Key Points
- Extraordinary global fiscal and monetary policies are starting to build a bridge across the void
- Markets are beginning to look beyond COVID-19 case trends, and towards solving the pandemic with tests, a new standard of care and vaccinations
- Quality companies, with strong balance sheets, are performing well
- This is a time to stay at home and be kind, it is also a time to pay close attention to discipline in investment decisions
In the first 30 days of March, the New Zealand equity market has fallen 14%, and the ASX200 has fallen 19%. While the NZ equity market has fallen less than many other markets, this is still an extraordinary reaction to the uncertain environment.
COVID-19 has become a pandemic and has spread far further and more rapidly than expected a few weeks ago. Many countries have followed the earlier examples set in Asia and instituted stay at home policies to enforce physical distancing of their populations. Like China, in February, this has seen economies step into a partial void of activity, especially in the tourism, education and retail sectors. At the same time, the near cessation of cases in China and the flattening of COVID-19 curves in much of Asia has, in many cases, positively surprised.
Nevertheless, we are now facing a global recession as physical distancing and border closures shut down many businesses for an uncertain time period.
We are reluctant to place any forecasts on economic growth at present. However, a common scenario is that we get two large negative quarters of economic growth, with the declines possibly exceeding anything recorded since perhaps WWII. Despite that, it seems a solid recovery is now underway in China (99% of Chinese workers are back to work and production is also recovering with rates varying across different sectors), and we are expecting a major announcement on stimulus in China.
The ameliorating consideration for markets is that this enormous global challenge is being met by unprecedented monetary and fiscal policies (many of which have never been used before).
There is a strong prospect that physical distancing, border closures and other measures stunt the pace of COVID-19 case growth. There is also a possibility that extraordinary stimulus could succeed in developing a V-shaped recovery.
There are close to 60 new standards of care being trialled to battle the COVID-19 virus (for example, Gilead Science’s Remesdivir is in multiple global trials), and we have counted over 40 reports of potential, but as yet unproven, vaccines (for example Moderna’s mRNA-1273) moving into, or towards, early trials. It is very early days, and perhaps the most promising new development is reporting of FDA approval of Abbott Lab’s testing kit for COVID-19. Most of the medical advice in success in dealing with COVID-19 is now focussing on aggressive testing.
Despite both the scientific evidence and the extraordinary policies, it is easy to imagine economic and unemployment outcomes that rival that of earlier long-lasting recessions. We are not in that camp, but we are wary as the exit process from physical distancing policies and business closures remains uncertain.
We have some comfort that the extremes of financial stress are being tackled head on. Central banks have introduced very significant liquidity, and there is a recognition globally that we need to keep people employed and businesses alive to build the bridge beyond COVID-19. Early and large (circa AUD$1bn) funding packages, for Qantas from the banks and Cochlear from the equity market, are encouraging.
However, we are equally not in the full V-shaped recovery camp. It seems likely that the banks will see higher non-performing loans and bad debts, despite mortgage relief and large central bank balance sheet expansion. We are also aware of the potential for some housing sector stress, should we see a sustained rise in unemployment. Again, recent fiscal and monetary policies have very significantly lowered the potential stress on households and the housing sector, but we will be monitoring housing stress closely. Although, for the next few months, there are likely to be very few housing transactions in order to gain insight on pricing trends.
There are challenges in building the bridge across the void. For one, anchoring on the other side remains uncertain.
At the moment, we believe equity valuations are unlikely to be a driver of near-term equity returns. Earnings uncertainty is limiting meaningful near-term valuation comparisons. In the next quarter, across a range of equity markets, earnings could fall anywhere between 10-40%. The New Zealand market, however, is somewhat defensive.
After a recent bounce in prices, many equity valuations remain broadly within long term ranges. We are gradually becoming more constructive on companies with strong balance sheets, but we need to see evidence of progress in flattening New Zealand’s COVID-19 curve. Additionally, we expect a number of companies to renegotiate banking terms, and some may need recapitalisation to bridge two to three quarters of a probable deep void in revenue.
Bond markets have been volatile, reflecting a variety of influences. Some market commentators described the market as becoming close to dysfunctional prior to the large interventions in the last week.
Gradually, liquidity is returning to government bond markets. There will be a lot of new bond issuance, and we will be monitoring closely the steps taken by central banks to absorb the new issuance. In recent days, we have been more encouraged with greater stability in bond yields and much better liquidity.
However, in credit markets the possibility of financial stress has seen a sharp widening in spreads, lower liquidity and significant dispersion in yields across sectors.
Harbour’s equity portfolios
At the beginning of March, we did not expect the rapid spread of COVID-19, nor did we expect such a severe reaction in equity markets.
As at close of business on the 30th of March, most equity portfolios were about 15% lower than at the start of the month.
The dispersion of returns has been remarkable with the two largest stocks, a2 Milk and Fisher & Paykel Healthcare, performing very strongly when compared to the rest of the market.
Many stocks directly exposed to the tourism sector have removed earnings guidance, cancelled dividends and, in the case of Air New Zealand, have been effectively partially recapitalised via a loan from the Government. There have been some unusual market moves partly associated with indiscriminate selling of the equity market to provide liquidity. Many global funds have used the equity market to provide liquidity for things such as margin calls, as the corporate bond market has been largely closed in recent weeks.
Harbour has not changed its equity investing approach or process through the recent period of market volatility. Harbour’s investment process reflects research which shows that, over the long term, companies that grow their earnings sustainably, deliver the best returns. The process also reflects learnings from previous crisis events, with the quality score component highlighting balance sheet strength.
While we have not made major changes to the portfolio through this period, we have taken advantage of some pricing extremes and liquidity dislocations.
We have followed process by adding to holdings where earnings have been upgraded, and reducing where there have been downgrades or removal of profit guidance.
At an aggregate level our equity portfolios have increased overall investment in the following sectors:
- Healthcare
- Consumer Staples
- Materials
In aggregate, the portfolio has decreased overall investment in:
- Consumer Discretionary
- Information Technology
- Communication Services
While we see ongoing risk to earnings from extended period of COVID-19 market valuations, in price to earnings ratio and yield terms, equity prices have moved to significantly lower levels reflecting the tough trading conditions.
Many stocks we invest in will not require additional capital to sustain and grow. A few might, and we will assess those opportunities as they arise.
Conclusion
There is dispersion of views on the outlook for economic growth and earnings. Our view is that New Zealand has a large capacity to provide further fiscal and monetary support, should COVID-19 lead to more severe levels of job loss and threaten a spiral towards a much deeper recession.
In New Zealand, a six-month 5% to 15% loss in gross domestic product (GDP) seems like a good starting point for thinking about activity levels. However, New Zealand has also announced a 6.3%+ fiscal stimulus package matched with a $30bn active quantitative easing plan. Over time, these packages should lower the impact on job losses and business closures. Australia has recently announced a 10%+ fiscal stimulus plan, also packaged together with a large supportive balance sheet expansion from the Reserve Bank of Australia.
It appears we are going to be active in building our bridge across the void through extraordinary fiscal and monetary stimulus. In addition, the much lower New Zealand dollar provides some offset for the demand shock; however, for some industries, no price level will be enough to encourage activity. Revenue for the retail, tourism and education sectors could be severely dented for a long time.
If the road map for COVID-19 looks like China and Korea, New Zealand’s economic activity may come back on stream later this year. Alternatively, if physical distancing does not stop the infection spreading, we are in much deeper trouble.
We are confident in the ability of corporates to survive, innovate and then invest, in people and production, once we see the data stabilise on COVID-19 and policy responses kick further into action.
In the coming weeks, we expect headlines on COVID-19 cases in New Zealand may improve; but the narrative will move from focussing on health outcomes to economic outcomes. Anxiety in the economy, may overcome concerns regarding covid-19.
Overseas in some countries, particularly in Asia, there are tentative signs that the rate of growth in COVID-19 cases is slowing. There is also an exceptional amount of science being applied to new standards of care (the first step to reduce the impact of COVID-19) and then also to seek a vaccine. In the meantime, we would expect a conservative approach to the movement of people. This doesn’t mean, however, that all businesses will be closed. Some businesses might trade very well through this period.
In the meantime, what we can do ourselves is wash our hands, stay at home and, while we are home, monitor carefully the indicators that companies are getting back to work, or learning how to work in different ways. There are many companies in our equity markets that are likely to continue to grow revenue and earnings through this timeframe and beyond.
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Harbour Asset Management Limited is the issuer and manager of the Harbour Investment Funds. Investors must receive and should read carefully the Product Disclosure Statement, available at www.harbourasset.co.nz. We are required to publish quarterly Fund updates showing returns and total fees during the previous year, also available at www.harbourasset.co.nz. Harbour Asset Management Limited also manages wholesale unit trusts. To invest as a Wholesale Investor, investors must fit the criteria as set out in the Financial Markets Conduct Act 2013. This publication is provided in good faith for general information purposes only. Information has been prepared from sources believed to be reliable and accurate at the time of publication, but this is not guaranteed. Information, analysis or views contained herein reflect a judgement at the date of publication and are subject to change without notice. This is not intended to constitute advice to any person. To the extent that any such information, analysis, opinions or views constitutes advice, it does not consider any person’s particular financial situation or goals and, accordingly, does not constitute personalised advice under the Financial Advisers Act 2008. This does not constitute advice of a legal, accounting, tax or other nature to any persons. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. The price, value and income derived from investments may fluctuate and investors may get back less than originally invested. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Actual performance will be affected by fund charges as well as the timing of an investor’s cash flows into or out of the Fund. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Neither Harbour Asset Management Limited nor any other person guarantees repayment of any capital or any returns on capital invested in the investments. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this or its contents.