Quarterly Market Update – Q3 2020
September Quarter 2020
Market and Asset Class Views
The ASX200 participated in the global risk market recovery through the June quarter, with a bounce of circa 30% from the March 23rd low. Despite a nationwide shutdown in response to the COVID-19 pandemic, investors chose to believe the vast stimulus provided by the RBA and Governments would lead to a strong economic recovery in 2H20 and CY21.
The record fiscal stimulus support packages total approx. 8.5% of GDP (or $165bil), as Government initiatives such as JobKeeper/Seeker payments and early superannuation release pushed liquidity into the system. However, the economic data has started to show the impact of the shutdown with unemployment, retail sales and GDP releases recording adverse numbers. The March quarter GDP fell -0.3%, which was the first negative reading since 1Q2011 and expectations for the June quarter are currently negative 8.5% (-5.0% for CY20), meaning we will experience our first technical recession since 1991.
Companies have been quick to turn to shareholders to bolster their capital positions, with in excess of $20bil having been raised since mid-March. As yet, we are still to see the shutdown impact on earnings with the June half reporting season due to start imminently. Earnings expectations have continued to be downgraded with most now expecting FY20 EPS to be a negative high-teens outcome, however, the consensus is for a rebound to circa +10% for FY21. The ASX200 forward PE valuation of ~19.5x has risen back above the pre-pandemic peak, which we caution on, given a number of hurdles for the economy remain.
We see a number of challenges for the economy in 2H20, being the expiry of the Government JobKeeper program in late September and potential unemployment consequence, the impact on industries/companies that have taken the brunt of the pandemic (travel, tourism, education, hospitality, etc.), including their ability to remain solvent. Recent commentary from both government and corporate CEO’s have raised underlying issues, such as unemployment, as challenges for the shape of the recovery.
We retain our Neutral weighting.
US risk assets witnessed an amazing reversal in the June quarter from the major drawdown experienced in the prior quarter. The enormous liquidity provided by the Federal Reserve and US Government, the flattening of the Coronavirus curve and the reopening of the US economy saw markets factor in a “look-through” mentality, believing we will experience a “V-Shaped” type economic bounce.
Equity markets bounced back from March 23rd lows to be trading at or near all-time highs, with a tech rally pushing the Nasdaq index to a record closing high. This is despite corporate earnings in Q1 being the weakest since 3Q2009, with EPS for the S&P500 falling approx. 14.5%. Expectations for Q2 earnings are for a further decline of circa 40% YoY. The forward PE valuation for the S&P500 is now at 21x, a 20-year peak.
The economic data nevertheless saw historic records broken as the economy ground to a halt with GDP falling 5% in Q1, industrial production seeing the largest month-on-month drop in its 101-year history and unemployment recording its largest monthly drop ever. The negative Q1 GDP data brought to an end the longest growth period in US history and an inevitable likelihood of a technical recession.
The Federal Reserve’s dovish testimony in its June meeting of a “long-road” to economic revival raises concerns on the shape of the recovery. They forecast maintaining a low interest rate environment (0–0.25%) out to 2022 plus a commitment to its bond-buying programme (now including individual corporate bonds), with fiscal stimulus being required to assist the rebound into 2021, post an estimated 6.5% contraction in 2020 GDP.
Despite the markets enthusiastic rally, we highlight areas of caution as we enter the second half of the year, being a possible COVID-19 second wave outbreak, earnings weakness, China trade relations and the impending US Presidential election on November 3rd.
We maintain our Neutral stance.
The EU region has been particularly hard hit by COVID-19 with strict national lockdowns across a number of the major economies. The latest economic data has confirmed this with record breaking negative readings on industrial production and GDP numbers, showing Germany, France and Italy all entering technical recessions.
Governments and central banks across the region have continued to provide significant stimulus to assist economic recovery. The ECB increased its Pandemic Emergency Purchase Programme of bond buying by €600bil to €1.35tril and similarly the BOE increased its programme by £100bil to £745bil. In addition, the EU announced a €750bil Recovery Fund which would provide a combination of grants and loans to member states. Individual countries have also provided stimulus with Germany approving a €130bil package and job/wage retention payments operating in UK, Germany, France and Ireland.
The significant impact on industry has seen governments act to bailout some corporates. The Germany government announced it will take a ~20% stake in airline Lufthansa for €9bil, the French government provided a €5bil loan to car manufacturer Renault and Italy is providing a €6.3bil credit facility to Fiat Chrysler. Earnings estimates (EPS) for CY20 have been slashed to in excess of a 20% decline.
The ECB recently revised its 2020 GDP estimate to minus 8.7%, with a strong recovery in 2021 to +5.2% (previous estimate +1.3%), predicated on the significant monetary, fiscal and labour market policy measures supporting incomes and economies.
An apparent flattening of the COVID-19 curve and an EU-wide relaxation of lockdown restrictions provide some hope the worst is behind the EU in the first half of the year, with the reopening coinciding with the key summer economic period.
We move our weighting back to Neutral on the positive expectation of the restart of economies and a more attractive equity market valuation (for both CY20 and CY21), at an approx. 20% discount to the US market.
Emerging Market Equities:
While developed countries are mostly past the worst stages of the COVID-19, many developing countries are now at the centra of the pandemic. Brazil, Russia and India now have the highest number of cases outside the US, ranked the second, the third and the fourth respectively. India recoded its slowest GDP growth since the data became available, while the unemployment rate also hit record high. Similarly, Taiwan’s Manufacturing dropped to the lowest reading on records, with substantial falls in output and export sales. Supply chains remained under pressure due to limited capacity and restrictions around travel.
The Chinese economy shrank 6.8% YoY in the first quarter of 2020, the first GDP contraction since records began in 1992. However, in contrast to the US, which saw the biggest rise in unemployment rate since Great Depression, China’s jobless rate rose from 5.2% in January to just 6.0% in May. The Manufacturing PMI also recovered and rose to 50.7 in May. This was the highest reading since January, as industrial activity resuming.
The crisis has sharpened the power competition between the US and China, with increased tensions due to a number of events: 1) the US’s restriction on some foreign companies from manufacturing semiconductors for Huawei, 2) the US blaming China for failing to act fast enough to stop the global spread of COVID-19, 3) Beijing’s introduction of national security law in Hong Kong and 4) Trump responded by saying the US will remove some of Hong Kong’s preferential status.
However, China has increased its focus on capital market to foster growth as it seeks technological self-sufficiency. China announced in mid-June that it will revamp the Shanghai Composite Index by including more technology and innovation companies and removing stocks with ‘risk warning alert’ (i.e. loss-making companies). This will be the first time for China to restructure the Index since its launch in 1991, which will help restore market confidence.
Over the past three months, EM equities have underperformed their developed market counterparts. From a valuation standpoint, EM looks compelling. The unprecedented stimulus policies in developed markets and a weak USD will also be positive for EM countries.
Overall, we retain our Neutral stance on EM Equities for the next three months.
REITs came back strongly in the June quarter in line with other risk assets, after having underperformed in the March quarter.
The COVID-19 has had a major negative impact on two of the three main subsectors of the asset class, with Retail and Office landlords suffering significant rental income interruptions. Especially for Retail as its operating condition was already challenging due to the long-term structural change shown by the accelerating e-commerce activities, the pandemic has further accelerated this shift in consumer demand from traditional retailers to online. During the lockdown where businesses shifting to working-from-home, many firms have started reassessing their lease agreement and negotiating for a lower rent, which is a major challenge for Office landlords.
In comparison, the Industrial sector is in a better position, however the disappointing employment numbers has also impacted the demand for industrial warehouses in the short-term. The strength of industrial property, combined with the relatively higher dividend payment from property investments given the low yield environment, may provide some support to the REIT sector. But for the near term, the REIT sector remains under pressure, despite the gradually lifting of lockdown restrictions across major cities.
The price movement of REITs is historically highly correlated to the equities market; however, its leverage and operating model may lead to a longer recovery phase for REITs after this market downturn. We continue to hold the view that Industrial sectors with long WALE are considered to be more resilient under the currently environment and with a better growth potential in the long run. Overall, we remain Negative on A-REIT and I-REIT in the September quarter.
As a longer-term diversification strategy, we continue to encourage clients to increase holdings in alternatives. Adding low-correlated exposures is an effective way to strengthen overall portfolio diversification. Given the level of uncertainties in the current market environment, Alternatives play an increasingly important role in portfolios to help protect against the downside.
Sharpe spikes in volatility and the speed of asset price reversals, have tested many Alternative strategies. Quantitative strategies in general struggled in recent periods, as their models are mostly designed to operate and price assets in normal market conditions.
Global macro strategies, on the other hand, is better positioned as it is able to quickly react to changing market conditions and re-shaping their portfolios more quickly than most other Alternative strategies.
We prefer strategies with lower correlations with the broader market. Historically, Private Equity has higher correlation with equities than other Alternative assets, we therefore avoid PE exposures for the short term.
We retain our preference on Gold as a natural hedge for financial market risks, and prefer physical gold investments or ETFs (vs. specific gold companies) due to its lower correlation to equity markets.
We also consider hedge funds such as Long Short and Market Neutral strategies given the market uncertainties, but recognises that manager selection is crucial in this space.
We remain Positive on Alternatives for the next three months.
Fixed Interest market yields have spent the past quarter anchoring lower around the levels targeted by their respective Central Banks. In Australia we now have formal yield curve control with the curve out to three years effectively set by the RBA. Oldtimers will have trouble where to put the decimal place i.e. cash at 0.25%, 6-month bank bills at 0.16%, 3-year swap rates at 0.23%, 10-year bonds at 0.90%. With inflation expected to remain in the 0.5% to 1.5% range in the immediate term, investors will now experience an extended period of negative real rates.
With cash and bonds costing us money in real terms, welcome to financial repression. What is the role of these assets in the portfolio? We will still receive minimal nominal yield and a security of nominal capital “sleep at night” factor. Cash gives us liquidity and immediate investment flexibility in deployment. The main purpose of FI at this time is to offer defensive ballast to a diversified portfolio. If the health prognosis on COVID-19 deteriorates, then we would expect to see further deflationary forces pushing bond yields down. The RBA has stated that we are at the end point of official rate easing but further economic deterioration/ failure to rebound will see unconventional measures adopted and bonds to be supported. Bonds protect us from left tail economic and equity risks. A counterposing rise in rates is not seen as likely with inflation a 2023+ story.
Credit markets continued to rally after their large sell-off last quarter. Having paused, where they stand now offers a less compelling investment thesis. The Fed Reserve’s ability to hold Investment grade corporate bonds is an effective put option on this market. Issuance has been strong as Corporates that can issue debt have done so at reasonable pricing. We see this market as “fair” in value. The subprime market is somewhat opaque, as the deferred economic damage of the COVID-19 on Issuers starts to play out in August and September. Domestically, Major Bank Hybrids will remain bid as TINA and will drive investors to the table.
Overall, we remain Neutral on both Fixed Income and Credit asset classes. Duration based returns are expected to be minimal but required for portfolio ballast. In Credit markets we are in there for credit margin carry. Yield hunters are advised to stay in the higher quality domains in respective markets lest they get COVID burn.
Over the June quarter, investors have seen gradual reopening of major economies, further fiscal and monetary stimulus and the recovery of risk assets as a result. PMIs in some countries are starting to recover with rising consumer confidence levels.
Many latest economic growth expectations are pointing to a ‘V-Shaped’ recovery. However, the concern around the ‘second wave’ of new COVID-19 cases remains, as well as the possibility of it delaying the global economic growth recovery.
AUD has been volatile, rebounded aggressively after dropping below the 2008/09 level to 20 years lows (+20% from trough to peak).
RBA and Feb have kept the interest rate on hold at 0.25% and 0-0.25% respectively with other short-term rates remain at very low level.
Cash offers protection during volatility spikes, and we remain Neutral on Cash as a balancing item in the portfolio.
We shift our negative view to neutral and believe the AUD is trading at fair value and will continue to move in-line with risk sentiment and market conditions.
Markets witnessed a trading range of 10 cents last quarter, from the low circa 18%.
If optimism continues – the AUD will grind higher to the mid-70c.
If we encounter a second wave of the virus or another significant risk off event, we can easily see half of the gains achieved last quarter given back and the AUD retracing to 65c. Despite, expecting the un-expected – several significant fundamental factors that are currently supporting the AUD higher is commodity demand driven stimulus out of China and the massive fiscal spending programme by US Govt and the Fed.
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