Mike Kerley, Portfolio Manager, Pacific equities, shares his views on the latest developments in Asia and discusses the investment implications from an income point of view.
- Falling interest rates favor high-yield stocks as when the dust settles, the need for income for an aging global population in a low or negative interest rate environment should prevail.
- Growth-orientated stocks, which previously had been dismissed on valuation grounds, are looking attractive, particularly in the consumer and technology sectors.
- Although earnings will come under pressure in Asia, especially in the short term, we believe dividends may prove more resilient.
In recent weeks, the world has endured an unprecedented increase in volatility with market moves reminiscent of the Global Financial Crisis in 2008. The COVID-19 coronavirus started as an Asian problem with the potential to disrupt supply chains. It has now gone global, with draconian measures being implemented across the world to contain its spread, and is seriously impacting demand for many goods and services.
The fear that the slowdown in consumption could tip the world into recession has prompted central banks to cut interest rates aggressively. But the feeling is that monetary stimulus alone will not be sufficient and that a more progressive fiscal response is needed. The significant rally in government bonds is reflective of both risk aversion and the view that global growth prospects are seriously impaired.
Oil and the Energy Sector
The turmoil has been exacerbated by the significant sell-off in oil prices. The breakdown in talks between Saudi Arabia and Russia has led the former to threaten to increase production, pushing oil prices considerably lower. Although this is positive for consumers in general and countries that are net importers of oil, it has drawn attention to the debt levels in the energy sector, especially in the U.S. Given much lower oil prices currently, many energy companies may no longer be viable. It is no surprise therefore that high-yield credit spreads in the U.S. have risen while the increase in volatility has raised concerns in this relatively illiquid sector.
It remains difficult to ascertain the impact of the COVID-19 pandemic on global growth until new levels of infections have peaked. Some experts seem to think that the virus will run its course as temperatures rise toward the middle of the year but the impact between now and then is unclear. It is fair to say that the V-shaped recovery investors initially expected will not materialize, and that even a recovery in the second half of 2020 is not a certainty.
The aggressive containment measures undertaken by China appeared to have worked; at the time of this writing, there is a significant drop in daily new coronavirus cases. A similar trend is also evident in South Korea. Without wanting to be complacent, it appears that Asia is now over the worst. Additionally, targeted measures to boost recovery along with cuts in interest rates are allowing manufacturing production in some sectors to gradually return to normal. However, movement between countries will remain subdued and the tourism and transportation sectors will struggle for some time to come.
Expectations and Investment Implications
Although it is difficult to quantify the impact on global growth, there are a few things that are easier to foresee:
Interest rates will most likely continue to fall and remain low for some time. We believe that the low interest rate environment favors high-yield stocks as when the dust settles, the need for income for an aging global population in a low or negative interest rate environment should prevail. In our view it should also be positive for equity income, especially if the pressure on high-yield bond markets continues to build.
We think lower interest rates should also be positive for asset prices, though banks will likely come under pressure from narrower interest margins while small- and medium-sized enterprises will likely struggle with their loans under a global cash crunch. Banks could also come under pressure to perform “national service” (a directive from the government) by extending credit terms which may not always be viable.
China appears to have the most flexibility to face the challenges in the months ahead. Government policies in China are focused on adding liquidity to reduce the pressure on corporate cash flow while emphasis has been placed on fast-tracking infrastructure projects. Further supportive measures for the property sector are probable. We think the outlook is generally positive for property, construction, materials, consumer and financial services, but we remain cautious on the likelihood for the banks’ national service. We also remain constructive on materials, mainly driven by the recovery in China.
Market volatility is presenting investment opportunities. We think growth-orientated stocks, which previously had been dismissed on valuation grounds, are looking attractive, particularly in consumer- and technology-related areas.
Although earnings will come under pressure in Asia, especially in the short term, we think dividends could prove more resilient. We expect there will be dividend cuts in this environment, but dividends from some companies are backed by relatively low payout ratios, strong cash flows and resilient balance sheets.
Primarily from a valuation viewpoint, we remain cautiously optimistic on the outlook for Asian equities. In our view, current valuations are attractive versus global markets, especially following the recent bout of volatility. In the short term, markets await some positive news on the COVID-19 virus as worsening economic data across the globe concerns investors. In addition, policy action by global central banks –such as the U.S. Federal Reserve cutting rates twice in the space of two weeks – and elections uncertainty will also have the potential to impact investor sentiment, alongside geopolitical tension.
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