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Macro Overview - June 2020 BY ANDREW CLIFFORD 15 JUL...

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    Macro Overview - June 2020 BY ANDREW CLIFFORD 15 JUL 2020

    Stimulus Fuels Breakdown Between Markets and Economic Reality

    The global economy has only just commenced its recovery from the depths of the largest economic setback in modern history, yet stock markets have bounced strongly from their mid-March lows to be just 5%-15%below their pre-COVID-19 levels. This extraordinary recovery in stock markets stands in stark contrast to other periods of economic weakness, such as the global financial crisis (GFC), where even five years later, markets had not recovered to their previous highs.

    The market’s response can most likely be attributed to the enormous monetary and fiscal measures taken by governments and central banks around the world. This leads to the obvious question, what happens next?

    While we can identify attractive opportunities in individual stocks as a result of the market collapse, for the moment, significant uncertainty around future economic activity, together with high stock market valuations, are good arguments for investors to retain a cautious stance.

    As lockdowns are lifted, economies will experience a strong ‘re-opening bounce’, but a full recovery is likely to be at least three to five years away. As we noted in our March 2020 quarterly report, the economy is “real” and labour is a key “factor of production”. If people are restricted from going to work, then activity will fall. As such, we concluded, “economic activity will stop falling and start to recover when people can return to work”.

    It is not surprising that we are seeing signs of a strong initial recovery. The question is, how close does this initial recovery get us to where we were before? Again,as we noted last quarter, after the GFC, which was a mild downturn by comparison, the US took three years to return to prior peaks in activity, Japan took five years and Europe took seven years.

    We expect the recovery to take some time to play out again for the following reasons:

    ·Firstly, small- and medium-sized enterprises, by and large, tend to live on the edge of viability at the best of times. Many that have had to close their doors will struggle to return, especially if they have significant fixed costs, such as rent, that still need to be covered. To date, government programs in many countries (such as theJobKeeper Payment Scheme in Australia) have aimed to keep these businesses afloat and their employees paid. It is likely that, as the reopening proceeds,many of these businesses will fail, and while their employees are ready and able to return to work, they will not have jobs to return to.

    ·There are also some industries where the recovery will be slower, as government restrictions on the movement of people persist, or potentially changes in behaviour triggered by the lockdown, result in reduced demand for some services.

    ·Finally, the recent acceleration in COVID-19 cases in parts of the US and elsewhere, raises concerns about the impact of a second wave of infections. Whether this results in a return to lockdowns or not, it is likely to suppress consumer and business confidence. Further, the spread of the virus remains uncontained in much of thedeveloping world, with significant expansion of cases in the important economiesof India and Brazil.

    Once the initialre-opening bounce has occurred, it is likely that unemployment levels willremain significantly elevated relative to the pre-COVID period. Market forceswill see excess labour eventually absorbed by an ongoing recovery and new jobswill be created, but it will simply take time. While the development of avaccine will accelerate the recovery, allowing certain industries to returnmore quickly, it is still likely that a return to prior peaks in economicactivity will be measured in years.

    It is almostcertain that governments will continue to implement additional monetary andfiscal measures to support an economic recovery, but there are limits on whatcan be achieved.

    On face value, thefinancial alchemy of quantitative easing has been an apparent success. Over thelast decade, central banks, hand-in-hand with their governments, have been ableto resolve problems in their financial system, see their economies recover andmaintain low interest rate regimes, without even the slightest appearance ofthis money creation being inflationary (unless you have an eye on assetprices).

    This same financialalchemy has been front and centre in the funding of government spending inresponse to the current crisis. So far so good, with respect to placingspending power into the hands of many of those in need and the maintenance oflow interest rates, again with no obvious signs of inflation (other than inasset prices).

    Undoubtedly,governments will continue to push on with central banks funding their spendingif economies do not recover quickly. Presumably though, there are limits onthis approach. When considering the rapid increase in government debt aroundthe world in recent months, it certainly gives rise to a question of sustainability.Fig. 1 illustrates the extraordinary increase in US federal government debt asa percentage of GDP. The US Central Budget Office (CBO) is forecasting thelevel of indebtedness to rise to near World War 2 levels by 2021.

    Assuming thatlimits do exist on this financial engineering, we need to understand at whatpoint these limits will be reached and what will be the implications ofexceeding them? These questions are not easily answered, but certainly,possibilities include a rise in goods and services inflation or conversely, theglobal economy enters a period of Japanese-style deflation, as governmentscrowd out the private sector.

    The creation of newmoney that has arisen from recent monetary and fiscal policies is highly likelyto have been a major contributor to the unprecedented rebound in stock pricesfrom the March lows.

    Well knowneconomist, Milton Friedman observed that, “Inflation is always and everywhere amonetary phenomenon in the sense that it is and can be produced only by a morerapid increase in the quantity of money than in output”.

    Today, in the US,M2 (one measure of the amount of money in the financial system) is rising by arecord annual rate of 25%3 (see Fig. 2), while economic outputhas collapsed. Of course, we haven’t been able to observe inflation in thetraditional CPI that focuses on goods and services, as most are in excesssupply in this downturn. Where we have been able to clearly observe inflationthough, is in asset prices, particularly in bond markets (higher bond pricesare the other side of falling interest rates) and parts of the stock market.

    As this new moneyhas washed around the system, it has found its way to the shares of companiesthat are perceived to be immune, or that have even benefited from the economiccollapse. Many of these companies have stock prices near, even well above,their pre-COVID stock prices.

    In some cases,companies have benefited from the lockdowns, notably, e-commerce players thathave seen an increase in the use of online shopping and other services (asdiscussed by our portfolio manager, James Halse, in the feature article of our June 2020 Quarterly Report, Will thePandemic Change our Spending Habits Long Term?). Undoubtedly, the enthusiasm of investors for many of these companies is justified, in the sense that they have strong positions in their markets and look set to grow for many years to come.

    However, when thisassessment of their prospects is then amplified by excessive money creation bycentral banks, the outcome is that stock prices have moved well beyondwhat can be justified, given even the brightest assessment of their futures.

    If our analysis ofthe situation is correct, the risk for investors who own these popular namesare two-fold. For any given company, a significant risk is they fail to deliveron their shareholders’ high hopes, a very real possibility given the longtimeframes over which they need to deliver high levels of growth. The otherrisk though, is that the money creation process that has driven these risingstock prices slows, or even possibly stops, or that the money migrateselsewhere.

    On the first point,as stated earlier, it seems likely that governments will want to continuespending to encourage a recovery and this should ensure the ongoing creation ofnew money, however, the current rate of growth may be hard to match. Thisassumes that potential limits on the levels of government debt discussedearlier do not occur at some point. As for the money migrating elsewhere, thisis difficult to predict, but one possibility is that it flows into the realeconomy, as output steadily recovers over the coming years. None of this reallyhelps with identifying the timing of any of these events, but to stay investedin these types of stocks is like being involved in the investment equivalent ofa game of musical chairs.

    The rest of thestock market, outside of these popular sectors, is behaving much more like onemight expect in a major economic collapse. That is, theirstock prices have fallen significantly and although they have bounced fromtheir March lows, they remain well below pre-COVID levels.

    Many companies inthese out-of-favour sectors, when assessed against a likely three-year recoveryperiod, represent attractive investments. It is amongst these companies that wesee the real opportunities arising from the current crisis.

    Typically, thesecompanies either have greater sensitivity to economic growth, or in some caseshave been directly impacted (e.g. travel-related businesses) by the lockdowns.

    It is worth noting,that as the world recovered from the GFC, it was precisely these types ofcompanies that made the best investments over the following two to three years.What is unknown of course, is precisely when we will see these investmentsperform. Most likely, this will occur with some swings and roundabouts, in linewith the broad recovery in economic activity that we expect to come throughover the next three years or so. Potentially, as government spending movestoward longer-term projects, such as infrastructure or decarbonisation of theeconomy, this could well accelerate the recovery for many of these economicallysensitive sectors. These opportunities are further discussed in the Platinum International Fund June 2020 Quarterly Report.

    https://hotcopper.com.au/data/attachments/2309/2309168-af59a50c0118839479d16856d1f84eed.jpg
    www.platinum.com.au/Insights-Tools/The-Journal/Market-Update-13-July-2020
    Last edited by Jason.ctpics: 17/07/20
 
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