The Covid-19 pandemic continues to consume all our lives. Markets have faced unprecedented upheaval. However, there are tentative signs that the situation is gradually improving. Here, we take a look at what this all means and how it translates to European equities.
First, the positives. After the dark days of February, we are thankfully starting to see a stabilisation in both coronavirus infections and related deaths across Europe. This has, in no small part, been down to the comprehensive lockdowns, enforced social distancing and other measures that policymakers imposed throughout the region. Spain, Italy and Germany are slowly easing restrictions on their citizens. Many are returning to work. While we are far from the end, these developments are undoubtedly good news.
Markets have also rebounded strongly from the mid-March lows. The pace of this rebound should not be underestimated. Between 20 February and 24 March, European equites plunged 35%. Since then, they have rebounded over 20%, recovering more than half of the earlier losses.
This rapid recovery in markets has been a result of the stabilisation of Covid-19 cases, and the extraordinary fiscal and monetary policy actions around the world. The magnitude of these stimulus measures has been impressive. Central bankers have slashed rates and pumped huge amounts of liquidity into global markets. This has prevented a health crisis becoming a full blown financial crisis.
The relative financial strength of the banking sector has also been a helpful factor. Spurred on by increasingly tough regulations, balance sheets are far stronger and more resilient than they have been in recent crises. Improved liquidity metrics are allowing banks to continue to fund the real economy in more stressful times.
Earnings and dividends – not as bad as you think
Of course, that’s not to say we are out of the woods just yet. Take earnings. A widespread economic shutdown and evaporation of revenues will hit earnings hard. On a mild scenario, this could equate to a 20% drop in aggregate earnings for 2020. A more challenging prognosis could see a fall in earnings of around 70-80%. Given the current climate, we would say a 50% base case is reasonable.
Time to panic? We don't think so. The overall economic impact of one bad year on a company can be relatively modest. After all, good companies don’t become bad overnight. The permanency of the pain depends on the strength of balance sheets and how long it takes a company to recover. It is these factors that will determine share-price performance over the medium to long term.
And then there are dividends. Many companies have cut or postponed their dividend payments, particularly banks and financials. However, much of this has been due to the actions of politicians and regulators, rather than the underlying economic performance and outlook of individual companies.
So, while dividend cuts look substantial, we believe this misses the underlying fundamentals of many businesses. We would therefore expect to see a significant rebound in payments in 2021 – even if the economy only improves steadily.
As it stands – and while bouts of volatility are likely – it looks as though, across most sectors and companies, markets are no longer pricing in a worst-case scenario and have started to anticipate an improvement in end market conditions.
Looking back to look forward
What about the longer term? To help answer this, it's worth looking back. In Europe, in a typical bear market we have seen declines of around 42%; so far in 2020, we have witnessed around a 35% decline to the lowest point. This compares to 57% during the financial crisis.
More importantly, the recent bear-market rally has been one of the most powerful in history, and significantly greater than the average. Of course, it's fairly easy to dismiss this rally, but we think it’s worth noting and could point to a more permanent shift in investor sentiment than some predict.
What does this mean for investors?
While there are undoubtedly challenges ahead, we are still positive on Europe. This is predicated on a selective approach given the company-level potential we see, rather than a ringing endorsement for the entire region. After all, Europe was facing its own challenges before the Covid-19 outbreak. These problems aren’t going away overnight.
We believe that uncovering the fantastic opportunities in Europe requires an active approach. Through that lens, there are many fine companies operating in tech, branded consumer goods, healthcare and more. There are also some niche opportunities in financials and industrials. Further, Europe remains a leader in ESG – environmental, social and governance. These factors will be increasingly important – and financially material – as we navigate an uncertain world.
Final thoughts…
The Covid-19 crisis is like nothing any of us has ever faced. The toll will be great. However, we are starting to see a glimmer of hope. Markets, too, appear to be over the worst. For investors taking a company-specific view, and prepared to look through the inevitable volatility associated with the current crisis, now could be the time to judiciously consider putting their money back to work.
Ben Ritchie, Head of European Equities
Aberdeen Standard Investments