When tomorrow comes

05 June 2020

5 minute read

By Julien Lafargue, CFA, London UK, Head of Equity Strategy

As quarantine measures ease and economies restart, shaping a post-COVID-19 world can start. Many industries may be scarred for good, but “quality” companies look set to outperform and trade at a premium.

A fascinating feature of the effect of the coronavirus pandemic is the way that equities seemed to have dismissed 2020 and looked to 2021.

In the eyes of most investors, tomorrow will be different but, according to the bottom-up consensus, earnings won’t. Consensus points to earnings recouping all they are expected to lose this year in 2021.

This implies either a return to a semblance of pre-pandemic normality — likely requiring a vaccine — or a way to recuperate lost ground despite social distancing and other COVID-19-related challenges. Seeing any of these scenarios materialize in the very short term appears unlikely, in our opinion.

Short-term memory bias

This time, pandemics are likely to feature in several investors’ biggest risks list

Over the medium term though, we can envisage a few changes. The financial crisis of 2008 left many wondering what the next bubble to pop would be. This time, pandemics are likely to feature in several investors’ biggest risks list.

Yet, the risk of another global health crisis on the scale of COVID-19 in the near future is low, statistically speaking. Indeed, as a society, we are probably better prepared to tackle one now than was the case this time. However, short-term memory bias — assuming that what has just happened will occur again — will likely translate into a higher risk premium for equities. While hard to gauge, this could cap company valuations for the time being, at least in some sectors.

Lower returns ahead

In a world where low interest rates have enabled most companies to thrive, the COVID-19 crisis has exposed some weaknesses that had been underappreciated

In a world where low interest rates have enabled most companies to thrive, the COVID-19 crisis has exposed some weaknesses that had been underappreciated. First and foremost, leverage is likely to be a renewed focus of interest for investors.

In recent years companies have often been penalised for not increasing debt-to-equity levels enough to take advantage of widely available, and cheap, funding. Balance sheet strength will likely be a bigger priority for investors now.

For companies this means a possible reversal of the recent trend by which debt was used to compensate equity holders and support share prices. Moreover, shareholders may be asked to support bondholders with more equity-to-debt swaps likely. There would be clear repercussions for company returns, both in the form of lower dividends and share buybacks. Furthermore, depressed return on equity could then weigh on valuations.

Growth and selectivity to fore

In the space of four months, COVID-19 has accelerated many trends like never before. Retail space, for example, has been under growing pressure from online rivals for years. In February, before the epidemic took off in America, online shopping in the US outsold general merchandise for the first time.  With most stores forced to close during lockdown, the dominance of online has been reinforced, transforming a long-term process into an existential threat almost overnight.

The same forces mean that the need for office space may be permanently impaired, global supply chains may be more at risk and spending on healthcare could ramp up exponentially. As a result, some business models now appear challenged, while others seem ideally positioned to profit.

From an investment perspective, we can draw two conclusions. First, it is likely that the premium commanded by companies with “future-proof” business models will keep expanding and so growth is likely to outperform value over the long term. Second, selectivity (or active management) can help position portfolios well for what might lie ahead.

Stick with quality and diversify

A post-COVID-19 world is likely to be a place where aggregate equity valuations are capped. However, increasing disparities are likely at the company level between the haves and the have-nots.

It’s likely to be a world where quality, earnings visibility and balance sheet strength are sought-after attributes. Shareholder returns, in the form of buybacks and dividends, may also take a backseat. Finally, it’s a world where additional risks, such as mounting debt burdens, possible return of inflation or government involvement in some businesses, may need to be taken into account and diversified away.


Market Perspectives June 2020

Financial markets have bounced further from March’s sell-off as more countries ease COVID-19 restrictions. But risks of another bout of COVID-19 infections and geopolitical tensions remain.


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