Weekly update on the impact of COVID-19 on the financial markets
Roy Maslen - AllianceBernstein - Tuesday 5 May 2020
Paul O'Connor (POC): Welcome to the Netwealth Portfolio Construction Podcast series. My name is Paul O'Conner and I'm the head of investment management and research. Part of my role at Netwealth is to manage and govern the investments that we make available to you through the Netwealth investment platforms.
I feel fortunate to have this interaction ongoing as it provides a lot of insight into both markets and the securities held by fund managers in their portfolio and provides the opportunity for us to really develop relationships with the portfolio managers and their research teams. Today we're fortunate to have Roy Maslen from AllianceBernstein who was appointed chief investment officer of Australian equities in 2012 and has been managing Australian equity portfolios at AllianceBernstein since 2005. Good morning Roy, and we appreciate your time this morning.
Roy Malsen: (RM): Good morning.
POC: Given Roy's focus is Australian equities, I thought for today's podcast we'd mainly concentrate on discussing the Australian economy and listed Australian equity market. I recall Roy when AB announced you as the new head of Australian equities some eight years ago, so I can't believe time's gone by so quickly. How are you and the team interacting given the challenges created by the isolation policies as a result of Covid-19?
RM: Thank you. Well, first of all, I'd like to send our best wishes to everybody that's listening in, friends and family. First and foremost, this is a personal tragedy in Australia and around the world, so we send our best wishes to you.
POC: And the interaction with companies was positive? Not being able to see them face to face there, but obviously doing it over a software like Microsoft Teams or over the traditional phone?
RM: Yes, I think we aspire to have two way discussions with the management teams that we speak to. So it's not just a case of us asking them a bunch of questions, but build those relationships over the last 20 years. So we've actually found management teams, even in the early stages of the crisis, were keen to talk to us to hear what their key investors thought and hear our thinking and what we were seeing around the market.
So we were, I guess almost pleasantly surprised that the level of engagement was substantially higher in those early weeks. So what were the companies saying? Well, in those early stages it was a great change for them because things were changing so quickly. So there was a huge amount of uncertainty. So it was in many regards around scenario testing and stress testing with a really strong focus on cash flows and balance sheets.
POC: Starting with Covid-19 what's your current outlook for the spread of the virus and do you believe countries are now containing the virus?
RM: Yeah, so there remains a large amount of uncertainty as to exactly how this would play out, but we can talk about maybe a couple of areas where it's more positive and a couple of areas where we think the risks aren't fully appreciated by markets. So the bright spot would be Australia in particular, where our ability to contain the virus and flatten the curve and possibly even eradicate it I think has exceeded certainly our expectations. And there are a small number of economies around the world that are in that category. I would put Australia, New Zealand, and Taiwan in that category.
Moving to Europe. There's clearly been a terrible kind of human tragedy play out in Europe. But there's very strong signs that, and certainly places like Italy and Spain, big chunks of Europe now that they've gone beyond flattening the curve and could contain it.
The two areas I think are for risk are both for individuals and also for markets are the US and emerging markets. So in the US for four weeks now, we've had reached about 30,000 cases a day. It hasn't really trended down to any significant extent. There is some encouraging signs in the USA because the number of tests are up on the number of positive tests as a lower number. So, that is slightly encouraging.
But we remain concerned in the US about their ability to contain this because the US political environment, the healthcare environment, and also I guess the focus on civil rights is going to make it potentially challenging for them. So there are more risks of a wave in the US than there are, for example, in Europe.
However, the area that the markets and the mainstream media aren't focused on as much as emerging markets. Outside of China, we think it's going to be difficult to contain this. So there's a big chunk of an emerging markets that aren't as wealthy as, for example, South Korea, and I'm thinking here, places like India, Pakistan, Bangladesh, Indonesia, Mexico, Brazil where we think that there is unfortunately a quite a high probability that the virus cannot be contained and the head towards herd immunity, which is going to have profound impacts on their economies and also make it very difficult for them to reengage with countries such as Australia that's managed to contain it. So in many ways, the biggest downside risks here, both at a personal level and importantly for markets, is in those emerging areas.
POC: What do you mean there Roy? By herd immunity? Are we talking about the virus actually being spreading effectively uncontained through a country?
RM: Effectively. The reason that this is important in emerging markets is we believe one of the primary drivers of the virus is the population density and the ability for individuals to social distance because they have the wealth to contain food. So, I like to take, for example, Calcutta in India, their population density is 1,600 times greater than Wuhan and people cannot afford to stay socially distance for a month. So if we see Covid-19 take root in, for example, those major cities and the high density areas, it's going to be hard to contain it.
So we're seeing cases now take off in India, that's a concern. But actually close to Europe, there are 3.6 million Syrian refugees in camps. And there are early signs from Médecins Sans Frontieres, that Covid-19 has started to get into those camps and if he gets into the camps, it's clearly going to really create fear and potentially geopolitical risk as those people try and enter Europe.
So this kind of emerging market, so it has a profound impact. If I might just talk about what that means for economies. If I take Thailand as an example, if this gets out of control in Thailand, 17% of their economy is based on tourism, and I think clearly tourism is going to be constrained for an extended period of time. If we see a broad based Covid-19 there. However, the physical products such as the cars they make to replace the ones we used to make in Australia will still probably come from Thailand to Australia. So, it's not the whole economy will be shut down, but if they have to separate themselves from the developed world, I think that's going to be very challenging for those-If they have to separate themselves from the developed world, I think that's going to be very challenging for those emerging markets.
POC: So Roy, what do you believe is the chance of a cure or a vaccine being developed over the next 12 to 24 months? Or do you think we'll have to contain the virus via isolation policies?
RM: So I think there's a significant uncertainty around how technology will impact the spread of COVID-19. I think about that in three ways. One is vaccines, one is cures, and then the abilities to identify and trace and test people that are potentially ill. In terms of vaccines, the challenge here is the kind of illness is a hard one to cure. Coronavirus is basically a surface born illness. So it actually sits on the lung, outside the lung wall. Historically those are tough to solve. The good news is we're spending more money and more effort and more focus on this than we've ever spent on any illness in the past. We certainly can't be in a situation where we're expecting a virus solution to come out in coming weeks and months. It's more likely to be at best end of this year or early next year.
RM: Even if a vaccine is made, there are concerns around how quickly you can make it and whether that's actually just a temporary cure or a lifetime cure. So vaccines, I think although they're important to solving the social problem, are unlikely to have a big fundamental impact on markets. In terms of cures the way a cure that could come through is in the short term, if something already existing such as the Gilead Drug actually helps treat. I think we would be fortunate if the world finds an existing drug that is a complete cure. That does however, have really positive benefits even if it just reduces mortality or gets people out of hospital.
Firstly, it can help frontline medical staff recover. Importantly, it may make it politically easier for governments to open up their economies if there is some kind of cure that's available. The area of technology that's likely to have the greatest impact though is to being able to industrialise testing and to trace people that are ill. I think governments will be more open to ending lockdowns and restrictions if they believe if there's a second wave outbreak, they can quickly identify it and do industrial level testing. What I mean via industrial level testing is moving to a situation if there's a breakout in one suburb, in the Mornington Peninsula, that you can just go through and test everybody and come back two weeks later and test everybody again and eradicate it that way. So in many ways testing is going to be the most important part to contain the virus.
So when we think about any economy, there's really three questions we're asking ourselves. One is how much damage has already been done if restrictions are reduced? Secondly, what's the chance of a second or potentially third wave? Thirdly, through all the government action and central bank actions through fiscal and monetary stimulus, could that cause stresses in the system?
For Australia our focus is the first of those questions because we think a second and third wave we're hoping and at this stage, we think is unlikely. Although we're now printing money, we might come back and talk more about that, fiscal and monetary stimulus is less of a concern.
So, the real question is how much damage has already been done is not dissimilar to maybe the RBA and consensus of some of the major economists is that towards the end of the year we would see unemployment probably add or adjust abour 10% and then starting to drift down in calendar year 2021. What that means is by the end of 2021 or the start of 2022, the economy would be about the same size as it was in calendar 2019. So effectively we've lost two whole years worth of growth.
Now the downside risk to that could be several. One is obviously the second or third wave, but perhaps more importantly is the impact of a slowing global economy dragging Australia down further. We actually think that Australia has greater risk from the slowdown in countries such as the US and emerging markets bring a draw on our own economy.
POC: Yeah, well I guess it'll be interesting also to understand China's fiscal response to the crisis and the economic slowdown given the impact they're spending heading 2008, 2009 on the Australian economy and the demand for iron ore, which really carried us through the global financial crisis back in those days as well.
RM: So just on that point. One of the big surprises this year has been how little China's stimulated their economy and there's a debate as to why has that not happened and are they going to spend more to stimulate their economy? I think there's a few important differences. Out of the 2008, 2009 economic cycle, the Chinese fired an economic bazooka to stimulate their economy, but it created a lot of debt issues and they have continued to support the growth of their economy through increasing debt, both at a corporate, financial, and government level. As a result of this, the Chinese are increasingly concerned about not having too much debt in their economy. So they're trading off stimulus that is debt funded through not trading excess leverage. At this stage, I think they have moved to a situation where they're cautious about firing that economic bazooka again and printing a lot more debt.
I think it somewhat helped politically because the belief within China now is that they have managed this crisis better than many of the Western world economies and as a result, there's a lot of support for the way that China's handled this and they don't feel the same need to have a big economic stimulus. So although we believe the economic stimulus in China will grow from here, we're not at this stage anticipating this big blockbuster spending that we saw in 2008 and nine.
POC: Before we bring you the second part of this chat, a little bit about who we are. Netwealth is an ASX listed company established to help Australians take control of their financial futures. With a wide range of super and investment accounts, a huge variety of investment options and market leading online tools, we can help you manage your wealth your way. Partner with us to see wealth differently and discover a brighter future. Visit the Netwealth website to learn more and get the PDFs which you should read before making a decision. Products issued by Netwealth Investments Limited.
Yeah. China certainly does appear to have handled and manage the crisis better than a lot of countries. Particularly the European countries that you spoke to earlier there Roy. In terms of the RBAs monetary response and the fiscal response of the Morrison government, what's your view on those policies and do you think they're having a significant impact on Australia's economy?
In this episode, Christopher Joye from Coolabah Capital joins us to discuss the impact of COVID-19 on the Australian economy, including the potential damage to the GDP, current state of the fixed interest market and an outlook on Australian property.
RM: Yes. So let me just take the RBA and then the government separately. So first of all, if I go back to 2008, nine the financial failures around the world were predominantly, not entirely, but predominantly liquidity related. So ultimately a financial institution can fail in one of two ways. Either the bad debts mean that there's no equity left in the business. That typically takes some time to play out. What happens much more quickly, and this drove under Bear Stearns and Lehman is if there's a loss of confidence and therefore a liquidity issue, then financial institutions can fail very quickly. Central banks in Australia, the RBA and around the world have learned the lesson of 2008 and nine. So they have flooded the world with liquidity. The numbers are truly mind-boggling.
If I look at the Fed in the U.S., they've signed up to print four to $5 trillion of money. Since March the first, they printed two and a half trillion dollars of money. To put that in context, that's almost twice as much as they did in the whole of the financial crisis, twice as much as the whole of the financial crisis just since the start of March. What that's meant is that financial institutions are not concerned about liquidity. So that rapid failure model has been basically taken off the table at this stage. In addition, the RBA - In addition, the RBA has targeted their QE in a way that has out reduced the funding costs to the banks, which is also good for their earnings and cash flows. So the benefit of that money printing has been effectively to take that systemic financial risk off the table.
In terms of the government response, the fact that it's been focused on JobKeeper and retaining the economy, so when we come out the other side of COVID-19 makes a lot of sense to us. So the way we were thinking about the impact on unemployment, if I go back maybe two months, we were thinking unemployment would be in the 10% to 15% range. Probably prior to the JobKeeper package, it was closer to the 15%. As a result of the JobKeeper package, it was closer to the 10%. And given the strong containment of COVID-19, that gives us more confidence that it will be closer to that 10%. So those packages have been really important.
The question is going to be for the Australian economy coming out of this is not just the total economy wide impact, but which segments within the economy will recover most quickly and which will be most challenging. So we think there is going to be an ongoing recession, for example in international tourism, but other parts of the economy, particularly in healthcare such as elective surgery is likely to recover much more quickly.
POC: Well, turning our attention to the Aussie equities market, what's your view on the market? It must be very difficult to understand and gauge the impact on companies earnings as a result for the economic slowdown. You've touched on the impact on the travel industry, et cetera, but what are your comments and observations on looking at the ASX at the moment?
RM: The ASX is clearly a reflection of what's happening to earnings here in Australia. But the biggest determinant of our level of the market is still US S&P 500. That drives the sentiment for equity markets around the world. So if I think about the outlook for the markets for me, it's really hard to call on the short term and we don't look to build portfolios that are making a call on short term. I think there is a very credible bull case from here and there's a very credible bear case from here. I would argue the risks are skewed to the downside, but it's hard to call. So let me just talk about the bull case and what could potentially drive markets higher.
Let's just come back to the US economy. It's about a $20 trillion economy, and the expectations are now that it will be probably close to 2 trillion smaller this year that we might have expected prior to COVID-19. If I line up against that close to $2 trillion problem, as I mentioned earlier, there's going to be $4 to $5 trillion of money printing and $2 to $3 trillion of financial stimulus in the US. So we're throwing $6 to $8 trillion at a $2 trillion problem. These are mindbogglingly huge numbers, but this is what is actually been driving the market since they troughed in March, is the wall of money coming in, which is providing fiscal support to the economy and purchase of the bond market and driving equities up.
So the bull case from here is that restrictions will ease and the economy will be solved by this wall of money. And the same is true for Australia. What's the bear case? Well, the bear case is in part because of this wall of money, markets got ahead of themselves. So in Australia, the PE of our market today is 17.5 times earnings. That's about a 20% premium to its 10 year average.
The market is starting quite optimistic about the future and the recovery in earnings because we're 20% higher than the long run average. And when we look at companies bottom up, the market's downgraded earnings about 20% this year. But there are still many areas where earnings and cash flows are come downgrade and balance sheets will become stressed.
So if you look at companies bottom up, we think there's a concern. And secondly, on the downside risk, we don't believe the potential risk of a second wave in the US and in particular in emerging markets and the impact on the global economy is fully priced in. So in the short term, hard to call. We'd say the risks are probably more skewed to the downside from here, most because of the weakness in earnings and cash flows and the fact we're starting on quite a high multiple.
POC: So given your views skewed to the downside, I'm assuming your current portfolio position would be fairly conservative and you'd have a fairly high cash exposure in your portfolios at present?
RM: Yeah. So for those people who aren't that familiar with our portfolio strategy, our goal is to be very defensive. So in any market, a month the market's down. We aim to fall half as much, about 50%. In any market, a month the market's up. We aim to capture about 80% of the upside. So 50% downside, 80% upside. We've delivered close to that over now six years. And obviously that's been attractive in downside protection. So we're inherently defensive.
However, as I said, I think we are so skewed to the downside. So the kind of companies we want to invest in are those that have strong, stable businesses, strong cash flow, strong balance sheets and as a result stable share prices. So where do we find opportunity to find those kinds of companies at the moment? That's still in areas like supermarkets, it's in infrastructure, is in certain insurance companies where you play annual fees such as in IAG, it's in gold companies, it's in healthcare.
The areas that we remain concerned because we think there's downside risk would be in the area of banking, metals and mining, consumer discretionary where we still believe there's a lot of pain to come, and in property, in particular residential property exposures.
So that's broadly what we kind of like thematic claim, where we still see a lot of risks. You're right, our cash levels are a little hard typical. We often default to a fully invested basis, but at the moment we are concerned about those downside risks. Our cash levels are somewhat above 10%, which is harder than we normally have them.
POC: So the Australian banks have certainly received a fair bit of attention over the last week starting with NAB and their announcement of their dividend cap, which I think was over 60% of the dividend. What's your view on the banks and the health of the banks at the moment, and particularly the looming risks potentially in residential property in Australia?
RM: If you look at where banks were at the start of the year, I would basically characterise the bull and bear case on the banks. The bull case was the dividend. Everybody loves that dividend yield and the franking credits. And the bear case is pretty much everything else. So everything else was going against them. Fees were under pressure. Margins were under pressure. It was hard to get cost out. Bad debts or loan could only go up. There was regulatory pressures and stakeholder pressure. But that year was very attractive.
We run that through to today, obviously the yield is coming under pressure. I think the real debate is about bad debts. And the question is what's going to be the total bad debts across the banks over the next two to three years, because that will drive their ability to generate earnings and obviously provide dividends and franking credits.
So how do we think about that? Well, interestingly, in 2017 the regulator, APRA, actually did a stress test on our banking system, and some of the numbers are not dissimilar to where we are today. So in 2017, they asked themselves what if unemployment goes to 11.6% and drags down only about 1% the year after and then slowly thereafter? Their stress test had house prices dropping peak to trough about 35%.
On that scenario you had about $120 billion of bad debts from the banks. To put that in context, that's just over two years earnings for all four banks. Huge numbers. We are stress testing three scenarios with the banks, bad debts with $30 billion, $60 billion, or $120 billion. And we've been doing that for about the last six weeks.
I would say that market consensus now is about the $30 billion number. We're somewhere between 30 and 60 is our numbers. I.e., we expect somewhat worse bad debts than the market is expecting at the moment. So where are we different? Well, first of all, large individual names. We've obviously seen Virgin go bust. You don't need a lot of large individual names to go.
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We've obviously seen Virgin go bust. You don't need a lot of large individual names to go bust, and those have quite sizable impact on the banks. But obviously, the biggest driver across the book is mortgages. So there's a big question here as to what the bad debts are in that space, and it's probably one of the most live research topics as a team. So we don't think the full 35% that APRA was saying, but we're, I think, peak to trough the bad debt, sorry, the moving house prices are probably in that 15 to 20% range.
POC: So how does your estimation of what the banks are allowing for in terms of impairments compare with your view on where the mortgage market will go over the next 12 months, say? Do you think the banks have underappreciated the amount of impairments they'll experience or do you think they've allocated appropriately?
RM: We think that they've under-allocated, but this is not unusual within cycles. So to give you an example, Jamie Dimon, who's the CEO of J.P. Morgan, one of the CEOs who was being here all the way since the 2008 crisis. He's really been around. He's probably one of the most respected bankers in the whole of the US on. Their first-quarter results for March 31st, they came out with a bad debt number that was worse than the market expected. But he said, "Oh, it's two weeks after we put that number together. It's already gotten a lot worse." What I'm trying to call out from this is, the banks put together their numbers on each report date that they have, March 31st for a number of them. But historically, when the cycle gets worse, things deteriorate, and they have to provision more and more. So I don't think that they have kitchen sinked it that first time out. Far from it. In the $1-$2 billion range that they've done each, that's only the early stages of the bad debts that we might see play out.
POC: Are there any sectors in the economy or the listed Aussie equity market at the moment that are starting to present what you believe are investment opportunities, given the volatility and I guess the changing workplace behaviour and the way society is interacting at the moment?
RM: So I'd say in general, obviously with markets well off their highs that there are more opportunities, but we're, as I mentioned earlier, in some of those more stable areas such as infrastructure. But if you're asking the question about how has COVID-19 changed the shape of our economy and where does that create opportunities? I think that's an interesting question. What we see in the many crises that we've invested through, through the years is every crisis the general view is the world's going to change completely. And sometimes that's overstated. All the way back when 9/11 happened and that tragedy in New York, the expectation was that tourism wouldn't recover for many years because of that horrific experience. But six months later it was almost back to normal, so it happens really quickly. I think COVID-19 will be different. Clearly, international tourism is going to be challenging between countries where they haven't contained the virus, but there might be some overstatement of how much it really structurally changes the economy. The bigger question is the cycle we're going through.
That said, I think the success that many parts of Australia have had with technology will accelerate some trends that we're already seeing. We've seen, for example, the supermarket-sink huge lift in the amount of online purchases on food. I think a number of people have had positive experiences of that and I think we can see an acceleration on online retailing, which will be a real positive for them as they look to get to scale and have defence against the pending launch of more aggressive food strategies from the likes of Amazon. It will clearly have negative impacts more broadly on things like retail malls. In terms of offices, I think a lot of people have had positive experiences working from home. I was chatting to one chief operating officer of a large financial institution. They moved 4,000 people to work from home over a 10 day period and it's been much more successful than they could possibly hope. And the normal barriers to such major changes just got knocked down. They just had to do it.
I think this will have an impact on the demand for office space, and our view in the Melbourne and Sydney office markets, probably over the next 18 to 24 months they were going to soften anyway. I think there's a chance that that will be much more challenging, and we are going to see a lower demand and therefore moving to excess supply and putting price on those asset prices more quickly.
POC: Yeah, well I guess it's fair to say that as human beings we do everything we possibly can to resist change until our backs are against the wall and we have to change, and then we actually do surprise ourselves, I guess, in how well we adapt and change our behaviours there, Roy. So we usually finish those podcasts with asking our guests for any personal investment tips that you might be able to share with our listeners. And I guess particularly at the moment, given the amount of volatility in the market. Have you got any thoughts or any comments about, I guess, key points of your own personal investment philosophy that you've always applied to the way you look at an investment opportunity?
RM: Yeah. I'm looking at this through the lens of our managed volatility equity strategy. I think quite simply, that we think about risk very differently in that it is capital protection is that matters, and I'm going to coin the phrase here from Warren Buffett. If you're always looking for sage advice, Warren Buffett's the man to go. His simple rules of investing is rule number one, don't lose money. And rule number two is don't forget rule number one. So I think there are exciting times in markets where there are hot stocks and frothy stocks and it can be exciting to chase them, but our first and primary focus is in capital protection. So strong, stable businesses where we can see that cashflow strength and when we can see that balance sheet strength is where we focus.
The exciting chasing of those frothy stocks, we might leave those to others. And therefore, if I compare this to The Hare and The Tortoise, we're probably more in the tortoise-camp rather than the hare-camp and I think we've shown over an extended period of time that that actually wins in the end. So, that's probably one of our key philosophies here. Sorry, I might've got that the wrong way round, it's better to be the tortoise than the hare. The tortoise wins in the end. In my excitement I got that back to front. Apologies. It's the tortoise that wins in the end.
POC: Yeah, no, I think your point is well made though there, Roy. In my view, investing is a longterm game. We can't allow these short term and these medium term impacts of volatility and market downturns to change I guess our investment objective and what we're trying to achieve over the long term. It is not easy chasing those hot stocks, as you say, in the market that are the flavour of the month for a certain period and then obviously struggle to grow their earnings in line with what the share price has priced in. So some very, very good comments there. So Roy, thank you very much for joining us on The Netwealth Portfolio Construction Podcast this morning. We certainly appreciate your time and your insights, and I wish you and all the AllianceBernstein investment team all of the best through this difficult period that we're all experiencing.