Coronavirus impacts and opportunities: where to find quality companies

Global stock exchanges are retreating as government policies to slow the spread of the coronavirus are infringing on economic activity. In turn, fears of a global recession have triggered reserve banks and governments to respond with monetary easing and fiscal stimulus, respectively.

Chinese exchange indexes suffered the least as pandemic fears hit European stocks

Many leading economists are concerned the synchronised slowdown in global trade will lead to recessions in various markets. We don't disagree. Some economies are likely to slip into a few quarters of negative growth. While the overall global growth rate is certainly slowing, we anticipate 2020 global GDP growth to still be positive and increase by 1.3 per cent.

If a country is able to contain the coronavirus outbreak to four months, it's possible to avoid a recession, but given the global pandemic spread there's a good chance a recession will occur—although we think growth is still positive for the full year.

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In its January 2020 update to its World Economic Outlook, the International Monetary Fund estimated world GDP growth at 2.9 per cent in 2019 and forecast a global economic growth rate of 3.3 per cent for 2020. There was no mention of risks to China's economy from the coronavirus in the IMF's update. Therefore, we use this pre-COVID-19 growth forecast as our baseline of an undisturbed state of the global economy.

The intensive countermeasures taken by the Chinese government have hit economic activity hard in the first quarter. We lowered our 2020 China real GDP growth forecast by 250 basis points, to 2.2 per cent, some 100 basis points ahead of the average global decline.

However, the Shanghai and Hong Kong stock exchanges have performed surprisingly well year to date. Among select 12 global exchanges of G20 nations, the Brazilian exchange underperformed the most. European markets have underperformed US markets. The second quarter of 2020 is likely to be severely impacted outside of China. 

Make-or-break for mainland China

Perhaps the reason the Asia markets have lagged the recent rout in European and US markets is because Asia has had a head start on this outbreak and domestic spread cases have generally peaked. We are seeing a second wave in mainland China and Singapore recently due to returning residents who have picked up the virus on their travels, but the governments appear to be confident that this can be contained at the source through either mandatory quarantines for all returnees and visitors or by banning the latter outright.

If there are 14 straight days with no local cases, we anticipate a stronger recovery in consumer confidence. Notably, the US and Europe will still be seeing cases rise, so uncertainty will remain a drag and economic activity will still be sluggish in China on subdued global demand.

Market fair value screening as attractive

Earlier this year, we estimated the market fair value of Morningstar's global coverage universe was overvalued by 7 per cent, with a Market Fair Value of 1.07 as of 17 January 2020. Following the significant global market downturn, we estimate the global market fair value to be 0.70 or 30 per cent undervalued as of 19 March 2020.

Plenty of five-star opportunities for global investors

Opportunities abound, offering investors material margins of safety. Over half of our global recommendations are 4- or 5-star ratings. Besides the absolute price/fair value ratio, our uncertainty ratings are the other determining factor of our star ratings.

All else equal, a stock with a higher uncertainty requires a higher margin of safety to switch between star ratings. The 40 per cent or 607 names of our global equities coverage that are 5-star-rated present the most appealing investments on an uncertainty adjusted basis.

About 7 per cent of our global coverage still screens as overvalued, despite the sharp recent stock market declines, but only a mere 2 per cent of these are 1-star-rated. We rate 17 per cent of companies covered by Morningstar at 3 stars, which we expect to yield their cost of capital to shareholders, but don't offer a significant margin of safety.

Ignore the noise and focus on sectors set to rebound

Humankind is looking down the barrel of a global health crisis. For most, 2020 is shaping up as a year best forgotten from a personal health as well as a financial perspective, at least for now. However, we don't expect the world to come to an end.

While we anticipate the coronavirus impact to be taxing on global GDP growth and company profits in 2020, we don't envisage long-lasting effects. Rather, a strong rebound is highly likely once a treatment and subsequently a vaccination become available.

Reserve banks and politicians around the world have learned from the global financial crisis and reacted quickly with monetary easing and fiscal stimulus, respectively. We forecast these tailwinds, together with new infections abating, to underpin global economic growth above trend in 2021-23, before returning to trend growth from 2024.

The market's view seems to differ from ours. The steep discounts to our fair value estimates in some sectors suggest the market is extrapolating the current weakness to persist much longer into the future. This opens a raft of opportunities for investors willing to cut through the noise and instead in a disciplined manner assess the extent to which the pessimism toward long-term corporate earnings is warranted.

The heaviest sold-off sectors are energy, consumer cyclical, and financial services, all very procyclical sectors. However, as the term procyclical suggests, those sectors are likely to outperform when the economy recovers. Generally, the performance of the 11 sectors categorised by Morningstar is strongly correlated with our average price/fair values of the respective sectors. That is, we estimate those sectors, which experienced the poorest performance year to date, to be the most undervalued.

Hardest hit sectors generally offer the best discounts

Source: Morningstar. Period from Jan. 2, 2020 to March 19, 2020.

Conversely, utilities are at the relatively expensive end, although we see value emerging for the first time in many years. The US sector is 7 per cent undervalued based on Morningstar's fair value estimates.

Within the consumer cyclical sector, the market appears to view the auto parts industry as less exposed than footwear and accessories.

We agree with this view, that it is more urgent for many consumers to fix a broken-down car than buying the latest Adidas Kicks. Other discrepancies are intuitively not as easily verified. We question why travel services have been hit that much harder than airlines and the lodging industry.