A bearish outlook for the Australian economy
Lacklustre GDP and corporate earnings growth need not mean weak equity market performance. The reverse can be true too of course. Last year was a case in point and the very reason it was such a difficult year to embrace equities. We took an overweight view on equity markets back then but there were a lot of reasons arguing against that position at the time.
Again now we should resist the temptation to translate a bearish economic view into a bearish view for equity markets and other risk asset classes. There are additional factors that need to be taken into account.
With this in mind we share our bearish outlook for the Australian economy.
Economic activity was weak before the Covid-19 crisis hit in January. Even last year businesses were, in our assessment, hoarding labour. That is, many workers were underutilized. This happens when businesses decide to wait for a recovery in consumption rather than let go of their staff when they experience a lull in their revenues.
Instead of a recovery though, we have received a massive disinflationary demand shock.
Absent the swift and large monetary and fiscal response, the unemployment rate would be skyrocketing amid widespread business failures. The economy would have entered an L-shaped GDP growth trajectory. That is the counterfactual now but it helps frame the outlook. With that baseline in mind we can see that fiscal stimulus is not inflationary, it is anti-deflationary. Nor is the current fiscal package designed to lift long run potential GDP and productivity growth, an outcome which could lessen the Government’s future debt burden. It cannot possibly be designed in that way because of the nature of the health crisis it must tackle. It is nevertheless highly desirable and well-designed policy.
When the lockdown period is lifted we are unlikely to enter a sustained period in which consumer spending runs at full throttle.
We cannot hope to resume where we left off in January, which was a precarious economic position anyway. Many households will be more cautious about their longer term employment prospects or will anticipate an increase in taxes amid a much larger government debt load. That will keep spending even more subdued than it was prior to the coronavirus crisis. Businesses too will be more cautious as they reassess their resilience to crises. That will slow the pace of investment and hiring.
In short, the economic damage is severe enough to prevent the level of output that would have been reached without this crisis, from being achieved, even if GDP growth stages a V-shaped recovery later in the year. There may also be short term bottlenecks in some goods and services for a while, and the prices of these could rise as a result. Overall prices will still be under sustained downward pressure. That is because demand cannot hope to exceed supply. Supplements to income cannot fully make up for a real wage and a sustainable job. The policy response has been swift and immense but all it can do is buffer the slowdown, it cannot engineer a boom.
Households cannot make up for all those dining out dates they have missed. The unemployment rate is arguably the best measure of capacity in an economy and it will be in excess of what is needed to keep inflation stable. Disinflation lies ahead and very soon. The unemployment rate will likely continue rising even after the lockdown ends.
As a result of this, the good news and the bad news for investors is that bond yields, globally, will remain at historical low levels for a period of years rather than months. That is bad news when seeking risk free returns. But it is good news too; low bond yields will underpin most risk asset classes: equity markets, emerging market bonds and corporate bonds.
That sounds like more of the same. Last year equity markets had a great year, mostly thanks to multiple expansion (a rise in the ratio of prices relative to earnings). That in turn is completely thanks to low and falling yields on government bonds. Low bond yields have also encouraged companies to issue more debt, which has helped fund share buybacks in the US. Bonds and equities are locked in a tight embrace, but there are changes afoot. There are additional risk assets that merit review, now more than ever.
Global corporate bonds are relatively more attractive now than they have been for a very long time. Making historical comparisons is difficult when the size, composition and buyer base of the corporate bond universe has changed.
The regulatory framework governing the financial system is also different to what it was before 2008. The last of these means that liquidity in corporate bond markets can dry up in times of acute stress and so investors are likely to demand a higher liquidity premium going forward. In the near term there is more risk of defaults and downgrades ahead. More compensation needs to be demanded for that too. On the other hand central banks have stepped in to provide support to corporate bond markets.
One of the many things that makes this crisis unique is that there is little concern about moral hazard when it comes time for policy makers to help out financial and non-financial entities.
This is because this crisis has not resulted from over exuberance or lax lending. It is no one’s fault. Nevertheless support will come with strings attached. The upshot of this will be less payouts for shareholders. That is good news for bond holders. In short there are a lot of factors that need to be weighed in order to assess whether corporate bonds are fairly valued. There is still a lot of negative news that needs to reverberate across corporate bond markets but the reward for risk from investing in corporate bonds does look to be slowly improving relative to equities. This is likely to be a lasting dynamic.
Emerging market bonds have in recent crises held up well and actually delivered attractive risk adjusted returns. They have stacked up well relative to the usual safe haven assets at times when crises have originated in the advanced economies. Risks associated with emerging market sovereigns are still plentiful but the asset class is large and diversified in terms of sector, region and currencies. Aside from sovereign bonds there is also corporate and quasi sovereign bonds in the universe. Segments of emerging market bonds are providing attractive valuations at the moment. It is reasonable to expect that they will, in the years to come, be regarded as a mainstream asset class. As they make that journey there will be an attractive yield premium which investors can harvest.
The coronavirus crisis has hit us all very dramatically and very quickly, exposing our day to day lives to risks we may never have contemplated before. As a result many of us may adapt our habits permanently to reflect the realization that we are more vulnerable than we previously thought. We can protect our computers from cyber threats, we can follow the health advice to avoid becoming infected with new and more lethal viruses, and we can apply sunscreen to minimize the hazards associated with sun exposure. There is a tradeoff: a life with more experiences will require facing risks. If we are aware of them we can manage them and take the necessary precautions.
The same way of thinking can apply to our investments and savings. With yields so low in Australia, we must embrace more possibilities if we are to have a chance at a reasonable rate of return in the future. There is no risk- free lunch, and income generation will require more thought, and benefit from more possibilities going forward.
More possibilities also means more risks. We believe it is better to approach income generation via a diversified portfolio because this will deliver more ex ante stability in investment returns than the alternative.
Australian household savings have slowly become more exposed to global equities. Looking ahead, the coronavirus crisis will potentially shake up the fixed income portion of our savings too. It is not the right time to venture out of our homes too much, but it is a good time to relax the home bias in our portfolios, especially within the fixed income component.
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Jasmin has primary responsibility for the fixed income funds in the DPM team and is a member of the Australian Investment Committee, contributing to the strategic and tactical asset allocation process at Credit Suisse Australia Private Bank.