While economic indicators continue to signal a recessionary environment, equity markets choose to paint a rosier picture. February’s equity market sharp sell-off was followed by a dramatic rally over the past few weeks, most notably in the US. European equity indices still lack behind the US equity market benchmark by approximately 10 per cent.
The larger technology exposure in the US equity market and the scale of monetary stimulus pushed through the economy by the US Federal Reserve are the primary reasons as to why equity markets have bounced back up from the trough. However, the upward trajectory might not be so plain sailing, as the Fed chairman Jerome Powell openly remarked that “additional policy measures” may be necessary to counteract the long-term economic repercussions of COVID-19.
The extent of divergence between equity markets and the real economy is captured through the forward Price to Earnings multiples. The S&P500 is currently trading at forward PE multiple of 20x, a sharp increase from the 13x PE level at which the index was trading when the price fell to its lowest point year to date. The increase in forward multiples is driven by the 24 per cent increase in price from the trough and the simultaneous downward revision of earnings expectations, down by 16 per cent so far. As the forward PE multiple has continued to tick higher, investors are left to assess the probability for earnings to catch up as quickly.
The first quarter earnings season has presented investors the first opportunity to get a hint of the severity of the impact of covid-19 on business operations, and more importantly to attempt to understand the trajectory for the subsequent recovery. Given that most companies have now reported their quarterly earnings, we set to highlight common themes that have emerged from this earnings quarter. Difference in sector performances reflect the extent of the sector’s exposure to the government imposed measures that seek to contain the spread of COVID-19.
Understandably, the hardest hit sectors were those that provide non-essential products including the consumer discretionary, industrials, materials while the sharp decline in oil prices dragged energy companies. Those companies which depend on consumers feeling comfortable to have face-to-face interaction, whether it is to shop, travel or consume a service, are expected to carry a more long-lasting impact on their bottom line.
A key common theme featured throughout the quarter was the removal of guidance on future earnings expectations. Management’s hesitance on providing guidance highlights the extreme uncertainty brought about by COVID-19, as governments limit business activity in order to contain the spread of the outbreak. Instead, companies with exposure to mainland China, which was the first to emerge from government lockdowns, highlighted encouraging signs of a recovery.
Nonetheless, the extent of a recovery across different countries depends on where that country stands on the pandemic cycle and the government responses in place. As a result, the business recovery in China cannot be easily extrapolated to other countries.
The quarterly earnings also signalled the acceleration of business digitalisation. Forced closure of retail shops shifted consumption online. Subsequently, companies which had already invested in their online infrastructure benefitted from the increase in e-commerce business and are likely to continue to benefit as we expect online usage to persist beyond COVID-19.
Another observation was the mixed impact on costs. Demand and supply chain disruptions triggered a number of business decisions to preserve business continuity. Companies reported lower labour costs due to layoffs, furloughs and lower salaries. On the other hand, logistical and transportation issues and the reconfiguration of product lines to ensure the health and safety on employees led to higher incurred costs.
Finally, the most notable theme across all companies was the priority for management to preserve cash flow and ensure liquidity. The heightened concern over future expectations led companies to reduce capital expenditures which were not deemed critical, and announce the removal or reduction of share buybacks and dividends. Balance sheet strength remains a fundamental priority, and the ultimate key for companies to weather the downturn.
Disclaimer: This article was issued by Rachel Meilak, CFA equity analyst at Calamatta Cuschieri. For more information visit www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.