Warning:
The information in this post is of a general nature only. In regard to the current COVID-19 situation, the environment is changing day to day, and in some cases rapidly.
This post does not take your specific needs or circumstances into consideration, so you should look at your own financial position, objectives and requirements and seek financial advice before making any financial decisions. We cannot emphasis that strongly enough.
COVID-19 Update
To say this has been an extraordinary week is somewhat of an understatement, it has continued on into the weekend, and as I write this on Sunday evening, a lot more has happened today.
Obviously the latest events of the shutdown of non-essential services, may come as a surprise to some (in the community), however does not really come as a big surprise from where I sit. It certainly makes sense.
We do recognise that these times are disconcerting since this market downturn was triggered by a health crisis, but in reality it could have been any number of things.
Previous financial market downturns have largely been triggered by other financial events, such as the global financial crisis, the tech wreck, the Asian financial crisis, the bond crash, the 1987 sharemarket crash, the 1974 bear market, the 1980 bear market, and so on.
This particular downturn is heightened by the underpinning of a health crisis in the form of pandemic, and the need of the Government to limit human to human contact in order to control the virus. We point out that this is not unprecedented since this also occurred to some degree in 1918.
But that is not to downplay the anxiety that many in our community are feeling, as I’m sure are you.
The Current Environment
I will begin the economic discussion with a quote from our asset allocation research analyst Farrelly’s, in their market update on 17 March 2020.
The asset allocation update handbook at the beginning of March noted;
“the market correction at the end of February has taken us back into Fair Value and Cheap territory for most asset classes. This is a time to be fully invested – even though it may feel uncomfortable. This is what long-term investing is all about.”
And noted in the 17 March Update;
“Today, that statement is even more true. This is a time to buy, not sell”.
The market over the past two weeks has been interesting to say the least. During the GFC, I was witness to wild swings in the market, and was in New York at the time of the greatest one-day points fall in history, which was quite surreal knowing that some 9 hours later the Australian market was about to be hit hard.
Last Friday however, we saw the Australian market down around 12% during the day, only to finish 4% up. It is the single biggest intra-day turnaround in Australian sharemarket history.
These are no doubt big moves, and have highlighted some of the confusion of the current market, and some might say in uncharted territory. At the beginning of every bear market however, we are always in uncharted territory since they all have different causes, different speeds, and different depths.
Everything is different, yet it’s always the same.
Every Bear Market is Different
It is now safe to say that we can call the end of the bull market which began in February 2009, and officially ended 11 years later at the end of February 2020. This is true across global share markets as much as it is for Australia.
As to the degree and severity of this bear market, it is important to place the current market into context of previous bear markets. We do note however that each economic downturn, and subsequent market fall is different and terrifying in its own way.
The chart below shows the history of the Australian sharemarket since 1875.
As you can see there have been many times when markets have fallen by significant amounts. The largest, a fall of 73% ahead of the 1974–5 recession, which came about during the oil crisis of that time.
The one thing that we know, is that every bear market has a beginning, and an end. We just don’t know the duration and the depth.
The simple question we need to ask ourselves during every bear market, and particularly now, is what impact will this economic downturn have on long-term company earnings. The emphasis here is on long-term, since we are pricing today’s market on the expected company earnings in 2030, not next year or even the year after, but in 10 years time. I will venture to suggest that by then the coronavirus will be a distant memory.
Long-term Earnings Outlook
Notwithstanding the short-term impacts, and notwithstanding the disruption that the coronavirus will have on our economy and way of life over the next few weeks, the impact of the coronavirus on company earnings in 10 years time will be modest.
Business will obviously need to rethink diversification of supply chains, but this is already happening. Even a 10% hit to long-term profits, would only reduce expected returns by 1% per annum over the next decade.
Cheap assets are still cheap.
It would also seem pretty clear that the economy will go into a recession, and despite what the Government might have been saying earlier, this was pretty much locked in as soon as this virus got into the wild.
It is also pretty clear that Governments globally will pull out all stops to support their economies, and we are already seeing evidence of that. Farrelly’s expectation is that corporate failures will be relatively low, since the level of corporate debt is not excessive worldwide and interest rates remain very low.
In recent days there has been unprecedented action by The Government, the Australian Office of Financial Management (AOFM), the Reserve Bank of Australia (RBA), The Australian Prudential Regulatory Authority (APRA), and the Banks.
Together they will support business, and individual households, and most commentators have given them all a very big tick.
Like every recession however, there will be casualties. We expect unemployment to increase, but it is worth noting that during the recession of the 70s, unemployment reached 11%.
The economic impacts of the coronavirus will be with us for at least another six, perhaps 18 months. There will be many more announcements along the way, some good news and some bad. The economic numbers are likely to be terrible and will cause large falls when they emerge.
In between times, we will see major rallies as investors reassess the value (in the market) on offer. The net result is that we could see much lower prices, or we could now be seeing prices close to the bottom. We just don’t know.
To put the recent volatility into perspective, for all the ups and downs this year both the US, and Australian markets are down around 26% since the beginning of the year. Whilst these falls are nasty, they are not unusual (remember in the GFC they fell over 50%). Volatility has increased, and a volatile market makes things feel worse than they actually are. Moves in the market have been very large and very fast.
Risk
At the time of writing, we are going into a lock-down period in Australia in order to get ahead of the virus curve, and to reduce the impact both on the health sector, and the economy in the longer term.
If we look to Italy however, where they were slow in reacting and unable to get in front of the curve, their market is currently down roughly the same as ours, around 26%. This would seem to indicate the market over there is separating the economic impact from the health situation.
We think the situation in the US is slightly different. We believe US shares were overpriced at the beginning of the crisis, and remain so today. In fact according to Montgomery Investments, in the US the pandemic has struck at the time of the second-most over-valued stock market ever.
Montgomery, as well as Farrelly’s have considered this to be the case for a good couple of years now.
The effect of low interest rates has caused investors to take on ever-increasing risk in order to generate a return. In this regard they (the Investors) have not considered risk, or appreciated the risk they have been taking on, in fact to a large degree risk has been off the table.
The same to also applies in Australia markets, where investors who were not appreciative risk, have continually paid more for a dollars worth of earnings. As we have been saying for some time, the more you pay for an asset the lower your future return.
This is true for all markets, and will likely see prices unwind in property markets as well, since these have been pumped up for nearly 30 years by falling interest rates.
We have always taken the view that investors should invest within their risk tolerance, and ensure that they hold sufficient defensive assets such as term deposits and/or cash in their portfolios. It may be frustrating when returns are low, but a 1% return is better than minus 20%, but we must always pay due respect to risk.
Looking Forward.
We will likely see some spectacular falls in some stocks in the days and weeks ahead. As we have noted this particular sell-off is different to previous sell-off’s.
You can stimulate your way out of a downturn, with the underlying health crisis however is unlikely that similar stimulus will work. If you give someone $1,000 now, it is unlikely that they will spend it at the shops since they are worried they might get sick if they go out to do so.
So this whilst this downturn is different to previous downturns, we know that the reality is usually a lot better in the long-term, than the sentiment at the time. It is important to note that the panic will be worse than the pandemic.
It is also worth noting that whilst some people are suggesting a total shutdown of the world, we are seeing China begin to scale up and get back to production after 60 days of quarantine. Western economies, are around 90 days behind China in regard to the virus.
One of the keys to understanding and controlling the virus has been in the rate of community testing. In South Korea testing rates hit 16,000 tests on 18 March. This high rate of testing has allowed South Korea to identify cases, back channel and isolate people have had contact with a positive case.
In Italy, they were hit with an avalanche in terms of the virus, due to the high number of Chinese companies, and Chinese working in that country chasing the coveted “Made in Italy” label (as opposed to made in China).
This meant that at around the time of the Chinese New Year, there were a large number of Chinese Nationals moving between their home base (in China) and Italy, resulting in the outbreak in the Lombardy region.
Italy were slow on the uptake with testing, and (unlike South Korea) as a result there has been significant impact on their health system, people and the economy.
The point of all this is that the US is following the same path in terms of testing. Their testing rates are very low, and as a result, so to is their detection rate. As we see testing rates increase in the US, we will also see a huge jump in cases.
This is likely to have a negative effect on markets, since we think that markets are still too high in the US.
We should then be prepared for more bad news out of the US, but we should also understand that they are coming off a very high peak. As noted, they were in the second-most overvalued market in history.
In terms of a famework for the 2020 market downturn (and previous crashes), it will have three stages;
Stage I (We are getting through this stage);
- unwinding of the growth premium (revaluation of overpriced stocks)
- markets are shocked by the extent of the infection
- there is an information vacuum
- and people take a “the world is ending”, viewpoint
Stage II (We are currently in this stage)
- the economic impact and downturn (beginning of a recession)
- corporate revenues will be cut
- corporate earnings guidance will be suspended (we are seeing this now)
- unemployment will rise (this is happening now)
Stage III (We are beginning this stage);
- liquidity shortfall (Government providing stimulus)
- credit risks (will occur where business and individuals have extensive borrowings), and
- Government bailouts (for important businesses and business sectors)
In almost all cases to the ending of a bull market and the subsequent market downturn is that markets overreact, and we think there will be no exception this time. Investors are often irrational in these times, just the same as the frantic buying of toilet paper is irrational.
The outlook for the 10-year returns from Australian shares at these levels is around 13.5%. If we take into account a slight adjustment for a recessionary environment of say 1% per annum, then this would reduce the expected return from here to around 12.5% per annum.
We cannot say when markets have reached the bottom, this is only evident in hindsight.
On one hand we know that there is a long time to go before the medical crisis is over and that this market (in particular) reacts violently to bad news.
On the other hand, the falls have already been quite significant and much bad news has been factored in, only time will tell.
What we do know is that valuations in markets are now attractive. The chances of long-term investors earning returns well in excess of term deposits over the next 5 to 10 years are very, very high.
The consensus is that when we start to see the flattening of infection rates, the subsequent rebound is in markets is likely to be sharp. The general consensus in terms of an economic impact, and the subsequent recession is likely to be of a shorter term, but only time will tell in that regard as well.
One thing that we can be absolutely sure of is that there will be an overload of news, most of it grim, and a fair chunk telling us how much we have “lost” financially. As was the case in the GFC, and as will be the case in this market, we have lost nothing when we continue to remain invested.
Instead, we begin to adjust asset allocations according to the changing market valuations and potentially benefit from lower asset prices.
In such markets, and in this market there will be a large transition of wealth from those that sold, to those that purchased. Since that is always been the case, there is no reason to believe this time will be any different.
Next Steps
I understand there is a lot to take in during this time and there is a massive amount of information flowing through. The one thing that I have noticed this time (as opposed to any other time) is the sheer abundance of information flows through social media channels. Some of it is good, but a lot is very misleading.
We will seek to keep you informed as news becomes available.
We will seek to clarify the extent of the Government stimulus, and Government support over the next day or so, with a particular emphasis on what it might mean for you directly.
We also recognise that these are unprecedented times, in our lifetime at least. Accordingly if you need to talk to us please feel free to do so.
There will be many people impacted as a result of the Government’s requirement for many businesses to stand down and individuals to self isolate in order that we get ahead of the curve and beat down this virus.
If you know of anyone that needs help, please feel free to provide them with our contact details. We will endeavour to help them where we can.
We are now set up and operating in full capacity from home.
Take care, and where you can take the necessary steps to self isolate.
We would also point out, that under no circumstances should you take action on the basis of this post. It has never been more important to obtain good quality advice from a qualified Financial Planner before you do anything.
Kind regards, and enjoy good things.
Andrew Rowan
