Debt-ridden companies face contamination as virus saps supply chains, cash flows

Peter Warnes  |   24th Feb 2020  |   7 min read

Deaths from the coronavirus are nearing 1,500 and easily exceed the 774 deaths of the SARS outbreak in 2003. Only one death has been reported outside China. From a health viewpoint, this suggests the virus is China-specific, although there are confirmed cases in 24 countries.

From an economic viewpoint, the coronavirus is and will have far reaching global implications. The market should be focused on the extent of the disruption to the global supply chain and the impact on cash flows, rather than deaths or making comparisons with earlier viral outbreaks.

Markets are currently taking a positive view and looking through the impact of the coronavirus. That is a normal reaction, but we should not underestimate the seriousness of the situation. Complacency currently knows no borders whether possible dangers are economic, geopolitical or health-related, as is the current situation. It has spread at a faster clip than coronavirus and can be just as dangerous financially.

Prolonged disruption to supply chains will have an impact on the cash flows of many companies. The strong will be OK, but companies affected are likely to include some highly leveraged zombies, companies whose interest cover (EBIT/net interest expense) is less than one, where the outcome could be less palatable.

In 2003, China represented less than 5% of the global economy. It has grown to over 17% since. Its economy is now entwined with all major trading nations. It is a meaningful source of manufactured goods and components but is also a major customer of exporting nations for raw materials, energy and finished products. The rapidly growing middle class is now the world’s largest consumer base and consumption has been slashed.

Over 80% of China’s manufacturing base has been affected by the coronavirus. Many are struggling to re-open after the enforced extended Lunar New Year holidays. The longer production lines remain silent the greater the impact on the global supply chain. The knock-on effect could have serious implications and shortages are almost certain to result. A stroll down the aisles at Bunnings will reveal the prevalence of products with a “Made in China” tag on the shelves. I estimate at least 40%.

Already a diverse selection of Australian companies including Blackmores, Cochlear and Aurizon have detailed the impact of the virus. Importers including China National Offshore Oil Corporation (CNOOC), the country’s largest importer of LNG, has declared force majeure on LNG contracts with at least three suppliers. Copper smelters have also joined the force majeure queue.

The lack of component supply has already closed auto plants in Japan and South Korea. Further disruptions to manufacturing outside China are likely as shipping schedules have been shredded, delaying the delivery of exports.

The return to normality could take weeks as travel restrictions and health precautions remain in place to stop the spread of the virus. As workers in their tens of millions return to work there is a risk of reigniting the spread of the virus.

China’s 1Q20 GDP growth will suffer a large blow as the outbreak coincided with the Lunar New Year festivities and the associated spending tsunami. This will also trim global GDP growth. While normality will return, this spending impetus has been lost.


US jobs data remains positive
The Federal Reserve (the Fed) is not concerned about the strength of the US jobs market. Its focus is on inflation and it would have welcomed the latest lift in wages growth to 3.1% year-on-year for January. It will allow the economy to “run hot” for a while before it starts the unenviable task of tightening monetary policy.

It comes as no surprise that debt disciple President Donald Trump’s wish list suggests a budget deficit of US$4.8 trillion for 2021. The danger of unfunded fiscal stimulus of an unparalleled dimension is ever present. Record government and corporate debt remains a concern.

Australia stuck in the slow lane, housing upturn continues
Business surveys from both the National Australia Bank and Westpac confirm Australia’s economy is moving crab-like, with most key metrics stuck in the mangrove flats and below trend. The government’s surplus has evaporated under the intense heat from bushfires and the untimely outbreak of the coronavirus.

December’s jobs growth of 29,000 consisted entirely of part-time positions encompassing the seasonally sensitive retail, hospitality and tourism segments. The bushfires and coronavirus have meaningfully affected all three. The January and February labour force reports are likely to be subdued, with job losses a distinct possibility.

Consumer sentiment as measured by the Westpac-Melbourne Institute Index improved slightly in February with easing concerns around bushfire-stricken communities as widespread rain doused several of the large fires. The coronavirus had a minimal impact. The overall sentiment level is still well below the long-term average and household consumption remains subdued.

There is more encouraging news on the housing front with December’s housing finance report blowing away consensus estimates. The total value of housing loan approvals grew at a 4.4% month-on-month (m/m) clip in December, well above consensus at 1.6%. This strong finish to 2019 is encouraging for 2020. Owner-occupiers are leading the charge, with first- home buyers in the ascendency. The value of loans for owner-occupiers was up 5.1% m/m and up 23% since May and closing in on the record levels reached in 2017/18. Investor interest is more subdued, as yields shrink with pressure on rents and prices rising. Despite an increase of 16% since May, the value of loans to investors is still below the 2016 low.

The test will come when supply normalises later in February and affordability issues become a little more restrictive in a low wage growth environment.

Westpac is particularly bearish, forecasting two interest rate cuts and a bout of quantitative easing. In the US the bank expects the Fed to cut rates three times, halving the federal funds rate to 0.50%–0.75%. This despite almost full employment and a 50-year low in unemployment. What nasties do they see in their crystal ball to prompt such action? And what do they mean for financial markets?

The reporting season has opened with a few surprises. Boral and Cochlear downgraded. Bapcor, Challenger, and JB Hi-Fi have been rewarded by comfortably beating consensus. The two largest companies by market capitalisation Commonwealth Bank and CSL both reported solid results helping to underpin the market.


Healthcare sector: Oozes quality, but at what price?
Premiums abound in this quality defensive sector. The least “sexy”, glove manufacturer Ansell is the cheapest of the line-up while also boasting the lowest uncertainty rating.

Dividend yields are skinny and PE multiples are well above the elevated market average, excluding resources and financials. The three truly global companies, Cochlear, CSL and ResMed boast market shares of over 30% and are highly regarded on the world stage. All are growth companies with a strong research and development ethic deeply ingrained in their respective cultures. Financial strength is a major attribute to ensure the product development pipeline is free flowing.

The healthcare sector is Australia’s corporate gold medal winner, hands down. I believe CSL is the best managed Australian company by a meaningful margin.

While not suggesting investors exit the sector, even the share prices of the best companies retrace to some extent in a market correction

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