Market Commentary Update - July 2020

Here is a summary of investment markets for the month of July 2020

Global share markets rise

Global share markets rose in July as investors bet that ongoing government and central bank support will continue to drive the recovery even as many countries reported a further spike in new coronavirus cases. In Europe, we saw the European Commission agree to a EUR750 billion spending package aimed at helping those member nations most affected by the pandemic. The agreement, spearheaded by France and Germany, will see European countries raise funds by selling bonds collectively rather than individually, with those funds then distributed as grants (instead of loans to be repaid). Elsewhere, government officials in the US moved closer to agreeing a sizable new relief package for people impacted by the virus, while the Federal Reserve said it would keep interest rates low until it was confident the economy has weathered recent events and is on track to achieve its employment and inflation goals. Stocks also benefited from positive developments on the vaccine front (though a widely available vaccine isn’t expected until next year), improving Chinese manufacturing activity and news the world’s second-biggest economy expanded by more than expected in the June quarter. China’s economy grew 3.2% for the year to 30 June, ensuring the country avoided recession after a 6.8% annualised contraction in the March quarter. Sentiment was further buoyed by some encouraging earnings results from the likes of Goldman Sachs, IBM and Coca-Cola. US earnings have generally fared better than first thought, with many companies beating analysts’ expectations. In saying that, the bar for earnings had been set relatively low due to the anticipated impact of coronavirus.

Limiting the advance were increasing concerns over a second wave of coronavirus, with countries like Brazil, India and Russia all reporting a surge in new infections. Perhaps more worrying, though, was the rising death toll in the US. At the time of writing, the number of virus-related fatalities in the country had surpassed 160,000, forcing many states, including California, Florida and Arizona, to backtrack on reopening their economies and reintroduce strict lockdown measures. Stocks were further impacted by ongoing Sino-US tensions and sharp contractions in US and eurozone growth. Tensions between the US and China escalated after the former challenged China’s claims to the South China Sea and President Donald Trump issued an order that will end Hong Kong’s special trade status with the US. Meanwhile, a preliminary reading showed the US economy shrank 9.5% in the three months to 30 June and a massive 32.9% for the year – the biggest decline in annual growth since records began in 1945. The eurozone’s economy contracted 12.1% in the June quarter, led by steep declines in Spain, Italy and France. On an annual basis, the region’s economy shrank 15.0%.

At the country level, US stocks performed well, with the benchmark S&P 500 Index gaining 5.5% for the month. The index has now gained 46.2% since its low on 23 March. Chinese stocks were also materially higher over the period, while share markets in the UK, Japan and Europe were all weaker.

Australian shares made modest gains in July. Like their global counterparts, local stocks benefited from continued fiscal and monetary policy support, with the Federal Government extending its JobKeeper program for a further six months and the Reserve Bank of Australia (RBA) reaffirming its commitment to maintain its policy response to the coronavirus for as long as it’s required. Sentiment was also buoyed by good gains across the mining sector, vaccine hopes and encouraging Chinese growth. Gains were limited by the Victorian State Government’s decision to reintroduce lockdown measures in response to a surge in new virus cases, mixed performances across the ‘Big Four’ banks and a series of disappointing economic data; notably the latest jobs and inflation figures.

Domestic interest rates on hold

The RBA maintained its policy settings in July, including the targets for the cash rate and the yield on three-year government bonds of 0.25%. In its posting-meeting statement, the Bank noted that leading indicators had generally picked up, suggesting the worst of the global economic contraction had passed. In saying that, officials recognised that the outlook remained uncertain and that the recovery will depend upon containment of the coronavirus.

Here in Australia, the RBA said domestic government bond markets had continued to operate effectively. As a result, the Bank had not purchased government bonds for some time. Officials had committed to buying government bonds as part of the quantitative easing program it implemented in response to the coronavirus pandemic. However, the Bank did say it’s prepared to scale-up its bond purchases again to ensure bond markets remain functional and the yield target for three-year government bonds is achieved. This yield target will remain in place until progress is being made toward the RBA’s goals for full employment and inflation.

In terms of the economy, the Bank noted conditions had stabilised and that the downturn had been less severe than earlier expected. Nonetheless, the uncertainty about the health situation and the future strength of the economy was making many households and businesses cautious, and this was affecting both consumption and investment plans. Whilst the substantial, co-ordinated and unprecedented easing of fiscal and monetary policy in Australia is helping the economy through this difficult period, it’s likely that fiscal and monetary support will be required for some time yet.

The RBA concluded its meeting by saying it remains committed to doing what it can to support jobs, incomes and businesses and to ensure that Australia is well placed for the recovery. The Bank also noted that its policy action in response to the coronavirus pandemic would be maintained for as long as it’s required. Moreover, the RBA said it would not increase the cash rate target until progress is being made toward full employment and officials are confident that inflation will be sustainably within the Bank’s 2–3% target range. [Note: the RBA left interest rates on hold following its early August board meeting. The Bank also said it would resume its purchases of government bonds after the yield on three-year government debt moved a little higher than the RBA’s 0.25% target.]

We believe the near-term economic outlook has become a little more uncertain due to the reintroduction of lockdown measures in Melbourne. However, we expect the RBA to maintain its current policy settings and instead rely on fiscal policy. Given the Bank expects the unemployment rate to remain elevated through the end of next year, we believe the official cash rate will remain low for an extended period.

Australian dollar extends gains

The Australian dollar (AUD) rose for a fourth consecutive month in July, benefiting largely from improving risk appetites and general US dollar (USD) weakness. The USD posted its worst monthly performance in a decade in July. Limiting the currency’s advance were rising concerns over the spread of coronavirus, both here and abroad, and a series of disappointing domestic economic data.

The AUD rose 5.1% against the USD and 1.8% against the Japanese yen. It fell 1.6% against the British pound and 0.7% against the euro, while the broader Australian Trade-Weighted Index1 closed the month 3.2% higher.

Looking ahead

Markets have rallied on hopes of an economic recovery and easing lockdown measures globally, while the cycle outlook has improved amid vast fiscal and monetary stimulus. However, the market rebound means value is no longer compelling for global equities or credit. Though markets may be vulnerable to negative headlines in the near term, in our view, the supportive cycle outlook should allow equities to continue to outperform bonds over the medium-term. We believe the recovery from the recession will lead to a long period of low-inflationary growth, with central banks likely to keep interest rates low once inflation rises.

We maintain our preference for non-US equities over US equities; a view driven largely by expensive relative valuations. However, we also believe the post-coronavirus recovery will see corporate profits improve. This scenario could favour cyclical and value stocks over defensive and growth names, which would be more supportive for stocks outside of the US. We believe emerging markets equities should benefit from China’s early exit from lockdown and additional stimulus measures.

For fixed income assets, we continue to see government bonds as universally expensive. Low inflation and dovish central banks should limit rises in bond yields during the recovery phase. In terms of credit, we have a neutral view on high-yield and investment-grade debt. Since their levels in mid-March, credit spreads have compressed and, in our view, only now adequately compensate for the likely rise in default rates following the recession.

In the currency space, we expect the USD to weaken into the global economic recovery due to its counter-cyclical behaviour, which has historically seen it decline in the recovery phase. Economically sensitive ‘commodity currencies’ like the Australian, New Zealand and Canadian dollars should be the main beneficiaries of this.

Moving forward, the major risks to our outlook include a second wave of virus infections and the US elections in November. In the next few months, we’re likely to know if a second wave is underway. Most countries appear to be better placed to manage a second wave in terms of treatment and healthcare capacity. The US elections will become a bigger focus for markets if the Democratic presidential nominee, Joe Biden, sustains a commanding lead in the polls. Biden plans to reverse some of the Trump Administration’s corporate tax cuts from 2017, which could deliver a negative hit to earnings in 2021. One of the key watchpoints of the election outcome will be if the Democrats seize control of the White House, Senate and House of Representatives, which would make corporate tax hikes more likely and increase the risk of further corporate regulation. The other risk is a re-escalation of the US-China trade war, though with President Trump’s re-election chances tied to a recovery in the stock market and the US economy, we expect he will not endanger this by rebooting trade hostilities. We remain alert to risks and volatility as we enter the recovery phase of the global economic cycle. Importantly, we believe this is an environment that will favour our active management approach.

1 The trade-weighted index for the AUD is an indicator of movements in the average value of the AUD against the currencies of our trading partners.