Investment sector review - March quarter 2020
Colonial First State Investments and some of our alliance partners reflect on how the first three months of 2020 played out across the principal asset classes.
We’ve seen an extraordinary sell-off and extraordinary rebound in financial markets over recent times, but a recovery is never that simple – particularly since the unique characteristics of Coronavirus have impacted economies, businesses and financial markets in idiosyncratic ways unseen even during the Global Financial Crisis. While it seems markets have survived the initial waves of volatility, what could happen next? As we approach the half-year mark, the Colonial First State Investments team reflects on these developments, reveals where investment opportunities could exist, and shares insights into the possible path to recovery for financial markets in the future.
In their efforts to stabilise economies against the fallout of the pandemic, the main central banks became even more dominant in bond markets. Some central banks established bond-yield targets – for example, the Reserve Bank of Australia, which now targets the three-year bond yield at 25 basis points. Some central banks, most prominently the US Federal Reserve (the Fed), have also committed to almost open-ended asset purchase programs. This has created both distortions and opportunities in fixed interest markets. For example, the Fed announced it would purchase “fallen angels” in the secondary market – that is, previously investment-grade corporate bonds that have been downgraded to non-investment grade. This drove up the price of eligible securities, even before purchasing began, and distorted pricing between eligible and non-eligible securities. This distortion has become particularly pronounced in the market for securitised assets. We’ve also seen primary fixed interest markets remain open to large, blue-chip companies and an increase in the level of newly issued bonds as corporations build up their balance sheets. This is a positive sign that large companies have been able to defy poor economic conditions and refinance themselves.
Looking ahead, it’s unlikely that there will be a linear, V-shaped path to recovery. Nonetheless, there may be investment opportunities available, particularly on the riskier end of the fixed interest risk spectrum – for example, riskier corporate bonds and securitised assets, which haven’t yet bounced back in quite the same way as investment-grade corporate or sovereign bonds. The investment-grade corporate bond space could also be interesting to watch given the large number of ratings downgrades by rating agencies. While the number of defaults will likely increase, particularly for high-yield corporate bonds, some of the risks of an increase in defaults have already been priced in. Fixed interest fund managers should be able to see clearer differentiations between good and poor credit, and could therefore add quite a lot of value through issue selection over the coming year. In the meantime, sovereign bonds (at least, in the developed economies) will largely remain flat over the near term, as central banks continue heavily influencing sovereign markets to keep bond yields low and support the economy. The safer the investment, the lower the potential returns – so investors may need to balance their need for safety with their desire for higher returns.
Last quarter, there was a broad dispersion of performance across different alternatives strategies as each was uniquely impacted by Coronavirus. Unlike the Global Financial Crisis, which was an issue within financial markets that passed on to the real economy, the pandemic impacted the real economy first and then flowed on to financial markets. This meant certain asset classes didn’t behave the way they normally would in a crisis – as we saw with traditionally defensive investments and hedges such as US Treasuries, gold, currencies like the US Dollar or Japanese Yen, and some other well-known relationships that didn’t hold either. Commodities faced headwinds, with energy particularly impacted when the lockdown in China (the world’s largest importer of oil) led to a significant decrease in demand. Given the rapidly evolving environment, strategy speed and faster data sets that captured changing sentiment were specific contributors to positive performance.
Looking ahead, with uncertainty in both economic and financial market outlook, there are risks – but also opportunities. Managers with broad mandates, experience, and specialised skills could exploit these opportunities and manage risks in portfolios in these uncertain times. For example, the pricing dislocations across and within asset classes have created more opportunities for macro managers with broad mandates – directionally and through relative value trading. In long/short equity, the dispersion of returns of stocks within sectors like Technology and Healthcare has increased significantly, but managers with good fundamental stock selection skills should be able to exploit those opportunities. Similarly in credit, with central banks’ participation in certain segments of credit markets, the impact of the pandemic on sectors like Energy and Retail and redemptions from high-yield and loan exchange-traded funds are creating opportunities for managers with fundamental credit analytical skills. Another area of focus for managers will be identifying new risk management tools and risk mitigation strategies for portfolios given traditional hedging strategies involving defensive assets weren’t particularly effective last quarter. In particular, there may be some discussion about gold as a better hedge in portfolios compared to the US Dollar given the high level of debt the United States currently holds – reportedly in the trillions of dollars.
Despite the defensive, resilient nature of infrastructure investments (which have historically delivered solid returns), we saw a notable fall for this asset class in the March quarter. This was a result of the pandemic’s impact on the way people gather and move around – with the social-distancing rules and lockdowns borne from a need to combat the contagious Coronavirus. Toll roads and airports were two notable decliners for the quarter, as the halt to travel reduced demand for those assets. Interestingly, low oil prices benefited oil storage holders as a decrease in oil demand coupled with an oversupply of oil made storage space difficult to find and therefore valuable.
As lockdowns gradually loosen and as people transition back into society, we are seeing signs of a recovery across transportation assets hit hardest by the lockdowns – i.e. toll roads and airports. However, with the threat of secondary waves of infection still looming, some people may continue staying indoors and working from home. Over the coming months, this could mean a persistent demand for utilities servicing residential premises and telecommunications towers – sectors that retained their strength when the broader market was volatile. This contrasting performance between infrastructure assets during the correction and the recovery highlights the importance of having diversified exposure across the various infrastructure sectors.
Infrastructure is vital to any economy, and can be considered a long-term investment with a time horizon of several years. When returns are viewed largely with a long-term focus, the short-term shape of recovery is less relevant. Nonetheless, it’s important to note that over the last decade (following the Global Financial Crisis), infrastructure investments performed extremely well and benefitted immensely from falling interest rates. The value of many of these investments has been heavily discounted over recent times, meaning there may be opportunities for investors to buy in at a discounted price and benefit again from a valuable future income stream in the likely low interest rate environment going forward.
As lockdown measures came into place and as many businesses faced temporary closures, hotels and, in particular, the retail property sector (i.e. shopping malls and strips) were heavily impacted last quarter – with some landlords reportedly facing difficulty in collecting rent from their struggling tenants. Conversely, as Coronavirus kept people indoors, the industrial property sector (i.e. large-scale storage and distribution centres supporting ‘stay-at-home’ stocks like Amazon) was a beneficiary.
In coming months, we could see continuing challenges for the retail property sector which, prior to the Coronavirus, already struggled with the shift away from physical shopping centres and toward online retailers. This trend, accelerated by the pandemic, should benefit industrial property. The good thing is that property is an adaptive and convertible asset class that comes in all shapes and sizes, meaning we could see unused retail space converted into office or residential buildings in future, particularly for property hotspots in CBDs, though this may be offset by an oversupply of office space as a result of changing working habits. There is often overlap between the property and infrastructure sectors as both are longer-term investments with an investment horizon of years. While it’s difficult to forecast what shape a recovery will take, the bottom line is that property will eventually recover over time – particularly benefitting from the low interest rate environment.
The Coronavirus effectively led to the shutdown of economic activity, impacting even traditionally defensive sectors with stable cash flows – for example, shopping centre operators such as Scentre Group (which operates Westfield centres in Australia). The pandemic had flow-on effects on other sectors too. Energy is one example – impacted by an oversupply in oil markets following a significant decrease in demand with a world in lockdown. While anything of a Consumer Discretionary nature was also affected during the quarter, names like Harvey Norman and JB Hi-Fi actually had increased sales as people stayed at home. Consumer Staples also showed its resiliency – particularly as supermarket names like Coles and Woolworths saw an increase in sales as consumers hoarded supplies ahead of the lockdown. So, too, did Telstra and data centre operator NextDC.
As we look ahead, there’s a lot of talk about a V-shaped recovery. However, progress is unlikely to be linear, and it’s possible that there will be a sharper recovery in some market segments compared to others. Iron ore has remained resilient over time as Chinese demand has remained strong, but this has the potential to change given the escalation in trade tensions between China and Australia. As lockdowns are eased, businesses go back to work, and people begin feeling more confident with spending, there could be a rebound in sectors that were negatively impacted last quarter. For example, parts of the Consumer Discretionary sector could benefit, particularly domestic air travel and tourism as Australians with cabin fever are able to travel again – even if only nationally, thereby injecting funds into the Australian economy. However, this may be mitigated by social distancing on planes and lower demand for business travel as corporates embrace technology to communicate. Other areas such as casinos could rebound when lockdowns are loosened. So far, the likes of Crown and the Star have significantly cut operating costs and are in hibernation during this time – preserving their cash reserves while readying themselves to reopen. On the other hand, banks continue to face challenges as reflected in higher provisions for Coronavirus-related losses and impacts to dividends – with NAB reducing its dividend, and both ANZ and Westpac deferring their dividends. Dividends across many parts of the market have also been impacted as corporate earnings have fallen during the pandemic.
Global share markets reached new highs in February, but rapidly declined only weeks later as the Coronavirus impacted economies, businesses and households worldwide. During the month of March, defensive sectors held up the best – with Healthcare and Consumer Staples falling the least. The best performing region was Asia, led by China and Japan, while the best performing countries were Switzerland and Denmark. As developments continued to unfold, developed markets fell more than 20% (with the MSCI AC World falling 23.4%), while Asia fell around 15%, peak to trough (19 February to 23 March). But by the end of March, global indices were down only 9% (with the MSCI ACWI down 8.9%). The Australian Dollar fell in March, reducing the magnitude of these market falls for Australian domiciled investors.
Looking ahead, the differences between reported company earnings and consensus expectations could be a space to watch as markets gradually recalibrate valuations to appropriately reflect reported earnings and guidance. Given the uncertainty surrounding earnings and the macro economy, the market appears to favour more defensive sectors and industries that could continue operating in this non-standard environment. On a sector basis, markets may favour Healthcare as companies race against the clock (and each other) to improve testing solutions or to develop a vaccination. Some strength has also been observed across Information Technology, as well as companies with business models suited to online consumption and other businesses that can continue operating regardless of the circumstances.
In spite of the general uncertainty (whether it be at the economy, sector or industry level), share markets appear to have priced in a V-shaped recovery. As markets have responded well to positive developments around how countries are managing the pandemic and planning ahead for a return to economic normalcy, expectations seem to be moving ahead of reality. Other recovery shapes have also been suggested for a less optimistic playbook, including a longer-term U or W shape – the latter of which may involve a series of false starts before a real recovery takes hold. When markets have previously staged a real recovery after suffering a downturn, the recovery has been observed to have been initially led by cyclical sectors aligned with the value investment style – such as Materials, Financials, Industrials and Energy. This has occurred after uncertainty was resolved or once confidence returned – as was the case after the Global Financial Crisis, where the strongest performing sectors were Financials and Materials. In the current market, economic weakness, record low interest rates and energy sector volatility have all provided meaningful headwinds to cyclical sectors in the value investment style.
Compared to developed economies, emerging markets may face more challenges due to the less developed state of their infrastructure and health facilities. Their path to recovery could also depend on how well they are able to manage the pandemic from an economic perspective, with governments needing to deploy large fiscal stimulus to fill the void of lost economic activity. The industry sector mix of a country’s economy will also determine the ability to emerge through the recession. For instance, oil-importing countries could benefit from record low oil prices – namely, a number of Asian countries. Conversely, this could be a challenge for oil-exporting countries in the Middle East. Similarly, each country’s economic strength prior to the pandemic and economic slowdown may determine the depth of the recession.
The Coronavirus has highlighted the interconnected relationship between world economies and financial markets – each of which were impacted in idiosyncratic ways. Consequently, some investments didn’t perform the way they normally would, suggesting that a recovery in some asset classes may differ from previous episodes – for example, following the Global Financial Crisis. Given outcomes hinge largely on Coronavirus, it’s difficult to forecast exactly what will happen next.
But while there are still many unknowns, what we do know is that the path to eventual recovery in markets will depend largely on how quickly world governments can curb the spread of the virus to a sufficient enough point that they can reopen their economies and restart activity. Easing restrictions faster will be more helpful to countries putting themselves in debt to fill the void of economic activity, but opening too quickly could put them at risk of a new wave of infections – sending them into potentially deeper recessions should they need to lockdown again.
Governments are faced with the difficult task of balancing the health of their economies with the health of their citizens. For Australia, growth could detract 6% for the 2020 calendar year and break even by the end of 2021. Still, the damage has been done, as we’ve seen in unemployment – which is set to sit above 7% by the end of next year, but remain higher than pre-pandemic levels (5.2%). Some countries are further ahead in the reopening process, yielding mixed results and multiple stop-start cycles. This suggests that even in Australia, a recovery could be slow and non-linear across the board – at least until a vaccine is developed, and the most optimistic timeframe for that is at least a year.
Considering the above developments (and regardless of the shape), our broad consensus for a global market recovery is a slow one that extends well into 2021 and is punctuated by episodes of risk aversion – outlined below:
The Coronavirus has slowly come under the control of the developed world, and we’re optimistic on the resilience of economies to manage and control of a second wave of infections. However, we do anticipate that businesses and consumers will continue to be cautious – thereby hampering the pace of economic activity. Naturally, this will have flow-on effects to financial markets. But while the economic outlook is uncertain, our portfolio managers believe there are opportunities that skilled investment managers can harness to generate investment returns in future.
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Colonial First State Investments Limited ABN 98 002 348 352, AFSL 232468 (Colonial First State) is the issuer of FirstChoice Personal Super, FirstChoice Wholesale Personal Super, FirstChoice Pension, FirstChoice Wholesale Pension, FirstChoice Employer Super offered from the Colonial First State FirstChoice Superannuation Trust ABN 26 458 298 557. It also issues interests in the Rollover & Superannuation Fund (ROSCO) and Personal Pension Plan (PPP) offered from the Colonial First State Rollover & Superannuation Fund ABN 88 854 638 840 and interests in the Colonial First State Pooled Superannuation Trust ABN 51 982 884 624. Colonial First State also issues interests in products made available under FirstChoice Investments and FirstChoice Wholesale Investments. This is based on the understanding of current regulatory requirements and laws as at June 2020. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including Colonial First State or any member of the Commonwealth Bank group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information. This document provides information for the adviser only and is not to be handed on to any investor. It does not take into account any person’s individual objectives, financial situation or needs. You should read the relevant Product Disclosure Statement (PDS) and Financial Services Guide (FSG) before making any recommendations to a client. Clients should read the PDS and FSG before making an investment decision and consider talking to a financial adviser. The PDS and FSG can be obtained from colonialfirststate.com.au or by calling us on 13 18 36.
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Unless otherwise specified, this document has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State) based on its understanding of current regulatory requirements and laws as at the date of publication. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including Colonial First State or any member of the Commonwealth Bank group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information. Colonial First State is the issuer of interests in FirstChoice Personal Super, FirstChoice Wholesale Personal Super, FirstChoice Pension, FirstChoice Wholesale Pension, FirstChoice Employer Super offered from the Colonial First State FirstChoice Superannuation Trust ABN 26 458 298 557. It also issues interests in the Rollover & Superannuation Fund (ROSCO) and Personal Pension Plan (PPP) offered from the Colonial First State Rollover & Superannuation Fund ABN 88 854 638 840. Colonial First State also issues other investment products made available under FirstChoice Investments and FirstChoice Wholesale Investments, other than FirstRate Saver, FirstRate Term Deposits and FirstRate Investment Deposits which are products of the Commonwealth Bank of Australia ABN 48 123 123 124, AFS Licence 234945 (the Bank). Colonial First State is a wholly owned subsidiary of the Bank. The Bank and its subsidiaries do not guarantee the performance of FirstChoice products or the repayment of capital from any investments. This document provides information for the adviser only and is not to be handed on to any investor. It does not take into account any person’s individual objectives, financial situation or needs. You should read the relevant Product Disclosure Statement (PDS) before making any recommendations to a client. Clients should read the PDS before making an investment decision and consider talking to a financial adviser. PDSs can be obtained from colonialfirststate.com.au or by calling us on 13 18 36.
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