Fundamentally, economies operate on the relationship between supply, demand and finance. The coronavirus (COVID-19) outbreak has resulted in simultaneous shocks to all three components, causing disruptions to global supply chains, a sharp decline in consumption and significant practical barriers to conducting business across manufacturing and service sectors.
"A recession is likely and European output is expected to contract sharply"
In the short term, a recession is likely; European output is expected to contract sharply. Two questions are key to understanding the longer-term economic consequences: how long will major disruption last? And how effective will governments’ and central banks’ policy responses be in the face of such a sudden – albeit temporary – halt to economic growth?
In the first instance, the primary policy concern is to manage the spread of the virus. The efficacy of government measures will materially influence the duration of economic disruption. However, these efforts will also need to be balanced against economic costs, and policy missteps could cause long-lasting damage to financial markets. Already, governments in the UK and Europe have announced fiscal measures totalling hundreds of billions of euros to help businesses through the COVID-19 shock. Ultimately, though, fiscal and monetary policies cannot prevent the disruption inflicted by a major supply and demand shock; they can only compensate for it.
"One of the sharpest-ever declines in global demand is looming"
The impact on real assets – as with almost all asset classes – will be unprecedented: one of the sharpest-ever declines in global demand is looming. Real assets have historically performed well in stressed situations relative to other asset classes. They also provide diversification benefits and income at a time when government bond yields are likely to fall as investors seek safety. Nevertheless, pricing will come under pressure, at least in the short term, though some opportunities may also emerge.
The full impact of COVID-19 on real assets has yet to become clear, but there is some anecdotal evidence pointing towards a slowing of transaction volumes. Under these conditions, liquidity conditions and credit risks need to be closely monitored. Below, we explore the implications for the three main categories within real assets: real estate, infrastructure and private debt.
Commercial property occupiers have already been affected. Retailers were among the first hit. Already facing structural challenges ahead of this crisis, the sector will become even more vulnerable. Many retail businesses will be dependent on government support to survive.
"Many retailers are unlikely to make their rent payments and some could go out of business"
While non-discretionary retailers such as grocers and pharmacies may be less affected by the severe drop in demand, most retailers are likely to experience a decline in footfall, supply-chain disruptions and difficulties in staffing stores in the months ahead. Many retailers are unlikely to make their rent payments in a timely manner and, absent government support, some could go out of business. Retailers including Debenhams have already asked for rent holidays to cope with the impact of COVID-19.
Other sectors that rely on tourism, including hotels, restaurants and leisure operators, are likely to be in an increasingly challenging position as the crisis lingers on. Widespread business failures may also occur in the parts of the office sector connected to tourism, travel and manufacturing. Occupiers with healthy balance sheets and low leverage will be more resilient. In addition, those businesses that play an integral role in the functioning of society and the broader economy may be more likely to receive government support.
"A larger percentage of the population will become dependent on e-commerce"
In the logistics sector, occupiers will be impacted by the disruption to global supply chains and potential labour shortages. However, it is possible that a larger percentage of the population will become dependent on e-commerce during the period of enforced social isolation, providing some support for the sector.
Student accommodation is generally a defensive sector, and rental incomes here should be less significantly impacted than in many other sectors in the short term. However, if global travel and higher education remains disrupted by late-summer, occupancy rates for the 2020-2021 academic year will come under pressure.
Landlords and lenders are bracing for the risk of income disruption. They will need to work closely with occupiers and borrowers to help them manage cashflows through this difficult period. Exposure to good businesses with strong covenants in high-quality buildings will help. Downside mitigation efforts will also be needed as development projects may be delayed due to supply-chain disruptions and labour shortages.
Infrastructure investments are generally long term in nature and designed to withstand economic downturns. Government-backed, long-dated cashflows will be beneficial in the current environment. Relative to other asset classes, social infrastructure investments should be well positioned to weather the COVID-19 crisis.
"Most airlines could be facing bankruptcy by the end of May if governments fail to step in with support"
Economic infrastructure is more exposed. Airports, for example, are likely to come under intense pressure in the short term, as air travel is falling in an unprecedented way. In a stark warning issued on 16 March, the Centre for Aviation, an industry research body, estimated most airlines could be facing bankruptcy by the end of May if governments fail to step in with support. Ports are also likely to come under duress as container traffic falls. Motorway tolls – often dependent on heavy goods vehicle (HGV) traffic – will be similarly affected.
Power infrastructure, which is dependent on cashflows based on the energy prices, will be hit by a combination of the pandemic-related fall in demand and Saudi Arabia’s decision to ramp up oil production. In construction and manufacturing, infrastructure projects may fail to become income generating on schedule, due to time overrun and rising costs because of the potential shortages of labour, supply and equipment. Income streams, therefore, may be disrupted.
"Expectation that extensive state financial support will be provided in certain core sectors, including infrastructure"
However, the sector is key to the continuity and recovery of the economy. Real assets investors should take some comfort from the widespread expectation that extensive state financial support will be provided in certain core sectors, including infrastructure. Most infrastructure assets play an essential role in our society and will be vital in getting the global economy back on its feet, so government policy is likely to be supportive.
Low-risk private debt is generally a defensive asset class, but investment outcomes will be threatened by the expected steep economic downturn. Take hotel owners: they may find it hard to maintain debt payments as their revenues dwindle, triggering covenant breaches. But stronger sponsors will have the right to help prevent a breach by, for example, injecting additional capital before a default event takes place.
"Transport, retail and leisure sectors appear immediately vulnerable"
Nevertheless, the number of restructurings, debt forbearances and, ultimately, defaults is likely to rise. The transport, retail and leisure sectors appear immediately vulnerable, but other parts of the economy, such as manufacturing, trade and construction, are likely to follow. Working closely with borrowers will help them to maintain debt repayments over the medium term, protecting investments.
Since the 2008-2009 financial crisis, capital flows from institutional investors into private debt have reached record levels as many bank lenders retreated from the sector due to stricter regulations. As a result, yields in the asset class have fallen substantially, while risk levels have risen due to the increasing amount of capital chasing fewer deals. Significant opportunities could arise in the aftermath of COVID-19 to fund real estate and infrastructure projects at more attractive yields, with risk being well compensated.
Short-term disruption could give way to long-term opportunities
The nature of viral outbreaks such as COVID-19 is that it is difficult, if not impossible, to predict their extent and duration. The pandemic is wreaking havoc on financial markets in various ways.
"The key to good portfolio management in times such as these is not to predict, but to prepare for the unexpected"
The key to good portfolio management in times such as these is not to predict, but to prepare for the unexpected. In real assets, this approach involves holding diversified portfolios of high-quality assets and maintaining strong relationships with occupiers, borrowers and partners. Unlevered or lowly levered equity portfolios – while appearing more conservative during ‘risk on’ environments – add much-needed defensive characteristics during downturns.
While further volatility is expected, opportunities will no doubt arise alongside severe challenges. Mispricing is more likely to occur, and investors should be ready to act. Liquidity is currently top of mind, but the diversification benefits associated with an allocation to quality real assets will also be key to weathering COVID-19. With the medium-term future for the global economy unclear, it will be advantageous to own assets with an array of risk drivers. Investors can take steps to contain and eventually reverse the effects of what is clearly an economic emergency.
The Real Assets Research team will continue to analyse the impacts of COVID-19 on private markets as the situation evolves. We will share their perspectives on the outlook for real estate, infrastructure and private debt over the coming weeks and months.