Global share markets have continued to recover from the losses experienced in March, although we’re yet to see certainty and confidence at pre COVID-19 levels return. Sentiment and economic activity have been boosted by the record amounts of monetary and fiscal policy stimulus provided by governments and central banks around the world, along with potential vaccine developments and opportunities arising from changing societal preferences. While it is encouraging that economic activity has improved, the base was low and with new COVID cases rising and employment weakening, the next stage of the recovery will be more challenging.
During the crisis, things have changed so quickly that economic data published by governments is often a mere snapshot of recent history rather than an indicator of where we are or where we are headed. The point is that we are likely to live with the economic consequences of this pandemic for a long time, although it is too early and too difficult to discern what those consequences will be. Of course, this pandemic will be different from the others, not least because of the existence of medical technology and more sophisticated government policies. Still, we don’t know what we don’t know. For businesses, this is an especially difficult map to navigate.
For now investors have taken this on board and appear to have discounted this year in terms of economic growth, instead focusing on a recovery in 2021. While markets have had a strong quarter, investors should continue to expect higher than usual volatility in the short term, given elevated market volatility, ongoing news flow regarding COVID-19, changes in economic activity, policy responses and investor sentiment.
The coronavirus shock is also accelerating structural trends in inequality, globalisation, macro policy and sustainability. This is reshaping the investment landscape and will be key to investor outcomes. The most important action investors need to take today, in our view, is to review their strategic asset allocation to ensure portfolios are resilient to these accelerating trends. Normal business cycle dynamics do not apply, three areas of concern are:
- How successful economies are at restarting activity while controlling the virus spread;
- Whether stimulus is still sufficient and reaching households and businesses;
- and whether any signs of financial vulnerabilities or damage to productive capacity are emerging
The strong recovery in risk assets is consistent with investors having essentially written off the first and second quarters. While the recovery appears to be global—in large part due to the global nature of the virus that triggered the recession—there will still be winners and losers. The capacity to provide fiscal and monetary stimulus is likely to be a key determinant of the pace of recovery. So too will be choices around how to contain any future outbreaks of COVID-19, although we expect many countries will want to avoid a new round of lockdowns, preferring more targeted restrictions that minimise economic damage.
Economic analysis (Australian Update)
While we as a country prepared for more significant falls in economic activity over the second half of 2020, the true impact of the economic shutdown is still to be revealed. Recent data released by the Australian Bureau of Statistics showed Australia’s economy contracted by 0.31 per cent in the three months to 31 March. While the figures for June have not yet been released for the June quarter markets are anticipating another negative quarter. A recession is defined as two or more quarters of negative growth in gross domestic product (GDP) — the measure of all the production the entire economy manages to generate. Thus would end the extraordinary run of growth which began when Paul Keating dragged the economy out of the 1991 global recession, referring to Australia’s experience as “the recession we had to have”. Australia weathered the early 2000s worldwide recession, the 2008 Global Financial Crisis (GFC) and minor blips along the way such as the 2015 Chinese stock market crash and the EU bond crisis.
The Australian Federal budget moves sharply into deficit during economic recessions. The marked contraction in activity associated with economic shocks or recession leads to the jaws of death for the budget: falling revenues and rising expenditures. Monthly financial statements are available to May. These show that the deficit for the year to date, the eleven months to May, is some $64.9bn. Revenues for May were down on the same month a year ago by close to 19%. Expenditures have exploded to be almost 50% higher than the same month a year ago. The Morrison government will record the largest deficit since the collation of budget figures by the federal Treasury which is the $54.5 billion deficit recorded by the Rudd government in 2009-10 during the global financial crisis. It equated to 4.2 per cent of GDP.
To further stimulate the economy the government now has plans to expend an additional $72 billion to accelerate 15 major transport and resource industry infrastructure programs to provide about 66,000 jobs on top of three active stimulus packages valued at $154 billion. Scott Morrison also stated that the finances were likely to get worse as global economic plunge has ruined the demand for Australian exports. He added that the record deficit was not only because of high expenditure due to coronavirus, but revenues have been equally affected. The impact on revenue is expected to be long-lasting as revenues have taken a large hit, and lower expenditure measures have been formed to be more targeted and time bound. A recalibration of fiscal strategy is needed for this to happen.
The government is now facing the challenge to balance the need to ease back on the JobKeeper/Seeker payments (which are scheduled to expire in September) and the requirement to maintain support for the economy particularly for those employers who will continue to have their businesses affected by the ongoing restrictions which will be necessary to maintain control of the virus.
The ASX200 finished June up 2.5 per cent for the month, up 16.2 per cent for the quarter, down 11.8 per cent for the half-year, and the financial year down 10.8 per cent.
While the falls in markets has presented some buying opportunities since the beginning of April in the next month or two may see some weakness, so those looking to add should still get the opportunity. Based on consensus expectations, financial year 2020 earnings are expected to decline by 20%, approximating what occurred during the GFC. A lot of bad news has been factored in. But like the GFC, earnings are expected to recover – by 8% in 2021 and 13% in 2022. Not only are earnings expected to recover, but there is evidence that earnings upgrades are starting to filter through, as companies gain confidence in forecasting future earnings and economic data is not as bad as previously feared. The retail sector has been surprisingly strong as consumers spend superannuation withdrawals, receive government support, and the increase in expenditure to enable work from home.
The large miners are also due upgrades based on spot iron ore prices. Energy producers should also see upgrades based on the current oil price. Even the banks appear to at least be meeting expectations as bad debts are contained so far. We believe economic and earnings data will continue to improve as the economy opens. Australia’s effort in controlling the virus, leverage to China which is essentially back to work, and massive fiscal and monetary support, should continue to see an improved earnings outlook. Australian equities have already recovered The ASX 200 has risen 31% since its March low. Capital gains have occurred against the backdrop of earnings per share (EPS) downgrades, such that the market’s price-to-earnings (PE) multiple on a 12-month forward consensus basis has risen disproportionately to almost 19x. Investors have now started to question whether the market has become too overbought, if not too expensive. To be sure the easy gains have been made, but the rise in PE is very similar to the GFC experience as the recovery got underway. PE’s early in an earnings recovery should be high. Admittedly the PE is higher than the recovery phase of the GFC, but very low interest rates do justify a higher PE going forward, as the discount rate applied to future profits is reduced. Historically, PE falls with earnings recovery rather than a decline in share prices. Apart from showing some absolute upside in the medium term, we also think Australian shares look attractive relative to international shares.
In second quarter 2020 commodity prices rebounded as some optimism returned to the industrial commodity markets. Chinese demand began to rise, crude oil made a comeback, and base metals and other raw material prices rose. If the impact of central bank and government stimulus in the aftermath of the 2008 financial crisis is an example for industrial commodities, we could see prices move a lot higher over the coming months and years. The amount of stimulus in 2020 is far higher than in 2008. At the same time, the value of the US dollar index declined by 1.76% in Q2, which is also supportive of base metals, industrial raw materials, and other commodity prices. The bottom line is that the response of governments around the world supported the industrial sector of the commodities market in the second quarter. Coronavirus in Q1 caused the price of nickel to collapse, but the price held the $11,000 per ton level and moved higher over the second quarter.
Falling real yields, thanks to expansionary monetary policy, coupled with the global economic uncertainty brought about by the coronavirus pandemic, has provoked traders to diversify into precious metals. Gold prices, having weathered the storm of improved risk appetite, appear to be gearing up for another move to fresh yearly highs, and their highest level since 2011. Gold prices have a relationship with volatility unlike other asset classes, even including precious metals like silver which have more significant economic uses. While other asset classes like bonds and stocks don’t like increased volatility – signalling greater uncertainty around cash flows, dividends, coupon payments, etc. – gold tends to benefit during periods of higher volatility. Heightened uncertainty in financial markets due to increasing macroeconomic tensions increases the safe – haven appeal of gold.
Oil has recovered from its 21-year low of below $16 in April. The oil market is getting closer to balance as demand gradually rises and OPEC+ continues cutting production. Since May OPEC has cut oil production by 9.7 million barrels per day after the coronavirus crisis destroyed a third of global demand and caused a price collapse. We expect oil prices to continue to recover as economies come out of lockdown providing a much-needed resurgence in demand.
The short-term implications of COVID-19, which have hit the Australian real estate investment trust (AREIT) sector, should not detract investors from the sectors long-term outlook, given that REITs are currently far better positioned to recover than during the Global Financial Crisis (GFC).
Although some sectors continue to be more severely impacted than others. The office subsector continued to be affected by softer tenant demand which was expected to persist in a recessionary environment, the vacancies across the Sydney and Melbourne’s CBDs were still at low levels and the introduction of social distancing measures may further assist in pushing against the densification of workplaces.
Nobody doubts retail landlords face severe economic, e-commerce and legal (rental contract) headwinds. The question is, how much of that is already priced into valuations? Coronavirus health outcomes are far better than expected. Social-distancing restrictions continue to ease. Shopping-centre landlords report rising foot traffic and store reopening. Longer term, we do not expect that consumers will switch in masse to online shopping after COVID-19
Overall, REITs are managing through a very challenging environment… they were at the front line of closing the economy but are poised to lead in the recovery. Additionally, AREITs benefitted from monetary policy and extensive fiscal stimulus measures announced by the Federal Government which also provided some support for the sector. As a result, Australia was ahead of expectations and opened the economy which had a positive impact on the REIT sector. Most ASX REITs haven’t yet told the market what their intentions regarding dividend payments are for the rest of 2020. But we are expecting further cuts in yields.
Global PMIs have shown that economic activity improved further in June, though conditions remain depressed. The next stage of the recovery will be more challenging as pent-up demand is likely to fade while COVID concerns are intensifying.
COVID-19 brought about significant increases in the size and scale of government debt programmes. The current support to Australia’s economy is almost 10% of GDP, while in the US it will exceed 19% of GDP for 2020. This increase in government debt is a global phenomenon, with the deterioration in debt-to-GDP ratio most severe in Europe. The substantial increase to debt burdens will impede governments’ flexibility to provide long-term stimulus and support. So, how economies respond to the increased debt burdens will likely define the strength of future growth.
European economies are emerging from lockdown and, so far, there has been no evidence of a significant second wave of infections. Europe’s disadvantage heading into the COVID-19 crisis was its lack of policy ammunition. The European Central Bank (ECB) policy rate was already negative, there were strict rules around increasing fiscal deficits, and high-debt countries like Italy were at risk of a re-run of the 2012 debt crisis. The policy response has surprised to the upside. The ECB has increased its asset-purchase program by more than 12% of GDP. Rules on fiscal deficits have been temporarily relaxed, resulting in fiscal stimulus of around 3.5% of GDP across the region.
In Europe, the unemployment rate has remained quite low compared to that of the United States, even amid a historic decline in economic activity. This is because many European governments have implemented employment protection programs, which offer subsidies to employers for keeping workers on the payroll even when businesses are closed. In the five largest economies in Europe—Germany, France, the United Kingdom, Italy, Spain—these programs have helped 45 million workers, or about one third of the labour force. The result is that in June, the unemployment rate in eurozone was only 7.4%. However the subsidies are only meant to be temporary, although many governments have extended the programs by a few more months. The cost is enormous and most governments expect to ultimately end these programs, with the hope that employment will quickly rise as economies recover. It is likely that there will be a spike in unemployment as these programs end later this year.
China’s economy is certainly improving but has not yet returned to pre-crisis levels. Proxy indicators like traffic congestion levels may suggest a recovery since they are higher than last year. However, these levels are higher because people are social distancing and avoiding public transport. The recovery in China has continued through the second quarter of 2020, with the services sector starting to catch up to the manufacturing sector. Construction activity has seen significant improvement in the last month, and there remains a large pipeline of infrastructure projects to be started.
The Federal Reserve has taken extraordinary measures meant to assure that credit markets stay open and available amid the viral outbreak. At the beginning of the crisis, indicators of financial stress started to rise, leading the Fed to act quickly. It cut interest rates, bought assets on a massive scale, and loaned money to inject liquidity into the economy. These actions were successful in that measures of financial market stress quickly improved. A potential seizing up of credit markets was averted.
Given the stimulus the market rose about 45 percent in the 53 trading days from its March 23 low. This positive run has prompted predictions that the stock market is telling us that better days are near at hand, despite more than 134,000 deaths from the coronavirus pandemic, tens of millions of recently unemployed people, (even after last month’s reported, employment gains), civil unrest in cities and towns throughout America, and political and social divisiveness, which we suspect may be the country’s biggest problem of all. The S&P 500 is back above 3,100 on July 3 and the Nasdaq hit a record high on June 10. Meanwhile, commentators have been lining up to claim that markets are detached from fundamentals.
For sure, US markets seem to be priced for an optimistic outcome of no meaningful second wave of infections as lockdowns are lifted. But record levels of fiscal stimulus, sustained low interest rates and ongoing low inflation create a supportive environment for risk-asset outperformance.
The main risks come from a second wave of virus infections and the approaching U.S. federal elections in November. The U.S. federal elections are too close to call. They will become a bigger focus for markets if the Democrat nominee, Joe Biden, takes a decisive lead. Biden plans to at least partially reverse President Donald Trump’s 2017 corporate tax cuts. This could deliver a hit to earnings per share in 2021. One of the key watchpoints will be the election outcome of the Republican-led U.S. Senate. Democrat control of the White House, Senate and House of Representatives would make a corporate tax hike more likely. It would also create the risk of more corporate regulation.
During periods of market stability financial markets tend to be driven by where we are in the economic cycle, but this isn’t a normal cycle. The last cycle ended abruptly with global policymakers prioritising the protection of public health above immediate economic concerns. The huge spending programs can’t carry on indefinitely and as they come to an end, it’s hoped economies will pick up where they left off. However, the disruptions to supply chains and employment suggest there could be longer-lasting economic damage that will weigh on the growth potential of our, and other global economies.
With an unprecedented amount of cash in the system, equities and high yielding bonds are attracting a lot of interest from investors in the absence of acceptable yields from money markets and longer-term government bonds. That may continue to push risk assets higher, although valuations are approaching extreme levels. To keep this rally alive, we need more intervention from fiscal and monetary policymakers and for investors to believe that policies will be generous enough to provide further liquidity.
But there are plenty of reasons to be cautious, and we will almost certainly see bouts of volatility and market weakness along the way. It will also be interesting to learn more about the challenges that companies are facing when they report their second quarter results in the next few weeks and, in particular whether management have any more clarity on the future outlook. While there may be some link with reality and the value of stocks, a large proportion of what we’re seeing is a reaction to things seemingly not being as bad as first thought, and also a wilful desire to pretend things are not as bad as they are. For investors, it makes sense to retain sufficient hedges in place against some of the perceived risks including a weaker-than-expected growth environment or the emergence of rising inflation sooner. Thus this earnings season should provide some clarity after more than two thirds of companies failed to provide guidance in the first quarter.
Dividends and distributions form an important source of income for investors portfolios and we have seen a hunt for yield as monetary policy interest rates, which form the base for other interest rates, are at around the lowest levels in history. Previously investors looking for income-distributing asset classes have found shelter in Australian large cap with high dividends pay-outs. But the Coronavirus pandemic has jolted investors as well as businesses. A sudden stop to cash flows translated into companies looking to preserve cash and raise capital to sail through the other side of the crisis. Hence we expect that dividends and dividend payout ratios will continue to be suspended or cut. But the long-term benefits of preserving cash amidst an extremely uncertain crisis like we are in today will outweigh the short-term pain of a dividend cancellation/suspension.
Investors can continue to rebalance the property component of their portfolio to their full Australian Retail Investment Trust (REIT) weighting as per the current Merlea Models. Many REITs are currently trading at share prices well below their NTA and yields remain attractive within the sector.
Investors should focus their attention on ensuring that their overall portfolio is suitable for their risk tolerance, their lifestyle needs and their long-term return requirements. Market performance is difficult to predict, particularly over the short term but putting together an appropriate mix of Australian and international equities, fixed interest, property, cash and alternative investments is more likely to achieve an investor’s long-term goals compared to reacting to market events without the benefit of a plan.
Diversified portfolios with a mix of asset classes have managed to post acceptable returns over longer time frames of 5 or 10 years despite market volatility. This reflects the short-term nature of many of the equity market declines, together with the other asset classes being influenced by different drivers, and therefore providing an offset when equities perform poorly.
Merlea Investments recommended portfolios are generally designed to diversify assets across a range of asset classes to obtain low volatility given a stated return goal. The actual goal, or targeted return, from a portfolio is perhaps the most important influence in a portfolio as once a goal is stated the ability to assign asset allocations becomes a matter of maths. We will always prefer to gain as much return as possible from cash and defensive type assets and then augment this return with the higher risk/higher return possibilities from growth assets.
Opportunities exist to accumulate specific sectors that are showing market weakness, this has given us the opportunity to focus our models back towards the top ASX200.