Three key themes for volatile markets
The most recent Crestone Investment Forum was held on 26 February, yet much has transpired globally and in Australia since that time. Most pressingly, the coronavirus (a topic discussed at the opening of our forum), has spread rapidly outside China, with more new cases now occurring worldwide than at the peak of China’s outbreak. Globally, human activity has been sharply curtailed following outbreaks in South Korea, Italy and Iran, while fears are growing that US authorities are not well enough prepared.
On 11 March, the World Health Organisation declared the coronavirus a ‘pandemic’. In tandem with evidence of a rising near-term impact on global growth (even as China returns to work), this has led to a sharp move weaker in global equity prices and market interest rates have also fallen sharply. Policy makers globally have been moving quickly over recent weeks, with interest rates being cut in many countries, including the US, the UK and Australia. Fiscal policy has moved more stimulatory in Europe, the US and many parts of the emerging markets. Adding to concern, the recent breakdown in negotiations between Russia and OPEC has delivered a 30% fall in oil prices, raising concern of rising stress in global credit markets.
Diversified portfolios remain the best defence through periods of unexpected drawdown in risk assets, including appropriately weighted allocations to unlisted alternative investments and defensive fixed income assets. These are the periods investors are most tempted to try and ’time’ markets, which research reveals overwhelmingly to be an underperforming strategy in the long term.
The Crestone Investment Forum allows for the exchange of views with our key partners, providing our investment team and advisers with the opportunity to challenge our thinking. While the extent of recent developments was not wholly revealed in our discussions, the much more cautionary tone led us, on the day, to move portfolio positioning modestly more defensive.
We retain a constructive view on the outlook for Australia and the world economy, and expect a recovery through H2 2020 and 2021. But risks to the near-term outlook remain elevated. The impact of the accelerating curtailment of economic activity outside China is yet to be seen, with some risk the expected rebound in growth through H2 2020 may be slower than expected. For now, we remain neutral equities (while reducing exposure to international credit) and watch for key signals of a more supportive environment for risk, including a deceleration in the pandemic’s spread and renewed negotiations around oil.
Three key themes emerged from the forum
The coronavirus will have a significant impact in the short term—Key sectors, such as tourism, travel and consumer spending, will be impacted, and global supply chains impeded. China’s growth will slow sharply, impacting Australia. Credit markets were viewed as vulnerable given current tight spreads.
Maintain a focus on your investment horizon—There will be short-term volatility ahead, so look for opportunities where long-term earnings will remain intact. Policy support remains increasingly accommodative. Recent developments have not undermined the medium-term investment case for emerging markets.
Australia is well positioned but rates will still go lower—Growth is likely to be impacted in the short term and, with inflation low, it is likely monetary and fiscal policy will be eased further. Australia’s equity market was expensive and risks of a further drawdown remain.
HOW WILL THE CORONAVIRUS IMPACT MARKETS?
The impact of the spread of the coronavirus is dominating news. While the effect is likely to be felt on tourism and education sectors within Australia in the short term, it is important to not lose track of the long-term themes at play in markets. We asked the panel for its views on the impact of the virus, and the key things investors should look out for.
The impact on tourism and education will be significant
Stephen Halmarick, Managing Director, Head of Global Markets Research at CBA, believes the coronavirus is likely to compound the effect that the recent devastating bushfires has had on the tourism and education sectors within Australia. He acknowledged that, although Australian Q4 growth figures are not yet available, concern was already being raised about the impact of these events on early 2020 growth.
Halmarick expects a fairly large reduction in China’s growth for Q1 2020— potentially from 6% to 4.5% and expects it could be trimmed again to 3%. He sees calendar year growth being trimmed from 6.5% to 5.5%.
The speed of the virus' spread will be key to watch
According to Halmarick, the first order of effect is to assess the impact on individual countries from the perspective of tourism, education and activity. Subsequently, any negative impacts on supply chains will be key. He emphasised that, if the virus affects the supply chain, then this could quickly turn from being just a Q1 issue to a long-standing impact: “If the coronavirus affects the supply chain, then the effect could go on for many months.”
Over the longer term, earning should remain intact
Domenico Giuliano, Deputy Chief Investment Officer at Magellan Asset Management, highlighted the importance of considering your investment time horizon. Although there will clearly be some short-term volatility over the next few quarters, Magellan is not changing its view of the world, nor the stocks it has conviction in. While short-term earnings per share (EPS) may be impacted, longer-term EPS should remain intact.
How will the virus impact China?
Alex Duffy, Portfolio Manager at Fidelity International, provided input from an emerging markets perspective. In countries like China, where there is a high level of debt to GDP, Fidelity International focuses on the developed parts of the economy. However, with 80% of the population employed by small to medium enterprises (SMEs), if credit dries up, this is likely to have a widespread effect as most SMEs will not have enough cash to survive beyond three months. He sees tier 2 and tier 3 cities particularly at risk. Considering this, it will be important to monitor how effective authorities are at injecting liquidity into struggling balance sheets. From a medium-term perspective, monetary policy remains supportive, and Duffy expects there will be a fiscal response. The important question is whether this will lead to an inflationary push in the longer term, and how investors manage a portfolio with this in mind.
While it is unclear whether the Chinese authorities will adopt a broad-based response, or if SMEs will get preference, Duffy believes that the longer China pushes monetary policy then adds fiscal policy, its ability to control the balance of payments and maintain the Renminbi over the long term will be challenged. For now, however, he believes China’s policy response has been sufficient.
Amy Xie Patrick, Portfolio Manager at Pendal Group, echoed Duffy’s comments around China’s policy response. She added that things had been fairly stable in China prior to the emergence of the coronavirus. Its presence now changes the game. However, she feels that the worse the situation gets, the more of a concerted effort we are likely to see from global central banks.
Xie Patrick explained that tourism, travel and consumption are likely to be impacted by the coronavirus. Even when supply chains recover to normal levels, some sectors, such as travel, may recover more slowly: “Just because travel restrictions are lifted, flight demand doesn’t just double overnight.”
Rob Osborn, Portfolio Manager at Lazard Asset Management, added that China is key to production, producing 30% of the world’s manufactured goods. The issue for him is that if equity prices become cheaper, money/debt will also become cheaper. But if we see inflation pick up, then there could be a V-shaped recovery: “The coronavirus is clearly very contagious, and the issue is how long it will last.”
Duffy explained that through his conversations with Taiwanese suppliers, they had expressed it would take some time to get back to normal. The many checks and controls imposed on factory workers make it extremely difficult for them to travel to and from work. While some businesses had seen a high profit margin build-up, the risk now is that there would be a reset.
But what does this mean for markets?
Steve Goldman, Managing Director and Portfolio Manager at Kapstream Capital, emphasised the need to separate between what economists think and what financial markets are doing. In the past 18 months when equity markets were rallying, fixed income had been used as a hedge—but with the outbreak of the coronavirus, buying duration is now getting harder as lower rates mean hedging has become more expensive.
He explained that, since the outbreak of the coronavirus, there had been a rally in all risk-off assets, with rates falling, and it was unlikely the market would see a V-shaped recovery in rates. He does not believe investors will stop trying to hedge their risk-on assets, so interest rates, credit default protection and other risk-off trades, such as long Japanese yen, Swiss francs and gold, will get more and more crowded. The question is how much lower rates will go if markets remain volatile: “All risk-off assets will continue to set new records.”
Duffy stressed that, with the short-term effects of the coronavirus unknown, equity managers are essentially managing balance sheet risk in the immediate term. In this environment, it is sensible to keep diversification levels relatively robust while keeping one eye on the long-term fiscal and monetary support as structural themes. Whether markets sell off enough to give you a favourable valuation input is a separate question.
Xie Patrick gave her fixed income perspective, stating that the worse the situation gets, the sharper the snapback is likely to be, and this would be driven by policy response. She expects this to continue to be built into fixed income and equity pricing.
Goldman feels there would not be a meaningful US fiscal response, as he feels there is no fiscal discipline in the US to change anything substantially—and it would be extremely difficult to get any political agreement. However, markets are pricing in two to three rate cuts over the course of the year, which he feels is realistic.
Are Emerging Markets still the place to be?
Scott Haslem, Chief Investment Officer at Crestone Wealth Management, asked the panel whether the coronavirus now changes the long-term structural view on emerging markets, and whether this is likely to have an impact on President Xi’s leadership and his goals for China.
Halmarick felt these issues are likely to be a short-term challenge as demographics (particularly the rise of the middle class and rising incomes) remain supportive for emerging markets. There is likely to be a continued strong policy response from China—but if the situation persists, we might begin to see President Xi come under political pressure.
Xie Patrick said that, whilst the obvious drivers of emerging markets are still there, large debt burdens will be a headwind to long-term structural growth trends. Yet, Halmarick felt the chance of rates going up aggressively is very low given the country’s high debt burdens.
For Duffy, growing capex is a challenge, as China dominates in this area, which creates problems for the rest of Asia. He feels that we will continue to see a distorted cost of capital with capital goods being dumped by North Asia. Goldman felt domestic-led demand is never going to be strong enough to sustain the growth story, which means that Asia will always need to rely on its exports. As a result, currency wars are likely to persist for much longer.
Giuliano added that, at Magellan Asset Management, they have been ignoring the noise, and looking for companies that can deliver GDP-plus growth. He feels that the supply chains out of China are incredibly difficult to replicate.
TRADE DEALS, ELECTIONS AND BREXIT—WHAT’S IN STORE?
Geo-political tensions calmed as 2019 drew to a close. The US and China established a phase-one trade deal and the UK secured Brexit. How will these developments impact the outlook for 2020? How could November’s presidential election impact the outlook for the US economy and global financial markets?
What happens to the Trade Deal now?
Goldman felt that the US-China trade deal is not meaningful and will likely morph into something else. He explained that President Trump has always focused on economic growth and the stock market as a measure of his success and that will continue to be the case. Resolving intellectual property theft issues have never been realistic and China will never comply on that front.
Halmarick added that the situation between the US and China could escalate given US elections have a right-wing and potential left-wing bias, which means there would likely be even more pressure on China given bipartisan support across the US political spectrum to re-shape the US-China relationship.
Who will win the presidential election?
Halmarick explained that traditional measures of economic performance are likely to play a big role in determining the winner in the US presidential elections, while Goldman felt that Sanders is unlikely to even win the nomination for the Democratic Party.
Giuliano said Magellan Asset Management is taking a cautious approach to the US elections. It has taken some risk off the table in case a Sanders or Warren victory comes to fruition as this could pose a regulatory risk on some stocks.
How are Central Banks likely to measure themselves going forward?
Haslem explored the issue of how central banks measure themselves against their inflation targets. “Given central banks have under-achieved their inflation targets for many years, this is likely to keep rates low for a very long time”. While risks have risen near term, this is “a very supportive backdrop for risk assets over the medium term”.
Halmarick explained that the US Federal Reserve (Fed) is undertaking a review on how it measures itself. Going forward, it may no longer only be in relation to inflation, especially since it is no longer near its targets. Halmarick felt that central banks around the world need to understand what has kept inflation so low for so long, and explained that, as a base case, CBA is expecting two rate cuts this year in the US and Australia. He felt the risk of inflation breaking out is extremely low and that monetary policy is likely to get easier and easier.
What's the outlook for the UK Economy and market?
Duffy explained that, over the past number of years, Brexit has caused so much chaos from a confidence and sentiment perspective—but now that Prime Minister Johnson’s government has a bit more impetus around it, this creates more certainty for companies to plan on a forward-looking basis. However, trade negotiations with the European Union are likely to be challenging and have the potential to drag on. Nevertheless, Duffy feels that UK equities are compelling from an asset price perspective.
We will be discussing how Australia is positioned and its near-term growth prospects in our next wire. Click 'FOLLOW' below to be notified as soon as we publish.
Learn what Crestone can do for your portfolio
With access to an unrivalled network of strategic partners and specialist investment managers, Crestone Wealth Management offer one of the most comprehensive and global product and service offerings in Australian wealth management. Click 'contact' below to find out more.
5 contributors mentioned