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Plotting the path to recovery: V, L or Nike swoosh?

When the coronavirus pandemic eventually recedes, what will a recovery in equities look like? Here we consider three potential outcomes and how our Asia ex-Japan portfolio is positioned to weather the outbreak.

The current economic environment is in many respects unprecedented. In the last century, perhaps with the exception of the world wars, almost all financial crises have been ‘financial’ in nature – generally dealing with changing claims on assets rather than the assets themselves, while the productive capability of advanced economies remained unscathed. In 2008, for example, the crisis could be distilled into a series of events that cascaded from an underlying cause of too much debt in key segments of the economy (mainly certain parts of the US housing market) and an inability of those who owed money to repay it.

Today’s crisis is different: it is not just about ownership or claims on assets, it is a public health crisis. In recent weeks, countries around the world have been implementing measures to slow the spread of the coronavirus, from national quarantines to school closures. And with more than a third of the planet’s population under some form of restriction, production and consumption in many key industries has ground to a halt.  This in turn threatens free cash flow, which underpins value and is the engine of wealth creation, credit productivity and perhaps capitalism itself.

From life before coronavirus to after: three possible scenarios

In the fight to stop the coronavirus pandemic destabilising the global economy, central banks have intervened to calm capital markets while governments have announced vast spending initiatives to protect their economies from severe recessions.

But when the pandemic eventually recedes, what will a recovery in equities look like? Investors are considering three potential outcomes:

This scenario envisages a situation where there may be an effective treatment developed quickly, an accelerated vaccine timeline, a reduction in transmission resulting from warmer Northern Hemisphere weather or the development of widespread societal immunity, and little damage to the consumer and producer psyche. Such a scenario would facilitate a quick rebound to previous levels of economic activity, with subsequent growth intact. However, few believe that the economic disruption will be short and shallow.

In this scenario, a relatively short but deep economic disruption ensues: many companies (those with high debt at present and even some with low debt but with a high fixed cost structure that results in rapid cash outflows) will fail and entire industries will struggle despite some forbearance and potentially non-dilutive government support. Such a scenario would nevertheless allow economies to bounce back relatively quickly and continue to grow.

Under this scenario, many companies – indeed, entire industries – will fail and unemployment will rise, structurally denying growth to all industries as consumption will fall and the world economy will not rebound for many years. Some attribute this scenario specifically to the pandemic, while others believe it would represent an acceleration of the stagnation that had already taken hold in certain industries and economies. 

This scenario would likely be accompanied by a backdrop of sustained ultra-low, global risk-free interest rates, and eventually extremely high government borrowing and higher interest rates. That’s because fiscal spending in the context of lower tax receipts would result in government and high-grade credit investors questioning the government’s ability to repay even local currency borrowings without printing money and reigniting inflation.

On a relative basis, ‘safe’ companies (that is, mega cap, quality and dominant companies operating in defensive industries that have the ability to grow earnings above the low and then eventually higher inflation rate) would do well in this scenario. In absolute terms however, these companies would likely not do well. That’s because the valuations of these stocks are high, and they too would face challenges owing to a decline in consumption.

A swoosh-shaped recovery seems likely

With volatility comes dislocation – and recent stock market falls appear to suggest an outcome somewhere between scenario two and three. This would indicate a Nike-shaped swoosh recovery rather than a V-shaped recovery (scenario one) or L-shaped stagnation (scenario three). Of course, even ‘scenario two’ investors differ in their assessment of whether the ‘swoosh’ will be closer to a ‘V’ or ’L’.

We expect a Nike-shaped swoosh of uncertain gradient, but one that implies an ultimate recovery. Of course, we do not know for sure what the outcome will be.

Adapting to the new normal

The relative positioning of our Asia ex-Japan portfolio remains similar to how it has been for several years. Our stocks, on average, are cheaper, lower quality and smaller than the average benchmark stock, with less debt.

Last year – predating the coronavirus – we substantially reduced our underweight in mega caps by adding to our holdings in Samsung, TSMC and Alibaba. This move was partly informed by our expectation that the low interest rate environment would persist. Since the beginning of 2020 and the economic disruption resulting from the coronavirus pandemic, the relative performance advantage of mega caps has sharply accelerated given the safety provided by size, dominance and liquidity in the context of elevated uncertainty and a still lower, still longer interest rate environment.  

Overall, we do not believe that our holdings are at significant risk of financial distress because they generally have strong balance sheets, strong business models, strong industry positioning and/or are Chinese state-owned, implying a very high likelihood of non-dilutive financial support if required.

There is however one plausible exception: we have an approximate 0.5% interest in a Korean steel maker. Although we do not expect it to fail, it might. Nevertheless, we have retained our exposure to the company because we do not expect it to fail, our position is small, and most importantly, trading at 0.1x tangible book value, we believe the payoff structure is highly asymmetric at around 5:1 in terms of the potential gain if things work out ok (as it re-rates towards around half book) or if it falls to zero in the less likely, but plausible, event of it failing.

We will also continue to seek new opportunities where stocks have adjusted inappropriately in response to the changing economic landscape (because they have fallen too much relative to their changed bottom-up prospects).

For now, we remain focused both on the long term and on the possibility of interim financial distress. But when the economy recovers, we believe our portfolio is well positioned to outperform. That’s because although our stocks, on average, are more economically sensitive than the benchmark, they have less debt. As such, we expect the companies in which we are invested to survive the coronavirus pandemic (undiluted) and reach the other side, whenever – and whatever shape – that recovery might be.

Risk profile
  • The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
  • Any investments overseas may be affected by currency exchange rates.
  • Past performance is not a reliable indicator of future results and targets are not guaranteed.

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