Six months into the corona crisis much of the negative development has turned more positive. Will the markets continue to be saved by central banks' actions and is the summer's run in the equity markets sustainable, or are there threats out there?
We gathered three of Catella's portfolio managers to discuss the outlook for the autumn of 2020 - Thomas Elofsson and Stefan Wigstrand from the fixed income side and Mattias Nilsson from the equity side.
At the end of April, we gathered some of Catella's portfolio managers to discuss the situation in Catella Hedgefond. At the time, many saw hope in that decreased spread of the virus could lead to the economy opening up – and a lot of that has actually happened.
In the credit markets the development during the spring was dramatic and the portfolio managers said that the high yield bucket of the Catella Hedge at the time had an 11% yield.
Stefan Wigstrand describes the construction of the hedge fund, with an equity bucket which in general does not consume a lot of capital, and where portfolio managers actively try to invest the cash in the fund to achieve extra returns.
"A lot of the cash portion gets invested in credits. During the spring, credits had a tough time, there were pockets of difficulties in the market and liquidity had dried up. Some funds had to close for a period of time", says Stefan Wigstrand.
Thereafter the market has come back, and in particular during the summer, the portfolio managers have seen a recovery, with increased risk appetite.
"It's positive. I would estimate we are up around 5 percent on the credit portfolio during the summer months ", continues Stefan Wigstrand.
During the spring, the bonds in the portfolio were trading on average around 88 percent of nominal value during the spring, compared to around 93 percent today for the more risky credits.
But is there further performance to get here?
"We have good confidence in getting our money back, whether it happens this year or if it will take more time remains to be seen. But the credit duration in the fund is low. That will show during the coming two to two and a half years", says Stefan Wigstrand.
With regards to bankruptcies, or defaults, it was feared earlier this year that there would be a big increase from very low levels. But this has not really been the case.
Instead, support has been coming from many directions: shareholders have put in more money, banks have extended emergency credit lines and bond holders have accepted other concessions.
"We have been involved in a number of such discussions during the spring and the summer. This could be one explanation why we have not seen the dramatic value drops we thought could potentially materialise", says Stefan Wigstrand.
The question around the liquidity that is being pumped into the market and the long-term effects of these actions remains.
So called "zombie companies" can then survive because of the low interest rate environment even though they should probably have defaulted. Thomas Elofsson compares the world economy to a drug addict, that is getting used to big doses of monetary stimulus, and in addition to that is also getting fiscal stimulus.
"If the stimulus is temporary maybe it doesn't pose such a big threat, but it is easier to introduce stimulus than withdrawing it. If you look at the US they are averaging a budget deficit of around 16 percent right now, which clearly is unsustainable ", says Thomas Elofsson.
The US deficit is in Thomas view not a problem for the market right now, but in the long run it needs to be addressed and that could be tough, because you need growth to be high enough to make it possible.
"If you put on a bearish perspective, if you take normal pricing mechanisms out of play, as is being done from central banks, in the long run a lot of capital is being allocated to places where it shouldn't be invested. In the long term this leads to a lower growth rate, because you get an economy that functions less well", says Thomas Elofsson.
From the equity side in Catella's funds there was hope during the spring to regain some lost ground, after the big corrections during the early spring. With facts partially at hand, one can conclude that there was a V-shaped recovery for shares.
According to portfolio manager Mattias Nilsson the hypothesis was that decreased spread of the virus would lead to increased activity in the society. They looked carefully at what happened in Italy, Belgium and the other worst affected countries.
"What has happened since then is that we have seen a recovery and that the companies that were affected temporarily have come back strongly, like the engineering companies and also Nent that saw its share price halved because you couldn't watch any sporting events", says Mattias Nilsson.
Other shares that have recovered strongly, are the ones that have been winners during the corona crisis from a more a structural perspective, i.e. companies with digital business models that have been able to advance their market positions. On other hand, also in line with hypothesis, is that short term winners in the grocery business have developed quite poorly since April-May.
There is also a third group, where the portfolio managers have not managed so well: It is regarding quality companies, that were perceived to be expensive prior to the pandemic, but have performed really well since and have become increasingly expensive.
"It is in this area where things have not performed according to our expectations", Mattias Nilsson concludes.
Here you find some of the tech companies?
"There is no common theme, they are loved regardless of names, EQT, Nibe or Lifco", says Mattias Nilsson.
On the macro side, there are continued reports of decreasing GDP numbers from many directions. Despite this, equity markets have in general performed strongly. Mattias Nilsson explains this that even if GDP is weak this year, it will be less weak than anticipated a couple of months back.
The market in addition believes in stronger growth next year, where the discount period has been moved so that it rather looks at 2022 than the closer period.
Another effect observed in the equity market is that the expectations are for lower interest rates for longer, which has taken down the equity market's required rate of return for the whole equity market and as a consequence has lifted valuations another notch.
A fundamental factor for the recovery is that the spread of the virus decreases, Mattias Nilsson continues. The market expects some kind of vaccine during the coming six months, or that at least can be distributed during 2021.
The question around how sustainable it is in the long term to continue with stimulus for the economy remains. The budget deficit in the US is approximately 16 percent in the US and 10-14 percent in Europe. According to Thomas Elofsson it is a question on what horizon you have.
"You can probably do this for a year or a few years, but down the road it needs to translate into growth. If you can achieve growth and consequently higher tax revenues, the budgets will look better, he says.
But when more money is in circulation in society it becomes worth less. States sells bonds to finance deficits and the central banks buy. "You keep interest rates under control" Thomas Elofsson concludes.
Potential clouds on the horizon could be increased inflation, he thinks. If inflation would creep up to 3 or 4 percent that is a problem. However, that is not probable, according to Thomas Elofsson, as unemployment now is so high and there is slack in the system.
One could see expectations that long-term interest rates are beginning to move up?
"What they say now, and you have to believe in that, is that interest rates won't be hiked in the foreseeable future. The next question then becomes: Are there enough investors willing to buy long dated bonds at a very low yield? That is becoming increasingly difficult to see so that pushes central banks to continue buying", says Thomas Elofsson.
He adds that the highly compressed risk premium on long government bonds, creates a benign environment for credits, that today also can be acquired by central banks. And if you support the credit market you support companies and to a certain extent you also support the equity market.
In relation to valuation of the equity market Mattias Nilsson thinks that it is not really true that the market is so expensive at the moment. In the US the P/E ratios are high, perhaps 20-25 percent over a 20-year average, while in Europe they are around 15-20 percent over the 20-year average. And looking at Price/Book, the valuations are more in line with the historical averages, he points out.
Looking at the Swedish market, what stands out amongst the larger companies, is that the companies with the best performance had positive earnings revisions, and trade at around 30-35 multiple of earnings for 2021, while the worst shares have had negative earnings revisions and trade at around 14 times earnings.
"Hence it is a large span where you reward winners handsomely and punish the losers. But there is also a middle layer, where you have seen share price increases of 50 percent despite earnings estimates having been adjusted down by 10 percent", says Mattias Nilsson.
On the question on what the stimulus does, it is most telling to look at the small cap lists on the exchange to assess the risk appetite.
"On First North the share prices are up on average 35 percent year to date and have doubled for the biggest companies. At the same time the 360 companies on the list have in aggregate not delivered any profit in the last 12 months. Risk appetite is high, it is a situation that looks similar to year 2000", says Mattias Nilsson.
He adds that you need to be responsive to what drives share prices. Companies that are being valued at 50 times earnings in some cases deserve it, as they increase profits by 30, 40 and 50 percent per year. But then there are others, that have followed on pure flow effects.
"There we look at the negative side ", Mattias Nilsson says with focus on potential short positions.
But what type of companies do the portfolio managers look for in a rising market? Mattias Nilsson mentions four categories.
One category is companies that have been affected in the short term by the corona pandemic, where the market expects the situation to be affecting in the longer term. The number of companies in this category are according to Mattias Nilsson fewer than 3 months ago, but there are still several cases.
The second category are growth companies that the market has still not appreciated – here Mattias Nilsson mentions as an example Electrolux Professional that delivers equipment to hotels, restaurants and public sector and that have an underlying stable growth, profitability and acquisition opportunities.
The third category is companies where the recovery is underestimated, which can be either in terms of volumes or profitability. Many companies have taken actions during the crisis that leaves them coming out in this period with higher profitability than previously.
The fourth category is flow related. In relation to ESG-related flows, during the last 1,5 years 120 billion has flowed into these types of funds, while all other equity strategies have seen outflows of 300 billion.
"There is a huge appetite amongst investors in finding these types of investments. We also invest our time in this area to try to discover new companies", says Mattias Nilsson.
In relation to the recovery of the economy, Mattias Nilsson, portrays a picture that is not easily digested.
"A bit anecdotally, we have met many companies after the summer, big engineering companies. They describe the situation as complete standstill in April, gradual opening up in May and June. When they opened up, many companies had orders that had not been delivered upon since the spring, and then had to run at a high pace. But in August you have had commanded vacation in many cases, and more vacation than last year. Hence, the companies don't know what will happen during the autumn. Everyone is a bit in the dark", says Mattias Nilsson.
In the credit market you can observe that the movements in investment grade, the part of the credit market for more secure corporate bonds, has been a of movement during the corona crisis...
"One should have had more investment grade bonds in hindsight, that can be established, as this segment has been very strong. Even the Swedish central bank, Riksbanken, nowadays buys investment grade bonds. But from this level it is not as appealing", says Stefan Wigstrand.
How about the high yield-segment?
"It has had good performance during the summer, a lot can be explained that no new issues have been coming to the market. The banks have had to absorb that capital need and they have done it with the support of the Riksbank. But now it is time to roll out more issuance, and we have seen that starting. It probably won't tighten as aggressively in high yield as it did in investment grade from here, but probably a gap will be closed in some segments of the market. Part of the high yield market is very interesting ", Stefan Wigstrand says.
In April you mentioned that probably a part of the fixed income portfolio can push and recover some of the returns in a portfolio.
"That is the case. High yield is high yield for a reason and that is that these companies are highly indebted. That segment is as dependent on that the signals this autumn are that the economy is coming back in a sustainable way, because then also the credits will do well", says Stefan Wigstrand.
What do you see as the greatest risk factor looking ahead the coming six months?
Thomas Elofsson brings up speculation, and the risks associated with it.
"The largest risk is that there are a number of signs of that it is quite speculative out there. I saw yesterday that Tesla has 2 percent of the auto market but 40 percent of the market capitalisation among car companies. If you look at Zoom, that enables videoconferencing, they are as highly valued as IBM. Even if it is a structural winner, how much can you value them? You can hit an air-pocket. I am less worried about inflation, brexit or the US election", he says.
Mattias Nilsson adds another risk factor.
"And if politicians start closing down societies again, then it will be tough."
We however don't expect that but are cautiously optimistic during the coming period.