Commentary on Political Economy

Wednesday, 22 July 2020

Investment giant warns market’s ‘free pass’ will end

The global investment strategist at Boston's MFS Investment believes investors are ignoring the damage COVID-19 will do to demand, even as economies reopen.
Some things don’t change, regardless of a pandemic. It’s summer in Boston right now, and at the 90-year-old investment giant MFS Investment Management, the season’s traditional internship program is in full swing – albeit remotely.
On Tuesday night, Rob Almeida, portfolio manager and global investment strategist at MFS, had his usual pep talk to the interns. And as he does each year, he passed on what he says is the most important lesson he’s learnt from a career in the markets.
Investors have sent stocks back to pre-COVID levels with little thought for the state of earnings, Rob Almeida says.  David Rowe
“All that matters to investing is that you’re paying for future cashflows.”
Of course, working out what future cashflows look like right now isn’t easy. Almeida points out 80 per cent of companies in the S&P 500 have no earnings guidance in the market, so what hope do investors have?
And yet he’s struck by investors’ apparent confidence in the outlook, as shown by the 46 per cent rally on Wall Street since late March, which has taken valuations back at or near pre-COVID-19 levels.
Almeida is having none of it. He has positioned his long/short strategy as bearishly as possible, with maximum cash and just 10 per cent exposure to equites.
He’s betting that eventually, it will all come back to cashflow.
Yes, the US economy is reopening, and the prospect of companies running at 15 per cent of pre-COVID-19 levels is off the table. But demand is still weak. Should a company that’s running at 75 per cent of its pre-COVID-19 revenue really be worth what it was before the crisis?
“One in three companies in Russell 10000 was unprofitable before the crisis. I can’t imagine that’s improved,” Almeida says.
“I’ve got to believe we reach a point – I don’t know when – when investors stop giving companies and the economy a free pass on horrendous data.”
Almeida acknowledges the reckoning he’s been expecting for some months may not arrive for a while yet.

Balance sheet at their worse in 100 years

When he visited Australia in February – a journey he said highlighted how serious COVID-19 actually was – he warned company business models and balance sheets were in bad shape. Borrowings had been steadily rising since the GFC, but that debt had been used for share buybacks and dividends, rather than business investment.
The COVID-19 crisis has only made things worse, as companies have borrowed to replace lost revenue, supported by a US central bank that Almeida argues has been effectively funding corporate operating losses through its unprecedented intervention in bond markets.
Almeida describes it as a bet on the elasticity of societal behaviour that he thinks won’t pay off.
Yes, activity will lift, but it won’t get back to where it was any time soon. He gives the example of his own habits. Where he once bought three coffees a day from his local café, he hasn’t even been near the place since March.
“Companies have extended the balance sheet future in the face of collapsing demand, in the expectation that demand will bounce back. And I’m not sure it will,” Almeida says.
“The quality of balance sheets, particularly in America, is the worst it’s been in over 100 years. There’s just no getting around that.”
But what’s the trigger for that to start weighing on share prices?
Almeida says government support will eventually fade, noise around the US election will start rising and the already visible signs of increasing bankruptcies will continue.
Weaker financial results should also spill into the bond market, as highly leveraged companies are downgraded by ratings agencies, and BBB and BB debt gets pushed below investment grade, potentially causing a rout in debt markets.
Still, given where markets sit today, Almeida is spending a lot of time wondering where he could be wrong.
There is a chance money printing might cause a wave of inflation that lifts all boats, allowing economies to grow their way out of a debt trap like they did after World War II.
It might be the case that companies can learn to live with higher debt loads, particularly if the Fed continues to backstop global markets.
But he’s resolute that cashflow will matter again. “The catalyst should be financial results,” Almeida says. “I’m not sure if it’s this quarter or the next quarter. I think investors are under appreciating how important scale and operating leverage is.”
If there’s one bright note for the investor, it’s that companies that can withstand this COVID-19-19 environment will prove to have lasting strength. MFS is hunting in areas such health technology and digital payments for winner that Almeida expects will enjoy strong investor support when the market turns.
“Where I have the greatest optimism is that if this plays out like we believe, it will be painful for everyone in the short term, but there are enterprises that have durability. And that durability…should drive pretty significant scarcity value.”

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