More than half a year has passed since the global pandemic wreaked havoc in societies and financial markets worldwide. Regrettably, the virus remains virulent so has slowed the pace of economic recovery and caused a multitude of social implications to remain prominent. The path towards a vaccine seems promising, with more than 130 projects globally, funded almost limitlessly, with accelerated clinical trial processes. A rapid rebound in consumer confidence and associated economic activity is expected should a successful vaccine become widely available.
In the meantime, governments have come to the rescue. Money apparently now has no limit and governments have embraced a ‘whatever it takes’ mentality. Australia’s recent federal budget is a good example, distributing extraordinary largesse, almost entirely debt funded with a nary a blink about how a future society might handle the legacy of more than a trillion dollars of debt. That this became necessary indicates just how severe this downturn is.
The necessity for government to react so assertively to the current severe downturn is laudable. But the concentration of so much financial power in so few hands is concerning, as historically such domination has led to unexpected outcomes. It’s not too much of a stretch to coin recent actions as monetary dictatorship. Governments and their agents, the central banks, have taken almost complete control of the monetary systems. They dictate the cost of money, the level of interest rates, both short term and long, they determine who gets and who misses out, and by utilising policies such as JobKeeper, influence the employment markets. Of course, by engineering interest rates to nothing, they ameliorate the cost of massive borrowings, and propagate the fallacy that it does not matter how much you borrow when interest rates are ultra-low. The problem with this theory is that irrespective of the interest rate, the principal still needs to be repaid. I can only imagine the pressure on financial markets when the more than billion dollars per day (yes, it’s that much!) needs to be repaid or refinanced (every day) when these bonds reach their maturity dates.
Risk assets such as shares and real estate benefit from the low interest rates, and corporations benefit from government stimulus spending. Consequently, share and real estate markets have performed remarkably well this year, considering the economic circumstances.
The US Presidential election next month looms as an important social and economic event, more so than usual. Rarely has there been such disparity between the policies and philosophies of the incumbent and the challenger, and whatever the outcome, markets will be in a reactive mood, and civil unrest in the United States might exacerbate near term volatility risks.
The Australian stock market, as measured by the S&P ASX200 Index, fell slightly by 1.4% in the September quarter, and is down by 13% so far in 2020, though this is much improved from the low point suffered in March. Ex-dividend payments are usually significant in the September quarter, but this year they were considerably less, as many companies chose to conserve cash for economic and business prudence. There are few signals yet of an increase in dividend payouts, so we expect the half year payments in early 2021 to be similarly low, but perhaps some improvement will be evident by this time next year.
Individual stock and sectoral performance remained unusually unpredictable this last quarter. Some economic sensitives such as Boral had large gains, and price rises in pandemic affected sectors such as Sydney Airport reflected some recovery optimism. Bank shares were down a bit as they navigate slow credit growth conditions, impending, but in many instances still deferred, loan impairments and generally low net interest margins. In healthcare, Sonic and Ansell continued their stellar performance whilst CSL and Ramsay were steady. The worst sector in the September quarter was energy, which suffered from demand weakness, disinflationary conditions and low prices for oil and gas. Woodside has become a valuation standout in this sector, causing us to add to holdings recently.
One key valuation determinator of pricing in share markets is the concept of equity risk premium. This is essentially the excess return an investor need above the prevailing real interest rate to compensate for the higher risks associated with shares. When the risk-free rate is close to zero, as it now is (indeed negative in some instances when inflation is subtracted) the required return on shares is also lower. For example, a 4% earnings yield on shares, which is acceptable only when interest rates are near zero, translates to a price-earnings ratio of 25 times. This phenomenon, above all else, explains the remarkable resilience of shares this year.
International stock markets were mostly positive in the September quarter, with the MSCI world index rising by 7.5%, in US dollar terms. This was bolstered by good performance in the United States (+8.5%), China (+7.8%), Japan (+4%) and Germany (+3.7%). Shares in Britain declined by 4.9% as the pandemic persisted and the Brexit deadline looms, and prices in Hong Kong and Singapore were also marginally lower. The Australian dollar rose by 3.8% against the US dollar, on top of a 12% rise in the June quarter, which negated some of the price gains for Australian based investors.
By sector, growth styled stocks and consumer defensives generally outperformed, at the expense of more economically cyclical businesses. However, as usual there has been considerable volatility on an individual stock basis. In our model portfolio Kion, a German warehouse automation business, rose considerably, as did Nidec, the Japanese industrial electronics company. Stalwart US stocks such as Disney, Amazon, Alphabet and Starbucks all rose modestly but our preferred European healthcare stocks Roche and Sanofi were both a bit lower, although conversely there was a sharp rise in the price of Danish diabetes company Novo Nordisk. In Spain, telco company Telefonica fell sharply whilst the US cyclicals Wells Fargo and General Electric were also down.
Like Australia, international markets and valuations have been supported by varying degrees of monetary and fiscal stimulus, considerable in Germany, Japan, and the US, but less so elsewhere. In the US the most recent stimulus package is currently being fiercely debated, with staggering amounts of between 1.6 and 2.2 trillion dollars being negotiated. Stock markets are focusing so much on will they/won’t they stimulate decisions, which says much about the times we are in, and the controls central authorities can influence over markets.
In the coming months, there are some important potentially market sensitive events and timelines. The US holds Presidential, Senate and House elections on 3rd November, which might be a catalyst for some market volatility. Vaccine trials are progressing rapidly everywhere, including in the US where their ‘warp speed’ program is directing enormous resources towards their objective of having 300 million doses of safe and effective vaccine available by January. And importantly, the economic and profit implications of the downturn, and various statistical data releases, will shape market movements for a considerable time.
Prior to the pandemic the broader Asian economic bloc was growing more quickly than the global average. The economic downturn in Asia in 2020 has been severe, but seemingly short-lived, with some data points indicating a rapid recovery. Consequently, some Asian stock markets, including Singapore, Korea, and Japan, are now ranking as good value, with above average forward performance potential.
The share prices of Australian Real Estate Investment Trusts (REIT’s) rose by 6.7% in the September quarter, considerably better than the overall stock market. This sector, more than others, is a beneficiary of the dual stimulus of ultra-low interest rates and fiscal support. Double-digit percentage rises for the quarter were enjoyed by Charterhall Social Infrastructure, Goodman and Stockland.
It is disconcerting that at-risk asset prices such as some real estate trusts have recovered so quickly whilst underlying economic signals, which normally drive such valuations, are so negative. It seems that the normal relationship sequence between asset prices, interest rates and economic activity remains askew. There have been worrying anecdotes in the commercial sub-leasing market, indicating rental declines of more than 25% in some CBD office buildings. As rent relief protocols and deferrals come to an end, the possibility of material valuation reductions becomes more likely, particularly as the extent to which workers return to office locales from work-from-home remains uncertain.
Whilst commercial property markets struggle, logistics parks, shopping centres anchored by a significant supermarket, and regional tourism accommodation are all doing well, the latter benefitting from a sharp recovery in domestic vacations due to state and international border closures.
Residential real estate has also remained resilient, supported by a relative lack of stock, widespread loan deferrals and low interest rates. Banks are sitting on perhaps hundreds of thousands of overdue mortgage repayment notices as part of their customer deferral strategy and are hoping that government stimulus gets people back to work so that the issuance of many of these notices becomes unnecessary. The next six months will be key for loan deferrals and arrears, as it will for the economy and markets overall.
The present economic climate, and indeed this generally disinflationary era, have caused interest rates globally to trend lower and lower, at or approaching zero in many countries and across many durations. In Australia, the pandemic and economic downturn has caused the state and federal governments and the Reserve Bank (RBA) to initiate emergency stimulus policies, the effect of which is to force interest rates even lower. The process includes the RBA operating in the short-term bank bill market at 0.1% and holding both the official cash rate and the three-year commonwealth bond to 0.25%. Moreover, the RBA has extended its other incentive, called the term funding facility, which provides almost unlimited 0.25% funding to the banking system.
It is this cheap term funding facility that is causing the banks to not need as much funding from customer deposits, so consequently the term deposit and bank account interest rates have been reduced significantly. Unfortunately for depositors, the RBA is likely to reduce rates again soon, perhaps to just 0.1% for the overnight cash rate, the three-year bond and he term funding facility.
Risk-free interest-bearing investments include cash accounts, term deposits (up to $250,000) and government bonds. Each of these investment types now offer a sub 1% return, meaning that they don’t offer a positive real rate of return. Term deposit rates are typically now between 0.4% and 0.8% with little likelihood of change till well into next year. A precursor to higher deposit rates would be when the RBA begins to withdraw its term funding facility. The recent highly stimulatory federal budget and the weak national accounts suggest that this is some time away, perhaps not before the middle of next year. Consequently, cash type deposits, including term deposits, will pay miserable interest for the foreseeable future, so their primary purpose is capital preservation.
Credit spreads, which blew out during the market upheaval in March and April, have retracted considerably, even for some higher yield junk securities. Hybrid prices and yields in Australia are approaching their pre-pandemic prices and have a smaller current cash yield due to their reference rate, the bank bill, being so low.
When interest rates are very low the temptation is to invest in other non-guaranteed securities that promote higher interest rates. This sector is broad, and covers hybrid securities, a variety of managed funds, corporate bonds, credit securities and mortgages. The more secure of these offer appealing interest rates of typically 2% to 4%, whilst the riskier might pay more than 5%. A diversified portfolio of interest-bearing investments, of the lower risk variety makes sense, as risk is spread over a range of issuers, and portfolio income is enhanced. However, investing in high risk interest-bearing investments often lacks sense, as investors might be better off on a risk/reward basis buying ordinary shares, which provide capital gain potential as well as income.
There is a bit to navigate in the coming months, including the US election, bank profit results, dynamic and unpredictable economic data, lockdowns and their consequences, vaccine development, and the propensity for stimulus to be proffered, or withdrawn. Markets for shares and fixed income securities are likely to exhibit further volatility in the manner we have witnessed in recent months.
Consequently, we remain inclined towards a defensive and cautious investment approach, but not shy of adding quality stocks to a portfolio if and when opportunities arise. Our objective remains to find suitable investments during this downturn, but to understand that investing during a recession benefits from patience.
To conclude, thankfully 2020 is drawing to a close, as it’s been a challenging year for so many reasons. 2021 offers more prospect, a recovery in employment, vaccines to help consumer health risks and confidence, and a recovering economy.
Joseph Palmer & Sons
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