Quarterly Market Update – Q4 2020
December Quarter 2020
Market and Asset Class Views
The ASX200 traded in a sideways range through the September quarter, as we digested the June half reporting season and the official economic data which saw Australia slide into its first recession (two consecutive quarters of negative growth) since 1991.
The longest period of uninterrupted GDP growth in the developed world came to an end as the COVID-19 pandemic took its toll, with the June quarter contraction of -7% being the largest on record. Whilst a sharp deterioration, it compares well to other developed nations that experienced June quarter GDP declines of mid-teens to 30%. The government has maintained its record fiscal stimulus extending the JobKeeper payments by six months to March ’21 (at a reduced level and with new eligibility tests), lifting total stimulus to over $230bil or approx. 12% of GDP. In addition, the early release of superannuation has seen $33bil of payments made to eligible members.
Corporate reporting season was better than initial expectations, albeit we still witnessed a 20% decline in earnings for the ASX200, the largest since the GFC. Dividends were correspondingly under pressure with a circa 25% fall in payout, although there was some relief for shareholder income with the regulator APRA revising its original guidance for banks of complete dividend deferment to a maximum 50% payout ratio. Valuations remain elevated with the ASX200 FY21 PE of 19x and only mid-single digit EPS growth forecast, but with near zero interest rates, expect risk appetite to remain.
Whilst the feared “fiscal cliff” of hard withdrawal of government stimulus appears to have been deferred, challenges for the economy remain. Unemployment recovered slightly in August, however the negative impact of the extended Victorian/Melbourne lockdown combined with state border closures has seen a number of economists lower their GDP expectations, with some now forecasting a negative Q3 outcome, which would herald an unprecedented three quarters of decline. We also note recent anecdotal commentary from CEO’s of the major banks on the continued pressure on businesses and the expected rise of insolvencies into 2021.
We maintain our Neutral stance.
The appetite for US risk assets was unrelenting until early September, with both the S&P500 and Nasdaq indices hitting new all-time closing highs which erased all losses from the initial COVID-19 induced market collapse in March. A combination of improving economic data releases, a better than expected reporting season from the initial conservative analyst estimates and Federal Reserve/Government liquidity have buoyed the market.
The Q2 reporting season did, however, experience the largest year-on-year earnings decline (-32%) since the GFC, albeit this beat earlier estimates of -40%. The rally has been very concentrated with mega-tech leading the market. As we opined in our September CiN-sights monthly, valuations for the S&P500 had expanded to the highest PE (~22x) since the dot-com levels of 2000. The investor exuberance was fuelled by growth expectations for these tech names, stock splits by Apple and Tesla and was combined with substantial increases in retail trading volumes and options activity. An alleged squeeze and quarterly expiration in the latter, did drive a tech correction mid-Sept. Estimates for S&P500 Q3 and FY20 EPS are minus 22.5% and minus 18.5% respectively. For CY21, earnings are expected to rebound 26%.
GDP data confirmed the US entered a technical recession in Q2 with the largest quarterly contraction ever, recording a decline of 31.7%. Other economic releases nevertheless reflected signs of recovery as the economy reopened from lockdown. The latest August industrial production, unemployment and retail sales numbers have printed up to four consecutive months of improving data. Whilst we are still below pre-pandemic levels for these indicators, the April lows are hopefully behind us.
The Federal Reserve left interest rates unchanged (0-0.25%) in its September meeting and flagged rates being lower-for-longer (until 2023) with an accommodative stance being maintained until inflation rises to 2% plus. The Fed stated COVID-19 remained a significant issue for economic activity and poses considerable risks to the outlook over the medium term. They have also called on the government to move forward with more stimulus which has stalled in Congress.
US equities are currently priced for perfection, as ample liquidity and anaemic returns elsewhere have driven the market up. We remain vigilant given elevated valuations, increasing China trade tensions, COVID-19 and the impending Nov Presidential election. If Joe Biden was to win it would likely lead to higher corporate tax rates (28% vs. current 21%) and tougher regulation, whereas President Trump is more pro-business, he has shown unpredictability, particularly dealing with major trading partners.
We maintain our Neutral stance.
The EU region fell into recession in the June quarter as member states recorded mid-teens to 20% reductions in GDP courtesy of the March/April COVID-19 lockdowns. More recent economic data for July industrial production and retail sales have shown some recovery with three to four months of consecutive gains, albeit we are still below pre-pandemic levels of activity.
The ECB retained its fiscal stimulus programmes at previously announced levels, but some individual countries like the UK have augmented their existing support with a further £30bil business bonus package plus announced a new Job Support wage scheme for an additional six months to replace the original programme which expires end of October. Likewise, France announced a 2 year €100bil stimulus package equivalent to 4% of GDP.
The BOE left rates unchanged at 0.1%, echoing the US Fed comments of lower rates for longer until inflation pushes back to a minimum 2% level. They also announced they have explored how “negative rates” could be effectively implemented.
The significant monetary, fiscal and labour market policy measures have helped lift economies in the last few months, but the recent resurgence of COVID-19 infections seen in some EU regions may threaten this recovery, particularly as we enter the winter flu season. France and Spain are reporting new daily record COVID-19 cases in September, with the prior reimposing social restrictions. Germany’s daily cases are back to April highs and the UK has included travel restrictions on some EU jurisdictions and is reintroducing new lockdown measures.
CY20 GDP expectations for the region were marginally upgraded by the ECB to -8.0% from June’s estimate of -8.7%, with CY21 left constant at +5.0%. Earnings estimates have deteriorated for CY20, with a fall of ~30% now expected, but the consensus view is for a V-shaped rebound in CY21 with mid-30% EPS growth. A current proposal by the UK government to override parts of the agreed Brexit Withdrawal Agreement, may impact this in short term, however equity valuations remain attractive compared to international developed peers trading at a 22% discount to the US market.
We maintain our Neutral stance.
Emerging Market Equities:
The emerging markets during the quarter posed a stark contrast in performance; with China forging ahead in its path towards Covid-19 recovery and countries like India and Brazil falling further behind.
The Chinese economy grew by 3.2% yoy in the second quarter 2020, rebounding from a record 6.8% contraction in the previous three-month period and beating market consensus of a 2.5% expansion. Manufacturing PMI rose to 53.1 in August up from 52.8 in July, beating market consensus of 52.6 and posting continued factory expansionary activity since the outbreak in Feb 2020. Retail trade grew by 0.5% from a year earlier in August 2020, the first month of increase since December 2019 signalling a gradual recovery as demand improves. With only sporadic outbreaks across the country, China was the only G20 country to post a positive GDP result in the June quarter, and is on track to be the first country to emerge from the COVID-19 crisis.
The Indian economy shrank 23.9% in the second quarter, the worst on record, while Brazil’s contracted 11.4%. During the quarter, both India and Brazil began reopening their economies, targeting localised/targeted lockdowns for virus management. With very little fiscal stimulatory support, and significantly populations we see this move as crucial to avoid an civil unrest situation.
US-China tensions continued during the month, with the Trump administration adding 24 new Chinese companies to its sanctions list, this time for their involvement in helping the Chinese military build artificial islands in the South China Sea. With further developments on a US-China trade deal on hold until after the US election, Trump upped his rhetoric of a potential “decoupling” from the Chinese economy.
For the 3 months ending Aug 2020, emerging markets have posted a better performance return than the MSCI World index 19.53% vs 14.74%. Emerging market equity is also cheaper on valuation basis, with a PE of 15.6 vs. 18.9 for developed markets.
Looking ahead we expect 1) increasing geo-political tensions 2) Upcoming US presidential election and 3) the rise of populism to weigh in on market sentiment. Conversely, any developments in an effective vaccine could propel global equities significantly higher.
Sustained recovery in key emerging market economies, led by China, should contribute to overall growth in the sector. However, the risk of renewed Covid-19 infections and global political turbulence remains ever present.
As such, we downgrade to a Negative on Emerging market equities.
A-REITs outperformed the broader market in September quarter, largely attributed by performance of Goodman Group (GMG), with Retail and Office sectors generally posting meaningful negative returns. Both A-REITs and I-REITs are trading significantly below their 2019 levels, down 15.8% and 20.6% YTD respectively on currency adjusted basis.
The outlook for Retail and Office assets remains negative. In Australia, an unfavourable revaluation cycle and muted employment market continue to weigh on the Office market which was already challenging due to increase in supply, with some forecasting office vacancy rate in Sydney and Melbourne to increase to 10-15% together with a 10-20% rent reduction in the near-term as landlords lose pricing power.
The accelerating shift to e-commerce from retail shopping malls has supported the strong demand in Industrial sectors. Some are expecting the warehouse space requirement to increase by 7-10% in next 12-24 months, as the e-commerce penetration continue to grow. While Industrial assets continue to benefit from this change in consumer behaviour, rent collection for Retail REIT remains the lowest among other sectors despite the improvements over September quarter.
We continue to favour Industrial sectors with long WALE in the current environment, and we are wary of the A-REITs’ concentration risk with Retail and Office make up over 50% of the index on a look through basis. In comparison, I-REITs offer better diversification and greater access to sectors that are benefiting from the structural changes. As policy makers have committed to maintaining interest rates ‘lower for much longer’ around the world leaving cash and bond yields suppressed for the foreseeable future, the relatively higher yield of property may seem more attractive to some investors.
Overall, we remain Negative on A-REIT and move to Neutral on I-REIT.
High valuations in public equity markets and lower yields in fixed income in current times, have introduced an ever-greater need for alternative sources of diversification, yield and return. However, not all alternatives are the same and we recommend prudent utilization as a means to increase portfolio diversification and generate sustainable income.
Gold reached records highs over the past few weeks and raising concerns surrounding its sustainable performance going forwards. However, while spot gold price has soared over the last 15 years, gold price on a real-yield-adjusted basis (the gold price discounted by the level of real yields for its empirical duration) has held quite steady and is currently trading at the lower end of its post-2004 range. Expectations of low interest rates, rising inflation, and a weakening US dollar remain high, and given these drivers we continue to regard gold as an attractive uncorrelated asset with further upside potential.
As a core alternative asset, infrastructure appears to be a key beneficiary of the current low interest rates environment. In Australia, The Morrison government has already increased funding for local councils to spend on small-scale projects while signalling it will engage in a major expansion of infrastructure expenditure in its October budget as well as encouraging the states to do more. This increase in spending is on top of the government’s existing $100 billion infrastructure plan over 10 years. Across the globe, we expect similar trends to follow as world leaders ramp up their efforts to pull their economies out of a recession.
The Covid-19 pandemic has accelerated adoption of technology and increased focus on hygiene in both advanced and emerging economies. Private equity investments can offer access to early-stage and growth-oriented companies that will benefit from these structural changes in the industry and the increasing demand for health products. We consider stringent manager selection as key to benefit from opportunities within this space.
Finally, we continue to retain global macro strategies due to their lower correlation to other assets albeit muted returns.
Overall, alternatives play a key role in building resilient portfolios that can weather the downside in the prevalent market conditions.
As such, we remain Positive on the sector.
In Australia, shorter term (0-3 year) yields are effectively under the formal yield curve control by the RBA. Cash facilities, extended by the RBA to banks, at 0.25%, 180-day BBSW is 0.12% and 3-year bonds at 0.25-0.30% range.
Longer duration bonds had been more volatile with buyers unclear as to how much inflation premium is to be priced into the curve. However, rates are now back at the bottom of recent ranges. So effectively, no return for risk but we retain as ballast for the portfolio and protect against the left-hand tail risk of AUD rates going negative. The right-hand tail risk is a more rapid economic expansion stoking inflationary fears. At this time the downside risk to rates is greater than the upside risk.
Corporate spreads remain well supported as TINA buyers with no mandate to invest in equity are corralled into this asset class. Notwithstanding this, the majority of AUD investment grade corporate credits are fairly priced.
Within the global fixed interest markets, the largest issuers are Japan and the US. So, whilst technically risk-free in their currencies, they do represent fiat currency risk. Again, in central-bank controlled interest rate structures and the ability to neutralize bond issuance through purchase programs, the short prognosis is that “we ain’t going nowhere”. The UK and NZ have signalled preparedness to move to negative rates. If this eventuates, long duration investors will receive capital gains despite outright low or negative rates. Again, long term risk on deflation via economic slippage outweighs table “talk” of higher inflation rates. Interestingly, the Federal Reserve has signalled an “average” inflation rate of 2% over the economic cycle, but markets see more risk of “Japanification” and consequently markets have rallied back on the prospect of an inflationary spike receding.
Despite record level of corporate bonds issuance in both volume and term, credit risk in Developed markets remains attractive, with Central Bank market facilities providing a buffer support for investment grade credits. Arguments split the market as to whether this record issuance is good or bad. We believe that ultimately this depends on what the proceeds are used for, but in general see the absorption of large volumes as positive. With a “Central Bank” Put option in place, we remain positive, with any sell-offs on the back of weak equity markets providing a buying opportunity.
We retain Neutral settings.
The AUDUSD trended higher over the quarter from 69c to a high of 74c, closing the quarter at 71.61c.
Price movement has tracked broader risk-on assets and the continued positive market and investor sentiment, ignoring the economic impacts of the pandemic.
The AUD has been trading above the pre-Covid high of 70c for the last several months, which was tested and remained supported this week.
We retain our neutral view on the AUD for the December quarter as it moves in-line with market sentiment.
It remains well supported in this stimulatory environment.
However, in contrast the global pandemic is still in full effect with the emergence of second and third waves breaking out in some areas. We also recognise domestic growth will be impacted by the Victorian stage 4 lock-downs and conscious of the potential impact of the US election scheduled for November as it creates additional un-certainty on several of the macro factors that sill remain in play that are sensitive to the AUD, specifically the Sino trade wars and further US$ weakness through additional stimulus.
We maintain our Neutral stance.
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