Top Predictions for 2020

Special Report – Market Update March 10, 2020 FAT-AUS-961

Fear and capitulation

Global stock markets were a sea of red on Monday, with Australia enduring its worst day since the GFC as panic reigned supreme. The ASX200 tumbled towards bear market territory, falling 7.3% to close at 5760, as a 35% collapse in oil prices since Friday acted as an accelerant for investor fears over global economic growth as a result of the coronavirus outbreak. The market has however risen today – so will this be a lasting bounce?

Oil producers led the declines, with Oil Search losing more than a third of its value while Santos and Woodside lost 27% and 18% respectively (all three have recovered a bit of ground today). Energy related exposures were also at the sharp end of the selling, with BHP closing down 14%.

The catalyst that pushed stock markets (which were already fretting over coronavirus) over the edge was the plunge in the oil price, after Saudi Arabia effectively commenced a “price war” with Russia. Oil plunged more than 25% on Monday after losing over 10% on Friday. The collapse in the OPEC+ cartel appeared out of the blue to knock stock markets already very fragile from Covid-19.

Oil prices crashed on Monday, which opened a floodgate of selling on global stock markets.

Currency markets were also volatile, with the A$ getting as low as 63 cents before regaining some composure.

The plunge in the oil price caused mayhem, yesterday, in Australia and also in other energy heavy markets.

The VIX volatility index also spiked on Monday pushing up above 60 before settling back to around 55. Our view that peak fear level in the VIX was seen

last week has clearly proved wide of the mark. The VIX has surged to the second highest level in history, eclipsed only by the GFC.

That said, no one saw the traumatic action in the oil market which came from left field. In fact, OPEC+ had primed the market with rhetoric, in late February, around a 600,000 to 1.0 million barrels potential cut to the group’s production, to counter flagging oil demand outlooks.

Saudi Arabia seems intent on lifting production to force prices even lower and this will cause significant disruption in the global energy industry with many countries having uneconomic production. The US shale industry is going to face widespread output cutbacks if prices remain at that level for long. It seems that the energy industry including Russia will be forced to consider output cutbacks before too long, particularly if the oil price continues to fall towards $20, which was the nadir of the bear market during the last price war in 2015.

Many globally are concerned about the deflationary impact posed by the drop in oil prices, but the silver lining to the global economy is a dramatic reduction in energy costs. This will effectively act as a tax cut for the global economy and boost consumer spending power, as well as profit margins for companies.

The big question following the two-week rout that has seen many stock markets correct sharply from record highs is what the collective responses are

going to be from governments. To this end, Donald Trump has already announced some ‘major economic measures’ in response to Covid-19, with support for wage earners and businesses.

For the Australian government, the plunge in oil, and market rout, will only further reinforce (and increase) the need for the further economic stimulus that was already needed due to Covid-19, and also arguably the bushfires.

Scott Morrison today talked about ‘support’ as needed, and is expected to announce details of a major stimulus package later this week. Treasurer Josh Frydenberg said yesterday in the media that ‘the virus is having a significant impact on tourism, education, agriculture and manufacturing’ and “the government will soon be releasing its economic response.” Morrison has said the plan will be “targeted, measured and scalable,” with an emphasis on protecting business cash flow and jobs.

The Australian economy has been through a lot, and now has the oil market collapse to deal with. A saving grace on the other side is that petrol will become cheaper, and put more money in consumers’ pockets. But fiscal stimulus may be key to keeping the economy out of recession. Another question is whether the RBA also steps up in an unconventional manner and unleash a QE style bond buying program, purchasing government, and quasi-government debt across the yield curve.

We have questioned previously whether the rate cuts from the RBA would have much real impact. These were more a ‘sign’ of intent, and I think now matters have got to the stage, where the RBA will want to make investors, consumers, and businesses sit up and take notice. Desperate times call for desperate measures.

Australia did not employ QE during the GFC, and such a strategy along with a massive stimulus program from the government may once again help Australia to stave off recession. Such a plan could also greatly reinvigorate investor optimism and confidence.

Sessions such as yesterdays’ are rare, and indeed the price action was the worst since the global financial crisis. Selling was indiscriminate, even companies with relative recession-proof business models, and good prospects, under significant pressure. Common sense and logic appeared to have been replaced with outright panic and capitulation.

We were clearly wrong on our scenario of a short-term bounce, as markets look through to the other side of the coronavirus, but few saw a collapse in oil coming, and as major producers effectively embarked on an all-out price war.

As of yesterday, the ASX has fallen more than 1400 points since the record highs only two weeks ago, with a loss of just under 20%. The puts the market into bear market territory.

When the market is effectively crashing it is difficult to get some sense of perspective, but that is also exactly when it is needed the most.

Recent market volatility of course has been attributable mainly to the spread of coronavirus, and the consequent economic impacts. We have held the view that Covid-19 will not be the virus which spells global economic Armageddon, particularly given China, the original epicentre of the virus, has seen the infection rate plateau, and recovery rate rise. China appears to be getting back on its feet, with reasonable containment measures in place, and so too will the rest of the globe, in time.

This is not GFC part 2 in our view. Many businesses may well come under pressure, but we do not see widespread corporate failures under a burden of debt (and as credit dried up), which was the case some 12 or so years ago. Money remains cheap, and pent up investment will come through in our view.

The energy sector has new pressures now, and that will be a cause for concern, but not enough in our view to undermine the entire corporate sector.

We therefore believe that the recent market sell-off has created strong value in a number of areas.

Defensive, well positioned businesses

Several companies whose business models are relatively defensive, but also have strong growth prospects, have been unduly sold off in our view, and offer robust value.

A prime example is Domino’s Pizza Enterprises. People are not about to stop eating pizza any time soon, and indeed the company’s deliver model will do even better if people decided to ‘coop themselves indoors’ over the coming months, and until the angst over Covid-19 blows over. Domino’s also has a strong offshore expansion plan which will drive growth longer term. We maintain a buy recommendation on Domino’s Pizza Enterprises.

It is a relatively similar story for Collins Foods. While less delivery intensive (this may now pick up), people are not about to abandon KFC (or Taco Bell). The company likewise has a strong offshore growth levers longer term. We maintain a buy recommendation on Collins Foods.

Insurance is likewise hardly a discretionary expenditure. The falls in QBE Insurance, in our view, are way out of whack with the pressures on investment income as a result of falling bond yields. A reduction in capacity in the catastrophe sector is driving premiums higher, and all while QBE’s own turnaround program is delivering. The yield appeal of QBE also just got more appealing, given falling interest rates. We maintain a buy recommendation on QBE Insurance.

The telco sector also has a strong defensive growth profile, particularly with the advent of 5G to drive this further. We regard weakness in Telstra as an opportunity, and also given the yield appeal just got greater given falling interest rates. We maintain a buy recommendation on Telstra.

High growth, but lowly value digital businesses

We have largely avoided high growth, high PE, IT stocks and these have certainly been dealt to during the recent correction. We however consider Nine Entertainment to have a number of strong digital earnings drivers in the form of Domain (with the property market set to turn around further over the medium- term due to lower interest rates) and Stan (which may also benefit as more people ‘stay inside’). Nine also continues to drive synergies out of the merger with Fairfax and trades at a PE of just 11 times. We maintain a buy recommendation on Nine Entertainment.

The banks

The bank stocks have also been under severe pressure following the RBA rate cuts, and this week’s market plunge. While net interest margins will tighten, the prospect of further fiscal stimulus and even QE could be a real boost to sentiment. We are not ready to call a wholesale bottom on the sector but the yields now are very appealing. We maintain a buy recommendation on NAB, and have moved to a buy on Bank of Queensland (see today’s report for further details).

The diversified miners

We issued self-half recommendations on both BHP and Rio Tinto last year at $41 and $104 respectively, on our view that iron ore prices had peaked. With the shares having lost 34% and 23% respectively since, and following this week’s downturn, that looks to have been the right call. However, given our view that a global recession will be avoided (and China gets back on its feet), we are now considering the prospect of moving back to a buy on both stocks. We would like to first see a global/unified stimulus initiative by governments and central banks before we consider this.

BHP

RIO

The energy sector

Part of our hesitation on moving back to a buy on BHP is that it is a heavily energy related stock. Yesterday’s sell-off or course was prompted by the seemingly illogical actions of the world’s biggest oil suppliers, which have effectively engaged in an all out price war when it was least needed. While high oil prices are seen as a tax which crimp growth, rapidly falling prices are seen as deflationary, and investors (highlighted by the bond market with US yields below 1%) now see a global recession as a more likely prospect.

Oil prices were off 10% on Friday but collapsed a further 25% yesterday, as Russia refused to buckle to Saudi Arabia’s assistance for output cuts. The events of the weekend were out of character with the cohesiveness that OPEC+ and especially Saudi Arabia and Russia had shown over an extended period of time. This came as a shock to the oil market which has been hampered by a soft demand outlook due to the virus, and now a supply headwind due to the actions of the cartel’s biggest producers.

Oil price volatility can be expected until an agreement can be reached – the time horizon for this is not clear, but the budgetary demands of OPEC members cannot be withstood forever. Russia for instance generates almost 70% of its export revenues through oil, and the percentage is even higher for Saudi Arabia.

The fall in the oil price is clearly deflationary, and this is also what has the market worried. However, for every action there is an equal and opposite reaction. The price war which Russia and Saudi Arabia appear to be embarking on will have a clear consequence for producers at the margin, and particularly the US shale industry, which have a much higher cost structure. The resulting supply reaction, as we have seen previously, will also come through at some juncture.

Share prices in Australian oil producers have been hard hit by the oil price turmoil, with quality producers trading sharply lower in yesterday’s trading. Many Australian oil producers however have strong balance sheets and revenue exposure to LNG where pricing has been less effected by the crude market upheaval.

These oil producers are also in far better shape than they were during the GFC, and also in 2016 (when the oil price last plunged). Santos for one has since engaged in a capital raising, and the company’s break-even oil price has almost halved from the US$50 a barrel it was during the GFC. Santos, Oil Search, and Woodside also now have more advanced LNG projects, and the relative greater success of Woodside’s Pluto perhaps saw it hold up (slightly) better yesterday.

While a risk globally, we don’t think we will see wide-ranging failures in Australia’s energy sector (and until OPEC and Russia come to some form of agreement). We may see cost bases trimmed further, but our energy companies are generally in good shape.

That said for now, the energy market may be in the ‘too hard’ basket (other than as a very speculative buy). Much will depend on when Russia and Saudi Arabia can get back to the negotiating table. Ultimately any agreement may be months away, if not much longer. For now, we recommend that Members continue to hold Woodside, Santos, and Oil Search.

The markets generally have been “knocked for a six” in the past few weeks, and while it is hard to see them getting straight back up off the canvas; but recover they will. We need to see stability and sensibility return to the oil market, which we think will happen. The public hysteria around the coronavirus also needs to settle down, as the world learns how to get on top of this new disease. But get on top of it the world will.

The next few weeks will be important in terms of government responses, and not just in terms of the medical response, but what can be done to shore up the global economy. If the GFC was anything to go by, we learnt that governments were prepared to step up through quantitative printing and fiscal spending measures, that were successful in preventing back then what could have become a global recession.

Disclosure: Interests associated with Fat Prophets holds shares in Domain Pizza, Collins Foods, QBE Insurance, Telstra, Nine Entertainment, National Australia Bank, Bank of Queensland, BHP, Rio Tinto, Oil Search, Woodside and Santos.

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