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March 2020

Mar 26

What’s the Market Worth?

By Insights - Financial adviser, Insights - Institutional investor

The Coronavirus outbreak has blindsided markets since mid February, with equities down nearly 30% off their peak. What investors need at this juncture is a line of sight on valuations, to get a sense of what sort of scenario this sell-off represents. Analysis of this sort is vital to build a profile of the probability landscape around different coronavirus outcomes.

There are two drivers of the sell-off:

1. Projected Earnings hit: the extent to which earnings are impacted is hard to gauge but will be pronounced. The market anticipates a raft of downgrades.

2. Increased uncertainty: we have little idea what to expect in terms of the length or extent of the disruption to the economy caused by this virus. Because we can’t quantify anything, realised financial market volatility becomes extreme; making equities a less attractive investment on a relative basis to alternative investments.

We can look at quantifying the impact of point 1 and 2, to get an idea of what sort of scenario the market is pricing in; and to make a decision, given the virus data that we can track, as to whether equities is likely too bullish or bearish.

Increased Uncertainty

One of the hallmarks of financial markets over the last ten years has been anaemic volatility. Driven ultimately, in our view, by a total absence of inflation, it has been a key driver of making equities incrementally attractive and driving up the market’s fair multiple.

Let’s estimate the relationship of volatility and fair multiple. As fear and risk perception elevates, the fair multiple collapses. Conversely, as visibility and a line of sight appears on earnings and the economic hit, volatility will progressively moderate, and the fair multiple of the equity market rises.

In order to quantify the relationship, Resonant has built a simple model to estimate the sensitivity of fair multiple to the implied volatility index (S&P/ASX 200 VIX Index). Clearly, this is an exercise in educated guesswork, we still feel that a rough estimate is better than no estimate at all.. It is however no substitute for following the markets closely over this period, but it helps enhance the research process.

To estimate our relationship, we look at historical data on the Australian Equities market between 2010, when the VIX series starts, and end of February 2020.

Figure 1: S&P/ASX Australia VIX (LHS, source S&P/Refinitiv) vs Equity Risk Premium (Source: Resonant Asset Management)

Based on the relationship, we have quantified every doubling in VIX, to a 1% increase in the risk premium (ie. The equity market sells off).

Earnings Hit

Volatility and earnings are intrinsically linked. Only now are we starting to see economists quantify the full impact of the virus on the domestic economy. We are looking at two quarters of negative GDP Growth for Australia, should the lockdown succeed and the virus be contained. Citi is forecasting that GDP will contract by 4.4% over 2020 (See: Forecasting the largest percentage change GDP growth contraction in history, 24th March 2020, by Josh Williamson, Citi Economics Research)

If we assume that the stock market is an adequate representation of the economy – then we can project sales revenues (as opposed to earnings, which will be much more pronounced) for companies to fall approximately 5% over 2020. The disparity in outcomes will be huge, with some industries (tourism, travel), impacted far more than others (healthcare, supermarkets, cloud computing).

To translate the sales/revenue hit to earnings we need a sense of where corporate margins sit. And their likely trajectory. Shareholders ultimately should care about Net Margins, which have a cyclical component, and a policy component, amongst other things.

Cyclical Component: We would expect that aggregate margins would fall, as companies face fixed costs of keeping the lights on, regardless of broader conditions.

Policy Component: Governments look to cushion the blow as much as possible, by implementing tax policies and stimulus to minimise the hit to margins.

In addition to the revenue hit, we need to estimate the margin hit, to get a sense of impact on earnings.

Currently the weighted average net margin for an S&P/ASX 100 ex Financials company is currently 13%. As you can see it has fluctuated with Commodity prices in particular – the trough being in late 2015.

Figure 2: Index weighted 12m forward net margins for the S&P/ASX 100 index (source: Resonant Asset Management calculations, Refinitiv data)

Over the next twelve months, what can we possibly expect to happen to Net Margins, Revenues and Earnings?
In order to answer this question, we’ve put together a matrix of outcomes, broadly splitting the economy into V-shaped (12 weeks), U-shaped (2 quarters), and L-shaped (1+ years).

Figure 3: Approximate Revenue, Net Margins under different macro-economic scenarios

Market Projections

We think the VIX will settle around 25-30 at the end of March, and trend towards 20 for the rest of the year, as uncertainty as to the course of outcomes for this virus continues to play out. For us to get to 20, we would need a clear example of a western democracy that has successfully managed to “flatten the slope” and manage the hospital overload. For example, if Italy were to consistently and successfully slow the increase in cases, then that would bring market volatility right down, as it would demonstrate to other countries what is required to achieve this, and on what timeframe.

We suspect that if the social distancing and lockdown policies in Italy have been successful, then we are looking at a U-shaped recovery for Australian corporate earnings.
That means 12 month margins of 10% (from 13%) and a 5% revenue hit, in total a 30% hit to earnings.

Figure 4: What’s the Market Worth Under Different Volatility, and Earnings outcomes

We see our base case described above, where the market is worth 5019 points, a U-shaped recovery, 5% negative GDP Growth, and a volatile equity market to the order of a VIX at 20 from April for the next 12 months, as a price target just a tick above 5000. That would correspond to a yield of around 4.5% plus franking, and an additional 5% upside from the close price on the 24 th of March.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Mar 18

Coronavirus and Markets

By Insights - Financial adviser, Insights - Institutional investor

Finally Politicians are listening to scientists, and pursuing an appropriate strategy to change behaviour and minimise the infection rate. This is not only necessary from a health/humanitarian perspective, but also from an economic perspective. If coordinated properly and effectively across the globe, this could help minimise the economic disruption while simultaneously maximising the humanitarian outcomes.

Market Fragility

Another tumultuous week for equity markets last week, which began on Monday with a huge sell-off and continued throughout the week. Two events coincided to create a perfect storm for Growth assets: Coronavirus and OPEC Oil negotiations.

The signpost for us that the markets had changed to a new regime, occurred on February 28 th . That was the day that the domestic market forgot all about reporting season, fundamentals, and focused on the virus and its effects. The day’s trading sufficiently spooked us to think that a rejig of the portfolios was necessary.

Who Cares about Earnings?

The last time we saw a meaningful regime change such as this in markets was 2008. Over these periods, which naturally occur every ten years or so, the market becomes entirely focused on speculating the future prospects of companies over the next two quarters, at the expense of all else. This means typically a giant unwind of the most speculative active positions towards a more defensive orientation. And that is exactly what we have seen. As ever with these events, hedge funds are leading the charge.

In our portfolios, we looked at our individual stock positions over the weekend of the 29 th February and 1 st of March, and jettisoned any stock in the eye of the storm – first on the chopping block where travel, tourism and education, followed by deep cyclicals such as resources, retail, & media. We rotated nearly 20% of our direct stocks portfolio into cash.
The timing was fortunate, because this week has been the most volatile and unsettling for equities investors since the GFC.

Thank Goodness for Diversification

Our multi-asset portfolios have held up relatively well amongst the carnage. In our International Equities sleeve, we have been conscious of the prospect of a tail event given the strong run equities have enjoyed over the last few years, and have positioned unhedged, and overweight Japan (and most importantly the Yen), and Asia, underweight expensive US and underperforming Europe. Yen strength is an inevitable predictable consequence of a dramatic sell down such as this, given the repatriation of the enormous quantity of foreign invested capital which inevitably occurs.

The advantage from a risk management perspective of using precision instruments such as ETFs is only too apparent in these markets. The biggest delta has been from managing the currency right, just as it was in 2008.

Looking Ahead: Our Base Case

While it feels as though we are currently staring at the abyss, there are now reasons to start thinking of the future.

This morning the US announced that it was stopping any EU visitors for 30 days, a move that is both draconian but necessary. We expect Australia to follow suit – cases in Europe are now expected to escalate and the trend looks quite terrifying. We expect however that these extreme measures are indeed what is required to get this virus under control, along with school closures, minimisation of travel and public gatherings, and working from home.

We are now moving into the step where governments have a clear role to play, pulling massive fiscal and monetary leavers to manage what Boris Johnson described as the “once in a hundred year health crisis”.

The coordinated fiscal and monetary response will be massive in our view. Governments and central banks can ill afford to sit on the sidelines and moralise about cheap money, this is the difference between a transient global recession, which may last a quarter, and a prolonged depression that takes place over a number of years.

To put it in context, we have to think that we are staring down the barrel of sitting at home for much of the next six to 12 weeks, as this virus is contained. If we can successfully navigate this without business closures, job losses, and a total ramp up of unemployment, we can come out the other side of this with a huge ramp up in activity one this has passed, which you would have to think would somewhat compensate for the initial recession.

That is our base case: this is contained, we get an enormous stimulus both fiscal and monetary stimulus, in which case this is a buying opportunity to hold for the long term. Sentiment will whipsaw investors from now and certainly until the end of April, but we feel at this point that the base case is priced into markets.

A Gloomier Scenario

To construct a gloomier scenario, we would have to think that:

  1. Infection rate in developed markets of around 70%
  2. Quarantine lasts up to one year
  3. Massive speight of corporate defaults
  4. Mass unemployment, double digits.
  5. House price crash.

None of this is likely; governments have woken up to the health crisis and steps are being taken.
Under this view, you would currently be selling equities further.

Looking Even Further Ahead

Assuming our base case comes to fruition, how does this change the world?
A few geo-political risks on our radar:

1. Iranian and Middle Eastern instability. The conservative religious government in Iran came into this health crisis with waning popularity, a botched missile launch. Iran was hit harder than most, and struggled, weighed down by inadequate health infrastructure. To rub salt into the wound, the oil price collapsed to $30, likely to trigger an economic meltdown in the country if this persists. The middle east has typically been about two camps, Saudis and Iranians. The collapse of Iran could herald more wholesale changes across the region.

2. Global Supply Chains entail sovereign risks. Back on the political agenda will the repatriation of manufacturing of key products. The electorate has woken to the sovereign risks of outsourcing all of your manufacturing and production offshore.

3. Europe is ultimately re-invigorated. This is less certain but an effective fiscal response to help Italy will dramatically alter the electorate’s perception of the European project. This is potentially a second order factor, not before much economic and political pain.

4. Locally mortgage rates hit zero or thereabouts as we enter QE. Given the cashflow crisis that many over indebted households will face over coming weeks, this effectively reduces interest payments to near zero, and allows Australians to “hibernate” until the virus passes.

These four key factors will drive:

The end of the bond market bubble – we think that the massive deployment of fiscal stimulus combined with onshoring manufacturing and production will possibly raise the spectre of inflation.
A change in behaviour – this will draw a line on the post GFC period and open up the market to more volatility and risk taking behaviour. This will draw a line on income and wealth inequality. The electorate will demand this. The business cycle will return.

More selectivity and active management will be required – the pure passive ETF model will die with low volatility and non-existent inflation. Skilled stock pickers and asset allocators will benefit hugely from the regime change.

A wholesale change in work practices. Work from home, flexible work, and so forth will all become mainstream as we get a sense of our own fragility and mortality and reconsider our priorities – economic growth is not dependent on our ability to attend an office in a CBD for 70 hours a week – software and remote access, teleconferencing, will become mainstream.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

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