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Schroder Oriental Income expects tide against globalisation to draw strength

Schroder Oriental reports marginal underperformance

We have included the following outlook extract from Schroder Oriental Income (SOI)’s management report, as part of its interim results released this morning (to 29 February 2020).

‘The economic impact of covid-19 has made the global financial crisis of 2008 seem like a mild inconvenience’

“It would have been difficult to imagine events that could leave the global financial crisis of a decade ago (GFC) looking like a mild inconvenience to markets and economic activity. The key difference between then and now is, of course, the fundamental risk to human life that covid-19 presents, necessitating actions that threaten to cause economic paralysis across the globe. We are seeing virtually unprecedented degrees of government control and targeted support for the most vulnerable; certainly measures difficult to imagine in peacetime. It is unsurprising that a wartime analogy is widely drawn, and depending on how long the current situation persists, the stock of public debt in many developed economies is likely to end up at levels akin to post-war levels.

The speed, and extent, of the market correction as the crisis has escalated has reflected both the scale of the perceived economic shock, but also equity valuations being generally towards the expensive end of historic ranges. In Asia’s case, valuations were not excessive at the end of 2019, but did reflect a measure of hope that there would be a meaningful recovery in regional earnings in 2020. Such hopes have been utterly extinguished.

‘China’s fiscal response has been measured’

Given the unique circumstances, current levels of volatility should be of little surprise and there will undoubtedly continue to be significant market movements in both directions over coming months. Recent market lows reflected the fear of the unknown as much as the deterioration in the economic environment which had seen the sharpest eight-week decline in growth expectations since the GFC. As a consequence, unprecedented monetary and fiscal stimulus is now being brought to bear to support economic activity. Besides concerted action by central banks, we are seeing fiscal packages in major economies ranging between 3-6% of GDP. This has included a number of Asian countries, particularly those with enviable room to manoeuvre given years of relative fiscal conservatism such as Korea, Hong Kong and Singapore. Perhaps of note, China’s response has thus far been more measured, including suspension of social security payments, reductions in VAT and support for lending to small and medium sized companies.

If the impacts of the virus can be ‘successfully’ managed, or are less profound than some of the more extreme scenarios envisaged by some, global equity markets could see sharp recovery over coming months, more realistically towards the latter half of the year. If not, we will likely see a different path of recovery. One complication is that a number of countries/governments appear to be somewhat in denial as to the measures required, primarily among emerging markets. It is also evident that recovery is likely to be erratic at best, as governments gradually relax and then tighten controls in response to case progression, while sentiment will be subject to traumatic headlines from the emerging countries that are inevitably less able to manage the crisis or afford the dramatic economic cost of lockdowns. So far the experience in India and populous emerging ASEAN has been fairly benign, but that could well change.

It is clearly positive that numbers of new cases in China have fallen to relatively low levels and industrial activity is almost back to pre-crisis capacity. We would expect a gradual pick-up in domestic consumption as day-to-day life is slowly normalised. With China taking the pain of its own lockdown ahead of the rest of the world, this leaves the country (and to a lesser extent the region) slightly ‘ahead of the curve’; however, the recovery is expected to remain patchy as some sectors, such as travel, tourism and leisure, are likely to take much longer to recover fully. Furthermore, there are still real risks of a secondary spike in infections if the lockdown is eased too quickly, as recent experience in Singapore has shown. The export sector across the region also faces a secondary demand shock given the collapse in demand as Western countries moved into their own lockdowns, and this will have an impact on employment, income and investment spending if the downturn lasts for more than a few months.

In the shorter-term attempting to navigate recent volatility has been challenging both due to the speed and quantum of the share price movements over the past few weeks, and the degree of uncertainty regarding the near term growth outlook. But as long-term investors we have sought to take advantage of this volatility. We must work on the assumption that it is a matter of “when” not “if”, a degree of normality will be achieved, but the uncertainty is timing. Consequently, while we are prepared to take a degree of operational risk at a holding level (we believe it is too late to be extremely defensive), balance sheet, cost flexibility and the ability to weather an extended downturn is key.

‘Tide against globalisation to draw strength’

It seems likely that the tide against globalisation (trade, supply chains, people movement) will also draw strength from this epidemic. The portfolio does have exposure to a number of export-oriented companies, but our focus has always been on market leaders and higher value-added businesses. These are not easily substitutable, and have already been subject to rigorous audit by their mainly blue-chip Western customers, themselves under increased scrutiny by regulators, consumers, NGOs and media. Furthermore, in general our investee companies, fully aware of the cyclicality of their operations, have been conservative in terms of balance sheet structure. In general, many of the information technology holdings continue to benefit from the increased need for data storage and connectivity.

Greater tensions over trade are part of a broader pattern of rising geo-political rivalries. These include the political tensions in Hong Kong which had been at least temporarily smothered by the covid-19 lockdown, potential instability on the Korean peninsula, scrutiny of illicit technology transfer, and a greater focus on the strategic risks of complex supply chains. These need continual monitoring, but also validate the maintenance of a well-diversified portfolio by both sector and geography.

Strong management, sustainable business models and resilient balance sheets seem more than ever crucial, along with retaining a focus on longer-term underlying fundamentals. Asia is generally in good shape to face the subdued medium term prospects, partly thanks to (in most cases) vigorous and timely government responses to covid-19, along with strong national balance sheets, and a publically listed corporate sector with amongst the lowest debt to equity ratios in the world. Furthermore, dividend pay-out ratios immediately pre-pandemic were not excessive relative to historic averages. Thus far, dividend cuts have been relatively muted, and largely confined to banking and property sectors. However, at time of writing realistic assessment of the length and depth of the covid-19 recession is impossible to determine.”

 SOI: Schroder Oriental Income expects tide against globalisation to draw strength

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