Mar 31, 2020
31 March 2020The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole.
The new decade had been expected to start positively with consensus forecasting 2020 earnings growth of 7 to 8% in Europe, back in January. This was to be driven by a broad variety of sectors, ranging from pharmaceuticals and capital goods, through to energy and financials. Even six weeks ago this outcome seemed feasible.
However, the global coronavirus outbreak has led to a significant change in top-down views. A material double-digit earnings decline is now being anticipated. Travel bans and lockdowns are having a substantial impact on both demand and supply in a range of sectors. As consumers stay at home, companies such as airlines, cruise operators, restaurants and non-food retailers are suffering steep declines in demand. Less travel has reduced demand for fossil fuels, so oil prices have fallen sharply. This was exacerbated by the breakdown of OPEC+ oil supply negotiations, prompting an increase in production from Russia and Saudi Arabia. In response to these virus-related headwinds central banks globally have commenced monetary easing, which is reducing revenue expectations in the banking sector.
As a result, there will be a narrower range of companies offering earnings growth this year. Many will be in defensive sectors such as pharmaceuticals and consumer staples. Businesses with subscription related rather than transactional revenues will fare better, as will digital models such as online retail and entertainment as the public becomes more accustomed to spending time indoors.
Following the recent sell-off, we note that the European benchmark is trading at price/book levels similar to the 2008/2009 financial crisis. As such, many sectors are arguably oversold. Earnings headlines in the coming months will clearly not make for attractive reading, however this does not mean that share prices cannot appreciate in anticipation of an eventual improvement. For context, there have been three instances in the past decade where European equity markets have risen while earnings estimates have been falling – 2012, 2013 and 2019.
In light of this, we are wary of being too defensive, or indeed out of the market. Europe is an export-led economy, and there is already clear evidence that activity levels are improving in China, with companies reporting that factories are operating at more normalised levels. Consumer-facing companies in the country are also seeing demand start to normalise, albeit with a shift to online channels.
Given that analyst estimates have yet to fully rebase downward to reflect weaker outlooks, and many companies are withdrawing dividends to conserve cash, we are focusing on price-to-book as the most meaningful valuation metric in the short term. The shape of recovery will depend on two primary factors. First, the spreading of Covid-19 and how long it takes for the number of cases to peak. Secondly, the scale and efficacy of the fiscal and monetary response.
In the context of the recent drawdown, we have maintained or added to our positions in defensive stocks that we believe will still be able to deliver earnings growth in this environment, such as our large cap pharmaceutical and food producer holdings. We have paid careful attention to the resilience of company balance sheets during what will be a period of weak cashflow and have trimmed or exited names that have outperformed despite the current environment challenging our investment case.
It is also important to assess developments in Asia, where many nations have successfully reduced the number of coronavirus cases and trends there may provide a roadmap of what to expect in other parts of the world. We are conscious that the sell-off will provide opportunities in names that we have previously viewed as over-valued, and so continue to work to maintain an appropriately balanced 4Factor portfolio.