SINGAPORE (Mar 13): Now we have it, the answer to the oft-asked question, “When will the longest-ever bull market in US history end?”
The Dow Jones Industrial Average fell 1,465 points on March 11, taking total cumulative losses to over 20% from its all-time record high — on Feb 12 — and meeting the definition of a bear market. The longevity of this bull market was driven by unorthodox and ultra loose monetary policies, which flooded the world with liquidity and pushed up asset prices, including stocks. As it turns out, the cause of the bull market’s end was a transient shock in the form of the Covid-19 outbreak, against which monetary policy is largely ineffective.
Global stock markets tumbled as fears over the widening spread of Covid-19 were compounded by the free fall in crude oil prices. Investors are struggling to put a price tag on the economic — and corporate earnings — impact from the viral outbreak. As the selloff in stocks intensified, investors fled to haven assets, sending yields for the benchmark 10-year Treasury to as low as 0.64%.
Admittedly, we have underestimated the severity of the Covid-19 outbreak. Despite better preparedness, on the back of experience gained in China, its spread in the rest of the world has been rapid. Italy, Iran and South Korea emerged as new epicentres for the disease. On March 12, the World Health Organization (WHO) declared the coronavirus a global pandemic.
On a more positive note, the situation in China is improving. The number of daily new cases has fallen sharply. All 16 makeshift hospitals in the city of Wuhan have closed, as the last of the patients were discharged. Factories and offices are gradually resuming operations. Foxconn Technology Co, the main contractor for Apple, said production in China would normalise by end-March; Alibaba Group Holding’s delivery package network (outside of the initial epicentre, the Hubei province) is up and running.
So, from the first case in December, the cycle has taken three to four months to play out. The recovery from global supply chain disruptions will take longer, owing to the cascading impact. We may be seeing a similar cycle unfolding in South Korea, where the government’s response has been aggressive in terms of testing and containment. As a result, the spread is slowing and the number of new cases has also been falling. Its prime minister expressed hope that the country was near the turning point (see Chart 1 and 2).
If this timeline holds true — though it is highly dependent on each country’s response to the outbreak — we would expect the situation in the Middle East, Europe and the US to get worse before it gets better. In short, the world will see a sharp slowdown in growth for 2020.
Confidence was further buffeted by the collapse in oil prices, clouding the outlook and resulting in sharp losses for the oil and gas sector. After failing to secure Russia’s agreement on sharper production cutback to support prices, the Organization of the Petroleum Exporting Countries, led by Saudi Arabia, made a sharp policy U-turn. Instead of cutting output, the cartel will now cut prices to boost volume sales. Given that global demand is inelastic in the short term, however, the only near-term effect is just low oil prices. Oil producers will be badly hurt and someone will blink. It is now a game of chicken, between Saudi and Russia.
Frankly, I cannot understand why global equity markets reacted badly to the sharp fall in oil prices. Surely there are more winners (consumers) than losers (producers)? Notably, should oil prices remain at current levels, the risk of inflation — the single main threat to continuous monetary expansion — will be significantly diminished. Therefore, are markets overreacting? I can understand the negative effects of Covid-19, but not oil. In fact, it was the huge rise in oil prices that once caused a global recession. It cannot be true that when the opposite happens, it also causes a recession!
Looking ahead, there is little reason for a reversal to prevailing accommodative monetary policy. Yes, monetary policy has limited impact right now — lowering interest rates does not work if people are under quarantine and staying home — but it would provide a tailwind to the eventual recovery. The viral outbreak has only a transient effect and a fiscal boost is what is needed, more than simply injecting liquidity — whether to put cash into the hands of consumers or to reduce costs to producers.
Analysts are cutting back earnings forecasts. According to FactSet, earnings for Standard & Poor’s 500 companies are now expected to contract by 0.1% in 1Q2020, down from a growth of 4.4% at end-December. Growth for the full year is estimated at 6.7%, down from about 10% at the start of the year.
These numbers do not yet include fallout from the oil price drop. Thus, we will very likely see further reductions in earnings forecasts. In view of the heightened uncertainties, short-term volatility will probably persist. The eventual earnings impact from the viral outbreak remains very much a guessing game at this point. We suspect that most companies, if not all, will be affected, but to different degrees.
ServiceNow
ServiceNow is a software as a service (SaaS) provider for internal workflow automation. The nature of its business suggests minimal near-term earnings impact and disruptions from physical mobility restrictions, owing to the coronavirus. Its subscription-centric business has a high retention rate, customer renewals were at 97% in the latest quarter. However, the stock trades at above-market average valuations, thanks to its high growth potential. That makes it more susceptible in a selloff.
Future growth could be hurt if uncertainties persist and the global economy slows, causing existing or potential customers to trim their capital spending. In addition, travel restrictions could hinder the company’s ability to secure new customers and penetrate new markets. North America is currently ServiceNow’s biggest market, accounting for 66% of revenue. That said, the company sees international expansion as its core strategy for future growth. Europe, the Middle East and Africa represent 25% of sales whereas Asia-Pacific accounts for the remaining 9%.
Its latest earnings results for 4QFY2019 handily beat market expectations, with revenue growing 33% year on year to US$952 million (RM4.05 billion) — almost all of which came from subscriptions — and net income expanding 37% to US$646 million. Gross margin held steady at 86%. The company remains a leader in workflow automation software and serves 80% of Fortune 500 companies. In January, ServiceNow had expected subscription revenue to grow 30% this year. It has not issued a revision to this guidance.
Adobe
Adobe is in a similar situation. The company has shifted its business model from licensing to one that is subscription-based and does not require physical sell-through for revenue and earnings recognition. As such, the viral outbreak should have limited impact on demand and subscription revenue for its cloud-software solutions. Its suite of products, including Adobe Creative Cloud, Document Cloud and Experience Cloud, are go-to names in their respective market segments.
Adobe performed very strongly in financial year 2019. Revenue grew 21% y-o-y to US$11.2 billion, driven by recurring subscription-based revenue. Diluted net income per share was up a strong 15% y-o-y, in line with growth in operating income. Its business is highly scalable. Current operating margin and return on equity, at 29.25% and 29.67% respectively, are up from 18.83% and 9.14% five years ago. The company generates strong free cash flows annually. It repurchased 9.9 million shares last year and returned US$2.7 billion cash to shareholders.
Looking ahead, Adobe has guided for a 17% y-o-y growth in revenue and 21.9% y-o-y growth in earnings per share (EPS) for FY2020. Its core growth strategies include the introduction of new products such as Photoshop Camera and Adobe Spark; accelerating document productivity, specifically in the areas of scanning, editing, collaborating and signing; and powering digital businesses through its Adobe Experience platform, which provides data and insights on optimising the business and enhancing customer experience.
Microsoft Corp
Microsoft, on the other hand, did issue a warning that sales for its More Personal Computing (MPC) segment for the current financial third quarter would not meet initial guidance. This is the segment that consists of Windows licensing, Devices, Gaming and Search, including Surface and Xbox, and accounts for roughly 36% of total revenue. In addition to supply disruption for Surface (manufactured in China), sales of Windows OEM installed in other computers have also been affected. Manufacturing ramp-up is slower than expected but gradually returning to normal.
That said, this segment is neither its most profitable nor fastest-growing business. To recap, the tech giant operates three main business segments: Productivity and Business Processes (PBS); Intelligent Cloud (IC); and MPC. PBS includes Microsoft Office subscriptions, LinkedIn and Microsoft Dynamics 365; IC comprises server products, cloud services and enterprises services such as Microsoft SQL Server and Microsoft Consulting Services. These businesses will continue to benefit from the secular trend of the digitisation of people, places and things.
In the latest earnings results for 4QFY2019, revenue was up 14% y-o-y while operating income and diluted EPS grew at outsized clips of 35% and 40 respectively. The strong performance was attributed to the cloud business, where revenue for Azure grew 62% y-o-y. The viral outbreak is resulting in more companies directing staff to work from home. This is another secular trend — the rise of the remote workforce — that had been unfolding well before the current crisis. Schools are also moving classes online. Analysts have noted that Microsoft is already seeing a jump in cloud subscriptions and cloud computing business.
Current operating margin and return on equity stand at 36.74% and 43.83% respectively. The company returned US$8.5 billion to shareholders in the form of share repurchases and dividends in the last quarter.
The Global Portfolio fell sharply for the week ended March 12, down 14.5%, mirroring the broad market decline. All 13 stocks in our portfolio ended in the red last week. Some of the biggest losers were The Boeing Co (-33.2%), Builders FirstSource (-25.5%), BMC Stock Holdings (-23.5%) and Lennar Corp (-19.9%). Last week’s losses pared total returns for the Global Portfolio to just 1.3% since inception. By comparison, the benchmark MSCI World Net Return Index is now down 2.2% over the same period.
Tong Kooi Ong is the chairman of The Edge Media Group, which owns The Edge Singapore.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
