Economic and Asset Performance Comment – July 2020
In addition to the surreal global situation caused by the COVID-19 pandemic, investment markets are experiencing quite an amazing period. The medium-term outlook for markets is heavily dependent on the outcome and impact of COVID-19. At this stage, the markets and the economies are on divergent paths and it is quite an unknown when and how they eventually converge. Markets experienced one of the most severe sell-downs recorded during March and has been followed in the June quarter by an equally steep recovery.
In short, the massive fiscal and monetary stimulus provided by central banks and governments around the world has supported expectations for a recovery sooner than was first thought. Equity markets have always been forward looking, not backward, and although hard to rationalise, while the stimulus is providing markets an economic recovery expectation, the control of and time frame of the pandemic remains a total unknown. What is known, is that the debts and capital expansion packages that have been put in place, so far, will impact the global government balance sheets for many years to come.
The government-imposed lockdowns put economies into hibernation. To avoid a global depression, that would result in significant future suffering and cost, the losses have been socialised. Stimulus packages will add to global government debt, of which some countries are better placed than others, however, it is hard to imagine the support being totally unlimited. To consider how this may play out; following the 2008 GFC, the Federal Reserve balance sheet expansion that provided economic life support was never reduced after the private sector had stabilised. Therefore, it is hard to expect it to be reduced following the current crisis. Are massive government and central bank balance sheets part of the new normal, or will future inflation wash away the debt problem, or will there be a bout of sovereign debt defaults and currency devaluation? Only the future will tell. Manage and, to a reasonable extent, control the pandemic crisis, and the economies and markets should return to more normal growth patterns, albeit with abnormal levels of debt.
There are other factors and risks at play, however unfortunately the coronavirus is front and centre at this stage, and there will be some form of resolution and global economies will continue along a path, although there is significant uncertainty of timing and composition. Another observation is that the coronavirus has caused an acceleration of digital and technology driven influences in the broader economy which is likely to bring further productivity and earnings gains.
The OECD consider the following to be the process flow and consider that “this is a marathon not a sprint, and we are only in phase 2 of the pandemic crisis”. In reality, a vaccine is no certainty, but treatments are likely.
COVID-19 has had a significant impact on the modern world. There has not been a news report since the middle of February that has not discussed the topic in some way. The chart opposite highlights the growth of new cases which has not begun to subside, although many countries have contained the problem.
It remains clear from the chart below that the United States, South America, Russia, and India contain half the global cases. The United States is roughly half of the world economy and therefore the degree of control will be quite influential on the outlook for the global economy.
The trend lines shown below indicate a degree of control being achieved, however, recent commentary from the chief US health officer may suggest otherwise. Time will tell.
Fortunately for Australia (see below), early and strong controls have paid off in a health sense, and we now need to see if the economy can be sufficiently remediated.
It feels like some form of apology is required, providing so much commentary on a medical related topic rather than an economic or market aspect, but that is the world that we are currently living and the medical outcome will drive the economic outcome.
The GFC, a banking system crisis, was 10 years ago. The banking system all but stopped one day and the Federal Reserve was forced to make a very quick decision to fund and restart the banking system, after what appeared to be a major cardiac arrest, from later reading of FOMC meeting notes. From memory the opening offer of assistance was circa USD1 trillion and steadily grew to USD4.7 trillion. Other central banks followed suit. The method of surgery applied seemed to work, but unfortunately the stimulus involved was never recalled out of the system. During Q4 2018, the Federal Reserve started to withdraw funds from the system and caused a major market selldown.
The coronavirus is a health crisis, that is having a similar effect to the global economy as the GFC. Following the acknowledgement of the severity of the coronavirus to world economics, the opening offer from the Federal Reserve was circa USD4 trillion. Reasonable questions include: How much more will be required? What time frame before the economies has been helped through the current heart attack? Will the initial magnitude of stimulus provided be sufficient support to kick start the economy? The answer is clearly: We do not know!
Above is a great chart from the IMF comparing the stimulus applied during the GFC and the early phase estimates for the coronavirus.
The following chart from the IMF is busy but it highlights the volumes and complex support from various countries and groupings. How will this support be paid for or repatriated to the beneficiaries? It feels like a massive global devaluation, but it’s too soon to know.
The chart below is cleaner and shows the Federal Reserve balance sheet during the GFC recession period, and the right-hand side is the early phases of the current crisis.
The positive side of this debate is that for every previous crisis, no matter how significant, equity markets recovered and grew (note the chart below). The unknown has always been along the lines of, whether markets and stimulus will follow the same format as previous or if there is an unrelated reset. We feel reasonably strongly that there will be a reset, along the lines of pre-corona and post-corona business models and economies. Some business and sectors will not exist, while others will be stronger and more dominant. Think, blacksmiths and bricks and mortar retail shopping. Will the growth in earnings from technology related or driven companies absorb the change of fortunes for older style business models and industries? Major shifts in these factors are most likely to occur.
The economy and the impact
It is very early days, however global GDP growth, a major driver for equity pricing, indicates a major downturn during 2020. The stimulus is designed to reverse that trend in the shortest possible timeframe.
Below are charts that highlight the impact to the Asia Pacific nations.
While there has been a massive spike in United States unemployment and a significant retraction of the overall US economic index, the tail on the chart below indicates an equally sharp, although early phase, recovery. We will only know the true position in 3 to 6 months from now, after the effect of the stimulus sugar hit saturation is known, and the economic and health reality has set in. The same could be inferred for the rest of the world.
Close to our hearts in Australia, China suffered a 12% GDP hit during Q1 2020, compared to 5% following the GFC.
China managed the coronavirus with military precision in the early days, arresting the manufacturing downturn, almost immediately, as shown in the PMI chart below.
China’s retail sales growth has been in decline for several years, which may highlight a generally softening economic trend, however, it did come to a cliff during Q1 2020.
China is integral in the future growth and development of the world, but more so for Australia.
While Australia has managed the coronavirus exceptionally well, economically we are very dependent on the global economy. As shown below, business and consumer confidence has reversed from the lows, however, it remains fragile.
There are no surprises that spending on goods (aka Bunnings) expanded during the crisis, while spending on services contracted. The initial recovery has been quite strong, but this will have been supported by job keeper/seeker, and the unanswered question is whether this will be maintained at a level that will support a transition of business from pre-corona to post-corona. Unemployment levels are currently distorted (at 7.1%) and would be expected to remain at elevated levels for a long period.
A key driver of economic growth and confidence is residential house pricing. The chart below highlights Australian house prices have rolled over slightly, however; sentiment has plummeted.
Australia has a high private mortgage debt relative to many other developed nations, however, this is supported by the ever-reducing interest cost and increasing serviceability.
Global equity markets suffered, if not the largest, one of the largest and deepest sell-downs in history, and then followed by the most amazing steep short recoveries, as if nothing had happened. Well something has happened and, unless a vaccine is developed and deployed effectively, the global community and economies are unlikely to be the same again. That does not mean worse, and may even mean better, eventually, but in the meantime the world is filled with uncertainty. Generally, markets do not like uncertainty with so many unknowns. Which is perplexing, with markets as strong as they are, with the known knowns.
A very interesting point to note is highlighted in the chart below. The gold line is the five major US tech stocks; the light blue line is the S&P 500 (ex 5 tech stocks); the dark blue line is the MSCI World (ex US). Quite an amazing chart. It highlights what has really been occurring since the 2000 Dotcom boom. Technology is infiltrating the system and driving productivity, communication, transport, health, and anything else that you like to list. Post-corona will be heavily influenced by technology. Anything with a meaningful business and a disruption model is being priced at ridiculous multiples. Some will fail, but many will change our lives. As a general comment, five years ago, Amazon was priced at an eye-watering multiple and many analysts called it a monumental failure about to happen; and Tesla has been described in a similar manner. Amazon is now one of the largest and most influential companies in the world and Tesla has recently grown to a higher capital value than Toyota and the combined value of GM and Ford. The market is developing a view about the future of these technology driven companies. The blacksmith industry disappeared and most likely, eventually, so will the petrol engine. The importance of technology continues to grow, while selectively old industries are likely to subside, and this is all happening while a coronavirus pandemic is affecting the modern world.
In the chart below, the Dow Jones (in gold) has outperformed the All Ordinaries (in black) by about 15% over a one-year period. Australia is often considered a proxy for emerging markets and heavily reliant on demand for resources from China and others.
Equities are priced on many valuation, economic and sentiment factors. One conundrum we face is that price to earnings ratios are at historic highs. In simple terms, earnings transform to dividends and dividends are compared to other opportunities available such as interest rates. Interest rates are at long term lows and therefore it is not unreasonable for equity PE’s to be at long term highs, which is one of the many factors that affect equity prices, and these are currently supportive.
Another factor is the stimulus. Some may refer to it as the Federal Reserve ‘backstop’; and Trump is a markets guy; so it is not unreasonable to expect the Federal Reserve to be supportive of the markets, at least until the US elections. Fiscal and monetary stimulus is being applied at unprecedented levels across the entire world.
If we re-consider earnings in a post-corona environment. The influence of technology may well shift the balance of earnings towards technology stocks, and further, that earnings will shift away from many old-style industries. But we have no idea of the actual dollar value that will transition either way, and therefore, the earnings outlook remains quite uncertain.
The US 10-year Treasury Bond rate going back to 1962 (below) shows that we have had low rates before and the peak was 1981. A very long cycle.
The US 10-year bond is currently 0.60% and some have suggested it can not remain at these levels for long. We have the view that rates can remain low for the foreseeable future, as the system is awash with liquidity, leaving supply and demand in favour of the borrower and continued low rates. It may also be reflecting slowing economic activity and this may eventually affect inflation but that should be a few years out from here.
Credit spreads (see above) have retraced back towards pre-corona levels, while high yield is lagging investment grade credit. This is a sector that may provide opportunity, but the risk is high if there is another sell-off of equities. Credit is a hybrid with margins and risk that sit between equity and treasuries.
Australian property has provided a strong return over the eight-year period shown above, largely driven by demand for yield. The March sell-down highlighted the vulnerability of the sector, however, although the recovery should follow, we question the future of property, as a general comment. We favour infrastructure due to more predictable earnings, broadening portfolio diversification and a smoother returns profile when comparing to equities and property.
Global political and health issues are controlling the newswire. The degree of uncertainty is quite unnerving. However, the quantity of stimulus and the telegraphed intention to maintain the high levels of stimulus remains supportive for risk assets, while the level of uncertainty, risk and questioned economic outlook is at elevated levels. The phrase, ‘don’t fight the Fed’ comes to mind, but exposures should be moderated as price levels increase.
Source: Lonsec, Bloomberg
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