The enormous economic shock resulting from the pandemic will exacerbate or accelerate the existing problems and imbalances facing many companies and countries. For investors, an even more granular approach will be required when choosing between winners and losers.
In this environment, ‘quality’ and ‘resilience’ are likely to become even more important investment themes, especially against the backdrop of an imminent profits recession and the certainty of rising defaults.
Quality as an investment attribute can be can sometimes be a nebulous concept – is it return on equity, balance sheet strength, market position, growth, or a mix of all these and others? What is clear is that companies that possess some or all of these traits have a chance of surviving and thriving.
Some of those that do not have already fallen by the wayside. The oil, retail, travel and leisure industries are among those hardest hit. These are sectors where structural problems have been debated for years. As ever, leverage has added to to the problems. Companies in the S&P500 (ex technology) index, for example, had more debt on their balance sheets than at any time for a quarter of a century. This leaves a little less room for manoeuvre, given structural challenges, never mind the global recession that we are hurtling towards.
In the UK, the likes of Flybe, Oasis and Debenhams have entered administration or bankruptcy. All were in sectors where we have been debating overcapacity, structural change and increasing competition for years – and so more examples an acceleration of existing trends.
Like these companies, many individuals, and organisations have little scope to borrow any more. We have described the impact of the virus as a “re-leveraging event”. In other words, an event that will require many individuals, companies and indeed countries to borrow more.
However, even if they could afford to, it’s unlikely they would all find available credit. In March, some of the more leveraged areas of the bond markets, such as high yield and some areas of emerging market debt were effectively closed at points in March. But even when they opened the rates being offered were higher than many would like (or indeed afford).
Pleasingly the equity markets are the markets that are generally always open – but in these sorts of periods not at prices or terms that will please Finance Directors, or existing shareholders in some of these more challenged sectors of the economy.
The damage wrought on company balance sheets by Covid-19 is being reflected in the harm done to the global economy. We think economic growth will fall by c.10% this year – a number that dwarfs the global financial crisis (GFC) and bears a more striking resemblance to the depression of the 1930s. Our forecasts also confirm an expectation of permanent damage to the global economy – not just growth postponed.
Resilience will be rewarded
This is not a particularly pleasant backdrop from which to consider the landscape beyond the virus. So where should investors look?
It would seem likely that economic and corporate resilience will continue to be rewarded for some time to come. It is interesting that the poster child for excess in many of its forms in the Global Financial Crisis, the banking sector, has looked like a paragon of virtue in this crisis.
A decade of sometimes painful rebuilding of balance sheets has left the sector being seen as part of the solution, rather than part of the problem. Our investments in bank debt continue to serve us well – bondholders being rewarded for the prudence of chastened managers over a long decade.
There are many companies who may be wishing that they had built in a little more resilience over the past few years. Many more will have to start now. Whether shareholders wish this or not, broader society will surely question some of the just-in-time business models and capital structures that have relied so much on leverage.
From a market perspective, the impact of the virus has, as I noted above, so far, acted as an accelerant of existing market trends. One trend that has been all-prevalent since the financial crisis is that of “growth” over “value”. Investors have spent the last 10 years awaiting the re-awakening of ‘value’ .
But in a world where growth is increasingly scarce, it is prized even more highly by investors. With the expectation that government bond yields will be lower for even longer, the discount rates used to value future earnings has fallen. Investors are therefore willing to pay even more for the prospect of some earnings growth.
Hence the tech-heavy Nasdaq index is almost unchanged on the year, as more value-heavy markets are buffeted by the collapse of earnings expectations and the disappearance of dividends, two of the main planks of the value argument.
The growing importance of ESG
There are many other issues that the economic, market and societal consequences of the virus will throw up.
There are many other issues that the economic, market and societal consequences of the virus will throw up. The role of the state, ‘fair’ tax rates, globalisation, the environment, healthcare spend, to name but a few. However, the thread that runs through all of these areas is environmental, social and governance (ESG). It seems certain that this will be one of the most significant accelerating trends.
How companies behave, as members of the communities from which they draw their staff and customers, has rarely been under more scrutiny. How they treat the broadening list of stakeholders who have a charge over their cashflows and behaviour is also a matter of increasing debate.
The ‘experiment’ of the silencing of the internal combustion engine and the grounding of the airline fleet is one that could only have been dreamt of by the most ardent environmentalist But its impact in terms of clean air and the clearing of vistas around the world not seen for decades is not going to be forgotten.
How investors also behave as owners of equity and debt – both public and private – will also be under scrutiny as never before. How we work with the companies in which we invest in order to help them thought this unprecedented period will be remembered long after the virus has passed. All these areas are facets of what ESG means. It was important before the virus, and it will be even more so after it.
Unfortunately, we are still in an early chapter of the economic and market story of the coronavirus. However, it is already clear that its impact will be far-reaching, potentially affecting areas we have not yet considered. This uncertainty further highlights the requirement for resilience.
In discussions with colleagues portfolio managers and clients before the virus, we talked of the necessity to have portfolios that could survive the bumps in the road that we could see, but also the bumps in the road that we couldn’t. We didn’t quite expect the yawning crater in the road that we are currently navigating. Nevertheless, that advice stands true today more than ever.