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Quarterly Wrap: September 2020

Senior Investment Manager George Lin reveals what drove markets during the September quarter, and shares his thoughts on what we could expect to see by the end of the year.

       Written by George Lin
Senior Investment Manager | Colonial First State
 

 

 

After a strong start to the quarter, financial markets became volatile in the month of September. Geopolitical tensions between the US and China, rhetoric surrounding US presidential campaign developments, and expensive valuations across technology stocks (which led to a subsequent correction) all contributed towards the decline – with September’s volatility erasing many of the gains investments made in July and August. Australian and global shares delivered generally mixed returns – with the S&P/ASX 200 down 0.44% and the MSCI All Country World Net Index (AUD hedged) up 6.5%. By quarter’s end, the Australian Dollar (AUD) was trading at 71.7 US cents, or about 3 cents higher than the beginning of the quarter.

Developments in Australia

Australia’s share market managed to gain against rising uncertainty

 

Over the quarter, Australian fixed interest delivered a small return of about 1%. However, shares were somewhat mixed depending on the index. While the ASX 200 generated a negative return of about 0.44%, the All Ordinaries Index made a minor gain of 1.1% – a reasonable result given the uncertainties generated by Coronavirus, a lacklustre company reporting season, the poor performance of large-cap stocks, as well as escalating tensions between Australia and its largest export partner, China. The AUD had a roller-coaster quarter, surging to a high of 73.9 US cents in late August as the global economic recovery accelerated and pro-risk sentiments soared. But as major share markets began correcting in September, the AUD followed suit and fell sharply – ending September at 71.7 US cents, which is 4.1% higher than its end-of-June level of 68.9 US cents.

Source: Factset
Australia’s uneven economic recovery continued  

 

Economic data suggested an uneven recovery in Australia, which was hindered partially by Melbourne’s lockdowns. Employment increased for three consecutive months, with about 457,000 (mostly part-time) jobs created since the lowest level of employment in May. However, the pace of job creation slowed somewhat in July and August, with employment still 416,000 positions below its pre-Coronavirus peak. Various income assistance programs such as JobKeeper have helped Australians maintain their spending, but retail trade fell by 4.2% in August after the strong recovery that started in May. Worryingly, the pullback in August suggested a bi-furcation in the recovery – a 12.6% drop in retail sales in Victoria compared to the rest of Australia, which fell by 1.5% in August.

Source: Factset
Figure 1
Source: Factset
Figure 2
Speculation on the direction of Australia’s central bank


The Coronavirus crisis has seen all major central banks engage in unparalleled programs involving sharp reductions in policy rates and aggressive asset purchases. In Australia, there is an increasing expectation that the Reserve Bank of Australia could make changes to its own plans, by cutting its target cash rate to 0.1%, adopting a 0.1% three-year bond target and adjusting the rate on any drawdowns on the term-funding facility to 0.1%. This could happen at its next board meeting.

Developments globally

 
 
September’s volatility reversed some earlier gains

 

Over the quarter, global fixed interest delivered a positive return of about 1%. Global shares – when hedged to movements in the AUD – were also positive, rising 6.5%. A higher AUD meant the returns of unhedged global shares returned a lower (but still positive) return of 3.9%.


Hong Kong’s Hang Seng fell about 4% – making it the worst performing developed share market index for the quarter due, in part, to China’s national security law, which was a shock to Hong Kong’s status as a global financial centre. 

Elsewhere, the US market was a standout – at least until September, when large-cap technology stocks became volatile and led to a broader market decline. The S&P 500 reached a peak on 2 September – a rise of 60% since its trough in March (in US Dollar terms). But after reaching its peak, the index fell by 9.6% to return 8.5% by quarter’s end. The technology-dominated NASDAQ also reached a peak on 2 September – a rise of 75.7% since its trough in March (also in US Dollar terms). But like the S&P 500, the NASDAQ also declined after its peak – falling about 11.8%, but still returning a strong 11% by quarter’s end.

 

While it is difficult to pinpoint the exact cause of the correction across technology stocks, the most simple – and likely – cause may be attributed to stretched valuations. At its September peak, the NASDAQ was trading at a forward price earnings multiple (which compares a company’s reported earnings per share to the market price of its shares to help judge how expensive it is) of 35.9, which is significantly above its long-term median of 18.5. Now, it is trading at a multiple of around 31.1.

Source: Factset
Figure 3
Geopolitical tensions continued bubbling

 

A constant theme in markets has been the escalation of geopolitical tensions between China and the US and its allies, including Australia. The quarter began with China imposing a draconian national security law in Hong Kong, which attracted strong criticism from the US and its allies. Over recent months, the US has imposed various sanctions against senior Chinese officials, tightened the technology embargo against Huawei, closed China’s consulate in Houston and also forced the sale of TikTok, a major Chinese social media platform that has made headlines. China retaliated by conducting increasingly risky and aggressive military exercises near Taiwan, including sending its fighters across the midline in Taiwan Strait – the unofficial line of separation between China and Taiwan. China is also drawing up a list of “unreliable entities” for unspecified sanctions, with America’s HSBC, Federal Express and Cisco rumoured to be members of this list.

The uneven economic recovery was a global occurrence

 

The global recovery continued, albeit at an uneven pace and with signs that the speed of recovery began to slow towards the end of the quarter. The global Purchasing Managers’ Index (PMI), a leading indicator of economic activity, recovered to a level above 50 in both the manufacturing and services sectors. This suggests that both sectors are now in expansionary territory after suffering their sharpest declines in history. However, an examination of the PMIs at the country level revealed the patchy nature of recovery in the services sector. China, which managed the spread of Coronavirus better than some other countries, recovered from the service recession first, followed by the US and Europe. But in all three cases, the pace of expansion has slowed.

Source: Factset
New policy framework announced for the world’s biggest central bank

 

One of the most powerful central banks in the world, the US Federal Reserve (the Fed), announced a new monetary policy framework in August that could have far-reaching consequences. The Fed, like many central banks, has an inflation target policy, which means that if inflation falls below a certain level (2% in the case of the Fed), it will tighten monetary policy and vice versa. Chairman Powell announced in August that the Fed will switch to targeting an average inflation rate of 2%, noting that the policy rate will stay at its current level until “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment, and inflation has risen to 2% and is on track to moderately exceed 2% for some time”. This subtle but important shift leaves the Fed with considerably more flexibility to allow inflation to “overshoot” its target and to maintain the current low-interest rate regime for a longer period of time.

Looking ahead, what could we expect?

Despite the recent decline in share prices, a repeat of the sell-off in March is unlikely. However, we do expect the economic recovery to continue with occasional setbacks.

 

One of the key pillars supporting risky asset prices remains the extremely accommodative monetary policies of central banks, including their universal commitment to maintain current policy settings and their willingness to do more if required. While the effectiveness of monetary policy on the real economy has diminished somewhat, its impact on financial markets remains potent. For this reason, our team retains a relatively positive outlook for higher-risk assets, like shares. With the best share market returns (in terms of a recovery) most likely behind us, it’s possible that shares could post modest returns, albeit with a high level of volatility, over the next six to nine months. 

 

There are three key developments to monitor over the December quarter:

 

  1. Coronavirus vaccine developments. A number of vaccines currently under stage-three trial are expected to announce preliminary trial results by Christmas. Positive announcements on a vaccine, in particular surrounding regulatory approval, will likely lead to a rally in higher-risk investments. However, the reverse is also true. We caution against overreacting to any positive news, as an approved vaccine may not be widely available until mid-2021 and even then, it will take more time to achieve widespread immunity across developed economies.

  2. The US presidential election. Current figures suggest Joe Biden maintains a comfortable lead of around 7% in national polls. However, Biden’s lead in crucial swing states, which will determine the election, has shrunk. In fact, Trump’s Coronavirus diagnosis has raised questions as to the closeness in polls. This could potentially lead to a hung election, similar to the 2000 election between Bush and Gore, which was decided by the Supreme Court.

  3. Tests in the tumultuous US–China relationship. The lead up to the election is also a period of risk for the US and China. So far, China’s response to US sanctions has been comparatively restrained. For now, Chinese leadership seems to be adopting a “wait and see” approach in hopes that a Biden administration will adopt a less confrontational posture towards China. But its restraint may be tested if the US chooses to pursue policies that cross China’s line in the sand. One example is the establishment of formal diplomatic relationship with Taiwan.

 

Our team’s baseline scenario is that the global economic recovery will continue at an uneven pace despite episodes of data weakness. The main risks to our scenario are familiar:

 

Firstly, large-scale lockdowns caused by surges in Coronavirus cases. As the northern hemisphere enters winter this could pose a risk to economic activity. However, governments seem reluctant to impose sweeping, nationwide lockdowns due to the economic costs, and people have proven very adaptive to the conditions of a post-Coronavirus environment.

Secondly, elevated share market valuations. Despite the recent market correction, some share markets still look expensive by historical standards. In terms of the trailing 12-month price-to-earnings ratio (P/E), the S&P 500 is trading at around 24.2, which is significantly above its long-term median of 17.2. The expensive valuation of the US market is concentrated in large-cap tech stocks. We can see this in the valuation gap between the S&P 500 and technology-dominated NASDAQ, which is trading at a trailing P/E of 30.9 compared to a long-term median of 19.1. While part of its valuation premium is justified by better growth potential, stronger free cashflows and the structural shift to an internet-based economy, expensive valuations mean the sector is vulnerable to sudden shifts in sentiment.

Source: Factset

As we move into the next quarter and round out what has already been an eventful year, we remain confident that in the absence of a significant shock, the world economy and financial markets can continue recovering. But with some key developments occurring over the coming months, the path to recovery will likely have twists and turns that lead to episodes of volatility for asset prices.

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