David Lebovitz:  Welcome to the Center for Investment Excellence, a production of JP Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Today's episode on transportation has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Adarag Agural, head of portfolio management for the Global Transportation Group. Welcome to the Center for Investment Excellence.

Adarag Agural:  Thanks for having me, David.

David Lebovitz:  For listeners who missed our most recent episode, all upcoming Center for Investment Excellence episodes will focus on current market volatility, the impact on various asset classes and how investors can best position themselves to withstand both current and future market conditions. Today we're talking about transportation, exploring how COVID-19, the Fed's recent rate cut and market volatility are impacting the sector.

So, Adarag, kicking things off here, you know, the transportation sector is front of mind given the global spread of COVID-19. Vessels have been quarantined. There have been airline travel restrictions in many of the affected countries. I want to start by asking you, how do you see this outbreak impacting the transportation broadly and, particularly, as it relates to dry bulk versus container shipping.

Adarag Agural:  Yes, thank you, David. For sure, as we all deal with the development as well the uncertainty tied with the COVID-19 situation globally, transportation as an asset class and transportation-related companies, particularly those that we often talk about in the public markets, have been in the eye of the storm.

So let me try and put this in context in that I think it's important to understand just the context of how transportation fits into the broader sort of context of global trade.

So at its simplest, we think about global trade as being a function of supply and demand. So if you look at the impact from a supply side, you have to look at China. And really, you know, you also have to look at China when you think about where COVID-19 actually first was coming from. So quick sort of history here is that we sort of got into the early part of the year as always, expecting Chinese New Year, which is annual event which pretty much takes a little bit of a sort of slowing down effect on the supply side of global trade because China takes anywhere from three to four weeks off.

So this is already in the books, people were expecting this. But unfortunately, as the Chinese New Year holiday was happening, we discovered COVID-19 and the coronavirus pandemic out of China forced China to go into quarantine. So what that simply did was that we saw an extension of the Chinese New Year slowdown get extended by anywhere between four and six weeks, which had a severe impact on the supply side. The factories in China were closed. Certainly, nothing was being made. So on the finished goods side, we saw no (unintelligible) coming out of China. And in terms of China being a very large importer of iron ore for their infrastructure projects, that work was also stalled, and we saw drop in demand iron ore which then impacted the dry bulk markets.

So when it came to the supply side, initially, the impact was felt more in the markets because of what China was going through. However, if you look at where we are today, we have sort of moved on to the point where China seems to have caught up with I think being able to manage the spread of the pandemic. And in terms of the Chinese workforce coming back online, we're experiencing a slow sort of return. And when I slow, our expectation is that China is probably 75 to 80-85 percent back in terms of its manufacturing capacity. And the same goes with its infrastructure projects. There is a huge stimulus announced by the Chinese government which, again, supports their infrastructure-related activity.

And then China, obviously, is a big consumer of food grain products. So agricultural products tend to be more stable in terms of their needs. So all this to say that China seems to be coming back online, and the supply side of global trade has pretty much improved significantly than what it was about six or maybe even eight weeks ago. The problem now, however, is not on the demand side because, as we know, the western world is pretty much closed for business. So when North America, Europe, Australia and all these countries that consume a lot of the products coming out of China slow down the way we have, we're now seeing the impact of global trade being felt on the demand side of trade.

So currently where we are is, while we are seeing some return of volumes on the dry bulk side, particularly with iron ore and food grains going into China, we're certainly expecting there to be a slowdown of volumes of finished goods coming into the western world, particularly North America. And one of the things we're all trying to assess as we speak is how long is this slowdown going to remain for and, more importantly, when will we see consumer sentiment pick up again?

So the current expectation is maybe we will see containerized volumes be down somewhere in the two to four percent range for the year, but this all depends on when North America comes back because of the fact that, in the second half of the year, we have the holiday period coming up which always tends to support demand.

David Lebovitz:  Yes, I think that there are a lot of questions around the contours of the recession that we may already be in but, certainly, that is coming. One thing that I think has gotten overlooked is a lot of folks have focused on COVID and the impact of the virus has to do with the fact that bubbling the background there's still this oil price war going on between OPEC and Russia. And so can you talk a little bit about the impact of lower oil prices on the transportation sector in terms of what this means for costs, what this means for tanker rates, therefore, what this means margins? Would love to kind of bring that element into the conversation as well.

Adarag Agural:  Surely, and this is kind of one of those silver linings or bright spots in terms of an area in the broader transportation and shipping world that is actually seeing a little bit of a pick-up given what we are experiencing with where the price of oil is today. So the quick backdrop here, as we all know, is that OPEC has failed to agree to production quotas. This is a dispute between Russia and Saudi Arabia and, as a result of that being the case, we have seen the price of oil per barrel spiral down into the twenties.

Now, interestingly, what that has created is it has created the dynamic of Contango in the oil markets where the forward calls and, if you look at where the price of oil is expected to be on that forward cycle, is a lot higher than the current price of oil. What we tend to see at times like this - and we've certainly been here before - is that at times when the price of oil is so low that it becomes very attractive as a commodity, countries and end users that tend to use the commodity tend to stockpile the product. And that certainly creates a high demand for tankers and product tankers, not only to move these volumes of products from the producers to the consumers or the end users but, in most cases, we also see product tankers getting used as floating storage units because the cost of renting the tankers, when added to the low cost of oil, still ends up being fairly attractive when you look at that forward call.

So interestingly, at a time like this where the rest of the world seems to be really getting impacted, the low price of oil is really supporting the demand for product tanker commodity-related services. And to give you a little example of that, VLCC, which is a very large crude carrier, about eight weeks ago was trading on average in the spot markets, which is the shorter-term duration markets, anywhere between $35,000 and $45,000 a day, and we saw that number go as high as $350,000 a day. Now this is an extraordinarily high jump in prices but, again, it is purely a reaction to the short-term demand for oil carriers because of this dynamic oil Contango.

David Lebovitz:  Interesting. You know, I think it's funny because a lot of my client conversations have centered around the impact of COVID-19 and what's GDP going to look like. What's going to happen to employment? I think a lot of people have overlooked this energy issue. So thanks for those comments there. I want to switch gears a little bit and focus specifically on aviation. So this morning we got a fiscal package announced that contains $50 billion in earmarks for passenger airlines and another $8 billion in support for cargo airlines. You know, as you think about the aviation space, what's the impact on airlines of COVID-19 beyond the travel bans?

Adarag Agural:  Yes, I mean, this is a hard one because there isn't any other way to put this, but the aviation sector has been under a lot of pressure. And I think globally what we are seeing and we're expecting is that there will be a loss of revenue. I think this loss revenue will come from the fact that most fleets of aircraft in the world today are grounded. Particularly, we know what's happening here in North America, and this has created an outlook where there is low demand, and there is going to be a need for just liquidity. And most airlines are preparing for what we think is going to be in the near term a negative working capital environment.

Now, as you think about how all this is going to play out and, certainly, the new from this morning is positive to the extent it shows the willingness of the government to support these airlines. I think we're seeing airlines pursue liquidity options and, beyond the support that they expect from the governments, in the form of tax relief, bailout packages, grants, et cetera, we're seeing airlines also try and shore up their balance sheets by drawing down into as much of their available liquidity options, whether it's lines of credit, whether it's across the capital structure accessing different markets of capital. So we're certainly seeing that behavior.

And then more importantly, for those airlines that actually have an ownership of ownership of aircraft, so they have assets on their balance sheet, this is a good time for them and they're certainly thinking about monetizing some of those assets by doing sale-leaseback transactions. So when it comes to liquidity options, it's really these three options. You either get support from the government and/or you have existing liquidity on your balance sheet by way or case or you have lines of credit, or then you have to consider doing sale-leaseback transactions.

However, given the uncertainty of how long this negative working capital environment is going to impair and affect the airlines, I think what we are also starting to see and we expect in the marketplace is a request for lease payment deferrals.

Now, this is again something that we have seen in the past. So in difficult times, what airlines will do is, in an effort to manage their own cash flows, they will oftentimes come to lessors and ask for some kind of restructuring of their payments of their leases where a percentage of those payments get deferred to anywhere, you know, on a rolling basis or then we see it getting deferred beyond six or nine months.

So I think there is a plan for the industry to deal with this. Our view is, look, there's going to be some winners. There's going to be some airlines that will come out of this because they have a good business model. They strong balance sheets, and they have the prospects to come out of this when the markets return. But there's certainly going to be - in our view, you know, there's going to be credit defaults. There could be credit downgrades and, certainly, the possibility of some bankruptcies also looms large.

David Lebovitz:  Got it. Really appreciate those insights. I think, you know, the aviation industry is front of mind for a lot of folks today, given some of the numbers that have been thrown around in their minds and, obviously, given the direct impact of the virus on the aviation industry. So one more question to kind of bring us home.

A couple of weeks ago I had Andy Dacy, the CIO of our Global Transportation Group on the podcast, and he mentioned that a focus on capital intensive, income generating assets contracted over long periods to high-quality end users was the most attractive and exciting opportunity for folks in the space. Can you talk a little bit about how a focus on core-plus transportation assets makes investors a bit more resilient in the type of market and economic shocks that we're facing at the current juncture?

Adarag Agural:  Definitely. And I think is a really, really important question because, as you see all the headline news and all the discussion about - some people are calling it the end of aviation, some people want to see - you know, and talk about sort of worst case scenarios across all of what we are experiencing in the markets today, it is extremely important to try and dig deeper and understand and isolate where most of this impact is being felt.

So when you think about just transportation assets and you go back to the simple premise that you can invest in the sector taking two different approaches, you can invest in underlying asset value-based appreciation which typically tends to also then require the assets to be traded on shorter duration leases or on, oftentimes what we call the stock markets.

That's the market where the assets are looking for employment every three-six months, sometimes no more than 12 months. That market has severely gotten impacted because, clearly, if you are at this point in time an owner of asset that is looking for employment, regardless of whether it is a shipping asset or an aviation asset, you are facing a very challenging market.

However, if you switch over to the quote-plus approach of investing in the transportation sector, what you're fundamentally doing over there is you're actually firstly investing in assets which are large and are critically embedded into the core operations of supply chains of some of the world's largest corporations.

So that certainly provides you with some protection because, even as these corporations look to compress their business to match supply and demand, they will actually first focus on the shorter-term assets which are more discretionary in their supply chains before they get to these core supply chain assets which are really fundamental to their business. So that's one.'

Two is, and most importantly is, you are typically investing in assets that attract long duration leases, and the ability to have duration gives you a significant distancing from the on goings of what is happening in the market today. So in our view, if you have invested in long duration leases to large corporations that for the most part represent fairly strong balance sheets and corporate credit, you do have the ability to ride through a shock in the system like we are experiencing right now because, if one has to believe the pundits who are saying anywhere between three to six months on the shorter side, maybe 12 to 18 months on the longer side, before the markets start coming back to normal and we start seeing most of the impact of COVID-19 really work itself through the global system. If you have a lease today that is well north of that, five-six years and beyond, you're not going to be facing the market for that period of time.

So then as long as your counterparty is in business and your counterparty remains sort of strong in terms of its corporate credit, I think the expectation from a core-plus point of view is that these assets should continue to produce a cash flow which actually then becomes income. So there is a little bit of a sort of barbell approach here where the shorter-term assets are the most exposed. They are the ones that are experiencing most of the negative impact that we've been talking about. But the longer duration assets are far more resilient, and those are expected to actually ride through the storm - no pun intended - and do much better.

David Lebovitz:  Excellent. Well, Adarag, as always, thanks for joining me on the center for investment Excellence. Always a please having you on. Thanks again.

Adarag Agural:  Thank you, David. It was a pleasure. Stay safe.

David Lebovitz:  Thank you for joining us today on JP Morgan's Center for Investment Excellence. CFA Institute members are encouraged to self-document their continuing professional development activities in their online CV tracker. If you found our insights useful, you can find more episodes anywhere you listen to podcasts as well as on our website. Recorded on March 25, 2020.

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