March 2020 Quarterly Economic Update: markets rebound, but uncertainties abound
By chief investment officer James Cook
Following a sell-off of almost 37 per cent, equity markets have now recovered to only 20 per cent from recent highs. This has been driven by a combination of large fiscal stimulus measures, accommodative monetary policy and positive signs on COVID-19 containment. While we believe that these factors have reduced the tail risks for the global economy the rebound in equity markets looks premature given the looming recession and the ongoing uncertainty.
Sharp GDP contraction expected, but softened by stimulus The International Monetary Fund (IMF) now expects global Gross Domestic Product (GDP) to contract by 3 per cent in 2020, which has been downgraded more than 6 per cent from forecasts in January. The medium- term impact will depend on the length and severity of lockdown measures, as well as whether we see further waves of virus infections. While Chinese economic activity is now ramping up, the country saw GDP contract by 6.8 per cent in the March quarter. In the US we have also seen jobless claims reach 22 million over the last four weeks, which is equivalent to the number of jobs created over the last nine years.
The depth of the looming recession has no doubt been reduced by the unprecedented fiscal stimulus and accommodative monetary policy. In Australia, the federal government’s fiscal stimulus represents more than 10 per cent of GDP. Even with this massive injection of cash, Treasury forecasts the unemployment rate to hit 10 per cent in the June quarter. Yet without the JobKeeper package the Australian employment market faced an even more dire prediction of 15 per cent unemployment. These measures are certainly welcome, but this will ultimately mean lower fiscal spending or higher taxes in the future. From a monetary perspective, the Reserve Bank of Australia (RBA) has cut the cash rate to 0.25 per cent and implemented a quantitative easing program (purchasing longer-term securities from the open market in order to increase the money supply and encourage lending and investment), while the Federal Reserve has committed more than US$2 trillion in emergency measures to support the US economy.
Corporate earnings and dividends under pressure Despite the best efforts of central banks and all levels of government, we expect corporate earnings will be significantly impacted in 2020 due to direct disruptions to sales, operations and supply chains. This will likely continue into 2021 as the global recession reduces consumer spending and business investment. In Australia, an increasing number of companies have withdrawn earnings guidance due to COVID-19 (Macquarie estimates a third of the ASX 100 at end of March, which will continue to rise). We’ll see more detail on the impact to corporate earnings as US and European quarterly reporting begins.
While earnings forecasts have come down, we expect these to decline further. Factset consensus forecasts for the S&P 500 and ASX 300 indices have earnings per share (EPS) declining by 9 per cent in 2020 compared to growth in the mid to high single digits at the start of the year. While this is a new scenario, historically recessions have led to much larger drops. Capital raisings have risen across the ASX as companies manage liquidity and solvency pressures. We expect this trend to continue with raisings this year at 1 per cent of market capitalisation compared to 11 per cent during the global financial crisis. Many companies have also deferred or suspended first half dividends, while the Australian Prudential Regulation Authority’s (APRA) directive to banks and insurers to retain capital means that substantial dividend cuts are likely.
Valuations look stretched After the recent rally, absolute valuations for equity markets look stretched with the S&P 500 Index trading on a forward Price-to-Earnings (PE) ratio of 19 times compared to a 10 year average of 16 times. The ASX 300 Index is similarly trading on a forward PE ratio of 16x and ~10 per cent above the 10 year average. While record low bond yields probably justify a premium compared to historic levels, the earnings outlook remains uncertain. However, on a relative basis equities may still be attractive given the low fixed income and cash yields that are on offer.
Defensive stance still warranted Overall, a sustained rebound in equity markets looks premature given ongoing uncertainty. With positive signs on the containment of COVID-19, along with massive fiscal stimulus and the implementation of accommodative monetary policy measures , the recent bounce seems to imply a “V-shaped recovery” is possible. We view this as too optimistic. We are still going to endure a global recession, there is no certainty on COVID-19 containment (or the development of a vaccine) and valuations look stretched when factoring in declining earnings.
As such, we believe that a defensive stance is still warranted. The Growth Portfolio remains overweight cash, while underweight Australian equities and listed property. The Australian and international equity portfolios also continue to hold higher levels of cash and have been increasing exposure to stocks with more resilient earnings. Lower interest rates have pressured term deposit rates for the Enhanced Cash Portfolio and the fund remains overweight major bank floating rate notes for liquidity and asset quality purposes, although has been actively reducing hybrids exposure to lower tail risks.
Undoubtedly there will be more ups and downs to go before we can get off the COVID-19 roller-coaster. The next few months will continue to challenge leaders and citizens alike but at this stage Australia appears to handling the crisis better than most. The U Ethical team will continue to navigate our way through as things edge, ever slowly, towards a new normal.
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