Navigating the market rebound

July 16, 2020 08:03
While the government mandated lockdown may have worked for the Indian upper class and some in the middle class, the vast majority of the population only suffered more as their livelihood was suddenly cut off. Photo: Reuters

In an effort to mitigate the economic impact of lockdowns, stimulus from central banks—especially from the US Federal Reserve—has been a major factor in helping drive a rapid recovery in equity markets. Central bankers now have clearly shifted their mindset beyond orthodox policy measures of controlling inflation and maximizing employment. The massive monetary support has given the market confidence to expect a fairly quick normalization of corporate earnings. Based on this strong policy response, as well as signs of a quick recovery of economic activity following lockdowns and a limited amount of business failures, we believe that markets are responding appropriately; though longer term there may be a price to pay.

Relative to other parts of the world, Asia Pacific as a region has navigated the COVID-19 outbreak remarkably well.

Developing markets are most impacted by lockdowns

In assessing the impact on markets, there is going to be a difference in terms of the impact on human life versus the impact on the economy. Often in more developed countries, these two factors can be inversely correlated. But in more developing countries, the lockdown response may actually exacerbate the negative impact on human cost; that's the tough equation that many developing countries in the Asia Pacific have. Broadly speaking, developing economies don't have the same tools to respond to the crisis, and as a result will likely face the full brunt of the outbreak when you add both costs together.

India is a good example. While the government mandated lockdown may have worked for the upper class and some in the middle class, the vast majority of the population only suffered more as their livelihood was suddenly cut off and, due to the large migrant population, in many instances cut off from their family support network as well. Ultimately, India took policies from more developed countries, which may work in circumstances where home ownership is high and jobs are more flexible to accommodate work-from-home (WFH) arrangements; but where resources are limited and sources of income are more transactional, these policies only make things worse for the average Indian. Hence, as a result, Indian corporate profits may have a more difficult time returning to normal as household incomes will likely take longer to recover.

Despite this weaker economic outlook in India, not all industries will be impacted equally. The IT services industry, for example, has been able to navigate the coronavirus event better than most. Since these companies earn a meaningful percent of their revenue overseas, and given the nature of the work allowed for a rapid transition of their workforce to a WFH environment, the impact on revenues has been relatively minimal. The industry as a whole was very successful in supporting their customers’ transition to WFH, which has only bolstered their reputation. Longer term, as companies realize the need to further invest in more robust IT infrastructure and guard against further business disruption, and as the world recovers, IT services will likely see an acceleration of demand.

IT services sector benefited from the crisis

The example of the IT services industry shows that it is important to look at the supply chain for each industry separately. While few industries like textile manufacturing can relocate rapidly in response to labor costs, their focus will increasingly be on efficiency and automation. For industries like consumer electronics and IT that evolved in a fairly borderless world, the supply chain is more defined by industry clusters and competitive advantage. In certain parts of the supply chain, fixed costs are high, and, as a result, shifting locations takes longer and is more costly to move. In any event, any supply chain move is more likely to occur within the Asia Pacific region, rather than onshoring to the US or the EU. Hence, South East Asian countries would be more likely to benefit.

While the focus right now is on a recovery from coronavirus, the trade war between the US and China continues to linger and is not going away any time soon. The current manifestation is the growing list of restrictions on Huawei. But even for Huawei, there is some hope. The focus of the US government is primarily on telecommunications equipment and much less so on the company’s successful handset business. As exemplified by the previously similar incident with ZTE, there are things Huawei might do to help alleviate the pressure on it. For example, a commitment to buy more chips from US companies like Qualcomm would be seen in a positive light.

The information technology and semiconductor industries have been winners coming out of this crisis. Many companies are still going to need more investment to maintain the stability and robustness of the enterprise IT infrastructure as employees work from home. And from a consumer standpoint, we expect further investment in e-commerce and other technologies that will allow for contactless retailing.

Equity markets are pricing in a fairly strong recovery in earnings at this point. Across companies, it may turn out that in some instances the market was overly optimistic. However, there are still opportunities to find high quality companies where the market has underappreciated the earnings power of the business and will result in an acceleration of profit growth.

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Portfolio Manager at Vontobel Asset Management