The COVID-19 pandemic may have changed the way that we live, which in turn will have significant influence on the future of the economy and investment markets. During February 2020, a coronavirus story developed that many felt would dissipate in a similar manner to SARS, and by March the inevitable global health impact became obvious, causing unprecedented global dislocation. The level of monetary and fiscal liquidity support that has been pumped into the system, the rate of recovery of equity markets and the lowest interest rates on record, may have developed a picture of prosperity while we are in the middle of a one in a hundred-year international health and social crisis.
There is no doubt that 2020 will be etched into history books as one of the most difficult social and economic periods. In addition to the pandemic and directly related factors, in 2020 we were faced with confronting global domination issues developing between the United States and China, the frustrating Brexit divorce, the most unusual circumstances surrounding the US elections, and climate change and environmental challenges.
The strong equity market recovery during 2020 (first chart below) defied the early thoughts on the impact of the COVID-19 pandemic on markets, however, equity markets will not always reflect the economy, and are more often reflecting future expectations. When comparing previous market selloffs and recovery rates, this V shaped recovery re-wrote history. On reflection the reasons have become obvious. The degree of fiscal and monetary input support aimed to avoid the economic cliff was the primary driver, coupled with record low interest rates resulting from these inputs, helped create a turbo charged equity market. At the same time the low interest rates have removed the traditional defensive income option for investors causing them to shift out the risk curve in search of yield/income, providing support to equity/growth/risk assets. The chart on the right highlights the options of yield/income previously available to investors during market selloffs that are not available this time.
ASX All Ordinaries (blue) / S&P 500 (black) – 1 year
While the pandemic induced strong government and central bank support was being introduced to support economies, other positive key themes continued to play out. The infusion of technology into mainstream old business and the newer disruptors were continuing to have a significant influence on business costs and efficiencies, along with the tectonic shift of investment thinking towards sustainability and ESG factors were beginning to drive a performance gap. These are in addition to the negative factors mentioned earlier, making it possible that 2021 may also become an even more interesting year for investment markets.
While the degree of uncertainty about so many important issues is elevated, we are quietly optimistic for investment markets, while acknowledging equity and bond market valuations appear stretched in many cases. Continued stimulus injections and government spending programs; low interest rates; the rapid development of vaccines providing a positive game changing scenario; and a more predictable government in the United States, can continue to provide support to risk assets. The current economic cycle is also being supported by the infusion of technology into new and old business models and improving efficiencies at a rate not seen before. Inflation has been tamed over recent years while input costs have been reducing, however, the scope for inflation to filter into the system is now greater than the past.
We acknowledge the seemingly high equity valuations, especially in ‘big tech’. Some correctly are pointing to a bubble developing, however, markets may remain irrational for longer than expected. However, policy stimulus has created a level of liquidity never seen before, and base short and long interest rates do not provide sufficient income for those that need it. We feel that there is a need to develop resilient portfolios, holding quality assets and that are well diversified across asset classes and geographic regions. This situation is forcing investment managers to reassess asset allocation and how the sub-asset classes will be viewed in the future.
Global coronavirus cases pass 80 million
COVID-19 will continue to be a significant influence on our lives and financial markets during 2021. It is hard to believe that with current science and medicine knowledge that we face a global pandemic, but that is a financial market thought and the sciences relating to such a pandemic are obviously very complex.
Potentially three or four widely available vaccines is a game changer of sorts, but it is hard to see life back to the previous normal or Australian international borders open until the rest of the world has the virus under control. It is interesting and disappointing to hear the self-interest views circulating, both private and business related.
The phrase, ‘only in America’ has shifted to a new level. The most dominant, democratic, capitalistic nation has a riot over elections – truly amazing! Holding guns at the door of the main US government building is more like a coup attempt. It is hard to decipher the theatre and reality with the election saga. Not wishing to take a view on political persuasion, it appears that the Democrats will control the government and the Senate, which should provide stability and a government that should be able to enact policy, with a more traditional leadership.
Monetary and fiscal policy – liquidity
The rapid response from global Governments and central banks providing monetary and fiscal stimulus avoided a major depression, and the level of support is unprecedented.
The chart above showing the growth of M1 (money stock) in the United States, which would be representative of many western countries.
Central banks and governments have tried to smooth economies over the years by different means which seem to have evolved over time. In the early years (not that long ago) interest rate policy was the lever most used; this flowed into quantitative easing following the GFC; and now there is co-ordinated fiscal-monetary policy actions. Similar to QE not being repaid over the last 10 years, neither are we likely to see the latest repaid for many years, or possibly generations.
The chart above shows the growth the US Federal Reserve balance sheet, with the recent move making the GFC expansion in 2008 look insignificant.
The next initiative, after the social support, is likely to come through public infrastructure spending which will favour sectors such as infrastructure and resources.
After the WOW thought about the volume of fiscal and monetary support being applied to global economies, we feel it is worth considering two factors: the funding costs has never been lower, which also provides incentive to keep rates low; and we feel this is like a support and rebuilding program after the devastation of a world war – it will likely take several generations to reduce the government debts created.
China remains the major and critical trading partner to Australia. Recently released Australia/China November trade data indicates it was up 11% for the month compared to October, and for the year earlier. One big client has never been a good business policy and changes should be made asap.
It is hard to understand the David and Goliath comment from the Australian government about locating the original source of the virus, however, the real problems for the China/Australia relationship began well before then which is not dissimilar to many other countries, albeit the gross percentage impact may be significant for Australia.
The US/China trade tensions have expanded under Trump. Early indications suggest a more balanced approach from the US in future; however, China has been called out on several important issues including a desire for global and regional domination. This aspect does cause concerns and history suggests there is potential to cause broader disruptions.
GDP and economic output
After the initial shock of the contraction during 2020H1, the output rebound during 2020Q3 has been strong. The chart below shows the percent change from 2019Q4 to 2020Q2 and Q3. The outlook remains positive, albeit not on a solid foundation.
Australia has been hit less severely than other countries. The OECD expect Australian Real GDP to contract by 3.8% in 2020 but projected to grow by 3.2% in 2021 and 3.1% in 2022. The vaccine rollout is expected to impact global GDP, however, at this stage the OECD expect global GDP to lift by 4.2% in 2021 after a fall of 4.2% during 2020.
Equity market valuations
There are a range of views regarding equity valuations. Equity markets are driven by expectation and sentiment, which can be quite fluid. Jeremy Grantham from GMO is calling the equity market ‘a fully-fledged epic bubble’, while others highlight the top 10 US stocks have driven the broader index performance. Likewise, elsewhere in the world we can find examples of key large companies driving the index levels, such as BHP in Australia.
Only 10 stocks divide the US and Europe
Outside 10 mega-cap growth stocks, the S&P 500 market cap tracks much closer to the Stoxx 600 in USD terms.
It is not that valuations do not matter; it is more that there are many inputs that make up a market and it is very difficult to properly rationalise and corelate each input. Our view is that the stimulus and level of interest rates are the key drivers (with the vaccine issues also on the radar), and if the dynamics of those factors change or are expected to change to the negative then the bubble scenario may come into play.
S&P 500 price earnings ratio
We feel the key is to focus on robust quality companies with strong balance sheets and earnings, that will be good and strong companies following a market sell-off.
While policy and longer-term rates are at multi-year lows, the 10-year US and Australian bond rates have ticked up over the last month. There is commentary that rates cannot stay low and therefore must rise, which would be negative for equities, other commentaries question what would push rates much higher than current levels, with the latter more likely in our view.
We find it hard to accept that longer term rates can go much higher as the liquidity argument would suggest a strong appetite to buy bonds if rates were to explore higher levels, creating a resistance for rates to go much higher. Likewise, central banks have made it clear they see policy rates remaining at current levels until the 2023/25 time frame.
US 10-year bond rates
The area that we would see the most risk if rates were to rise would be the corporate bond market. If rates were to rise the corporate bonds would suffer margin blowouts on top of any rate movements. While the low rates are also camouflaging zombie companies.
Another factor that would affect interest rates is inflation. The US and Australian central banks have indicated they would be looking at average inflation rates rather than capping or targets. The liquidity that has been pumped into the system should eventually affect inflation, however, that was the call when quantitative easing was being pumped into the system in 2008, but it never eventuated. However, the scope for inflation to filter into the system is now greater than the past. Further, mild inflation would be somewhat of a positive for asset prices. It should also be noted that the past 10 years has seen a balance between inflationary and negative inflationary factors. So where do we go from here with regards to balancing inflationary pressures?
Growth and defensive components
The traditional 60/40 growth/defensive diversified portfolio concept that has served portfolios well for a long time could now be tested and may require some tweaking.
The defensive component traditionally contained income, risk diversification and portfolio ballast. With income falling and long interest rates at record lows, the balance of risk for interest rates is biased to go higher not lower, albeit probably not for some time. However, it does highlight the defensive component now contains some issues. We have a view on how to structure this component but that entails proper advice not a newsletter comment.
The growth component has favoured growth (not value) assets for many years. While some style rotation has crept into performance attribution, we are not sure if the growth to value rotation will occur in the traditional manner. Technology infusion, and similar, will continue to significantly influence business efficiency and drive profits. It would seem the value/growth metrics may be shifting, and investors may need to rethink other complimenting factors other than the traditional perspectives.
The components of the traditional balanced portfolio may need some adjustment to bias the growth component to be more defensive and the defensive component needs to be adjusted to reduce risk. As an example, the anticipated infrastructure spend will attract new capital and provide reasonable cashflow, while providing a less volatile exposure and diversification away from mainstream equities, within the growth component. However, some forms of infrastructure do contain full equity like risk.
ESG, sustainability and impact
We have been discussing ESG, sustainability and impact related investing for several years. We feel this will continue to have a dominating influence as investors become more aware and more concerned. The gap between premium and discount pricing in this space is expected to continue to widen and will continue to do so for many years. As an example, think of mining companies that have regard for socially conscious aspects of the impact of mining and those that do not. One may trend towards a premium while the other may trend towards a discount. We feel investors are being forced to be more conscious today. Over time this should have a significant effect on compound return.
While vaccines and a decisive US election outcome provide a degree of robustness to global economies and investment markets, the degree of uncertainty remains elevated while a range of risks remain fluid.
Markets still seem to be in a super cycle mode and although at high levels, we remain quietly optimistic for investment markets.
We feel the level of stimulus with tangible signs of it being continued as required, low interest rates, and efficiencies being built into equity earnings in some areas, will all provide support for equities for some time. Quality (balance sheet and cashflow) and liquidity are the key attributes required for equity and fixed interest assets, and in turn look to develop longer term resilient portfolios.
Index Returns – 31 December 2020
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