+1 Added to my documents.
Please be aware your selection is temporary depending on your cookies policy.
Remove this selection here

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

 

 

 

Header

 

Flag-UK

 

1. Auteurs
  • 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.

 

Market correction due to Covid-19 crisisMSCI All Country World Index

The spread of coronavirus outside China to the rest of the world, notably Europe and the United States (the two collectively represent 75% of MSCI ACWI) triggered a worldwide stock market crash, with falls ranging from 30% to 40% across the world in just 16 days. The rebound that followed has been significant but still partial. At the time of writing, many questions remain unanswered: how long will the pandemic last? How deep will the recession be and how long will it last? We use three scenarios to depict the situation. Under the rosy scenario (30% probability), we forecast a U-shaped recovery that could begin in the third quarter. The central scenario (50% probability) also calls for a U-shaped recovery, but with a lower and longer bottom, and a recovery that would not occur until the fourth quarter or even the first quarter of next year. Finally, a risk scenario (20% probability) has a pattern that would appear to be L-shaped and a recovery would be weak initially.

During the 1987 and 2008 crises, equities were very volatile for around three months before moving in the opposite direction. This time, market direction would depend largely on the evolution of the healthcare crisis

A comparison with the 2008 GFC and the 1987 market crash

The current stock market panic, which started on 20 February 2020, is of the same order as the crash of October 1987 and the Lehman moment in September 2008, with reference to the S&P 500, which lost 30% in a short time span. The two historical shocks present differences: 1987 did not lead to a recession, whereas the bankruptcy of Lehman Brothers prolonged the subprime crisis, which started in 2007 and led to a recession. However, there are also some similarities. In both cases, equities were very volatile for around three months before moving in the opposite direction. This duration is interesting to note because it is about the same time it took for China to contain the current Covid-19 outbreak. If we draw a parallel, as we write, equity markets would be within this volatile period.

2. Graphique page 3

In a rosy scenario, with a recovery from Q3, a 1987-style rebound would be possible. If a recovery does not take place until the end of this year or even by Q1 2021, the 2008 crisis could be a better reference point

 

 

Irrespective of the path taken by equities during the two previous crises, stock markets converged to around 20% below their pre-crash levels one year after the crash started

 

 

It is a given that a recession will take shape in the first half of 2020, despite fiscal support measures. These measures — above 3% of global GDP — and the monetary policy responses have been much stronger and quicker than in 2008. But, the direction that markets take will depend largely on the evolution of the healthcare crisis. In a rosy scenario, with an economic recovery from the third quarter, a 1987-style recovery would be possible. However, if a recovery does not take place until the end of the year or even by the first quarter of 2021 (our central scenario), the 2008 crisis could be a better reference point. In November 2008, the US Treasury, under the TARP, stepped up and took direct stakes in the capital of the most fragile financial institutions [1]But this did not prevent markets from repeating a downward move of a further 25% vs. the lows reached after the crash, before eventually finding a bottom on 9 March 2009. Regardless of the path taken by equities during the two previous crises, stock markets converged to around 20% below their pre-crash levels one year after the crash started. When we transpose this to the current context, it roughly corresponds to a level of 2,700 for the S&P 500.

Based on these simulations, we conclude that in the present situation, a first reference point was reached with the first large downward move. It remains possible that equity markets will go down one more step. At the same time, investors that started to build long-term positions on this type of level during the crises of 1987 or 2008 would have ended up as winners over a reasonable time horizon.

[1] TARP: Troubled Asset Relief Program was a plan of the US government to purchase toxic assets and equity from financial institutions to strengthen the country’s financial sector during the 2008 crisis.

Impact on valuation

At a time when visibility is low, building scenarios in terms of valuations and mean reversion could offer some objectivity. A central scenario could retain the hypothesis of a mean reversion of the 12-month trailing PER to its 10-year average [2] .A bearish scenario would use the assumption of a return to the average minus one standard deviation. Finally, an optimistic scenario forecasts a return of indices to their 200-day moving average.

3. Graphique page 4

[2]  Price-Earnings Ratio.

According to our central case, we could see a mean reversion of the 12-month trailing PER to its 10-year average, whereas under a bearish scenario, PER would return to its 10-year average minus one standard deviation

These mechanical scenarios would target 2,450 for the S&P 500 (bearish scenario), 2,780 (central) and 3,000 (optimistic). It is interesting to note that this central scenario result corresponds approximately to the same level as the ones mentioned above in parallel with 1987 and 2008. Applying the same logic to the Eurostoxx 50, the result would be 2,550 (bearish), 3,100 (central) and 3,500 (optimistic), respectively.

We can also model an extreme case (value at risk in the chart). What would happen if the shares were paid for at as cheap a rate as at the market bottom on 9 March 2009? In this case, the S&P 500 had reached a 12-month trailing PER of 10.5x, which would correspond today — all other things being equal — to around a 1,710 index level. Of course, such a perspective cannot be excluded completely from our discussion; it would require a second-round impact with a more-entrenched-than-expected coronavirus pandemic and/or a large wave of company defaults, although this is what policymakers are trying to avoid with their strong commitments. While this could be a scary outcome in the short term, if we were to follow the 2008 pattern, such a further decline would likely only be temporary.

 

Focus: Assessing European earnings growth and how this would respond to the current crisis

In terms of earnings growth, depending on the scenario — optimistic, central or bearish — we foresee declines in year 1 (2020) by 35%, 60% or 110%, respectively. Then, in year two (2021), earnings should rebound to their initial level in the rosy scenario, 10% below that in the central one, and 60% below in the pessimistic scenario.

4. Tableau page 5

Given current uncertainty, we cannot completely rule out a new surge in market stress, especially if the pandemic were to last. Alternatively, we cannot completely ignore the possibility that in one year, earnings could start to rebound

A regression between forward profits and the level of the MSCI Europe index suggests that the market is already pricing a 35% drop in for 2020 EPS, in line with the rosier scenario (-35%), but less than in the 2008-09 period and also less than our central forecast of -60%. This calls for two concluding remarks: on the one hand, we cannot rule out a new surge in market stress, especially if the pandemic were to last or if there is a second-wave of infections. However, another interpretation would be that in one year, earnings could start to rebound, even in our darker scenario and the market will anticipate. Therefore, it is appropriate to say that while volatility scares investors in the short term, it could also bring long-term opportunities.

5. Graphique page 5

The effect of Covid-19 crisis on earnings could be worse than in 2008 because the outbreak points to a severe recession, given the unprecedented confinement measures affecting demand, supply and solvency

Impact of the crisis on earnings growth

In order to have some benchmarks, we look at the earnings dynamic during the GFC of 2008-09. At that time, MSCI Europe EPS fell by 20% in 2008, out of which -60% was in Q4 (-12% and -33%, respectively, for the MSCI ACWI) [3] . Then, European EPS nosedived by -47% in 2009 (-43% for ACWI). All in all, by end-2009, European EPS were 57% lower than their pre-crisis level of end-2007. By sector, on the same timeframe, the worst drops were registered by autos (-114%) and financials (-99%), whereas utilities (+2%), telecom (+6%), healthcare (+11%) and consumer staples (+24%) proved more resilient.

Compared to the GFC, the impact of the Covid-19 crisis on EPS could be even worse. This is because the outbreak of the pandemic points to a severe recession. We foresee 2020 real GDP growth ranging between -1% and -4% in the Eurozone and 0% to -2% globally. In 2019, European and global growth were +1.2% and +3.1%, respectively; in 2009, they hit -4.2% and -0.1%. The expected range for 2020 growth is unusually large as it depends very much on the longevity of the virus outbreak, the severity of the lockdowns, and the depth of the economic disruption and its impact on corporate default rates.

 

To illustrate that, in France, the National Institute of Statistics and Economic Studies (INSEE) has estimated that French GDP is contracting at a pace of around 35% during the lockdown. In other words, each month under lockdown would shave approximately 3% off French GDP. The EU has given similar indications of a reduction of 2% per month, as the lockdown is less stringent in the northern part of Europe. Ultimately, each passing week brings us closer to the bottom of the forecast.

In 2009, European EPS dropped by 47% vs 2008 and by 57% compared to 2007. This time, the EPS fall should be equivalent — or even worse — given that the unprecedented confinement measures affect supply, demand and solvency. Furthermore, the drop should be concentrated in a single year whereas in the GFC, the fall was spread between 2008 and 2009. On top of that, beyond the Covid-19 issue, the oil crisis will also leave its mark on EPS growth, and not to forget the plummeting buybacks. The peak of the freefall should occur around March-April, when the lockdown will be the most acute. 

As per our central scenario for European earnings, with the pandemic peaking in Europe by Q2, with some normalisation in Q3 and acceleration afterwards, we could see a 60% decline in 2020 EPS

The real unknown relates to the second half of the year. Our European forecasts have been developed around three scenarios. According a central scenario, with the pandemic peaking by Q2 in Europe, some normalisation seen in Q3, and acceleration thereafter, we could see a 60% decline in 2020 EPS with a quarterly sequence as shown in the chart below.

6. Graphique page 7

[3]  MSCI ACWI = MSCI All Country World Index

In a more negative scenario, we could see a delay in economic normalisation, with 2020 EPS falling by 110%. An optimistic case would see an overall EPS drop of c.35% in 2020

EPS growth should be -40% in Q1, with further losses in Q2, a sequential improvement in Q3, but not on a year-on-year basis (-55% year-on-year in Q3), and -40% in Q4. Given the base effect, in 2021, we could see a massive rebound (above 100%), although 2021 EPS would probably remain lower than 2019 EPS, given the lack of pricing power and the rise of restructuring charges and goodwill depreciation.

Under a more negative scenario, we could see a delayed normalisation of the economy due to risks of resurgence of the epidemic post the initial confinement measures. In this case, 2020 would be in red, with a 110% EPS decline, and losses could extend until Q1 2021. Finally, in a more optimistic scenario, we could witness rapid availability of a treatment, with stabilisation from end-May. EPS would be down 70% in H1 and almost stable over H2. This would result in an overall EPS drop of around 35% in 2020, before a very strong rebound in 2021.

Counterintuitively, looking at the distribution of changes in EPS growth over 2019-22, the bulk of the uncertainty occurs between Q3 2020 and Q2 2021, but not in Q2 2020, as shown in the chart below.

Looking at the distribution of changes in EPS growth over 2019-22, the bulk of the uncertainty occurs between Q3 2020 and Q2 2021, but not in Q2 2020

7. Graphique page 7

To summarise, depending on the scenario — optimistic, central or dark — we foresee declines in year one (2020) of 35%, 60% or 110%, respectively. In year two (2021), earnings should rebound to their initial levels in the rosy scenario, 10% below in the central one, and off 60% in the pessimistic scenario.

In this phase of uncertainty and of a sudden economic shocks, markets have distinguished companies with strong balance sheets from those with weaker ones

Fundamental investing amid the Covid-19 outbreak

The first correction phase was indiscriminate, with stocks falling across the board and even assets such as gold, considered to have safe-haven status, declining. We saw a ‘liquidation’ phase as investors sold out of even the most liquid assets to limit portfolio volatility or face redemption pressure. The second phase was more discriminate as central banks stepped in and investors became more selective, favouring companies with strong balance sheets and resilient business models, as shown below.

8. graphique page 8

Equities look vulnerable, but as active, bottom-up investors, we focus on companies with strong balance sheets and resilient business models trading at a significant discounts to their fair values

Still, equities look vulnerable overall. While there has been a significant sell-off, the economic impact of the current health crisis is also significant and its severity still uncertain. Visibility for companies is extremely low. Multiples have de-rated, but earnings estimates have not yet been cut sufficiently, in our view. Uncertainty remains very high. 

We evaluate companies from a bottom-up perspective to identify solid businesses with forecastable business models, trading at significant discounts to their intrinsic fair values. Market environments like these typically create opportunities for long-term active bottom-up investors, and the current environment is no exception. Good opportunities look to be available in both defensives and cyclicals, but the common denominator is that we prefer companies with strong balance sheets and cash flows, and resilient/non-disrupted business models. For instance, the luxury sector appears interesting in the long run, as the inventory is not perishable and customers could return after the crisis.

However, some weaker companies in weak industries may not survive the current economic situation and avoiding these will be critical. National incumbents in the auto and airlines sectors look very vulnerable, and some are likely to require debt guarantees, equity issuance and potentially nationalisation in a matter of months. We consider telecoms and utilities to be less exposed to this trend.

Certain structurally appealing and resilient sectors, which were previously very expensive, now look compelling. In this area, we see new opportunities in healthcare, consumer staples and luxury within consumer discretionary. Technology also remains on our radar.

Value also presents some idiosyncratic opportunities due to attractive valuation. Value has never been this cheap relative to growth in Europe. Bond yields and PMIs are holding back an overall reversal of the value underperformance, but great idiosyncratic opportunities exist within value, particularly in materials and industrials. In contrast, other parts of value look like they could continue to be vulnerable, such as energy, media and autos at this stage. All in all, we maintain a bias towards quality and financial solidity.

There is potential for fiscal stimulus to be further targeted at the ‘green deal’, especially in Europe, on initiatives such as the energy transition from fossil to renewable fuel. A rollback of environmental legislation, if at all, will be temporary

A first assessment of the long-term implications of Covid-19

There are concerns about the permanent impact of the crisis in certain industries. It seems evident that the role of governments may be bigger as they are implementing significant fiscal stimulus measures. Consequently, debt accumulation is significant, and at some point, this has to be addressed. We see a world of lower rates and ultimately some form of debt monetisation. This is important: equities overall look to be positioned well longer term.

Companies that are helped during the crisis by governments will likely have to carry larger social burdens and face more regulation. We are already seeing a wave of dividend cancellations at the recommendation of regulators as a first sign of this. We are also debating whether there will be an increase in de-globalisation as a result of this, with changing supply chains, shifting consumer behaviour in travel and leisure, different working patterns with more remote working, or different levels of public investments in healthcare.

An immediate result of the crisis may be to roll back some environmental legislation in an effort to support economies. If this were to happen, we think changes would be temporary only. There is potential for fiscal stimulus to be further targeted at the ‘green deal’, especially in Europe, on initiatives such as the energy transition from fossil to renewable fuel. The current low oil prices are unlikely to materially affect this push towards a greener economy. In addition, and as noted earlier, the immediate impact of the crisis may be a further increase in the role of governments. This could support the social pillar in areas such as employment, wages and health. Overall, the need to focus on ESG is as strong as ever — the issues are structural and growing — for long-term investors.

9. Auteur page 10
11. Icon page 10

Luxury companies and sporting goods manufacturers are areas of opportunity, while the retail and automotive sectors remain more challenging

Sector opportunities amid Covid-19 crisis

10. Tableau page 10
11. Icon medoc

Med-tech names with resilient business models and innovative pharmaceutical companies should be able to withstand the short-term volatility

 

 

 

 

 

11. Icon usine

De-carbonisation, growth in renewables and efficient transport will remain key trends. For airlines and aerospace, although there is less visibility on a recovery, we believe long-term drivers for air travel demand are intact

11. Tableau page 11

12; Icon banque

 

The crisis will shake out banks with weak balance sheets, so we look for quality banks with strong capital levels. In diversified financials, ethical-social approaches to investment/savings propositions will be even more critical

12; Tableau page 12
13. Icon microbe

 

We are looking for large, geographically diversified telecom companies; in IT, we believe businesses operating around connectivity-related themes will benefit

13. Tableau page 13
ELMGREEN Kasper , Head of Equities
MIJOT Eric , Head of Equity Strategy, Deputy Head of Strategy Research
WANE Ibra , Equity Strategy
MOUZON Luc , Head of Equity Research
Send by e-mail
Covid-19 will redesign sector opportunities amid gradual normalisation and focus on earnings
Was this article helpful?YES
Thank you for your participation.
0 user(s) have answered Yes.
Related articles