Investment & Economic Review April 2020
Firstly, and most importantly, the wellbeing of all is foremost in our minds and we sincerely hope for a quick resolution to the awful crisis that is engulfing the world, and a reversion to normality without too much more hardship or suffering.
Stock markets are always the first and most obvious financial indicator when things go awry. When uncertainty leads to pessimism, (and ultimately fear), market pricing dislocates, as it has in the last month. This dislocation is amplified by the very mechanics of markets, where computer systems, short selling and algorithms drive volatility indiscriminately. This period of significant volatility should be relatively short lived, but significant uncertainties remain, such that we expect further bouts of sharp price movements in the coming months.
The economic and financial consequences of coronavirus will be significant. The interruption of supply chains, both global and domestic, the temporary collapse of consumer consumption and confidence, and the rise in unemployment at a time of already high indebtedness is of serious concern. Corporate revenue, profitability and dividends in nearly all economic subsectors will be negatively affected, considerably so in some sectors. The extent of the downturn, and its longevity, will be the primary determinators of how low stock prices go, and how long before their recovery cycle commences.
Governments and Central Banks globally have taken unprecedented actions to support and stimulate their respective society and economies. They really are doing whatever it takes. The introduction of unconventional policies by the Reserve Bank of Australia, by reducing the cash rate to just 0.25% and their aggressive multi-billion-dollar purchases of bonds in the secondary market to also hold the three-year bond yield at 0.25%, are truly extraordinary. Moreover, the RBA’s just announced term funding facility will provide at least $90 billion to banks for three years at the astonishing rate of just 0.25%, which is considerably lower than the banks’ current funding costs. In addition, the RBA will make available a further five dollars of this ultra-cheap financing for each dollar that a bank loans to small and medium sized businesses.
Governments are also assisting via various fiscal stimulus packages, focusing in Australia on seeking to mitigate the risks to livelihoods, businesses and jobs. These policies by Governments and Central Banks will provide a significant, but not immediately quantifiable, support to the collapsing economic ecosystem.
It seemed that the extraordinarily low interest rates of the last few years couldn’t go any lower, but the pandemic has shaken this further, causing rates to collapse to near zero across multi durations and jurisdictions. However, the recent rate reductions didn’t happen smoothly as there was an unsurprising blowout in credit spreads and consequential price declines in a multitude of corporate based interest-bearing securities.
Some of the pressing investment questions now relate to the stock market. Has it bottomed, or is there a further leg down, and when will the recovery start? Of course, nobody knows, but we do have some observations. Share prices are determined by a variety of factors, including profit ratios, financial health and an assessment of the present value of future cash flows. Sometimes this all gets overridden for short periods by investor psychology, which when euphoric can cause prices to be unreasonably high, and unreasonably low in times of despair. The fundamental value of a good business with sound financial metrics and a long-term future of reliable cash flows is not necessarily materially affected by six months of severe disruption.
It is this quandary that the market is currently grappling, and it is our view that shares in good businesses can be sensibly and cautiously acquired during this disrupted time, in a manner that doesn’t unreasonably stretch investors risk tolerance, and with an expectation that such investments will generate good long-term returns.
The remainder of 2020 is going to present many areas of investment and economic interest. The US election, somewhat overlooked during the pandemic crisis, will reemerge as a significant and fractious event, as the Republicans and Democrats have rarely been further apart in their core policies. Recent government crisis policy responses have caused an enormous rise in government debt, mostly by the issuance of bonds. In Australia, we ponder who might buy the hundreds of billions of bonds now being emergency issued. The market might be able to absorb an overload of sovereign debt for a while, or long-bond rates might tick up to reflect an oversupply, or perhaps the Reserve Bank will crank up the printing press.
The Australian stock market, as measured by the S&P ASX200 Index, fell cataclysmically by 24% in the March quarter. Many companies made dividend payments during the quarter, which provided some cash relief, but these were swamped by the collapse in prices. For the year to 31 March the market was down by 18%, a staggering turnaround from the positive returns of 2019.
The extent to which corporate profitability and dividends will be affected by the coronavirus pandemic remains uncertain. There will undoubtedly be very large declines in profits for the 2020 calendar year, and large reductions in dividends. As the crisis unfolds then ultimately eases, there will be more clarity about the profit and economic outlook and a better capacity to value individual shares. Suffice to say, based on current information, the stock market index level of about 5,000 points, having declined from over 7,000 points, represents good value from a long-term perspective.
Bank shares have performed terribly recently, exacerbated by their economic cyclicality and exposures to potential loan arrears. Offsetting this is the RBA’s new term funding facility incentive which provides banks with potentially lower funding costs and may help stabilise or indeed improve their net interest margin in coming years. Holding a modest investment in several of the four major banks plus Macquarie is our current preferred strategy.
In the industrial and materials sectors Brambles and Amcor shares have performed relatively well, helped by the fact that most of their business revenue is collected in US dollars. BHP and the other bulk commodity stocks have been partly protected by the iron ore price, which in A$ hasn’t declined. Boral has been a big disappointment, failing to capture sufficient share of the infrastructure boom, and now suffering a sharply declining share price. We’ve recently been buying shares in Sydney Airport, on the basis that the fundamental value of the underlying asset remains strong, being a very long-term operating concession of the airport infrastructure.
We continue to favour stocks in the healthcare sector and have recently been buying Ansell, the maker of protective gloves, in addition to holding CSL, Sonic Healthcare and Ramsay Healthcare shares. This sector remains prospective for the long-term.
Australia’s energy stocks have performed badly, including Woodside and Santos, both affected by the significant decline in the oil price. AGL Energy, being primarily a utility, has been less affected. The oil price decline was exacerbated by Russia’s and Saudi Arabia’s reluctance to reduce supply, which has the taint of some geo-political muscle flexing. There will be a wave of corporate activity ahead in the energy industry, of which Woodside is very well positioned to participate due to the suspension of their various capital-heavy new projects and strong financial position.
Other shares we own include Link Administration, being our preferred investment in financial services technology, InvoCare, an operator of funeral facilities, Costa, a leading horticultural food company and Telstra, which should retain its market share and dividend.
No international stock market was unaffected from the effects of the global pandemic, though some have fared worse than others. Australian investors in overseas shares have been spared moderately because of the sharp decline in the Australian dollar of late.
The United States stock markets have been particularly volatile, trading in wide ranges from day to day and intraday. The United States’ economy was in reasonable shape prior to the crisis, but the rapid spread of coronavirus and the consequential shutdowns is likely to drag their economy into a steep decline, lasting for the remainder of 2020 and beyond. Within the US market however, reside the likes of Alphabet, Amazon and Microsoft, some of the world’s leading businesses in technology, and other heavyweight industrial and healthcare companies, many of which operate globally and will likely navigate the current turmoil and prosper on the other side.
In Europe, a longer-term economic malaise was finally starting to ease last year, and the excruciatingly slow Brexit mayhem was ending. But the pandemic struck, setting everything back again. Despite this there are some beacons of strength in corporate Europe, including the leading healthcare companies such as Roche in Switzerland, Novo Nordisk in Denmark and Sanofi in France.
Asian shares have also suffered but remain appealing based on valuation. Japanese shares in the industrial automation and robotics sectors such as Nidec and Fanuc remain prospective, whilst internet and technology companies like Tencent in China have a bright future.
The outlook for overseas shares remains challenged by the economic and social crisis. Investors should own and selectively buy the leading companies but have a healthy regard for cash and exercise some caution.
The Australian dollar was largely steady in 2019, but the recent panic caused a flight to the traditional strong reserve style currencies, being the US Dollar and Swiss Franc, out of the more pro-cyclical currencies. Australia’s terms-of-trade has not deteriorated too badly thanks to strong bulk commodity prices, so it’s possible that the Australian dollar won’t decline much further, and may even rise a bit.
The property sector of the stock market, commonly known as Real Estate Investment Trusts (REIT’s), has been pounded by the pandemic and economic collapse. Commercial property valuations are under enormous pressure, as tenants close or temporarily vacate in droves, placing significant risk on rental cashflows. There are few sectors with as uncertain an outlook as discretionary retail, so stocks in this sector are now trading considerably lower.
One of the common metrics for REIT market pricing is the premium or discount they may be trading at relative to their underlying net property valuations, this commonly being known as Net Tangible Assets (NTA). Of late, some of the REIT’s have been trading at significant discounts to their disclosed NTA, in some instances as much as 50%. This indicates partly a market undervaluation of the security and partly a reflection of over inflated real estate valuations. Commercial valuations, which have risen inexorably in recent years, are now primed for a sharp fall
Within the sector the large-cap REITs such as Dexus, Goodman and BWP suffered less due to their strong tenancy profiles, but the REIT’s with shopping centre assets such as Scentre, Vicinity, Charter Hall Retail and Stockland fell significantly, reflecting the valuation and cash flow risks associated with those assets.
The outlook for the REIT sector remains clouded by economic uncertainty, but market prices have already fallen such that most trade at a discount to the underlying bricks and mortar property values, suggesting that further downside risks are likely to be less severe.
After reducing the local cash rate three times in 2019 to 0.75%, the Reserve Bank of Australia (RBA) made a further emergency cut in March to an all-time low of 0.25%. The RBA is also using unconventional policy to hold the three-year bond rate at 0.25%, also a record low.
Long-term bonds suffered a sharp selloff when the pandemic panic first hit, rising briefly by nearly a percent. However, the aggressive bond buying program initiated by the RBA quickly caused an about-turn, such that the long bond is now just 0.7%, also a record low. This short sharp spike in interest rates provides an indication of what might happen should the RBA not be able to adequately control its bond support program, or if the market forces deem an oversupply risk.
The principal concern in interest rates markets is credit spreads, and the pricing of higher risk securities such as lower-rated corporate bonds, mortgage securities and hybrids. The recent anxiety caused only a ripple in the higher-quality corporate debt market, but a wave of selling in the riskier securities. The prices of debt securities of many US energy sector corporates, for example, have fallen by 30% as investors fret about the financial effect of the collapse in the oil price. Similarly, the price of most Australian hybrid income securities has fallen by about 10%, even those issued by the big-four banks.
The outlook for interest rates for the medium term has clearly been determined by the Reserve Bank, that being a rate of 0.25% for both cash and bonds out to three years. After the crisis passes the government will need to deal with a mountain of new debt and the RBA will have a massively expanded balance sheet – meaning that the financial effect of these emergency decisions will be apparent for years to come.
In all the years I’ve been penning these reports I’ve never had as much difficulty gauging the outlook as I do now. Economically, Australia’s multi-decade period of uninterrupted economic growth is ending with a big bang. Unemployment will rise beyond 10%, corporate profit growth has evaporated, and the government is taking fiscal and monetary actions beyond their wildest dreams. And this is happening worldwide. Short-term forecasting of share prices and economic activity has temporarily become conjecture.
However, share prices have already fallen considerably, and most quality corporations will survive and then thrive when this crisis eases, and interest rates cannot feasibly go any lower. So, investors should maintain their cautious approach, but be prepared to invest modestly in the shares of some of the better-quality companies, in expectation of positive returns down the track.
To conclude, I’ll repeat my advice from my January report, being that investors should give careful consideration to the risks of shifting the security of their cash deposits to shares before proceeding, and one’s tolerance to risk should not be impulsively abandoned. The difference now though is that share prices are much lower, so those that are underinvested relative to their risk tolerance should be on the lookout for bargains.
Joseph Palmer & Sons
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