they are predicated on the coronavirus, of which much remains unknown. Historically, all market bottoms are only clear in hindsight.

We are fairly confident, however, of the market outlook in 12 months’ time. As we said before, there is light at the end of the tunnel.

The world would have by then, quite likely, found a vaccine. It will be mass-produced and widely available. Even if the Covid-19 is endemic, it would pose no more risks than the seasonal influenza.

The expansive fiscal and monetary stimulus, however, will still be felt and creating strong ripple effects globally. Indeed, we would expect to see fresh rounds of fiscal spending after the outbreak is under control, this time to focus on restarting and stimulating economic activities as compared with current aid to preserve productive capacities and livelihoods. As such, it is our intention to keep the Global Portfolio fully invested.

That said, we are switching it up a bit. This week, we pared some of our holdings in homebuilder Lennar and building materials stocks BMC Stock Holdings and Builders FirstSource as well as The Boeing Co.

The expected sharp rise in unemployment and provisions that allow homeowners to request forbearance on their mortgages create uncertainties on the liquidity of mortgage servicers. These mortgage servicers are key to the health of the housing market, originating about 60% of all mortgages in the US. In addition, JP Morgan was the first, but unlikely the last, big bank to raise lending standards for mortgages — thus making approvals more difficult — to manage risks amid heightened uncertainties.

Both of the above factors will result in overall tighter liquidity for mortgages. Positively, Fed chairman Jerome Powell said in a recent interview that the central bank was closely monitoring the situation and would step in to provide emergency funding, if required. The Fed is already committed to buying an unlimited amount of mortgage-backed securities.

But it could still be some time before the housing market returns to pre-outbreak health. Some 16.8 million Americans, or about 10% of the workforce, filed for unemployment benefits in the past three weeks alone — far dwarfing the total job losses of 8.7 million during the Great Recession. For perspective, a total of 24.8 million jobs was created in the last 10 years.

Given that most home builders and building material companies have relatively higher leverage on their balance sheets, we decided to pare back some risks. It is prudent to pivot towards larger-cap stocks and high-quality names with strong balance sheets. We reinvested part of the proceeds into relatively defensive healthcare giant, Johnson & Johnson. The stock did well, gaining 5.2% from our cost.

The Global Portfolio recovered another 6.3% for the week ended April 16, mirroring improved sentiment in global stock markets. All the stocks in our portfolio registered gains last week, save for BMC (-5.7%) and Builders FirstSource (-2.5%). Apple (+9.6) and ServiceNow (+12.8%) were the top gainers.

The total portfolio value now stands at just -0.7% since inception. By comparison, the benchmark MSCI World Net Return Index is down by 2.6% over the same period.

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