May saw a “risk-on” tone as markets responded to the unparalleled stimulus measures from governments and central banks across the globe. Markets appear to be tentatively looking forward for a way out of the COVID-19 health and economic crisis, with many countries beginning to ease lockdown restrictions.
Nevertheless recessionary conditions still loom. The earnings downgrades and/or removal of previous guidance due to COVID-19 has continued. Consumer cyclical stocks that are directly impacted by travel bans and social distancing, such as travel, gaming and leisure, were the first to withdraw guidance. Many non-essential businesses have been shuttered by order or by virtue that customers have dried up. Given cash flow concerns, company boards have reduced or cancelled dividends for the foreseeable future and capital raisings have been on the rise as another source of funds to allow companies to weather the storm. Thankfully, unlike the GFC, most banks are well capitalised, have enough liquidity and are being supported by the government and regulatory bodies to allow them to be supportive to customers that are under stress.
While the rapidly developing situation and ensuing uncertainty makes forecasting more difficult, we continue to reassess our earnings estimates. This includes reviewing short-term earnings and implications for dividends and balance sheet risk, as well as long-term earnings, which has implications for valuations. As well as assessing the risks associated with stocks in the portfolio currently, we are also actively assessing opportunities thrown up by any aggressive and, in some instances, indiscriminate sell-offs. Ultimately the impact on long-term earnings estimates and valuations will be a function of the depth, duration and damage inflicted during this period of enforced subdued activity.
“How deep” and “how long” are the relevant questions being asked within Nikko AM, as the past few months have seen a dramatic turn in the global economy due to the spread of COVID-19.The unprecedented speed of this correction and changing economic landscape due to government intervention is making assessment of sustainable valuation difficult. However, this provides opportunities within different sectors and stocks as the sell-off has been often indiscriminate.
Like other large market corrections, it is always difficult to pick the bottom and thus rotating slowly into some of the beaten down value names funded by reducing and exiting the outperformers is an approach that we have found has worked well in these type of markets.
History suggests that the market will experience a significant and aggressive recovery when greater clarity regarding the outlook is achieved. It is likely that the trigger for such a recovery in this current crisis will be a reduction in new cases and thus countries reopening their economies. Value stocks tend to be pro-cyclical and have historically performed strongly coming off the bottom of an economic cycle. The bursting of the dot-com bubble led to a switch to value and the GFC also caused a reversal back to value.
The defensive bond-sensitive and quality names remain in “bubble” territory and would be expected to correct heavily when the market moves into more rational territory. Indeed, we again saw some evidence of this at the end of May. The valuation divergence is illustrated by the gap between high and low PE names, which still remains extreme and as such there is significant upside potential in the portfolio as and when market valuations normalise to more appropriate levels.
Brad Potter, Head of Australian Equities – Nikko Asset Management