Australia | Oct 26 2020
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)).
The Australian equities portfolio has investments in defensive growth via the healthcare sector. The stocks include CSL ((CSL)), Resmed ((RMD)) and Fisher and Paykel Healthcare ((FPH)).
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.