The virus caused a direct negative shock to consumer demand
Developed market economies are fueled by consumption. In 2017, household consumption represented on average around 60% of GDP per capita in the Organization for Economic Cooperation and Development (OECD) countries and accounted for over 50% for all nations except Norway, where oil accounts for a large proportion of production, and Luxembourg and Ireland, where the export of financial services is extremely high. Economies generating sufficient income growth sufficient to maintain healthy consumption growth do not have to worry about what is happening in other countries (small share of exports in the production structure). This makes these countries less sensitive to demand shocks in other areas of the global economy. A virus pandemic is likely to have a profound effect on consumption-based economies. First, in countries where closure is ordered, consumers have fewer opportunities to consume. If we look at the US at current prices, then restaurants, hotels, personal hygiene and recreation together account for around 13% of personal consumption expenditure. These expenses are now withheld because these companies have been closed in many areas. Total retail expenses, apart from food and gasoline, make up about a quarter of consumer expenses, and are likely to decrease, although some of them can be continued on the online channel. Transport – another 4%, it is likely to fall sharply and travel will be discouraged.
Social distance affects not only direct consumption, but also employment. For example, a quarter of privately employed Americans work in the retail, leisure, and hospitality sectors, in sectors where work is often less secure, which means that these jobs may be particularly vulnerable. Early unemployment figures support this view.
Corporations are under pressure of supply and demand. For corporations, the impact of the virus took the form of a supply and demand shock. As discussed above, demand immediately expired in response to exclusions. This is most evident in the services sector. The fall in demand has caused a cash flow crisis for some companies. Expected sales are not currently carried out, resulting in a domino effect in supply chains, which in turn means that the consequences of the state of affairs are not limited to those sectors that are directly affected by social distancing measures. On the supply side, the pandemic has disrupted the supply chain and is likely to affect employee productivity. School closures mean that part of the population must quit their jobs to provide childcare. In addition, it negatively affects productivity in many industries, because companies adapt work practices in such a way as to facilitate social distance. Changing financial conditions also had an impact on corporations. Due to the fact that corporations used credit lines early and increased nervousness of investors, we have witnessed tightening of financial conditions, which increased pressure on companies. As in the case of households, we have already seen swift and decisive action on the part of governments, central banks and banking regulators directed towards enterprises during a pandemic. These efforts focused on providing bridge support for enterprises, reducing financing costs and encouraging banks to continue to make loans available. In the UK, to maximize the ability of large banks to lend to the wider economy, the British banking regulator Prudential Regulatory Authority has asked banks not to pay dividends and similar measures are being introduced in Europe.
Governments have entered and as a result loans will be much higher. Governments find themselves in a difficult situation of the need to balance costs for the economy related to the implementation of social distance measures with the costs of inaction for public health. Given the seriousness of the pandemic, governments have responded with resolute social distancing measures which, we hope, will be effective in reducing the number of fatalities, and will also reduce the time needed for such measures. Acting in this way in the interest of public health, governments required a significant increase in spending in a way that was hard to imagine before a pandemic. While central banks have long talked about the need for a greater fiscal stimulus to boost growth, the amounts currently required exceed a pandemic consensus. Higher spending on economic support is likely to cause that public debt levels will be much higher in developed markets in the future. Fortunately, central banks are proposing to make significant purchases of debt instruments, which should help keep the cost of government loans low. There will be a global change in the level of global debt.
Given that this is a new strain of the virus, the degree of uncertainty about how long social distance measures will be needed is a major challenge for governments. Solid fiscal measures by governments cannot be used for a long time. Policy makers will watch the economy launch and decide which path to take. The sooner this does without compromise in containment of the virus, the better for the global economy.
Global growth will be much lower this year, which in turn will have an impact on the growth of corporate profits and has already reduced some dividends. Stock prices have been overestimated, reflecting some likely declines in earnings. Given the uncertainty as to how long the shutdowns will last and the risk of secondary waves, it is possible that even these clear declines may not fully reflect the impact of the virus on profits. Progress towards a vaccine or effective treatment may be faster than experience would suggest.
In bond markets, the new global growth outlook will keep interest rates low for longer, which is generally beneficial for bonds. However, a significant increase in Treasury bond issue is a potential source of concern. Although central banks have committed to purchase bond programs, their appetite for assets is limited.
As for corporate shares and bonds, it is safe to look for companies with large working capital. At some point, social distancing measures will be abolished and growth will come alive. Our priority is now to set the right price for assets that will survive here and now and will be attractive to hold in the long run. Income will remain a challenge for investors. While bonds still play an important role in portfolios in times of market stress, high-yield bond yields remain low and dividends are at risk due to both poor corporate performance and regulatory intervention. With this in mind, the liquidity criterion is still valid and income diversifiers may gain new meaning.
Sector risks – an overview
In QI 2020, a record level of 126 risk assessment reductions were recorded. All reductions come from the direct and indirect impact of Covid-19: on demand (5 out of 10 reductions), profitability (4 out of 10) and liquidity (1 out of 10). In 6 out of 10 cases, the reduction is from “medium” to “sensitive” risk level.
Transport, automotive, electronics and retail are the most vulnerable. RPK (Revenue Passenger Kilometers) for major air carriers have fallen by 30% since December last year. The pandemic is exacerbating the problems of the automotive sector, which is facing existing structural challenges. The global market is facing a decline of over 10% in 2020 (after a 4% decline in 2019). Retailers/wholesalers are at the forefront, and suppliers are not particularly resistant to supply chain risks. The electronics sector is facing a worsening of demand in Europe, expecting much lower sales of electronics to local industries. In the retail sector, Asian and Pacific retailers have been severely hit by prolonged store closures and the collapse of Chinese tourists inflow.
Western Europe and Asia suffered the most. Most reductions took place in Western Europe (52) – the region with the largest number of countries (17) before Asia, and in Central and Eastern Europe (29 and 14 respectively). There were three reductions in North America.
Lock-down of one-third of the world’s population causes havoc in transport, especially in the air transport segment that could receive public support. In the automotive industry, strong dependence on three major markets exacerbates current structural challenges. The impact in the electronics sector is most noticeable in the case of APAC (Asia-Pacific), where players with low added value are at risk in all regions. Lock-down will have a negative impact on the retail sale of non-food products and will lower corporate margins. When it comes to energy, we see significant risk for shale in the US and solar energy. The metals are in retreat. Machines face challenges from the fragile global situation in many markets due to the economic environment. The risk of insolvency in the APAC sector in construction increased, mainly in China.
Transport is one of the sectors most affected by the pandemic due to its high dependence on China and activities closely linked to travel and international trade. Since the initial shock in China, all transport sectors (air, sea, road and rail) have been struggling with falling demand. Airlines expect revenues to fall by at least USD 100 billion over 2020, which will not be offset by falling fuel costs. The liquidity shock further complicates situation, and the global stock exchange index in transport fell by 15% in Q1 2020.
All companies must be monitored very closely, in particular those that are either heavily leveraged or low-income, such as low cost airlines and shipping companies that do not belong to any state group.
Reductions in the transport sector in QI 2020:
- Low to medium risk levels: Malaysia, Philippines, Singapore and Vietnam
- Medium to sensitive risk levels: USA, Belgium, Finland, Ireland, Luxembourg, Norway, Portugal, Sweden, Czech Republic, Estonia, Lithuania, Romania and Slovakia
- From sensitive to high risk: China, UK, Poland and Turkey
The dependence of the automotive sector on the three main markets is exacerbating current structural challenges
The automotive industry has a high exposure to China, which is both the largest automotive market in the world and a car manufacturing center. The decrease in sales resulting from the restrictive measures will be significant in the first quarter: in February there was a decrease of 80% y/y, after a double-digit decline in January. This impact is significant, primarily for local retailers and wholesalers, and results from the following two years of decreasing number of new registrations. The next most affected companies are domestic car manufacturers, especially the most sensitive companies operating in the electric vehicle segment. However, this impact is also significant for global car makers, since most of them produce vehicles sold in China locally with national partners as part of joint ventures. The supply side is severely affected, because Wuhan not only accounts for 10% of the country’s manufactured vehicles, but also brings together hundreds of auto parts suppliers that meet the needs of local operators and exports to the rest of the world. The latter constitute the majority of Chinese automotive industry exports. The prolonged closure of factories increases the risk of shortages and supply chain disruptions at a global level. Countries most dependent on imports from China are first found in APAC (13% on average), especially in India (25%) and Latin America (9%), then in Eastern Europe (4%) and Western Europe (2%) . The image above does not show the potential shortage of key components that can only be made in China.
The automotive sector has seen a noticeable drop in market capitalization, with a decrease in excess of -15% for car manufacturers and -20% for automotive suppliers, for six weeks after the outbreak. The pandemic shock is a major challenge for a sector that has been and is plagued by falling markets and the need for massive investments in electric vehicles, connected cars and mobility services. Well-known manufacturers have accumulated buffers thanks to a decade of growing sales and profits, but they need to increase resources to protect their financial indicators, in particular mid-range passenger car brands that are most exposed to price competition and smaller electric vehicle manufacturers. Especially in China, where overcapacity needs consolidation. In any case, small and independent retailers and wholesalers are most at risk, even if the shock were to be temporary.
Reductions in the automotive sector in QI 2020:
- Low to medium risk levels: Korea (M + S), Philippines (S), Singapore (M + S), Hungary (M) and Romania (M)
- Medium to sensitive risk levels: Belgium (M + S), Germany (S), Ireland (M + S), Portugal (M + S), Bulgaria (S), Czech Republic (S), Hungary (S), Lithuania (S), Poland (S), Romania (S), Slovakia (S), Morocco (M), Chile (M) and Peru (M)
- From sensitive to high risk: United Kingdom (M + S)
(M: Automotive manufacturers and retailers; S: Automotive suppliers)
The protracted closure of Chinese factories has resulted in reduced orders for new components directed to manufacturers of electronic components (semiconductors, active and passive components), especially in countries producing the most advanced memory systems found in consumer electronics, computing and telecommunications devices. South Korea (19% of the global added value of electronic components), Taiwan (13%) and Japan (12%), as well as Chinese producers (19%) are most at risk. Because they are intended mainly for regional clients and integrated players from Europe and the USA, they were not initially affected by restrictions on Chinese pandemic containment measures.
The sector’s global market capitalization has fallen by more than 10% since the pandemics outbreak. This shock occurs when the sector risk assessment indicates a deterioration of the situation in the sector in many Asian countries in previous quarters, in line with the slowdown in global industrial production and the collapse of memory semiconductor prices. In 2019, the Asia Pacific region saw a marked increase in large insolvencies. Like the intermediate goods industry, electronics react strongly to periods of economic recession. As the epidemic escalates, European and American producers would feel a strong decline in local production, while Asian producers, affected by supply shock caused by Chinese containment measures, would feel a decline in demand with more widespread global blockades.
Reductions in the electronics sector in QI 2020:
- Low to medium risk levels: the Czech Republic, Denmark, Estonia, Ireland, Panama and Vietnam
- Medium to sensitive risk levels: Belgium, Costa Rica, Guatemala, Indonesia, Luxembourg, Mexico and the United Kingdom
- From sensitive to high risk: Colombia
Energy: high risk for shale in the US and solar Energy
Oil producers face a double blow caused by falling demand and falling oil prices, because China and Asia are the largest oil and gas recipients in the Middle East and the world. Futures markets are in deep contango, which reflects a serious oversupply. Stock creation may exceed storage capacities. Oil prices are currently at levels where large reserves are unprofitable. This impact was reflected in a 20% reduction in the market capitalization of the energy sector.
The largest integrated major companies are financially resilient, with an average net debt to EBITDA ratio of only 2x. However, corporations are still striving to reduce their debt, and with a lean CAPEX investment and lack of flexibility in share repurchase programs, certain goals may be difficult to achieve. The most sensitive sector is the American shale sector. Our representative sample of relevant listed companies shows an average cash conversion of just 11% in 2019. The sector is largely devoid of funding while burning cash. While the sector used on average 40% of available credit lines, many companies have exhausted much more. Low oil prices stimulate the growth of existing assets, while providing an unattractive backdrop for new capital. At the same time, refinancing becomes more difficult because low oil prices reduce the valuation of reserves, which are the basis for granting the loan. If this situation is prolonged, this may affect indirect assets. Due to the usually stable nature of cash flows, these companies tend to have a strong financial leverage of 75-80%. If the capacity constraint were significant, this could endanger the cash flow of debt service. Refining operations will also be affected if long-term reduction in fuel demand occurs.
Electricity, power and electricity networks are almost unchanged. In addition to some industrial losses, these sectors are defensive.
Renewable energy sources have faced interrupted supply chains. The wind turbine sector acquires around 20% of its components from China, while the solar sector has a much larger proportion. Asia and China are the main production centers for the solar energy value chain, and the affected regions in the main Chinese production provinces are the supply facilities for the world’s largest solar producers along with their component suppliers. The result is shrinking inventory (lack thereof) and an increase in end product prices, which will probably be seen in the second half of 2020.
Machines and devices: challenges arising from the fragile global situation in many end markets due to the economic environment
The sector has China exposure of 20-30% of revenues. This is particularly true of the aviation industry because it is one of the main export sectors for Europe and the United States. China is an important supplier, accounting for 35% of global added value, there is a high degree of interconnection with respect to intermediate products. Before the Covid-19 outbreak, end markets were volatile because the machinery sector was experiencing slow growth in the automotive, but also agricultural and mining industries. The sector expected a low level of growth in 2020. Restrictive measures in China are decimating revenues while causing disruptions in the supply chain, mainly in components. In a sector that is in some cases highly integrated and has complex supply networks, interference can easily be multiplied. With the tightening of financial conditions and the spread to larger economies, the machinery sector may see late payments from struggling end customers. Companies are already facing project delays, and large-scale blockades strengthen this dynamics and cause significant interruptions in supply.
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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.