Merlea’s Economic Outlook

Summary

In the span of less than three months, the novel coronavirus has shuttered much of the global economy, bringing an 11-year economic expansion to an abrupt end. The coronavirus has challenged individuals, families, companies, governments and investment markets around the world. It is an experience that could fundamentally reshape consumer and corporate behaviour as well as financial markets. The quarantines and “social distancing” necessary to protect public health have triggered widespread shutdowns on the production side of the economy and a collapse of spending on the demand side. To make matters worse, economic uncertainty has spiked. At this point, it is difficult to project with any confidence how long these disruptions will persist. In response, central banks around the world have taken aggressive actions to provide liquidity to markets and support their economies.

Background

Sizable fiscal stimulus is also being implemented in many countries. While these efforts will help blunt the virus’ blow, the outlook for growth ultimately depends on how quickly the virus can be contained – the longer the contagion persists, the more severe the economic downturn. A longer-lived pandemic will also translate into more sustained damage to the economy’s underlying structure, likely meaning a more muted recovery once the virus abates. There are several paths that markets can take from here.

The best-case scenario is that the Coronavirus fears are overblown, and the pathogen is quickly contained. Moreover, lower oil prices help support most businesses and consumers in a period of low growth. This is a V-shaped scenario, as economies and equity markets will rebound as sharply as they have fallen.

The worst case is that global economies enter a deep recession as workers take ill or are otherwise unable to attend their places of work, businesses grind to a halt and consumer activity is stymied. Lower oil prices don’t help much in the face of widespread demand and supply destruction, and we enter a bear market for risk assets.

 In either case, there will likely be four distinct phases:

  • Phase 1 – economic and corporate shock. This phase will see global growth slow and corporate margins narrow as sales fall, costs rise and supply chains are disrupted.
  • Phase 2 – financial disruptions. This phase, which overlaps with phase 1, will be characterised by distressed selling and furious price discovery of assets.
  • Phase 3 – formation of a bottom. Stabilisation will happen first in financial markets and then the real economy.
  • Phase 4 – fears ebb as the “new” becomes the “new normal”. In this phase, the Coronavirus either runs its course or other solutions are found. Eventually, animal spirits will be reignited.

At present, we are clearly in phases 1 and 2 as markets continue to try and price the scale of the outbreak plus the other ever-present factors. Only in hindsight can you know for sure that we have entered phase 3 – it is not possible to know in real time. Our base case is for an eventual outcome between the two extremes described above resembling more a “U” than a “V”, but not falling into an outright worst-case recession. Why?

First, economic data would suggest that China – both where the virus originated and its epicentre – is returning to some degree of normalcy The economy appears to be healing too: 77.8% of the rail projects under construction, 68.2% of the road projects and 59.3% of the airport projects have restarted; coal consumption in the six largest power generators is more than 70% of the normal level compared to about 60% in mid-February. Traffic in Shanghai and Beijing is gradually increasing and well off the lows for both.

Second, regarding valuations, the investment landscape remains challenging, with little screaming value anywhere. Nonetheless, equities remain far more attractive than government bonds, and recent market gyrations will only have deepened that relative case (i.e. equites became cheaper and bonds more expensive). From current valuations, our quantitative models would suggest a mid-single digit annualised return from equities over the next five years compared with a slightly negative return from bonds. This would imply that a bias towards risk remains sensible for long-term investors.

Assuming the constraints on social life and business activity can be eased before the economy takes irreparable damage, the current market dislocations should offer long-term investment opportunities. Despite the attractive valuations and generous premia, we deem it best to wait before adding further to risk. In this regard, we will be looking for two important developments:

  • Firstly, evidence global COVID-19-infections have peaked (which would make an easing of lockdown measures visible) and that the risk of a second wave is contained and manageable.
  • Secondly, evidence that the economic freeze has by and large been successfully bridged, avoiding the creation of systemic risks to international financial systems, like those witnessed during the last crisis more than a decade ago.

 

Economic analysis (Australian Update)

S&P has revised its outlook on Australia’s ‘AAA’ credit rating to negative from stable.  The negative outlook reflects a substantial deterioration of fiscal headroom at the ‘AAA’ level; its debt burden will weaken materially because of several large stimulus packages in response to COVID-19.

In March, to combat the fallout from Covid-19 the federal government announced $213.6bn of stimulus measures on top of $11.8bn from the states and $105bn in RBA-government lending. Every state and territory has announced stimulus packages that, along with the impact of Covid-19-related closures on their revenue, are expected to put them all in deficit. The Reserve Bank of Australia also continued to cut rates and the cash rate now sits at a new record low of 0.25 per cent as it moves to buttress the economy against a worse-than-expected hit from the coronavirus. In his address following the March board meeting, RBA governor Philip Lowe said earlier forecasts that the economy had reached a “gentle turning point” were now under a cloud. He said the RBA board remains prepared to ease monetary policy further. To put current rates in perspective the Reserve Bank raised the cash rate to a 12-year high 7.25 per cent in March 2008 before a series of cuts prompted by the Global Financial Crisis. This quarter was exceptionally tough for the Australian Dollar. It fell 13.1% against the US Dollar over the period, closing at US 61.0c.

 

Australian shares

On 31st of March 2020 the ASX 200 set a record. On the last day of 2019, the ASX 200 closed at 6684, compared 31st of March 2020 the ASX200 closed at 5076 resulting in a quarterly performance of -24%, the worst quarterly performance since the inception of the ASX 200 index.

 The cause of this performance is of course the impact of the Covid-19. Share prices have entered a period where getting an accurate read on their valuation is extremely difficult. The fall in share prices has been largely driven by fear of the unknown on what the real impact will be on companies, rather than actual announcements made. Executives globally have been withdrawing earnings guidance, cutting costs, raising capital, cutting and/or suspending dividends and executing lock down strategies, without giving any forward-looking statements at all.

 The extraordinary thing about all equity markets was the speed of the change. The first half of the quarter, up until the 20th February, the equity market rallied to an all-time high, with the ASX 200 touching 7179. In the days since, the market has completely capitulated, falling as low as 4402 on the 23rd March (down 38.8%) before the current rebound.

 Looking forward, how equity and fixed income markets move in the short to medium term is unknown. To combat the spread of the pandemic there have been full-scale lockdowns across the globe leading to a steep fall in economic output and longer the output gap, the deeper the economic damage. The duration of the output gap will largely depend on the effectiveness of the health response taken by governments.

 

Commodities

Commodity prices, other than gold, fell sharply over the quarter. As countries around the world halted activity to try to bring the spread of the virus under control, demand for most commodities declined, hitting prices. Oil was caught in a perfect storm with an agreement between OPEC and Russia to constrain supply breaking down just as the outlook for demand fell. This led the oil price to fall by more than 60%.

 

Gold

We expect that the interplay between market risk and economic growth will drive gold demand in 2020. We focus our attention to financial uncertainty and lower interest rates weakening in global economic growth gold price volatility. Over the long term, the price of the gold usually moves in the opposite direction to US interest rates. So, when times are good, there’s confidence in the economy and interest rates are increasing. Investors then don’t need gold.

But when uncertainty hangs over the US economy, and already low interest rates are cut further, investors look to gold for shelter. And that’s what happening now. The Federal Reserve is creating a supportive environment for gold. From a strategic point of view, gold is a good hedge against inflation, a valuable benefit these days considering our view that we’re facing long term inflationary headwinds. Everyone says gold is a hedge against inflation, but it is a hedge against capital destruction. In these abnormal times, we see gold as a good store of value.

 

WTIS

The collapse of the OPEC/Non-OPEC alliance was a major shock to the oil market. Oil prices fell through the floor after Saudi Arabia slashed its crude prices for buyers. Saudi Arabia opened the taps in an apparent retaliation for Russia’s unwillingness to cut its own output.

Since the initial price fall, oil continues to remain under pressure with traders sceptical that a deal to cut almost 10 per cent of the world’s oil supply could prop up a market devastated by the coronavirus pandemic. Saudi Arabia-led OPEC and producers including Russia agreed in April to remove almost 10m barrels a day from production in May and June — by far the biggest supply cuts agreed by the cartel. Despite the size of the OPEC+ cuts, analysts said they would be insufficient and arrive too late to compensate for the loss of up to 30 per cent of global demand as economies shut down to slow the spread of coronavirus.

 

 

A-REITs

The impact from the Coronavirus on A-REITs has been substantial. The A-REIT (Australian Real Estate Investment Trust) sector is renowned for its defensive characteristics and its ability to benefit from central bank stimulus. Despite these features, the overall A-REIT sector suffered a much steeper selloff than the broader market since the COVID-19 pandemic escalated in mid-February. The rout in the sector has seen the share price of some big name A-REITs sink to decade lows. Retail REITS were hit the hardest resulting in S&P downgrading a number of companies in the sector. The revisions are not unexpected given the current challenges facing retail landlords.

Until REITs announce the amount of rent concessions made, changes to occupancy and whether they have been able to successfully remain within the limitations of their debt covenants, investors will be operating with a partial data set. However, this also presents an opportunity. By analysing all publicly available information and taking a more granular look at each REIT as well as their respective tenants, more diligent investors will be able to make investment decisions with a more complete data set and thus improve their chance to identify significant mispricing of individual securities.

Dividend yield is an important component of a A-REIT’s total return. The particularly high dividend yields of the REIT sector are, for many investors, the primary reason for investment in this sector. As many REITs are currently trading at share prices well below their NTA, yields are currently quite high for many REITs within the sector. But investors should note that there is a risk that these dividends will be cut.

 It is very important to also note that when economic fundamentals change as suddenly and sharply as they have due to the coronavirus outbreak and resulting economic shutdown that NTA’s often take time to be updated and reflect the new fair value of each respective REIT. As a result, many of the following NTA’s do not yet fully reflect the current (and in many cases meaningfully reduced) appropriate NTA of each A-REIT.

 While earnings will be impacted A-REIT’s are in a much better position than there were prior to the GFC. At the December 2019 results announced through February the average sector gearing was 25%, its lowest level since the late 1990s, with significantly increased debt expiry profiles and diversification with far less reliance on Australian banks.  This approach by AREIT management teams and their enhanced debt management post the global financial crisis (GFC) provides a level of additional protection from potential recapitalisations.

 

Global News

For the first time since the Great Depression both advanced economies and emerging market and developing economies are in recession. For this year, growth in advanced economies is projected at -6.1 percent. Emerging market and developing economies with normal growth levels well above advanced economies are also projected to have negative growth rates of -1.0 percent in 2020, and -2.2 percent if you exclude China. Income per capita is projected to shrink for over 170 countries. Both advanced economies and emerging market and developing economies are expected to partially recover in 2021.

Around the world, governments are starting to think about how to reopen the economy once the virus is suppressed. It is not a matter of simply pulling a switch that turns on the lights. Rather, it is a matter of deciding on the sequencing of removing barriers to economic activity. Acting too soon risks reigniting the outbreak. Currently, much of the infrastructure for distributing goods lies idle. Once suppliers perceive increased demand, they can begin the process of reviving supply. That will mean retailers placing orders, container ships leaving ports, and ground transportation reviving. The risk is that, if companies are financially stressed, this process might be disrupted or delayed. That is why maintaining the fluidity of financial markets is so important. Recent initiatives by central banks and governments have been undertaken with the goal of providing businesses with enough funds and credit availability to revive business once demand picks up. The longer the crisis takes place, however, the more difficult this process will likely be.

While the market has been rallying on prospects of the economy reopening soon and the coronavirus (outbreak possibly) reaching some sort of peak but there are no guarantees here just yet and this is still significant uncertainty. We don’t think we are out of the woods yet but having said that we are not perma-bears – we don’t see the virus as bringing on a depression or the biggest recession since the 1930s.   The worst of the panic and fear is behind us now, and we saw this with the VIX continuing its decline (as at 16/04/2020 the close was 40.84). Just as with the 2008 GFC, after the preliminary spike to 85, the VIX systematically declined from thereon after, so in our view, the markets are through the acute fear and panic stage.

 

Europe

The economic fallout of the coronavirus pandemic has been unprecedented. For the first time in history, the EU suspended its fiscal rules on public deficits and the European Central Bank launched a 750 billion Euro stimulus package. Since the outbreak of Covid-19 in Europe, and especially in the countries that are most affected, such as the UK, Italy and Spain, many companies had to shut down completely.

 

China

The Chinese economy went into freefall over the first two months of the year, with industry, retail and investment all shrinking for the first time in history, each by double-digits. And while the slump was quite well telegraphed in advance surveys, such as the purchasing managers’ indices, the numbers were still much worse than the average forecast.

Western governments urged to view China’s ‘terrible numbers’ as incentive to be more decisive in tackling coronavirus economic fallout. Policymakers face a delicate balancing act of managing health risks and keeping economies afloat, amid unprecedented pandemic challenge.

 

America

Since March 23, the surge has faded, as the U.S. Federal Reserve cut interest rates again, injected trillions of dollars into the financial system and opened swap lines with other central banks to ease dollar strains overseas. The extraordinary measures taken saw US 10-Year government bond yields fall from 1.92% at the end of December 2019 to 0.66% at the end of March 2020. Equity market volatility rose, with the VIX Index finishing the quarter at 53.5 having peaked at over 80 in mid-March.

The U.S. economy could contract by a whopping 4% in the second quarter in light of the restrictive measures in place to combat the coronavirus epidemic.  The data and estimates we do have are already staggering. More than 16 million Americans have now lost their jobs in three weeks. If you compare those claims to the 151 million people on payrolls in the last monthly employment report, that means the U.S. has lost 10% of the workforce in three weeks.

 

Investment portfolios

The fact that the world seems to be complying with government implemented policies on social distancing is a good thing. When all markets quickly move to a risk off perspective the moves we have seen in asset prices are not surprising. Equities, being the highest risk class has fallen the most while treasuries and investment grade bonds have performed significantly better. That said, typically safe havens assets like gold have still suffered as the falls trigger selling in normally unrelated assets classes.   There is no doubt that until the medical problem is fixed, the economic one will not improve. The transformation in global markets, be it fixed income dislocation of investment grade bonds becoming sub investment grade or equity PEs contracting to historic lows will continue to add uncertainty and volatility to markets for some time yet. The outlook for employment and housing prices are issues that will no doubt come into focus as the next quarter unfolds.

Prior to the downturn our fundamental stock analysis concluded that there was a lack of attractive opportunities. While the current downturn will present opportunities the level of uncertainty facing markets currently will take time to recede as the impact on economies, communities and businesses is unclear. Equity and credit markets still face considerable risks from earnings, downgrades and regulatory changes. We believe the hit to corporate profits will last longer than the immediate shock of the health crisis. Record fiscal stimulus will result in higher debt loads across the public and private sectors, which could see lower growth in the future. Monetary policy will remain loose for longer to help anchor bond yields.

There is a wide range of outcomes and no precedent to which investors can turn to provide a pathway. In this context, the portfolios will focus on sectors with defensive characteristics such as utilities, healthcare, food and telecommunications.

Investors can 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.

We are monitoring several risks that could destabilise the current market prosperity, as such, we still believe that the patience to find appropriate entry points to build a robust portfolio is absolutely key.

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.

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