The virus will run its course, but the pain of record debt will become more acute


Peter Warnes  |   24th Jul 2020  |   5 min read

Coronavirus is affecting the global economy to a greater degree than any previous event.
Global supply chains are so interwoven that the initial disruption in the world’s largest
manufacturing centre triggered a meaningful slowdown in world trade and economic
activity. The spread of the virus and the ensuing lockdowns in critical economic hubs in
the US and several countries throughout Europe sent concern levels off the charts. For
now, the developed economies are taking the brunt of the impact.

Stimulus packages by governments and central banks are similarly unprecedented. In the
GFC, central banks bailed out the financial system. Liquidity was pumped into the system
via unconventional quantitative easing as trillions of dollars of financial assets, including
sovereign bonds, corporate bonds and residential mortgage-backed securities, were
purchased from banks and other financial organisations. This liquidity, associated with
all-time low interest rates, was the driving force behind a record-breaking run in risk asset
prices, predominantly equities, in recent years.

In the current crisis, it is labour—the workers—and consumers who must be bailed out,
just as capital—the financial system—was bailed out in the GFC. In the post-GFC bull
market, capital had a fantastic run. Investment returns were supercharged. Over the same
period, labour’s share of national income declined. Perhaps the coronavirus outbreak is
nature’s way of evening up the slate. Now the shoe is on the other foot and this could be
another example of reversion to the mean about to play out.

Disappointingly, comments from a Wall Street strategist, “What the Fed did is important
because it does help in the credit markets. But it’s not enough from an equity market
perspective”, demonstrate Gordon Gekko’s “greed, for the lack of a better word, is good”
mantra is alive and well, despite the trillions made since 2008. This is selfish, gluttonous
and very disturbing.

While central banks have unleashed substantial packages, governments have also raised
the stakes on the way to a combined “all in” approach to settle the economic disruption.
With governments being much more proactive in underwriting the rescue, in normal
circumstances their debt levels would meaningfully increase. Governments will require
their respective central banks to crank up the printing presses to provide the vital liquidity
to inject into the workforce and support consumption.

But due to the sheer scale of the monetary rescue package, some suggest Modern
Monetary Theory is now being put into practice, with central banks to print cash without
any corresponding government liability. This blows apart the traditional fundamental
principle of double-entry bookkeeping and accounting that states every financial
transaction has equal and opposite effects in at least two different accounts, which
satisfies the accounting equation: Assets = Liabilities + Equity. Going down this route could open a potential Pandora’s box for financial engineers.

It is likely central banks will be required to purchase bonds from governments to monetise
the economy. Central bank balance sheets will move to levels previously only thought of as
fictional. The US Federal Reserve’s (the Fed) balance sheet could increase to over US$8
trillion, from the current record US$4.7 trillion, as Chairman Jerome Powell stated the Fed
will buy US Treasuries and mortgage-backed securities “in amounts needed” to support the economy while launching new lending programs to support commercial, municipal and asset-backed debt markets. Translated into Mario Draghi-speak, this means “whatever it takes”.

It is unlikely institutional investors will line up to buy meaningful swags of government
bonds at current depressed yields. Just as central banks are the lender of last resort, they
may also become the buyer of last resort in the current crisis.

 

Ideas to think about before the dust settles
When the coronavirus is finally referred to in the past tense and things return to normal,
there will be a lot of soul searching. But financial markets along with all aspects of life will
ultimately normalise. I want to focus on a couple of ideas, some might think of as inane or
even insane.

The widespread closure of offices and the forced remote working will have management
asking questions. Subsequently, there will be reviews into productivity and the physical
and mental wellbeing of their employees. A key question is likely to be, “what is the right
balance between working in an office or from home in future?” The outcome is unlikely to
be positive for the owners of office towers. Going forward, are office REITs likely to be a
good investment?

Are there opportunities in the unloved retail REITs—Scentre (SCG), Unibail Rodamco
Westfield (URW) or Vicinity Centres (VCX)? Are very depressed prices signalling dilutive
equity raisings are on the way? I think shopping malls will continue to have a meaningful
place in the retail industry, while acknowledging the intrusion of the online digital channel.
Once the self-isolation period is past, malls will be crammed as the population craves for
open spaces and fresh air.

I have always thought investors should not buy vanilla REITs at a premium to their net
tangible asset (NTA) backing. Over the past decade, some have developed funds
management operations providing valuable annuity streams of income. Goodman Group
(GMG), Charter Hall (CHC) and Dexus (DXS) to a lesser extent, come to mind. The greater
the importance the funds management in the group income stream the larger the likely
premium to NTA. (Exhibit 1).

In the frantic search for yield, many REITs sold at premiums to their NTA as security
valuations were pushed higher by low discount rates and property valuations assisted by
declining capitalisation rates, both linked to the falling risk-free 10-year bond yield.
Remember, cash flow is the most important determinant of valuation, not the discount rate
applied to the cash flow.

Australia is one of a few, perhaps the only, country in the developed world with the
potential to double its population over the next 50 years. New Zealand may also qualify on
a smaller scale. Population growth will be a long-term tailwind for the owners of Tier 1,
strategically located retail assets. Humans are social animals. They do not enjoy prolonged
confinement, as the current situation is proving, and are likely to continue purchasing most
of their requirements in bricks-and-mortar facilities. There may be an opportunity in the
beaten-down retail REITs space.

Elsewhere, the embarrassing scenes in supermarkets of recent weeks reiterated the
demand for necessities had soared to levels never seen in this country, not even in
wartime. The elevated demand is global and while it is obvious the suppliers are flat out,
packaging companies are also sharing in the positive environment. Manufacturers of
flexibles, rigids and cardboard, including Amcor (AMC), Pact Group (PGH) and Orora (ORA)
are likely to report strong 2H20 and FY21 results. Brambles’ (BXB) CHEP pallets would be in
high demand across its global operations to support the movement of packaged goods
throughout the economy.

I am not suggesting one starts buying any or all the above companies now. In a rapidly
changing world, there could be changes to our ratings and forecasts. I have tried to provide some ideas that could be revisited when the investment climate justifies. Our recommendations are valuation rather than timing-based, which is relative in times of extreme volatility.

The Tina (there-is-no-alternative) Turner anthem Simply the Best drove and best described
the surge in equity markets and the investors worldwide joined in. But despite calls for
caution and prudence, I suspect not many investors tuned into and embraced Johnny
Cash. So, now perhaps they are humming Roy Orbison’s It’s Over and maybe Crying.
Dividend yields of 4% and 5% in January and February have morphed into “temporary”
paper capital losses of 30% plus. In some cases where the dividend has been withdrawn,
the yield was illusory. It will take several years for the capital value to return, but just as
was the case for purchases made prior to November 2007, value in sustainable companies
will return.

Markets are currently finding a little breathing space as more and greater rescue packages are announced. The sellers are showing some signs of exhaustion and the bear has nodded off, both temporarily. We will see rallies in this unfinished bear market. Use rallies to cleanse your portfolios of the lesser quality holdings. This bear still has some life. Continue to use cash sparingly and be careful when new equity is being shopped around at what may look like an attractive discount.

Yes, everyday we are getting closer to a vaccine and the pandemic being classified as past.
But economic disruption will continue for some time. It looks like Australia and several
other countries will record negative GDP growth in 2020. Record debt levels persist and are
being added to, so the underlying problem will still exist even once the virus has passed.

Other non-related comments
With the government’s attention on the health and economic crisis are the energy
companies up to their old tricks? I just received notice from AGL Energy that my expiring
plan would move to a new plan in May. Based on the same annual consumption, the
increase is 18.3%. So much for electricity prices falling, as the government suggests. AGL
has one less customer. Are you in the same boat?

Isn’t it strange the recent rainfall on the east coast, where most of the country’s population lives, has put out the bushfires and filled up the dams, just as we now need to wash our hands multiple times a day?

Originally posted 2020-03-30 00:10:53.

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