Adjusting to a fundamental shake-up

By Alexander Roose,
CIO Fundamental Equity at DPAM


Recently, a lot of ink has been spilled on the gargantuan fiscal and monetary backstop policies that came as a response to the Covid-19 pandemic. More is to come, especially on the fiscal side. However, the EU next generation fund consisting of EUR 750 billion in grants and loans is definitely a giant leap towards safeguarding the European project. Approval is needed by all 27 EU member states but France and certainly Germany’s backing of the plan should facilitate a positive outcome. Clearly, on the monetary side, the ECB has excessively lowered its deposit facility rate, into negative territory, which has put the banking sector under huge pressure. We doubt that the Fed will make the same mistake and will stick to its forward guidance policy or potentially revert to YCC or yield curve control. Still, Powell released a statement referring to negative deposit rates last month, which was not exactly crystal clear: “for now, it is not something we are considering”. Not only do we have to deal with negative deposit rates in the EU, but we are also facing spiralling credit losses due to the lockdown’s major economic fallout. In addition, some banks have been forced to suspend their dividend policies, rendering the banking sector quasi uninvest-able. This is eerily reminiscent of the path taken by its Japanese peers a couple of decades ago (i.e. continued P/B multiple compression and subsequent underperformance compared to the benchmark). As economies have started to re-open, we remain sceptical as to how fast animal spirits will be revived among consumers and corporates. Indeed, China reopened its workplaces nearly three months ago, but domestic demand recovery has been rather tepid. In the eventuality of a material second Covid-19 wave (note that, except for SARS, all pandemics in the last 100 years have had a second wave), governments around the world would have to carefully consider their next steps, as another global lockdown would be tantamount to economic suicide. In this scenario, a selective confinement of the most vulnerable individuals would make more sense: It would allow the healthy, and active population to keep working, in order to try to sustain the welfare state. More testing will be crucial to facilitate such an outcome. Complete normalisation will only be possible when we have a fully-functioning and widely available vaccine. Note however, that COVID19 cases continue to rise (as a result as well due to the increased testing) in important US states, like California, Texas or California so calling and end to the first wave of the pandemic is premature. Supposedly, a vaccine developed by the university of Oxford, in partnership with Astrazeneca, has been effective on rhesus monkeys. Its production has already started. However, there is no proof yet that it is also safe for humans. Fortunately, if this one fails to be successful, then there are still close to 350 other vaccines and treatments that are being evaluated to combat the coronavirus. It is only a matter of time before humankind finds an all-encompassing solution to eradicate the coronavirus.

Regarding geopolitical developments, ominous clouds have swiftly gathered on the horizon. Last month, Trump drew China’s ire by encouraging Taiwanese wafer fab company TSMC to erect a state-of-the-art 5nm plant in Arizona. The project is scheduled to begin in in 2024. To make matters even worse, the US administration has decided to cut Huawei off from global semiconductors supplies and related intellectual properties. It has imposed an export license on every semiconductor manufacturer that fabricates chips (designed using US software or a US-based kit) for Huawei. This comes on top of earlier actions, which already restricted export sales of a wide range of technologies to Chinese military-linked companies. In addition, the US has also previously prohibited one of its USD 770 billion retirement plans for federal employees to invest in Chinese equities. China has responded by imposing its National Security Law in Hong Kong, which basically upends the ‘one country, two systems’ model that was implemented in Hong Kong since 1997. Is the sequel to 2019’s trade war upon us, or is it merely posturing to divert attention away from the reality of the economy? We are inclined to think it is the latter, as it is clearly not in Trump’s (nor Xi’s) best interest to send stock markets down the drain five months before the US presidential elections. But surely, this latest geopolitical wrangling between the US and China brings an additional layer of uncertainty to the markets, and will only further push companies to adapt their supply chain strategies.

With Q1 reporting nearing its end, we would like to share some interesting trends on the company/subsector level:

One notable point of interest is the significant outperformance of the Nasdaq Composite over most global indices. As always, when tech performs well, (retail) investors get vertigo, because this “must surely be another tech bubble”. However, we need to carefully consider a crucial underlying trend to get a clearer picture of the current outperformance. The digital transformation of the global economy has been underway for many years. This has been happening on many fronts. Companies are increasingly adopting software as a way to enhance productivity, to create a competitive edge or to save costs. Meanwhile, consumers are also adopting technology at a speed hitherto unseen, ranging from an increased usage of e-commerce, to digital solutions in payments and healthcare. All this, in turn, necessitates bigger, better and faster networking- and cloud capacity (see graph below on the increased cloud adoption, in the US and China). Covid-19 has fundamentally shaken up the world, and incumbent companies need to recognise that change is necessary to survive.

Cloud penetration is around 18% in China versus 34% in the U.S.

Source: Gartner data and estimates, Bernstein analysis

Companies which were ahead in their digital journey are now taking over market share (think Nike versus Adidas). These firms are willing to further accelerate their digital investments to keep up their winning streak. However, other companies are now forced to undertake a massive digital catch-up in order to stay afloat. A Fortune poll of several CEOs cites that only 6% said they would slow down their digital transformation process due to Covid-19. Meanwhile 63% said they would actually accelerate their digital transformation. Indeed, the digitalisation of the global economy has noticeably shifted into a higher gear. Recent results and management comments have confirmed the clear acceleration of the above-mentioned trends. As the CEO of PayPal stated during the company’s latest conference call: “I believe we will look back at this time as a tipping point, where digital payments both offline and online became an essential element of our lives“. This explains largely why we have seen a significant rise in the stock prices of many software and internet companies. To a certain extent, we argue this is also caused by investors’ rational behaviour. In times of high volatility and high uncertainty, they prefer to seek refuge in companies which benefit from these trends, and offer both high visibility and good momentum. Moreover, as long as investors are unsure about the shape of the recovery, or the likelihood of another big wave, they are unlikely to change their strategy anytime soon. The probable continuation of the low-rate environment further confirms this perspective.

If we were to exclude the US, the Nasdaq’s market cap is now close to the global total equity market cap. Its strength has also been driven by the Biotech sector, which has reached all-time highs, thanks to a pickup in innovation pushed on by an increasing number of FDA drug approvals (e.g. in oncology for companies like Seatlle Genetics and Incyte). Additionally, cell- and gene-based therapies are becoming increasingly promising and could offer a solution to the pandemic. Moderna is currently one of its frontrunners in this regard. The biotech sector has also proven to be safe in past downturns, as the biotech indices (BTK & NBI) declined by only 1% during the last three economic recessions.

There is a lot of buzz around the well-known FANG stocks, but decent positive returns year-to-date have also been achieved by the gold miners (regrouped under the acronym BANG: Barrick, Agnico Eagle, Newmont and Goldcorp). Investors are increasingly flocking to gold, and gold-related investments. As central banks debase their currencies, gold is left as the default store of value with no counterparty risk. As such, we imagine this trend to continue, since we do not expect a scale-back in QE policies anytime soon.

Lastly, we have witnessed a large-scale closure of US meat plants. Their inherent high-labour densities form a significant health risk during the pandemic. This has led to an increased willingness to invest more in automation technologies. It has become a matter of survival, as the current working regime of the meat packing companies has long since passed its expiration date. So again, companies with innovative technologies (e.g. 3D vision, or sensor systems to detect bones or foreign material) will win.

Massive liquidity injections and backstop fiscal policies have staved off a full-blown solvency crisis. At the same time, these have also created a clear dichotomy between economic reality and stock market behaviour, the likes of which we have rarely seen before. We do not disregard the merits of stock markets’ discounting mechanism, but we are ahead of ourselves, in part driven by massive retail flows. Companies will go bankrupt, consumers will up their savings rate, and it will take more than a couple of quarters to have an effective and widely available vaccine. In this range-bound equity environment, not all is doom and gloom. There are still clearly plenty of investment opportunities for the active fund manager.


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