March 9, 2020
The coronavirus outbreak has wreaked havoc on global equity markets, creating rare opportunities for a disciplined investment approach. We share our assessment of COVID-19’s impact on economies and markets and an update on portfolio positioning for Causeway equity strategies.
• We expect the outbreak of the coronavirus to weigh on global gross domestic product (“GDP”) growth, with the greatest drag on China and South Korea, as well as on already weak economies in Europe and Japan. The length and severity of the demand shock from the virus scare remain unclear. A China recession—even if not recognized in the official data—has negative ramifications for most major economies and markets.
• Sovereign bond yields have fallen dramatically amid uncertainty over the virus’ economic impact. Virus-related fear has pushed an already compressed term premium (the additional compensation investors require for lending for longer periods) to a near-record low of -116 basis points. The “fear factor” element implicit in the negative term premium will likely remain in place until further clarity emerges regarding the economic impact of the virus.
• Many multinational companies, as well as those operating entirely in their domestic markets, will likely continue to suffer supply chain delays and rising costs, largely from work disruption in China, Japan, South Korea, and parts of Europe. However, we believe the earnings and cash flow setbacks will ultimately be temporary, and normalcy should return to supply chains and logistics as virus fears recede over time.
• Monetary policymakers already have begun implementing supportive measures to ease the financial pain of a prolonged slowdown, such as the People’s Bank of China’s 10 basis point cut to the loan prime rate. The US Federal Reserve (“Fed”) made an emergency 50 basis point cut to interest rates in early March, attempting to combat the impact of widening credit spreads on financial conditions. Australia and Canada lowered policy rates in March as well. The interest rate cuts will likely not have a significant effect on consumer behavior in the short-term, but we believe they should allow for better flow of capital through credit markets and provide ample liquidity in an activity lull.
• A more direct response to counter the effects of the demand slowdown from coronavirus is fiscal stimulus. The Chinese government has pledged to be more proactive in its fiscal policy. Forms of stimulus may include more traditional infrastructure investment, such as rail and power, as well as new economy infrastructure, including 5G and health care. We believe the virus outbreak may act as a catalyst for European economies, in particular, to enact fiscal stimulus.
Panic can be one of the best times to invest fundamentally—especially with a value approach.
Causeway Positioning and Investment Outlook
Causeway Global and International Value Portfolios
• We are taking advantage of investors’ pessimism and unwillingness to hold risk. Panic can be one of the best times to invest fundamentally—especially with a value approach. The recent market downdraft has presented Causeway with a rare opportunity to build positions in high-quality companies in some of the industries most impacted by short-term fear, such as transportation, travel and leisure. Though we anticipate temporary earnings reductions for these hardest-hit stocks, assets have not been impaired and we are confident in these companies’ management teams. Valuations are increasingly attractive given the precipitous stock price drops in recent weeks.
o In February alone, we added seven new holdings to unconstrained Causeway Global Value portfolios, including a luxury goods company, an aerostructure supplier, and a cruise line operator.
o In unconstrained Causeway International Value portfolios, recent additions include a construction and mining equipment manufacturer and a Chinese international airport.
o With positive real interest rates few and far between in the developed world, we have broadened our scope to identify well-managed attractively valued banks with franchises in emerging markets.
o We are funding purchases in Causeway Global and International portfolios by selling and trimming stocks that our research team believes face longer term structural headwinds or offer considerably less risk-adjusted expected return. These include stocks in the energy sector, as well as stocks that have experienced significant relative outperformance in sectors including utilities and communication services.
• Strong balance sheets and abundant cash flow help economically exposed companies withstand demand disruption. Though the late February sell-off broadly punished equities, we have seen the continued divergence between economically cyclical and defensive areas of the markets. In a demand slowdown, we believe stocks at the intersection of cash flow constraints and high debt levels will face larger challenges, which underscores our emphasis on portfolio companies exhibiting superior balance sheet strength. We believe our overweight position in cyclical stocks relative to broad benchmarks positions our client portfolios for an eventual recovery in demand for the goods and services from some of the world’s, in our view, best-managed companies with strong balance sheets able to withstand the temporary slowdown.
• Dividend income provides ballast. As we await clarity on the virus and its economic effects, the dividend income from our portfolio holdings is even more attractive relative to sinking bond yields. If the coronavirus does not spark a prolonged period of demand destruction, we feel confident that these companies can maintain their dividends.
• Quality of managements has never been more important. In our fundamentally managed portfolios, we are working to engage with management for an improved trajectory of earnings. There is no shyness with management because we recognize we are in a race against time for satisfactory returns for our clients.
Causeway Emerging Markets and International Small Cap Portfolios
• Portfolio positioning emphasizes sectors with attractive valuation and earnings growth characteristics. Emerging markets (“EM”) earnings growth expectations relative to developed markets excluding the US have stabilized as the coronavirus spreads globally. Despite the disruptive impact of COVID-19 on the information technology (“IT”) supply chain, IT continues to be the only sector in EM that experienced net positive analysts’ projected earnings upgrades over the last three months. We maintain our largest sector overweight to IT given this attractive earnings growth. The EM portfolio’s exposure to IT has partially driven an overweight position to China (which is one of the top performing emerging markets for the year-to-date period).
Given the wide disparities between growth and value, as more clarity emerges on the coronavirus situation globally, we believe value factor performance will recover.
• We maintain a value emphasis in our multi-factor quantitative process. The MSCI EM Value Index trades at a wide discount to the MSCI EM Growth Index, particularly after weak performance in calendar year 2019 and 2020-to-date. Using these indices’ valuations, investors are paying over twice as much for each dollar of next year’s earnings from growth stocks than they pay for earnings from value stocks, while the dividend yield for growth stocks is less than half that of value stocks. Value tends to underperform in times of uncertainty, but given these wide disparities between growth and value, as more clarity emerges on the coronavirus situation globally, we believe value factor performance will recover.
• Overweight positions in International Small Cap portfolios reflect earnings growth potential. As in our EM portfolios, we are overweight IT in our International Small Cap portfolios, given the attractive earnings growth profile of these stocks. Within our China exposure, we also maintain an overweight to longstanding industries such as infrastructure, which should benefit if Chinese authorities proceed with additional fiscal stimulus.
Causeway Global Opportunities and International Opportunities Portfolios: Emerging Markets Allocation
• Investor risk aversion is increasing the appeal of emerging markets equities. Versus broad market benchmarks, we have been overweight EM equities since the beginning of 2020. One of the five quantitative factors in our allocation model is risk aversion, where we take a contrarian approach and buy into fear. When risk aversion—as measured by various volatility measures—spikes, we consider this to be a positive indicator for EM. As investors’ risk appetites return to more normal levels, riskier EM assets tend to outperform typical safe haven assets. Following the sharp increase in risk aversion concurrent with the recent market selloff and fear-based selling related to the coronavirus, the EM equity asset class appears more attractive.
This market commentary expresses Causeway’s views as of March 2020 and should not be relied on as research or investment advice regarding any stock. These views and any portfolio holdings and characteristics are subject to change. There is no guarantee that any forecasts made will come to pass. Forecasts are subject to numerous assumptions, risks, and uncertainties, which change over time, and Causeway undertakes no duty to update any such forecasts. Information and data presented have been developed internally and/or obtained from sources believed to be reliable; however, Causeway does not guarantee the accuracy, adequacy, or completeness of such information.
International investing may involve risk of capital loss from unfavorable fluctuations in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. These risks are magnified in emerging markets.
MSCI has not approved, reviewed, or produced this report, makes no express or implied warranties or representations, and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.