Macro Matters – September 2020

(Source: Merlea Macro Matters)

Summary

If recoveries in the US and Europe were to continue at the pace of the past couple of months, GDP would return its pre-virus level very soon, forming the much debated ‘V’-shaped rebound and mirroring what has been seen in China. However, I think this is too optimistic and instead we will see the recovery slow from 4Q20 as the initial boost from re-opening fades.  With the Coronavirus far from contained, social distancing behaviour and restrictions are likely to persist through 2021 and consumers are likely to remain cautious in light of the sharp rise in unemployment that has already happened in the US and is expected in Europe later this year. It is also likely that businesses will slash investment. My view is that the recovery path for the US and Europe continues to look decidedly ‘swoosh’-shaped, with a slow haul back to pre-virus GDP levels taking 18 and 30 months, respectively, from the April trough.

Over the past few months a sharp rise in new virus cases in the US and Spain, plus a rise in France’s mobility rates underscore the ongoing downside risk to the forecast from a renewed deterioration in the health crisis. While the response to the recent surge in cases has been more targeted, a reversion to full lockdown approaches cannot be ruled out, particularly if hospitalisation and death rates start to rise rapidly again and threaten to overwhelm health systems. Such a scenario could prompt renewed falls in GDP over the winter months. However, it seems likely that the shock would not be as severe as that in 2Q20 given improved healthcare capacity and experience in dealing with the virus, treatment innovations, testing and tracing frameworks and the adjustments in economic and social behaviour. Optimism over the possibility of a vaccine becoming available is also growing, a development that would entail upside risks to the economic outlook. Overall, we have arrived in a world of stagnating growth. While no widespread global recession has occurred in the last decade, global growth has now dropped below its long-term trend of around 2.7 percent. The fact that global GDP growth has not declined even more in recent years is mainly due to solid consumer spending and strong labour markets in most large economies around the world. Of course, current conditions and future challenges differ in regions throughout the world

Financial markets have continued to recover from the impact of the recession, although there has been a retreat in equities in recent days. Financial conditions improved for major advanced economies in August, in part due to policy efforts to keep markets functioning. How bank lending standards evolve is an issue to watch, with a tightening already evident in the US. While advanced economy banks now have limited policy room, emerging market central banks have continued to ease rates.

Although the coronavirus was, by far, the biggest event of this year, the result of the US presidential election in November is likely to have a significant impact on the global economy, business environment, and geopolitics in general. The U.S. federal elections are too close to call. They will become a bigger focus for markets if the Democrat nominee, Joe Biden, takes a decisive lead.

Biden plans to at least partially reverse President Donald Trump’s 2017 corporate tax cuts. This could deliver a hit to earnings per share in 2021. One of the key watchpoints will be the election outcome of the Republican-led U.S. Senate. Democrat control of the White House, Senate and House of Representatives would make a corporate tax hike more likely. It would also create the risk of more corporate regulation.

The other election risk is a re-escalation of the US/China trade war. A recovery in the stock market and the economy provide President Trump with his best chance of re-election. We expect he will not endanger this by re-starting trade hostilities. This calculus could change if Trump’s poll ratings show him in a losing position a couple of months from the election. He may conclude that nationalism and China-bashing increase his chance for victory.

Bonds

Bond yields are indeed at historically low levels, an indication of the emergency settings in place to keep the world from descending into a depression. Now the reality is that bond prices cannot keep going higher unless yields keep going lower, which is why, unlike with equities, the upside potential in bonds is inherently capped.

The pace of central bank balance-sheet expansion has recently slowed but this largely reflects eased fears about financial stability rather than a desire to scale back monetary policy accommodation. The Fed’s recent switch to a flexible average inflation-targeting framework and the move to an asymmetric employment target – downplaying the role of very low unemployment rates as an independent signal to tighten policy– seems to hard-wire what was already a highly dovish bias. While we have not seen fresh announcements of additional asset purchases from the major central banks in recent months, we sense no reluctance to implement such moves if the recovery falters. Monetary policy makers will be closely watching signs of tightening credit availability in recent bank loan officer surveys, although evidence is also mounting that the US housing market may be starting to respond to lower long-term interest rates.

The change in Fed target may well push inflation expectations up, prompting workers to push for higher wages, which would potentially shift inflation too. At present though, the ability of workers to do this is low. To be sure, inflation could become an issue down the track. The enormous fiscal and monetary easing alongside with re-emerging supply chains and disillusionment with globalisation in favour of local independence could all provide the impetus for rising prices. One possible scenario sees a global economic recovery brought about by vaccine development and widespread distribution, lockdown removals and the effects of stimulus combining to resemble the periods following World War II.

The initial market response has seen a “bear steepening” move in the US yield curve, where yields on longer maturity bonds rise more than yields on shorter maturity bonds. Maturity is the period after which the bond is repaid. For August, the yield on US Treasuries maturing in 30-years rose from 1.20% to 1.45% (bond prices move inversely of yields and interest rates).  This essentially indicates markets expect rates will be higher over the longer term as growth and inflation picks up, which is the intention of the Fed’s policy. A more sustainable move to higher inflation will mean more volatility for bond markets and higher yields, but I believe this is some time away as central banks stay very accommodative and in control of yield curves.

Listed Property

A wide range of indicators from GDP, labour markets, housing markets and commercial real estate are consistent with continued economic growth and improving real estate markets and Real Estate Investment Trust (REIT) earnings in 2020.

Despite the challenges COVID-19 is throwing at the real estate sector in the near term, businesses still require real estate as an operating platform as part of the value chain. It is still too early to tell what extent secular changes (which were already underway) will be fast tracked by these events. The rise of online retail, the increasing importance of logistics centres and greater demand for flexibility in office utilisation are all themes being accelerated by current events. Landlords are acutely aware of these changes and for the most part are pivoting to meet them.

With all these uncertainties, it was not surprising that most REITs have withdrawn guidance. A few exceptions where guidance was provided included Goodman Group (GMG), Charter Hall Group (CHC), Charter Hall Long WALE (CLW), Charter Hall Infrastructure Trust (CQE), APN Industria REIT (ADI), Centuria Capital (CNI), Centuria Industrial REIT (CIP) and Waypoint REIT (WPR). This is due to their cash flow being resilient in the wake of COVID-19.

A strong performance by Australian REITs, which jumped 10.7% during the month of August, outperforming a 5.6% gain in local equities. The major outperformers were Stockland, Vicinity Centres, and Scentre Group, as investors expected a rebound in consumption that would help boost the retail sector. Looking ahead, A-REITs are expected to continue to show strong performance against a favourable macroeconomic backdrop.

Given REITs have a strong income focus, in a world where the ‘lower for longer’ interest rates scenario has extended out to previous unforeseen levels, the merit of real estate remains intact. Post this crisis, we believe the demand for income generating assets will continue, if not actually increase. While there are undoubtedly some who will lose out, others stand to gain.

Australian Equities

Australia’s not-as-bad-as-feared recession is largely playing out. The economy contracted by 7.0% quarter-over-quarter (q/q) in the second quarter of the year. The decline was almost entirely the result of a 12.1% q/q plunge in household spending. While the economic trough was lower than in many other developed countries, the drag could be worse given the restrictions that have been in place since the end of June. The RBA’s own forecasts in its Statement of Monetary Policy were for a slight upgrade to growth this year, but the outlook for the labour market remains the same and the path out of recession will perhaps be flatter than other developed markets. With the earnings season in Australia now complete, there was positive news in more companies offering up better-than-expected results, but the margin was not as high as in other markets.

The greater worry for many investors is the outlook and dividends. There was little corporate guidance on what to expect from here, leaving investors guessing as to what earnings and dividend payments, and by who, will look like in the future.

So, the question is – will this market grind higher? Even the most humble financial adviser understands that if you are discounting a company’s cash flow at an interest rate close to 0 per cent, the valuation of the company in forward terms is likely to be very high.

If a vaccine to COVID-19 is discovered soon, successfully provided to the world’s population and the virus is controlled, the world’s economy will get back on track quickly. Conversely, if the vaccine takes a long time to be discovered and provided to the world’s population, the economic disruption caused by the pandemic will continue to drive the global recession deeper. My take on all of this is that the market will continue to display some resilience, provided Central Banks keep interest rates to an all-time low and governments continue to pump money into the economy with social security benefit payments (Job Keeper, for example).

My view is that the market appears well overpriced, particularly if a vaccine is not discovered and successfully distributed quickly. Valuations remain elevated as the ASX 200 trades of a forward price-to-earnings multiple of 20.2x.

Global markets

After one of the shortest periods of bear market decline and recovery in the post-war era, the equity market remains close to pre-crisis highs, even in the wake of early Septembers sell-off. September tends to be a weak month for stocks historically. Despite the reversal. The fact that this is taking place while we are in a recession, signals a developing disconnect between some asset classes and the real economy. There are some good reasons for this, including accommodative monetary policy, record fiscal stimulus, abundant levels of liquidity and structural changes in the economy favouring companies exposed to new ways of working.

But, in addition to concentration risk and toppy markets, the increasingly uncertain outcome of the US presidential election is fast approaching and geopolitical tensions between the US and China seem to only ratchet up. The market rebound means that value is no longer compelling for global equities or credit. On the other hand, the cycle outlook has improved as fiscal and monetary stimulus announcements continue and economies start to emerge from lockdown.

The bottom of a major recession when stimulus is flowing is one of the few times it is possible to have a relatively confident view on the cycle. Sentiment, unsurprisingly, is no longer as supportive.

Russell Investments composite contrarian indicator, as of mid-June, is providing a neutral signal. This means that the support from oversold conditions is waning and markets are at greater risk of pulling back on negative news.  Above Neutral value, neutral sentiment and a supportive cycle give us a more balanced view on the investment outlook. Looking near-term, markets are vulnerable to negative news after a 40% rebound and with sentiment on the verge of triggering an overbought signal. Over the medium-term, the supportive cycle outlook should allow equities to outperform bonds.

For now, we do expect consolidation after the earnings season as some enthusiasm wanes, cyclicals attempt to balance out the high growth sectors, and investors remain grounded with the presidential election approaching. This is an opportune time, in our view, to re-examine portfolio strategy and have plans ready for the next “breaking away” period in the economy and equity markets.

America

Despite failure of the US Senate in passing another round of stimulus, future fiscal stimulus policies are still possible  The timing remains uncertain given the upcoming November election and partisan disputes, but I do not see this as the end of the process as both parties have a strong incentive to provide extra help to the economy. More monetary stimulus policies from the Federal Reserve, which have been historic in size and scope, are likely to be announced in the coming months, with more guidance from the Fed at its mid-September meeting. The recent inflation policy overhaul suggests a long period of easy policy.

The Fed now has greater willingness to tolerate inflation overshooting the 2% target before tightening policy. On spending, most Americans maintain a cautious attitude. Among those who are currently able to save money, as many as three-quarters plan to keep increasing savings over the next six months, and less than one-third intend to spend more on basic goods and services. Even fewer are thinking of allocating cash to less-essential expenditures like travel or holidays (just over one in 10).  At the same time, only one in 10 respondents plan to pay down debt. Additional income is mostly being set aside as dry powder, presumably for when the virus and economic uncertainty will have cleared; this could provide a precious buffer and allow for an eventual faster rebound in spending.

Americans, it would seem, are saving for sunnier days. While the US market as a whole looks rather expensive by historical standards, trading on a price-to-earnings (P/E) ratio of 23x 12-month forward earnings this valuation is distorted by growth stocks, which are up 25% this year and are trading on a P/E of 29.5x. While not all growth stocks are overvalued, some of the cheaper stocks in the market could have more upside if a vaccine is announced, compared to those that have already performed very well this year. Over the next few months, it is likely headlines will be filled with news on vaccine trials, political uncertainty, a deepening recession, and more social unrest. But underlying this are fundamental disruptions in our economy that will impact how we live and work—this also presents opportunities for active investors who are observing the longer-term trends.

Europe

Although an increase in COVID-19 cases was almost inevitable as Europe’s economies emerged from lockdown, the pace of the increase in some countries is worrying. This is particularly true of Spain, where the infection rate has surged above its March peak. The only consolation is that hospitalisations and the mortality rate remain much lower than earlier in the year in all countries. And while this remains the case, governments are likely to respond to rising cases with targeted measures and localized restrictions on economic and social activity rather than new national lockdowns.

In the Eurozone, inflation turned to deflation in August as energy prices continued to fall sharply. Specifically, consumer prices were down 0.2% in August versus a year earlier. When volatile food and energy prices are excluded, core prices were up 0.4% from a year earlier, the lowest level of underlying inflation on record. This means that the weakness of the economy is overwhelming the impact of a large increase in the money supply. Personal and business savings have increased, suppressing demand. Moreover, even though reported unemployment remains low, the reality is that many people are not actually working but are being supported by government furlough schemes that are about to expire. Hence, the decision to save heavily makes sense. Meanwhile, the European Union reports that the reported unemployment rate in the Eurozone is increasing rapidly, hitting 7.9% in July. This is the highest rate since late 2018. This means that, despite the various furlough schemes that have provided income to temporarily dismissed workers, many employers are permanently eliminating positions. In some cases, this reflects business failures. When furlough schemes do expire, the unemployment rate could increase quickly.

United Kingdom

While the economy continues to be hampered by the effects of the pandemic the headline rate of unemployment remained low over the summer. It has been kept in place by the government’s Job Retention Scheme. As the scheme comes to an end, the UK economy faces considerable job loses this winter. A no deal Brexit could see a sharper increase in prices due to tariffs imposed on EU goods, with the overall impact depending on the UK’s choice of tariff regime. While goods imported to the UK from the EU may be more expensive, those from elsewhere may not. It depends on how UK tariffs compare to EU ones. Temporary factors, such as the cut to VAT for retail and hospitality and the ’Eat Out to Help Out’ scheme will push inflation down in 2020. (As these measures are gradually lifted, the effect will play out in reverse.) The UK has made some good progress in both vaccine development and the planning of its roll-out (Phase II clinical trial). Large-scale Phase III trials have begun in the UK, Brazil and South Africa so we are well on track to see some conclusive results about its applicability by the end of this year.

Japan

As anticipated, Suga Yoshihide has won the election for the leadership of Japan’s Liberal Democratic Party (LDP) following Prime Minister Abe Shinzo’s decision to step down. Suga defeated rivals Kishida Fumio and Ishiba Shigeru in a landslide victory.  Investors expect no major change of economic policy under Suga. He has stated that his priority is to help Japan through the COVID-19 crisis and he has indicated that he will support low interest rates and more fiscal stimulus, aimed especially at helping Japan’s less developed region. He said he would raise the minimum wage, promote agricultural reforms and boost tourism.  On foreign policy, too, he is expected to follow in Mr Abe’s footsteps, prioritising Japan’s long-running alliance with the US while also maintaining stable relations with China.

Japan slipped into recession earlier this year following two successive quarters of economic contraction. Its latest data for the April to June quarter was the biggest decline since comparable figures became available in 1980 and was slightly bigger than analysts had expected. One of the main factors behind the slump was a severe decrease in domestic consumption, which accounts for more than half of Japan’s economy. Exports have also fallen sharply as global trade is hit by the pandemic. The downturn puts further pressure on a Japanese economy that was already struggling with the effects of a sales tax hike to 10% last year, along with typhoon Hagibis. I believe Japan is likely to do better than other economies, even though their largest trading partner is in the midst of a second wave of infections, its health care systems aren’t overwhelmed, and new cases have started to decline. I would expect to see third quarter GDP bounce back – and continue through to next year.

China

China’s recovery is undoubtedly impressive, especially when compared to other major economies that are mired in the pandemic. The government has encouraged this inflow of capital as part of its effort to create a larger and more sophisticated capital base with which to generate future growth. Meanwhile, the government also reported that Chinese banks increased lending by 29% from July to August. Lending to households was up 11% while lending to business was up a stunning 119%. The increasing demand for credit reflects the growing confidence of businesses and households about the state of the Chinese economy. It also reflects the easing of credit conditions by the People’s Bank of China (PBOC), China’s central bank. The PBOC has cut interest rates, reduced bank reserve requirements, and provided direct loans to companies disrupted by the virus. It is likely that the surge in business demand for credit will lead to an acceleration in investment, and possibly an increase in equity and corporate bond issuance. At the same time, the five biggest banks in China report that profits have fallen sharply due to an increase in bad loans.

The surge in credit activity and inbound investment is consistent with measures of real economic activity, which indicate that China is likely amid a robust, V-shaped recovery. However, what is increasingly clear is that much of that growth is driven by government investment in infrastructure and that underlying private sector demand is not commensurately strong. But economists have warned that the Chinese economy is simply completing the easiest part of its comeback, and that the unbalanced growth pattern – with industrial production and construction activity strong but consumer spending remaining weak – could linger into next year, meaning it is time for the government to pay more attention to long-term structural risks and challenges.

Commodities

Gold

Gold is a clear complement to stocks, bonds, and broad-based portfolios. As a store of wealth and a hedge against systemic risk, currency depreciation and inflation, gold has historically improved portfolios’ risk-adjusted returns, delivered positive returns, and provided liquidity to meet liabilities in times of market stress. All the bullish factors for gold are in place: a “black swan” event that has created huge fear and uncertainty, imploding global stocks and sending traders/investors flocking to safe havens like the US dollar, US Treasuries and precious metals. The demand for Treasuries has pushed up their prices, causing their yields to fall to new lows. Negative real yields (yields minus inflation) are bullish for gold, and we expect yields to remain negative for some time, even if prices are beginning to deflate. And then there’s debt. We have been able to draw a very straight line between debt-to-GDP ratios and gold prices. Gold rises proportionally to debt. While governments are wrangling the coronavirus, we fully expect national debt piles to keep growing. Indeed, the political pressure on governments to help the most vulnerable in society, for fear not only of losing power, but in some countries, extreme social unrest, is bound to keep the stimulus taps flowing. I would look to purchase precious metals during periods of price weakness and market corrections. All signs continue to point higher for the metals that are stores of value during inflationary and uncertain times.

WTIS

Many countries have eased national pandemic-related lockdown measures despite the increasing number of new coronavirus cases in some countries. We do not assume a second round of strict lockdowns globally, and therefore we envisage an oil demand recovery that continues in 2021.

Indicators of economic activity have largely been higher than market participants’ expectations, particularly in sectors such as housing and in indicators like new durable goods orders. Nonetheless, economic recovery in some sectors that are important for oil consumption, such as personal travel and tourism, has been slower. EIA estimates that global oil consumption in August grew by 1.0 million barrels per day (b/d) from July, the slowest month-over-month increase since consumption began to recover in May and the first time during that period that consumption growth was surpassed by growth in world oil production. Despite the different pace of increase between global oil production and consumption during August, EIA forecasts oil market balances to continue tightening for the remainder of 2020 because of continued demand.

A sharp demand drop in 2Q20 was partially offset by OPEC+ production cuts. The initial headline cut of 9.7 million barrels a day (mmb/d) in May and June 2020 was extended to July. In August, it was reduced to 7.7 mmb/d, as planned. The cuts are planned to be further reduced to 5.8 mmb/d between January 2021 and April 2022. This OPEC+ agreement has been the primary driver for oil price stabilisation, meaning that lower-than-expected cuts or conflicts within the group would put renewed pressure on oil prices as OPEC+ countries have very large unutilised production capacities.

Sector 12 Month Forecast Economic and political predictions 2020
 

AUD vs USD

 

Upside 74c

Downside 67c

 

Heightened global concerns of course influence riskier currencies such as the Aussie dollar.  However, it has certainly been helped by its significant correlation to the Chinese economy.  Iron ore is Australia’s main export earner and is therefore a significant fundamental driver of AUD value. The rise in iron ore prices since March has in a large part been driven by demand by China, where government stimulus initiatives have seen demand for iron ore rise as new development projects come online. However, the rally in iron ore might be coming to an end with China’s infrastructure and real estate sectors faltering. I do feel the AUD is due for a short term pull back.

 

 

Gold

 

Gold to stay in holding pattern could retrace to $1,750 an ounce in the short term

 

The latest FOMC statement and economic projections signal are that the interest rates will stay at zero until the end of 2023.   Well, the Fed’s statement is clearly dovish as it signals that the Fed will not drop its policy of zero interest rates for years to come.  The US central bank made the tightening starts dependent on more rigorous conditions, and since the ultra-low nominal bond yields and the negative real interest rates will stay with us for much longer, investors should get used to them, which should provide support for gold prices in the process.

 

 

Commodities

 

The nickel price is up around 70-80% year-to-date as a result of strong demand for stainless steel, combined with increasing new demand from the rapidly growing Electric Vehicle industry. Other factors have also played into the nickel price rise, such as the Indonesian ore ban due to come into force in 2022. Indonesia announced that it would bring forward the ban to January 2020. Many analysts predict further price increases and we are seeing that investors are becoming increasingly interested in the nickel market.

 

 

We are neutral on commodities in the coming months, except for gold and iron ore, for which still-supportive fundamentals will keep prices in an uptrend for now. We believe oil prices will continue to range-trade in the coming months, while base metals are likely to pause and could pull back slightly following their impressive recovery to pre-Covid levels.

 

Looking at 2021, we are mostly positive on commodity prices, towards energy (oil and natural gas) and towards softs.

 

Property  

Prefer Infrastructure, Data centres and Industrial REITs

 

Valuations have gotten more reasonable and the long-term prospects of many REITs have improved. COVID-19 is something of a unique situation, no-one knows when or how current restrictions will be eased or even re-introduced. That makes pricing in expected loss of earnings for retail REITs very hard right now.

 

Market dislocation is a good thing for value-minded investors. I think the A-REIT sector share price could move higher if we see restrictions ease quicker than expected.

 

 

Australian Equities

 

Hold

 

What we have seen on the ASX 200 over the past week is ‘froth being blown off the top of the market’. My view this correction is likely to have further downside in the absence of some positive news (like a US fiscal package or vaccine developments).  Whilst this is not good news for investors today, I think that it is a temporary setback for ASX shares. In the short term, we maintain a cautious outlook for Australian equities.

 

 

Bonds

 

Long dated bonds 5-year duration

 

Inflation liked bonds

 

 

The RBA is targeting a risk-free interest rate further out along the yield curve. On 19 March 2020, the Board announced a target for the yield on 3-year Australian Government bonds of around 0.25 per cent, to help lower funding costs across the economy. The Bank is purchasing Australian Government bonds across the yield curve to help achieve this target.

 

The Bank expects to maintain the target for three-year yields until progress is being made towards the Bank’s goals of full employment and the inflation target

 

 

Cash Rates

 

0.25 %

 

Hold.

 

Global Markets
 

America

 

Underweight

Risk to US stocks include concerns about the pandemic, fading fiscal stimulus, volatility around the election and worsening relations with China

 

 

August consumer prices rose by more than expected (again), lifting by 0.4% in August or 1.3% over the year. Core CPI is running at 1.7% over the year. Consumer price growth is likely to slow from here given the large amount of spare capacity created by the collapse in GDP.

 

Europe

 

Neutral

 

Europe’s exposure to financials and cyclically sensitive sectors-such as industrials, materials, and energy-gives it the potential to outperform in the second phase of the recovery, when economic activity picks up and yield curves steepen.

 

 

The GDP outlook was a little stronger, based on good data recently and core inflation in 2022 was revised up slightly by 0.2 percentage points to 1.1% per annum. While the latest economic data has shown a solid bounce back in growth, the more subdued medium-term outlook (with rising COVID-19 cases, Brexit risks and some expiring wage subsidy schemes) argues for more policy support from the central bank.

 

Japan

 

Underweight

Although a recovery is expected, it is expected to take at least two years to return to pre-infection profit levels

 

 

Suga, who was recently elected for the country’s top job, has indicated he sees no need for any immediate changes in BOJ policies that have helped keep financial markets stable and get credit to companies amid COVID-19.

 

Emerging markets

 

Underweight

China remains ahead in terms of the extent of its recovery, which, along with a weaker dollar, should be supportive for emerging markets and for the materials sector.

 

Emerging markets are in many ways facing tougher economic challenges from the pandemic, given more-limited social safety nets and healthcare capacity and less scope for aggressive macro policy easing. Many EMs now face economic contractions on a scale comparable to or larger than those seen in Europe despite much higher underlying growth rates. Nevertheless, the easing in global credit conditions following massive central bank liquidity injections in 1H20 has provided some relief.

 

 

China

 

Underweight

US-China relations have plunged to a new low this year, just months after the signing of the phase one trade deal. From the origins of the coronavirus to Hong Kong’s national security law to human rights issues in Xinjiang. Washington and Beijing are locked in disputes over a growing range of issues.

 

 

Investors should focus on opportunities arising from China’s domestic consumption story and avoid technology companies with exposure to the US.

 

 

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