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Weekly market update - 17th of March 2020

Written and accurate as at: Mar 17, 2020 Current Stats & Facts

The market began pricing in a widespread and extended economic recession last week as a result of measures to manage the spread of COVID-19.

The local index fell -10.98% last week. The fall had been far greater until a 13% rally – built on the hope of major policy action – pared the losses.

From a markets perspective, the key uncertainty is the scale of the economic price to be paid to resolve the COVID-19 issue.

It’s apparent from China, Singapore and South Korea – as opposed to Italy for example –  that substantial government intervention in social activity is required to limit the spread of COVID-19 and ensure medical infrastructure is not overwhelmed.

Measures such as mandatory 14-days isolation for overseas travellers and the banning of non-essential gatherings in Australia are dramatic examples of the necessary steps.

These steps – and others overseas – give some confidence that the worst outcome of a global pandemic can be avoided. However these measures will also have a severe effect on the economy –  especially small business – which in Australia will outweigh any stimulus measures announced so far. We are set to see widespread closures of stores, gyms, similar businesses and public areas.

Concern over a knock-on effect for corporate credit and bad debts – and the impact on the banking sector – also rose last week.

The announced expansion of oil production by Russia and Saudi also made itself felt. Brent crude fell from US$45.50 to US$34.70 a barrel. Uncertainty over possible second-order effects on oil capex and credit for the US shale market exacerbated market volatility.

Central banks and governments are taking steps to underpin liquidity and shore up the financial system to reduce the risk of it freezing up. With so many businesses potentially facing closure for a period – plus fund redemptions and positions closing in systematic trading strategies – there is a material draw on liquidity.

Hence the US Fed’s rate cut to zero on Monday morning, accompanied by an asset purchase program and FX swap lines to ensure a liquid market remains in Treasuries along with necessary access to US dollars.

The RBA is likely to cut Australian rates further. Meanwhile some are looking to the government to step in with funding measures for banks and possible support packages for hard-hit industries.

US 10-year Treasuries yields backed up from 0.77% to 0.98%. Despite risk aversion some of the safest assets sold off, probably given relatively high liquidity. Gold fell -8.5% for the same reason. Australian 10-year government bond yields rose from 0.68% to 0.97%. Copper was off -4% while iron ore remained resilient, up +1%. The iron ore complex has continued to outperform, possibly on the view that China is further advanced in containing the virus’s spread.

As the possible scale of the economic impact is digested, its duration remains the key uncertainty. Modelling now suggests a China-style lock-down – an option that has probably passed in many countries – can result in peak infections within two weeks. The path taken by some European countries is expected to result in peak infections within 20-30 days. A scenario without social distancing measures could result in endemic and 20-40% of the population infected.

As a result, near-term data is likely to remain soft. The coming week is likely to see further detail on how directly-affected businesses will handle reduced demand and the impact on workers. People will also be looking to the government to provide a safety net for those companies and people facing near-term disruption.

The upshot is that we are likely to face further volatility until people have a better handle on how long the economic dislocation is likely to extend – and gain some confidence that government action will be able to underpin the economy during this period. At that point, we expect investors will start to recognise the undoubted value that is emerging in parts of the markets on a 3-to-5 year view.

Every sector ended in the red last week. Energy did worst (-20.8%), while Industrials (-14.5%) and Materials (-14.1%) also underperformed. The adefensives held up best. Health care was down -1.4%, Consumer staples -2.8% and Communication services -7.4%.

Qantas (QAN, -31.8%) was the worst performer in the ASX 100. A large seller dumped stock into the close, which meant it did not participate in the surge on Friday afternoon. We believe QAN’s balance sheet and structure can weather a period of international travel dropping to almost nothing and a material hit to domestic. The question the market is grappling with is the scale of shareholder value that will disappear on the way. The travel impact also hit Flight Centre (FLT, -27.7%) and Sydney Airport (SYD, -20.4%), with investors concerned over the latter’s degree of leverage in a period in which demand falls markedly.

The concern over leverage was also apparent in the performance of Boral (BLD, -25.2%) and Unibail Rodamco Westfield (URW, -24.6%), two of the higher geared names in the ASX 100. We observe that debt levels generally are much lower than was the case in the GFC. We are also mindful the government will want to avoid COVID-19 triggering a debt crisis.  Nevertheless, the market is expressing its concern here and we are spending time understanding how a sharp fall in demand is likely to affect the balance sheet position of each company in the market.

The oil/LNG names weakened alongside the oil price. Santos (STO, -31.6%) and Oil Search (OSH, -31.6%)  underperformed, as did Woodside (WPL, -20.5%).

Afterpay Touch (APT, -29.5%) demonstrated how possible second-order effects are starting to be priced in, as companies with business models requiring access to lines of credit came under pressure. In this case it isn’t helped by APT’s previously high valuation rating.

Xero (XRO, +6.9%), in contrast, was the best performer in the ASX 100. It is one WAAAX stock without any balance sheet issues. Although there is a high likelihood of disruption to near-term subscriber growth, it has a business model that can manage its free cash flow quite well.

Only five other stocks posted positive total returns for the week. Cochlear (COH, +5.4%) has been seen as a potential beneficiary given it has a small respirator business, while fellow health care stock CSL (CSL, +0.2%) was another of the few that posted gains.

Fortescue Metals (FMG, +3.4%) benefited from a resilient iron ore price. With a weaker oil price and Australian dollar the iron ore miners are in something of a sweet spot as long as the iron ore price continues to hold up. The perception that China is closer to resolving the effects of the virus than other parts of the world also helped BlueScope Steel (BSL, -2.6%) hold up relatively well.

The supermarkets continued to benefit from hoarding and panic-buying, with a remarkable surge in sales. Coles (COL) was up 2.2%, while Woolworths (WOW, -2.5%) and Metcash (MTS, -8.0%) outperformed. We are conscious that supermarkets are likely to benefit from a reduction in restaurant demand, however at some point before long hoarding is likely to subside and sales will return to more normal levels.

There was a divergence between the packaging companies. Orora (ORA, -1.2%) maintained its more defensive profile, while Amcor (-21.1%) came under attack from a shorting report. The short sellers called out the company’s leverage and lack of free cash flow – which we regard as more a function of the recent Bemis acquisition and restructuring rather than a fundamental issue with the company. We regard its packaging business as one of the more defensive parts of the market.

Finally, JB Hi-Fi (JBH, -2.1%) has seen a surge in purchases of fridges, freezers, laptops and other IT equipment as the population prepares to hunker down.

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