Paul Xiradis talks: The economic outlook, earnings, dividends and banks in the wake of COVID-19

Paul Xiradis

What is your outlook for the global economy and are governments and central banks doing enough to ensure an eventual economic recovery?

It’s fair to say that the current macro experience is quite dynamic, and is very much subject to how well the world will be able to suppress the spread of COVID-19. Rather than focus on the noise in markets, from a top-down macroeconomic perspective, a number of things are becoming clear.

While the COVID-19 virus and the path to its suppression remains unknown, a number    of countries have successfully flattened the curve, including Australia. The US, Germany, Spain, Denmark, New Zealand and Austria are already planning to gradually open their economies as is currently occurring in China.

The decisive intervention by governments and central banks with co-ordinated monetary, fiscal and health responses has been entirely without precedent. In aggregate, the global measures announced are running at round 10-15% of global GDP. Australia’s total fiscal and monetary stimulus package alone stands at a record A$320bn or 17% of GDP.

US fiscal packages to date total US$3.4 trillion (15.7% of GDP), with QE and an additional US$2.3 trillion in Federal Reserve credit facilities. Congress is considering further aid totalling US$800 billion for State and local governments, and direct stimulus payments to individuals and households.

China is expected to announce targets for GDP growth, fiscal and infrastructure spending levels. The Bank of England stands ready to finance the UK’s fiscal spending. EU finance ministers agreed on the need for a Union Recovery Fund flagged at €1 to €1.5 trillion or 5% to 10% of EU GDP. The ECB will accept non-investment grade bonds as collateral for loans to banks, and Eurozone finance ministers agreed to issue €240 billion, without conditions, to help member countries fight COVID-19. The Bank of Japan moved to unlimited QE, with the government launching a massive fiscal package of US$990 billion or 19.6% of GDP.

Each package in its own way is designed to loosen credit, increase liquidity, increase demand spending, lower the unemployment rate, and help support individuals and families with minimum wages. Credit markets and spreads have settled somewhat, so too have yield curves, and banks are operating with more confidence.

It is accepted across markets that authorities have done everything possible, in quick time, to underwrite an economic recovery later this year that will strengthen into 2021. We believe this recovery will be U-shaped as governments begin to implement the planned alleviation of lockdowns, as stimulus underpins demand, and the world economy slowly returns to productivity.

Markets have already priced-in the expectation of recession, in the US, Australia and globally, and are now looking through the negative data with more confidence, the main unknown being COVID-19 itself. For this reason, there will be bounces in optimism and pessimism in the coming months, on both the macroeconomic and market front.

While the current collapse in the price of oil is seen as compounding the deflationary environment, and as an indicator of a world economy in recession, down the track, the availability of cheap oil is likely to be seen as a positive for businesses as they begin to recover with the economy. Interest rates will also assist recovery and will stay lower for longer, possibly for years to come.

What does this mean for earnings and dividends?

In the COVID-19 environment of volatility and uncertainty, we are seeing buying opportunities we have not seen at these levels, in some sectors, in over a decade. In taking advantage of such opportunities, we believe there is a need to be very selective in both sectors and stocks, regardless of the low prices prevailing across the market.

Both balance sheet strength and earnings outlook are critical in making the right decisions. It is now a ‘buyer’s market’ for carefully selected high-quality stocks that stand to benefit from global stimulus and the eventual shift to recovery, particularly in the Health Care, Software & Services, Transportation, Energy, Banks and Resources sectors.

At an economic level, we believe Australia is heading for a U-shaped recovery. But what this looks like across the equity market differs by sector and company. At this stage, balance sheet strength trumps everything. We are making sure that the balance sheet is great, the business model is intact, and there is a safe foundation from which earnings can normalise and grow as the economy enters recovery.

We have been stress testing every company as the fundamental first step in evaluating the outlook and glide path for earnings, before even considering increasing existing positions, or adding new names to our portfolios.

On dividends, over the last decade, total return for the S&P/ASX 200 was 7.1% pa of which 6.1% or 87% of the total return was from dividend and distribution income. Over 50% of dividends are paid by just eight companies, with two-thirds of dividends paid by 18 companies. Dividends are important for investors who require the income stream they offer, but for long-term investors, earnings matter more.

It is hard to determine the impact of COVID-19 on dividends other than to look at the Financial Crisis as a guide. In 2008/2009, some 65% of companies cut or suspended dividends, with dividends falling some 30% in value. We are expecting a similar impact this time around, however, we also expect this to be temporary.

In terms of the risk of dividend reductions in the COVID-19 environment, the story varies by industry. For some colour on this, Ausbil’s review of the risk of dividend reductions covers low, medium and high risk bands. We consider food retailing, telecommunications, pharmaceuticals (especially CSL), agriculture, technology, regulated utilities, iron ore and gold producers to have a relatively low risk of dividend reductions. With a medium risk of reduced dividends are companies in the financials (ex-banks), metals, discretionary health care and building industries. Companies in travel, casinos, retail shopping and energy are at the higher risk end of the spectrum for risk to dividends.

Given the nature of the COVID-19 crisis and their role in the monetary stimulus equation, banks are already reducing dividends, but this is expected given their ongoing focus on maintaining acceptable levels of capital and provisioning.

Of course, these risks will fall as the virus subsides, and as we roll into subsequent reporting seasons. The coming FY 2020 reporting season is likely to be an outlier on dividends compared to normal years, but we expect this has already been reflected in prices, and will normalise in the subsequent reporting season, and as we see the economy recover into 2021.

What sectors and stocks do you think will do relatively week in this environment?

In terms of the glide path for earnings in the wake of COVID-19, the experience will be different for each sector and company.  Moreover,  many sectors will have companies   that have different recovery experiences, emphasising the need for a deep and granular understanding of each company’s specific earnings drivers.

For some like the leading data centre and cloud storage group NextDC in the Software & Services sector, and Goodman Group who have warehousing and logistics clients such as Amazon in the Real Estate sector, earnings are showing resilience with an outlook for growth.

Sectors like Resources (including Rio Tinto, BHP, OZ Minerals and Independence Group), Consumer Staples (like Woolworths), Consumer Discretionary (such as JB Hi-Fi), Health Care (like CSL and ResMed), Telecommunication Services (such as Telstra), Commercial & Professional Services (like Brambles) and Software & Services (like Altium) are likely to see earnings relatively unscathed, and in some cases, rise.

There are companies where there have been steep falls in earnings from COVID-19 restrictions, and the question is not if they will bounce back, but simply, when? This includes companies such as Qantas (Australia’s major airline), Ramsay Health Care (one of Australia’s leading health care and elective surgery providers), Sonic Healthcare (a global health care and pathology group), Transurban (one of the world’s leading listed toll road companies), Seek (Australia’s leading recruitment company) and Afterpay Touch (the leading buy-now-pay-later company which has already bounced in a V-shape). These companies were immediately and severely impacted by COVID-19 restrictions. We expect to see V-shaped rebounds in their earnings as customers and users of their services return with gusto as lockdowns are eased.

For other sectors, we are expecting a U-shaped recovery as the economy unwinds from its current COVID-19 limitations and heads for growth. This includes high quality companies such as Lendlease (the global leader in large scale urban and city redevelopment), BlueScope Steel (Australia’s leading steel producer for export and building products) and Santos (Australia’s pure-play natural gas leader, temporarily impacted by the fall in oil prices).

In terms of outlook, at this stage, the market is still looking for hard information and guidance from companies on which to base forecasts. Many have withdrawn guidance, and consensus has still not caught up. Regardless, we believe that quality companies will settle back on the growth paths along which they were headed before the crisis.

This crisis has offered a rare opportunity to cycle capital into the highest quality portfolio at the most favourable prices, ultimately setting a foundation for future outperformance. The key to success in the current environment is not to be overly defensive, but to remain invested for the recovery that will come.

Paul, there are varying views concerning the outlook for the banks, what are your views?

Banks tend to be a proxy for the state of the economy and, as such, with the economy heading into a recession, it is right to ask questions of the banks, their balance sheets and the sustainability of their earnings.

Today, banks are unquestionably stronger in terms of capital and balance sheets than when they entered the Financial Crisis. One of the great things to come out of the Financial Crisis in 2008/2009 was the streamlining and strengthening of bank balance sheets and capital adequacy under Basel III and IV.

With COVID-19, we have seen the banks trade back below net tangible assets for the first time since the GFC, making them very attractive on this measure, but the key difference   is that balance sheets here are substantially stronger than they were back then. Banks will also benefit from the liquidity and stability that monetary and fiscal stimulus has provided.

While investors do not like to see dividends trimmed, we are seeing banks hold back some of their dividends and in some instances raising capital to further strengthen their balance sheets and provisions. Ultimately, this is a good thing going forward for earnings stability and growth.

In terms of bad and doubtful debts, though banks are prudently increasing provisioning, they are not as exposed to commercial lending as they had been in the past. They have not been exposed for years, having corrected for this back in the great post-GFC deleveraging. Major commercial landlords and the largest retail property owners moved to listed and unlisted trusts, and even though there is some level of gearing, it is not to the same extent as in the GFC.

On housing, the concern is that we could see immigration soften for a year of two, and that would take away demand for rentals and new starts. You could see property values come back, and if the unemployment rate stays high you could see a higher rate of bad and doubtful debts. But it will not be too much for banks to handle as they have already commenced provisioning. Other measures have already been introduced such as refinancing loans for longer periods, the availability of temporary payment relief and massive stimulus packages, all of which will help arrest some of this pressure.

Now we are in the recapitalisation phase of this downturn, where do you see the opportunities?

To participate in recapitalisation opportunities you need to be invested. Fortunately, some of the best recap opportunities have come in some of the names we hold, in a market rich in choice. Our starting position for recap opportunities, as with earnings, is the integrity of the balance sheet. Moreover, we are only taking recap opportunities where we can see earnings normalisation and growth through the current COVID-19 noise.

Some balance sheets are so far under water it’s almost a rescue. We have seen some of those particularly in the travel sector where business models have come under pressure. You really have to pick your recaps carefully as some may find it difficult to operate as consumers change their behaviour.

There are other groups that have been recapitalised that are raising money because they see opportunity in, and beyond, the current situation. We have seen that in Ramsay (healthcare and elective surgery), QBE (global insurance), Lendlease (in global real estate development), National Australia Bank (one of the top four domestic banks), and NextDC (cloud storage and data centres). We participated in these capital raisings because of their strength now, and the earnings growth opportunities ahead when the market normalises. We believe that the capital raisings in which we have participated will contribute to future outperformance for these companies.

Paul Xiradis is the Executive Chairman, Chief Investment Officer and Head of Equities