Trending violently sideways
Since writing our last investment update to you on 30 March, most investment market indices are roughly at the same point. If it weren’t for the extraordinarily large intraday moves, one might say not much has changed. This is illustrated on the ASX200 graph. Of course, this is not true. When we look around the world, change is everywhere, forced upon us, forcing us to adapt.
Since the volatile trading on Friday 13 March, markets around the world have resembled Luna Park’s great scenic railway – violently up and down, invoking fear and threatening to fall apart, before ending back where we started. This is classic bear market activity as short term market participants pinball between fear and then fear of missing out.
Last Wednesday we had our first monthly Investment Committee meeting via Zoom. It’s extraordinary that just about everyone in the world now knows about Zoom software – in January we’d guess 1 in 10 people had even heard of this Californian company. Similar things are happening to other video conferencing platforms. More impressive is how quickly people have mastered video conferencing. The meeting went remarkably well and we even recorded it – something we hadn’t done before.
One of the very positive things coming out of this horrible virus is how quickly people seem to be adapting their lives and behaviour. We won’t be the same after this and in some ways there will be silver linings.
April Investment Committee Meeting – Calm and Calculating
The implications of the coronavirus and subsequent government response dominate discussions at the moment. In our last note we said “everything depends on how easy governments make it for businesses to hibernate”.
Incidentally, “hibernate” has become the #1 catchword…taking over the mantle from “unprecedented”.
Our expert asset consultant Tim Farrelly has spent the previous weeks personifying the 4 C’s: cool, calm, clinical and calculating; Tim is very much a numbers man.
He makes sensible assumptions and then goes about crunching the numbers and lets the numbers tell the story. It takes a bit longer to do this than making snap judgements, but it’s worthwhile in the end.
Tim postulated two scenarios:
- the “V” scenario – a deep but short recession with a quick rebound; and
- the Pessimistic (or Doomsday) scenario – a long, protracted recession, permanent damage and a slow recovery
He articulated these scenarios in detail, but more importantly crunched the numbers around them.
Warning! The following gets a little technical. For those not interested in technical detail and numbers – go straight to the conclusion at the end. Those who are interested in the technical background to Tim’s forecasts should read on.
Scenario 1: The “V” scenario – A deep but short recession with relatively quick rebound.
Economic assumption: A full 12 months of profit is wiped out and dividends are cut by 50% for 2 years before returning to current levels. Economy recovers to previous levels after 12 months.
This scenario depends on the following:
- Government intervention policy works reasonably well. Business failures happen but are limited to only the few sectors that are most exposed. We accept in principle there is a need to share the pain (Government, banks, landlords, businesses and people) to allow us to lay low and resume when this is over. Mostly there is co-operation and generally we play pretty nicely with each other.
- Reasonable progress is made against the virus. While it’s unlikely that a vaccine is available in less than 12 months (and it’s true the medical crisis is not truly over until a vaccine or cure arrives) this may not be required for a V style economic recovery to happen. Instead, excellent containment could be sufficient:
Early availability of quick, accurate testing. If we could reliably identify those infected quickly it would make a significant difference to containment. In some instances, businesses and society could begin to resume if it was easy to accurately identify who is infected and who isn’t.
Social distancing is effective in slowing growth rates in the short-term.
Scenario 2: The “Doomsday” scenario – long, protracted downturn of 2 to 3 years plus and a slower recovery
Economic assumption: 3 years of profit is wiped out and takes the full 10 year projection period to recover to current levels. Dividends are only two thirds current levels for the whole period.
Tim feels this is unlikely but it’s incumbent on us to consider this. This is the scenario where the V scenario assumptions break down and a deeper longer recession ensues, followed by a slower recovery. This could happen if:
- Infections keep rising before eventually cures and vaccines arrive.
- Social distancing lifts too early and a second wave or relapse occurs.
- Government policy fails to avert larger scale businesses failures. Societal and economic patience is lost and it becomes a dog-eat-dog environment.
Tim believes the V scenario is still far more likely (or something not far off it) given the progress made to date.
Nevertheless, the Forecast & Assumptions table illustrates the10 year forecast return numbers from the status quo (i.e. Aust. equities has 11.9%p.a. 10 year return, assuming no change to earnings and dividends (which we know won’t happen)).
However, just below this is the subtraction allowing for an appropriate downwards revision under both the V shaped recession and Doomsday scenarios:
Under the V model: Australian equities would have a reduction in profits and dividends which takes 1-2% p.a. (say 1.5% p.a.) over 10 years. This leaves a return of 10.4% p.a. Meanwhile, term deposits (secure debt) provide 1.4% p.a. (1.9% -0.5%). Therefore, the risk premium (expected return over term deposits) is 9.0% p.a. under the V model.
Under the Doomsday model: Under the same method but using the Doomsday model assumptions, Australian equities return 6.9% p.a. while term deposits return 0.9% p.a. Risk premium is 6%. In fact, all risky asset classes are still well above term deposits under the Doomsday model.
The only other adjustment that requires explanation is the variance between the scenarios in relation to the performance of the property sector. This very different outcome under the 2 scenarios (8%) is due to large scale vacancies and significant dilution from equity raisings.
Why 10 year forecasts you ask? Without going into further detail, this forecasting period has academic and empirical reliability which shorter forecasting periods lack. With gains in reliability however, we lose the ability to time the shorter term moves (we don’t believe anyone can do this well) – but we do get a very good overall sense if something is cheap, fair value or overpriced.
Conclusion for equity markets
Welcome back to all those who don’t like numbers!
The 2 key conclusions from Tim were:
- The bond and equity markets appear to be pricing in the more pessimistic scenario already
- Under either scenario the equity risk premium remains above the average historical equity premium of 5% p.a.
In either scenario, it’s clear we should remain invested.
The short term is still unpredictable but what these numbers do say very clearly is that the chances of equity investors earning returns well in excess of Term Deposits over the ten years is very, very high – despite what might happen in the coming months.
In the absence of a short term crystal ball, the way we manage short term uncertainty is the famous “buckets”, and hopefully by now as clients of First Financial you don’t need us to tell you how they work.