September 2020 Quarterly Economic Update: Markets stable in the face of ongoing pressures.
By chief investment officer James Cook
Quarterly Economic Update: Markets stable in the face of ongoing pressures
The Reserve Bank of Australia (RBA) reminded the market last week of just how much the COVID-19 pandemic has impacted the Australian economy. The RBA set the cash rate at an unprecedented 0.1%, which is unlikely to change for a number of years. This is a clear signal that the economy will struggle to resume the levels of growth we have grown accustomed to over the last few decades. Importantly, with reference to unconventional methods of economic stimulus such as ‘quantitative easing’ and expanding government deficits, a consequence of spending across a range of projects to boost economic activity, we are reminded of just how fragile the economy has become. We are in an era where innovation, disruption, and a growing disparity between the rich and poor has highlighted an unease that has settled upon the world. The rising emergence of populism and strong-arm governments is testimony to this, however the results of the US presidential election, could point to a brighter era.
Little reaction to bad news
Through the recent turmoil of trade tensions, pandemic and political upheaval, the reaction from financial markets has been relatively benign. Bonds markets and credit spreads , another indicator of financial risk, have been relatively constant, although locked into a very low trading band. Equity markets too, while bombarded with lots of mixed messages surrounding the earnings and operating outlook, have maintained elevated valuations and indices at levels close to record highs. It is worth noting however that the returns from equities can be very misleading, depending on when you measure performance. While pundits record the US Dow Jones index is up 15% from its lows earlier this year, returns are virtually flat over the last two years.
Further cuts in the cash rate to spur growth
As expected, the Reserve Bank Board decided to cut the cash rate target from 0.25% to 0.1%.along with a range of additional stimulatory measures on Melbourne Cup Day. The Governor confirmed the objective of lowering the Australian dollar through a lower long-term bond rate to improve the competitiveness of Australia’s exports. The action will push business borrowing costs even lower in the hope that investment intentions lift to reduce the unemployment rate which now stands at 6.9%, an improvement from the recent peak of 7.5% posted in July. The RBA remains concerned despite the improvement with estimates that the current national effective rate is 9.3% with the figure masked by JobSeeker and the unemployed Youth Allowance scheme.
The RBA also announced growth forecasts of 6% (year to June 2021) and 4% the following year (year to June 2022). With significant spare capacity in the labour market, there is unlikely to be much in the way of wage growth which will keep a lid on inflation for the foreseeable future. The RBA’s inflation expectations at below 1% for 2021 and a mere 1.5% by the end of 2022 sit below its long-term target range of 2-3% - another reason to expect interest rates will stay low for the foreseeable future.
While rates are expected to stay low over the next three years, it means returns from savings accounts and fixed-income investments are likely to remain very subdued. With a large increase in money supply as a result of all the stimulatory action, the financial system is flush with cash. While economic activity remains soft, the banks have little incentive to take on deposits which would normally be required to fund lending activity. This has added to pressure on local savings rates and returns from our Cash Management Trust and Enhanced Cash Trust.
No alternative to equities?
The flip side of this dynamic is the performance of equities and property. While returns from equities have been muted since the Australian ASX 200 peaked in mid-February (-13.%), the gains since that level have been marked, up 28%, despite the ongoing impost from a global recession and the broad constraints arising from various lockdown measures to counter the pandemic.
One theory suggests TINA – ‘there is no alternative’, in recognition that with the very low returns offered across cash and fixed-income, equities, if only in the form of a dividend yield, offer a better chance of a decent return. Corporate earnings continue to be mixed along with very moderate management guidance as corporates roll through the annual general meeting season. In some areas, the pandemic has had a devastating impact, particularly across earnings exposed to areas such as hospitality and tourism. The flip side is that some areas have done remarkably well revealing just how quickly an economy can respond to matters such as a global pandemic. Our International Equities Trust has profited from significant gains across technology and online retailing – two areas that have enjoyed a boost to activity through the pandemic.
A new dawn in US politics
On the cusp of a new US President taking office, it is difficult to write a commentary without reflecting on what that might mean for financial markets. At the time of writing, Joe Biden appears to have been successful in winning the Presidency, while the Democrats look certain to retain control of the House of Representatives - while Republicans may just hang onto control of the Senate. The official election result is likely to be stalled in a Supreme Court wrangle, and with a split government majority across Congress, one could be excused for thinking such a gridlock would heighten uncertainty - something financial markets don’t like. Despite the political ambiguity, Wall Street has rallied over the week of the election with the S&P 500 gaining 7.3%, at the same time as another wave of COVID -19 infections spread across the USA and major European economies – hardly a bullish scenario.
Wall Street rallied over the week of the election with the S&P 500 gaining 7.3%
In trying to determine what the underlying dynamics might have been, it is worthwhile revisiting the central tenet of investing in equity markets which is to discount the future. It is fair to assume that valuations and most importantly, investor expectations, had already factored in the current scenario, or something even worse. Although political uncertainty prevails, the most likely outcome is that further stimulatory action and a progressive tax regime will be the product of a Biden presidency. With a committed Federal Reserve supporting financial markets as well - the TINA principle has held firm.
The outcome may continue to support equity markets, however we remain cautious. The levels of government debt continue to pile up while recent economic gains, albeit off very low bases, may be reversed with the second wave of COVID-19 infections across major economies. The next major stimulus may well come from a vaccine breakthrough with AstraZeneca stating it expects the results of its phase-3 trials to be available within the next eight weeks (the vaccine is in late-stage trials in the UK, US, Brazil and South America). China is also now conducting Stage 3 trials. A sense of normalcy across business operations would be welcome, however the elevated levels of equity markets suggest this is also well priced in. The flow of news remains diverse and varied with uncertainty across various pockets remaining high.
Past performance is not indicative of future performance. This material provides general information only and does not take into account your individual objectives, financial situation, needs or circumstances.
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