Covid-19 update: navigating a path through lockdown

As we move from April into May the world economy remains in the grip of the Covid-19 crisis and its associated social-distancing lockdown but, thankfully, estimated fatality rates are being revised downwards and the rate of new infections is on a clear downtrend in most countries.

There could be a moment where infections suddenly ‘melt’ away as seen in Germany. This is believed to occur as the number of positive cases is partly a function of the number of tests available. As hospital admissions fall, surplus tests are used more widely within the community and pick up infections with less serious symptoms. The infection rate glides down gently but the detection rate is increasing, leading to a sudden fall off as infections rates continue to fall and detection rates peak.

Germany is thought to have the most efficient testing programme in Europe, and this effect could explain the swifter fall, with infections falling from 6,000 per day to less than 150 in a little more than a month.

Most jurisdictions, including the UK, have either already begun easing lockdown restrictions or are preparing the groundwork to do so. Stock markets have already begun discounting the likely economic recovery generating strong returns in April. That said, the still uncountable cost of the lockdown will require enormous government spending for years to come.

As it will be impossible to fund this spending through taxation without generating a recession, governments must now turn to their central banks for funding. In stating “now is not the time to worry about federal debt”, Fed Chairman Powell has made clear his intention to provide whatever funding is needed. It is likely therefore that rising stock prices are anticipating both an economic recovery and monetary devaluation. Both these factors are likely to push stock markets to new highs over coming years.

In the short term, however, risk remains, as a resurgence of infections could derail the optimism rapidly. On the other hand, medical science and technology could accelerate the recovery potential. The risk of a second wave in the winter is also possible but likely to be discounted by markets in the short term.

There is evidence of market dislocations in valuation terms and we continue to believe that being invested with high levels of diversification across a range of high-quality assets is appropriate, especially given the uncertainties which currently exist.

Operating through a world in lockdown

Over the last few weeks a number of companies have released Covid-19 related trading statements. The broad effects of coronavirus on the economy have, so far, been largely negative with corporate profits falling and in some cases dividends being suspended BUT there have been an encouraging number of net positives.

Although we don’t often refer to individual companies as Clarion invests through Funds and Unit Trusts, I thought it might be interesting to share the recent results and comments from some of the companies in which our fund managers invest.

Many companies in the consumer branded goods, healthcare and digital sectors are relatively well insulated to both the lockdown-measures and broader economic fallout. This type of company forms a core bedrock of resilience in terms of the cash generation and profitability in the funds deployed by the Clarion Portfolios.

Procter & Gamble, for instance, announced organic sales growth of +6% in the January-March quarter, and management continue to expect sales growth of +4% to +5% for their full year results. As P & G management put it when presenting their results last week:

“Consumption of our products is not likely to dissipate. In fact, the relevance of our categories in consumers’ lives potentially increases. We will serve what will likely become a forever altered health, hygiene and cleaning focus for consumers who use our products daily or multiple times each day. There may be an increased focus on home, more time at home, more meals at home, more cleaning of homes, with related consumption impacts.”

Unilever, another holding in our funds, is more impacted than P & G given a portion of its sales are generated from out-of-home food consumption. However, approximately 80% of sales are through supermarkets and online channels and the company’s exposure to categories such as soaps, hand sanitisers and surface cleaners will be helpful over coming weeks. Organic sales were flat in the company’s first quarter (January-March).

Large software and technology firms such as Microsoft and Intel have noted a pick-up in demand for digital services (Microsoft Teams etc.) and IT infrastructure products (to increase server capacity, facilitate working-from-home etc.). Microsoft commented that the world has experienced “two years-worth of digital transformation in two months from remote team work and learning to sales & customer service to critical cloud infrastructure & security”. All positive developments for the future.

Sage, though impacted by lockdown given its customers are mainly small and medium-sized businesses, is helped by its recurring revenues and still currently expects to grow organic sales for the full year, though at a lower rate than previously expected.

Healthcare company Roche last week announced sales growth of +7% in the first quarter, and reiterated guidance of growing sales and earnings for the full year. Roche has infection and antibody diagnostic tests for Covid-19 and has moved quickly to increase production for both products. The company also has a promising combination therapy to help treat severe Covid-19 pneumonia.

Spontaneous online shopping seems to be on the rise. Zalando, Europe’s largest online fashion retailer and another favourite holding by one of our fund managers, reports that new customer growth in April was at its fastest ever. Demand for dresses is down, but home-based chic has boosted sales of sports and casual wear. In April the shares rose 10% to an all-time high.

The cold mathematics of the bond market are also worthy of mention. As an example, the 2.75% Treasury 2065 is trading at £182.8. This will eventually mature in 2065 at a value of £100, having paid out £2.75 per annum through the intervening period, equating to an overall yield of 0.47%. If the Bank of England are successful in achieving their 2% per annum inflation target, the erosion of spending power, after accounting for the yield, will be very close to 50%. This does not meet the primary goal of most investors to achieve a real return on capital, i.e. adjusting for inflation. Given the level of stimulus being applied both monetarily and fiscally, the long-term inflation outlook is increasing despite the short-term deflationary factors driven by falling demand.

Adaptability

Well-managed businesses have a general habit of being able to incrementally adapt to changing conditions in the economy, the political environment and their own industries as time passes.

A strong culture of adaptation has been more valuable than ever this year, given an operational environment unlike anything we have seen before. It is fascinating to see the speed at which companies have dealt with and adjusted to the issues at hand. Where deemed essential, operations have largely continued to run with new measures in place. Many companies have been able to keep the majority of their facilities open on a ‘business as usual’ basis, whilst working hard to ensure they are complying with World Health Organisation guidance and keeping their employees safe. Some of these companies, among other things, form an important part of the supply chain for vital medical devices such as ventilators and diagnostics testing kits.

This culture of adaptation will remain important over coming months and years. The operational environment will remain subject to quite dynamic levels of change, as will shifts in customer demand trends, habits and mind-sets as life begins to get back to a ‘new normal’ post lockdown.

It is interesting to note that companies operating in emerging markets are perhaps particularly well practiced at responding to unpredictable, dislocating shocks, given that these events can be quite regular occurrences in these regions, even at the best of times. Companies that have effectively digitalised their businesses over recent years will also be well placed to adapt quickly and flexibly.

Global crises have in the past unleased dynamic new trends and it is very likely that the coronavirus crisis will, in time, do the same.

Good stewardship

A number of companies are putting a great deal of thought into the health of their long term franchise and the important role that they play in the ecosystem in which they operate: the actions that companies take this year will be remembered for many years to come.

Unilever, for instance, has always been managed with an eye to the long-term and pursues a ‘multi-stakeholder’ approach to running the company. True to form, management have been quick to free up 500 million euros of working capital specifically to support its smaller suppliers where necessary. The company has also quickly re-jigged its production lines to maximise the manufacture of products such as soaps, hand sanitisers, surface cleaners and basic food, donating more than 100 million euros of these products to healthcare systems and vulnerable individuals globally.

It is difficult to measure intangibles such as these and they won’t be easy to spot in a financial spreadsheet. But these incremental actions (now and always) add something important to the long-term health and reputation of a company from a multitude of perspectives.

The shadow of the crisis

No one knows quite how this crisis will unfold from here. However, it is likely that for many people life will begin to return to normal as we exit lockdown, and there will be a release of pent-up demand, at least initially. Then, antivirals and vaccines are likely to emerge, which should also help the mood.

However, this path may be rocky, and consumer habits will change, with many of these habits outlasting the proximate crisis. Health and hygiene will likely remain a key priority for instance, well after the peak of this crisis has passed. International travel may be slow to recover, people may work from home more often, and online shopping is likely to continue its inexorable rise.

The psychological scars are also likely to be significant. A brief scan of economic history demonstrates that ‘once in a generation’ downturns tend to happen more regularly than, well … once in a generation. We have now experienced two in just over a decade, and consumers will inevitably want to spend less and save more in response. Higher levels of unemployment, borrowing and (potentially) higher tax rates, certainly on wealth if not on income, will add to this sense of caution.

A similar psychological scarring will occur within the corporate sector, which is likely to lead to a desire for a greater margin of safety from both an operational and financial perspective. The emphasis will shift from ‘efficiency at all costs’ to ‘appropriate resilience’. Globalised, just-in-time supply chains won’t seem as attractive after Covid-19, and the cheapest supplier may not always be the most reliable. There may also be some shift towards more localised production (a trend that had already begun prior to the crisis as a result of trade tariffs) and a higher level of investment in automation and digitalisation.

In terms of financial robustness, in the last few years the rising levels of borrowing in the corporate sector and cheap debt has been used to fund acquisitions and buy-backs to artificially ‘juice up’ earnings growth (and, in some cases, to fund unsustainable dividend payments). This move to more ‘efficient’ balance sheets will, in hindsight, appear questionable. To use the major US airlines as an example, they have spent $43 billion on share buy backs in the last 6 years whilst at the same time increasing their total net debt. In the same period the four CEOs pocketed $430 between them. The industry has just needed US government support of $25 billion and is also raising additional capital.

At a market level, we are likely to see a shift back to more financial conservatism and a subsequent retrenchment from large buy-back programmes and acquisitions, at least over the next year or two. Many of these shifts may impact profitability in the corporate sector somewhat over the short-term, but should in many ways be viewed as a healthy development that will lower the stock market’s risk profile for the medium to long-term investor.

However, not all consumers and companies will stay prudent forever! Many of the above lessons were learnt following the 2008/9 crisis and promptly forgotten over the subsequent decade. As a seasoned financial market observer once put it, “in science knowledge is cumulative, but in finance it is cyclical”.

It is also possible to predict with reasonable confidence that the dramatic increase in money supply created by the massive stimulus to fund fiscal deficits will continue to cause asset price inflation which augurs well for the medium to long term prospects of stock markets.

In conclusion, from a personal and human point of view, when this is all over the amount of money we spend and where we spend it is likely to change. When the storm passes, I expect we will see more domesticity, a simpler life and a stronger focus on the people we have in our lives and the people we love… not the things we want.

On behalf of us all at Clarion, best wishes to you for continued safety and good health.

Keith W Thompson
Chairman Clarion Wealth Group