Market Update 05 June 2020

Investment markets and key developments over the past week

Share markets continued to power up over the last week as developed countries saw further reopening along with more green shoots of recovery and some countries unveiled more stimulus measures, all of which swamped concerns about protests in the US and ongoing tensions between the US and China. Reflecting the strong global lead, the Australian share market rose to its highest level since early March with very strong gains in banks, energy, retail, property and industrial stocks but with the defensive health, telco and utility sectors lagging. Reflecting the strong “risk on” tone bond yields rose sharply (but continued to fall in Italy and Spain helped by ECB actions), and oil, metal and iron ore prices also rose. The Australian dollar rose to just below $US0.70, its highest since early January with the US dollar falling.

Shares climbing a wall of worry! From their March lows global shares are now up 36%, US shares are up 40% and Australian shares are up 32%. While the continuing rise in share markets in the face of bad news – such as US riots and the news that Australia is almost certainly in recession – may surprise many its not illogical. Shares anticipated bad news (including recession) in March with a roughly 35% plunge but are now taking their lead from a combination of falling new coronavirus cases in developed countries, positive news on the medical front regarding the virus, the reopening of developed countries, massive stimulus measures, green shoots of recovery and pessimistic and underweight investors being forced to buy into the market as it rises. Shares are very overbought technically signalling the risk of a short-term pause, but overbought conditions are of the extremes often seen coming out of major bear market lows that augur well for 6-12 month returns. If April proves to be the low point in economic activity as we expect then given the massive policy stimulus seen since March shares should be higher on a 12-month outlook. The rebound in share markets is also being confirmed by a rebound in other “risk on” growth assets including commodities, the Australian dollar and credit markets. Even government bond yields are edging up.

The three big risks remain: a second wave of coronavirus cases (which is a big risk in the US); collateral damage from the shutdowns resulting in a delayed or very slow recovery as bankruptcies surge and unemployment goes higher; and a serious escalation in US/China tensions.

But what about civil unrest in the US following the police killing of George Floyd? So far despite the images presented on TV its not big enough to significantly impact US economic activity (much like most terrorist attacks) and there are some signs it may be calming down. And historically protests have not had a big impact on shares possibly because they lead to policy measures to calm the problem and they don’t tend to last long (although a failure by the US to get unemployment back down is a clear risk here).

However, the list of things that are bad for President Trump ahead of the election in less than five months has now expanded with civil unrest adding to recession, very high unemployment and a pandemic. These would normally all be bad for the incumbent, but they are even more so given Trump’s mishandling of the pandemic and the civil unrest as well. Trump looks to have inflamed the situation with calls to put troops on the streets. While its aimed at his base the danger for him is that it motivates more to show up on polling day and vote against him. PredictIt betting odds now favour Biden and Trump’s approval rating has dipped to 43%. But the latter is in his normal range so not bad enough yet for Trump to conclude that he has little chance of winning if the economy improves. However, should his election chances plunge, Trump may conclude he has nothing to lose by ratcheting up the conflict with China – by say ramping up tariffs again – with the hope of rallying Americans around the flag. This would hold bigger risks for the economy and shares. But hopefully it occurs close to the election such that investors don’t take it so seriously. The US under Trump now also has the problem that its moral authority to question China’s handling of human rights issues and Hong Kong is seen as seriously dented.

There was nothing really new on the coronavirus front over the past week. New cases continue to trace out an uptrend.

This reflects a declining trend in developed countries (although new cases appear to have stopped falling in the US which is a concern), but a rising trend in emerging countries.

Australia is continuing to see few new cases.

The risk of a “second wave” of cases remains but so far the only real example of that I have found in the countries we monitor is Iran. A combination of social distancing rules, handwashing, rigorous testing, quarantining and tracking should be able to manage this risk (although the onset of winter in Australia is a risk). So, we will have to keep an eye on these charts for a while yet.

As a result, lockdowns are continuing to ease in developed countries and this includes Australia.

While much attention is on data showing how bad the hit to economic activity from the coronavirus lockdown is – such as the decline in Australian GDP in the March quarter that given an almost certain slump in June quarter GDP makes it almost certain that Australia has now fallen into a “recession” – this is really old news that was anticipated by investment markets back in February and March (when shares plunged around 35% over the course of a month). Its no surprise that when people are told to stay at home big chunks of economic activity shut down due to an inability to work or spend. So statistical measures like GDP and retail sales showing that this has happened are of no real surprise. More importantly as we have been noting for several weeks now, more timely high frequency data continues to indicate that economic activity likely hit bottom back in April. This is confirmed by our weekly economic activity trackers for the US and Australia based on high frequency data for things like restaurant bookings, confidence, retail foot traffic, box office takings, hotel bookings, credit card data, mobility indexes & jobs data which hit bottom in mid-April. In Australia there has been a clear uptrend for seven weeks in a row.

Meanwhile, government stimulus continues to roll out:

• Germany’s coalition Government agreed a new bigger than expected fiscal stimulus of €130bn (nearly 4% of German GDP and 1% of Eurozone GDP) focussed on increased spending and tax cuts.
• The ECB expanded its pandemic quantitative easing bond buying program by a greater than expected €600bn, extended it to at least mid 2021 and indicated that it would reinvest maturing holdings until at least end 2022. Combined with the latest German stimulus and the European Commission’s planned Recovery Fund, Europe is really getting its act together on the stimulus front which is positive for Eurozone assets.
• In Australia, the Government is now moving into industry-based assistance with the announcement of a Homebuilder stimulus package for the housing construction sector. It’s small at just 0.03% of GDP but assistance also looks to be on the way for the arts sector and probably also the tourism sector.

The Australian Government’s Homebuilder construction stimulus package should help support housing construction activity, but it’s a potential negative for existing home prices. The Homebuilder stimulus will provide $25,000 grants for the construction of new homes or renovations. The grants are means tested, capped at projects of up to $750,000 and need to be signed up for by year end. The program is uncapped but is estimated to cost $688m. The history of such grants is that they boost construction as homeowners bring forward demand with the Government estimating it could lead to the construction of 27,000 dwellings/renovations. This is needed as the slump in immigration over the year ahead at a time of higher unemployment will reduce underlying dwelling demand by around 80,000 dwellings per annum. So, its good news for home builders. As far as additional economic stimulus goes its trivial though with a total costing of just $688m or 0.03% of GDP, and although it does have the “benefit” of being geared up as homeowners borrow, it’s not big enough to change our economic forecasts. What’s more by only applying to the purchase of new homes (in contrast to past homeowner grants that related to new and existing homes) it will boost new home demand at the expense of existing homes potentially adding to downwards pressure on existing home prices. This could be intensified if it has the effect of supporting the supply of new dwellings – albeit only marginally – at the same time that immigration remains weak resulting in an oversupply of houses. So, it could be a small positive for affordability but at the same time that it’s a small potential drag on consumer spending via a negative wealth effects.

The horrible images of civil unrest and police brutality in the US remind me of a lyric from Safe In My Garden which was one of The Mamas and Papas best songs and was clearly motivated by the unrest being seen in the US in 1968: “Cops out with the megaphones. Telling people stay inside their home. Man, can’t they see the world’s on fire.” Which I guess also reminds us that the US has been here before.

Major global economic events and implications

US data was generally better than expected. While construction spending fell more than expected in April, the ISM manufacturing and non-manufacturing conditions indexes improved in May, PMIs for May were revised to show a slightly stronger gain, the ADP employment survey showed a much smaller than expected fall in May and initial jobless claims continued to fall. All of which is consistent with the US economy having likely passed the low point.

Eurozone business conditions PMIs were also revised up to show a slightly stronger gain in May.

China’s business conditions PMIs generally improved further in May and after a plunge in February have now traced out a deep V recovery consistent with other indicators pointing to recovery in the Chinese economy.

Australian economic events and implications

Australian economic data provided no surprises. GDP fell 0.3% in the March quarter which was in line with expectations and reflected falls in consumer spending on services, dwelling and business investment and stockpiles more than offsetting contributions to growth from public spending and net exports. Retail sales were also confirmed to have plunged in April, the trade surplus fell on the back of a fall back in exports and building approvals fell albeit by less than expected but with more falls likely on the way as the local government approval process catches up to the impact of the coronavirus shock. The June quarter will almost certainly see a huge plunge in economic activity reflecting the severity of the lockdown in April confirming that Australia has been in recession. However, four points are worth noting:

• First the fall in Australian GDP in the March quarter of -0.3% was small compared to -0.9% in Japan, -1.3% in the US, -2% in the UK and -3.8% in the Eurozone. In other words, its bad but it could be a lot worse.
• Second, as noted earlier the low point for the economy looks to have been in April with recovery now underway helped by policy support measures. This is indicated by our Economic Activity Tracker with consumer sentiment up for nine weeks in a row and business conditions PMIs rising in May. As such our earlier forecasts for a 10% fall in June quarter GDP are now too negative and we have scaled it back to an 8% decline.
• Thirdly, the contraction in the economy was to be expected given the lockdown in the economy.
• Finally, the recession or fall in the economy was a necessary price we had to pay to protect lives. If our death rate had been around that of the UK and Italy another 14,000 Australians would have died.

In other data, the current account surplus rose to 1.8% of GDP in the March quarter indicating Australia is net supplier of capital to the rest of the world and the MI Inflation Gauge showed underlying inflation falling to just 0.1%yoy in May.

CoreLogic average home price data showed a -0.5% fall for capital cities in May as the coronavirus shock started to impact, with falls in five of the eight capital cities. Significant policy support and the earlier reopening of the economy have made our worst-case scenario for a 20% decline in average Australian house prices unlikely. However, our base case is for home prices to fall around 5-10%, as “true” unemployment will remain high, government job and income support measures and the bank payment holiday end in September, immigration falls and new supply is likely to be boosted marginally via the Homebuilder scheme.

There were no surprises with the RBA leaving monetary policy on hold and retaining a very dovish bias for the third month in a row. Surprisingly there was no mention by the RBA of the rebound in the value of the Australian dollar which is now around $US0.70 which is where it was earlier this year and well up from around $US0.55 at the height of the coronavirus driven financial market panic in March. The rebound likely reflects a combination of “risk on” that sees the Australian dollar move up with shares, perceptions that the Australian economy is doing better than the US economy, strength in Australia’s key export market of China and the Fed’s QE program swamping the RBA’s. Right now, the RBA does not appear to be too concerned but the surge in the value of the $A may become a problem for the RBA as its a defacto monetary tightening which could dampen the economic recovery. While it may be tempting to think that the RBA should take interest rates negative to make the $A less attractive and so pull its value down, our view is that this would be a mistake: negative interest rates would just create confusion amongst the Australian public and there is little evidence that they have helped in Europe and Japan. As such RBA Governor Lowe has said on numerous occasions that negative interest rates are “extraordinarily unlikely” in Australia, and we think this will remain the case. Rather the preferred approach to providing more stimulus and to bring down the $A from here if needed would be via increased quantitative easing allied perhaps with the introduction of a ten-year bond yield target of say around 0.5%.

What to watch over the next week?

In the US, the Fed is expected to make no changes to monetary policy. However, it may undertake some fine tuning of existing policies and will be watched for firmer guidance around a commitment to keep monetary policy easy and in relation to an eventual move to a regular monthly amount of quantitative easing. On the data front expect core CPI inflation (Wednesday) to fall further to 1.3% year on year. Data for job openings for April (Tuesday) will also be released and are expected to show a sharp fall.

Chinese CPI inflation for May (Wednesday) is expected to fall further to 2.6% year on year and producer price deflation is expected to intensify to -3.2%yoy.

In Australia, the NAB business survey for May (Tuesday) is expected to show an improvement in business conditions and confidence consistent with the start of the reopening, Westpac’s consumer confidence survey for June (Wednesday) is expected to rise further consistent with the ongoing improvement in weekly ANZ/Roy Morgan consumer sentiment index, but housing finance commitments for April (also Wednesday) are expected to fall.

Outlook for investment markets

After a strong rally from March lows and uncertainties around coronavirus, economic recovery and US/China tensions shares are vulnerable to short term setbacks. But on a 12-month horizon shares are expected to see good total returns helped by a pick-up in economic activity and massive policy stimulus.

Low starting point yields are likely to result in low returns from bonds once the dust settles from coronavirus.

Unlisted commercial property and infrastructure are ultimately likely to continue benefitting from a resumption of the search for yield but the hit to economic activity and hence rents from the virus will weigh heavily on near term returns.

The Australian housing market has slowed in response to coronavirus. Social distancing has driven a collapse in sales volumes, home prices are starting to fall and a sharp fall in employment, a stop to immigration and rent holidays poses a major threat to property prices into next year. While government policies to support jobs and incomes and the bank payment holiday out to September have headed off the risk of a 20% plus fall in prices, they are still expected to fall by around 5 to 10% into next year.

Cash & bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.25%.

Although the Australian dollar is vulnerable to bouts of uncertainty about the global recovery and US/China tensions, a continuing rising trend is likely if as we expect the threat from coronavirus continues to recede. Particularly with the US expanding its money supply far more than Australia is via quantitative easing and with China’s earlier recovery likely to boost demand for Australian raw materials (assuming political tensions between Australia and China are kept to a minimum).

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