Covid-19: How Will The Recovery Play Out?

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As economies begin to tentatively reopen in Australia and across the globe, analysts consider the possible bounce-back scenarios and sector and stock winners and losers.

-Not much to compare to
-The China experience
-Work and play variations
-Falling earnings forecasts
-Winners and losers
 

By Greg Peel

Lessons From History

While the world has experienced many an economic shock in the past century – the most recent being the GFC – all agree the Covid-19 shock is like nothing ever experienced in our lifetimes, given it is a health-based crisis, not a common or garden financial sector crisis or cyclical blow-off. To make any sort of comparison we have to go back to 1919.

The Spanish flu, which originated in the US and had nothing to do with Spain whatsoever until it arrived in that country before spreading to the UK – hence the (derogatory) label, is not a great comparison, being back in another era altogether, but it’s all we’ve got, and importantly it did feature social distancing and economic shutdowns.

At least for a period. Once restrictions were lifted, multiple outbreaks reappeared – a cautionary tale.

The only viable data in 1919 were generated in Sydney, hence Macquarie has made comparisons to the Covid experience only for NSW, which has been the worst hit state anyway. The broker found that adjusting for population, the Spanish flu produced four hundred times more cases in NSW than Covid, and resulted in three hundred times more deaths.

Notwithstanding a second Covid wave we don’t know about yet. And one need only point to technological advances in the meantime, not just medically but in rapid-speed communications, in order to downplay the variation. The Spanish flu tracing app didn’t get many takers.

Interestingly, Covid is set to send the country into an economic recession greater than any in our lifetimes in terms of depth, albeit balanced in likely duration. Macquarie can find no evidence of there even being a bear market in 1919. The 2020 pandemic followed (nearly) thirty years of uninterrupted economic growth. In 1917 Australia’s GDP fell -3% and in 1918 -4% (bit of a war on). In 1919 the economy actually grew as wartime restrictions were lifted.

So can we learn anything? Not really. Macquarie draws only upon the last two decades to note valuations are high at present, particularly in comparison to contractions over that period. The broker continues to suggest investors upgrade the quality of their portfolios.

For now, Macquarie believes the Australian market will remain range-bound between the March low and April high.

FIFO

While the Covid crisis is unlike no other in our lifetimes, and the Spanish flu is too long ago to be worthy of comparison (other than second wave risk), we can draw upon a more immediate experience – FIFO. Nothing to do with airborne mine workers, but rather First In-First Out.

Australia ramped up to full lockdown in March. In mid-February, lockdowns in China were already being lifted. Not everywhere in the country – lockdowns lingered longer in more impacted provinces – but the experience at the source provides some level of guidance as to what Australia might expect as it, too, begins to gradually reopen.

There are good reasons to question China’s infection rates, Morgans notes, but unquestionable economic trends can be reliably analysed. The broker also suggests that if the virus was still rapidly spreading in China, Beijing would have not pushed for a reopening, and nor could any exponential increase be able to be covered up for a full two months.

The rebound in activity in China was fairly rapid. And the rebound was actually initially held back by the fact the lockdowns had trapped workers who had returned to hometowns for what were meant to be Lunar New Year celebrations. Even so, by early March it was evident, Morgans notes, that mid-February re-openings had led to a substantial recovery in activity across different sectors.

Morgans does not draw upon government-generated monthly data but on real-time indicators such as passenger numbers on subways, long distance travel, property sales and power output. A simple average of these four indicators reveals a 22% increase from 2019 levels after the restart in mid-February, rising to 52% by mid-March.

The recovery has nonetheless been uneven. Power demand has recovered 90% from the level a year ago, reflecting Chinese industrial activity, while service sector activity, as suggested by the other three indicators, has been more subdued. This makes sense, Morgans offers, given services depend more on social interaction and concerns about infection will linger.

If we translate this into Australian terms, Morgans suggests we could see a quick restart for industries such as resources, construction and manufacturing, but a more subdued start for service-oriented industries such as office REITs, travel, entertainment, bricks & mortar retail and non-essential health services.

As policymakers continue to roll out new support measures – both the government and the RBA are basically in “whatever it takes” mode – it is unlikely the pandemic will morph into a full-blown financial crisis, Morgans believes. Yet the ultimate impact on corporate balance sheets remains beholden to the uncertainty of how quickly the virus can be brought under control and thus how quickly economic activity resumes.

Equities are unlikely to stage a sustained recovery, Morgans warns. The stock market may have bounced back 25% but that does not imply investors can stop exercising caution when picking stocks.

The broker continues to favour companies with the strongest competitive/market positions, the strongest balance sheets and offering strategies that are able to adapt to the “new normal” and reposition in order to thrive through an eventual recovery. Investors should hold their nerve, as rare opportunities may present in the coming weeks and months.

To Work and to Play

Citi’s economists point out the obvious that different sectors will experience a diversity of recoveries. Adopting a global perspective, Citi divides all sectors roughly into two groups – “work” and “play”.

Sectors associated with “play”, or “unstructured” activities, include those that suffer most from social distancing, and may experience deeper contraction and/or slower recoveries than those associated with “work” or “structured activities", for which social distancing has less of an impact.

Play sectors include hotels and restaurants, air travel, arts, recreation, personal services and retail.

Work sectors include financial services, business services, and “high tech”.

Manufacturing is the odd sector out in global terms (not so much in Australia, where manufacturing is minimal), given the outsized scale of manufacturing in China and Western Europe in particular and the industry globally. The industry comes under the “structured” label, but significant declines in activity due to the virus suggest a longer recovery period.

We could look at this as a social distancing factor, given the necessary proximity of workers on factory floors (unless they’re all robots).

Citi’s base case scenario is that the global economy bottoms in the June quarter and begins to rebound in the second half of 2020. A more rapid rebound could be seen if economies lift lockdown and social distancing restrictions in the June quarter and the lingering fear factor among workers and consumers is low enough as to provide for faster normalisation of activity. This would suggest a V-shaped economic recovery.

More popular among pundits is an expected U-shaped recovery, based on fear lingering into the second half of the year, leading to lengthier disruptions in activity and/or a significant lag in a return to normal consumer demand.

Citi’s worst case scenario is one in which monetary and fiscal policy measures fail to overcome the economic impact. This would suggest an L-shaped recovery, which isn’t a recovery at all, rather a Depression.

The Earnings Lag

During the GFC, note the strategists at UBS, the stock market’s price level troughed when the speed of earnings per share (EPS) forecast downgrades overtook that of the net share price fall. In this crisis to date, the market has rebounded as EPS downgrades have accelerated. This suggests the market is looking through the earnings downside and may have already launched a longer lasting recovery, UBS suggests.

In FNArena’s last feature story, The Outlook For the Economy And Stock Market (https://www.fnarena.com/index.php/2020/04/29/the-outlook-for-the-economy-and-stock-market/ ), it was noted that each day brings more and more EPS downgrades from the seven brokers in the FNArena database. However, this does not mean that brokers are downgrading forecasts again and again for the same stocks, as they foresee a grimmer picture than previously assumed, but rather that with some 400 stocks under coverage across seven brokers, and one single factor impacting on all stocks one way or the other, re-analysing them all in the face of the virus simply takes time.

And there are many fewer analysts employed by brokers these days as there were before the GFC, implying the one analyst now has more stocks to analyse.

Here we are in May, and still analysts are updating their views and downgrading forecasts and target prices for stocks they last updated in the February result season, back when the virus was clearly just a Chinese problem. There have indeed been some updates leading to forecast upgrades on a second review, from initially dire expectations, but the conclusion remains that the accelerating EPS downgrades to which UBS refers is more about catching up across all stocks than applying increasingly negative views. (UBS is one of the seven, by the way.)

And having said that, analysts have admitted that EPS forecasts are a bit of a shot in the dark, in many cases, given the sheer uncertainty of virus impact and duration, and a lack of any guidance from the company itself for the same reason.

Thus if we return to UBS’ observation about the GFC – that the market bottomed out when EPS downgrades accelerate — we must take into account the lag factor in analyst updates.

Nonetheless, the UBS strategists note the recovery for the stock market has been extremely rapid and their own analysis suggests further EPS downgrades ahead. Therefore they believe it makes sense to look for sectors in which valuations and EPS forecasts are further along the process of digesting the crisis.

The sectors which have seen the largest EPS downgrades compared to the GFC (the two crises being very different), and for which price/earnings (PE) ratios have already begun to re-rate are gaming, technology and general industrials. Discretionary retail has also begun to re-rate. Insurance and media also stand out but for these sectors UBS is more cautious.

UBS’ analysis suggests the market EPS forecast is likely to see ongoing downgrades for at least the next month (writing a week ago). The strategists’ model indicates that insurance, media and transport could still experience larger EPS downgrades ahead.

Clearly the Covid downturn is different to the GFC, notes UBS, and is likely to be more temporary. That means 2021 growth rates should not turn negative the way 2009 growth rates did during the GFC. However, in Australia, consensus EPS forecasts are generally revised lower over the course of the year, with negative revisions accelerating into the August result season, and then again as we approach the February result season the following year.

Another point to note with regard EPS is the sheer number of companies raising fresh capital in response to the crisis. Some have gone to the market out of desperation, some out of caution, and others opportunistically to provide for a chance to pick off the weak from the sector herd as the fallout continues.

New capital implies an increase in “S” – the number of shares on issue – which means EPS will fall if “E” remains constant. Analysts have been downgrading their earnings per share expectations, and then having to downgrade them again given a greater number of shares.

EPS in most cases informs DPS – dividends per share, and thus yield – given most companies distribute on the basis of a payout ratio (of EPS). Some pay fixed values, until adjusting that fixed value, and others pay out more or less dependent on growth plans or otherwise, but for the bulk, payout ratios are the norm.

As EPS falls, so too does DPS on a payout ratio basis (and again on capital raisings). Of course, this observation is all but redundant at a time so many companies have abandoned, suspended, deferred or slashed their dividends, if not just for this period but for the next as well. A combination of lower EPS forecasts, leading to lower analyst target prices, and lower or no dividends, means a big impact on forecast total shareholder return (capital gain plus dividend) for investors.

Reasons to be Cheerful

While UBS is only one of many warning Australia’s stock market V-bounce from the March bottom, to roughly half way back, is underestimating the economic realities ahead, which most foresee will trace out more of a U than a V, stockbroker Baillieu remains convinced the economy will indeed V-bounce to match the stock markets’ forward-looking expectations.

Baillieu provides five reasons.

First is Australia’s world-leading success in containing the virus in just five weeks. Not sure about world-leading – the Kiwis might argue – but certainly right up there. As Baillieu points out, Australia has dramatically outperformed Western peers, with the likelihood of dying from the virus 95x higher in Western Europe and 49x higher in the US than in Australia (as of last week).

Second is Australia has satisfied the criteria for a safe restart, in terms of testing capacity, tracing capability (which admittedly relies on the app) and response capability to new outbreaks, as was successfully tested when a cluster emerged in Burnie in Tasmania.

Add in a strong supply of masks and other PPE, with doctors rather than politicians driving this policy, and we’ve seen elective surgery recommencing, retailers reopening, states easing restrictions after just 5-6 weeks when longer lockdowns were originally assumed, and other restrictions being reviewed weekly by the National Cabinet. The timeline is consistent, Baillieu offers, with a 2-3 month disruption envisaged by the V scenario.

Four is the unprecedented monetary and fiscal stimulus that has been provided, with monetary support being near instantaneous and fiscal support now flowing to those in need.

Five is the “windfall gain” from the oil price crash. Don’t tell the energy sector. Baillieu estimates current lower oil prices should add more than 1% to real GDP, with the first sectors of the economy to restart gaining the greatest cost advantage.

Finally, Australia’s high exposure to the FIFO countries. China is one, as mentioned above, but Taiwan, Hong Kong and Japan were also early to go in an early to come out of the crisis in terms of restrictions, and 85% of Australia’s exports are sent to Asia.

Baillieu suggests the hardest hit of Australia’s sectors will be the key winners from a restart of the economy. These include non-essential retail, pubs, clubs and restaurants, leisure and entertainment, travel and tourism.

From a listed stock perspective, Baillieu highlights three sector winners and two losers as restrictions are eased.

Discretionary retail is a winner, as stores reopen. Not just clothing and electronic goods but cars as well.

Gaming wins, given the two casino owners have seen earnings disappear in the lockdowns while Tabcorp ((TAH)) lost all its pub/club gamblers, albeit picking up some online players.

Domestic tourism and transport wins. Too late to save Virgin Australia, or to ward off deeply discounted capital raisings from the likes of Flight Centre ((FLT)), but Qantas ((QAN)) will rise anew (noting the airline generates more profit from domestic than international), and hotel/leisure businesses such as Event Hospitality & Entertainment ((EVT)) and Village Roadshow ((VRL)) should benefit.

Losers include international travel and tourism, given international travel is likely to remain severely constrained until a vaccine is developed, hopefully by next year. This will still weigh on Qantas, and on Flight Centre and peers.

The other is food retailers. But only in the sense that following their time in the sun even before the lockdowns began, in the days of toilet paper madness, business will now return to normal as the frenzy abates and home eating gives way to eating out once more.

Large parts of the economy will be unaffected by restarts, points out Baillieu, given they have remained “essential” during the crisis. Mining and energy, agriculture, manufacturing and construction have seen little impact form lockdown policies and as such, should see little benefit as lockdowns ease.

Breaking it down further from sectors to industries, Baillieu identifies seven likely to benefit.

Banks. The banks have taken large provisions against anticipated bad debts and following pressure from the regulator, raising capital and/or deferred dividends. Valuations have de-rated to below net tangible asset value, suggesting the downturn is expected to be a capital event as well as an earnings event. By contrast, says Baillieu, a V-shaped recovery should limit such losses, and even a U-shape should not drive the banks into losses.

Beverages. The likes of Coca-Cola Amatil ((CCL)) and Treasury Wine Estates ((TWE)) have still been selling their products through supermarkets and their bottle shops, but these sales are low margin compared with on-the-go drink sales and restaurant wine sales. They will benefit from reopenings.

Discretionary retail. The likes of Premier Investments ((PMV)), Myer ((MYR)), Accent Group ((AX1)), Adairs ((ADH)) and Kathmandu ((KMD)) are all in the process of reopening, which will also aid retail landlords such as Scentre Group ((SCG)) and GPT Group ((GPT)).

Leisure. As suggested, Crown Resorts ((CWN)) and Star Entertainment ((SGR)) will go from zero to slowly back to business, also assisting Aristocrat Leisure ((ALL)), while Tabcorp will see pub punters return.

Transport and infrastructure. Qantas will benefit competitively against whatever version of Virgin Lite might re-emerge. Domestic planes back in the sky and cars on the road will reignite Sydney Airport ((SYD)) and Transurban ((TCL)).

Technology. Many up and coming tech companies have actually benefited from the crisis but the big online classifieds providers have suffered. Thus Seek ((SEK)), REA Group ((REA)), Domain Group ((DHG)) and Carsales ((CAR)) will see business gradually return.

Housing. The housing downturn expected from the virus will come with a lag, as there has been little evidence so far. Record low interest rates will not be able to offset hits to income and confidence. But the earlier the restart, the sooner lower-for-longer rates will provide support.

Baillieu has handily provided a list of ten, flowing on from the above analysis, which the broker calls “Ten stocks for an Australian restart”.

They are Commonwealth Bank ((CBA)) and Westpac ((WBC)), Wesfarmers ((WES)) for Bunnings and Officeworks, Star Entertainment, Event Hospitality & Leisure, Qantas, Transurban, Reece ((REH)), for a rebound in plumbing services, Rea Group and Seek.

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