Market report April 2020

Day 28.04.2020 * Reading time: 15min.


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Market report April 2020


A new approach to earnings forecasts and a review of the effectiveness of existing valuation models

The shutdown of the global economy due to the COVID-19 epidemic has prompted an unprecedented number of US companies to periodically discontinue the publication of earnings forecasts. Equity investors should focus investment analysis on a broader range of output data. Short-term analysis of enterprise results in combination with model estimates has ceased to be possible. Until April 29 this year 141 American companies with market capitalization exceeding USD 2 billion each stopped publishing forecasts of results from operations. This creates a problem for many market participants. It is common investor’s practice to agree on profit forecasts with company guidelines, which in turn enables anchoring the valuation horizon in shorter periods. While investors often talk about focusing on the long term, earnings expectation models are customarily calibrated for the next quarter in the current financial year. This procedure makes the models very precise. Given the regularity of quarterly earnings, perhaps forecasts with such short feedback loops give a sense of control and precision in relation to the investment result. Enterprises participate in this undertaking, setting guidelines that they want to achieve and even exceed. According to estimates, approximately 70% of US enterprises have exceeded quarterly expectations for results since the second quarter of 2013.
In the absence of short-term forecasts, the exogenous virus shock has wiped out any attempts to predict the near future. The scope of discontinuation of publication of results forecasts is very wide, which is why we expect greater volatility of expectations regarding profits than it has been so far. Relying on short-term measures, such as next-quarter earnings (EPS), gives false assurance. In fact, measuring a company’s profit potential with a single point estimate is arbitrary in our view.

That is why we propose a new approach to earnings forecasts and a review of the effectiveness of valuation models used so far.

The current period is a good opportunity to reassess the effectiveness of EPS forecasting and share valuation based on price/earnings (P/E) ratios. In today’s market conditions, estimation error is not the only problem. Even with the possible EPS S&P 500 forecasts for 2020, any reasonable investor would argue that this year’s profits are not representative of the long-term market potential and should be normalized. In other words, the accuracy of the estimates does not prove their reliability. Shifting the forecast horizon by several years reduces short-term volatility and can help shape a more readable picture of the company. It also enables the perception of a company value in the context of its long-term business. Of course, extending the duration of the model causes the appearance of variables that are difficult to estimate, which in turn can affect the accuracy of the valuation model. An analysis of the likely paths of asset growth and profitability is needed to defend valuation in good and bad times. This exercise not only informs about the ultimate earnings potential of the company, but provides insight into the factors driving today’s profit model. This does not mean that investors should ignore current operating results and challenges. This means that investors do not need to accurately forecast short-term results to create a fundamental thesis and picture of the company’s situation. By extending the investment perspective, investors gain freedom of action in a variety of ways in the face of heightened uncertainty. Dispersion of the EPS ratio will cause greater volatility, especially when many companies suspend guidelines or provide forecasts of questionable validity. These are great conditions for bargain hunters. When short-term investors leave the deck, long-term active investors can step in by using attractively priced assets with long-term return potential based on foundations rather than false expectations.

The FED’s balance sheet is likely to double at the end of the year

The transitional liquidity programs launched by the FED are accompanied by the long-term expansion of the FED’s balance sheet by purchasing treasury and mortgage-backed securities. The latest version of quantitative easing is open and certainly larger than the previous ones. We expect the Fed’s balance sheet to rise to almost $ 10 trillion by the end of this year, more than double the figure before the crisis. The Fed will strive to keep interest rates low, enabling potential economic recovery.

Growing public debt and falling tax revenues

In addition to the growing balance of FED, the US government’s debt will also increase. To prepare the foundation for future recovery, the government must increase spending. When tax revenues collapse with economic closure, the budget deficit increases rapidly. We expect higher tax rates and a more progressive tax policy to play an increasingly important role in financing the government over time. The scale of the deficit will require more debt financing. We expect the public debt-to-GDP ratio to grow in the short term and are likely to remain high. This means more government bond issues, and the higher the interest rates, the higher the bill for servicing this debt. The government will issue more debt, and the FED will defend low interest rates while increasing its balance sheet. We have entered a new era of policy making in which monetary and fiscal policy are interrelated. The US economy and government cannot have higher interest rates, and the Fed will do everything to avoid them. In the long run, monetization of debt (public deficit) leads to higher inflation and lower economic growth. This phenomenon is intensified by populist pressure, referred to in the media as programs aimed at reviving the economy and maintaining the functioning of financial markets.

Inflation is not a significant risk in the short term. It is unlikely to grow at a time when the US economy is in a deep crisis. But policymakers will eventually have to face the effects of unprecedented political action.

Corporate insolvencies from bond issues will increase

In March and April, when economies around the world stopped and liquidity challenges soared, investors sold corporate bonds in record numbers for fear of increasing rating downgrades and corporate insolvency. Forced sales caused a spiral of liquidity, corporate bond spreads increased as prices fell.

According to J.P. Morgan default rate on the US high yield bond market (HY) increased to 3.2% year-on-year. We believe that the economy of the United States and other developed countries will remain closed until early summer. The business will probably start slowly in the second half of the year. In this baseline scenario, we expect the default rate for high yield debt in the US to rise to 11–14% over the next 12 months. If the pandemic required a longer shutdown or if we are dealing with a deeper recession than we estimate, the default rate on the US high yield bond market may reach even 15-20% in the negative scenario. With the opening of credit market instruments, corporate profitability spreads have fallen from their highest levels. However, a significant portion of the market still trades with spreads over 1500 basis points. This suggests that the market is pricing in line with our baseline scenario. In other words, spreads on many corporate bonds compensate investors for the oncoming wave of default.

There are more „fallen angels” coming into play

An increase in the insolvency rate is not the only worrying potential effect of a sudden and deep recession. Even in good times, the bottom ladder companies are becoming “fallen angels.” On average, USD 72 billion investment grade bonds were downgraded to high yield every year in 2009-2018. Concerns about “fallen angels” are particularly pronounced today, and not just because of the virus pandemic and the oil market situation. In the last decade, the volume of BBB-rated bonds has increased rapidly. Bond investors said this is hard to ignore. The wave of rating downgrades between the investment class and the high yield may bring large losses in the case of a strategy limited to the investment class and cause a destructive overestimation of prices on the high yield bond market.

This year, given the sudden emergence of liquidity challenges and a lack of access to capital, the value of “fallen angel” bonds exceeded $ 150 billion, breaking the 2009 record. The energy and retail sectors are leading. Three of the seven largest registered fallen angels have taken place over the past two months. Credit forecasts prompted us to revise upwardly total expectations for fallen angels. We estimate that 9-10% of the US investment grade corporate market will be lowered below the investment level. This is close to the experience of previous crises such as the 2002 recession (10%) and the Great Recession (8%). Because today’s investment class corporate market is four times larger than in 2008, “fallen angels” can be bonds worth around $ 50 billion. This makes it potentially much more harmful to the relatively small US high-yield bond market.

Chart: “fallen angels” in global terms (in USD billion):

Source: JP Morgan and RCieSolution Research, data for April 17, 2020

Chart: Share of “fallen angels” bonds in the structure of the high yield (HY) bonds market:

Source: JP Morgan and RCieSolution Research, data for April 17, 2020

In the past, the high yield bond market has absorbed large numbers of “fallen angels”. A blizzard of “fallen angels”, which is sweeping through the high yield market in terms of both volume and difference in average bond duration (interest rate sensitivity), has put tremendous pressure on BBB- and the highest rating high-yield bonds. The US Federal Reserve is ready to buy and provide liquidity to qualified “fallen angels”. About $ 35 billion of debt of “fallen angels” will be eligible for purchase under the Fed’s Secondary Corporate Credit Mechanism (SMCCF).

The lion’s share of the “fallen angels” will be emitters from industries directly affected by the virus crisis. These include cyclical consumer goods such as cars, games, entertainment, airlines, home manufacturers and retailers. Finance and utilities may be less susceptible to the risk of downgrading to the rating of a fallen angel. Together they account for only one percentage point of our 9% forecast for US fallen angels. While the profits leave room for improvement, the balance sheets of large banks found themselves in a relatively solid financial form, unlike 2008. Revenues of utilities providers should remain stable, but with a noticeable change in commercial consumption for housing in the near future. The foundations in the financial and utilities sectors may also deteriorate as the crisis continues and uncertainty persists.

Oil Market

The price of West Texas Intermediate WTI (benchmark for American oil) has dropped to negative levels for the first time in its history. The collapse of global economic activity caused by the virus has reduced the demand for oil, which in contact with the excess supply has led to the depletion of available storage capacity. In the absence of radical cuts in production (which is partly dictated by technological considerations), very large stocks of raw material and limited space for its storage have been created. Oil contract holders faced the prospect of being unable to store goods due to expiring contracts. They were forced to sell at any price, causing negative prices. Although the price of oil has risen since then, it is still likely to happen again if storage capacity remains limited. While low oil prices benefit consumers, persistent low prices can prove to be a challenge for nations dependent on oil revenues to finance state spending.

European Central Bank

The ECB has re-modeled the rules on what assets can be used as collateral for access to cheap ECB financing. The ECB will accept bonds even if the rating agencies downgraded them below an “investment” grade, which makes them so-called “fallen angels”. This change allows access to finance for countries such as Italy, which are still threatened by a downgrade due to high levels of debt and low economic growth. The Organization for Economic Cooperation and Development (OECD) estimates that approximately USD 300 billion in corporate bonds may be downgraded below investment grade next year. As a result, the question arises as to whether the ECB will decide to include below investment grade bonds in its asset purchase program.

Meanwhile, European leaders met to discuss a recovery plan. Disputes persist on key issues such as risk sharing in financing the resolution fund.

Global stock markets

Global stock markets: respectively in terms of 1 week (1 WEEK), 1 month (MTD), calendar year (YTD) and the last 12 months (1 YEAR), are shown in the table below:

The table includes rates of return in terms of pound sterling (GBP), local currency (Loc.) And relative (Rel.) As at 28/04/2020

Source: RCieSolution Research

Rafal Ciepielski

Rafal Ciepielski

CEO RCieSolution

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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.