Markets & economy

Making sense of current market conditions

The current market volatility is understandably causing investors much stress. Allan Gray and Orbis examine the impact of coronavirus and offer clients some perspective.

Fears about the coronavirus have dominated both news headlines and markets over the past month. Global asset prices are under extreme pressure as investors rush to perceived safe-haven assets in the face of a global economic slump brought on by the coronavirus. In situations like this, our job is to remain disciplined and calmly assess the impact on your investments. As always, our focus is on the relationship between market prices and company fundamentals, and on the long term rather than the next month or quarter.

There is little doubt that the coronavirus is spreading around the world and could cause a sharp economic slowdown. Given the current case number growth rate, it seems peak infections may occur within five months and subside quickly thereafter. The direct impact on asset valuations could potentially be a single year of lost earnings. For a company trading on 15 times earnings this would indicate a 7% price fall. If businesses lose in a single year what they would have normally made, this indicates a 14% price fall is appropriate. The downside scenario is if the coronavirus economic slowdown causes a far greater rolling recession as in 2009.

It is also notable that the total number of coronavirus active cases has been manageable. It is arguable that the media’s focus on cumulative cases (which can only ever rise) has created a false impression of the spread of the disease. Overall, people are recovering about as fast as new infections are taking place, so the number of people out there with the disease has been flattish. For some context, it’s also worth bearing in mind that, even at current run rates, coronavirus is causing one tenth as many deaths as seasonal flu.

There is uncertainty in the current economic environment, and we have no edge in predicting how this will play out. A case in point is the collapse of oil prices which fell by more than 30% on 10 March 2020, suffering the worst losses since the Gulf War in 1991. Brent fell to $31 a barrel. The collapse was as a result of OPEC members and their allies failing to reach an agreement over concerns of slowing global oil demand because of the coronavirus outbreak. Russia resisted the proposed cut in oil output and in response Saudi Arabia slashed prices for its crude oil by the most in 30 years and promised to ramp up output.

We have seen similar pandemics in the past, and typically the market does tend to overreact in the short term despite there often being little long-term impact on business fundamentals. An example is Honda Motor, a holding in the Orbis funds, which has half of its Chinese production capacity in Wuhan. Those factories are closed, as are most auto dealers in China. This will hurt profits. But at their year-to-date lows, Honda’s shares were down about 15%. Is the coronavirus really going to reduce the long-term value of the business by 15%? We think not. People in China will resume buying cars and factories in Wuhan will resume producing them. Not to mention Honda’s auto businesses outside of China, its world-leading motorcycle business, its prudently profitable financing arm and the cash on its balance sheet.

For other companies, the financial impact may not be negative at all. NetEase, which also has a holding in the Orbis funds, makes and operates online games in China, and its subsidiary Youdao offers online education services. For many in regions locked down by the contagion, going out of the house for entertainment or education is out of the question, and games and services from NetEase provide a way for people to entertain themselves or study at home.

More broadly, shares perceived to be economically cyclical, including energy companies, have been hard hit, and these too may face fundamental pressures in the short term. However, at current valuations, many of these shares embed such low expectations that even a half-decent future would come as a tremendous positive surprise to the market.

Domestically, the impact on local securities prices has been far more muted. It is likely that those directly impacted may soon show price weakness as a result (e.g. tourism-related counters given the expected drop-off in leisure travellers). More broadly, it’s likely that mining revenues will suffer due to the weaker global economy, leading to lower government revenues.

It goes without saying that we have no idea how the virus will progress from here. It could fade quickly or get much worse. As contrarian investors we invest in assets that we believe are trading at a discount to their intrinsic value. The recent price action has widened those discounts and in the past, the rewards of investing at times like this have been substantial. We will therefore be vigilant and continue to look for pockets of opportunity.

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