Recovery vs. Reality
Summary: The week begins on a shaky footing, and Asia equities trade subdued with US futures remaining under pressure and in the red most of the session. Nikkei -0.85%, KOSPI -0.03%, Hang Seng +0.16%, ASX200 -1.13% at the time of writing. Further keeping a cap on risk sentiment, WTI crude futures are also trading lower, the May contract, expiring tomorrow, is trading below USD 15 a barrel for the first time in over two decades as traders shy away from physical delivery. However, the now more actively traded/spot June contract, where contracts are trading at 5x the volume relative to May is trading lower but holding up above USD 20. Something our commodity strategist Ole Hansen has been well across.
For Aussie stocks, the energy sector was a drag on the index along with financials. Index heavyweights financials, remain under pressure as the outlook for the economy weighs but also the outlook for dividends. This morning NAB announced a $1.14 billion hit to first half earnings, reminding investors that the reality of dividend cuts is incoming, as we have previously flagged. APRA have taken a softer approach relative to NZ, UK and EU regulators but have stated they expected ADI’s to “seriously consider” deferring decisions on dividends, rather than stipulating outright deferral. The Aussie banks are heavy weights on the index and a key holding in many retail and retirement portfolios. As the outlook for the banks and their traditionally juicy dividend payments becomes cloudier, the opportunity cost of these holdings grows. And it is not just the near term, digitisation, neobanks, increasing competition is just one structural headwind to earnings growth the big four face. More immediate term, headwinds include rising consumer credit defaults and bad debts across residential mortgage books and higher impairment charges denting profits. The share prices have already corrected significantly, but there is capacity for ongoing pressure particularly as we expect dividends will likely be deferred to 0 for the first half of 2020. The panic deleveraging of Q1 may be past, but dividend cuts remain a prompt for retail selling, particularly for pensioners reliant on dividends for income. Until this uncertainty is resolved when the big 4 (CBA, WBC, ANZ, NAB) update the market in May, it will be hard for Aussie stocks to push much higher from these levels.
The big question remains this week, as we continue to push through technical resistance levels on many equity indices, whether the bullish upside momentum can continue or whether risk will begin to roll over joining the real economy outlook. Sentiment remains optimistic relative to fundamentals, particularly whilst visibility remains so poor and many companies have opted out of giving guidance. There is little buffer in current valuations and the risk of incoming shocks to growth/earnings is high. . The ongoing sharp contraction in both the real economy and corporate earnings leaves little margin for error at current above average valuations, which are based on what are likely overstated earnings estimates. Aside from the divergence with the real economy, main street employment realities and earnings outlooks, the internals of the recent move are less than encouraging. As the chart below shows the S&P 500 is now more concentrated than ever in the 5 largest stocks.
The debate really boils down to whether this crisis is a one quarter and done impact, or whether there is a more lasting impact via the second order effects of the simultaneous supply and demand shock that take hold and drag on the recovery. We sit in the latter camp.
There are several reasons why. Even as lockdowns are lifted, opening up will be a process and will be a phased transition in order to avoid a second wave of infections, as we have seen in Singapore. For that reason business will not return to normality as swiftly as many believe and some parts of the economy may remain in lockdown. The labour market recovery and consumption rebound will also be key to the rebound dynamics. Jobs around the world have been lost with frightening speed, we only have to look to US jobless claims to see that in full swing. According to the International Labour Organisation 2.7bn workers worldwide are now affected by lockdown measures, representing around 81 % of the world’s workforce.
How quickly will they return? It is true that this recession has been “self-inflicted” and therefore the labour market may rebound more quickly than in prior recessions. But if opening up is a phased transition that begins from a position of economic fragility it is far from likely the employment recovery will be V-shaped. This in itself creates another headwind as the negative externalities and second order implications then have the ability to cascade, presenting an additional lag on economic activity. Job insecurity, lost savings and personal safety concerns dampen consumption as consumers choose to save more and spend less, preventing a one-quarter and done impact. And on the other side of the employer/employee relationship, with many businesses forced to operate on reduced staff we may find the post virus picture is not one of mean reversion. There could be jobs that are never re-instated, primarily as businesses increase their focus on digitisation. On the flipside however, there will also be opportunities for redeployment in other industries that benefit from the structural changes post COVID-19. A UK business survey highlighted by the Financial times reports 21,000 more UK businesses collapsed in March 2020 than the same month a year ago – representing a 70% yoy increase in business failures. With lockdowns in the UK extended throughout April, the hit is likely to be equally as dire, if not worse. Not a great sign for hopes of a V shaped recovery in employment, in the UK at least. In Australia, a key area of vulnerability remains the high levels of household debt that becomes a systemic issue as unemployment rises.