Economic Update – September 2020
by Infocus Author
Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.
New highs on Wall Street:
- Earnings season in US beats expectations, noting that expectations were lower due to COVID-19
- The US market buoyed by large Tech companies still leading the charge
- Australian jobs data show some strength but not out of the woods yet
Wall Street’s second quarter (Q2) earnings reporting season, held mainly in August, provided a stronger result than expected on bottom line i.e. profits. Companies usually set a ‘low bar’ but this quarter’s ‘beat’ was much bigger than normal.
Admittedly, the main strength was in the tech sector – and mega-caps at that – but there were plenty of other good results. The Nasdaq (tech dominated) index made new all-time highs. The broader based S&P 500 also hit new all-time highs in August but the Russell 2000, representing smaller companies, did not fare so well.
Wall Street is on a roll but is it sustainable? Many argue that its success is largely due the Fed’s loose monetary policy. That is certainly true in part but it’s not the whole story.
Low yields on bonds and low rates on cash – which both come from the Fed’s policy stance – mean that equities are about the only place to earn income. However, massive improvements in technology and their impact on companies’ efficiencies are also at work.
That US earnings were largely under-predicted goes to the notion that many analysts’ views on over-valuation were partially misguided.
At home, our first-half company reports have also thrown up many upside surprises but our ASX 200 index has struggled to keep pace with Wall Street. Perhaps if we had a few Amazons, Netflix and Facebooks, things would be different. But we haven’t (yet?)! However, that doesn’t mean we can’t maintain growth in equities – but not necessarily at the same pace as Wall Street.
Our analysis shows us that only now does Wall Street start to look a little bit “toppy” but that does not mean a correction, or worse, is necessarily on the horizon. But it might mean the big short-term gains are behind us. In the long haul, we fully expect decent returns on Wall Street and at home. We do not think it is a time to sell – particularly when capital gains tax is included in the mix – but pausing between market entries with any excess cash, or dollar cost averaging, might be the way to go.
A lot is being talked about sector rotation and portfolio styles. Value portfolios (which are usually characterised by being cheaply priced relative to current earnings) have gone nowhere in recent years.
Growth portfolios (which are usually characterised by low dividends because companies prefer to re-invest earnings within the company rather than distribute them as income to the investors) have done well in recent years.
Apart from the relative performance in the steep market decline last March and the steep ascent since then, growth has beaten value by a country mile. However, our analysis suggests that these two aggregated sectors might be more on level-pegging terms in the year to come.
Diversification means that prudent investors shouldn’t take big bets on any stocks, sectors or styles. But prudent portfolio managers who have the flexibility in their mandates should try to anticipate changes in performance – but glide to a new position rather than lurch.
We think it is fair to say that much of the macroeconomic data has been corrupted by the impact of the sharp – but necessary – virus-related shut-downs and the consequent rush back to re-opening.
However, there have been a number of bright lights among the sea of data deluges. The US has witnessed some particularly positive housing data. China looks resilient. Indeed, the CEO of BHP just stated that ‘China is in a V-shaped recovery and looking good’.
The Fed held its big annual international central bank conference virtually rather than actually this year in Jackson Hole, Wyoming at the end of August. Nobody seemed to expect any big announcements this year. It was only going to be lower rates for longer but Fed Chairman, Jerome Powel, came up with a headline!
The ’old’ target for inflation of 2% was replaced by an ‘average inflation’ target of 2%’. The Fed had already baked in some wiggle room over slight breaches of 2% but this new target gives them even more room such that they could take a marching band with them!
The Fed does not want to stunt economic or market growth with a quick rate move. More importantly, it doesn’t want the market to try to second guess them so they’ve put this extra barrier around themselves.
In a previous meeting the Fed said they were ‘not even thinking about thinking about thinking about raising rates.’ Now they are not even thinking about the previous statement.
We think we can reasonably conclude that the Fed will not upset the apple-cart again – as it did a few years ago when Powell hiked rates and then had to recant.
So, with rates low for a very long time, what should we fear? We think there is no reason to expect a pent-up inflation boom to build in the near term at least. The only big changes in inflation since WWII in the US followed the Korean war in the fifties and the OPEC oil prices hikes in the seventies.
And what if there is a boom in economic growth? We should applaud growth – unless it causes inflation. There seems to be reasonable evidence that low rates promote growth (greater than it would otherwise have been) but the link to inflation is tenuous.
Macroeconomics is an uncertain science at best – even compared to microeconomics and econometrics. The accepted linkage between growth and inflation is the so-called “Phillips curve”. In 1958, Kiwi Bill Phillips published a seminal academic paper on the relationship between unemployment and wages growth. He pushed the idea no further than that! But acolytes took this empirical study to the limits, even though new data did not support such a stable relationship.
In truth, academic economists and central bankers cannot find empirical evidence to support a stable relationship between unemployment and inflation and – by extension – between interest rates and inflation.
There has also been a growing following for Modern Monetary Theory (MMT). It didn’t exist a few years ago but the thesis of its proponents appears to be – grow the budget deficit with no consequences (unless inflation builds up). It’s interesting to note that academics who support this theory also seem to cover their tenure (i.e. a life-time job no matter what) which means that MMT proponents are safe from any come back if they are wrong!
So, where do we stand? We think we need a modicum of common sense when it comes to printing money and creating debt and that we are currently on a sensible path. Growth is building and is close to being sustainable without central banks.
We think it will be many years before any problems arising from Fed action surface – if at all – so we choose to think in terms of investing in a stable medium-term strategy.
Unlike in the US, our unemployment rate has not yet started to fall. But the last published increase was only from 7.4% to 7.5% and 114,700 jobs were created (of which 43,500 were full-time) in July. The participation rate continues to climb reflecting that people from outside the workforce are being encouraged to look for work.
James Bullard, president of the St Louis Fed, recently stated that the US growth for Q3 will likely come in at the biggest ever (largely because of the sharp fall in Q1/Q2) as we argued earlier in the year. If it does come in at around 20% (annualised) as Bullard suggests, that might be a big boost for Trump less than a week before the presidential election. Since most people probably don’t understand all of the important data and statistical issues it could be some ‘fake news’ that works in Trump’s favour!
The ASX 200 posted its fifth straight month of capital gains in August. However, our analysis does not suggest that it is significantly overvalued.
The Consumer Discretionary, Property and IT sectors were the strongest of the 11 sectors that make up the broader index during August. The Telco and Utilities sectors posted big capital losses in August.
The earnings reports for the first half of 2020 that have been posted so far have overall been better than many expected but there have been a number of quite poor results. This patchy success stresses the importance of appropriate diversification strategies.