When financial markets are on edge, any unanticipated movements create a lot more uncertainty. With cases of COVID-19 spreading across the globe, we have witnessed some extraordinary market developments over the past few weeks, including falling global equity prices, government bond yields plunging to all-time lows as well as a surge in implied market volatility. The latest bout of anxiety has been spurred by plummeting oil prices as a result of a fallout among oil producers.
Slumping demand for oil following containment measures in China as a result of COVID-19 prompted a meeting between OPEC and its members recently where the focus was on production cuts in an effort to stem the drop in oil prices. Market expectations of a positive outcome went unrealised when a disagreement between Russia and low cost oil producer Saudi Arabia caused the latter to retaliate by boosting production and sparking a price war.
The resultant impact on equity markets was a significant share price drop amongst large listed oil producers and the prospect of a dip in earnings should lower oil prices persist. A knock-on-effect was also felt in the junk and high yield bond markets, in which oil companies comprise a large part. Markets are concerned about highly leveraged companies that need to roll over their debt, and in particular, the access these companies will have to credit at a time when their earnings will take a hit. The sentiment around lending in high yield markets also affects other areas of the fixed income market and eventually feeds into the equity market, which has already been hit by lower short term earnings expectations.
Investment strategy firm MRB Partners assesses the magnitude of the possible fallout from COVID-19 by framing the analysis in terms of direct impact versus fear and countermeasures. They assert that the direct impact of the virus is manageable from a purely economic perspective. The virus mortality rate of around 3.4% and the skew towards the elderly implies that most of the fatalities are outside of the working age population and while there may be some social implications, it is unlikely that long run growth rates of any country will be impacted.
They attribute the economic ramifications of the virus entirely to panic and public health counter-measures. The impact of quarantine counter-measures will become evident in manufacturing and trade as well as in the services sector, which includes hotels, restaurants, casinos, etc. Whilst the manufacturing sector may benefit from some pent up demand at the end of the crisis, for the services sector, lost business cannot be recouped. It is worth noting however, that MRB Partners’ research asserts that that while counter-measures and fear will amplify the economic slowdown with a series of temporary shocks, it is unlikely to result in a prolonged recession.
Equity market shakeouts provide an opportunity for investors to add more quality names to their portfolios. Bank stocks, particularly in the US and Euro area, look attractive as they have been recapitalised and have healthy balance sheets. The global healthcare sector also offers strong earnings support and has lower correlation with bond yields than some other sectors such as utilities, telecoms and consumer staples, which limits their risk if yields begin to rise again. Communications services stocks are also attractive as a result of their high cash flow generation and the potential benefit from the COVID-19 virus due to more companies encouraging their employees to work remotely. Emerging Asia such as China and South Korea offer opportunities in the form of firm underlying earnings and attractive valuations as these countries recover from the effects of the virus. Possible sectors to avoid would include those that require either strong growth or high capital expenditure such as global energy, materials and industrials.
Absa’s global offerings remain well positioned. The equity managers that we are currently invested in come with a successful history of adding value over the longer term and continue to search for and invest in fundamentally strong companies with healthy balance sheets. Our message to investors at this time of indiscriminate sell offs is that fear is the greatest enemy to watch out for and whilst we should always remain vigilant, regardless of market conditions, we should also not overreact to the current volatility.
Absa Multi Management