Feature Stories | Jan 29 2020
A sluggish economy and a strong stock market in 2019. Forecasts for 2020 are becoming increasingly diverse.
-Equity valuations stretched
-Bushfires/coronavirus cloud monetary/fiscal policy assumptions
-Economic data suggest weak December quarter
-Commodity prices considered key
By Greg Peel
When stock market analysts and economists began preparing their annual market outlooks for the year to come back in November, the US-China “phase one” trade deal was yet to be signed and the UK election was yet to be held. (2020 Outlook: Australia)
Since those reports were complied, Boris Johnson’s landslide victory has all but taken Brexit off the list of global risks, pending EU trade negotiations notwithstanding, and the signing of the phase one trade deal has led to no further tariffs or tariff increases and indeed some tariff reductions.
While pundits agree phase one is more show than substance, it has at least reduced uncertainty and lifted global spirits.
In Australia, virtually all in the market were forecasting an RBA rate cut in February due to the sluggish economy, specifically an unwilling consumer. But consensus conceded that further rate cuts were likely to have little impact, thus requiring the Morrison government to lend support with fiscal initiatives. At that time the Morrison government remained hell bent on retuning the budget to surplus.
Morgan Stanley – to choose one forecaster – was assuming a February rate cut but also assuming, albeit without great conviction, Morrison would bring forward the next round of promised tax cuts to the 2020 May budget.
In the interim, the surprisingly swift rebound in house prices, leading to a return of “bubble” warnings, and a surprisingly strong December jobs report have led to the market greatly reducing the odds of an RBA rate cut in February. As for the fiscal side of the equation, nature has intervened.
Fire and Pestilence
The Australian fire season begun last year in August and was raging by November. Then it got worse. The government’s response has been in no way swift, but subsequent announcements of assistance handouts equate to some level of fiscal stimulus.
However, even if we assume these government injections square off the GDP against bushfire cost, we’re still where we were last year: with monetary policy requiring fiscal policy to provide support.
Morrison has, however, hinted that given the circumstances, a budget surplus is no longer the specific focus. A second round of tax cuts in the May budget?
The government could go one of two ways. It could maintain its stubborn surplus target and use the bushfires as an excuse not to draw down further on the budget, or it could abandon or at least wind back its surplus target while maintaining face with the electorate, using the bushfires as the excuse.
We can look to the US experience of natural disasters and stock market responses as a guide to economic impact.
Not that long ago Wall Street would sell off on natural disaster, such as a hurricane, but then recover again as lost economic growth in the immediate wake of the disaster gave way to a surge in activity in the rebuilding phase. In more recent times Wall Street has pre-empted such a dip-and-rebound, to the extent there is no dip in the first place.
Witness the Australian stock market in January. Outside of the sheer tragedy, the impact on the Australian economy was immediately evident, from holiday cancellations on the NSW south coast right through to the US warning its citizens not to travel to Australia at all lest they be incinerated. From wiped-out food production to massive losses of livestock. Yet how did the Australian stock market react?
Best January in decades.
At least up until Tuesday. Nature has again intervened.
While at this stage experts do not expect the coronavirus will become a devastating global pandemic, they cannot make any promises. What is clear nonetheless is that the Chinese economy will be heavily impacted. The timing – lunar new year – could not have been worse. When China sneezes, Australia catches a cold.
A common theme among analysts as 2019 drew to a close was that Australian stock valuations were stretched on a price to earnings (PE) basis. At the time, the ASX200 was trading around 6700. It has since hit 7100. For such valuations to be justified, corporate earnings need to back up investor sentiment. For PEs to ease back from historically high levels, E has to catch up to P.
All will be revealed next month in the local earnings season. But before the numbers start to flow, we can make a few observations, courtesy of the analysts at EL&C Baillieu.
Australia’s GDP grew 1.7% in the September quarter, well below a long term average of 3.2%. Growth appears to have remained sluggish in the December quarter, if we consider: vehicle sales down -7.6% year on year, the lowest since 2011, core retail sales (ex-food) up only 2.2% year on year, almost a full percentage point lower than 2018; dwelling approvals down -14.8% year on year, consumer confidence down -8.2% year on year, the worst reaction to an RBA easing cycle on record; business confidence at a six-year low; ANZ Bank’s job ads series down -14.2% year on year; and tourist arrivals up just 1.9% year on year.
That last one pre-dates the true bushfire impact on inbound tourism.
The ASX200 underperformed overseas markets in the December quarter, falling -0.1% in price terms (ex-dividends). Over 2019 the index rose 18.4%. January has been a different story, with the ASX200 shooting up 10% prior to this week, but one must ask what has changed?
A not unsubstantial contribution to that rally has been made by healthcare heavyweight CSL ((CSL)), Baillieu notes, which outperformed in the December quarter and has not looked back as the coronavirus crisis has escalated. Sector peers Ramsay Health Care ((RHC)), ResMed ((RMD)) and Cochlear ((COH)) also outperformed.
A rally in the quarter for oil prices, largely due to geopolitical tensions, provided for solid gains for the likes of Woodside Petroleum ((WPL)), while sustained high iron ore prices supported BHP Group ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)).
Solid gains were seen among industrials Amcor ((AMC)), Transurban ((TCL)) and Brambles ((BXB)), while Wesfarmers ((WES)) waved the flag for the consumer discretionary sector as consumer staples sagged (ahead of Kaufland’s capitulation).
The big drag was of course the banks, or at least three of the majors, which fell -10-16%. Commonwealth Bank ((CBA)) fell only -1.2%.
Towards the end of 2019, the analysts at Macquarie were among those calling Australian equity values stretched. They have not since wavered from that belief, but have now looked to the US to suggest that high valuations can be sustained through to mid-2020.
The latest OECD indicator shows an accelerating US economic recovery, Macquarie notes. Importantly, Macquarie states “We do not think the coronavirus will have a material impact on the cycle”.
The analysts expect the US economy to progress to an expansion phase by March. To that end, and while valuations are high, Macquarie believes the accelerating economic momentum that characterises an expansion phase should provide support for Australian stock prices. Cyclicals tend to outperform during an expansion phase, with bond proxies underperforming due to a rise in bond yields.
Macquarie still favours some rotation to resources given an improving cycle should lift commodity prices. However, an accompanying rise in the Australian dollar will provide a headwind for all stocks with high foreign sales exposure.
Central banks were the key driver of the 2019 bull market in stocks, the analysts note. Volatility could thus rise as we “lap” the first rate cuts of the cycle. The Fed cut in July, September and October last year and is currently expected to remain on hold for the time being. The RBA cut in June, July and October and is currently expected not to cut again until mid-year.
One caveat: If the coronavirus fallout appears extensive, more so than today’s mild rebound in the ASX200 suggests, the RBA may yet cut in February.
For stocks to keep rising after we lap these events, warns Macquarie, we need to see a stronger earnings cycle. At this stage, the analysts note, earnings growth forecasts are generally still falling.
More will be revealed next month.
For now, “Make hay while the sun shines,” suggests Macquarie. Equity investors displayed an optimistic mood in 2019 and into January. While such returns cannot continue, accelerating economic momentum and the benefits of central bank easing can support stocks till mid-2020.
Baillieu is less enthusiastic.
Aforementioned data suggest the December quarter was as sluggish for the Australian economy as the September quarter. Looking ahead, Baillieu sees more headwinds than tailwinds, keeping pressure on earnings.
The broker expects the RBA will cut twice in the first half of this year, to 0.25%, but believes this will do little for growth. And given we are still two years away from the next election, the government will indeed focus on a return to surplus rather than tax cuts, Baillieu suggests.
The housing recovery under way will peter out in the broker’s view, due to limited “pass through” of RBA rate cuts into borrowing rates, poor affordability, record household debt, “bubble” valuations and oversupply.
With returns on cash at zero and ten-year bonds around 1%, funds will be driven into risky assets, Baillieu warns. To that end, investors need to be selective amidst high valuations.
Macquarie believes the Aussie dollar will appreciate on the back of stronger commodity prices, driven by US-led expansion. Baillieu is forecasting the opposite, based on record negative rate spreads, anaemic relative growth and deteriorating commodity prices.
Seems we have “a market”.
Baillieu is underweight Australian equities in a global context given the risks surrounding bubble-like home and equity valuations at near-zero interest rates.
Within the Australian market the broker prefers global leaders.
Commonwealth Bank’s economists have their own view on commodity prices.
CBA believes, writing ahead of coronavirus escalation, the risks to the Chinese economy and commodity prices are skewed to the downside. The phase one trade deal merely represents a truce, the economists insist, given the bulk of US tariffs on imports from China remain in place.
CBA suspects any stimulus from Beijing this year will involve infrastructure investment. More will be known following the government’s “Two Sessions” in March.
In the oil market, CBA suggests China’s commitment within the phase one deal to buy energy products from the US looks exceptionally challenging. China has committed to buy US$18.5bn of US energy products in 2020 and US$33.9bn in 2021. In 2017, China bought US$9bn. To meet the targets China would need to buy US crude oil and LNG. That suggests someone else will miss out.
CBA estimates 8-10% of Australian LNG exports are exposed to substitution as a result of the phase one deal.
In terms of price, CBA forecasts Brent crude to average US$63/bbl in 2020 as supply discipline from OPEC-Plus keeps oversupply – mostly US shale – contained. Supply disruptions are always a threat, particularly if tensions between the US and Iran heat up again, but CBA believes these threats are only likely to provide temporary price support.
For iron ore, it’s a battle between increasing global seaborne supply and China’s winter steel production cuts. CBA sees prices well supported in the March quarter but pressure thereafter.
Rising seaborne supply is also an issue for accompanying coking coal. Prices have improved so far this quarter but CBA expects a lower trend through 2020 on rising supply along with Chinese import restrictions and subdued demand from India.
Rising seaborne supply and Chinese import restrictions are also issues for thermal coal, as is the trend to switch from coal-fired electricity generation to cleaner gas-fired. CBA expects prices to track sideways through 2020.
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