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Investment Outlook Q2 2020

23rd April, 2020

The persistence of low interest rates in the years since the Global Financial Crisis (the ‘GFC’) has caused investors to wonder what firepower central banks would have to fight the next recession. Coronavirus (COVID-19) has brought a recession to the global economy at a speed and severity that has not happened in living memory. It has also answered the question of firepower – a lot more of the same from central banks, and huge, targeted fiscal support from governments. 

The Fed goes unlimited

Ordinarily, massive fiscal stimulus requires massive debt issuance down the road, and bond yields should be rising in anticipation. But in these extraordinary times, central banks have committed to buy colossal quantities of these bonds for their own balance sheets to keep interest rates low. Lest anyone doubt their resolve, the US Federal Reserve (the ‘Fed’) went a few steps further than it had in the GFC.

On 23rd March, just before markets opened in New York, the Fed announced sweeping measures to support the financial system. The Fed would buy unlimited amounts of Treasuries, mortgage-backed bonds and, for the first time, would buy corporate bonds directly from companies and in the secondary market. It was the Fed’s “whatever it takes” moment, but the equity market fell by almost 3% on the day. Equity investors’ attention was elsewhere, fretting about bipartisan wrangling over a fiscal support package. 

By the following morning, it emerged that a bipartisan deal on a monumental $2trn fiscal stimulus package was close to being agreed. The news drove the S&P500 up 9.4% on the day and helped underpin global equity markets. 

Jobless surge

While the Fed’s backstopping of the financial system is of huge importance, there is an urgent need to get money directly to employees who are being laid off in their millions. Some of the $2trn package will send cash directly to households and some will boost unemployment assistance. The equity market’s indifference to the Fed’s announcement and embrace of the fiscal package reflected the reality on the ground.

The surge in US layoffs is the most startling economic effect of COVID-19 so far. The speed and size of the layoffs reflects the extent of the current lockdown measures, with over half of the US population under restrictions. By February 2020, US unemployment had hit a 50-year low of 3.5% before the lockdowns resulted in almost 10 million people claiming for unemployment benefit in just two weeks. 

While using fiscal policy to support incomes is the right policy response to alleviate hardship in the current environment, lockdowns result in supply constraints which are making it harder for consumers to spend if they chose to. As restrictions are relaxed, economies will recover, and activity will rebound.

Asian rebound

In the first quarter of 2020, China’s economy is expected to have experienced its first quarterly contraction since 1976. As lockdowns come to an end, recent PMI data suggest that a recovery is underway in manufacturing. The speed of that recovery will depend to some extent on demand in the rest of the world recovering, which will not happen before restrictions are lifted.

A recovery in China’s domestic economy would be helpful to other trading partners in the region such as South Korea, whose country managed to control the outbreak without lockdowns.
For reference, the Wuhan lockdown began on Jan 23rd and ended after 11 weeks on April 8th. In relation to other lockdowns, Wuhan’s started 46 days before Lombardi and 60 days before New York city.

Europe’s divisions

 “We are not here to close spreads.” With those words, European Central Bank (‘ECB’) President, Christine Lagarde sent Italian bond yields higher at a time when Italy was struggling to contain its COVID-19 outbreak. Ms Lagarde was referring to the interest rate spread that Italy borrows at relative to Germany. COVID-19 has revealed once again the deep divisions within Europe about how to respond in a crisis, particularly regarding debt. 

It took the ECB less than a week to announce that “there are no limits to our commitment to the euro.” That statement accompanied the announcement of a €750bn Pandemic Emergency Purchase Programme (PEPP) to buy public and private sector debt, with a promise to increase to scope of the programme “by as much as necessary and for as long as needed”. Less than a week after her original comment, the ECB’s package succeeded in closing the Italian spread after all.

Figure 1. 10 year Italian Bond spread over 10 year German Bunds
 
Source: Davy Global Fund Management and Bloomberg as at 10th April 2020


The ongoing concerns in the eurozone “core countries” about budgetary restraint have been set aside as individual countries have brought forward packages designed to provide short-term relief.

Equity markets 

Of the four pillars within our QUALITY* framework, Profitability, Persistence, Protection and People, the Profitability pillar performed best during the Feb-Mar drawdown. In past dislocations, such as in Q4 2018, Protection outperformed. We believe this time around, the market has favoured companies with stable long-term profit records over cyclical stocks. This has been reflected more broadly in the sector performances, with Consumer Staples, Health Care and Technology outperforming, while Energy, Financials and Industrials have lagged.

Dividends in the firing line

We regard the return of excess capital to shareholders as one of the marks of a QUALITY company. The sudden and severe nature of the current economic crisis means many companies will have no choice but to cancel or defer dividends and stop share buybacks. In some countries, there are calls for companies receiving government support to suspend returns to shareholders. 

Financial regulators in many European countries, mindful of the damage the recession might have on regulatory capital, have advised banks and insurers against paying dividends in the current environment. The ECB has requested eurozone banks to suspend dividend payments until at least October so that the impact of COVID-19 on banks’ capital positions can be evaluated. 

The European Insurance and Occupational Pensions Authority (EIOPA) advised insurers to do the same. While EOPIA has no power to enforce this recommendation, some national regulators have mandated it while others have not. 

The inconsistency in the application of the recommendation has frustrated some European management teams. Axa’s French regulator agreed with the EIOPA recommendation, whereas Allianz’s German regulator has not required it to cancel its payout. Axa’s CEO, Thomas Buberl, told the Financial Times that “it is difficult to accept that we live in a common Europe”.  

During the GFC, financial companies were the epicentre of that crisis, and cutting dividends was an essential move to preserve long-term equity value for regulators and shareholders. In the current environment, we believe it makes sense for them to defer payments until the effects of COVID-19 can be assessed. Our preliminary analysis of dividend cancellations suggests that companies further down our QUALITY rankings have been first to cut.  

Sticking to the plan

The COVID-19 pandemic is first and foremost a medical crisis, which highlights the importance of health care systems to our economies. The use of lockdowns and restrictions to “flatten the curve” has been implemented to protect these health care systems and save lives. In turn, the unprecedented financial packages put in place across the globe have been designed to support economies as these restrictions remain in place. 

As the outbreak is brought under control, restrictions will be lifted, and economic activity will recover. Nobody can tell what the trajectory of that recovery will be, but the monetary and fiscal supports to companies and workers are significant.

There has never been so much uncertainty heading into a quarterly earnings season, and company managements will find it difficult to give guidance for the rest of the year. This may bring some further volatility in share prices in the weeks ahead.

We believe at times of elevated uncertainty clients should stick to their financial plan. As asset managers, we have an investment process focussed on QUALITY, which is guiding us through the current crisis. It is helping us to identify mis-priced opportunities.

These are companies that fit with our QUALITY approach and are run by management teams who know how to allocate capital in shareholders’ long-term interests. We believe QUALITY companies, with proven business models, that manage their ESG risks will survive the current downturn and recover quickly when the pandemic passes.

 

*Davy Asset Management - “Quality Matters” White Paper – Chantal Brennan, Paraic Ryan, Hannah Cooney: 2016. Available on request.

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