In one word, MESSY – there will be a lot of dispersion at a single stock level. This will continue to reward investors and traders that take a more active approach relative to passive index investing, with bottom up stock picking set to shine in terms of generating alpha.
Investors have been very much flying blind with respect to how the pandemic is affecting companies bottom lines. We have seen with the sharp recovery off of the March lows for risk assets, the ASX 200 has rebounded 33%, that investors have been happy to look through the collapse in earnings resulting from COVID-19 induced demand and supply shock, so in many ways the company guidance will be a lot more important that the numbers themselves.
The stock market is not the economy, the real economy and nascent recovery is vastly different to the speculative advance seen in risk assets. G5 Central Bank balance sheets have expanded at a rapid pace, well beyond measures taken in prior downturns, as the spectres of crises past has seen policymakers committed to flooding the world with liquidity. Alongside no shortage of central bankers proclaiming a “whatever it takes” mantra, actions to date have proved successful in detaching risk asset pricing from fundamentals. 20% of all US firms have debt servicing costs higher than their profits according to Deutsche Bank research, its zombie company galore! A recovery that lags expectations, a true 2nd wave of COVID-19 with lockdowns re-imposed once colder weather returns in the Northern hemisphere, fiscal cliffs, persistently high unemployment, geopolitics – any number of downside risks will be met with action from Central Bankers who have already exhibited their pain threshold is relatively low. The lack of alternatives driving price discovery to the wayside and greenlighting yield hunting behaviours. Valuations have been exposed to a long run shift as current ZIRP/NIRP interest rate dynamics skew the risk vs. return proposition. With investors attempting to escape the secular stagnation that accompanies the present era of financial repression and state capitalism via the valuation premium provided by earnings duration, growing free cashflow and high forecast future cashflows in secular growth sectors, essentially meaning “value” can be found in growth. Hence the perpetual bid for seemingly infinity bound momentum and growth stocks, with earnings duration pathways boosted by record low rates set to extend for years to come. However, despite these concurrent dynamics which will persist for an extended period, the margin for error provided in current valuations is slim and expectations are running high for growth stocks (readily dominating technology/healthcare sectors). This means there is still an onus for delivering on those lofty embedded expectations. Although we believe the companies leveraged toward these secular growth thematics will outperform in the medium/long run, valuations and excessively one sided positioning make us tactically cautious with respect to entry or increasing allocations at present. In other words don’t buy growth at any price!
We know the upcoming reporting season will be a shocker, at the index level EPS are forecast to drop ~15% vs. FY19, but this is not unexpected, what happens next is far more important!
Uncertainty - Company outlooks will draw far more attention than usual over the numbers themselves, although there will be less companies offering guidance than usual. The problem with the root cause of this crisis being a global pandemic, there remains a huge amount of uncertainty as no one, not even the epidemiologists can tell us definitively how this plays out, and some experts are on record saying it could be 2 years before a vaccine can be successfully implemented. There is still a lot of uncertainty that remains with respect to the virus, the consumer and the trajectory of the economic recovery, both locally and globally, which will mean companies offering up guidance far less than usual.
Easier to meet a lowered bar – Analysts were relatively pessimistic and slashed earnings estimates during the period of peak uncertainty and panic back in March. This is a theme that played out in the US Q2 earnings season and we expect that to be replicated in Australia. Perversely the lowered bar gives companies a helping hand and for those beaten down companies that manage to do a lot better than expected, there will be opportunities.
Jobs (or lack of) – Another feature of the US earnings season was companies announcing corporate restructures and job cuts, something which may be replicated in the local market. An unfortunate feature of this development is a persistently elevated pace of layoffs centred around more permanent white collar jobs. A phenomenon that will weigh on both the speed and shape of the economic recovery, alongside the need for ongoing fiscal support. A recovery without jobs can only extend so far, as job insecurities, income uncertainties and consumer caution weighs on consumption. This dynamic on the demand side is going to continue to create a lot of problems for businesses, hiring, and bankruptcies in 2H as the “return to normal” is a long way off.
For both businesses and consumers, the uncertainty is pervasive. Investors have been looking through the earnings hit, to the recovery, but the realities of a plateauing recovery and failure to return to pre-crisis levels of output that sees businesses operating revenues and cash flows squeezed for a prolonged period will eventually catch up.
The winner takes it all, and an acceleration of pre-crisis trends. This is true not just in financial markets but throughout the global economy, pre-crisis trends have been accelerated – increasing income inequality and social unrest; digitisation and disruptive technologies; secular stagnation and proliferation of zombie companies; trade tensions and deglobalisation; fragmenting of geopolitical architectures – all are examples of structural inhibitors that have been accelerated by the emergence of the global pandemic. For many industries, lockdowns and the fallout from the COVID-19 crisis has created an increasingly winner takes all environment, with leaders retaining an ever increasing share of profits. Many companies and businesses struggled at hands of lockdowns and the resultant collapse in economy, but those with more agile operations or business boosted by the pandemic, have been able to capitalise on others weakness and use this period to gain market share. Many companies possessing the ability to leverage off of the COVID economy, or quickly adapt and grow market share/online presence – working from home; e-commerce; cloud computing; SaaS and DaaS; digitisation and online trends – have managed to outperform those leveraged to the old economy.
Dividends – Income return for the ASX will fall for the coming year as companies look to insulate their balance sheets, the right decision amidst unprecedented uncertainties. We expect a substantial amount of ASX listed companies to lower payout ratios as earnings and cash flows are impacted throughout the year ahead. Particularly with the virus resurgence and fresh lockdowns in Victoria providing an extended hit to many businesses with the second round of lockdowns having more lasting repercussions, and the global struggle to control COVID-19 providing a drag on local economy even as Australia on a relative basis has fared better in suppressing the virus. However an undue focus on dividends alone can cause investors to misconstrue risks. With stock prices having fallen it’s important not to chase seemingly high dividends or yield traps at the expense of capital losses, future investment into long term growth and low-growth sector exposure, as a deteriorating capital base will usually be more painful for long term portfolio returns than accepting lesser dividend yields.
However, yield traps aside, although the ASX 200 dividend yield is well below 10 year average, the premium over government bonds yields remains elevated and therefore on a relative basis remains attractive. A dynamic which continues to support inflows into equities and multiple expansion, as alternatives lack appeal.
We also caution confusing comparably high dividend yields at investment offset with the prospects of earnings duration and capital growth alongside a sustainable dividend growth trajectory. The power of compounding returns via sustainable dividend growth, over excessive payout ratios that hinder investment into future growth prospects, should not be underestimated.