24 April 2020
In reality it’s only a few weeks since we wrote our last update, but – as you are no doubt feeling too – in many ways it feels like months ago.
The Bennelong Kardinia Absolute Return Fund has generated a positive return of 0.71% for the year to date, while the ASX300 accumulation index has fallen 21% (figures at 22 April 2020). In line with our aim of minimising our investors’ exposure to market weakness, we achieved this by owning high quality companies with strong balance sheets; maintaining a sizeable short book of poor quality companies with poor outlooks; and operating a disciplined risk management process, including a stop loss policy.
We have been focused on the short-term impacts of COVID-19 on the economy and share prices, but are now turning our attention to some of the longer-term ramifications for markets. As we said in early March, we believe that in time, COVID-19 will be seen as a catalyst which quickly evolves into a crisis of solvency, trade relations and financial markets. The virus itself is not the main event.
Evidence is starting to emerge that the risks of concentrated production in any one location are being acknowledged. Japan has earmarked $2.2bn of its stimulus to shift Japanese manufacturers out of China. According to a recently released survey by the US National Association of Manufacturers, more than half of all manufacturers are planning changes to their supply chains in the coming months as a result of the pandemic. Larry Kudlow, Director of the United States National Economic Council, recently publicly stated that the government should compensate every US firm wanting to move out of China.
We believe the grounds are shifting into terms of trade relations and geopolitics, which over the medium to longer term have the potential to affect global financial markets. This is certainly worth watching as the situation evolves. It could be the case that costs are permanently higher and margins lower, and trade skirmishes the norm rather than the exception.
Our economic system is not set up for companies earning zero revenue for three months. Corporate Australia needs to recapitalise, and the process has started.
We are actively focused on high quality companies looking for balance sheet repair, and we have recently taken placements in companies including Reece, Ramsay and IDP Education. It should be noted that more recent raisings have not performed as well as the early deals, which may offer an early signal of investor fatigue.
Global strategists are forecasting a 30-50% collapse in global earnings over 2020. Stock analysts clearly need to catch up, with earnings downgrades to date suggesting a fall in earnings of only 10%. Widespread central bank and Government fiscal stimulus has excited the market for now, but we believe the weight of downgrades will prevail in the end. Markets tend to move with underlying earnings with a lag. Should earnings collapse to the extent of the forecast 30-50% over the coming 12 months, the ASX would trade on a PE of over 20x. This is too high, and we believe a multiple in the 15x-16x range is more appropriate given the risks.
What everyone wants to know, of course, is whether the ASX close of 4500 on 23 March is the bottom in this bear market.
The market fell 36% from its peak on 20 February 2020, and has seen a bounce driven by large Government stimulus programs and emergency central bank easing measures. Our view is this bounce is unsustainable and the market will resume its downward trajectory in time, so our positioning remains cautious. However, we are mindful that this thinking has become consensus, so we are wary of pushing our net exposure to the market too low in the short term. Furthermore, the full economic impact of the COVID-19 restrictions could take months to play out, and rallies during these times can be violent. We currently hold a conservative net long position.
Most importantly, we hope you and your family are keeping well in this unprecedented time.
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