Australia | Oct 26 2020
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While short and medium-term concerns prevail, should investors be focusing on policy, profits and positioning?
-US election and covid-19 concerns
-A new era of fairness?
-Growth versus value investing
By Mark Woodruff
As restrictions have been eased around the world and many markets have retrieved most of the losses from March lows, short and medium term worries still weigh upon sentiment.
Concerns over a contested outcome in US elections and covid second waves are currently uppermost in investor’s minds. The time needed for economic recuperation from the virus has clearly been occupying the minds of economists, with an increasing portion of the alphabet devoted to the shape of the recovery.
But are there even larger structural forces that investors should be focusing on?
In part one of this article, FNArena examines these considerations from an Australian perspective. By focusing on the three P’s (more on this later) it’s possible to assess relevant stocks within sectors that may benefit from not only structural tailwinds but also virus effects and US election outcomes.
Part two will look at policy initiatives in both the United States and the eurozone and the relative merits of investing internationally across the various asset classes.
Australia and The Three P’s
In uncertain times it can be calming to take a step back and contemplate the bigger picture. Randal Jenneke, Head of Australian Equities at T Rowe Price, suggests it’s important to develop a framework around what drives markets.
In a recent online webinar he distilled the framework down to three key factors, namely the three P’s.
The first P stands for Policy. It’s timely to reflect upon how both monetary and fiscal policy affect interest rates over time. These interest rates influence growth and inflation which in turn impact on markets. A 70-year graph illustrates how low interest rates have fueled social inequity by lowering wages (as a percentage of GDP), while simultaneously bidding up asset prices.
Now we are at historic low levels of interest rates thanks to unconventional monetary policy and growth assets in particular have benefited greatly. These low interest rates are important to ongoing market valuations and the prospect for the style rotation that keeps threatening to happen (growth to value).
A graph going back to the 1930’s shows compound average corporate EPS share growth has been 6%. Over the same time period, the total return of the Australian share market has also been approximately 6%. Hence, T Rowe price reminds us – profits do matter. This is shown later when reflecting upon style rotation.
Finally, an analysis of the average fund manager's positioning in the Australian equity market shows an allocation to cash of greater than 3%. This is considered to be cautious by the American global investment management firm. Other sector allocations in the equity market demonstrate Australia generally has been a value market for some time. This is important, because positioning plays an important role in driving markets in the short to medium term, notes Jenneke. This is especially true in a time of change or indeed a change of eras.
A Change of Eras?
According to T Rowe Price, the world is moving from an era of efficiency to one of fairness. Formerly, maximising shareholder wealth was front of mind, but now the focus is on inequality. The winners have been asset rich at the expense of wage earners. During covid, low paid jobs have taken the biggest hit (think tourism, hospitality and retail). So the pandemic has now accelerated the recent trend toward fairness, notes the investment management company. Increased pressure has been placed on governments to respond. This is evident in the US elections for which inequality has become a major issue and stark contrasts exist between the two parties on this issue.
Just ten years ago the focus was on the wealthy 1% (via buybacks, maximising wealth, globalisation and deregulation). Now attention is trained on the 99% and the inequality of income, wealth and opportunity. This is shown by the current focus on workers, wealth taxation, ESG and maximising health.
Jenneke considers government will be asked to play a bigger role in the transition from efficiency to fairness. This will be achieved via the size of government and regulation going forward.
Australia is a good example of the new era of big government. While acknowledging current spending has been forced by the pandemic, T. Rowe believes this will be an ongoing trend to deal with the current job destruction and ongoing inequality.
The current rate of spending in Australia has only been rivalled during the world wars. The budget deficit is now large and will stay relatively high, T. Rowe notes. The focus for the government is squarely on jobs, not efficiency. Monetary policy still has a role, but fiscal policy has come to the fore.
Effect of Fiscal Policy on Interest Rates?
How does fiscal policy flow through to growth and inflation and what does it mean for interest rates going forward? Harking back to the three P’s and in particular policy, the Australian treasurer recently made it clear the government is able to respond with big budgets because interest rates are low.
Now the aim will be to keep them there according to T Rowe Price. The treasurer was recently very supportive of measures taken by the Reserve Bank of Australia to buy government bonds in the secondary market to keep rates low. This shows to the US firm, that if Australia is to grow its way out of debt, the maintenance of low rates is the solution going forward.
Investment Styles Under Three Scenarios – US
There are currently three scenarios for markets which are driving investor positioning, according to T Rowe Price.
1. US election – either party wins with a split congress. This leads to greater stimulus, but lower than it would be if one party had control of all the arms of government. Under this scenario, growth stocks continue to outperform value.
2. A Democratic sweep (Blue Wave) – should result in much greater fiscal stimulus. In this environment cyclical and value stocks do well. Growth cyclical stocks also do well.
3. Vaccine – questions will surround the efficiency of a vaccine and the time it may take to reach the population.
The US firm believes the impact of covid will fade over time, either via treatments, a vaccine, or we simply learn to live with the virus. As the impact fades, growth is likely to improve. The real question about the speed of growth returning revolves around the question of herd immunity.
Investment Styles Under Three Scenarios – Australia
In Australia the budget settings assumed a vaccine by the end of 2021. The arrival of the vaccine is a considerable swing factor in future growth rates. Jenneke is less hopeful for a vaccine by that date and thus has a growth bias to the downside compared to budget projections.
In Australia, growth has outperformed value due to fundamentals around growth in sales, growth in earnings, and growth in cash flow. Profits do matter!
So for any prospect of a style rotation there first needs to be better fundamentals for value.
T Rowe Price says it’s important to hedge bets across the three scenarios, to avoid binary outcomes. Importantly, it’s considered growth will continue to outperform value under all three scenarios. However, growth may be split into four spectrums.
The four spectrums include defensive growth, cyclical growth, extreme growth and recovery growth. Of these, cyclical growth is the most likely to outperform in all three scenarios because economies and growth will improve as populations learn to live with covid and interest rates will remain low.
Stocks to Invest – For the Three Scenarios
T Rowe Price have taken profits in the extreme growth part of the portfolio and transferred to cyclical growth. Examples of relevant companies in this space are James Hardie ((JHX)), Domain Holdings ((DHX)) and Seek ((SEK)).
An allocation toward recovery growth would ideally include IDP Education ((IEL)).
Overall, the US firm believes equity valuations do not currently look stretched, especially when compared to equity alternatives.
If one were to heed the advice of T Rowe Price and invest in some of the above stocks, many of them have global reach and may be affected by swings in the US dollar.
Russell Investments believe the US dollar is likely to weaken amid a recovery, due to its counter-cyclical behaviour. The dollar typically gains during global downturns and declines in the recovery phase. It’s considered the main beneficiaries should be the economically sensitive commodity currencies such as the Australian dollar, the New Zealand dollar and the Canadian dollar.
US dollar depreciation has been a significant trend in markets over the last few months notes Aviva Investors. Looking ahead the key question will be to what extent this trend can continue.
Historically, changes in the US dollar have had a counter-cyclical relationship to global growth, with the US dollar appreciating as growth falls and vice versa. It is unsurprising to the asset manager, therefore, that the US dollar would depreciate once growth bottomed and we moved into a more risk-friendly environment.
The timeline for a widely available and effective vaccine appears to have been brought forward by comparison with views from earlier in the year. It is possible that more than one vaccine could be approved in the fourth quarter and distribution could begin in early 2021, notes Aviva Investors. While that roll-out process may take a year or more, it would remove much of the uncertainty that hangs over the service sector.
The prior worst case assumed the re-imposition of national lockdowns and a related secondary dip in activity levels. Although that is still possible, the global asset manager considers the likelihood has fallen as most nations seem to be dealing adequately with second waves by means of more localised and targeted measures. This has mechanically reduced the scale of GDP declines in 2020 and also the size of the rebound in 2021. The outlook is still uncertain and dependent in substantial part on the progression of the virus. Higher frequency indicators do show that the pace of economic revival has slowed in recent months and we are now entering the critical Northern Hemisphere winter, when the course of the pandemic – or reactions to it – could change significantly.
With only a short time to go until the election, Vice President Joe Biden and the Democrats have retained a comfortable lead over President Donald Trump and the Republicans in both national and key swing state polls. But nothing is certain and the mood can change, says Aviva Investors.
Sentiment could shift quickly in the light of three things …economic developments, the path of the virus itself and Trump’s policy stance in a number of possible fields.
There is also the risk of a contested result as there was in 2000, perhaps regardless of whether the officially called result is close or not. Trump and others have already been trying to instill doubt in the legitimacy of any Democratic victory, ostensibly on the back of potential voting irregularities that few others seem concerned about.
In broad terms a Democratic win (especially if Biden wins together with a House and Senate majority) would be expected to lead to a significant fiscal package aimed at providing support in the current economic environment. It would also be targeted at longer-term priorities, such as the green agenda. It would also likely be somewhat less favourable in terms of regulatory requirements on big business.
On the other hand, a second term for Trump would likely see a further ramping up in tensions with China (and potentially other countries) and a limited domestic agenda given the likely Congressional outcome.
In conclusion, what matters to equity markets are profits and over time uncertainties dissipate. The key focus should be on what is currently driving markets in both the short and long term.
Having settled upon the prevailing style (growth versus value), it is then important to diversify across the spectrum within that style.
In the second part of this two-part article, FNArena will address investment alternatives across asset classes internationally.
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