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Author: Provision Wealth

Market outlook Q&A – disconnect to real economy, growth v value, vaccines, property, gold, inflation and other issues

Date: Sep 04th, 2020

In recently presenting a market outlook webinar we received lots of questions about the outlook but were unable to answer them all given time limitations. Here we try and cover the main questions investors have in a simple Q&A format.

Have markets disconnected from the real economy?

Not necessarily. Share markets invariably lead the economic cycle. Shares led the coronavirus hit to the global economy when they plunged 35% into March. The rebound since then reflects the combination of government measures to minimise the economic damage, ultra-low interest rates which have made shares cheap, some slowing in new cases, positive signs for coronavirus treatments and vaccines and a rebound in a range of economic indicators (eg US GDP looks on track to rebound by around 7% this quarter). So, share markets are anticipating better conditions ahead and that economies will be able to withstand an eventual tapering of government support.

US shares are at all-time highs, what is the probability of a big move down versus a continuing rising trend?

Our base case with around 70% probability allows for a short term pullback in the next month or so then rotation away from US shares and relatively expensive technology and health care stocks into non-US shares and cyclical stocks and a continuing rising trend in shares on a 6-12 month view. This note provides our reasoning as to why the trend in shares likely remains up.

Our risk case with 30% probability is that share markets have another sharp leg down in the next few months with possible triggers being bad news regarding coronavirus, a renewed economic downturn, the US election, tensions with China or an unexpected rise in inflation/sharp rise in bond yields. Relatively expensive tech stocks could be at the centre of this.

Markets are often at all-time highs (as shares rise over time) so record levels do not necessarily mean a sharp fall is imminent.

Are technology/growth shares vulnerable to a crash?

The coronavirus shock has given US tech stocks – particularly mega cap names like Facebook, Apple, Amazon, Microsoft, Netflix and Google – and health care stocks a further boost. The tech heavy Nasdaq is up over 30% year to date and nearly 50% over 12 months. Not only have tech stocks been direct beneficiaries of the crises via stronger demand, but growth stocks with their long earnings streams benefit more from lower interest rates. This is different to the 1999/2000 tech boom as Nasdaq’s forward PE is now much lower at 32 times, tech sector earnings are now real and back then most share markets were expensive whereas that is not the case now. But there are several reasons to expect tech and growth stocks to underperform on say a 12 month horizon: their growth may slow as lockdowns ease; they are relatively expensive; interest rates may not fall much further; tech stocks are vulnerable to increased regulation and US/China tensions; and cyclical/value stocks should benefit as global growth recovers.

Will Australian shares continue to lag global shares?

Probably not. The main reason for the underperformance of Australian versus global shares in recent years is the strong outperformance by US shares. They have outperformed global and Australian shares this year and over the last few years. Eg over the last five years US shares returned 14.5%pa versus 7.5%pa for Australian shares. The US share market has a relatively higher exposure to growth stocks whereas non-US and Australian shares have a higher exposure to cyclicals (like industrials, resources & retailers) & financials. As the global economy recovers and interest rates bottom this will likely benefit cyclical sectors and financials and hence see non-US, including Australian shares, outperform. More money printing probably also helped in the US, but this will eventually slow.

How close is a vaccine? What is the market pricing?

We have seen positive news regarding vaccines (that they are safe at least initially and generate immune responses) and various treatments (eg, antivirals like Remdesivir and therapies like Dexamethasone which is a low-cost steroid). The University of Oxford/ AstraZeneca vaccine appears to be most advanced and some are already in production ahead of the completion of Phase 3 tests. However, mass deployment of a vaccine is unlikely until next year and they may not provide complete protection (more like a flu vaccine than a measles vaccine) and so may have to be combined with other treatments. The deployment of vaccines is partly but not fully factored into shares (eg, travel stocks are yet to recover much).

Are investors blind to massive levels of public debt?

Investors are well aware of the surge in public debt flowing from fiscal stimulus, but this is not necessarily as bad as it looks. First, it headed off a bigger hit to the economy and hence an even bigger blow out in public debt. Second, it makes sense for the public sector to borrow from the private sector to support the economy when the latter has cut spending. Third, public sector borrowing costs are ultra-low and often negative. Japan is an example where gross public debt in excess of 200% of GDP has not caused a major problem. It’s also conceivable that if a problem did arise, governments could simply cancel the bonds that their central banks now own (which would mean a loss for the investment in their central bank which is offset by a reduction in their debt liability – and so would have no major impact). Finally, in Australia public debt is relatively low. The real constraint to deficit financing is inflation, but its low.

Are bonds still a defensive asset to shares?

Yes. While bond yields are ultra-low and so offer very low medium-term returns, they are still a good diversifier to shares. For example, while Australian shares have lost about 8% year to date, bonds have returned around 4% and so having them in a portfolio has helped smooth out overall returns.

What tangible benefit is RBA quantitative easing?

The RBA’s use of printed money to boost liquidity in the economy by providing cheap loans to banks and buying bonds is keeping credit flowing and borrowing costs and the $A lower than otherwise. This helps indebted Australian households continue reasonable levels of consumer spending and helps businesses service their loans and employ people.

What is the risk of inflation v deflation?

Depleted inventories of some products (eg home goods & some foods) due to lockdowns and a switch in demand (from holidays & services to home goods) could boost inflation in some areas, but the main risk in the short term is low inflation or deflation due to lots of spare capacity evident in factories and in terms of unemployment keeping a lid on wages growth. This could be the case for one to three years. However, on a medium term view higher inflation is a bigger risk as the extra money being printed by central banks could at some stage be spent, central banks are now taking more risk with inflation and if the coronavirus shock to supply chains results in more production coming back onshore, particularly if protectionism increases.

Why didn’t QE after the GFC in the US boost inflation?

While narrow measures of money supply increased with QE it wasn’t lent out and post GFC fiscal austerity may also have headed off the impact on inflation. The same may happen this time, but huge fiscal stimulus is a big difference this time around so there is greater risk of inflation once spare capacity is used up, but that may be several years away.

Will the US dollar continue to fall?

Probably yes. The $US is a safe haven currency that often goes up in times of global uncertainty and declines when uncertainty abates. This reflects the relatively low cyclical exposure of the US economy. From its March coronavirus driven high the $US has fallen around 10% against major currencies and further downside is likely as the gap between US and global interest rates has collapsed, the $US is expensive, the Fed is printing more money than other central banks & a global recovery will reduce safe haven demand for the US dollar.

What does a falling $US mean for other assets?

A falling $US is a sign that global reflation is working and the global outlook is on the mend. This is positive for: commodity prices because they benefit from stronger global growth and are priced in US dollars; non-US share markets including Australian shares because they are more cyclical; and currencies like the $A. We expect the trend to remain up in the $A towards $US0.80 on a 6-12 month view helped by rising commodities and a return to a positive interest rate differential versus the US.

Should investors have gold & bitcoin?

Gold and bitcoin are expected to rise in value as the $US falls. But this is likely just another cyclical fall in the value of the $US rather than a sign of a new crisis – particularly with commodity prices rising too, which is a sign of stronger, not weaker, global growth. There may be a case for gold and bitcoin as a hedge against inflation but it makes more sense to have a well-diversified commodity exposure, neither gold or bitcoin produce any income which makes them very hard to value and there are lots of crypto currencies competing with bitcoin so their supply is unlimited. So, I am not really a gold or bitcoin bug!

What is the outlook for commercial property?

The hit to economic activity and specifically traditional bricks and mortar retail space demand and office space demand (following the surge in online retailing and working from home) and hence rents from the virus will weigh heavily on near term returns from retail and office property. Industrial property is a big beneficiary though. All will benefit from the continuation of low interest rates & the search for yield beyond the short term.

Why COVID might result in more Europe, not less?

The coronavirus shock had the potential to expose fault lines in Europe, but so far, its brought it closer together with the ECB’s latest QE program buying member nation’s bonds on the basis of need rather than some formula based on their weight in the Eurozone and agreement on a €750bn recovery fund much of which will be financed by the common issuance of bonds (which sounds like a step towards a common fiscal policy).

What impact might the US election have?

Shares tend to prefer incumbents and so with 87% accuracy since 1928 a rise in US shares in the 3 months prior to the election would point to a victory by Trump; but a fall would point to Biden. Trump’s low tax policies & antagonistic policies to China and to a lesser degree Europe and Japan would favour US over non-US shares and vice versa for a Biden victory. Historically though, US shares have performed best under a Democrat president with a divided Congress and second best under a Democrat clean sweep (see this note) and I see no reason to expect otherwise should Biden achieve the same, albeit markets may initially sell off. Of course, a contested election result would also cause short term uncertainty.

What is the risk of increased tensions with China?

Trump is trying to appear strong on China for political reasons ahead of the election as he knows there is votes in it; but does not want to go so far as to threaten the US economic recovery with say more tariffs and China is biding its time. What happens next year will depend on who wins the US election. Trump will potentially ramp conflict up in a way that could impact markets (although direct military conflict is unlikely) with trade, Taiwan and the South China Sea being the key issues to watch. Biden would likely take a more diplomatic approach.

If Australian house prices fall, what would it mean for banks?

A 10-15% fall (our expectation) is manageable and the associated rise in bad debts has already been provisioned by the banks. A 20% fall would likely mean more trouble for them.

When will the Australian economy recover?

Australia’s economy fell by -7% in the June quarter, or -6.3% over the year to June which is the biggest annual fall since the Great Depression. However, the June quarter fall was less than seen in most other comparable countries (eg, the US fell -9.1%, Japan -7.8%, Europe -12.1% and the UK -20.4%) thanks to better virus control, better policy stimulus & exposure to China. Most of Australia is already slowly recovering, but Victoria has been hard hit by its second virus wave which will likely delay a national recovery out to the December quarter.

 

Source: AMP Capital 03 September 2020

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

Seven reasons why the trend in shares will likely remain up, albeit with bumps along the way

Date: Aug 25th, 2020

Share markets have had a spectacular rebound from their March lows. The rebound has been led by the US share market which is up 52% and has just risen above its February record high, making it the fastest recovery after a 30% or more fall on record. Other share markets have lagged but are still well up from their lows. This includes the Australian share market which recently rose to its highest level since early March.


Source: Bloomberg, AMP Capital

A common concern remains that the rebound is irrational. How can shares be so strong when June quarter GDP collapsed – by an average of -10% in developed countries and an estimated -7% in Australia – and coronavirus continues to reap havoc?

But as the investor Sir John Templeton once said: “bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria” and we have certainly seen the run up since March occur against the backdrop of a lot of pessimism. The plunge in shares into March led the coronavirus hit on the way down and surprised many at the severity of the fall and now it’s led on the way up despite lots of worries. It’s also worth noting that shares have spent much of the period since early June rangebound (and apart from the US share market, many still are) and this has helped correct the excessive speed of the run up into June that left shares technically overbought & due for a consolidation or correction.

More fundamentally though, the positives for shares continue to outweigh the negatives. Let’s start with the negatives.

The negatives

Several negatives continue to hang over shares and are often cited as the main reason to expect sharp falls ahead.

  • First, coronavirus has yet to come under control globally, particularly in emerging countries, and most developed countries have seen second waves. This poses the threat of a return to debilitating lockdowns and people behaving more cautiously. So far it’s seen the global reopening stall. In Victoria it’s been reversed, which will likely delay the recovery in Australian GDP into the December quarter.

  • Second, this is occurring at a time of a massive hit to economic activity and profits, and very high underlying unemployment. The US June quarter earnings reporting season saw earnings fall 32% year on year and 2019-20 earnings in Australia are expected to have fallen 22%, resulting in the worst slump since the 1990s recession, with 67% of companies to have reported June half earnings so far seeing a decline in earnings and 56% cutting dividends.


Source: AMP Capital

  • Third, the recovery going forward may be slow as some things will take longer to recover (eg, travel), some things may never fully come back (eg, a big shift to on-line shopping, working from home, education & health care) and businesses will use the uncertainty to accelerate cost savings. All of which will mean a long tail of unemployment and economic activity below its pre-coronavirus path. 

  • Fourth, we are now in a seasonally weak time of the year for shares, with August and September being the weakest months of the year on average for US shares. And consistent with this, the recent rise in the US share market to new highs has come on narrow participation amongst stocks suggesting the risk of another short-term correction.

  • Fifth, the run up to the US election has the potential to drive increased share market volatility if it looks likely that Biden will win and raise taxes, and if Trump decides he has nothing to lose and ramps up tensions with China & Europe. 

  • Finally, shares are expensive on traditional metrics like PEs and more esoteric measures like the ratio of share market capitalisation to GDP and the market value of companies relative to the book value of their assets.

The positives

However, there are a bunch of positives providing an offset.

  • First, the second wave of new coronavirus cases in developed countries has been far less deadly than the first. This likely reflects more young people being infected, better testing, better protections for older people and better treatments. This in turn has seen most countries avoid a return to a full lockdown and limited the hit to confidence.


Source: ourworldindata.org; AMP Capital

  • A decline in new cases in the US has enabled the recovery there in high-frequency economic indicators like credit card spending and mobility to resume after a pause in July.

  • Second, there has been good progress in terms of vaccines and treatments. Several vaccines have seen promising results and are in Phase 3 trials to see if they provide protection. Note though that mass deployment is unlikely till next year & they may not provide complete protection (more like a flu vaccine than a measles vaccine) and may have to be combined with treatments (of which there has also been positive developments with Remdesivir and a steroid). 

  • Third, easy monetary and fiscal policy is continuing to support economies, incomes and jobs in contrast to the situation when the first wave started in developed countries in late February. This is different to normal recessions where it takes longer for policy makers to swing into action. 

  • Fourth, the fall in the “safe haven” US dollar and rising commodity prices (with metal prices back to their pre-coronavirus levels) is a sign of global reflation and recovery.

  • Fifth, a range of economic indicators have seen a Deep V rebound starting in China and then in developed countries, suggesting significant pent up demand and that people still want to spend. This is most evident in business conditions PMIs. While developed country PMIs were mixed in August (with Australia and Europe down, Japan flat and the US and UK up) they remain consistent with recovery and have enabled share markets to look through the June quarter slump in earnings (which itself has been less bad than feared). On balance we see a gradual economic recovery from here as some things take longer to return to normal.


Source: Bloomberg, AMP Capital

  • Sixth, the plunge in interest rates and bond yields have increased the present value of shares, which explains why PE ratios are so high. So shares remain attractive despite lower earnings and dividends because the alternatives like bank deposit rates are even less attractive.


Source: RBA; Bloomberg, AMP Capital

  • Finally, investors are still cautious which is positive from a contrarian perspective. Despite day traders piling into some stocks retail investor sentiment is soft & there has continued to be fund flows out of equities in the US into bonds.

Concluding comment

On balance the positives dominate in our view. Shares remain vulnerable to short-term setbacks given uncertainties around coronavirus, the speed of economic recovery, the US election and US/China tensions. But the positives should keep any pull back to being a correction and on a 6 to 12-month view shares are expected to see reasonable returns.

But will the US share market continue to outperform?

As evident in the first table, US shares have outperformed since the March low. They have also outperformed year to date with US shares up 5.2%, but Eurozone shares down 13%, Japanese shares down 3.1% & Australian shares down 8.5%. The strong outperformance by the US share market reflects its relatively low exposure to cyclical sectors (like manufacturing, materials & financials) that were hit hard by coronavirus and a greater exposure to growth sectors like IT and health that benefit from coronavirus and very low interest rates. As the global economy gradually recovers and interest rates bottom, this will benefit cyclical sectors relative to IT and health which have become expensive and this will likely see US shares underperform relative to non-US shares, including Australian shares.

In terms of the US election, a Trump victory would likely benefit US shares (tax hikes averted) but a Biden victory would benefit non-US shares (more harmonious foreign and trade relations).

 

Source: AMP Capital 25 August 2020

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

Three reasons why the Coronavirus crisis might fix Australia’s housing affordability crisis

Date: Aug 12th, 2020

For years Australia has suffered from poor housing affordability. According to the 2020 Demographia Housing Affordability Survey the multiple of median house prices to median annual incomes is 5.9 times in Australia compared to 3.9 times in Canada, 4.5 times in the UK & 3.6 times in the US. Consistent with this the ratio of house prices to incomes relative to its long-term average is at the high end of OECD countries.  


Source: OECD, AMP Capital

It wasn’t always so – Australia was once seen as a country with relatively cheap and affordable housing. Having a house on a quarter acre block was an essential part of the “Aussie dream”. But that changed last decade as average house prices went higher and higher relative to average incomes and this went hand in hand with a surge in household debt relative to income. See the next chart. There have been several cyclical downswings in property prices that have brought short term relief in terms of affordability – around the GFC when average capital city dwelling prices fell 7.6% based on CoreLogic data, around 2011 when prices fell 6.2% and in 2017-19 when prices dipped 10.2% – but they have been short lived with prices quickly bouncing back.


Source: OECD, AMP Capital

The coronavirus shock may have a more lasting impact. It has brought lots of pain and suffering on a human level but also on an economic level. And it has caused much disruption to the property market in the short term with more likely to come. But it may have a lasting positive legacy in relation to property – that is more affordable housing in Australia.

Why is Australian housing so expensive?

To understand why this may be the case its necessary to consider what has caused poor housing affordability in Australia in the first place. It’s been popular to blame tax concessions, foreign buying, government related housing infrastructure charges and stamp duty and low interest rates and easy credit. But none of these really explain it.

Lots of other countries have a variety of housing tax concessions too, but with much cheaper housing. Foreign buying is a relatively small part of the overall market and has declined in recent years. Infrastructure associated with housing is hardly unique to Australia. Stamp duty adds to the cost of transactions and is a silly tax, but if anything may have kept prices lower than they otherwise would be (when supply is constrained). The shift from high interest rates to low interest rates enabling bigger loans has enabled ever more expensive housing – but other countries have also seen ultra-low interest rates in recent decades and yet have much cheaper housing.

Rather the basic problem has been a surge in population growth from mid-last decade and an inadequate supply response (thanks partly to tight development controls and lagging infrastructure). Since 2006, annual population growth averaged about 150,000 people above what it was over the decade to the mid-2000s. This required the supply of an extra 50,000 new homes per year. See the next chart. Unfortunately, this was slow in coming. But with an insufficient supply response to surging demand, prices were able to stay elevated. And so poor housing affordability got locked in.


Source: ABS, AMP Capital

Each cyclical downturn in house prices has brought hope of a solution, but it was invariably dashed as the fundamental supply demand imbalance remained or re-established itself. The same looked to be applying more recently with average house prices surging 10% between June last year.

The longer-term impact of coronavirus

The coronavirus shock has the potential to change this dynamic of cyclical fluctuations around ongoing poor affordability. It has already triggered a renewed downturn in property prices with capital city prices down 2% on average since April, with Melbourne prices down around 4%. JobKeeper and the bank payment holiday are preventing faster falls at present. But further declines in national prices are likely, as high unemployment, the depressed rental market and the collapse in immigration impact. We now see average capital city prices falling 10-15% from their April high out to mid-next year with Melbourne most at risk and likely to see a 15-20% decline.

Past experience would suggest that this may be just another cyclical downturn and once coronavirus comes under control and the economy rebounds it will be back to normal with poor affordability. Particularly with record low interest rates making it feasible to borrow up big. However, the coronavirus shock has the potential to change this for three reasons.

  • First, the hit to economy from coronavirus is bigger than anything seen in the post war period. While most of the activity hit by lockdowns should bounce back once the virus is brought under control some things will take longer to recover (eg, travel & tourism), some will be permanently changed for ever (with eg, a big shift to on-line shopping, education, health care & watching sports) and businesses will use the uncertainty to accelerate cost savings. All of which will mean a long tail of unemployment. JobKeeper has shielded Australia from what otherwise would have been 15% unemployment in April and 11% unemployment now. But officially measured unemployment is still likely to hit 10% by year end and will probably have only fallen to around 9% by end 2021. This will likely result in more forced property sales and act as a drag on home prices, as income support measures & the bank payment holiday wind down.

  • Second, immigration has been a big driver of property prices and it’s taken a huge hit and may take a long while to recover. Thanks to travel bans, net immigration is likely to have fallen to just below 170,000 in 2019-20 and to around 35,000 this financial year from 240,000 last financial year. This is a huge hit which will take population growth in 2020-21 to just 0.7%, its lowest since 1917. See next chart.This will reduce annual underlying demand for homes to around 120,000 dwellings, compared to underlying demand last year of around 200,000. This could result in a significant oversupply of dwellings, and in turn could reverse the years of undersupply that has maintained very high house prices since mid-last decade. (See the population versus dwelling completions chart above.) A big cut to immigration is not something many other countries have to deal with, so their experience is not directly translatable to Australia. Of course, if this is just for a year, it wouldn’t have much lasting impact. And the return of expat Australians may provide a short-term offset. But with unemployment likely to remain high for some time, it will be hard politically for the Government to quickly ramp up immigration to previous levels, even once it is safe to do so from a coronavirus perspective. After the early 1990s recession net immigration stayed low at around 90,000 pa until the mid-2000s. All of which points to a long period of constrained housing demand and hence more constrained house prices.


Source: ABS, AMP Capital

  • Finally, a mass shift to working from home potentially has huge implications for residential property prices. Prior to coronavirus, working from home was only slowly creeping in. Now coronavirus driven lockdowns and social distancing has shown that its feasible for most white-collar workers and can be good for productivity. Of course, full time working from home does come with costs in terms of team cohesion, corporate culture, the development of younger workers and less opportunities for spontaneously exchanging ideas. So, some sort of hybrid may become the norm – some at home all the time, some in the office all the time, but most doing half and half. And working from home works best in houses where there’s lots of room as opposed to apartments. All of which could revolutionise residential property demand – and from what I am hearing anecdotally maybe already is. Which will mean less demand for property close to the CBD, greater demand for property in suburbs, with a decent community and environment and increased property demand in regional centres. All of which could break down the dominance of the city with its expensive property. This would turn the trend of recent decades favouring more condensed living close to the city on its head. Some office property (and possibly also some retail property impacted by the shift to online retailing) could be repurposed for residential use, thereby boosting housing supply. By fostering decentralisation, a shift away from cities to regional communities could dramatically improve housing affordability over time.

Concluding comment

We are still fighting the war against coronavirus but it’s likely, as we have seen with various shocks in the past, we will get over it, and go back to something more normal. But not everything will go back to normal. A lasting impact could be more affordable housing in Australia. It’s not our base case that this will come in the form of a property crash (and that would be a bad outcome for the economy anyway via negative wealth effects) but it could come in the form of much softer property price gains over time (after the initial hit into next year).

 

Source: AMP Capital 12 August 2020

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

RBA holds – but more stimulus likely as Victorian lockdown to knock at least $12bn from national GDP

Date: Aug 05th, 2020

RBA on hold again

As widely expected, the RBA left interest rates on hold again for the fifth month in a row. It still sees its massive March monetary easing package as working as it expected and signalled more bond buying to keep 3-year bond yields at its 0.25% target but this is just a continuation of its Yield Curve Control program as opposed to new easing. It also noted that the coronavirus outbreak in Victoria is adding to the uncertain economic outlook and looks to have downgraded its 2021 growth outlook to 5% growth (from 6%) after an unchanged expectation for a 6% contraction through this year) and now sees the unemployment rate rising to 10% later this year. It reiterated that it remains committed to do “what it can to support jobs, incomes and businesses.” However, while it left monetary policy on hold, with Melbourne now in a stage 4 lockdown, pressure for further stimulus – particularly from the Government but also the RBA is building.

Victorian lockdown to cost at least $12bn

After a stage 3 lockdown of Melbourne for three and a half weeks failed to sufficiently slow new cases, Melbourne has now been placed into a far stricter stage 4 lockdown with the rest of Victoria moving into a stage 3 lockdown, both for six weeks.


Source: Covid19data.com.au, AMP Capital

Based on New Zealand’s experience with a stage 4 lockdown and allowing for the fact that Victoria had never fully recovered from the initial lockdown, we estimate that this will cost the Victorian economy around $12bn to $14bn. This is up from an initial estimate of the cost of the stage 3 lockdown of Melbourne of $5bn.

Prior to the stage 3 lockdown of Melbourne we had been assuming that national GDP would rise 2.5% this quarter after something like a -7 to -8% hit in the June quarter. The rebound in indicators like retail sales following the reopening in May was directionally consistent with this.

However, a $12bn hit from Victoria would take this back to around flat and negative impacts on confidence could see the economy even decline slightly again in the September quarter. This is consistent with our Australian Economic Activity Tracker of weekly economic indicators like credit card data and job ads flatlining since June after a decent pick up from mid-April.


Source: AMP Capital

Note though, that this would all mask a large contraction in the Victorian economy (25% of national GDP) but growth in the rest of Australia, assuming of course that confidence impacts on the rest of Australia are kept to a minimum and that the virus is contained outside of Victoria.

The net result though could be a further delay in the start of Australia’s overall economic recovery as measured by GDP into the December quarter – assuming that coronavirus is brought under control in Victoria again and that it can safely reopen.

Pressure for more fiscal stimulus…

At time of the Federal Government’s Economic and Fiscal Update we felt that the deficit projection of $184.5bn for this financial year was too optimistic and saw it closer to $220bn reflecting softer revenue and more stimulus than the Government was allowing for. The tightening lockdown in Victoria has added to this and we now see the deficit this financial year as ultimately being closer to $235bn. Our revised budget projections are shown below. Of course, these should be treated with greater than normal caution given the uncertain economic outlook.


Source: Australian Treasury, AMP Capital

We are assuming that the slower economy depresses tax revenue by a further $25bn this financial year compared to the Government’s projections (see the line labelled parameter changes) and that an extra $25bn in stimulus occurs. The Federal Government has already announced paid pandemic leave of $1500 for two weeks for Victorians without sick leave but it’s likely that both JobKeeper and JobSeeker will now end up costing more than projected two weeks ago, as hundreds of thousands of Victorian jobs could be impacted by the stage 4 lockdown. Additional stimulus is also likely to come in more industry support packages, a bring forward of the 2022 tax cuts and investment incentives.

While the deficit and debt blowout to the highest levels since WW2 will alarm some, we remain of the view that without it the economic outlook will be much worse and that its made viable by ultra-low interest rates, Australia’s low starting point deficit and debt levels compared to other advanced countries and Australia’s lack of reliance on foreign capital.


Source: RBA, Australian Treasury, AMP Capital

…and likely more monetary easing

However, while the bulk of the pressure for further economic support stimulus will fall on fiscal policy, the RBA is also likely to end up doing more too. In terms what the RBA might do if it does ease further in the months ahead – it has all but ruled out negative interest rates, foreign exchange intervention and the direct monetary financing of government spending. But it sees still lower but positive interest rates and the purchase of more government bonds beyond what’s necessary to achieve the 3- year bond yield target of 0.25% as possible options. A rate cut to 0.1% would hardly be worth the effort (but they may still do it) which leaves more quantitative easing as the main tool for further easing. The latter could take the form of bond purchases beyond 3-year bonds and a possible target for the value of bond purchases. Meanwhile, rate hikes are at least three years away.

Concluding comment

All of this begs the question: why are shares holding up so well? The answer is simple – while the second wave of coronavirus cases has increased the uncertainty around the economic outlook, its being offset by more positive signs of containment (fingers crossed) and hence recovery outside Victoria, ongoing positive signs regarding coronavirus treatments and an eventual vaccine globally, policy stimulus supporting the economy and ultra-easy monetary policy making shares look relatively cheap. So, we remain of the view that while shares are vulnerable to corrections, they are likely to rise on a 6 to 12-month horizon.

 

Source: AMP Capital 5 August 2020

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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