Expect turbulence ahead. The demand for airlines looks bleak as governments and businesses around the world increasingly restrict travel. Air traffic and bookings are declining at an unprecedented rate. Lower fuel costs will not be enough to offset the severe decline in passenger traffic. Fortunately, the major North American airlines generally had stronger balance sheets going into this crisis compared to previous disruptive periods. Globally, airlines are reducing capacity and preserving capital to help them manage cash burn and liquidity in the short term. Government intervention should help some carriers, though the situation remains fluid. The longer the fear and the travel restrictions persist, the more carriers may be at risk.
The impact of COVID-19 will likely be another blow to the already struggling auto sector. Many auto manufacturing plants in China shut down in early February and only began reopening in the first two weeks of March. Because China is the source of a large amount of global auto parts, there is potential for supply shortages to disrupt production. So far, US auto manufacturers have avoided major disruptions. Many had elevated inventories heading into planned shutdowns ahead of the outbreak and have been able to find some alternative sources for now. As the virus continues to spread, we believe temporary disruptions in other manufacturing hubs in Europe and North America are likely.
More importantly, we think a likely slowdown in demand will have a more pronounced impact on the auto industry. Global auto sales are currently expected to fall 3%-5% on weak demand. We’d expect further downward revisions as other major economies impose quarantines and consumer demand weakens. While China saw a nearly 80% decline in auto sales in the month of February due to quarantines, we don’t expect the same degree of decline in other markets. We expect to see some recovery later in the year. Though the collapse in oil prices is a positive for some auto makers, especially in the US where the focus is on trucks, we don’t think it’ll be enough to overcome sluggish sales, potential supply disruptions and mounting expenses.
Railroad companies are likely to see indirect impacts from supply chain disruptions and reduced demand. With Chinese manufacturing largely offline for about a month now, cargo volume entering key US ports has declined materially and railroad traffic has suffered. If manufacturing starts shutting down elsewhere, or if the US were to enter a recession, demand could slow even further. In the US, we’re also watching the impact of lower oil prices on railroads. Notably, railroad balance sheets are currently very strong and all companies in the sector have ample liquidity to manage through a downturn.
Recent events have decimated the energy sector. Oil demand was in secular decline before the COVID-19 outbreak, and China’s quarantine efforts weakened demand further. OPEC’s price war with Russia was the final nail in the coffin, sending oil prices below $30 per barrel as of March 17, 2020. With oil prices expected to stay at depressed levels for at least the next year as Saudi Arabia and Russia grow production, many companies will likely slash budgets by 20% to 50% to survive and protect their balance sheets. Defaults could spike as companies look to restructure or opportunistically lower debt levels at discounted prices. If oil prices remain at or below the low forties, we would expect a significant amount of company credit ratings to get downgraded to high yield. Given the drop in oil prices, we believe we will see a significant drop in US shale production as few, if any, shale companies can turn a profit at current price levels.
While the oil companies are in for a tough ride, the implications for natural gas may actually be positive, in our view. As US oil production falls, natural gas produced in the oil wells will fall as well. This should lead to a rebalancing in the market over the next year as natural gas producers had already moved into maintenance mode prior to the recent downturn.
We continue to have a neutral outlook for the healthcare sector. Despite recent developments, the group continues to be more defensive than the broader market. We estimate that there will be a medium impact from COVID-19 on the healthcare sector with an overall low impact on related supply chains.
There is growing global concern that an extended epidemic could have a material impact on healthcare utilization rates for providers and medical device companies. Data has shown a dramatic decline in elective procedures in China because patients are concerned about contracting the virus in hospital settings. We believe a reduction in these typically higher-margin income sources could weigh on earnings. Notably, medical technology companies focused on orthopedics could be more exposed to lower utilization rates compared to cardiology-related companies, which tend to offer fewer elective services. We expect any disruption to be short-term in nature as the majority of procedures remain medically necessary and are delayed rather than cancelled entirely.
Additionally, long-term care providers are at risk for increased costs and lost revenues associated with managing the virus.
We expect a relatively medium impact to the supply chains associated with pharmaceutical companies. Pharmaceuticals remain an essential product and as such, should experience limited impact absent a prolonged disruption. Recent commentaries from these companies indicate that manufacturing remains at full capacity, with limited exposure to the impacted region. Those with higher exposure to Chinese demand noted that the virus could modestly impact first-half results. In our view, the market could be underestimating supply-chain disruption risk and any potential drug shortages.
Branded pharmaceuticals are better positioned to withstand a prolonged supply disruption. Most have noted 6 to 12 months of active pharmaceutical ingredients (API) buffer stock. Generic manufacturers present a more acute risk given their lower margins and need to operate with leaner inventory levels.
The spread of COVID-19 appears to be causing a global recession amid the shutdown of large portions of economic activity. As a result, risks for homebuilding, building materials, distributors and aggregates companies have risen materially. That said, the large majority of companies in these industries maintain solid balance sheets and liquidity. While housing fundamentals were strong entering 2020, we expect a near-term decline in buyer traffic, new orders, labor availability, and building product availability due to disruptions in supply chains. We believe home inventory will likely rise as order cancellations increase.
Three key pillars of housing are likely to experience a material negative impact in the near term: consumer confidence, population mobility/household formation and employment. Additionally, if oil prices remain low, homebuilders with operations in oil-exposed markets like Houston, San Antonio and Denver are likely to see additional pressure on order activity, backlogs and pricing, similar to the experience during and after the 2014-2015 oil price collapse. Furthermore, lower Treasury yields have not been translating into lower mortgage rates. In fact, the opposite is happening right now amid very tight liquidity, which negatively impacts affordability. Demand for aggregates (for roads, bridges and highways) will likely decline as well given pressure on state and local budgets and the limited probability of new federal public infrastructure spending.
The economic impact of COVID-19 on manufacturing and industrials is still unclear and remains a fluid situation. That said, prospects look challenging for at least the next couple of quarters. Manufacturing PMI in China dropped off a cliff in February and demand may slow substantially as global economies try to mitigate the virus’ spread with quarantines and travel bans. Adding to industrial woes is considerable uncertainty about potential supply chain impacts. Many industrial companies have limited visibility beyond the first level of their supply chain—they don’t know who supplies their suppliers. If more countries begin shutting down production to help contain the virus, there could be significant unanticipated supply chain disruptions.
However, if we can avoid a prolonged downturn in global economic activity, we believe manufacturing and industrial companies could start to recover in the second half of this year. Balance sheets are generally in good shape and many of these companies are expected to benefit from reduced trade frictions.
So far, China’s response to COVID-19 has inflicted some pain on metals and mining companies through lower industrial commodity prices since mid-January. However, commodity prices are still well above the lows seen in the 2015-2016 commodity downturn. Gold prices have bucked the trend and outperformed due to lower real rates and demand for relative safe havens. The economic disruption from the virus has weakened industrial commodity demand, translating into higher seasonal inventory levels, particularly for copper and steel.
We’ll be watching the pace of Chinese PMI recovery as well as commodity inventory levels to see if demand recovery in China can offset potential weakness elsewhere as the virus spreads. We believe stimulus and quantitative easing could contribute to incremental commodity demand, which would help absorb excess inventory built in the first quarter and rebalance markets later in the year. The good news is that many big mining companies have reduced debt on their balance sheets since 2016 and appear to be in a better position to withstand any short-term economic weakness.
Overall, we expect the virus’ influence on sector businesses to be low-to-medium with supply disruptions minor. There are areas of concern within the sector, including cancellations of high-profile events such as the Olympics and major league sports games and closures of theme parks and movie theaters, which would have implications for financial results. In addition, a shortage of components for 5G equipment and handsets could delay the launch of full 5G, recalibrating earnings outlooks for related companies. With probabilities for economic recession increasing, advertisers could also see a downturn in revenues.
Within the sector, these developments could be offset somewhat by providers experiencing skyrocketing demand for connectivity services. We expect both wireless and wireline usage to soar due to large-scale telecommuting and “home-bound” entertainment demand. Moreover, video game publishers may benefit from popularity of activities that allow interaction without physical contact.
The software/services subsectors should experience very little supply chain pressures. Keep in mind, so far, technology companies in these groups have provided limited commentary and/or indicated only implications for a temporary disruption scenario (i.e., approximately one quarter). We take this to mean there will likely be another wave of guidance revisions, and potentially ratings actions.
SOFTWARE/SERVICES
In the technology sector, software and services companies deriving revenues from subscription services could be somewhat insulated from the economic pressures presented by the virus and/or oil shocks. These business models could generally perform better through a recessionary scenario. In contrast, are those companies reliant on new license wins. Their longer and/or higher-touch sales cycle could push out forecasted revenue improvements.
Software and services distributors could see slowing orders as a result of supply chain issues impacting hardware availability. Also, travel restrictions and work-at-home directives could negatively influence customer buying decisions.
Lastly, payment processors/merchant acquirers may experience revenue pressure in the event of a protracted macro slowdown weighing on individual credit levels. More favorably, the synergies projected from the recent consolidation in this space could provide a meaningful buffer for bottom lines. In addition, balance sheet repair after these large transactions are reportedly ahead of schedule.
HARDWARE/SEMICONDUCTORS
In the hardware/semiconductor groups, global supply chains are complex with many moving pieces. To date, this space has seen a limited and controlled impact. To some extent, the implications of the global virus outbreak for the sector were "stress tested" during the tariff wars. Companies have already adopted changes to production where it made sense.
Notably, hardware and semiconductor companies tend to be cyclical, therefore largely driven by GDP changes. That said, each subsector can have its own cycle away from the broader business cycle. As of now, companies have limited visibility on what COVID-19 may mean for their businesses. Most have only made comments on current-quarter impacts. The companies most affected so far have been tied to mobile (smartphones), which saw material sales declines in China. With a recent announcement by a car company that global deliveries were down 25% in February, we also expect to see weak numbers from semiconductor names that have large exposures to automotive end markets.
It is obviously a very fluid situation and the reality is most management teams do not know the duration or impacts beyond what they are seeing right now.
We expect COVID-19 to have a mixed impact on the consumer staples sector. While the impact on packaged food and home and personal care companies should be limited, certain sub-sectors could experience idiosyncratic pressures. For example, toy companies that source a significant amount of their finished products from China could face earnings pressure. Significant delays in the supply chain up to mid-year could have negative implications for the holiday season.
Global alcoholic beverage companies will likely see a notable impact on first-half results. In-home and on-premise consumption in China is down significantly, and we expect a similar trend in Europe and North America. Additionally, global spirits companies may be negatively impacted by a decline in global travel as they generate a portion of sales through duty-free travel retail. Similarly, beauty companies that generate meaningful revenues from China as well as travel retail announced that 2020 fiscal year results will likely reflect lower sales.
The entire lodging sector is under pressure as concerns over COVID-19 have halted business and leisure travel, not only in the US, but worldwide. The outlook has rapidly deteriorated over the past two weeks as President Trump issued a ban on international flights between Europe and the US and the industry saw a steep increase in conference and event cancellations. Then, following increased efforts in the US to increase social distancing, a number of companies announced temporary closures, both voluntary and mandated, including the cruiselines.
Depending on the subsector under consideration, the impact from the virus will be varied. We expect the cruiselines to be the most heavily impacted due to suspended sailings expected to last a month, negative press surrounding COVID-19 outbreaks on ships and near-term refinancing risk. The impact on hotel companies will also be high in the second quarter as quarantining efforts ramp up. We would expect the lodging sector to improve in the second half of 2020 assuming the virus is contained by that time. However, we could see room rates and occupancy levels somewhat depressed versus last year. US-based hotel companies with exposure to China/Asia, Europe and US gateway cities will likely be the most impacted in the group.
In terms of opportunities in the sector, the market appears to be pricing in a potentially dire situation for the cruiselines, but some measure of recovery in the second half of 2020 for the hotel companies. With respect to the cruiselines, buying opportunities could arise down the road given the value proposition of cruises and their tendency to eventually bounce back after epidemics and other shock events. However, a prolonged suspension on cruising would be highly detrimental to the group. We currently prefer more asset-light lodging names that generate much of their revenue and cash flow from the management and franchising of hotels. Also, time-share companies could be more insulated given their higher mix of recurring resort fees and management revenues. However, prospective customer tours will likely be impacted, which could be reflected in weaker-than-expected 2021 growth estimates.
The impact on the retail sector could be high. Consumer confidence, spending, unemployment trends and supply chain disruptions will likely have a powerful influence on the sector.
On recent earnings calls (prior to the acceleration of COVID-19 social distancing), 2020 guidance missed expectations, but management teams commented that they are being cautious in light of COVID-19 uncertainty. Overall, the likely winners in this scenario should be limited to those with supermarket-like end markets. Key factors we are watching include geographic concentration of hot-bed exposure areas and supply chain diversification.
SUPERMARKETS AND BIG-BOX RETAILERS
Potential winners in the space could include supermarkets and large big-box retailers with a diversified supply base. Many of these companies have made statements about an uptick in demand from consumer restocking efforts. Anecdotally, many of us have seen the uptick of demand at local supermarkets. On the other hand, likely laggards include retailers with concentrated supply chains or those heavily impacted by tourism/consumer confidence, such as specialty-mall-based retailers and department stores.
RESTAURANTS
Of the consumer-facing industries we cover, we expect restaurants to be the most negatively impacted. Decreased travel through airports, declines in business and personal travel, increases in working from home, schools shifting to online classes and various local bans of dine-in eating should weigh on domestic revenues. Store closures are increasing, and while there will be some offset with delivery services, this will likely be very negative for the sector overall. We are monitoring the liquidity of this sector and stress testing cash needs by credit. Furthermore, it is worth noting that many restaurants are paying salaries despite closures and their margins will feel the impact. After social distancing mandates for public health end, it is unclear how quickly the consumer will return to normal dine-out patterns. We would expect dining out to decline for the remainder of 2020.
We foresee a low-to-medium influence on the banking sector from the virus and a low impact from supply chain issues. Specifically, the significant decline in interest rates will put downward pressure on net interest margins and net interest income. With a slower global economy, loan loss provisions will likely tick up in anticipation of possible asset quality deterioration in the coming quarters, especially given new accounting standards for loan loss reserves. While some commercial customers will draw credit lines initially, loan growth rates in commercial and consumer loan portfolios are expected to slow as the global economy weakens, with the exception of mortgages. Downward pressure on revenues could start in the first quarter of 2020 with some asset quality deterioration possible in the second half at the earliest. Overall, historically strong asset quality and capital, as well as decent profitability, should help the US banks weather this period of uncertainty.
Based on their performance on many risk-off days, banks continue to be viewed as a safe place to hide during market turmoil. Given the day-to-day volatility and rapid pace of new developments in the market, it is difficult to quantify what scenarios the market is pricing into the outlook for banks.
Overall, we expect the negative impact from the COVID-19 outbreak on major emerging market (EM) banks’ credit fundamentals to be manageable (barring a few vulnerable cases). The banks are contending with a lower interest rate environment/compressed net interest margins, weaker loan volumes and fee income, and higher loan loss provisions. We expect slower economic growth in EM countries to pressure banks’ loan growth, asset quality and profitability. Nevertheless, we expect EM banks with diversified loan books, defensive balance sheets, and strong capitalization and liquidity buffers to remain resilient. We also expect continued countercyclical policy measures by major EM regulators and banks to mitigate some of the negative macrofinancial impact.
With regard to investment implications, EM banks have outperformed corporates and sovereigns in the recent market selloff. In current market conditions, we view selected “systemically important” EM banks as relative safe havens in EM.
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