Themes For August

10 September 2020

Equity markets continued their strong advance in August led by the US, which became the first major developed market to breach its pre-COVID level. The S&P 500 advanced 7%, however, the booming technology sector propelled the NASDAQ almost 10% higher. The Australian market returned a healthy 3% boosted by a recovery in consumer discretionary stocks and a strong IT sector. The overall market return was dampened, however, by lacklustre returns from the banking and materials sectors, which comprise over a third of our market’s capitalisation. Markets around the world all posted solid gains including Japan 6.6%, Europe 3%, and China 2.6% and the UK 1.1%.

Commodities continued their rise led once again by iron ore +13%, which rose in anticipation of strong steel production to meet demand from infrastructure projects. The AUD continued its strong run and rose by a further 3% primarily on the back of a weaker USD which fell on the announcement by the US Fed that it would adopt a more “accommodative” inflationary targeting approach, interpreted as meaning rates would remain lower for longer. Bond yields were once again remarkably subdued despite large issuance to finance stimulus packages designed to cushion the economic impact of coronavirus suppression measures.

Australian Recession Confirmed

In a stark reminder of the divergence between financial markets and the real economy, the much-anticipated Australian recession was confirmed with the release of the June quarter National Accounts that showed Australia’s GDP contracted a whopping 7%. If not for the Federal government’s JobKeeper and JobSeeker financial support programs, this figure would have been much worse and unemployment well into the double-digits. These results came as no surprise given the economic ramifications of the government’s virus suppression measures on business activity. With Victoria representing 20% of National GDP, the September quarter is also likely to show further contraction, given the parlous state of the Victorian economy as a consequence of its severe stage 4 lockdown measures. With the cost to date of the Federal government’s fiscal support programs now in excess of $100 billion, it is unlikely these will continue past the scheduled conclusion in March 2021, at which point a much more nuanced approach to managing the virus will have to be employed to allow a more robust level of economic activity. The anticipated opening of State borders later this year will be constructive for tourism and interstate commerce.

Despite the dire economic news, there is no doubt that equity market returns are reflecting a degree of optimism that business will be able to operate more freely from 2021 onwards. This is due to growing confidence that an effective vaccine may become available early in the year in addition to better therapeutical medications to treat the symptoms of the viral infection and improve mortality rates. The recent news that one of the leading candidates produced by AstraZeneca has recorded a severe adverse reaction in one of the participants in its final phase-3 trials is a reminder that a vaccine is no foregone conclusion. With so much uncertainty concerning the earnings outlook, arriving at a fair market valuation is problematic. The following chart highlights the earnings path over the next 2 years. Following a sharp negative revision of around 20% in 2020, a modest earnings recovery is anticipated in 2021 and 2022. It’s worth noting that even at the end of this forecast period, aggregate market earnings will still be below pre-COVID levels. Based on this forecast, the Australian market is trading on a multiple of around 20 times 2021 earnings, certainly not cheap, but supported by very low interest rates and ample liquidity in the financial system.

In the current investment environment, large active shifts in asset allocation are unlikely to be rewarded and hence staying the course remains our preferred strategy approach. While the economic outlook remains captive to policy settings solely designed to supress COVID-19 infections, is it very difficult to forecast key variables with any degree of certainty. The picture is likely to become clearer as we enter 2021 out of either sheer economic necessity or through more balanced policy choices by our elected leaders. With cash and fixed income yields so low, return-seeking investors will naturally gravitate to equities, with international markets providing the best opportunities to benefit in the e-commerce, digital economy that is thriving in the COVID market environment. Full valuations and unconvincing earnings forecasts temper our enthusiasm for equities somewhat, highlighting the need to maintain a healthy level of downside protections for risk mitigation until the market outlook becomes clearer.