Rudi's View | Mar 26 2020
Dear time-poor reader: this Grand Bear Market isn't done growling just yet, but maybe a near-term bottom is in sight?
Things To Watch, Expect, And Avoid
By Rudi Filapek-Vandyck, Editor FNArena
There are still investors out there who think this year's Grand Bear Market is all about previous herd exuberance and share prices rising too far, but that is so outdated already.
Following an exceptionally strong performance in January, exuberant share price levels might have been the initial reason why the sell-off was so fierce so quickly, but it didn't take long before the financial system started to screech really loudly and central banks across the globe had to pull all levers to prevent a major global credit crisis.
By then, however, the world's focus had already shifted back to what triggered the share markets selling off in the first place, the covid-19 pandemic. It is clear by now global authorities are finding it hard to limit this virus spreading and as they put in place ever more Draconian policies, the damage to economies is accelerating really fast.
This is why, on the weekend and last week, I felt all those investors hoping for a relief rally were simply too optimistic. Such a relief rally, I think, cannot happen until global statistics are starting to indicate this global pandemic has progressed past its peak, and we can all start looking forward to less testing times ahead.
So we know what we are looking out for. Alas, to date the covid-19 numbers are still climbing steadily, including in Australia where from tomorrow onwards a lockdown light version will be implemented across the two most populous states, NSW and Victoria. Other states have started to close their borders. The economic damage, already ginormous, is simply becoming even larger.
The damage will continue to grow the longer these exceptional measures remain in place.
I don't think any of us can reasonably assess the ultimate set-back this pandemic will inflict on households, businesses and economies at large. What should be above any doubt, is that every business listed on the ASX is affected, and will be more affected from here onwards. We are no longer talking "safe" & "defensive" versus "weak" and "vulnerable" – that's outdated too.
The conversation now has to be to what degree can companies insulate themselves? Next topic will be to what degree can they bounce back once tomorrow's lockdowns can be removed?
While it is true the world will get through this, and we will all learn and adapt, and progress onto better times again, as history shows time and again, it is also true these observations are so much easier to make in hindsight.
We should all not underestimate the propensity of bad news to bring out more bad news. US corporate debt is currently estimated to total nearly US$10trn, of which US$2.5trn in financials. Corporate debt in the US is now equal to 47% of GDP, an all-time high.
That what makes investors nervous is the highly speculative corporate debt, estimated at US$2.5trn. Globally, US$1.9trn in corporate debt needs refinancing this year, including US$350bn in the US. There is a lot of leverage to the oil price hiding in those numbers.
As I have tried to explain over the weeks past, these Bear Markets are a developing story. The answer to questions such as how long and how deep is closely related to today's unknown: how much bad news is still out there?
I don't think it's a good idea to start speculating about what more can still go wrong; we already have enough to consider and pay attention to.
But it should be clear to everyone, the broader framework to consider here is not any of the three mini-bear markets we have lived through over the past decade. What we all should keep in mind is that this year's Grand Bear Market is a close relative of 2007-2009, 1987 and of 1929-1930s.
The reason why I point this out is because if you are managing your own money, you have to seriously weigh up the possibility that share prices can still end up a lot lower (not necessarily tomorrow or next week), and we both don't want you to get wiped out, as happened with too many others during the three Grand Bear Markets I just mentioned.
The positive news is, as the Australian share market suffers yet another savage shellacking on Monday, more and more equity strategists are daring to step forward and declare we should be at or near the bottom in this down-draught.
About time I hear many of you thinking. From the record intra-day high of 7197 in February the ASX200 has now lost -2795 points or an incredible -38.8% in just 23 days when measured against Monday's intra-day low of 4402.
Always remember: indices don't tell the story of individual stocks. It is now imperative investors are aware of the risks they might be exposed to. Bear Markets have a particular focus on risk and vulnerability, and they punish immediately, without mercy.
Profit Warnings & Dividend Cuts
The first, and obvious, risk is that companies will no longer be able to meet guidance and expectations. This is not really a risk because I think none of previous guidances or expectations should still be treated as valid. As said earlier, all companies are by now affected, one way or the other. Some are simply less so than others.
Macquarie analysts counted 43 companies that have back-tracked on their previous guidance in the last two weeks. Expect a lot more of the same in the days and weeks ahead.
What is interesting though is Macquarie's observation that shares are punished harder when companies simply withdraw guidance instead of offering a revised outlook.
The key danger that lays behind these profit warnings, of course, is the risk that companies might be forced to raise fresh capital, see Webjet ((WEB)), or will suspend, reduce or scrap their dividend. Given current context, investors should expect to see a large number of dividend deferrals, cuts and removals between now and year-end.
The easiest explanation for this is that dividends in Australia were already under pressure. Last year Australia was one of few markets where total dividends paid out actually went backwards, and the February reporting season once again showed many companies in Australia were barely getting by.
Since dividends for shareholders are considered sacrosanct by most corporate boards, the average payout ratio has been running at 73%, well above this country's long-term average of 65%, on Morgan Stanley's estimates.
Put one and one together and we are guaranteed to see another fall in total dividends paid out this year. Actually, analysts suspect many boards will use this year's crisis to reset payout ratios to a lower, more sustainable level.
This is positive for the future, and makes it easier to achieve growth again in the years ahead, but in the short term this means dividends will fall more than corporate profits.
Analysts at Macquarie have started updating their forecasts and concluded no less than 40% of all companies under coverage are now expected to reduce dividends for shareholders this year.
Macquarie also suggests the total percentage will most likely be higher by year-end. During the GFC, recall the analysts, no less than 63% of companies under coverage cut their dividend, while an additional 3% suspended it.
Macquarie analysts think investors should prepare for similar numbers this year. Readers of FNArena's Daily Broker Call Report will have noticed analysts from various stockbrokerages are already incorporating dividend cuts into their updated forecasts for Australian banks.
Bell Potter recently updated forecasts for regional lenders and all of Auswide Bank ((ABA)), Bendigo and Adelaide Bank ((BEN)), Bank of Queensland ((BOQ)) and MyState ((MYS)) are now expected to cut dividends in FY21.
The message to investors should be loud and clear: companies with high pay-out ratios are extra-vulnerable during times of economic duress. Quality will separate itself from the pack, but Quality usually doesn't offer high yield. Be extra careful out there if your strategy revolves around deriving income from the share market.
Some positive insights can be gained from REIT sector analysts in Australia who are equally busy going through balance sheet numbers and likely forecasts for the sector.
Most AREITs seem fine and well ahead of debt covenants, with Scentre Group ((SCG)) the only large cap in the sector with debt maturities within the next 18 months that are not covered by existing debt facilities or cash.
Lendlease ((LLC)), though much more than simply an owner of property assets, is also often lumped in with the other AREITs, but investors should be aware the overall level of risk for a typical project developer as is Lendlease is now many times higher than five weeks ago.
Also worth keeping in mind, if we do get a full-blown credit crunch a la 2008 commercial property prices will fall across Australia and this will be the worst case scenario for AREITs, argues Citi. REITs are probably best avoided under such circumstances, including the names that are usually on analysts' lists of sector favourites such as Goodman Group ((GMG)) and Charter Hall ((CHC)).
Oil In Pain
One of the secondary shocks that happened this year is the collapse in oil prices. Not only is the production limit agreement between Russia and Saudi Arabia/OPEC no longer in place, the global recession that has followed causes a double whammy for the sector via a slump in demand.
WTI recently fell below US$20/barrel; a level not witnessed since the late 1990s. The problem for Australia's Oil & Gas sector is that balance sheets and business plans are made in 2019, when WTI traded mostly in the US$50s per barrel. The sector will now cancel most of planned investments, which is awful news for contractors such as Worley ((WOR)).
But the damage will reach much farther. On Monday, Freedom Oil & Gas ((FDM)) called in the administrators. Shareholders are unlikely to recoup anything from their equity holdings. This will not be the only casualty.
On Citi's revised forecasts, Brent oil, which trades at a premium to WTI, is forecast to average US$17/bbl throughout the June quarter, so the news is likely to get worse still.
While most sector analysts remain convinced such low oil prices cannot be sustained medium to longer term, investors better be mindful of the bad news that can still follow from such a severe price shock in the meantime.
Oil Search ((OSH)), for example, needs additional funding but it is likely credit markets are now firmly closed for the oil & gas sector (also because of high yield corporate debt angst in the US).
This raises the prospect of a capital raising, which not only puts further pressure on the share price, it also means less potential upside for investors (because of dilution from the additional shares).
Analysts at Morgans believe the sector could be staring at a prolonged period of downgrades since market consensus forecasts still sit 63% above the current spot oil price; that's how fast this latest price correction has unfolded.
Again, the same warning here applies as with yield stocks: investors should not focus on cheap valuations. "Resilience" is the new magic word, offers Morgans.
That's another way of saying: focus on companies that have enough production and cash to weather out this down-cycle. Avoid/sell those that need refinancing or raise fresh capital, or need to make investments to achieve growth.
Above all: be patient. This ain't gonna be solved in a hurry. That's a guarantee from me.
Avoid Balance Sheet Stress
All Bear Markets Big and Small have one element in common: you don't want exposure to companies whose balance sheet cannot withstand added pressure. Risk averse investors will sell first and reserve questions for (much) later.
A recent analysis by analysts at UBS put the focus on companies including Costa Group ((CGC)), G8 Education ((GEM)), Downer EDI ((DOW)) and Link Administration ((LNK)) for potential balance sheet stress while the likes of Nanosonics ((NAN)), A2 Milk ((A2M)), Magellan Financial ((MFG)) and Netwealth ((NWL)) were highlighted for their strong balance sheets.
Other companies highlighted in a negative sense (potential fragility) include Nufarm ((NUF)), oOh!media ((OML)), Mayne Pharma ((MYX)), NRW Holdings ((NWH)), Southern Cross Media ((SXL)), Nearmap ((NEA)), EML Payments ((EML)), Cimic Group ((CIM)), Qantas Airways ((QAN)), IOOF Holdings ((IFL)), Treasury Wine Estates ((TWE)), Challenger ((CGF)), Reliance Worldwide ((RWC)), and AMP ((AMP)).
Of course, the big unknown here is nobody knows at this stage how much of a profit downturn each of these companies is experiencing, but it pays to pay attention for the prudent investor who likes to avoid even more bad news during testing times.
A Glimmer Of Hope
A glimmer of hope comes from a recent Quant and Derivatives commentary by JP Morgan which intimated that fixed-weight asset allocation portfolios by now are some -4% underweight equities (against bonds) given the sharp falls over recent weeks. The suggestion made is twofold:
-on one hand this implies these funds will re-allocate circa 4% out of bonds into equities, and they likely will do so before month's end
-given the current conditions, including record low liquidity, JP Morgan suggests the overall impact on equities can be much larger than 4%, potentially up to 4x times as large
(This story was written on Monday 23rd March, 2020. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: firstname.lastname@example.org or via the direct messaging system on the website).
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