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28.04.2020 46

Covid-19 will redesign sector opportunities amid gradual normalisation and focus on earnings

Published April 28, 2020

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The essential


  • Current assessment: The spread of coronavirus in Europe and the United States triggered a worldwide stock market crash in March, followed by a partial rebound. Many questions -- such as the length of the pandemic and the extent of the consequent recession -- remain unanswered. We outline three scenarios to analyse the situation. In a rosy scenario, a U-shaped recovery could begin in Q3, whereas in our central scenario (50% probability), a U-shaped recovery would have a lower and a longer bottom, and a recovery would not occur until Q4. In a risk scenario, the pattern would be L-shaped and the initial stages would be very weak. According to our analysis of three different scenarios of potential index returns for US (S&P 500) and European equities (Eurostoxx 50), each index level would be 2,450 and 2,550, respectively, in a bearish scenario, 2,780 and 3,100 in a central case, and 3,000 and 3,500 in an optimistic situation.
  • Comparison with 2008 GFC and 1987 crash: A recession is already under way, despite the quick and massive stimulus enacted. Going forward, in a rosy scenario with an economic recovery from Q3, a 1987-style recovery would be possible. If a recovery does not take place until the end of 2020 or even by Q1 2021 (our central scenario), the 2008 crisis could be a better reference point. From a market perspective, in both the above crises, stock markets converged to around 20% below their pre-crash levels one year after the start of the crash. Based on these simulations, a first reference point was reached with the first large downward move. It remains possible that the equity markets will go down one more step. Meanwhile, investors who started to build long-term positions on this type of level during the crisis of 1987 or 2008 would have ended up with attractive performance over a reasonable time horizon.
  • Risks and opportunities: The fall in European EPS could be equivalent to or much worse than that recorded in the 2008 crisis, given the unprecedented confinement measures. It is key to keep a strong focus on stock selection and a clear tilt towards quality. Investors should evaluate companies from a bottom-up perspective to identify solid businesses with forecastable business models, trading at significant discounts to their intrinsic fair values. Balance sheet strength is critical. While there are opportunities within healthcare, consumer staples/discretionary and utilities, we are cautious on energy, and financials. There are also selective opportunities arising from the historical valuation disconnect between value and growth in Europe. 
  • Permanent disruption and resilient stories as a result of crisis: We could see a ‘lasting impact’ on certain industries, given that governments are increasing their roles through significant fiscal stimulus. Debt accumulation will be significant and interest rates will remain low. Companies that are helped during the crisis by governments could have to carry a larger social burden and face more regulation. However, not all companies will be supported by governments. Therefore, from investors’ perspectives, it will be critical to distinguish companies and sectors that can survive the crisis (better positioned) from those that cannot withstand the downturn. This is possible through a case-by-case analysis of balance sheet sustainability and individual business models. Investors need to be careful about their exposure to disrupted business models, and allocate resources to names that will be able to transform themselves. On the other hand, what was expensive and good quality before the crisis is now more affordable. So, this can be another area of opportunity for long-term investors.
  • Impact on ESG evolution: As the crisis evolves, there is a potential for fiscal stimulus to be targeted at the ‘green deal’, especially in Europe, on initiatives such as the energy transition from fossil to renewable fuel. An increasing role of governments could be positive for areas such as employment, wages and health. This could result in some rebalancing of the three pillars, with ‘S’ gaining prominence. ESG remains an integral part of stock selection.

 

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