“Lift your eyes and look down field”
A key tenet of our investment approach is to not be distracted by short-term noise and train our focus on longer-term fundamentals believing they are much more important for genuine investors. This has never been more relevant than in the current environment where there is a deafening cacophony of noise. It staggers me just how much intellectual capital is being devoted to the microscopic analysis of short term economic and earnings data. Given the arbitrary nature of the disruption to economic activity by direct government intervention, this data is of no relevance to long-term valuations. RBA governor Phillip Lowe recently pointed out the self-evident truth that the pace of the recovery would be dictated by the degree to which restrictions can be safely lifted. The Australian government has outlined a 3-stage plan for a progressive easing of restrictions with a July target for the reopening of most of the economy. Over and above this, it would be reasonable to assume there will be some degree of consumer reluctance until fears of the disease begin to wane. All of this points to a slow grinding recovery rather than the “V shaped” bounce-back optimists are hoping for. Some segments of the economy will progressively reopen at limited capacity such as restaurants, cafés, retailers and cinemas. Others dependent on international travel such as tourism and tertiary education will take much longer to recover to pre-COVID levels. Immigration is a major growth driver for the Australian economy and will be severely curtailed for at a least a year. This will hit the property market hard which is already suffering from reductions in household incomes from the high level of unemployment, a collapse in the rental market together with limits on open house inspections and public auctions. Not surprisingly, property transactions were down a hefty 40% in April alone. The good news for Australia is that the initial spread of the virus has been well contained and there is plenty of spare capacity in the hospital system so any “second wave” of infections can be adequately handled without the need to reinstate lock down measures.
Long-term market consequences
While the initial focus of policy makers was quite rightly to contain the spread of the virus and preserve as much life as possible, the actions taken have come at a hefty cost to the global economy. Australia’s fiscal response led the world in percentage of GDP terms and was uniquely targeted at preserving employment via the innovative JobKeeper scheme. Other countries placed more emphasis on cheap loans, which although still helpful, are not as impactful as direct fiscal support. Fortunately, Australia’s budget was close to balanced at the time COVID hit so we were in a strong position to provide fiscal support.
Other countries were not so well placed and the added debt burden will constrain their ability to provide fiscal stimulus in the future. Fortunately, low bond yields provide a cheap source of funding but this may not be the case when they mature. In addition to this, the enormous expansion of Central Bank balance sheets has massively enhanced global money supply potentially bringing longer-term inflationary consequences once demand recovers. The sheer size of the US Fed’s QE program of up to an additional $US 4 trillion, is likely to see a secular downward trend in the USD placing pressure on emerging market economies laden with USD denominated debt.
Fortunately for Australia, iron ore shipments to China continue apace as their economy restarts well ahead of the rest of the world. The March quarter saw Australia post a record trade surplus which will mitigate some of the sharp downturn in domestic demand. Our trade dependence on China will help in the short term but presents a looming threat in the future. There will undoubtedly be a severe global backlash against China as a result of their negligence in preventing the spread of the virus outside their borders. This will be led by the US which has been particularly hard hit and will no doubt ratchet up their anti-China rhetoric in the lead up to the November Presidential election.
The recently signed “phase one” trade deal between the US & China must also be at some risk as well as the possibility of other sanctions by Europe and Japan especially if China refuses to cooperate with an investigation into the origins of the virus. There will also be strong tax incentives and political pressure for US manufacturing to repatriate from China to shore up critical supply lines in areas such as pharmaceuticals and personal protective equipment. Australia’s large trade surplus with China places us between a rock and a hard place given our strong political ties and military alliances with the US. If China is marginalised on the world stage, expect to see heightened military tension in the region towards Taiwan over the disputed South China Sea Islands as well as a harder line against Hong Kong protesters and more tacit support for North Korea.
The “stay the course” approach held our multi-asset portfolios in good stead to benefit from the April recovery in equity markets with the bias to the outperforming US market paying off handsomely. We see no reason to change this stance until a clearer picture of the economic recovery path into 2021 emerges. Our expectation is that for the Australian market, aggregate earnings per share will take at least 2 years to recover to pre-COVID levels, although the outlook for US earnings in the technology sector look more appealing. With earnings being the major driver of share prices, this is not a particularly rosy picture, although the massive liquidity programs, low bond yields and the absence of attractive alternatives will provide support for the market. The need to finance massive government deficits will keep bonds in healthy supply although safe haven demand to mitigate equity risk and Central Bank QE buying will keep yields contained for now. As always, prudent diversification and downside protection are key principals not to be ignored in these uncertain times.