As we now know, March 2020 was an extraordinary month on stock markets.
Such was the uncertainty surrounding the viral global pandemic that at the close on 21 February the All Ordinaries index was sitting at 7,230… 30 days later we closed at 4,560 – a 37% drop.
Most markets around the world suffered a similar sell-off. Curiously, we are now also up over 30% from 23 March, but basic maths means this doesn’t get the market back to the starting point.
On 9 April, the day before Good Friday, we opined about whether the future held a “V” style recovery or Doomsday (Depression) scenario and what that meant for stock market returns. These forecasts are the best tool we have to get a sense of whether asset prices are cheap or expensive in the long term (10 years).
They are far from perfect and tell us little about short-term market forces, but they did suggest for the long-term investor the market may have been oversold in late March. Specifically, we concluded it was important to stay invested and, if anything, a time to be buying and certainly not selling.
Now as we sit near 6,000, following a significant 10-week rally from the 23 March lows, it would seem that, in the short term at least, the guidance was helpful.
So, is it too early to call COVID-19 a V style event?
The terminology “V recovery or event” is a gross oversimplification to describe what looks to be a short but deep recession. I’ll refrain from this terminology in future, because it is not particularly helpful.
Even the attached chart doesn’t really look like a V. In all likelihood, we are not yet out of the woods and we’ll likely see further volatility before this crisis is behind us.
We are in an unusual recession
It should be noted that while markets have bounced, economically we are certainly now technically in recession for the first time in 30 years as the March and June quarters will be negative GDP.
This isn’t a typical recession. A typical recession is preceded by a boom – inflation goes up, share markets reach lofty valuations and the central bank tries to control it with higher interest rates, then we have a bust.
The situation preceding this recession was almost the opposite – growth was low, interest rates were at record lows and share markets were fairly priced. This provides some confidence that when the medical emergency subsides, the economy should have reasonable conditions to bounce back from.
We haven’t had the classic build-up of excesses you’d normally see before a recession, and people have been restricted from spending because of lockdowns, not simply because of a lack of desire or confidence to spend.
This means there is pent up demand, which can find a home as restrictions continue to ease.
The antipodean response to controlling the virus has been the best in the world and we are now getting ready to open up our domestic economy gradually. We now have clarity on the first stages of the COVID-19 medical crisis, yet there still remains enormous uncertainty about the road back to normality.
Our key catalysts in terms of economic recovery are below; we have added a tick, cross or question mark on the progress verdict so far.
Factors for a quick recovery
- Availability of quick, accurate testing ?
- Government policy allows businesses to hibernate ✅
- Social distancing slows growth rates in the short term ✅
Drivers of a long, protracted downturn – 2 to 3 years plus
- Infections keep rising; until cures and vaccines arrive ❌
- Social distancing lifts too early – relapse ?
- Government policy runs out, businesses start to fail, it becomes a dog eat dog environment ?
I would argue we need three ticks at the top and three crosses at the bottom to be out of the COVID woods. Until the question marks are resolved there is still scope for volatility (both up and down) in markets.
The Question marks – re-opening, the end of government stimulus and the risk of a second wave
As with most countries, Australia introduced a government stimulus package to avert large scale business failures and financial hardship. This included initiatives such as Jobseeker and Jobkeeper as well as small business loan schemes, rent moratoriums and mortgage holidays. This has been particularly useful in the industries highly impacted by social distancing such as hospitality, sports and arts, and retail.
In a happy mistake, the government revised the number of people on Jobkeeper from 6 million down to 3.5 million, saving roughly $60 billion. Despite this, the government seems adamant that the programs will not be extended past the scheduled end date of September.
So, does this mean we are headed off an economic cliff in September?
In our view, this seems a little melodramatic, particularly at this early stage. The end of September is almost four months away and we’ve already seen last month a clear shift from the federal government from virus containment to reopening the economy. I suspect between now and the end of September, this impetus will continue and the federal and various state governments will do all they can to ensure more businesses can open their doors and therefore hire more people before the safety net is removed.
The Coalition’s image rests on effectively managing the economy and they have always maintained that the ‘best form of welfare is to have a job.’
There may be the occasional outbreak or hot spot, but those risks seem to be more manageable now that we know the virus is in low numbers, testing capacity has increased and tracing and quarantine have proven to be effective.
Long-term impact of COVID on corporate earnings
Our economist, Tim Farrelly, suggests the COVID-19 crisis will permanently lower earnings per share (EPS). Corporate costs will rise as companies rethink supply chains, more companies will fail than usual, and many will be forced to conduct dilutionary capital raisings.
Reasonable estimates of these factors reduce long-term EPS growth by around 0.9% per annum. Tim illustrates that this implies that a theoretical appropriate share market response to COVID-19 would be a 10% fall. Anything more has been an over-reaction.
We are not yet done with the volatility
While the news on the medical front is mostly good, it is still early days and there will be many more good and bad announcements to come. As we end the June quarter, the economic numbers will be awful, but bear in mind these are trailing indicators and were largely priced into shares many months ago. We expect volatile markets while the economy re-opens.
By our assessment, it does appear likely that the share market is now closer to fair value and that hindsight will reveal the larger share market gains were in April and May. There is still a significant forecast return premium over term deposits but future gains could be more of a grind from here.
In the unfortunate event of a second wave of infections and tighter restrictions and shutdowns, we will see further falls in markets. Even in this case however, our numbers suggest long-term investors will still be better off in growth assets even if the journey will be extremely uncomfortable.
The value of good advice, good valuation tools and appropriate communication may never be more important over the coming year.