Taal selectie

Pension funds

How Long a
Shutdown ?

Pascal Blackburne, CIO 2020-04-01

Photograph: REUTERS/Carlo Allegri

With almost half of the world population currently in confinement, the question is not whether recession will occur but how long it will last. In turn, this depends crucially on medical developments: might any of the ongoing tests of (combinations of) existing drugs soon be found to work or will a return to “normal” social and economic activities have to wait for a vaccine?

EURO STOXX Europe 600 VS EURO STOXX Banks
Stoxx(Source : Bloomberg)

The last few weeks have certainly been trying, as the public health emergency became acutely evident throughout Europe and – with somewhat of a lag – in the US. The collateral economic damage caused by country-wide shutdowns is also already very obvious, with European PMI business surveys plunging and US weekly unemployment claims spiralling to an unprecedented 6.6 million. And, of course, financial markets suffered their worst blow since 1987, with ETF outflows, margin calls and a lack of liquidity in some segments compounding the correction.

From a medical perspective, first, where do we stand? With so much space taken up in the media by coronavirus-related news, it is sometimes difficult to distinguish correct from fake information. Focusing on official sources, what we do know is that a large-scale clinical study of various existing drugs (including combinations thereof) has begun in the EU, under the coordination of Herman Goossens, professor of medical microbiology at Antwerp University. This will include Sanofi’s anti-malaria “Plaquenil” that is touted by French professor Didier Raoult – on the basis of just a small sample of patients, though. If, within a few weeks, a successful medical treatment for Covid-19 is found, then confinement measures could readily be lifted. This is the optimistic scenario. Otherwise, some continued form of semi-isolation – or a stop-and-go approach – will have to be maintained during at least the next 12 months until a vaccine becomes available, in order to keep healthcare facilities from imploding.

In the latter (worst-case) scenario, most economies would not revert back to “normal” growth for at least a year. Which would mean that a large number of companies go bankrupt or survive only thanks to government intervention. Reflecting on the banking sector evolution post the 2008 Great Financial Crisis, we can safely predict that such state rescue operations would come at a cost. Banks that required propping up, back then, by government or government-controlled funds have since undergone tightened regulation, notably in terms of dividend payments – not a very rewarding situation for shareholders (see chart) This time round, it is companies in the transportation industry, airlines and car manufacturers notably, as well perhaps as pharmaceuticals that could come under much greater state control.

Investors thus face a binary outcome. Either a medical solution is found soon, the economic shock proves transitory and the equity rebound – initiated by announcements of massive monetary and fiscal support – continues. Or the world has to wait for a vaccine, company valuations drop substantially further, the huge promised government funds need to be deployed, and the business operating environment worsens durably. To not miss out on the upside in the positive outcome, while preserving capital in the negative one, buying call options could be a solution, however premiums are currently very expensive.

Company Rescues : No Free Lunch

Monetary and fiscal packages are hot of the press and already there have been reports that Swedish policymakers may stop companies that require state support in relation to short-term layoffs from paying dividends. In France, the Minister of Economy and Finance recently made clear that dividend-paying companies would not be eligible for the various government support measures. And the USD 500 billion of bridge loans to companies included in the (USD 2 trillion) US Congress stimulus plan includes a ban on those tapping such facilities from repurchasing shares until a year after the loan has been repaid, as well as restrictions on executive compensation.

We take this as a clear sign that the story of the banking sector since its 2008 crisis is about to be repeated – affecting different industries this time. In our view, there is simply no way that government money put out to rescue companies will be free of charge. We talk here not of interest rates on loans, which central banks have all but assured will remain near zero for the foreseeable future, but of indirect costs in the form of greater regulation and compliance requirements. Indeed, how else could governments justify to the public that companies which have just experienced several years of very good profits, but largely used them up to pay dividends and buy back shares, are now granted state assistance?

In an attempt to hoard cash, companies themselves are already announcing dividend cuts, alongside drawing on their credit lines and issuing bonds, never mind the higher interest rate spreads. Not only are they preparing for a long period of possible cash drain, but it would certainly also shock the public opinion and the governments coming to their aid, if they were now to regale their shareholders with (high) dividends while part or most of their staff is unemployed

Beyond the many companies in the hardest-hit industries that will depend on state funding for survival, we would not be surprised to see pharmaceutical companies also come under closer state scrutiny in the coming years. Indeed, huge pressure is currently being put on governments by scientists to reconsider the patent system. They notably point to the importance of sharing scientific data – as they have actually been doing since the start of the coronavirus outbreak – both on positive developments and when tests fail. This, instead of private companies safeguarding their internal research on medical compounds, and then charging steep prices for successfully developed drugs.

Higher taxes down the road are a likely prospect too, given the formidable budget deficits that are liable to be run over the next quarters – depending of course on how long the Covid-19 shock lasts. There might well also be upward pressure on wages, notably in low-income worker categories that have been brought into the limelight by this sanitary crisis.

Increased regulation, taxes and wages: a recipe for durably more muted corporate earnings growth and a reversal in the multi-year uptrend in the profits/labour income ratio.

Oil Undergoing a Simultaneous Demand and Supply Shock

WTI Crude oil
OIL(Source : Bloomberg)

For oil producers, the massive hit to global demand caused by the Covid-19 pandemic is magnified by a shock on the supply side too. Indeed, the failure, on March 6th, of OPEC members and their non-OPEC allies to agree on continued output cuts has led to a ruthless price war. Saudi Arabia and Russia are currently dumping oil on the market, which has pushed crude prices down to levels not seen since the late 1990s (see chart) and will result in oil inventories skyrocketing.

Drawing down these inventories will unfortunately take a very long time – a period during which shale producers, as the higher cost marginal producers, will undoubtedly suffer considerably. At this point, investors such as ourselves have no other choice but to sit it out, focusing on the companies with limited or no leverage and that have the financial resources to withstand a least a year of very low oil prices. US government aid could also be counted upon, perhaps to obtain easier loan refinancing terms.

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