Economic Update

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

The new economy

– COVID-19 causes markets to tumble
– Governments act swiftly with relief packages
– Central banks co-ordinate significant monetary policy stimulus

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.

The Big Picture

The world is very different from when we last filed this monthly update. What was then seemingly largely a Chinese health problem that was largely under control has blown out to a full-scale pandemic.

It is important for all investors to realise the broad manner in which viruses are transmitted if we are to understand how to invest during such a health crisis.

At one extreme, governments could have let the virus run free and contaminate most people with consequent poor health cases – and worse. At the other extreme, all people could have been quarantined – as they did in China – so that the spread would be controlled and slowed down.

South Korea took a different route with lots of success. They had testing ready by early February and monitored the movement of infected people using credit card activity, CCTV cameras, and mobile phone tracking. That really worked but most countries might struggle with such a ‘big brother’ approach.

Without a rigorous approach to quarantining, most people who are not immune might get the virus. But, by taking a partial approach to quarantining, the speed with which the virus spreads can be controlled.

The reason to slow down the spread is to help hospitals cope with the maximum number of cases needing treatment at any one time. All countries will have experienced an increase in the number of cases to be followed by a fall in this rate. The timing of these peaks depends on the health policy among other personal factors.

Slowing down the spread is the so-called ‘flattening the curve’ approach. Britain started off by allowing the virus to take its own course and then very much implemented a ‘flattening’ policy. The US, to some extent, upped its game after a slow start.

The biggest danger in the flattening policy is to lift restrictions too early that then allows a second round of contagion. As long as there are ‘carriers’ in the community, a new pandemic could always start – that is, until there is a vaccine or cure.

It is impossible for any group of people to accurately predict the length of this crisis because different regions are taking different approaches and, importantly, changing those approaches over time.

The health statistics are easily misread. It is a relatively simple task to count the number who pass away from the virus. There would be some misclassification – especially in countries with lesser quality testing facilities. It is also relatively simple to count the number of people who recover as a proportion of the number who were deemed to have been infected.

What is extremely difficult to assess is how many people have been or are infected. Apparently, many younger, very healthy people could be infected and not even realise it – often by thinking they have the regular flu. To date the testing facilities in Australia and the US has been confined to people who have recently travelled or been in contact with someone who tested positive (or possibly the at-risk groups).

Since mortality rates and rates of infection depend very much on this ‘wobbly’ estimate, we may see differences across regions that are more due to the ability to test rather than health characteristics.

A new testing machine – apparently about the size of a toaster – became available from the end of March in the US. It can draw a conclusion about having the virus or not in 5 to 13 minutes – as opposed to the current far more intrusive testing process that takes three days.

If this new machine (or other better procedures) can be rolled out quickly we can have mass testing and work out who has recovered and, therefore, less likely to be re-infected (the US and UK authorities have stated that there is minimal chance of re-infection but some cases of re-infection have been reported in some other countries). Also, knowing who is infected can better alert people to self-isolate.

The Australian health authorities have said that there is an early indication that our new cases may have peaked! Of course, that is only possible if the current policies are maintained or tightened. Australia is slightly better off than our Northern Hemisphere friends. Many flu-type viruses are less rampant in warmer weather.

All life is precious but it is worth noting that the Spanish flu crisis of 1918-20 is reported by Wikipedia to have infected one quarter of the world’s population and killed 17 – 50 million people (with some reports as high as 100 million). That the current numbers are so low by comparison might be attributable to the action taken by governments around the world. It’s not easy to conform to social distancing and self-isolation but the impact of not so doing could be massive!

So, with that layman’s overview of how the health crisis has evolved to this point – and how it might develop going forward – we can now address the economic and investment implications.
Quarantining and related restrictions mean that some industry segments must close down for an indefinite period. Some people can work from home and some might be paid (at least in part) even if they are not actively working. The rest must rely on savings and/or government relief packages.

The current situation is very different from a recession. It is a self-imposed shutdown for health reasons. Recessions happen for a number of reasons but they usually build up in intensity and take ages to get out of. Once the virus is under control, our economies can bounce back to strength.

Of course, some people and businesses might never recover. That is why the government should, and is, preparing for that eventuality.

That brings us to how much relief (it is not really stimulus because it is partial replacement funding) is enough. Our answer is that no one knows, so why pretend we can say the Australian government’s $17.6 bn plus $66 bn plus $130 bn is appropriate? Rather, the question should be, “Is it enough to get the ball rolling and will the governments produce more if and when needed?” We think the answer to both is a resounding yes.

Along the same lines, it is pointless trying to work out whether data such as that on unemployment, retail sales or GDP is good or bad in the coming months. Ignore them. But when the virus is over, we will get some bumper numbers as the economy returns to normal and catch up spending takes place.

The US economy was quite strong going into the crisis and our economy was strong enough. The latest (pre-crisis) Australian data releases were 5.1% for unemployment and 2.2% (annualised) for GDP. What’s more the RBA has also acted swiftly and strongly.

The main thing to us is that we help each other as a community. Let’s not leave anyone behind!

So, what of the markets? Wall Street achieved an all-time record as recently as February 19th and we followed suit the next day. Both markets then sank the quickest into bear-market territory since 1987 and bottomed (for the first time?) on March 23rd. Wall Street made one of its quickest ever recoveries – gaining 17% in three days. Then volatility then kicked in again.

It seems far too late in our opinion to start selling unless forced. It is equally too soon to dive back in. Depending on risk tolerance, it might be the time for the brave to start dipping their toes in the water. Again, the big lesson to be learnt from this crisis is that these things keep happening so it is always important to try and stay on top of keeping our portfolios in shape when times are good! It is always too late when markets have crashed!

We will start to know it’s over and safe to watch markets again when volatility indexes return to normal levels. All of the standard volatility measures were higher in March than they were in the GFC! In 2009, it wasn’t until the beginning of March that the market started to build in a base in stable fashion – and that’s when volatility returned to normal.

We argue this scenario because a volatile market shows heightened uncertainty and so all news – particularly negative news – can cause another run down.

When we think of the fundamental value of companies and market indexes, we usually try to take a long-run view of earnings and dividends. If that is the case, a quarter or two of bad earnings would not typically play a big part in long-run considerations – especially as we expect a big bounce back above normal levels when the virus ends.

We have not yet witnessed any downward adjustment hence our reluctance to increase exposure to equities now on the basis that they are cheaper. It is worth remembering that the price of a security is primarily driven by the expected level and certainty of its future cash flows. While the stimulus measures and containment strategies are clearly positive, we still do not know what the ultimate impact on corporate earnings will be and hence we have sufficient visibility on earnings to determine the value of the securities and therefore the market on which they trade.

Next month we expect to have a much clearer picture of the economic consequences of COVID-19. With 24×7 news and self-isolation, it is too easy to get caught up in what is going on. Moreover, comparing fund performance is fraught with problems today. With such a short-sharp sell-off in bonds and equities, funds with a large allocation to illiquid assets that might not have yet been re-priced could look overly good. Don’t be fooled!

Asset Classes
Australian Equities

The ASX 200 reached an all-time closing high of 7,163 on February 20th 2020 and then fell sharply into the end of the month. It fell even more sharply into March 23rd. After that weekend, Wall Street bounced strongly as the $2.2 tn relief bill worked its way through the US Congress. Although our market rose too, we lagged Wall Street and many other indexes in the recovery.

All sectors were hit hard in March but, unsurprisingly, the Staples sector, including the big supermarket chains, fared best of the losers!

One needs to be careful with the big banks at the moment. The relief measures and rate cuts may well supress earnings which may, in turn, force some banks to cut dividends. It’s too early to say but we will keep an eye on the situation.

Foreign Equities

The S&P 500 reached an all-time closing high of 3,386 on February 19th 2020. The index fell sharply into March 20th but then had a stellar three-day recovery (the best on record) of +17%. Some say it is the quickest entry and exit from a bear market ever. Either way, it was quick but volatility then returned.

Bonds and Interest Rates

Several central banks including the Reserve Bank of Australia (RBA), the US Federal Reserve (Fed), the Bank of England (BoE) and the ECB made out-of-cycle rate cuts on top of those at the normal meetings.

The new RBA rate is now 0.25% while that for the Bank of England is 0.1%. The Fed quotes a range which is now 0% to 0.25%. Since we do not expect these banks to try negative rates, it looks like the end of the easing cycle. The next rate hike looks a very long way away.

These central banks also announced action similar to Quantitative Easing (QE) to allow markets to function properly while uncertainty runs high. The Fed has even gone the extra mile in announcing it will purchase corporate bonds as well as (government) Treasuries.

The US 10-year T-note went on a roller coast ride in recent weeks. It fell below 0.40% and then broke through 1.00% to finish between the two extremes at around 0.7%.

What is more important than the actual rate is the so-called bid-ask spread in the secondary market. If that gap gets too wide markets will not function as well. So far it is just manageable. Central banks are supplying sufficient liquidity.

The yield curve from the 2-year to 10-year Treasury-notes is now quite steep after “inverting” in the middle of 2019. The current slope is far from what one expects before a recession but the play book is out of the window.

Earlier in the year we believed rates were going to be lower for longer – as did most other analysts. We now say even lower for even longer. As risky as they may seem now, many investors will need to consider equities to boost their portfolio yields.

Other Assets

The price of oil went into free-fall over March ( 50%+). Some of this fall would be due to decreased demand from China and elsewhere. But the big problem is the price war between Saudi Arabia and Russia over supply restrictions.

Current oil prices are unsustainable but no one seems to have a clue when the price war will end. Until it does end, the energy sector of most stock markets is in trouble.

The Australian dollar has been unusually volatile fluctuating in a range from above US65c at the start of March to below US56c and finishing the month of March just above US61c.

Regional Review
Australia

The Labour Market Survey for February reported in March showed a decrease in the unemployment rate from 5.3% to 5.1%. Jobs’ growth was strong at +26,700. The labour market was strong before the onset of COVID-19.

Economic growth came in at 2.2% (annualised) against an expected 1.9% for Q4. But the forward-looking Westpac consumer sentiment index hit a 5-year low at 91.9 (firmly below the 100 cut-off between pessimism and optimism).

The government has launched two relief packages ($17.6bn and $66bn) with a third worth $130 bn under construction. With strict controls on social distancing and (currently) a low level of COVID-19 cases compared the usual countries we are in a position to deal with the crisis better than many.

Naturally, some poor economic data will be released in the coming months but we fully expect the economy to recover when all is done. We believe the notion that we will be heading back to normal within six months to be plausible. However, such things as a deeper economic malaise and mutations of the virus and other microbiological complications would change things. Moreover, in relation to the virus itself break-throughs on testing could shorten the down time.

China

The coronavirus outbreak started in China but, already, there are reports that the China economy is starting to get moving again. The problem they now face is that the countries that they would normally be exporting to are not yet ready to take them!

The monthly Purchasing Managers’ Index (PMI) was released on the last day of March – just as the lock-down in Wuhan was being lifted.

The manufacturing PMI came in at 52.0 against an expectation of 45.0 and a previous month of 35.7. Since 50 is the cut-off between ‘expansion and contraction‘, this outcome was a major positive.

The services PMI came in even higher at 52.3 compared to the previous month’s 29.6. Another massive beat.

We are less surprised than the interpretation widely seen on TV. The PMI survey asks a question similar to ‘are things getting better or worse than now without stating what now is’ (with 50 being neutral) and not about the predicted level of growth. Since things were bad at the middle of the shutdown, this number only indicates things are getting better. This stage is the first in what we anticipate to be a recovery.

US

The US labour data remained very strong just before the COVID-19 outbreak. New jobs totalled 273,000 for the month which was well above the expected 175,000 and the two previous months’ data were revised sharply upwards. The unemployment rate was at the 50-year low of 3.5% and the wage growth was a healthy 3.0%.

The latest weekly initial jobless claims data came in at 3.28 million which is four times the previous high. This figure was the first of what we see as a sequence of numbers that are impossible to interpret.

Trump has signed off on a $2.2 tn relief package and the daily briefings on the virus continue to report problems being overcome. Of course, the toxic feud between the two political camps continues to fuel conflict from time to time.

At the start of the month, Joe Biden effectively became the Democratic nominee to take on Trump in November. Trump’s popularity is at an all-time high in his presidency. There was even a 60% approval rating of the manner in which he is handling the pandemic.

Europe

Italy was the epicentre of the outbreak in the Western world but New York has since taken that unenviable spot.

Germany has pledged a relief package equal to about 30% of its GDP – or about three times what the US and Australia have so far each committed. It seems everyone is trying hard to get through this period with minimal political bickering. Wonderful!

Rest of the World

The Tokyo Olympics has been pushed back to 2021 as have other major sporting events. These are enormously expensive events to stage but, hopefully, the infrastructure and the athletes will come though. The latest Japan data on retail sales and industrial output were pleasingly better than expectations. Next month cannot look so good.

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

Good start to year for markets.

– US trade deals signed
– Stronger China data
– Better than expected Australian data.

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.

The Big Picture

We expressed strong reasons for being optimistic about equities in 2020 at the start of this year. The ASX 200 and the S&P then raced ahead in January so much so that our overpricing signals came close to calling the need for a slight correction!

Coronavirus jumped out of the shadows towards the end of January and that was enough to check the markets’ strides. The ASX 200 still gained 4.7% in January while the S&P 500 finished the month slightly down.

At this point, not enough seems to be known about the virus to be able to make a meaningful economic assessment. However, there are good signals that China and the rest of the world are cooperating in finding a solution. Put in the context of other recent medical alarms such as SARS and Ebola, there is no sign yet that markets might not soon start to recover.

Of course, we had the added problem of major bushfires at home to contend with. Even so, our market climbed just about as much in January as in an average full year!

The Phase 1 trade deal was signed as expected on January 15th so that put the stoush between China and the US on the back burner. Brexit seems to be going smoothly – certainly far better than most claimed it would be in the three-year run-up since the referendum.

The Trump impeachment trial started with all of the fanfare of a three-ringed circus coming to town. Few expect a conviction and an exit for Trump. The issue is what impact there will be on Trump and Biden in the run-up to the November elections.

By and large the relevant global macro-economic data in January have been quite favourable. China’s key monthly indicators were stronger than expected. Its economic growth came in as expected at 6.1%.

While some point to a falling growth rate in China, it is prudent to place this change in growth in context. China’s economy has doubled since 2011 while our economy is only up around 20%. That means that the value added for China from an Australian perspective is massive at 6.1% p.a. compared to 8% p.a. or so a decade ago!

The US Federal Reserve (the “Fed”) kept rates on hold in January as expected. However, they did downgrade the word they have been using to describe their labour market from “strong” to “moderate”.

The latest nonfarm payrolls figure came in a little under expectations at 145,000 new jobs for the month of December against the predicted 165,000. The unemployment rate stayed at 3.5% (a fifty-year low) but the growth in wages dropped from 3.1% p.a. to 2.9% p.a.

We have found it hard to be any more positive about the Australian economy than “stuck in a rut” (but not dying). The latest jobs data were, in fact, a little encouraging. The unemployment rate dropped a notch to 5.1% and jobs growth was moderately strong. Indeed, the rate of increase in full-time employment has been (gently) accelerating.

Even our inflation rate hinted at some signs of life. The headline figure of 1.8% and the RBA’s preferred “trimmed mean” number of 1.6% are not far off the 2% to 3% band that the RBA targets.

Importantly, the IMF believes that global growth in 2020 will be 3.4% against 2.9% for 2019. That is, most indicators suggest that the “bottom” is behind us. Cyclical growth can start again!

The upcoming reporting season in Australia will shape the year to come. The US season, already underway, has had some standout successes but also some big failures. Our interpretation of broker-based forecasts of earnings growth in Australia (underpinned by company guidance) has strengthened to level around 5%, enough to support the view that the ‘endless summer’ looks set to continue, the caveat being that the Coronavirus outbreak is quickly contained.

Asset Classes

Australian Equities

There were big gains in most sectors of the ASX 200 in January other than resources. Even Financials posted modest growth.

The January gain for the broader index of 5% is around the long-term average for a full year. We have the market modestly overpriced but the fundamentals have been improving steadily since November.

Importantly the ASX 200 has already climbed above the highest end-of-year forecast we have seen in the media. With the February reporting season just getting underway, we will see if the January surge was misguided or if the commentators will be forced to upgrade their forecasts.

Of course, the full impact of the Coronavirus has not yet fully worked through. When it is difficult to estimate the economic impact of such a health problem, markets often over-correct presenting buying opportunities.

We see no new major downside to the market in the near future but we do expect growth to moderate. The ‘endless summer’ in the markets will one day end but based on our forecasts we do not see sufficient justification to rotate away from equities at this point.

Foreign Equities

The S&P 500 did not fare as well as the ASX 200 during January but new all-time highs were reached in January in both markets. The S&P 500 gave up all of its January gains on the last day of the month – and then a little more.

The December quarter 2019 US reporting season is well underway with the likes of JP Morgan and Amazon spectacularly beating expectations – so much so that the Amazon CEO, Jeff Bezos, reportedly added $11bn to his personal wealth on the day of that announcement. Amazon went on to rally the next day while the broader market was being hit by the Coronavirus.

Of course, there were misses too but our take of the season so far is that there is, on balance, support for this rally.

Bonds and Interest Rates

The US Federal Reserve (the Fed) was on hold in January as was largely expected. Interestingly, the CME Fedwatch tool that prices possible Fed rate changes off futures prices put the ‘no-change’ probability at 87% but interestingly the remining 13% was for a hike and not a cut!

At that time, the same expectations for the period up to December 2020 were only for 26% on hold; 3% for a hike and the rest for one to three cuts. The Fed’s statement said that they expect to be ‘on hold’ throughout 2020 before a new hiking round begins – but at a much slower pace than last time.

After the Fed decision, and the further impact of the Coronavirus, the end-of-year probability for being ‘on hold’ is now only 10.8% with 1, 2 and 3 cuts this year being almost equally likely!

The US 10-year bond rate was just over 1.9% at the beginning of the year but this rate fell to 1.6% at the end of January. However, the 2-year rate also fell so that there was no recurrence of the “inverted yield curve” that worried some in mid-2019.

The Reserve Bank of Australia (RBA) was widely expected to cut rates at the start of February but the recent employment and inflation data reduced that probability a little. We expect a cut in the first half of this year. It is not clear if the RBA will react to the Coronavirus situation.

Other Assets

The prices of oil pulled back over January as some degree of peace returned to the Middle East.

The price of copper also retreated but coal prices posted a modest increase.

Regional Review

Australia

The Labour Market Survey for December, reported in January, showed a fall in the unemployment rate from 5.2% to 5.1%. The consensus forecast was for an increase to 5.3%. However, the sample size for this survey provides for quite a wide tolerance in outcomes.

There were 28,900 jobs added in December but all of those jobs were part time. However, the official trend employment data that smooths out random variations painted a brighter picture.

Our latest inflation data produced a 0.7% gain for the quarter or 1.8% for the year. The RBA prefers to use a so-called ‘trimmed mean’. Those figures were 0.4% for the quarter and 1.6% for the year. Markets had expected 1.5% for the year meaning that inflation is at a more encouraging rate than expected. The RBA is mandated to try and keep inflation in a target band of 2% to 3% (something it has failed to do for a number of years).

While these ‘hard’ data have been positive, the Westpac Consumer Sentiment Index fell from 95.1 to 93.4. That is, there are more pessimists than optimists and 93.4 is at the low end of observations since the end of the GFC.

Going forward, we will start to see data more affected by the bushfires. We expect that, after some volatility in the numbers, government expenditures will return the overall economic data to previous levels.

China

The Coronavirus outbreak in the Wuhan area is a major concern. The World Health Organization confirmed on January 30 that the virus is now classified as a global threat. However, the press release emphasised it might well be contained in advanced economies. It is a far more serious problem for countries with weaker public health systems.

A forecast of China growth reported on CNBC TV for the current quarter was 4.5% which is well below the previous quarter’s 6.1%. Few analysts so far are calling for any long-term detrimental impact on the global economy.

The China manufacturing PMI index came in at 50.0 which was right on expectations. The survey was taken in mid-January while the virus was only just emerging. The next reading could be well down.

China Industrial Output (6.9%), Retail Sales (8.0%) and Fixed Asset Investment (5.4%) all beat expectations.

US

The US labour data remain reasonably strong. The number of new jobs came in at 145,000 against and expected 165,000 but the unemployment rate again came in at a fifty-year low of 3.5%. The change in wage rate dropped from 3.1% to 2.9%.

Retail sales were on expectations at 0.3% for the month but housing starts stormed home at +16.9% to a 13-year high. Q4 growth came in at 2.1% just above expectations.

Trump signed the Phase 1 trade deal with China and also the replacement of the North America Free Trade Agreement (NAFTA) arrangement between the US, Canada and Mexico. Canada’s president Trudeau is yet to sign this new United States Canada Mexico Agreement (USMCA).

Neither trade deal is thought to provide a major direct improvement to trade but they do take away a lot of uncertainty that had been clouding investment decisions.
The impeachment trial in the Senate is underway. Few expect the economy to suffer or for Trump to be forced out of office. However, it may well impact the prospects for Biden and/or Trump in this year’s elections.

Europe

Brexit is at last underway. So far there is much less negativity about the economic consequences than during the run-up to Brexit which occurred at midnight local time on 31 January. The UK now has until December 31st of this year to cobble together some new trade deals with Europe and the rest of the world. During this transition period it may well be the case that the UK puts together some temporary deals while better longer-term deals are negotiated.

The Bank of England kept rates on hold in a 7-2 vote of the policy setting committee. Most expected a cut or at least a much closer vote. We take this vote as a positive from the Bank.

Rest of the World

The IMF shaved 0.1% off its forecasts for global growth in 2019 and 2020 to 2.9% and 3.4%, respectively, because of their perception of the India economy.  The important take away is that the IMF still expects 2020 to be noticeably stronger than 2019. Perhaps the next cyclical upswing is underway – notwithstanding the Coronavirus outbreak. Naturally Q1 of 2020 might see a health-related pullback in growth delaying the start of this next upswing.