04 June, 2020

Asset Allocation

The Consequences of the Virus

Government restrictions to control COVID-19 have hit the global economy like a sledgehammer. In many large developed economies, economic activity will fall substantially in the first half of 2020, resulting in declines of economic growth of between 4-5% for the 2020 calendar year, before recovering to a degree in 2021.

There is great uncertainty about the economic impacts, however. Impacts will depend on the progress of COVID-19, longevity and severity of government restrictions, resilience of businesses and workers to disruptions caused by restrictions, and the ultimate size and effectiveness of government and central bank support measures.

There is no doubt that governments and central banks around the world are doing all they can to reduce the economic impact of restrictions, with stimulus measures of unprecedented magnitudes. A likely consequence of the measures will be a continuation of near zero global interest rates for an extended period. There are short term and long-term reasons for this.

Central Bank Policy Interest Rates

Source: Refinitiv

First, many central banks have committed to keeping policy interest rates at ultra-low levels for at least the next 12 months. In addition, most major central banks will continue to engage in large scale buying of government and highly rated company debt securities. Indeed, it is possible that the Reserve Bank of New Zealand may begin to buy bonds direct from the government, as well as in the secondary market as it does now. Such measures will also suppress longer term interest rates.

Second, after the need for restrictions to control COVID-19 and economic support measures has largely passed, central banks and governments will still be keen to dampen interest rates to a certain extent to make it easier for governments and businesses to pay interest on the considerable extra debt built up in the current situation. This will likely entail continued buying of government debt securities by central banks and restrictions on bank lending and borrowing. This is often termed “financial repression”, which is an approach employed by countries such as the US and UK in the wake of World War II to help pay war debts.

In keeping interest rates low, central banks are likely to tolerate higher inflation than they have in the past. A little extra inflation can also aid the reduction in debt burdens as it reduces the size of the debt mountain relative to size of the economy, which grows in both real and nominal terms. This may become more of a factor as the economy heals and unemployment starts to come down again, thus helping to reignite inflation. However, there will be a difficult line for central banks to tread between supressing interest rates and allowing inflation to rise too far, which can cause long-term economic harm.

Global Equities

The recent equity market falls are justified considering the weaker economic outlook. However, we believe that the falls were exacerbated by a lack of liquidity (this has been corrected), forced sales by some investors (most of these will be complete) and emotion (fear on the way down and greed on the way up). Certainly, signs that we are getting on top of COVID-19 (fewer people becoming infected and fewer deaths) and restrictions being eased has enabled investors to become more confident that the scarier scenarios are less likely to occur. Should a second wave of infections eventuate, forecast earnings materially disappoint, or some other negative event occur a market correction (10% plus fall in equity prices) is likely. The occurrence of a correction would be in line with historical bear markets (20% plus fall in equity prices).

Experience suggests that equity markets valuation ratios rise and fall in line with changes in the level of volatility in the equity market, which is a proxy for the level of investor uncertainty. The changes in volatility go some way to quantifying the extreme swings in equity markets over the period from late-February to now. Price variability is still high, as shown in the chart below, and could swing in either direction from here.

Implied US Equity Market Volatility (VIX)

Source: Refinitiv

This reflects the highly uncertain outlook for the economy and company earnings, which is underscored by the large proportion of companies that have withdrawn earnings guidance. Similarly, stresses in credit markets are still apparent, even though these too have eased to a degree as central banks have pumped huge amounts of cash into financial systems. Therefore, in the short-term it is possible we continue to see relatively large ups and downs in equity markets. As mentioned earlier there are still many unanswered questions relating to COVID-19 and the global political environment remains as uncertain as ever.

Having rallied around 37% from the trough, global equities are down around 10% from their mid-February peak, although the variation between the best (US) and worst performing regions (Australia and emerging markets) is large at around 10%. The difference is explained mainly through market composition with a high proportion of the US equity market being technology companies whose valuation multiples and earnings have held up well. In contrast, the Australian equity market has a high proportion of banks and resource companies (including oil), which being cyclical businesses have experienced declines in earnings and valuation multiples.

In examining equity valuation ratios, such as the price -to earnings ratio, we use forecast earnings 12-24 months out, to look though the slump and subsequent rebound in earnings caused by the response to COVID-19. The chart below for the US equity market shows the forecast price-to earnings ratio fell initially, but is now back above where it was prior to the COVID-19 crisis, suggesting US equities have actually become more expensive.

US Equity Risk Premium and Price-to-earnings Ratio

Source: Bloomberg, Jarden

However, compared to government bond interest rates, which remain significantly lower than prior to the COVID-19 crisis, US equity valuations appear to be more attractive. The equity risk premium, or the extra premium investors currently demand for investing in US equities rather than US government bonds, has risen markedly (see the chart above). Over a longer horizon, therefore, there is potentially a higher reward from investing in equities relative to investing in safer government debt securities.

For New Zealand investors, one factor to consider when investing in global equities is movements in the New Zealand dollar. As we outline in the section on the New Zealand dollar later in this report, we expect our currency to rise (in particular against the US dollar) over the coming year as the US dollar generally weakens and as demand for New Zealand’s food exports supports the country’s terms of trade. If this comes to pass it will detract from the return from global equities expressed in New Zealand dollars.

New Zealand Equities

Many observers will point to the strong performance of the New Zealand equity market, being only 6% below where it ended 2019. However, without the contribution of its two largest companies, A2 Milk (ATM) and Fisher and Paykel Healthcare (FPH), which have risen 26% and 33% respectively, the New Zealand equity market would be down around 13% (similar to the US equity market). When we consider the New Zealand equity market, we ignore the undue influence of the large size of ATM and FPH.

With low benchmark interest rates expected for some time, investors are likely to be attracted to New Zealand equities as a source of investment income through the dividends and imputation credits paid.

New Zealand Forecast Dividend Yield Less the 10- Year Government Debt Interest Rate

Source: Bloomberg, Jarden

It is important that investors pay attention not only to level of the dividend yield, but also to the reliability of the dividend payment. Several companies have paid attractive dividends but are now not expected to pay any dividend for a time.

We have decided to reduce our underweight position to New Zealand equities and reduce our overweight to global equities. The closing of the large tactical bias to global equities reflects a switch away from metrics, which are skewed by a few large companies when analysing the New Zealand equity market. Having done so it is hard to justify such a large tactical bias to global equities. In addition, global equities returns are expected to suffer from a rising New Zealand dollar. From an economic point of view, while New Zealand has a small open economy and faces material challenges, government finances are starting from a position of strength, as are our key institutions. While acknowledging potential short-term risks in aggregate, we retain a broadly neutral stance between lower risk income assets and higher risk equity assets on a 12-18-month view.

The data in this article has been updated since it was originally published in the latest Jarden Investment Outlook. Read the May edition here.

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