The 2019/20 financial year was truly extraordinary. For the first eight months it was steady progress, with asset prices modestly inflating, interest rates staying low and consumer confidence elevated. Then the pandemic triggered the diametric opposite, a large deflation of asset prices, an economic conflagration and worrying social and health concerns.
My last quarterly report, in early April, coincided with the depths of the market downturn, at which time the wellbeing, social and economic effects and consequences of the global pandemic were entirely unknown. Three months later there is some clarity and a modestly improved stock market, but still immense uncertainties and rattled consumer and business confidence.
Investment market valuations are based on a variety of complementary measures. Financial strength, profitability and projections, dividend or rent capacity, economic activity, present values of future cashflows and investor confidence all play their part. So too does the relativity of the comparative benchmark, typically the long-term interest rate. It is this latter factor that has prevailed of late – essentially the activities of the global central banks to engineer no-risk interest rates close to zero, and hold them there, has stimulated at-risk investments such as shares and real estate. This is colloquially known as the ‘Central Bank Put’ meaning that there is an expectation that the Reserve Bank of Australia or the Federal Reserve in America or the European Central Bank will always come to the rescue when their respective economies hit the skids. Much of the improvement in share prices of late can be attributed to this phenomenon, seemingly flouting the weak economic fundamentals.
Turning to fundamentals, many listed companies will suffer a significant decline in revenue and earnings in the both the 19/20 and 20/21 financial years. This will likely be followed by a sharp improvement, most likely in the 21/22 financial year. Some companies will prosper notwithstanding, whilst others will have to endure an existential risk. The primary consideration in the stock market is the timing of this turnaround. One does not wish to overinvest in a recession, nor underinvest and miss the turnaround. We are paying particular attention to this and believe a cautious investment approach to be merited, given the weak corporate results expected in the August reporting season, the extremely fractious forthcoming US election campaign, the yet unquantifiable economic carnage caused by the reaction to the pandemic and the difficulties containing the persistent spread of Covid-19.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, recovered by 16% in the June quarter, but suffered a decline of 10.9% for the financial year to 30 June, all of the downside occurring in a short brutal period in March. Dividend payments provided some cash relief, but these were noticeably lower and fewer of late as companies chose to conserve cash for the troubles and opportunities ahead. We estimate the current dividend yield of the Australian market to be approximately 3%, which is a blunt sign of the times, being markedly lower than the very long-term average of about 4%.
The recent performance divergence of the stock market sub-sectors has been larger than usual. Healthcare stocks such as CSL, Ramsay, Sonic, Resmed and Cochlear have collectively performed relatively well, as too have consumer stocks such as Coles, Woolworths and Wesfarmers. The market views these sectors as less economically exposed and affected by the pandemic, so have applied a pricing premium to their shares. Meanwhile, the more economically sensitive sectors including financials, banks and energy have performed very poorly, suffering a sharp valuation discount due to their more uncertain outlook.
Much of the recent recovery in share prices has been driven by the extraordinary stimulus provided by central banks worldwide, including Australia’s Reserve Bank. The market is behaving like a tug-of-war, pulled higher at one end by the mountain of stimulus liquidity and low interest rates, and pulled lower at the other end by the recession and consequential decline in corporate profitability. This ebb and flow of optimism and pessimism will persist for a while, before a more predictable and sustainable market direction can be achieved, perhaps not till next year.
Next month most Australian companies report their results for the financial year. In many instances, the result will be significantly lower than previous corresponding periods, and outlook statements are likely to make bleak reading. In addition, the financial effect provided by the government’s various stimulus measures, including JobKeeper, will begin to wane in the third and fourth quarter of 2020. The coincidence of these factors, plus overseas market guidance and hopefully an improvement in the pandemic risks will determine the stock market direction for the remainder of this year.
Global Shares
All international stock markets suffered severely in March, but some have bounced back better than others. The Chinese, United States and Japanese stock markets have recovered quickly, whilst the markets in Britain and Australia remain relatively weak. The primary explanation for this disparity is the proportionally higher number of global leading health care and technology stocks in the former markets, versus more traditional economically cyclical businesses in the latter.
There is much commentary on this topic, particularly the plus-trillion-dollar values of the technology behemoths Apple, Alphabet (Google), Amazon and Microsoft. These companies are now individually larger than the entire ASX, and similar in value to the entire German, Swiss and Indian exchanges. Moreover, Tesla is now the world’s largest automobile company by market capitalisation, a full five times the market value and 50% higher than the enterprise value of BMW, for example, despite the latter’s significant production of electric vehicles. This phenomenon is out of kilter with reality, and a symptom of a ‘must have’ investor mentality, with scant regard to economic fundamentals. The reversion to normalcy, either by market price movements of regulatory intervention will be an investment theme of significance in the coming years.
The second half of 2020 contains numerous important market directional events and influences. The US political campaign, culminating in the Presidential, Senate and House elections on 3rd November, is shaping up as particularly fractious and divisive, and may precipitate exaggerated market volatility. Employment and other economic data indicating the likely duration of the US recession and the pathway to recovery will also be closely scrutinised.
Europe was struggling out of a long economic downturn, but now has COVID-19 to deal with. Generally, the economic prospects and market valuation status in Europe is favourable post-recovery, so we are paying analytical attention to many stocks in this region. 31st December represents the conclusion of the tortuous Brexit process, and the final economic and trade separation of Britain from the European Union. The parties are trying to negotiate at least a partial post-Brexit trade agreement by September, but cooperation remains elusive.
In Asia, the Japanese economy remains moribund, but China should enjoy a quick resumption of economic growth and industrial activity, albeit at a lesser pace than pre-pandemic. Global trade, partly dictated by the pace of economic recovery, and partly by the easing of supply chain disruptions will help determine Asia’s stock market direction. Any re-emergence of tariff and trade disputes will not be warmly welcomed by markets.
The Australian dollar suffered a seller panic in March when the pandemic caused a flight to the larger bloc US Dollar and European currencies but has since recovered all these losses. In fact, the Australian Dollar is now almost exactly where it ended 2019, a recovery broadly reflective of our lesser impacted economy, strong credit rating and satisfactory handling of the pandemic.
Property Securities
Few areas of the global economy have been affected as badly as the retail and some commercial real estate sectors. The share prices of these investments, commonly known as Real Estate Investment Trusts (REIT’s), were battered by the selloff in March, and some have not yet recovered.
REIT’s that contain property with discretionary small-scale retail tenants have been particularly hard hit, as many of these occupants have temporarily closed or vacated their premises in droves. Rental cash flow has similarly evaporated. Some office properties are under comparable pressure, with tenants adopting work-from-home protocols, or business belt-tightening, which will inevitably lead to higher vacancy rates in key commercial hubs. The recently robust CBD office regeneration and new construction cycle has created significant new office space coming available in 2021. It is likely that much of this new space will find a tenant, albeit with large incentives, but this will drag occupancy and rental rates lower in the older or less well-located buildings.
More positively, some retail centres with a large anchor supermarket tenant are far less negatively affected, and indeed may have seen an uptick in rents if leases contained a sales turnover component. Industrial based properties, particularly those with e-commerce distribution or big-box retailers have largely avoided the turmoil as the services of their tenants remain in good demand. Goodman (industrial warehouses), BWP Trust (mostly Bunnings stores) and Qube logistics (their Moorebank intermodal development) are examples.
Aside from the well-known conventional REIT’s there are some others of interest. Waypoint REIT owns a large portfolio of petrol stations, which were affected only briefly by the pandemic as road traffic volumes (but not public transport) recovered quickly. Charter Hall has numerous securities, including their Social Infrastructure REIT, which owns lots of childcare properties and some public sector infrastructure.
The stock of available residential real estate fell during lockdown periods, which waylaid some of the potential negative price consequences by keeping demand and supply close to equilibrium. There is however a stark increase in investment apartment vacancies in the major metropolises which will almost certainly lead to sustained price weakness for this sector well into 2021. The looming so-called furlough cliff, being the time when government financial stimulus drops away, might lead to more widespread market weakness as the equilibrium point might tilt towards higher supply.
Interest Rates
The Reserve Bank of Australia (RBA) made an emergency interest rate cut in March to an all-time low of 0.25%, but since then, without formally announcing, have been operating in the money markets to maintain short term rates at about 0.1%, representing a further stimulatory cut. The RBA is also using unconventional policy to hold the three-year bond rate at 0.25%, also a record low. This action, commonly referred to as Quantitative Easing (QE), involves the RBA standing in the fixed interest markets and buying bonds, the purpose of which is to use their virtually unlimited money supply to force interest rates down – in this instance to their targeted 0.25%. QE has been a popular policy internationally since the 2008 financial crisis. Proponents credit QE as the tool that helps smooth financial stability in anxious times, whilst the skeptics are concerned about the future inflationary implications. Either way, the bloating of central bank balance sheets of late and the massive increase in public sector debt is regrettably necessary in this era of economic calamity, but the future cost of unwinding and repaying is equally alarming.
Furthermore, the RBA has embarked on an ambitious program called the Term Funding Facility (TFF). This provides at least $90 billion of very cheap 0.25% funding to the banks, for them to on-lend to their customers. The RBA provides a carrot, being a further $5 of cheap TFF money for every $1 a bank lends to a small-medium enterprise. This is a windfall for the banks, if only they had more customers that had sufficient credit worthiness and demand to qualify for the loans. To date only $15bn of the planned $90bn has been drawn. When the banks start to transition their customers off the Covid-19 loan interest deferrals in the final quarter of this year, a further economic squeeze may follow. This could cause the RBA to embark on stage two of the TFF stimulus facility, perhaps using their balance sheet to provide zero cost funding to the banks, or even negative rates, which would be yet another extraordinary first in Australia’s financial history.
Credit spreads blew out during the market upheaval in March and April. This caused the prices of some credit-based instruments such as hybrids, corporate bonds and asset backed securities to decline sharply. The actions of central banks quickly arrested these declines and market pricing and stability has thankfully returned close to pre-pandemic levels. The US central bank has been particularly supportive of this financial market sector, extending its asset purchase program to assertive buying of corporate bonds.
The outlook for interest rates is rather predictable for a while, as the Reserve Bank is unambiguous in its quest to hold rates at 0.25% or below for both cash and bonds out to three years. It will be worth following the ups and downs of longer-dated bonds as this will provide some guidance as to the post-recession trends in rates, any emerging inflation risks and the duration of the downturn.
Outlook
The markets for shares and fixed income securities thankfully stabilised in April then rose in May and June. Markets are now vacillating between the positive valuation effect of financial stimulus and low interest rates and the negatives associated with the pandemic and the economic and profit downturn. This scenario will inevitably cause volatility. It is our expectation that a further market decline will occur by the end of 2020, but this decline is unlikely to be anywhere near as severe as suffered in March.
Investors should typically maintain a defensive and cautious investment approach, but not be shy of adding quality stocks to their portfolio during weak market periods. Our objective is to seek to have specific portfolios fully invested to their asset profile by the end of this downturn. There is a serious recession afoot, so patience can be virtuous in achieving this objective.
To conclude, it is likely that Australia will emerge from this downturn in a stronger relative position globally. Our fiscal status, political stability, handling of the pandemic, trade position and credit rating put us in a good position to recover. Investment markets will reflect this positivity in time.
Yours sincerely,
Malcolm Palmer
Joseph Palmer & Sons
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