In a particularly shaky market situation, and with great concern among investors, the world's stock exchanges have recently fallen steeply.
Catella Fonder brought together Thomas Elofsson, from the fund company's fixed income management, and Anders Wennberg, from the equities side, to try and provide some clarity on the current scenarios.
Since the New Year, news reporting has largely centred around the spread of the new coronavirus in China and, more recently, in other countries. For a long time, the stock exchanges seemed to take these developments with calm, but as more and more reports indicated the rapid spread of the virus outside China, the worries increased significantly.
Since the end of February and the beginning of March the nervousness has increased sharply, and there are already warnings from companies about the effects of the virus on earnings for the first quarter of the year.
"There will be a very big impact on earnings in the first and second quarters. These are major production disruptions that many companies are suffering, and there have been very limited sales in China throughout February. The impact of the virus has now reached Europe as well, and is obviously affecting sales, so the first and second quarters will be very weak," says Anders Wennberg.
What the market must consider, says Wennberg, although it is still difficult to form an opinion, is whether there will be a substantial recovery in the second half with some of the lost sales being recouped. Perhaps companies will want to build up a little more inventory to have some buffer.
In this scenario, the stock market would recover quite sharply in the second half of the year, but it is still too early to say. Wennberg emphasises the importance of taking a helicopter view: the valuation of the stock exchange was very high when the current storms arrived.
"The multiples were perhaps not the highest ever but high historically, and the economy was not very strong, with concerns about the trade war and other things. The stock market was ripe for a downturn anyway, so it is difficult to divide the slide into how much is due to the stock market being overvalued and how much is due to the coronavirus," says Wennberg, adding that a third question is whether the stock market is able to see beyond the virus and instead look forward to the second half and beyond in 2021.
Between inviting you and making this podcast, the stock market has fallen about 13 percent. This is from a high valuation, but it is more complex. Not all stocks were overvalued.
"Yes, and the complexity has become even more pronounced in the past week. Interest rates have fallen very steeply and this has benefited defensive companies and safe stocks. Cyclical companies have fallen much more than defensives," says Wennberg.
After a very weak fourth quarter of 2018 on the stock exchange, 2019 saw gains in the region of 30 percent. A drop to the January 2019 level from today would require another fall in the index.
"We are back to the levels of early autumn last year. So there is certainly more downside if this becomes drawn out. And in addition to the coronavirus, the other news is that interest rates have come down so terribly sharply. "There is no alternative", or TINA as it's known, has become even more relevant; there is no return on interest-bearing paper. How will this affect multiples, especially for defensive companies?" asks Wennberg.
Some measures have already been taken, including a rate cut by the US Federal Reserve. Thomas Elofsson hesitates to call the Fed's actions desperate, but describes the central bank as something of a slave to the market. Although cuts between meetings have been made before, this has been during significantly worse situations, according to Elofsson.
"It's too soon to call that the credit market will freeze up in a week. When the stock market drops 15 percent from its peak and you make a cut like this right in the middle, it certainly feels strange," he says.
However, he adds that what is being priced is for the US to come down to a policy rate of 0.25 percent later this year. With that perspective, you might say that what the Fed did now was only to partially catch up – they are still lagging behind what the market is pricing in.
Long-term interest rates have also been pushed down sharply, and Elofsson believes the Fed will cut as much as the market expects. But then the dry powder begins to run out.
"Then there will be no ammunition left in the gun and things get difficult. Using fiscal policy, lowering taxes or using other easing for companies or individuals is probably very close at hand if the turmoil does not subside," says Elofsson.
Traditionally, weaker periods have arrived due to increased interest rates, with unemployment then starting to rise. But now we have a situation of unemployment near the lowest rate ever in the US.
"I think they have ended up in a very bad situation. In a normal situation, interest rates would not have been cut when unemployment was so low. It is quite easy to lower the interest rate, but very difficult to raise it. Clearly, if assets go down it becomes a huge problem. The central banks understand this, which is why they are so sensitive to the stock exchange," says Elofsson.
According to him, there are two possible scenarios. One is that countries use stimulus because of the coronavirus, which may not be as dangerous as many people think. Then it is reasonable to believe that things will blow over and that the stock market and property prices will go up even more.
"If we get into a better economic situation in the second half of the year – partly normalisation, partly recovery – and recoup lost demand, there could be a good autumn and a very strong stock market rise," says Wennberg.
A more downbeat scenario is that the unrest continues and escalates, which right now feels more likely. At that point, China might not be the big problem anymore but rather those regions that do not have well-developed healthcare.
Elofsson points out that there are probably "very few", even in Europe and the US, that are sufficiently prepared to deal with something like the coronavirus outbreak. In addition, the valuation of assets is extraordinarily high in the Western world.
"Falling asset prices and consumers battening down the hatches, perhaps unemployment. Then we would be in a very bad situation. We are going into this with valuations that in many cases have never been so high. Being really bleak, it could be incredibly bad," says Elofsson.
What action do you guess would be taken then?
"The simplest thing that I think is close at hand is fiscal policy measures, but then you have to remember that the scope for this is not that big in many countries. The US already has a large budget deficit – how much could it have? We have scope in Sweden, and there is scope in Germany," says Elofsson.
If the upbeat scenario is realised, how quickly would it impact the stock market? Very quickly, believes Wennberg.
He believes the best thing to do right now is to choose shares that you want regardless of what happens in the future.
"One such share that we have in the portfolio is Essity. It is not extremely cheap at p/e 18-19, but it is cheaper than many other grocery company shares. It is a spin-off from SCA that does everything from paper tissues to sanitary towels and nappies – hygiene products. They could see a little extra demand from this situation, plus their overheads are likely to stay low thanks to this," says Wennberg.
He also mentions companies that have recently published good reports, like Millicom, where growth has accelerated and where there is consolidation in several markets. E-commerce market shares seem to have increased compared to physical stores as a result of the coronavirus situation, and the holdings include Boozt.
"We are very valuation driven, but the valuation must be set against the fact that estimates are uncertain, as are growth prospects, and the valuation must be seen in relation to that," says Wennberg.
Over a long time, expensive companies have become even more expensive on the stock exchange, while cheap ones have become even cheaper. In this valuation gap, Catella Fonder's portfolio managers have often chosen a little more of the lower-valued companies.
Has that picture changed as the market has become more troubled?
"That's not the case in the short term. The cheaper companies did better than the expensive ones in late autumn and January, but now it has gone sharply the other way. This is because the market flees into companies that are perceived as safe and have worked in the past," says Wennberg.
However, the managers have not changed anything in their basic principle of looking for undervalued companies, according to Wennberg. What has changed are the conditions.
Among the sectors that have recently had the most difficulty are travel-related industries like hotels and aviation. Here, the managers have chosen to sell and stay away.
"We had a small position in Norwegian in January, which I sold the first day I heard about the virus, and it has fallen 60 percent since then," says Wennberg.
Scandic Hotels is another tormented share, which has fallen in the region of 35 percent.
"It was on the list of things to look at in January. It was relatively cheap, and data from the Finnish market in particular was positive in January. But we never get around to buying, and when the coronavirus hit it disappeared from our radar," says Wennberg.
Interest rates have fallen back to extremely low levels in Europe. Before the turmoil erupted, the market had very tight spreads. However, this has changed, according to Elofsson. The spreads have widened by about 1 percent when looking at a generic high-yield index, albeit from a very low level. However, if the course of events surrounding the virus becomes negative there is more downside to go, according to the fund manager.
"High yield is, of course, typically either a slightly more risky business or highly indebted companies, and having high debt is an increased risk. On the other hand, interest rates being so incredibly low puts downward pressure on spreads. What could happen, and will happen if the economy gets worse, is that there will be insolvencies," says Elofsson.
He adds, however, that the low interest rates make it easier for companies to pay off their loans – the most difficult situation is, instead, higher interest rates along with lower cash flows.
Since last autumn, Catella Fonder's fixed income managers have chosen to sell off many of the companies that have functioned a little worse. Instead, they have sought out more stable business models, such as telecoms, food production and the like.
Back to equities. Is it index investment driving much of the multiple expansion in companies?
"Yes, what has affected markets a lot in recent years is the index flows that account for maybe half of the capital coming in. This is blind capital that affects valuations greatly. At some point it will be good for those who look at valuations, but that could be like trying to stand up against a flood," says Elofsson.
He continues: "Another trend that has continued for a long time is falling interest rates, and looking at multiples without looking at alternative investments is strange. It is possible to justify much higher multiples today because interest rates are so much lower. But at some point, that should calm down," he says.
Thomas Elofsson also points to a third trend that greatly affects valuations: ESG, environmental problems and the like, where investors adapt their portfolios and regulators are in control.
"Anyone watching oil will have seen that although the price of oil went up quite a lot last year, investments in oil companies were very bad business," says Elofsson.