The COVID-19 pandemic continues to dominate the landscape, from humanitarian/social and global economic perspectives. The impact of new waves of infection and the uncertainties surrounding the economic cost is confused by strong equity markets. The record low interest rates and government fiscal stimulus provide support for strong equity markets but also highlight the degree of economic hurt being felt.
There are several significant sideshows that are likely to influence equity and interest rate markets. The world has previously faced significant risks and imposition caused by other black swan events. However, it would be fair to say, for most of us, COVID would be the most significant and will most likely cause some change in the way we live. Humans are resilient and adaptive, and therefore we would expect this significant negative influence is likely to also cause positive change. We have previously described the COVID event in terms of pre-corona and post-corona, and six months on, post-corona is a developing definition.
There is no doubt that risks and uncertainty are currently at extreme and elevated levels. But there is always risk and uncertainty, which is what makes markets move and sells news media. A few of the risks and issues that we currently face include:
- How and when, or is it possible to, limit the impact of COVID-19 on our health and everyday life. What will be the resulting economic impact?
- US elections. Do they really matter?
- The growth of global debt. Will this be accepted as the norm, or will it cause a global financial collapse.
- Globalisation at the crossroads. Trade wars and cultural differences seem to have the world going along two paths.
- Lack of respect for the environment that we live in. A part may include ‘climate change’ but overall, we don’t seem to respect the planet which displays a degree of fragility. Investors are rethinking investment allocations.
The negatives are well reported, and we discuss some later in this note, however, positives also continue to influence our society. The most significant is the impact of technology in business and our general way of living. Moore’s law is an observation named after Gordon Moore, the founder of Intel (the computer microprocessor manufacturer).
According to Wikipedia, Moore’s law is the observation that the number of transistors in a dense integrated circuit doubles about every two years. Gordon Moore, in 1965, put forward the argument of the components per circuit doubling every year and projected this growth rate would continue for a decade. The infusion of technology into our way of life has been occurring way past Moore’s expectation, and at an increasing rate.
Over the last few years, technology has infiltrated our lives and has caused disruption to almost every aspect in a magnitude that can be compared with the industrial revolution that extended from 1760 to 1840. This infusion of technology has been so influential and recognised in equity markets by the rate of growth and concentration within half a dozen big tech stocks. COVID-19 has caused an acceleration of this infusion, with many saying 5 years of future influence has been compacted into as many months. Like technology or lump it, it is with us to stay and there are many companies taking advantage in a post-corona scenario, while many pre-corona companies begin to fail. Adapt or fail; we have the tools to adapt efficiently. Moore’s law continues within the broader economy.
COVID-19 was initially thought of as an animal-sourced virus that would come and go with little global impact, similar to SARS and MERS. As this virus engulfed the world, daily cases grew to around 250,000 between March to July 2020. The chart below from Johns Hopkins University shows the global growth of new cases has flattened, albeit at a high level.
Source: Johns Hopkins University
Australia has been fortunate to contain the virus, death rate and social impact to relatively low levels. Other continents have been less fortunate, and several centres such as the United Kingdom, Ireland and Spain are heading into second waves, while the United States is struggling with the first wave, and in the under-developed countries it is a disaster. The World Bank has recently supported Australia’s early lockdown saying, “without success on the health front, there would be no return to business as usual”. There is no doubt we need to adapt to living with COVID, until and if, a vaccine or suitable treatment is developed.
The reality is that no one knows the ultimate outcome. Without a vaccine in the near term there will be quite a dislocation from the previous norm, and further contraction from globalisation. It is not practical to continually go in and out of lockdown, and high death rates will not be acceptable. Vaccine, medical management, or movement restrictions seem to be the likely options.
It is quite painful to talk about the upcoming US elections in the United States. The coverage and antics are at a level never seen before.
Source: The Australian – Johannes Leak
It is difficult to predict the outcome; both candidates lack credibility and obvious competence; and in a sense the seemingly minor differences in policy will be sidelined while dealing with issues surrounding the pandemic. While Trump has been quite an unconventional president, the US elections may not have a big influence on market directions; although they are likely to generate a degree of uncertainty.
The awakening and development of China presents other challenges where what is a controlled economy has a desire to integrate with the free western world. Trump has called them out, but other western nations have similar concerns. Australia is in a difficult position; however, a greater degree of diplomacy from our government would be preferred when dealing with a major trading partner.
GDP and economic output
Global GDP output contracted sharply in the first half of 2020, as can be seen from the chart below.
There are no surprises from the Google search data (below). Travel, hospitality, and events suffered significantly, with little positive change at this stage.
The latest forecast GDP trajectory (below) is significantly lower than this time last year. The extent of the GDP contractions is hard to comprehend, however, after a reset, economic growth will continue, albeit taking a long time to recover back to previous gross levels.
Economic forecasts drive policy decisions. The chart below from the IMF highlights the fact that no one has a clue how COVID will affect the global community, either health or economically.
Source: Consenses Economics; and IMF staff calculations
The IMF in June projected global growth at -4.9% in 2020, being 2% lower than forecast in April 2020. Global growth in 2021 is projected at 5.4%, leaving 2021 being 6.5% lower than the pre-COVID projections made in January 2020. With such a high degree of uncertainty from organisation such as the IMF, with access to the best data sets, how do we expect companies and mid-size governments to effectively manage the near-term future and investment decisions?
Growth of global debt
The biggest experiment so far! For years we have been told debt is bad and we should reduce it. In the case of corporate debt, it should be in balance with asset backing and net earnings potential.
Source: St. Louis Federal Reserve
The chart above is the Federal Reserve total assets. Immediately following the GFC they increased by USD1.5 trillion and then steadily climbed to USD4.5 trillion. Immediately following the COVID-19 collapse their assets expanded to USD7 trillion, and anyone’s guess where it gets to over the next few years.
The expansion of global debt has only just begun and current broad global numbers are not yet circulating. The picture is that global governments, fiscal and monetary policy, and corporates are following the same paths as the Federal Reserve illustration above. But do they have an option? How does that finish up, regarding gross global debt levels and interest rates? It is hard to see how debt levels return to pre-GFC numbers, and equally hard to see how interest rates rise anytime soon. The latter is good for borrowers but bad for investors looking for low risk income.
The chart below highlights the growth of leverage within investment grade company balance sheets over the last few years. The system is awash with liquidity and masking the health and solvency of mid to low ranked corporates. We consider corporate credit to be the highest risk in the current markets, more from a negative perception shock to investors rather than an absolute perspective.
Equity market valuations
The chart below provides a significant piece for the jig-saw puzzle. Following the 2000 dot-com boom and the 2008 GFC, the risk-free rate (30yr US Treasury) provided safe haven and higher earnings than the S&P 500 Index dividend yield. This was an easy decision, sell risk and buy bonds, and receive a low risk income. The circumstances are quite different in 2020, where the alternative income return is close to zero. This phenomenon supports equities and helps explain the steep recovery during April and May this year, which was a surprise for most.
When we consider market price earnings ratios, and if interest rates remain low for a longer period, then we can expect the average PE’s to be a lot higher than the long-term averages.
US 30-year treasury yield versus US S&P 500 dividend yield
Source: The Business Insider
The chart below highlights the rate of valuation expansion for the five big tech stocks compared to ‘the rest of the market’. Firstly, the rest of the market performance is apparently flat, and secondly the five tech stocks have recently gone through a significant retracement. Our thoughts are that there must be plenty of companies in the middle ground providing opportunity. This is a global phenomenon, but the big uncertainty is if we fall off a global economic cliff, as support is curtailed, which is the great unknown.
The chart showing the regional equity market recovery rates is interesting and highlights areas of opportunity or defensive positioning.
While it is hard to understand the persistent strength of equity markets, not all are convinced, and a lot of cash has accumulated on the sidelines during the past year, as the chart below highlights.
It is true the risks are elevated, and the equity market strength is confronting while so much uncertainty prevails.
ESG, sustainability and impact
The investment world is now becoming firmly engaged with the health state of the planet. An increasing number of investors are restricting the investible universe, which is likely to see relative performance gap develop between ESG and non-ESG minded companies. Recently, BHP has announced plans to exit the coal business. Energy has shifted from high cost alternatives to lower cost alternatives, and they are now looking for alternatives that will work and be cost effective.
The earlier phase ESG ratings were not solid, and quite convoluted. An ethical manager that put forward an investment thesis suggesting banks would be more ethical after the Royal Commission and therefore one of his best picks, was putting forward a laughable proposition. The world has come a long way regarding ESG, sustainability and impact. The chart below highlights the divergence of the MSCI All Country and the FTSE Environmental Opportunities indexes (ignore the green lines). This trend is likely to continue.
Source: Nanuk, Bloomberg, FTSE, MSCI
The Australian Budget
Budget commentaries are available in abundance. We would like to narrow down a few observations.
The budget is pitched to provide a business led recovery after the biggest economic shock that we have faced in our lifetimes. Support funding is targeted to provide for business growth and employment. Tax cuts, tax incentives and employment incentives for companies and individuals.
Australia’s net debt is forecast to increase from $500 billion in 2020 to $1 trillion in 2024, representing 25% of GDP in 2020 and increasing to 44% of GDP by 2024. The chart below highlights that Australia had a relatively low debt to GDP ratio in 2019 by international standards.
The chart below shows fiscal measure estimates provided by the IMF in June 2020. The recent budget forecasts provide for a slightly higher level of spending. Given the ‘whatever it takes’ approach from most developed countries it would be fair to expect the other countries to also exceed IMF estimates.
The Budget is forecasting real GDP to fall by 1.5% in 2020/21 and then rebound by 4.75% in 2021/22. The key will be the consumer and whether budget measures favouring the consumer are directed towards spending or saving. Unemployment is now expected to peak at 8% in December 2020 and remaining above 6% through to 2022/23. The Budget is expected to remain in deficit through to 2023/24, with annual deficits running from 11% of GDP in 2020/21 down to 3% in 2023/24.
There are more unknowns than knowns, and markets do not like uncertainty. In that sense, markets feel fragile and should be expected to be volatile for the foreseeable future.
We are not overly phased by the appearance of high equity valuations when based on price earnings multiples or low interest rates. However, there is also an argument for equity and interest rate markets being at long term highs, leading to a cautious attitude. We are moving through a period of structural change and growth, which could extend the current cycle. It feels like we are in the middle phases of this structural change, which is likely to be supportive for equities, where the companies are positioned well for the change. Likewise, for interest rates, long dated rates are low but in the case of an equity market selloff, the flight to quality trade will prevail, supporting quality sovereign bonds. This will not be the case for long dated corporate bonds where we foresee challenging times and the riskier part of the market. Short-dated corporates are less risky, depending on quality.
Geopolitical risk also remains elevated, and Australia feels to be exposed as piggy in the middle of a larger global issue. Australia has been well supported by the resource base and would do well to broaden the client base and supply chains. Australia should also look to improve manufacturing, internal supply chains and its place in global technology development.
From the wide range of available alternatives, we favour transparent and liquid assets. In this type of market, liquidity premiums may look attractive but 2020 highlights the volatility and lack of true price discovery that can be present. Fixed income allocations should include government treasury fixed income assets. While interest rates may be low the ultimate features of liquidity, flight to quality, and true pricing are only revealed during equity selldowns. Higher levels of cash remain appropriate.
Index Returns – 30 September 2020
|Sector Returns (%)||FYTD||1-month||3-month||6-month||1 year||3 years||5 years|
|International Shares – (unhedged)||3.78||-0.31||3.78||9.94||4.3||6.69||11.20|
|International Shares – (hedged)||6.42||-2.94||6.42||25.40||6.38||4.13||6.97|
|Australian Listed Property – ASX||6.96||-1.50||6.96||28.30||-16.70||-0.72||3.72|
|Global Listed Property (hedged)||0.62||-2.57||0.62||9.26||-21.60||-5.65||-2.03|
|Global Listed Infrastructure (hedged)||-0.37||-1.77||-0.37||10.50||-17.90||-1.62||-1.13|
|Global Bonds (hedged)||0.68||0.37||0.68||2.96||3.47||6.59||4.66|
|CRB Commodity Index USD||7.64||-3.07||7.64||21.9||-14.60||-12.80||-6.74|
|Aust CPI (at previous quarter)||-0.09||-0.03||-0.09||-1.97||-0.95||0.35||0.86|
Source: Lonsec, Bloombe
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