Carmel Wellso, Director of Research, examines the implications of the COVID-19 pandemic on financial markets and discusses what Janus Henderson’s team of analysts from around the world are evaluating, including long-term behavioural changes.

    Key takeaways

• The Global Research Team are looking beyond the headlines and evaluating the detail, which includes some positives such as healthcare companies focusing on the development of faster tests and potential therapies for COVID-19, and capacity utilisation picking up in China.
• Carmel believes that there is not the systemic risk that was experienced during the Global Financial Crisis. Balance sheets of many companies are typically stronger, notably the largest index constituents, which are often net cash. Banks are also stronger holding less of the highest risk debt.
• Janus Henderson has a team of healthcare specialists who are examining COVID-19 issues, and a team of analysts based around the world who are feeding portfolio managers with data, and can pull together a good picture of developing trends and what the future may hold for companies around the world.

Transcript

Good morning, this is Carmel Wellso, I am the Director of Research at Janus Henderson Investors. And I am speaking to you today from my office. I am the only one here on the floor, so I am definitely far away from anybody who might have the virus. But what is more important is that everybody is set up to work from home at this stage. We started the process of testing remote access several weeks before we actually had to implement the split working conditions and now almost everybody is working from home.

So we are really lucky to have a team of great healthcare specialists who are looking at the COVID-19 issues on a minute-by-minute basis. And we have a team of analysts around the world who are feeding us a lot of data from China, from Italy, from the United States, and we can pull together a pretty good picture of how things are developing and what the future is starting to look like. So when did this start? The World Health Organization was notified at the end of December 2019 that China had an issue with a new respiratory illness. At that stage, we weren’t aware that it might be as contagious that it is and that it could spread to a pandemic. It wasn’t until January that we really got the alerts that this is a very, potentially dangerous illness. And that is when markets really started to fall apart. If we put it in perspective, if we take the end of January, at that stage China had 8,000 cases. Now they have ten times that number. If we talk about the five largest European Union (EU) nations, they had a combined ten cases at the end of January. Now they have over 100,000. And in the US we only had seven cases at the end of January and now we have more than 20,000. So it has grown exponentially, but there are a lot of things that we view as positive and that the second derivatives are starting to get better. And that is why you have to look into the details of what we are actually seeing and the headlines, we should start to ignore them. The important things are that in China, we have actually started to see an improvement in the number of new cases. So yes, the cumulative number is still going up, but the number of new cases on a daily basis is flat to down almost every day for several weeks now. So it is a positive trend there. And similarly, in the other hot spot that appeared early in this crisis, Italy, we see that the numbers in Northern Italy have actually started to stabilise and come down in terms of the number of new cases. So all the measures that we are taking, including the social distancing and the quarantines are actually working in reducing the number of new cases.

So one of the reasons we continue to see the cases going up in the United States is that we are actually testing more people. Companies have dropped what they are doing, a number of the healthcare companies, and they are only focusing on developing faster tests to test for COVID-19. And that has really paid off in identifying people who could have potentially spread the disease further and they are no longer going to be doing that, because we have identified them. Secondly, a lot of development is going into vaccines for this illness. And finally, we are starting to get more and more uplifting news around potential therapies once people do have this, which should reduce the mortality rate. So there is a lot of development going on behind the scenes, which don’t make the headlines as much, but our healthcare team is monitoring on a daily basis.

I think when you take a step back and you look at the markets, this is not a typical crisis. This is not an economic crisis that we could see coming. It is not that train wreck of the sub-prime crisis that we saw for years before it actually started to unfold. This is a very short term, very sharp correction or crash, associated with an exogenous factor that we really couldn’t have identified. And so the behaviour of the markets is slightly different this time around. Essentially people are exiting the market wholesale. They are not picking and choosing what they sell down and that leads to really different outcomes than we would typically see. Energy has by far been the worst performing sector over the last month, anywhere under any index down between 50 and 54% depending on which index you are looking at. And that is associated with the OPEC decision to actually, you know, keep the production high despite falling demand. And the numbers we are starting to see on demand are actually becoming more and more bearish, but again, this could just be a short-term issue that rebounds as the economy starts to stabilise and bounce back.

Similarly, we have seen downside in industrials and financials. Financials because with all the stimulus that is being put into the system and with all the potential non-performing loans that pick up during times of crises, people are trying to exit those areas pretty much wholesale. Industrials obviously are going to be affected and that is even more the case outside the US than inside the US, where exports have basically come to a halt.

There are some positive things that we are starting to see, we are starting to see capacity utilisation pick up in China, for instance, so we are starting to see some signs that those things are starting to turn around. But for now, they are basically on hold.

So we have had this backdrop of weak fundamental conditions and people ask me how bad could this get? Is everything priced in so far? And I have to break the market down into three pieces. The first piece is the short-term demand led crash. You know, I have a chart here, which shows the global discretionary consumer spending has fallen to zero. You know what? Can it get any worse? Actually, no. Revenues can’t go below zero. So you have already seen the full impact on that. It can’t get any worse than it already is in terms of revenues.

Then there is this second piece, that is the supply-related crash and some of the follow-up in non-discretionary spending. And that is where we are spending most of our time looking at companies, because we need to stress (test) those companies. Because it takes a much longer time for them to ratchet down production, it takes, their order books are longer term, so they still have revenues coming in. And so it takes longer for them to ratchet down in terms of their profitability and then to ratchet back up. If the first instance that consumer discretionary-type bucket is a V-shape recovery, the second one is more of a U-shape recovery. And a pretty probably a fairly sharp U-shape recovery. But it is still working its way through. There is a lot of uncertainty about how long this is going to last. And so that is where we are still seeing (valuation) multiples coming under compression.

And then there is the third one, and I think of that as the long-term implications. You know, we had short-term consumer discretionary, medium term, the supply-related crash, that is more in the industrial space, and the third one is long term. That is where behaviour just completely changes. You know, if people have setup their systems at home to use Zoom from their home, maybe they are going to start working from home more often, because they now have the capability to do it. If they use, if they started ordering their groceries online and getting them delivered, it is so easy, why wouldn’t they continue to do that? So there are going to be different changes in behaviour that are permanent coming out of this and we are trying to identify those companies as well.

So all in all, typically you do see markets bounce back from these types of situations. If we look back in history, the kind of correction that we had that second week of March is literally, going back all the way to 1926, only happens 0.26% of the time. And in 75% of the cases where something like that has occurred, it bounced back in  the year following, fully bounced back. So there is a lot of reason to think based on history, we get a bounce back from this. Companies are going to either fall faster and recover faster or they are going to fall slower and recover more slowly. But it is going to take, you really have to look at each company specifically, stress their balance sheet, and we are working very closely with our teammates on the fixed income side to really understand the covenants and the debt that these companies have, because that can often result in a much slower recovery or even bankruptcy in times of crisis like this.

Following on, history does tell us that generally markets bounce back. You know, 75% of the time in the following year. The best performing market year-to-date has been China, which is counterintuitive in some ways. Because they were hit the hardest. But as second derivative impacts improve, even as estimates continue to be cut, typically markets start to inflect and improve again. So I believe just as China has started to be the best-performing market, the rest of the world will play catchup once they start to see the inflection point in those second derivative impacts.

The second thing is there isn’t the systemic risk that we have seen in like say the great financial crisis. Why? Balance sheets of (many) companies are stronger, especially the largest index constituents, which are often net cash. And banks are stronger and hold less of the highest risk debt. So we aren’t, we shouldn’t see as large a crisis on the back of this, even if we do fall into a recession. We have had stimulus in the order of 5% of GDP globally, and that is a pretty strong factor to lead to more upside in the markets. And putting that altogether, the question is has everything been priced in? And I would say this, the yield relationship {between} bonds and equities on a trailing-free cashflow relationship, are the most advantageous they have been in 65 years. So there are a lot of bargains out there. The trailing multiple of some of the indices, and I think mostly of the US in this case, is not as low as it was in the last crisis. But again, it wasn’t as pervasive a crisis as last time, you know, where you have had leadership from growth companies, that has continued over the last few weeks. I would expect that to continue coming out of this.

Conditions are tough right now. I understand that better than most, as a former financial services analyst. What I do want to say is that typically things bounce back eventually, and how are we preparing for that here at Janus Henderson? Our centralised research team is gathering data points from our team all over the world. They are all feeding their data points into one centralised system and we are working very closely with the fixed income teams to identify companies’ balance sheets that aren’t as strong as other companies’ balance sheets. We are doing very strong systematic analysis. We are stressing the balance sheets and the earnings of companies, so that we know which ones can survive this and which ones are going to thrive in these conditions. And then we are taking a step back and saying which ones are the ones that don’t have all of the positives actually built into their share price, let’s put our money there. And that is how we have been handling this, just sticking to our process, sticking to what we know best, investing for the long term and looking through this crisis. I do want to say as Director of Research, we want to be here for you as the client, we want to be here and make the connection for you with what we are seeing in the field and we hope that you can rely on us to get that information.

I just want to say thank you for you continued trust in us at Janus Henderson. As I said, we want to be here for you.

Recorded on 23 March 2020, all figures are subject to change.