Investment & Economic Review October 2020

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.

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.

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.