Resilience metrics indicate sector divide
Against a more positive economic backdrop - even one that may be beginning to level off - Fidelity analysts believe that many companies will have strong enough balance sheets to survive another six months of local lockdowns. A smaller, but significant, proportion should be unaffected by any withdrawal of government support and able to handle an increase in infection rates.
However, as Chart 1 shows, there appears to be a divide between cyclical sectors such as financials, materials and energy and non-cyclical sectors such as telecoms, utilities and consumer staples. Non-cyclical sectors were better insulated from the crisis to begin with, with a North America healthcare analyst noting: “Healthcare's defensiveness gives it resilience. Some providers have been receiving federal funds but are no longer reliant on them. Utilisation will continue to recover through lockdowns.”
Contrast that with cyclical sectors hit hard by lockdowns that are taking longer to recover and remain most exposed to further restrictions. A consumer discretionary analyst covering European companies reports: “A significant increase in the virus trajectory would likely mean companies would once again see large negative free cash flow. The end of support will likely result in meaningful layoffs. Balance sheets can cope with intermittent local lockdowns but will be more stressed in the event of another full lockdown.”
Information technology, a blend of non-cyclical and cyclical subsectors, is benefiting from the particular nature of this crisis. For example, more remote working has meant more tech purchases, whereas in a ’normal’ business cycle you would expect computer sales to suffer during an economic downturn. One IT analyst says: “Everyone has just accepted this new way of working and moved on.”
Structural change is underway, but more may be needed
Roughly a third of all global companies have already made structural changes to their operations to cope with the pandemic, especially in retail and leisure areas most affected by social distancing rules. Indeed, this is reflected in an uptick in capex expectations for the September survey after several months of negative readings, albeit from a very low base. Companies have been spending money on Covid-related safety measures as well as adapting to shifts in demand in the broader economy.
Looking ahead, analysts are expecting certain sectors (financials, industrials and healthcare) to make more changes over the next two years. An industrials analyst covering airlines in the Asia Pacific region notes: “I expect airlines to make further structural changes to both operations and balance sheets once Covid is over.”
Banks in particular became highly politicised in the wake of the financial crisis. Now they are under pressure to help businesses affected by the pandemic to survive. They are discouraged from paying dividends and are being closely monitored by policymakers to ensure they fulfil their social contracts. This could make it harder for them to restructure operations even as working practices change. Still, our analysts report that many banks will be forced to accommodate the reality of lower rates and higher overall debt levels and overhaul the way they do business in the months and years ahead.
The same phenomenon is occurring across other sectors receiving government support. Once that support is rolled back, we expect companies to make further changes to their operations and balance sheets in order to make their businesses nimbler and ultimately more resilient.
Sentiment towards China still positive, but other regions are catching up
Despite these longer-term challenges, management sentiment and leading indicators have continued to tick up month-on-month as national economies gradually reopen despite localised outbreaks. While the outlook for China is still net positive, the country’s marked ‘first in, first out’ lead over other regions appears to have receded. Europe and the US are beginning to catch up as activity resumes, but from a much lower base as they took a much greater hit from the crisis.
Cautious optimism on the back of a less bad earnings season
Improving sentiment indicators match more optimistic analyst expectations for revenues and EBITDA numbers than even a month or two ago, after what one equity analyst called a “less-bad-than-expected” 2Q earnings season.
While the outlook for healthcare and technology firms remains strong, just as with the regions, sectors that had suffered most are now beginning to catch up. Materials have taken the top slot this month with a big increase in positive sentiment - a bumper 78 per cent of analyst responses report leading indicators are positive. This is due to various factors from resilience in Chinese demand to a weaker US dollar to a rush for gold.
Sentiment in the consumer discretionary sector is once again positive compared to the previous month, albeit in the context of “only having one direction to go”, as one European analyst put it, after being badly hit by the crisis. While the average consumer remains relatively weak and keen to save, those benefitting from the rising wealth effect of higher asset prices have begun to spend money where they can, purchasing or refurbishing houses, and buying more luxury items.
And despite some of the structural challenges outlined above, financials have also had a better month. The number of analysts reporting positive leading indicators outnumber those reporting negative ones for the first time since the crisis struck. This may be partly due to a more positive outlook for insurers, who find themselves in a better financial position than previously anticipated despite the virus’s impact. A North American analyst covering insurers summed it up: “There is increased clarity around total Covid losses, while a pick-up in housing transaction activity is benefitting title insurers. And sales are picking back up as lockdowns ease.”
EM companies to leapfrog US and China on CO2 emission discussions
While dealing with Covid-19 remains top of mind for many companies, our analysts expect those in sectors most exposed to climate change (physically and via regulation) to be at the forefront of open discussions about their scope 1, 2 and 3 carbon emissions by the end of 2021. (Scope 1 and 2 cover the direct emissions produced by a company’s operations and energy supply, while scope 3 addresses those produced along its value chain.) Sectors most likely to discuss emissions are, as expected, utilities, materials, and energy, as well as consumer staples, which has historically been at the forefront of ESG adoption.
More surprising perhaps is that, while Europe continues to lead on emissions disclosure, our analysts believe that companies in emerging markets in Asia and Latin America are likely to leapfrog those in China and the US on this issue by the end of next year.
A US financials analyst reports: “The US Department of Labor has released a clarification around ESG inclusion within US 401k plans. It seeks to de-emphasize the role plan sponsors should ascribe to ESG factors when choosing investment products. This has put the ESG drive generally on pause under the current administration and I don't see this accelerating again until after the US election (if there was a change in leadership).”
Green bonds have become highly sought after in recent years and typically trade at a premium to ordinary bonds. A recent issue by Mexico linked to addressing UN Sustainable Development Goals, including protecting the environment, was heavily oversubscribed and priced at fair value which is rare for a new issue. Emerging markets are often among those countries most exposed to climate change, so providing them with cheaper financing to address their transition and adaptation needs could be a significant step in the effort to limit global warming.