Themes For May

Equity markets continued to surge during May on optimism that the global economy would be progressively reopened as COVID infection rates continue to fall. The recovery in risk assets has been quite remarkable since the trough of March 23rd, which underlines the powerful impact of the fiscal stimulus and liquidity management measures taken.

The Australian market advanced a healthy 4.4% for the month on the back of a stronger resource sector as a surging iron ore price pushed major mining stocks higher which also catapulted the AUD through US70c, some 22% off its March lows.

The US market was also strong advancing 4.8% with the shock May employment gain of 2.5 million jobs (against a forecast loss of 8 million) causing a sharp reappraisal of the strength of the US economic recovery. The burgeoning technology sector saw the NASDAQ 6.9% higher, fast approaching an all-time high.

The risk-on mood saw a broad recovery around the world with Japan up 8.3%, Germany up 6.7% and the UK 3.3% higher.

Bond markets were fairly subdued but Australian bond yields pushed slightly higher over the month as investors switched into equities.

In commodity markets, the big story was the sharp advance of the iron ore price which broke through $US100/tonne as increased Chinese demand, together with supply problems from the COVID ravaged Brazilian mines, saw heavy demand from Australia.

Market not fazed by Australia’s first recession in 29 years

As mentioned in last month’s report, it is wise to treat short-term economic data with caution given the disruptive effect of the forced economic shutdown. During the month it was revealed that the Australian economy contracted 0.3% in the March quarter to record the first negative quarter in 9 years. Increasingly it is evident that financial markets are looking well into the post-COVID future and pricing companies on FY22 earnings forecasts, which should by then be assisted by a more robust economy.

This result was not surprising as the March quarter not only encompassed the start of the COVID shutdown, but also the economic impact of the devastating bushfires and subsequent floods. This outcome confirms that Australia will experience its first economic recession since 1991, as the June quarter will undoubtedly show a sharp contraction. In its May Statement on Monetary Policy, the RBA forecast GDP to contract by 10% in the June half of 2020.  Australia has been a world leader in containing the spread of COVID 19 with very low rates of infection and almost no community-based transmission. While international borders (excluding NZ), will quite rightly remain closed for some time, it is expected that the local economy will continue to open up over the balance of 2020. While there is some risk of a secondary spike in infections, it is highly unlikely this will prompt a re-introduction of shutdown measures as contact, trace and isolation will be used to deal with any outbreaks. With constraints on tourism, immigration and foreign students it is likely the economy will be operating at below pre-COVID capacity until mid-2021 at the earliest.

While iron exports to China are expected to account for a record $100 billion this year, there are looming trade tensions with our largest trading partner. Recently China imposed a 80% tariff on Australian barley and has restricted 35% of our beef imports. This is no doubt a shot across the bow following Australia’s call for an independent enquiry into the origins of the COVID-19 virus and tougher scrutiny of Chinese foreign investment, which has fallen 58% over the past year. More recently China has warned its citizens not to travel to Australia on personal safety grounds, made somewhat moot by the international travel restrictions currently in place. Global trade tensions with China are likely to become more prominent in the second half of the year as the US is certain to ratchet up its anti-China rhetoric in the lead up to the November US Presidential election. China increasingly regards Australia as a US surrogate given our strong political, intelligence and military ties to the US.

Investment  Outlook

The strong share market rally over the past 2 months has been welcome news for investors, recouping a good proportion of the losses recorded in February and March. While economic activity is slowly picking up, it is the impact of the unprecedented government fiscal stimulus and central bank liquidity that has buoyed share markets, despite the large degree of new equity issuance from companies keen to shore up their balance sheets. While it is reasonable to expect gradual acceleration in activity from here, it is still very difficult to get a clear read on the earnings outlook for FY21 and beyond. In our opinion, it is likely that markets have run a little ahead of themselves in the short term so a consolidation or even a correction would not be a surprise. This is not sufficient to warrant a reduction in equity weightings however, especially in the absence of more attractive investment alternatives. Australian bond yields of around 1% don’t sound that appealing, however they provide excellent liquidity and downside protection especially in an environment of such earnings uncertainty. The AUD advance to US70c has not been welcome for either the Australian economy or offshore holdings however we would expect it to retrace some ground as trade tensions with China begin to escalate in the second half of the year.