For many big corporates, the upcoming earnings season will be the first proper chance for the market to assess the damage of the COVID-19 pandemic.
How will markets respond and what could investors do to insulate themselves from the fallout?
With the Robin Hood rally running out of steam, swap a sword for a shield
For Australian equities, the beginning of the reporting season is likely to mark a turning point for the ‘Robin Hood rally’, where significant gains have been on offer for those brave enough to move during the depths of the sell off. Many large and retail investors jumped in early and made strong profits, and the ASX 200 index climbed as much as 70% in US dollar terms since1 (taking into account the effects of the soaring Australian dollar). Australian markets generally outperformed their global counterparts through the period, as one of the few larger markets where reopening after the pandemic was progressing relatively cleanly, that was until the “Victorian wave” and spot outbreaks further north are seeing cases increase on our East coast.
The market is now treading water and there are two clear signs emerging that the rally is now running out of steam and its now time to look for increased certainty:
First, the market has outpaced earnings expectations. According to the two-year/mid-cycle aggregate profit picture, consensus aggregate earnings for the S&P/ASX 200 index are about 15-20% below pre-COVID levels2, which seems reasonable in aggregate if Australia can continue to progressively reopen and a global vaccine is developed in a rapid timeframe. A number of sectors will have lower profitability over the medium term, due to continuing viral containment measures and changes to customer behaviour. Given that the S&P/ASX 200 index is currently 10-15% below the February peak3, it’s not unreasonable to suggest from a top-down basis that the easy money in the recovery has been made, and that small investors are now chasing a rally where valuations are full and reflecting a smooth recovery which may not eventuate.
Secondly, on a bottom up basis, there is a real lack of visibility of the short and long-term earnings profile of many businesses. Only 4 out of 10 businesses in the ASX 3004 have issued any sort of guidance and even where it has been given it’s usually less than is normally provided. Our team have noted across many sectors that the earnings estimates from different published analysts on stock and sectors are higher than they have seen in many years. The stage is set for a bumpy ride when companies publish their accounts for the lockdown period in August, and hope will give way to a desire for certainty. We believe now may be the time to pivot portfolios.
Valuations have popped in a sharp rally
But company guidance is thin on the ground
Searching for stability
We believe the only asset class currently offering reasonable valuations to history at this point in time could be equities, where fully-franked yields have the potential over the short to medium term to generate returns that are a distant memory for most asset classes. Following the quick rally and large valuation re-rating in this financial year, returns will have to be delivered the old-fashioned way, backed by cash flow and growing profits. The reporting situation will give strong indications as to which companies will be able to do so.
We expect income is going to be tight in August, but still relatively higher than cash or fixed income assets. We expect index dividends for the ASX 200 to temporarily drop by approximately 40% as the working capital squeeze triggered by the lockdowns works its way through the accounts. This will make life difficult for a while for those who rely on dividends as a major source of regular income, such as retirees and charities.
In the interim, our view is that investors will prioritise reliability of returns, and the following asset qualities will be highly sought-after:
- Industries and companies that will emerge as winners from structural changes brought on by the pandemic, such as the rise of logistics and same-day delivery;
- Growth stocks with the potential to outperform the current lofty valuations; and
- Those reliable stocks which have lagged the current rally but are still able to generate respectable cash flows and dividends (e.g. supermarkets, infrastructure, utilities and some sub-sectors of property).
We believe the final half of 2020 is likely to go down as one of the worst in history from an earnings perspective, but it is important to remember that this reporting season is about more than taking stock of the damage. A number of companies which have rightly been focused on survival rather than profitability will hand down some abysmal numbers for the last two quarters, but a substantial proportion of these might also provide more optimistic outlook statements. And while it’s not realistic to think that we will soon (or ever) return to pre-COVID-19 conditions, we should remember that our current situation is highly transient as well. Investors should keep a clear eye on the advantages and strategic options available to each company going forward, and not dwell too much on the sea of red ink.
1 FactSet. Data period 23 March 2020 to 30 July 2020 in US dollars
2 FactSet, as at 5 June 2020
3 FactSet. Data period 20 February 2020 to 30 July 2020 in Australian dollars
While every care has been taken in the preparation of these articles, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in them including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. Performance goals are merely goals. There is no guarantee that the strategy will achieve that level of performance. The information in this document contains statements that are the author’s beliefs and/or opinions. Any beliefs and/or opinions shared are as at the date shown and are subject to change without notice. These articles have been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. They should not be construed as investment advice or investment recommendations. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.
This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.