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Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

The recovery continues

• Equities continue to climb the wall of what appears to be ‘less worry’
• Economies are starting to re-open which is providing further support for equities
• Central banks and Governments continue to apply rescue measures as COVID-19 continues to see increased infections dampening social and economic activity.

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.

The Big Picture

We started last month’s update with the thought that the worst could be behind us but that volatility might still spook markets for a while to come. A quick look at key equity markets tells a more positive story for May with the ASX 200 adding 4.2% to the 8.8% gained in April. The S&P 500 added 4.5% to the 12.7% gained in April.

We still think it’s too soon to assume normal reliance on macroeconomic data. We expected the numbers to remain volatile and we were not disappointed.

The big picture we are focusing on is the mood in the markets about re-opening economies. In one month, we have gone from dire predictions of nothing opening to what looks like an orderly opening in Australia, the US and Europe. Yes, there are pockets of confusion but the stock markets seem to have been buoyed by the fact that an orderly return to work is already beginning to happen.

So long as there is one person carrying the virus there is a chance for others to contract it. There is a very high probability of a second wave. The question is – what form will that wave take?

In Australia, the shut-downs seem to have been largely successful. When someone in a newly opened bar or café contracts the disease, quickly responding to those exposed can minimise the spread. If left unchecked we can easily get back to the problem we had a month or so ago.

Of course, the systems and equipment we now have in place are better to deal with a new outbreak. Australians, by and large, appear to be reasonably responsible. Contrast that with the situation in the USA. There seem to be large clusters of vocal groups claiming all sorts of rights regarding employment and social mobility. It does not matter whose philosophy is correct, viruses only react to people close at hand. We would not be surprised if the relaxing of containment measures proves to be premature and a fresh outbreak occurred in the US and it might be big enough to unsettle markets. In light of the recent social unrest the potential for further outbreaks has likely increased. This will weigh on investment decisions.

Governments and central banks are still applying fiscal and monetary support in amounts that should assist to avert a further escalation of the economic impacts of the COVID-19 crisis. However, at the individual level some groups might be relatively disadvantaged.

Going forward, we are naturally keeping an eye on fresh outbreaks of COVID-19, potential vaccines and cures. They are all potential games changers.

Given the speed of the re-opening of Australia and the US we might expect to see some meaningful data on unemployment from July (to be reported from August). Until then our focus is more on intuition as meaningful forward looking data remains scarce. As economic data releases and in particular corporate earnings estimates stabilise, we will again be able to produce a more informed outlook.

Asset Classes

Australian Equities

The ASX 200 posted a strong +4.2% gain over May with a few sectors standing out. IT (+14.5%), Materials (+8.0%), Property (+7.0%), Telcos (+6.0%) and Financials (+4.7%) were the strongest sectors.

Based on the growing belief that we at least appear to have COVID-19 contained, then the market from a relative value sense is somewhat attractive but with ongoing uncertainty volatility will remain elevated.

Foreign Equities

The S&P 500 posted a +4.5% gain in May which followed a +12.7% gain in April. However, the S&P 500 is down ?5.8% on the year-to-date.

Many analysts have been quick to point out that the gains in recent years have been mainly concentrated in about 6 or 7 big tech stocks. Without those stocks, they say Wall Street would have just moved sideways.

Index investors need not overly worry about the concentration of strength in stock returns. Others need to be more careful about how they construct portfolios as COVID-19 and the respective Government and Central Bank responses to it have increased the relative attractiveness of some stocks and in particular, some industry sectors over others.

Bonds and Interest Rates

With most national bond rates close to zero, there is not much room for rates to move. We do not expect any of the major countries will be raising official rates any time soon.

With rates low, investors still have to consider deriving some yield from equities.

Other Assets

April was clouded by wild gyrations in the price of oil. West Texas Intermediate (WTI) prices even went negative mid-month as people got caught with the ending of the May futures contract.

We flagged that a repeat situation might occur in mid-May but no such disruption happened. Indeed, WTI oil prices (the relevant US price) were up 88% over May while Brent (the world price) was up 39.8%.

The OPEC problems and shortage of world demand are still big issues but the issue with the futures contracts seems largely contained for now.

After big changes during May the prices of iron ore, copper and oil finished May close to their intra-month highs. It is important for global stability for these commodity prices to stabilise at reasonable levels. At last, that seems to be happening. The Australian dollar (against the US) also finished May at near the intra-month high.

COVID-19 Review

The chart below is the latest from Johns Hopkins University Coronavirus Resource Centre.

The message is quite clear, the reported cases of COVID-19 continues to rise globally while we here in Australia have fared better than most, if not all. The reporting of COVID-19 cases is now escalating in the emerging economies of Brazil, India, Russia and counties in the middle East. Notwithstanding the US has reported circa 1.8 million cases which is in excess of three times that of Brazil in second place at 514,000.

While we in Australia are beginning to see a relaxing of containment measures, the real challenge is that other countries are also heading down this path. Whilst they have achieved apparent containment (i.e. they have flattened the rate of increase in infections), they are still dealing with many actual cases. Consequently, the risk of a second wave is statistically higher for them.  While we hope the relaxing of restrictions more generally is successful and does not lead to a second wave of the virus, it is too early to tell and the situation will remain dynamic, despite the more positive experience we are having in Australia.

Regional Review

Austrailia

Australia’s process of gradually returning to work is becoming politicised after several months of apparent bipartisanship. RBA Governor Philip Lowe highlighted that the September quarter proposed unwinding of Job Keeper and Job seeker payments may be premature. The market appears to be running ahead of the economy at this point.

China

China and the US are at it again but Trump’s end-of-month speech did not bring up the possibility of an escalation of the trade war.

China’s relationship with Hong Kong is still being thrashed out. COVID-19 did little to distract the protagonists.

US

Pockets of the US economy are aggressively re-opening. We are not filled with confidence that the whole process will go smoothly. US citizens seem fixated on their constitutional rights rather than what might be good for the economy at this point.

Europe

The EU has proposed another $1.2 billion recovery fund to assist member countries to weather the recession resulting from the Covid crisis as virtually all member countries have broken EU deficit limits as they support healthcare and businesses to try and sustain their economies.

Rest of the World

Perhaps by next month, news on the rest of the world will match the importance of news on a global pandemic. For now, we focus on how restrictions are relaxed and how lagging economies will be funded.

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

The recovery begins?

– Equities bounce back strongly in April as unprecedented fiscal and monetary stimulus applied
– Economies in early stages of starting to re-open as the COVID-19 rates of infection have slowed
– Oil prices face turbulent times and demand falls dramatically absorbing OPEC production cuts

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.

The Big Picture

After a really tough month for stock markets in March, the bounce back in April gave investors a chance to catch their breath. Of course, it is possible a new low will be formed at some time in the future but the news on COVID-19 is starting to get better.

It was quite rational for markets to have fallen as sharply as they did in March. After all, no one knew the extent of the devastation that the virus would cause. As soon as governments and central banks responded with stimuli, lock-downs and social distancing, markets realised that they had sold off too much.

We think the major markets are still cheap based on reported earnings but volatility and fear are elevated. As a result, the rate of price appreciation going forward over the longer term versus what we think of as fair pricing might be slower than what we experienced in April.

There have been so many stimulus packages and healthcare innovations, it is an impossible task to report all. And new changes are coming through with such speed that any attempted comprehensive report would rapidly be out of date. In the space of a month, global sentiment seems to have gone from doom and gloom in markets to ‘it’s not that bad’ after all.

We think the important take-away is that almost all major countries are rapidly responding to the challenges – unlike in the wake of the GFC in 2008 and 2009. Health authorities and scientists are seemingly working tirelessly to develop vaccines and provide cures. We think we are in safe hands! But Trump did take issue with the World Health Organisation (WHO) over their early responses (or lack thereof) to the onset of the crisis.

There are questions about whether or not people who have experienced a COVID-19 illness can be re-infected. As finance experts, we have nothing to offer on that question but we do take this uncertainty into account.

Many countries have already started to relax the lock-down restrictions – mostly in a phased fashion. It makes sense to respond in this fashion as it would be imprudent to run economies into the ground to ensure, like smallpox, the disease has been eradicated. That means that there will be future waves of infection in much the same way that there are usually weaker aftershocks following an earthquake. Because different regions are loosening restrictions in different ways there is a chance to learn from one another.

All economic data will likely be really bad for many weeks and possibly months – so there is no point in dwelling on them. If we look for a medical analogy, economies are experiencing ‘self-induced comas’ to allow doctors to deal with the patients’ needs in a timely fashion – rather than dealing with a recession-like trauma rapid-fire scenario in the ER.

Another point worth noting for less experienced readers is the bias that most forecasters put into some of their forecasts. It is well known that forecasters often indulge in so-called ‘rational cheating’ to use an academic term. It is often not in the best interests of the forecaster to publish their ‘honest’ best forecast but rather modify it in the light of the consequences of being wrong.

In the current situation, a forecaster who believes economies will be back to normal in short order would be well-advised not to say so. If the economy actually takes a longer time to recover, the optimistic forecaster is likely to be the object of much scorn. If the optimist is right, there are no particular prizes to win. On the other hand, a forecaster who overstates the time for recovery (at least by a little) will lose nothing if, indeed, it takes a long time. If a quick recovery happens, everyone is so happy that they ignore that the forecaster was, in fact, wrong.

With this bias in mind, we suggest that the consensus view for recovery that is published might be biased towards the longer run. Recall all of the eminent economists (including Nobel Laureates) who said, following the GFC, that a depression longer than the Great Depression was likely. How wrong they were – but can you now name them?

The impact of COVID-19 was more than enough for analysts to try and work through during April but oil prices also went into a tail spin! The timing of the two phenomena might be related as it is thought Saudi Arabia has been waiting for the opportunity to run the relatively new US shale-oil producers out of business. What better time is there to attempt such a price war than one in which people were already hurting?

There is always the incentive for independent oil producers to compete for market share – which is why OPEC was formed in 1973. Since Russia and the US are big oil producers that are not OPEC members, price control by OPEC is limited. In an attempt to become self-sufficient in oil, the US has turned to extracting oil from shale as well as oil wells. We ‘passed’ on such ‘fracking’ in Australia.

Shale oil is now such an important component of US production that its output had a depressing impact on global oil prices.

OPEC+ (i.e. including Russia and a few smaller independent players) agreed earlier in April to a material supply cut to start from May 1st. However, the massive lack of demand due to COVID-reduced travel on land, sea and air has made even that cut insufficient to stabilise markets.

The US has a massive underground oil storage facility in the centre of the country (Cushing, Oklahoma). It is nearly full so that there is nowhere for more US oil (known as WTI or West Texas Intermediate) to be stored. As a result, many players had to sell their forward contracts at negative prices to prevent being forced to take delivery! This is a phenomenon that is likely to recur monthly as each forward contract nears expiry (the next is due on May 19).

The global price of oil (known as Brent) has been more stable but it has still been impacted through interdependencies. The Saudis reportedly can withstand these price gyrations for many months if not longer. However, the newer shale-oil producers are less cost effective and the first bankruptcy proceedings have already started.

The oil price war is unlikely to have a major detrimental impact on the market in the longer term but these oil price spikes do seem to cause excess volatility in stock market indexes along the way.
With regard to COVID-19 and oil prices, we believe that the prudent investor who started the year with an appropriately diversified portfolio should probably stick with it. Even experienced fund managers find it difficult to pick the right time to buy and sell. And this suggestion brings us to the opportunity many people are now faced with in super funds as some are able to withdraw up to $20,000.

Super is a wonderful, tax-effective way to save and should be preserved if possible. For many people, $20,000 is a sizeable chunk of their savings. Assuming a balanced rate of return of 7% pa on investments with an inflation rate of 2.5% pa, a 30-year old person due to retire at 67 would be forgoing $244,472 at retirement (or $101,937 adjusted for inflation). Compound interest is a powerful force! Early exit can be massively expensive in the long run for the young.

Of course, some people might have no option but to withdraw the $20,000 or part thereof but it would be wise to look for alternative solutions first and, perhaps, not taking out the maximum amount even if alternatives are not available.

The withdrawal is reportedly more problematic with some industry super funds. The TV adverts often point to the superior returns of industry super funds over retail funds. In making such a comparison and in considering the maximum $20,000 withdrawal, it is important to take into account the reported fact that many industry funds are more heavily invested in ‘unlisted assets’ such as property and infrastructure that are not listed on the stock exchange – some funds reportedly have allocations of up to 40% in such unlisted assets.

The price of, say, CBA shares is priced by the second during the time the stock exchange is open and the stock is not in a trading halt. If any average investor sells all of their CBA stock the impact of the sale on the latest price is minimal. However, if the same investor tried to sell all of their stock in a company outside of the top 300, there could be a material price fall. This price fall in ‘illiquid’ stocks should be considered when considering a sale and it is why many investors should only consider the top 50 or top 100 stocks.

An unlisted asset, such as a large (unlisted) building has no transparent market price. Rather, a valuer infrequently makes a judgement as to what price could be realised. Unlisted assets appear to be less volatile because no one is valuing them often enough to detect the true pricing volatility!

Also, when an investor attempts to sell a part of an unlisted asset there is no ready market of buyers. At any point in time, one can view the ‘order queue’ of what potential buyers and sellers will trade a listed share on the ASX.

If one super fund, industry or otherwise, is heavily invested in one particular unlisted asset and a large number of members want to redeem capital, the potential sale of the unlisted asset could destabilise the value of the fund as the price ultimately realised may be less than the value of the asset reported by the super fund. Given that some industry funds are reportedly as much as 40% invested in unlisted assets, those funds might be forced to sell just their liquid assets instead making the resultant asset allocation even more skewed to the illiquid, unlisted side. We think it is important to take proper financial advice whenever possible concerning such withdrawals.

We hope to be able to paint a clearer picture next month as the dust on COVID-19 settles. The current company reports for quarter one in the US are giving little guidance to the future. Therefore, we must rely on our broader macro view of the longer term as we have presented in this section.

Asset Classes
Australian Equities

The ASX 200 posted a strong gain over April (+8.8%) but this should be considered in conjunction with the ‘bear market’ sized fall in March.

Financials did relatively poorly in April in part due to the NAB trading halt – when they announced a cut in dividends and a dilution of capital through a capital raising. ANZ announced that it will defer its dividend. The other big banks also took capital losses as investors anticipated similar behaviour elsewhere in the sector – as we foreshadowed might happen in last month’s newsletter.
In spite of the oil price war, both the energy and materials sectors – making the combined resources sector – performed very well.

Market volatility has fallen sharply since the March high but it is still nearly double what we might expected in normal times.

Foreign Equities

The S&P 500 performed even better than the Australian market (+12.7%). Other major markets moved more in line with the ASX 200.

The VIX so-called fear gauge remains quite elevated but far below its record highs in March.

Bonds and Interest Rates

Several central banks have committed to continue to support government and corporate bonds. The Bank of Japan (BoJ) went so far as to state that it has an unlimited target of what QE (quantitative easing) it is prepared to use.

The US Federal Reserve (Fed) is also being creative in trying to support bonds of all maturities. At its April meeting it reiterated its plan to keep rates low at least until the economy returns to full employment.

We still expect our rates to be lower for longer and for longer-dated bonds to have a higher yield than the short-dated.

Other Assets

The WTI futures contract price of oil for May delivery even went negative at one point during April but both WTI and Brent prices, while highly volatile, have recovered somewhat.
The Australian dollar has continued to be unusually volatile fluctuating in a range from US60.35c to US65.66c in April.

Iron ore prices have been relatively stable but copper prices rose by 6%.

Regional Review
Australia

The rate of new COVID-19 cases has slowed to a mere trickle in Australia. As a result, governments are starting to relax some of the lock-down restrictions. Since the rules vary by state, and they keep changing within states, there is seemingly much confusion about what is legal and/or wise.

Although new cases are few and far between, there are plenty of people with the virus to infect others as restrictions are relaxed. Undoubtedly there will be future (hopefully much smaller) waves of infection.

The March unemployment rate published in April surprised many as it fell from 5.3% to 5.1%. However, the data are gleaned from a survey conducted in the first two weeks of the month (March) – before the lock-down started.

China

The China economy is starting to gear up again but at a slower pace than many expected. One reason could be the lack of demand and logistics in other countries. For the second month in a row the Purchasing Managers Indexes (PMI) for both manufacturing and services were above 50 – the cut-off between expected expansion and contraction.

Both the US and Australia are in heated discussions with China over how it handled COVID-19 during the early stages.

US

The weekly initial jobless claims have ramped up sufficiently to make some predict the unemployment rate will exceed 16% at some point. Since many of these unemployed people will be receiving additional benefits, 16% does not mean the same at 16% at some other time. Moreover, there will be many more job vacancies than normal in a recession when restrictions are lifted.

Europe

The UK prime minister, Boris Johnson, was in intensive care with COVID but he is already back in the office. The UK is still aiming for completing the exit from Europe by the December 31st deadline.

Rest of the World

Kim Jung-un, the North Korea premier, has not been sighted for over two weeks and fears for his health abound. As they have an unusual hereditary premiership, and he has no son, the choice of a new leader is, indeed, problematic assuming such transition is required.