Market Commentary May 2020

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

Global share markets rise

Global share markets rose in May. Much of the gains were driven by expectations economic activity would pick up amid a further loosening of coronavirus containment measures and ongoing fiscal and monetary policy support globally. With more and more countries emerging from their virus-induced lockdowns, investors bet that the worst of the pandemic had passed and that growth would likely begin to accelerate through the second half of the year. In saying that, there were some concerns about a second wave of infections after countries such as South Korea and Germany reported an increase in new cases; highlighting the risk of reopening too soon. Adding to these concerns was news the virus death toll in the US had surpassed 100,000 even as many states were easing restrictions. Investors were also encouraged by further stimulus efforts in China, Japan and Europe, with the European Commission announcing a EUR750 billion aid package to help soften the virus’s impact on the region’s economy. These moves built on the trillions of dollars in financial aid deployed by the world’s governments and central banks at the height of the pandemic. Stocks also benefited from intermittent reports that a vaccine may be close; though an effective vaccine ultimately failed to materialise.

Limiting the gains were rising Sino-US tensions, with Washington continuing to voice its dissatisfaction over Beijing’s handling of the coronavirus outbreak as well as threatening to withdraw Hong Kong’s special trade status after Chinese officials moved to impose a new national security law on the former British colony. Adding to this were fears the new law could spark a fresh wave of violence as protesters took to the streets to voice their disapproval. Importantly, officials within the Trump Administration stressed that despite the more combative rhetoric between the two countries, their phase 1 trade deal, signed earlier this year, remained intact. Stocks were also impacted by news Japan and Germany – Europe’s largest economy – entered technical recessions in the first quarter and a string of disappointing economic data globally, including a rise in US unemployment to levels not seen since the Great Depression. Sentiment was further impacted by some disappointing earnings updates from the likes of Walt Disney, HSBC and Royal Dutch Shell.

At the country level, US stocks performed well, with the benchmark S&P 500 Index climbing a further 4.5% for the month. The index has now gained 36.1% since its low on 23 March. Japanese, European and UK stocks were also higher over the period, while China’s share market weakened.

Australian shares made good gains in May. Like their global counterparts, the local market’s gains were driven largely by expectations domestic economic activity would continue to pick up as federal and state officials rolled back more of the virus-induced restrictions that brought the economy to a near standstill in recent months. Stocks were also well supported by continued fiscal and monetary policy support and some strong performances from the major miners and ‘Big Four’ banks; which together comprise a large part of the market. Limiting the advance was a series of disappointing economic data, including the latest employment and retail sales figures, and ongoing frictions between Canberra and Beijing.

Domestic interest rates on hold

The Reserve Bank of Australia (RBA) maintained its current policy settings in May, including the targets for the cash rate and the yield on three-year government bonds of 0.25%. In its post-meeting statement, the RBA noted that the functioning of government bond markets had improved and that the Bank had scaled back the size and frequency of its bond purchases; which at the time of the meeting totalled around $50 billion. However, officials said they’re prepared to scale-up these purchases again and will do whatever is necessary to ensure that bond markets remain functional and the yield target for three-year government bonds is achieved. The RBA also broadened the range of eligible collateral for its daily open market operations to include Australian dollar securities issued by non-bank corporations with an investment-grade credit rating.

In terms of growth, the Bank said its baseline scenario was for output to fall by around 10% over the first half of 2020 and by around 6% over the year before bouncing back by 6% in 2021. Officials said unemployment would likely peak at around 10% in the coming months and would still be above 7% at the end of 2021, while inflation was expected to remain below 2% over the next few years.

The Bank concluded its meeting by saying it remains committed to doing what it can to support jobs, incomes and businesses to ensure that Australia is well placed for the expected recovery. Moreover, the RBA said it will 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.

Given the risks around the economic outlook right now, coupled with the RBA signalling that interest rates won’t rise until there’s been significant progress toward its employment objective, our view is that the official cash rate will likely remain around its current low level of 0.25% for an extended period. We also expect the Bank to end its government bond purchasing program before it raises interest rates.

Australian dollar extends gains

The Australian dollar (AUD) made further gains in May, extending its rise from the near 20-year low it hit in March. The AUD benefited largely from the ‘risk on’ tone that permeated financial markets throughout the month, as well as stronger commodity prices and further Chinese stimulus. The currency was also supported by general US dollar (USD) weakness. Limiting the advance was a series of disappointing domestic economic data, ongoing tensions between Canberra and Beijing and heightened Sino-US frictions.

The AUD rose 2.5% against the British pound, 2.0% against the Japanese yen and 1.4% against the USD. It fell 0.7% against the euro, while the broader Australian Trade-Weighted Index1 closed the month 1.7% higher.

Looking ahead

The coronavirus pandemic has stalled the mini-cycle rebound and made a global recession likely. Although the duration of the pandemic remains unpredictable, monetary and fiscal stimulus, pent-up demand and a lack of major imbalances argue for a solid upswing when the virus threat eventually clears. Provided the virus is transitory, the global economy should be poised to rebound in the second half of this year. However, whilst equity markets are likely to rebound once the virus is contained, the growth disruption from the virus is likely to trigger a 2020 recession, with global gross domestic product growth likely to be negative in the first quarter and at high risk of contracting further in the second. Progress in containing the virus will have a direct impact on the depth of such a recession.

Our view on global equities remains optimistic. Valuations have clearly improved after recent, large market falls. The outlook is more positive once factoring in the substantial stimulus measures being implemented, even though our near-term outlook is for a recession. Equity markets which have been hardest hit by the virus may be those that benefit the most from the eventual rebound. We believe UK and euro zone equities are attractively priced. Europe’s high weighting to cyclical stocks should help it outperform in the recovery. Emerging markets equities should also benefit from the eventual recovery as they too are attractively valued. We maintain an underweight to US equities, driven primarily by their expensive valuations relative to these other regions.

For fixed income assets, we continue to see government bonds as universally expensive. Whilst they may rally if the coronavirus pandemic escalates further, they nonetheless remain at risk of underperforming once the post-virus recovery commences. We believe high-yield debt is now very attractively priced. Although there is considerable uncertainty regarding liquidity risks in credit markets, the current spread to US Treasuries has historically been a rewarding point to add exposure.

In terms of currencies, we expect the ‘safe haven’ rally in the USD will unwind once we reach the post-virus recovery phase. This should favour currencies like the British pound, the AUD and the Canadian dollar, which are now significantly undervalued relative to long-term purchasing power parity comparisons.

Moving forward, the major risks to our 2020 outlook include more aggressive and longer containment measures should the coronavirus pandemic re-escalate when current measures are relaxed. The economic impact of the virus may turn out to be larger than expected, with a sharp plunge in cashflows causing highly-indebted companies to default, triggering a credit crunch in the broader economy. Further, it is possible that global supply chain disruptions could have a larger and more sustained negative impact on global growth. Nonetheless, we remain alert to risks and volatility as we enter a likely global recession. 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.