A tug of war unfolding

SG Hiscock & Company
Hamish Tadgell
Hamish Tadgell
SG Hiscock Portfolio Manager and Head of Research
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Nearly four months on from the onset of coronavirus and we are still adjusting to the new normal.

Social distancing, daily case updates dominating the news headlines and the constant threat of lockdown in its varying degrees is affecting everything we do. We are learning to live with uncertainty, enjoy closer engagement with our families and the absence of the daily commute, not to mention increased access to the fridge!  Rest assured our ability to meet the needs of our clients remains unchanged. We have invested in our WFH environment to ensure appropriate resources are in place to maintain sound body and soul.  

The market's response to the COVID-19 crisis has followed a distinctive path (refer to Chart 1).  As the pandemic hit, despair set in, resulting in panic and liquidation. Redemptions, margin calls and short positioning all followed, amplifying market moves and volatility. This was evident in the tracking of the VIX index through the last quarter. Co-ordinated policy support, tapering in infection rates, and reopening of economies has subsequently given hope of a recovery. As such, a relief rally followed.  It is surprising how sharp and rapid the rally was, given the extent of the economic shock. However, will the economic data continue to improve, allowing markets to continue to rise, or has the melt-up has been too fast, too soon?

Chart 1: Too much too fast -What is the shape of the recovery?

Source: SG Hiscock, Iress (prices at 30 June 2020)

We must remember that this was (and is) an ‘event-driven’ crisis. That is, an exogenous shock to demand causes a crisis, which tends to be shallower, shorter and quicker to recover from than cyclical or structural driven recessions. This instance is particularly interesting, as the government response to Covid-19 cases can continue to impact markets. Think of every lockdown as a mini even-driven shock, as it lowers demand. This is because there are two fundamental ways to stimulate the economy or raise GDP levels – producers produce more, or consumers consume more. Both of these are diametrically opposed to the stringent vagaries of social distancing and lockdown measures. Despite this, it is equally important to recognise that the scale and coordinated response of the global policy actions undertaken to date has been extraordinary. In aggregate, they now approximate around 5% of global GDP, close to the annual GDP of the US. This cannot be understated. Liquidity measures undertaken by the Federal Reserve alone are more than three times those undertaken in the wake of the GFC in dollar terms and have occurred much, much quicker. 

Chart 2 below elucidates the extent of the response from the US Fed. This is only the 10th time that YoY money supply growth has gone above 20% in the US. On all previous occasions, nominal GDP soon moved comfortably into double digits – though, it must be said, with the support of inflation.

Chart 2: US nominal GDP and money supply growth

Source: GFD, Deutsche Bank

Australia is leading the world in terms of its fiscal response as a share of GDP. The aggregate benefit of Australian policy measures including tax-free superannuation withdrawals ($15.5bn), deferred loans ($224bn), JobKeeper ($70bn), JobSeeker ($14bn) and free childcare ($2.1bn) amounts to in excess of $325 billion. In perspective, it equates to 15% of annual GDP, 11% of total credit outstanding, 17% of the all ordinaries market capitalisation, and is 2.5 times the size of our largest listed company, CSL. Chart 3 highlights the extent of the increase in household cash flows to date. This has done a lot to provide compensation, save jobs, and help build a bridge to recovery, but what happens when the assistance is withdrawn, and how long can it continue for?

Many have focused on the risk of a ‘fiscal cliff’ as current stimulus measures expire. In Australia, it is reasonable to expect support packages are to be scaled back, but it is hard to see the government and RBA ripping the rug out from under the nation’s feet and allowing the economy to fall out of bed, risking the good work done to date.

Chart 3: Household cash flow has risen in this recession…so far!

Source: Goldman Sachs, ABS, WHO, Department of Health

It is likely existing measures will be refined, recalibrated and subsequently extended to more vulnerable sectors of the economy; those affected by the demand shocks we spoke to earlier. This is likely similar for weaker areas of the economy. The government is focusing on new measures to create jobs, not just save them. This, coupled with further stimulation of the economy gives us some confidence it will not be free-fall from fiscal support. Infrastructure projects and tax reform are likely areas of focus, particularly the bringing forward of tax offsets. If ever there was a time to remove payroll tax (seen as a tax on jobs) the time is ripe, but the reality is it remains vexed in State and Federal politics and would likely require reshaping the GST.  

Chart 4: Unemployment rate masks the real situation

Source: SG Hiscock, Goldman Sachs Research, ABS

Unemployment remains critical. As Chart 4 above shows the headline unemployment rate has become an unreliable indicator. It is unclear how many temporarily furloughed jobs will not exist post-JobKeeper as businesses adjust to the new normal. The May headline unemployment rate was 7.1% but when adjusted for the decline in the participation rate and ‘those not working at all’ was closer to 14%. Unusually, business insolvencies this year are tracking down 17% this year on 2019 levels. Perhaps this should not surprise with around 300,000 small businesses on loan deferrals and a range of state government fees, charges and payroll tax being paused or waived. The hope is that most workers return to their jobs, but this seems optimistic and inconsistent with employment trends in prior recessions, particularly when we look at the nature of this recession.

Our conversations with companies and recent trading updates, particularly from more consumer-facing businesses suggest as lockdown restrictions have eased sales have generally exceeded expectations, (refer Chart 5 below) but it would seem to be too early to try and predict where activity levels ultimately return to. It seems support packages and pent up demand are underpinning retail sales for now. However, there remains a strong air of cautiousness, particularly given the relative impossibility of eradicating this virus without a vaccine. In general, most businesses seem unsure and uncommitted as to how we emerge from the current twilight zone, choosing to hedge their bets and position to respond to the risks and opportunities as they emerge.

Chart 5: Two-tiered economy rolling quarterly retail sales 

Source: SG Hiscock, ABS

The volatile way in which the market traded through June reflects the tug of war that exists between stimulus and unemployment, and broader downside risks. The resurgence in COVID cases in some hot spots and risks of a second wave remains alive as economies reopen. Whilst vaccine developments are continuing at pace, the consensus view from most scientific experts suggests a vaccine is unlikely to be available until the first half of next year, and then requires to be universally manufactured and distributed. Until then, the path of economic recovery is likely to be bumpy, with the main issue being the virus itself. Even if the path of the virus does not prove to be as disruptive as the first wave, it could take some time for activity levels to return to pre-COVID levels, and some sectors and companies may never fully recover. 

The bigger question over the medium to longer-term remains the degree to which the current shift in policy to welfare and minimum income reflects a temporary policy and will be reversed as the crisis recedes, or become more permanent. Milton Friedman famously said that ‘there is nothing so permanent as a temporary government program’. The moral hazard of removing these measures is high, as we saw with quantitative easing in the GFC, and is arguably higher in the current political environment, given the growing political demands around inequality and social justice.

Positioning for the period ahead


If lockdowns continue to ease and economies open up over the coming months, the sequential growth will look strong.  However, it is hard to see the pace of growth being anything but weak given the massive economic dislocation, higher expected unemployment and cautious approach to gradually reopening of economies. Although the investor panic around the COVID crisis might seem over, the effects of the panic are not, and are still to fully play out.  

Geopolitical risk has risen. The riots in the United States are worrying, and the divisive nature of US politics and leadership seems only destined to see greater social unrest heading into the US Presidential election in November. China-US tensions have escalated again, manifesting in Australia’s own position with respect to China and Hong Kong. 

In the coming months, political developments will return to the fore. EU leaders will shortly meet once again to discuss proposals for a recovery fund with joint debt issuance. Trade negotiations between the EU and the UK continue, ahead of a year-end deadline when the transition period concludes. In November, the US presidential and congressional elections could lead to sizeable policy shifts, as former Vice President Biden seeks to win the White House from President Trump.

Equity markets are so far unperturbed, fuelled by the overwhelming levels of liquidity and stimulus. The potential for investors to be disappointed relative to expectations is rising and markets could well trade sideways in the second half of the year leading up to the US election in November.

Beyond the inflection-driven 'hope' phase of the recovery, we see valuation expansion less likely to drive the market as interest rates are already at their lower bound. We expect bond yields to remain low, which favours longer duration growth stocks, including IT (NextDC) and healthcare (CSL, Cochlear and Ramsay) and selective infrastructure like assets (Transurban, Atlas Arteria and Chorus). We also expect nominal GDP growth to remain low, with the risk companies will face rising costs, including wages as the social contract and profit share shifts more to labour, and margins come under pressure. This favours higher quality companies and companies exposed to secular growth over the medium to longer term (Macquarie Group, Seek and CarSales).

In the short run, we also see the potential for more cyclical businesses to benefit from any inflection in economic activity, particularly where supported by fiscal stimulus and infrastructure building projects (Downer, Worley, BHP and Northern Star). Ultimately, stocks with good earnings growth and strong cash generation and balance sheets have the best chance to outperform, which is consistent with our messaging since the start of this pandemic, and the actions we have taken in portfolios.

Conclusion


For the moment, the market appears to be largely looking through the potential for a return to lockdown and broader recession as well as geopolitical downside risks and choosing to focus more on the potential recovery and pick-up in activity. Fighting the FED has been fraught with danger for many years.

The world’s output is far above its March/April lows; however, in the quarter ahead, many economic indicators will continue to improve, as if the light is back on. There remains the ongoing threat of renewed contagion, the incomplete damage assessment process, and the ultimate implications of government policy measures. These all suggest that a growth momentum rebound is not to be mistaken for a true recovery.

In summation, the clarity we are looking for on the path to recovery remains obfuscated while the threat of lockdowns remains. The reality of a vaccine or relevant treatment is still some twelve months away at best meaning the recovery will play out against a backdrop of behavioural change. Individuals will voluntarily try to limit social contact and business will be reluctant to invest and rehire. Consumer and Business confidence data will be a key signpost to monitor, as the recovery will be led by the consumer.

For investors, it is a judgment call as to which of the two opposing forces will gain the upper hand – COVID 19 resurgence or policy support. We favour the latter over the longer term.

Interest rates are at ultra-low levels, meaning bonds and cash have limited upside appeal underpinning our preference for riskier assets. Credit is expected to follow equities now that central banks have become the lender of last resort and we prefer listed preference shares and hybrids to cash at 0.25%.  We remain comfortable with exposures to equities, both foreign and domestic, as well as the potential for further recovery in the property sector.  

As always, we remain vigilant and balanced in our thoughts building diversified portfolios.

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We believe in buying great companies at good prices. We are firm believers in co-investment, demonstrated by our significant investment in our own funds. Our confidence in our investment approach means we always seed new funds with our own money. We have made the decision to cap our Funds Under Management at modest levels, to ensure that the funds retain greater flexibility to generate strong investment returns across varying market conditions. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.

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We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.