Long-term viral implications to ponder
In last week’s edition (Shares, 23 April 2020), this column looked at the potential near-term implications of the COVID-19 outbreak for financial markets. At the time of writing, markets are still trying to rally and are being encouraged to do so by the combination of ongoing monetary and fiscal support from central banks and governments and a gradual move in some nations to ending the lockdown. Italy, the initial epicentre of the European outbreak, is relaxing its rules step by step and Milan’s MIB-30 index continues to make steady progress as a result. The last reported number of new daily cases across Italy was 2,324 and the number of fatalities was 260, compared to the peak figures of 6,155 on 21 March and 919 on 30 March.
“Italy, the initial epicentre of the European outbreak, is relaxing its rules step by step and Milan’s MIB-30 index continues to make steady progress as a result.”
Milan’s MIB-30 index continues to move away from its 12 March low
Source: Refinitiv data
It is to be hoped that the trend remains down, for humanitarian reasons above all others, and if so investors might have to start thinking about not just the shape and nature of the economic recovery in the short term, but also the longer-term implications of the outbreak and how authorities, companies and individuals responded.
Trio of options
From this column’s perspective, looking at the outbreak purely through the narrow prism of investment, there are three crude alternatives: everything goes on as before; a few things change; or there are radical shifts in behaviour which could have profound implications for markets and asset valuations.
- Business carries on as before and firms behave in the same way as before. The world recovered quickly after 9/11 in 2001 and it was not that long after the financial crisis of 2007–09 that merger and acquisition activity, stock buybacks, ‘adjusted earnings numbers’ and other forms of financial engineering were back in fashion and WeWork was being valued at $48 billion by its backers. Moreover, private individuals who had been frightened about losing their money on a bank run in 2008 were, barely a decade later, at various stages paying $900 a share for Tesla and nearly $20,000 for a Bitcoin. To paraphrase J.K. Galbraith, such is the extreme brevity of the financial memory and it may be that risk appetite recovers quickly and markets carry on as before, especially as central banks seem happy to backstop them with bounteous liquidity in the form of the Quantitative Easing (QE) and zero interest rate policy (ZIRP) schemes.
- Company behaviour does alter in some ways. One change that is perfectly possible is companies abandon theories of efficient balance sheets and the primacy of return on equity and focus instead on cash. Just like any private individual listening to their financial adviser, their first step is to build a cash buffer and then sit on it, so that 6 to 12 months' operational and capital expenses can be met whatever the circumstances. Debt and leverage to goose returns go out of fashion. Managers breathe more easily but shareholders get lower profits, lower returns on equity and less dividend growth, perhaps with the result that dividends do not return to 2019’s levels for some time.
“One change that is perfectly possible is companies abandon theories of efficient balance sheets and the primacy of return on equity and focus instead on cash.”
FTSE 100 debt has mushroomed since 2007–09’s crisis
Source: Company accounts, BloombergThe logical corollary of all of this is that equities suffer a de-rating. Even as profits recover (the E in the price/earnings ratio), the multiple that investors are prepared to pay (the P) goes down and equity returns are crimped. Such fallow periods are not unprecedented. Japan turned away from borrowing toward saving after its bubble burst in 1989 and the Nikkei 225 stock index stands at barely half of where it did at its peak as a result. The irony, then, is that Japanese returns on equity (now on the way back up under Abenomics) could meet, say, American and British ones on the way down.
- Things change a lot. Under the first two scenarios, stock markets may rise or at least flip-flop to give traders something to tackle according to whether central banks are applying or vainly trying to withdraw stimulus. It is tempting to think Japan’s experiences cannot be repeated but the FTSE 100 peaked at 6,930 in December 1999 and it stands near 5,800 today, after some 21 years' huffing and puffing. Such a world also places an even greater emphasis on dividends as part of equities’ total return.
“The Government is providing support to many firms through multiple schemes. It may exact a price in the future.”
The third scenario is more serious still. The Government is providing support to many firms through multiple schemes. It may exact a price in the future. Banks and insurers have already been asked by regulators to cancel dividends and buyback programmes. Taxes could rise. Firms that are perceived by the public, politicians, or both to have 'behaved badly' may find themselves under greater scrutiny. Reputations could be tarnished in the current, extraordinary environment, fairly or unfairly, with long-term repercussions for how firms are perceived by customers, to the potential detriment of revenues and business levels – and ultimately the value of their stock.
“Such is the extreme brevity of the financial memory and it may be that risk appetite recovers quickly and markets carry on as before, especially as central banks seem happy to backstop them with bounteous liquidity.”
“The irony, then, is that Japanese returns on equity (now on the way back up under Abenomics) could meet, say, American and British ones on the way down.”
Will US and UK returns on equity sag to Japanese levels (and hit equity valuations as a result)?
Source: Bloomberg, based on MSCI indices
Greater regulatory or state intervention is generally anathema to financial markets (rightly or wrongly) and firms should do their bit to avoid this by focusing on the needs of staff and customers (stakeholders) more than ever. If they can do that well, the rest may well take care of itself over time.
This is where advisers’ and clients’ appointed fund managers can add value too, by sifting for the firms that have the right priorities and dodging those that may not.
Shareholder value comes from firms providing a service or product to customers and doing it well, to the satisfaction of those customers. Shareholder value is not an end or aim in its own right. It is impossible to create any value if you have no (happy) customers, as current circumstances show. But happy customers served by happy staff is the dream ticket that leads to profits, cash flows and ultimately the dividends which could prove even more valuable if the West really is about to get some Japan-style returns for a while.