Investment – Quarter ended 30 September 2020
The commentary features contributions from AMP Capital. The views expressed are not necessarily the views of the Board of Trustees of the National Provident Fund.
Global containment initiatives to combat the COVID-19 pandemic crisis and to lessen impact on economies, communities and profits continued to dominate markets and political discussion throughout the third quarter.
Since the COVID-19 pandemic spread around the globe in March earlier this year, our view was that global GDP would have an initial ‘V-shaped’ recovery (a big drop in growth followed by a sharp acceleration) followed by slower growth compared to its pre-COVID rates because of long-term negative impacts from the pandemic (less travel, social distancing restrictions and localised lockdowns). So far, the expectation of a V-shaped recovery has proven to be accurate as economic re-openings have seen a rebound in consumer spending and industrial production. Record central bank stimulus and government fiscal spending has helped to supercharge the current recovery.
The world’s key economies tentatively lowered the draconian restrictions on movement and personal contact that were applied in the second quarter to cut the scale of virus transmission and extended the already-massive economic stimulus and interest rate reduction programmes that have been adopted to cushion the contractionary impact of COVID-19. This drove interest rates lower and flowed through into labour markets with re-hiring of a share of the workers that had been made unemployed in the initial months of the crisis.
Sentiment has cautiously improved and retail activity has picked up markedly in the last three months. Industrial production has rebounded sharply in China and in Germany, indicating the manufacturing side of the world economy is gearing up for renewed consumer demand once the pandemic’s next wave recedes and activity picks up further into 2021. The fact that developed market manufacturing is also resuming is a positive, as partial lockdowns have continued in Europe with COVID-19 flare-ups requiring local restrictions, but countries are now dealing efficiently with contagion risk which allows for industrial economic activity to continue.
A resumption of more normal services sector activity, on the other hand, remains challenged as it often involves person-to-person contact and interaction. Services contribute the bulk of economic growth in most countries, so the burden on governments will continue to be extreme in supporting businesses and consumers until either an effective vaccine is developed and deployed or the virus itself becomes less threatening due to rising immunity and survivability. This appears to be happening already in some countries, as despite a large number of new infections being recorded, the number of resulting deaths has declined substantially compared to the situation in the first half of this year.
A sharp rebound in global activity in 2021 would depend on whether a vaccine becomes available for a moderate proportion of the population for developed economies by mid-next year. So far, the vaccine debate has been met with scepticism. There is concern that a fast-tracked vaccine has not met the same regulatory approvals and might be less ‘safe’ without the history to show any long-term side-effects. The length of the immune response of a potential vaccine is also being questioned. These are valid concerns. But the current state of play in vaccine development also offers a lot of reasons for optimism. There are currently 10 vaccines in ‘phase 3’ of development which is the stage where the trial vaccine is tested on a large sample before it can receive government approval.
If the vaccine approval and roll-out go smoothly, growth could rebound by 5.6% in 2021, led by a surge in Chinese activity of 9% but also supported by a 6% rebound in the UK, a gain of 4.5% in the US and between 3%-5% in Australia and New Zealand. However, the recovery in the Eurozone next year is likely to be muted, with 1.8% growth forecast, and not much better in Japan, where our expectation is for a 2% GDP gain next year.
Exceptionally low interest rates have assisted the construction sector around the world to swing back into action, and much spare consumer cash and newly available cheap debt is being recycled into building, upgrading or purchasing properties. This may assist sentiment and confidence through a housing ‘wealth effect’, but unless carefully handled housing values could easily drive households well above prudent levels of indebtedness. That said, in altered times, the safe haven aspect of housing and certain types of property has re-asserted its appeal and governments are politically unwilling to make any fiscal moves to disadvantage the asset class, either for consumers or for companies.
The state of the US labour market will be a critical issue in the November election and although there has been a strong recent upswing in hiring the 8%+ unemployment could go against the President. Unemployment has also risen in New Zealand but appears to be less of an election issue for the government due to the extensive wage subsidies that have been in place, and lending to business schemes developed by the Reserve Bank can also prevent business failures and subsequent lay-offs.
Globally, share markets continue to be supported by easy liquidity but are challenged by weak profits. The cyclical upswing in global indicators is positive for share markets because of the lift to earnings. Cyclical rebounds and reflation tend to be positive for shares outside of the technology sector. Recent falls in tech shares in the US (but also globally) and concern about valuation could drive tech shares down further. However, a big collapse like that seen in the early 2000s is unlikely as valuations aren’t as stretched compared to the dot-com era boom, and earnings for these companies have also lifted. Even if non-tech shares have some near-term rebound, the high concentration of tech in the US share market index could pull the rest of the index lower. The broad improvement in the global growth environment also tends to be positive for non-US shares, especially if the US dollar resumes its downtrend.
In summary, markets are priced to reflect the early recovery phase of the cycle following the COVID-19 recession. This implies an extended period of low inflation, low-interest-rate growth – an environment that usually favours equities over bonds. Technology stock valuations are elevated, and the US federal elections create uncertainty around tax policy changes, government regulations and the re-escalation of China trade tensions. Beyond this, the market looks set for a rotation away from technology/growth leadership toward cyclical stocks. This also implies a rotation toward Europe and emerging markets potentially the main beneficiaries in 2021. Europe in particular has lagged the US this year, but as the euro has strengthened and COVID has been more severe there, that is understandable.
Nevertheless, although we are more positive on the prospects for equity markets, their performance since June has been strong and therefore further upside should be a slow dynamic prone to reversals, which could well be driven by adverse COVID-19 or vaccine news flows. In the third quarter, global equities gained 6.7% which was led by the US S&P 500 Index’s 8.9% rally. New Zealand and Australian share returns were much more subdued, with a 2.6% rise in the New Zealand market and a flat performance across the Tasman for the ASX 200 index.
Global infrastructure remained a soft performer due to the travel restrictions and oil price volatility, declining by 1.5% for the second quarter. European shares were similarly anaemic over the last three months, with the EuroStoxx index slipping by 1% and the UK FTSE 100 losing 4.7% as concerns about COVID-19 and an impending deadline for Brexit on 31 December took their toll. Returns from global shares in NZ dollar terms were slightly lower as the New Zealand currency continued its rebound trend and gained 2.75% against the US dollar over the second quarter.
Remarkably, the US 10-year Treasury note closed on 30 September almost unchanged from its yield level on 30 June with a yield of 0.68%.
Central bankers are unwilling to allow extended bouts of weakness to develop and compound in asset markets. Nor do the monetary authorities wish to run the risk of crushing activity in their economies, already hit so hard by demand and supply shocks arising from the COVID-19 crisis. More extremely easy monetary policy lies ahead for the foreseeable future, which should support growth assets while income asset classes trend sideways.
Our forecasts are for a -3.3% contraction in global GDP growth for 2020, but the distribution of the deep recessionary conditions varies substantially by region. For example, the US, Australia, and New Zealand are likely to experience a 2020 full year GDP decline of between 4%-5%. While a savage downturn is clearly underway, as shown by the second quarter -12.2% contraction reported in New Zealand growth reflecting the very stringent lockdown, the situation in Australasia is better than that in Europe. The Eurozone is expected to contract by 9.9% this year and the United Kingdom by a full 10%. Japanese economic output is expected to shrink by 5.8% while China is likely to be the only major economy that will log an output gain in 2020, though a very small one by historical standards with the current forecast at 1.5% GDP growth.
Another worldwide stringent lockdown on the scale that occurred in March is unlikely. Instead, it is assumed governments would opt for localised mobility restrictions (if required) along with some ongoing limitations around domestic and international travel. This is evident in countries experiencing a second wave. Continuing improvements in treatment options for COVID-19 are also expected, including better management of symptoms and protection of vulnerable groups such as aged care home residents. The larger second wave of COVID-19 cases in Europe and the US but a lower mortality rate shows that it is possible to better treat and manage the virus without a full lockdown.
The medium-term outlook for earnings remains generally hard to predict and varies greatly depending on company specifics. Amid changing consumer dynamics, many companies will likely struggle for some time, while stronger businesses are expected to emerge from the COVID-19 crisis with greater market share. Although pressure on some global economies has begun to ease, further COVID-19 outbreaks and the way governments respond, remain a risk.
Governments generally continue to implement supportive monetary and fiscal programmes to ease short-term burdens and keep economies more resilient, although concern is growing around the sustainability of some programmes. Despite this, we believe the longer-term market trend will remain to the upside. As always, while the near-term direction of markets is impossible to accurately predict, we believe that investors with a diversified portfolio of quality businesses, bought at a reasonable price, are likely to do well over the long term.
Global listed real estate markets will likely continue to be subject to near-term volatility, which is affecting all risk assets, due to the impact of extensive COVID-19 containment measures on economic activity globally. We have reduced risk in segments that are directly impacted, such as lodging, and we will continue to assess and actively manage these risks, as well as those in segments that are indirectly impacted as additional information becomes available.
When there is a fall in the risk-free rate because central banks around the world are loosening their monetary policy, investors often turn to listed real estate as a reliable alternative for yield and a defensive asset class. However, this has not occurred yet due to the challenges some segments of real estate face because they are usually places where people gather. We expect this to happen once the extensive containment measures have been relaxed and economic activity begins to recover.
Opportunities to acquire individual companies at attractive valuation levels may arise as geopolitical developments lead to heightened volatility and diverging stock performance. However, retail is expected to remain challenged and see further store closures, especially those in peripheral locations with commoditised market propositions. Growth in online shopping, connectivity and data usage are likely to provide opportunities in logistics and data centres through the business cycle.
Our long-term outlook for global listed infrastructure remains positive, supported by a recovery in economic activity and industry-wide structural investment tailwinds. As an asset class we continue to see the potential for future outperformance as investors seek quality defensive assets that provide sustainable yield profiles in the current low interest rate environment.
Australian shares will likely continue to be primarily driven by global markets. Like its international peers, Australia’s economic growth has slumped, though evidence of a bounce-back has emerged in some sectors, supported by Chinese demand. Australia’s greater degree of government stimulus (relative to other countries) should help support Australian shares, though there are some near-term risks, such as soured trade relations with China and a continued lack of medium-term earnings visibility for many companies. Given large price rises since the March lows, there may be an increased risk of corrections, though we believe the longer-term trend is likely to remain positive. We continue to believe investors should be selective and, as always, maintain a longer-term perspective.
CASH AND FIXED INCOME
The 90-day bank bill rate was little changed at 0.305% in the three months to September as the OCR remained on hold at 0.25%.
In contrast, the 2-year swap rate fell 16 basis points (bps) to 0.06% over the same period as markets moved to price in 45 bps of further OCR cuts over the next 18 months. The 10-year swap rate also reached fresh lows, down 23 bps to 0.51% in the three months to September and seeing the 2s10s swap curve flatten 7 bps to 0.45%.
The NZ 10-year government bond yield fell 43 bps to 0.51% in the three months to September supported by an increase to the RBNZ’s bond buying programme to $100 billion.
The 10-year swap spread increased 18 bps to 4 bps over the same period as bonds outperformed the move in swap.
The 10-year breakeven inflation rate widened 22 bps to 0.98% over the three months to September in response to higher global breakeven rates and on RBNZ buying of index-linked bonds.
Global government bond yields moved lower in July as heightened geopolitical tensions and the ongoing struggle to contain COVID-19 held sway over upside surprises in US company earnings. Yields subsequently rebounded amid the inflationary implications of a move by the US Federal Reserve to adjust its inflation target and with sales and re-financing data pointing to sustained strength in the US housing market. Meanwhile, the prospect of a further US fiscal stimulus package remained elusive despite the US Federal Reserve Chair Jerome Powell reiterating that a lack of additional fiscal support represented a “downside risk” to the economic outlook.
The US 10-year bond yield ended the quarter three basis points higher at 0.69%. The German 10-year bond yield declined by six basis points to -0.52% and its Japanese counterpart declined by one basis point to 0.01%.
Global credit spreads tightened over the September quarter, driven initially by better than expected US corporate profit results. Although earnings were mostly lower, the extent of the decline was substantially less than expected, which provided a boost to market sentiment. Despite progress towards a further US fiscal stimulus package remaining mired in political wrangling, credit investors were encouraged by stronger than expected US employment data and the rapid pace of recovery in the housing market. Investors also largely discounted an increase in issuance post the US Labor Day long weekend, weakness in crude oil prices and a lack of substantive progress in the Brexit negotiations.
Global share markets rose strongly over the September quarter, rallying in the first half before pulling back towards the end of the period to finish up 6.9%, as measured by the MSCI World ex Australia Index.
Growing confidence about the speed of the global economic recovery, better than expected corporate earnings, improved manufacturing activity data and reasonably good US jobs figures all contributed to the strong rise. This was despite renewed fears about further waves of COVID-19 and more specifically, how governments might react to the outbreaks. Geopolitical tensions abounded, although this was mostly regarded as noise. Towards the end of the quarter, a marked correction in technology stocks occurred, which pulled the broader share market down.
Amid a strong Chinese economic recovery and growing demand for commodities, emerging markets also rose over the period, outperforming developed markets and returning 8.7% as measured by the MSCI Emerging Markets index. As in developed markets, the largest stocks dominated, which supported the performance of Taiwan, South Korea and China. India also performed well, retracing some of its losses from earlier in the year. Except for the small Pakistan market, other emerging markets underperformed. Russia was one of the weakest as oil prices slumped in September. (All indices quoted in local currency terms and on a total-return basis, unless otherwise stated.)
NEW ZEALAND DOLLAR
The New Zealand dollar (NZD) was mixed over the quarter. The local currency’s strength against the USD was cancelled out by the fall against other currencies, seeing the NZD finish the quarter relatively unchanged on a trade-weighted basis.
The 2.7% gain in the NZD/USD cross-rate was more about USD weakness as opposed to NZD strength, as the USD lost ground against the other majors