Model Portfolios – May
Every month we provide our readers with an update on a few of Powerwrap’s new and existing Separately Managed Accounts on the Powerwrap platform. Please keep in mind the information disclosed is general in nature and does not take into account your personal situation.
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The FED: Support Beyond the Pandemic
By John Bellows, Ph.D., Portfolio Manager, Research Analyst
30th April 2020
The Fed is far from done with its response to the immediate concerns confronting the economy.
The Federal Reserve (Fed) did not announce any significant change to its policies at today’s Federal Open Market Committee (FOMC) meeting. After re-iterating the Fed’s commitment “to using its full range of tools to support the US economy in this challenging time,” the post-meeting statement reviewed the current state of economic activity with a series of alarming observations that included: “surge in job losses,” “significantly lower oil prices,” “impaired the flow of credit” to name a few.
If anything, the Fed’s observations understate the severity of the economic emergency. Indeed, the statement itself hinted at broader set of consequences by saying that the situation “poses considerable risks to the economic outlook over the medium term.” The reference to the “medium term” is important, especially as the Fed’s prior statement in March had referred to only “near term” risks. By looking out to the “medium term” the Fed is setting up policy to be active and accommodative for an extended period of time, and almost certainly well past the resolution of the coronavirus/COVID-19 pandemic.
While there were no new policy announcements, the Fed is far from done with its response to the immediate concerns. Over the last six weeks the Fed has announced a tremendous amount of new policies, and its current task is to implement those policies quickly and to maximum effect. Chair Powell’s comments on that dimension today were encouraging in two respects.
First, Powell reiterated the Fed’s commitment to make these facilities count. After a careful description of what the Fed can and cannot do (Powell specifically mentioned that grants to individuals fall in the latter category), Powell said that “We can do what we can do, and we will do it to the absolute limit of those powers. We will keep at it.” Obviously the facilities that already have been announced are things the Fed can do—after all, the Fed lawyers have already approved those actions—so the straight-forward implication of Powell’s statement is that these facilities will be used aggressively.
Second, Powell made a specific reference to the Corporate Credit Facility and said that it is “near being finalized” and will be running “fairly soon.” Powell also observed that credit markets have stabilized since the Fed’s announcement of these facilities, and he took some credit for the “announcement effect.” The stabilization has meant that over the past month companies have been able to finance themselves and raise liquidity from private investors. This is obviously a good thing, not only for the companies and their investors but also from the Fed’s perspective. Rather than sounding complacent about the stabilization, however, Powell went on to say that, “Of course we have to follow it through. And we will follow through to validate that announcement effect.” For investors still waiting on the Fed to start the corporate purchase program, this comment was as close as could be hoped for in terms of assurance that the commitment remains and the purchases are coming.
Looking forward, there are two areas where we expect the Fed to do more in coming meetings. The first is with regard to its guidance on interest rates. In today’s statement the Fed said, “The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.” As mentioned above, if the current contraction in economic activity does indeed have medium-term consequences, then it’s likely that the Fed will keep rates close to zero well past the point of the economy having “weathered recent events” and well into the recovery. We expect that it will make such a commitment explicit in coming meetings.
The second is with regard to asset purchases. The Fed’s current posture is to buy US Treasuries and agency MBS “as needed” to support market functioning and financial conditions. At some point that posture is likely to evolve into a commitment to putting downward pressure on yields, in order to both support financial conditions and also to facilitate a continued fiscal response. The Fed has a number of options when it comes time for that, including yield-curve caps and fixed-dollar quantitative easing. While Powell made it clear that it was too early to disclose any specifics, he certainly didn’t do anything to dissuade us from thinking that an announcement in that space is coming at a future meeting.
The fiscal impact of COVID-19 continues to be felt as businesses grapple with an unprecedented downturn in demand. With earnings under pressure, it has been no surprise to see a host of companies seek an injection of new capital over the month. Despite the growth in cases of COVID-19, with the global tally nearing 3.2m infections and over 220,000 reported deaths, measures taken in Australia may have reduced the spread of the virus. That said this has come at a high economic cost to society, and future generations who are set to be saddled with debt. Buoyed by talk of possibly rolling back lockdown restrictions over the coming weeks and returning to some level of normality, our local All Ordinaries Index closed up 9.53% to 5,598 points.
National Australia Bank’s (NAB) mammoth $3.5b capital raise has highlighted the inherent leverage that sits within our banking sector. To that end we question the rationale of banks paying out a significant portion of reported profits in dividends. Considerable leverage coupled with unsustainably high payout ratios has required more capital top ups to navigate market downturns. While NAB cut its interim dividend to 30 cents per share, down 64% from last year, this will still consume $800m of their total raise.
Even pre-COVID, banks have had an unsustainable habit of borrowing from one hand to pay the other. We observed this when Westpac raised $2.5b in November 2019 at a price discount of 6%, only to pay out their usual December half year dividend costing $2.8b. Raising money from investors at a discount, to fund unsustainable dividend policies destroys value and introduces unnecessary dilution.
Since mid-March, there have been over 35 deals to raise in excess of $15b in fresh capital for listed companies attempting to improve liquidity or shore up balance sheets. Interestingly, technology companies including Megaport and Infomedia have raised new capital to leverage the recent market dislocation to pursue growth investments and M&A opportunities. We appreciate the difficulty of navigating current market dynamics and have participated in a number of these new capital raisings.
As the global economy has stalled, oil consumption has collapsed creating significant pressure on international storage capacity. For the first time, the futures price of West Texas International (WTI) crude fell below zero to negative US$37.63 per barrel. For oil producers, this is equivalent to paying someone to take product off your hands. While WTI crude has since rebounded to just under US$20 per barrel, this is still significantly below the US$57 per barrel price averaged over 2019. In response to this vast oversupply, OPEC and other oil producing countries have agreed to cut production by 10m barrels a day, reducing oil production to roughly 23% of the levels seen over May and June. Time will tell if this is enough to curb the global oil glut.
In this unprecedented and fast-moving environment, we continue to invest with a long-term perspective. We continue to seek businesses with:
- Competent management teams
- Business leadership qualities
- Strong balance sheets
- A focus on capital management
Infomedia (IFM:ASX) This month Infomedia, a leading automotive electronic parts catalogue (EPC) software provider, raised $70m in fresh capital through an institutional placement. In addition, a complementary Share Purchase Plan (SPP) seeking to raise an additional $15m is currently underway. This new injection of capital is expected to enhance the financial flexibility of the company, allowing them to emerge from the recent market volatility in a position of strength.
Infomedia has reaffirmed its FY20 outlook of delivering low double-digit growth in revenue and earnings. The company expects their revenue to be between $93m to $95m, an increase of 10% to 12% on FY19, with net profit after tax to be in the range of $18m to $19m, an increase of 12% to 18%. Trading to the end of March has met internal expectations with the company ending the quarter holding $15.2m in cash (prior to the capital raising).
Aristocrat Leisure (ALL:ASX) Due to continued uncertainty as to the duration and extent of the impacts of COVID-19, Aristocrat has withdrawn its FY20 guidance provided in February. Digital games, which contributed approximately 40% of total group revenue last year, have performed strongly over this period. Land-based operations, which accounted for the remaining 60% of revenue last year, have been significantly impacted by temporary venue closures around the globe.
As such, Aristocrat has enacted cost reduction measures including standing down 1,000 staff until the end of June 2020, removing a further 200 roles permanently, and reducing base salaries for staff and the Board by between 10%- 20%. The cost reduction initiatives are expected to deliver circa $100m in cost savings until September 2020.