It’s all about the dry powder

AS expected, quarter one (Q1) results season was as disappointing as trying to catch a sunset on a cloudy day.

With the movement control order (MCO) imposition with effect from March 18, it was not a surprise to see most corporates churning out disappointing quarterly report cards as business closures, especially among consumer names and the retail sector, were hit hard on revenue and earnings. Some corporates even experienced losses as revenue evaporated during the MCO period, while operating expenses ate into profits that have been earned in the early part of the Q1 period.

Due to the extension of time granted by Bursa Malaysia for companies to report their respective Q1 results to end of this month, some 20%-25% of the companies covered by brokers have yet to report their quarterly results. As such, not all brokers have made their summary report for the Q1 period reporting season.

Based on data from six brokers, the number of companies that reported disappointing earnings spiked up to 47% in 1Q20 against 31% in the preceding quarter while companies that surprised the market fell to 10% in the latest quarter against 19% in the 4Q19 period. Hence, the disappointing ratio plunged to 4.54x from 1.21x. The drop in the ratio is not surprising mainly due to the partial impact of the MCO period.

What is also not that surprising was the fact that almost none of the sectors exhibited any element of earnings surprises in the Q1 period. At best, it was just within expectations.

Disappointment in earnings was across sectors with the exception of course, the rubber gloves sector. Apparent weakness was seen among construction stocks, property players, gaming sector, oil & gas companies and some of the larger banks and almost all the planters.

With the disappointing earnings for the Q1 period, earnings forecast for 2020 has been slashed drastically, along with target prices as well as fair value for the FBM KLCI. On average, from the earlier earnings growth of 7.1% for this year at the end of the 4Q19 quarterly reporting period, the revised estimate is now at a staggering contraction of 14.3%, which is a drop of 21.4 percentage points (ppts).

For 2021, brokers are now projecting an earnings expansion of 17.9%, which is 9.4 ppts higher than the earlier estimate of 8.5% increase. The jump in earnings forecast for 2021 is mainly driven by the lower base effect due to earnings contraction this year. In essence, earnings growth in 2021 will basically cover back this year’s earnings contraction and 2021 earnings is back to the level seen in 2019.

Individually, compared with three months ago, with the exception of one broker that raised market’s fair value by 50 points (pts), all others cut their estimates by between 33 pts and 140 pts. On average, the market fair value has been reduced by about 80 pts to 1,421 pts from 1,501 pts at the end of the preceding quarter.

The current fair value of the

FBM KLCI now ranges between a low of 1,320 pts to a high 1,530 pts based on PER multiples that are pegged between 15.9x and 18x next year’s earnings. With the FBM KLCI at 1,562 pts as at Thursday’s close, the market is now trading outside the top-end of brokers’ estimate and about 140 pts or 10% above the mean value. Having rebounded by 28% from the March low, the FBM KLCI is not cheap by historical standard, trading at 21.8x this year’s earnings and 18.5x next year’s earnings.

Looking beyond 2020 for growth

As we speak, the world is not an oasis of prosperity as we have mountainous issues to be dealt with. Even the Covid-19 numbers, especially in a number of cases has not shown a trend that is positive.

In fact, over the past one week, the rolling seven-day average daily new cases is now at its highest point at 118,421 cases. The only consolation is that the number of deaths has been on a declining trend and the latest daily number of 5,499 on June 4 is 35% lower than the peak daily figure of 8,429.

While the world is battling against a virus, economies are beginning to open up and some form of “back to life” scenarios are beginning to show – green shoots, so to speak.

Even if economic data released turns out to be disappointing, the market is just ignoring them as it is looking forward, way forward, in terms of economic recovery. Hence, even if one in four American adult population that is in the labour market is out of job, it doesn’t matter, as jobs will come back in time. Even if consumer spending has plunged, it is not alarming to the market any more as market believes that the worse

is behind and can only get better.

Even if earnings are disappointing, so what? Market has ignored the Q1 data, will ignore another horrendous Q2 numbers and will likely focus its attention to next year, 2021, and that’s where earnings expectations and valuations are anchored.

In fact, some early economic data can be said to be positive, especially those related to IHS Markit Purchasing Manager’s Index (PMI) Indicators. Chart 1 shows the month-on-month (m-om) change in the manufacturing PMI indicators of selected economies.

With the exception of China’s official manufacturing PMI reading, which is above 50.0 but down 0.2 pts m-o-m, all other PMI readings are still below the 50.0 threshold. The reading in Singapore and Indonesia remained depressed as the May 2020 reading stood at just 28.6 and 27.1 respectively.

In Malaysia’s case, the reading jumped 14.3 m-o-m to 45.6, one of the highest increased on a m-o-m basis, and that signals that Malaysia is back on growth trajectory. For Malaysia, unlike other countries, a PMI reading of 31.4 signals zero growth and hence any reading above that threshold (and not 50) is actually an expansion of manufacturing activities.

On earnings, even the upcoming quarterly earnings this year will largely be out of the radar as investors will likely just focus on the recovery path of the earnings momentum rather than the earnings headline numbers itself. The recent mass protest and mayhem that we saw in reaction to the death of George Floyd, China’s apprehension on the phase one of the Us-china trade deal too has failed to stop market momentum.

In fact, one should not be surprised if the US were to retaliate with fresh sanctions or tariffs as it is very unlikely that China would be able to meet the targeted Us$186.6bil worth of US imports of goods and services for 2020. As at Q1 of the year, the total amount is only about Us$36bil in exports, comprising Us$22bil in goods and perhaps an estimated Us$14bil in services.

The Chinese have not been importing enough and is short by about 23% of the targeted amount on an annualised basis.

It is not only the local bourse that have rallied strongly from the low, but so has most of the developed market main stock indices as well as those in Asia Pacific.

As can be seen in Chart 2, the FBM KLCI’S 28% gain, of which probably about a fifth aided by the spectacular run in the nation’s top two glove makers, signals that the market is in a bull market phase, a catch phrase for all markets now, with the exception of Hong Kong’s Hang Seng Index and Shanghai’s Composite Index.

Demanding fundamentals

While fundamentals are demanding, even looking at 2021 earnings expectations, the market is driven by strong liquidity momentum, market velocity, opening up of the economies, globally, and the hope for a faster vaccine for Covid-19 to enable life to return to normal. This is fuelling the market’s fire. For now, the market’s rally can be said to be justified, but beyond that, at 18.5x forward 2021 earnings, the market is beginning to look expensive. Question is how much more expensive can it get before earnings catches up with market values.

According to Bank of America in its recent note to its clients, the year 2020 has been an amazing year in terms of numbers. We had 42.6 million Americans out of job over the past 11 weeks.

We have loss in global GDP to the tune of US$10 trillion, some US$18 trillion in government stimulus plans, a jump in global equities equivalent to about US$15 trillion, number of global interest rate cuts totalling 122 and we still have US$5 trillion in dry powder, waiting to deployed.

Perhaps this explains the market euphoria despite the challenging outlook.

With most asset classes giving investors almost next to nothing in returns (cash/bonds), perhaps the equity exposure is the one that can make up the difference to generate some decent returns.

The views expressed are the writer’s own.