Investment Outlook July 2020
16th July, 2020
At the time of our last update in April, equity markets were rebounding following the introduction of extraordinary support packages from governments and central banks. That rally has continued through the second quarter resulting in the strongest quarterly return for the MSCI World Index since the dot-com bubble of 1999. What has driven the rally, and can it be sustained?
The weighing machine
The recovery from the March lows has occurred despite collapsing profits and is testament to the equity market’s role as a discounter of future earnings. The move can be explained by a powerful combination of the expectation of a quick recovery in earnings following the easing of lockdowns, and the realisation that the discount rate applied to those earnings is likely to be lower for a lot longer than previously thought, which all else being equal, would justify higher equity prices.
The MSCI World Index is currently trading on a one-year forward P/E multiple of 20.2 times, well above the average of the past 20 years. But the market rarely puts a low P/E multiple on what are perceived to be trough earnings. Investors anticipate a recovery in earnings in the second half of the year and are looking through what is expected to be a short-term dislocation due to Covid-19. The upcoming earnings season may give investors some clues as to whether this expectation is justified.
Figure 1. MSCI World Index 12-month P/E ratio
Source: Davy Global Fund Management and Bloomberg June 2020
The source of much of the uncertainty surrounding company earnings has been the refusal of many companies management teams to give any guidance in the current environment. According to Factset1 investors expect S&P500 Q2 earnings to fall by 43.9% compared with the same quarter last year, which is the largest year-on-year fall since Q1 2008. This would suggest that a lot of bad news is baked into current prices. As we receive updates from companies in the weeks ahead, the market will be sensitive to any evidence of the recovery in revenues and profitability following the easing of lockdown restrictions. The V-shaped recovery thesis will be tested during this earnings season as companies describe the reality on the ground.
Lower for even longer
Whatever shape the earnings recovery turns out to be, the discount rate being used to value those earnings is unusually low. This rate has been falling in recent years as the general level of interest rates has also fallen, and now it seems that central banks are determined to keep rates low for the foreseeable future - only two Federal Reserve officials expect US interest rates to increase before the end of 2022.
For the time being, the Fed’s credibility with investors is not in doubt. It has not even had to use the firepower set aside for asset purchases to bring corporate bond yields down; private investors have stepped in and done that job for them. As long as these buyers believe that the Fed will step in and purchase bonds if interest rates start to rise, then rates will remain low. The same is happening in the eurozone with the ECB as the big buyer.
Maintaining rates at these levels is important given the massive expansion of fiscal deficits across the globe due to Covid-19. While the Federal Reserve may not yet have explicitly committed to so-called “yield curve control”, whereby it sets a target yield level and then buys whatever amount of bonds is necessary to keep rates at that level, the market is acting as if it has.
But what of all the debt that is being piled up due to the fiscal response to COVID-19? Our colleague Oliver Sinnott has written recently 2 about “financial repression”, a policy in which interest rates are deliberately kept below the level of inflation in an economy in order for debt to be “inflated away”. At current interest rates, even a modest level of inflation will gradually eat into the debt pile.
This approach is not without danger in the longer term. When the cost of debt is crushed to current levels, zombie companies can remain afloat, distorting competition and pricing in various sectors and driving down long-term returns on capital. Bank profitability can also be harmed as interest margins come under pressure from ultra-low rates. However, from a political point of view, this policy is far more palatable than raising taxes or cutting spending in order to balance the books.
Dividends under pressure
The meagre expected returns from bonds in recent years have made certain equities seem attractive from a yield perspective. However, the speed with which dividends have come under pressure since the Covid-19 crisis started has surprised many. As early as March, the ECB ordered euro area banks not to pay dividends or buy back their own shares until at least October of this year in order to assess the impact on their capital of the lockdown measures. The Bank of England has also requested that UK banks hold off on dividend payments until the end of this year.
Until recently, US financial companies had been under relatively little pressure to curb payments to shareholders in contrast to their European counterparts. However, following its most recent stress test analysis of US banks, the Fed has asked that share buybacks be suspended and banks limit dividend payments to the level paid out last year. Dividend payments should also be linked to the level of earnings that banks make. As a result, any bank that suffers losses during a quarter may be forced to cut or even omit a dividend payment altogether.
The regulatory focus on bank dividends is understandable given the uncertainty around the financial health of many borrowers and the potential for a slower-than-expected economic recovery. One would expect that cyclically-exposed sectors, such as Industrials and Consumer Discretionary, would be most at risk from dividend cancellations, and our analysis shows this to be true. However, our investment process focusses on QUALITY* companies with strong balance sheets and we expect this will help us avoid many of the dividend cancellations due to Covid-19.
By our analysis, companies that score better on our measure of QUALITY have had fewer dividend cancellations so far than those that score less well. Within the broad MSCI World Index, 1,316 companies are classed as dividend payers. 14% of those have cancelled dividends this year. The average QUALITY rank of those that have cancelled dividends is 54% as compared to 38% for those that have not (lower percentile means higher QUALITY). The largest number of companies cancelling dividends can be found in the Consumer Discretionary sector, followed by the Industrials sector. The Utilities sector has had the fewest cancellations this year. This pattern shows the pressures of cyclical exposure in the current environment.
Figure 2. Average Davy QUALITY rank of companies that paid or cancelled dividends
Note: A lower percentile means a higher Davy QUALITY rank
Source: Davy Global Fund Management as at 30th June 2020
A medical solution to a medical crisis
This equity market rally has been based on expectations of a recovery in the earnings cycle, coupled with the massive supply of liquidity that has forced down interest rates around the globe. There have been just a few corrections in equity market momentum since the low on 23rd March. Those that have occurred have been reactions to news of surges in Covid-19 cases, particularly in some US states following the easing of lockdowns. Dr. Anthony Fauci, Director of the U.S. National Institute of Allergy and Infectious Diseases, has said that the rate of daily infections could rise to 100,000 per day in the US from its current record rate of c.55,000. This is causing lockdown measures to be reinstated, potentially putting the economic recovery at risk.
These developments have re-focused the spotlight on the medical response to the virus. The World Health Organisation (WHO) has said that there are currently 16 groups trialling potential vaccines and many more are in the development stage. Many of those running trials claim to have produced neutralising antibodies in patients and are moving to much larger-scale trials involving thousands of volunteers. This is encouraging news in light of some of the setbacks we have seen in recent weeks.
Central banks and governments have done much to tackle the economic fallout from Covid-19. The weeks and months ahead will demonstrate how effective those policies have been. Ultimately though, it will be the development of a safe and effective vaccine that assures a sustainable recovery.
1John Butters 26th June 2020, Factset: Earnings Insight
*Davy Global Fund Management - “Quality Matters” White Paper – Chantal Brennan, Paraic Ryan, Hannah Cooney: 2016. Available on request
WARNING: Past performance is not a reliable guide to future performance. Investments may go down as well as up. Some figures are forecasts, which are only estimates. They should not be relied upon to make investment decisions.
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