Q2 2020 Quarterly Market Commentary
Global share markets higher
Global share markets made good gains in the second quarter, driven in large part 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; a view backed by improving manufacturing activity in places like China, Europe and the US. At the same time, governments and central banks worldwide continued to build on the unprecedented levels of financial aid they deployed at the height of the pandemic. We saw further stimulus efforts in China, Japan and Europe; where most recently the European Central Bank (ECB) increased its Pandemic Emergency Purchase Program by EUR600 billion and extended the Program’s duration to June 2021. This came on top of the EUR750 billion in bond purchases the ECB announced back in March and takes the Program’s total to EUR1.35 trillion. We also saw the US Federal Reserve (Fed) commit to using its full range of tools to combat the economic impact of the pandemic, including buying corporate bonds; a decision which will see the Fed bypass the banks and lend directly to the private sector. Meanwhile, US Treasury Secretary, Steven Mnuchin, announced that he was working with the House and the Senate to pass additional relief by the end of July. Stocks also benefited from intermittent reports that a vaccine may be close (though an effective vaccine ultimately failed to materialise) as well as a strong rebound in oil prices, which jumped 91.7% over the quarter after OPEC and its oil-producing allies agreed to cut output. Sentiment was further buoyed by better-than-expected US retail sales and consumer confidence data. The latter reading was particularly notable given consumers account for around 70% of all US economic activity.
Limiting the advance was news the US economy shrank 4.8% in the year to 31 March – an outcome that brought an end to the country’s longest ever economic expansion – and a spike in US unemployment to levels not seen since the Great Depression. Stocks were also impacted by news Japan and Germany entered technical recessions in the first quarter and heightened Sino-US tensions after Washington began the process of eliminating Hong Kong’s special trade status in response to Beijing’s move to impose a new national security law on the former British colony. Importantly, though, officials within the Trump Administration stressed that the phase 1 trade deal between the two countries, signed earlier this year, remained intact. Sentiment was further impacted by some disappointing earnings updates from the likes of Walt Disney, HSBC and Royal Dutch Shell, as well as growing concerns a potential second wave of coronavirus infections could derail the global recovery. Countries such as China, Japan and Germany all reported an increase in new cases during the period while the virus death toll in the US surpassed 122,000 even as many states were easing restrictions.
At the country level, US stocks performed very well, with the benchmark S&P 500 Index climbing 20.0% for the quarter; its best quarterly performance in over two decades. The Dow Jones Industrial Average (17.8%) and NASDAQ Composite Index (30.6%) were also stronger, with the latter even posting fresh record highs. Stocks were also higher in Japan (17.8%), Europe (16.0%), China (13.0%) and the UK (8.8%)1.
Australian shares made strong gains over the period, with the S&P/ASX 300 Accumulation Index closing the quarter up 16.8%. Like their global counterparts, the local market’s gains were driven largely by expectations 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 also benefited from continued fiscal and monetary policy support, including the Reserve Bank of Australia (RBA)’s commitment to keep funding costs low for as long as required, and strong performances from the major miners and ‘Big Four’ banks. Gains were limited by a series of disappointing, though not entirely unexpected, economic data; notably a contraction in first-quarter growth and rising unemployment. Stocks were also impacted by news China’s economy contracted 6.8% in the year to 31 March, ongoing tensions between Canberra and Beijing and our own second wave virus concerns after a late spike in new cases in Victoria.
RBA leaves interest rates on hold
The RBA left interest rates on hold at an historically low 0.25% in the second quarter, having cut rates twice in March in response to the growing economic threat posed by the spread of coronavirus. In its June posting-meeting statement, the RBA noted that domestic government bond markets were operating effectively, prompting the Bank to scale back the size and frequency of the bond purchases it committed to as part of its quantitative easing program. However, officials did say they’re prepared to scale-up these purchases again and will do whatever is necessary to ensure the 0.25% yield target for three-year government bonds is achieved. This target will remain in place until progress is being made toward the RBA’s goals for full employment and inflation. The Bank also broadened the range of eligible collateral for its daily open market operations over the period to include Australian dollar (AUD) securities issued by non-bank corporations with an investment-grade credit rating.
In terms of the economy, the Bank recognised the material declines in employment and household spending as well as the deferment or cancellation of investment plans. Nonetheless, officials believe it’s possible that the depth of the current downturn will be less than previously anticipated due to a significant drop in the rate of new coronavirus infections and the earlier-than-expected easing of some restrictions. In saying that, the Bank remains mindful that the outlook, including the nature and speed of the expected recovery, is still highly uncertain and that the pandemic is likely to have long-lasting effects on the economy. As a result, the substantial, coordinated and unprecedented fiscal and monetary policy support we’ve seen in recent months will likely be required for some time.
The RBA concluded its June 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 expected recovery. The Bank also noted that its policy action in response to the coronavirus pandemic will be maintained for as long as it’s required. 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. [Note: the RBA left interest rates on hold following its early July board meeting.]
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.
Domestic growth contracts
The Australian economy contracted in the first quarter of 2020, with gross domestic product for the three months ended 31 March coming in at -0.3%. It was the country’s first quarterly contraction since the first quarter of 2011. Household spending and weaker business investment were amongst the biggest drags on the economy. Partly offsetting these were rises in government spending and net trade. On an annual basis, the economy grew just 1.4%; down on the 2.2% growth recorded in the 12 months ended 31 December.
With growth almost certain to have declined further in the second quarter due to the Federal Government’s coronavirus-induced lockdown measures, the local economy appears set to enter recession for the first time in 29 years. Recession is widely defined as two consecutive quarters of negative growth.
Australian dollar rallies
The AUD made strong gains over the period, returning to its pre-coronavirus levels. The currency benefited largely from the ‘risk on’ tone that permeated financial markets throughout the quarter, as well as stronger commodity prices and general US dollar (USD) weakness. The AUD was also supported by the RBA’s decision to leave interest rates on hold throughout the period and additional Chinese stimulus. Limiting the advance were a series of disappointing domestic economic data, heightened US-China frictions and second wave virus fears.
The AUD rose 11.6% against the British pound, 11.1% against the USD, 10.6% against the Japanese yen and 9.0% against the euro. The broader Australian Trade-Weighted Index2 closed the quarter 9.7% higher.
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 Returns in local currencies
2 The trade-weighted index is an indicator of movements in the average value of the AUD against the currencies of our trading partners.