Are Markets Booming!?

Monthly Market and Economic Update – December 2020

Peter Flannery CFP AFA

 

 

“If you have one economist on your team,
it’s likely that you have one more than you’ll need.” 

Warren Buffett

MARKETS

The chart on the left shows the US share market (the Dow Jones) over the last six months.  The chart on the right shows the US share market (the Dow Jones) over the last year.

 

Key Points: 

  • Is Donald Trump making progress with additional votes?

  • What will Joe Biden do in his first 100 days?

  • What is China doing that could be a big concern for us?

  • COVID-19, winter, America, a bad combination?

  • Is Australia in real trouble with China?

  • Will NZ follow Australia and fall foul of China?

 

Markets continue to rise.  The main drivers appear to be the ongoing news around stage 3 Covid vaccine testing showing positive results with Pfizer and Moderna, among others, indicating positive data read.  Against this trend is the ongoing uncertainty around additional lockdowns in the US with Joe Biden now firmly targeting the Coronavirus along with potential lockdowns unfolding across Europe as well. 

This highlights the point about what I will refer to as ‘the sting in the tail’.  In other words, markets will quickly look through near term data into the future and overlook short-term challenges.  The economy on the other hand, being a lagging indicator, will take time to work it through.  It is likely we will see market uncertainty re-emerge from time to time causing volatility, as the positive news of vaccine rollouts is offset by lockdowns and the direct impact this has in terms of unemployment and bankruptcies.

Obviously this is less of an issue for the likes of China, Taiwan, New Zealand, Australia and other countries that appear to be more effectively controlling the spread of the Coronavirus.  The main large blocks of the global economy affected are obviously America and Europe.

Also there is near term uncertainty for the markets around the stimulus package which has dragged on for several months and that is the US elections.  Whilst a conclusion may be reached there is no obvious sign of this happening in the near term.  This of course does impact on market sentiment causing market volatility.

Although to a lesser degree, there remains the ongoing uncertainty created by Donald Trump and his team around the outcome of the election.  There is little doubt that Joe Biden will be president.  It is just a matter of how this proceed continues to unfold up until January 17 when the handover takes place.  At one point it looked as though there was the possibility of riots on the street with Donald Trump supporters taking up arms and rallying strongly to support Donald Trump.  This movement appears to have dissipated and now the uncertainty continues but appears less dramatic.

Pfizer indicated that it has scaled back its rollout of 100,000 doses of the vaccine back to 50,000 doses recently which was a notable but relatively minor setback.  Still this type of news does pique the market’s attention.

Further news driving markets related to the US Purchasing Manager’s Index (PMI) which came in at 55.6, a little bit behind the consensus view of 56.4 for November.  Still the markets remain encouraged because a reading above 50 means expansion and therefore is positive news for markets.

 

Market Volatility

The chart on the left measures market volatility from April 2004 up to date.  The chart on the right
 measures market volatility from the beginning of 2020 up to now.

Looking at the left-hand chart you can see the volatility over the Global Financial Crisis ( the spike prior to 2010).  From there volatility declined and from around 2013 until the outbreak of the Coronavirus, volatility was relatively stable. 

Looking to the right side of that same chart you can see the volatility spiked as a result of the spread of the Coronavirus and has subsided somewhat to a lower level of volatility from the peak, but nonetheless markets are still more volatile now than they were for many years. 

Obviously for those investors who are less advanced, volatility can be a cause of concern for them as they feel uneasy about the news in popular media and the volatility of their investments.  For those more advanced investors, of course volatility is our friend.  That is because lower prices mean better buying.

With elevated levels of volatility then, we have improved opportunity for better buy prices from time to time, bearing in mind of course that trading prices remain generally elevated with the Dow Jones recently reaching record highs of over 30,000 on that index.

The above chart measures the level of the Dow Jones Industrial Index starting from January 1981 up to now.

Can you believe that the Dow Jones Industrial Index was at only $972.78 in January 1981?  So, does that mean that the share market is expensive now?

The Dow Jones and markets are not expensive because the Index has grown and compounded over many years.  However if we look at simple measures such as the price to earnings ratio (the P/E ratio) we can start to see that indeed, compared to a market average for the Dow Jones of around 17, the current P/E ratio of the Dow Jones sits at 29.50 – expensive.  Even more expensive when we consider that the global economy is now based to a degree on monetary and fiscal stimulus, as distinct from straight out productivity.  So then, should we be concerned?

Although it is always difficult to predict future market direction, I believe that so long as we are investing in quality businesses, then volatility for us is more of an entry or exit point for our investments rather than a cause for concern.

Looking ahead, with the containment of the Coronavirus looking more likely, Coronavirus likely over the next 12 to 24 months, in the absence of another major event (there will be one at some point for sure), it would appear that markets are free to focus on growth which could see trading prices generally continuing to rise until the next major event emerges. 

Therefore, investors that are more advanced may continue to build on growth positions within their portfolio providing they are happy to take a longer term view generally.

 

The Global Economy

The above chart measures economic growth over the next 2 years.  It also compares November 2019  projections with the new trajectory as a result of COVID19.

 

Economic Growth Projections

The above chart shows economic projections for economic activity out to the fourth quarter of 2022.

Global economic recovery is underway, supported by those economies such as China and Australasia along with others who have successfully contained the virus.   The recovery remains uncertain and will likely be uneven.

Global economic growth (GDP) was 10% lower at the end of the second quarter of 2020 compared to the end of 2019.

The swift and strong response by central bankers around the world helped to stabilise the global economy.  The challenge now moving forward will be ongoing fiscal and monetary stimulus along with the balance between maintaining isolation and lockdown measures, along with the freeing up of those restrictions in order to allow economies to function.

Economies with restrictive lockdown conditions in place will struggle to grow.  Unfortunately the impact of those lockdowns means that smaller businesses and individuals at the margins are compromised and in many cases this is a permanent outcome for them.

As some economies recovered with control measures becoming increasingly effective, levels of saving and retail spending increased.  This helped to support economic recovery in those economies.

Global industrial production has also recovered, helped of course by the strong recovery out of China.  As we might expect, global trade volumes contracted significantly in the first half of 2020 with merchandise trades declining by 16% from its pre-pandemic level.

Also, international travel and tourism were largely curtailed as a result of the spread of the Coronavirus in the first half of 2020.

The above graph highlights the varying impact of the Coronavirus on activity across a number of countries.

Financial pressure leading to financial fragility appears to be greater in the hardest hit sectors such as recreation, entertainment, films and arts along with accommodation and food services. 

In Belgium around 20% of firms responding to a written survey indicated they could not meet their financial liabilities for more than 3 months without receiving additional equity or credit.  Other data confirms that the risk of bankruptcy was similar with, for example, in the United Kingdom around 18% of businesses reported moderate or severe bankruptcy risks at the end of September.  In accommodation and food services the number was 38%.

The above graphs measure the impact of a resurgence in the Coronavirus on activity in UK and other countries in Europe (the left side chart) and across some sectors (the right-hand chart).

As obvious as it may sound, those countries who have failed to implement Coronavirus containment measures have been adversely affected in terms of general economic activity. 

Some countries resorted to targeted and localised restrictions in specific areas and regions or on certain activities, however they proved to be only moderately effective. 

Also those countries that did not have effective track and trace and isolate systems in place, along with proper compliance and quarantine restrictions were also compromised by the spread of the Coronavirus and then the subsequent resurgence.  Slow economic growth of course leads to high unemployment and increased risk of bankruptcies.

The graph on the left-hand side measures the change in total hours worked by occupation in Australia.  The graph on the right-hand side measures the change in the number of Canadian employees working at least half the usual hours by wage decile.

Some mobility indicators related to retail and other recreational activities have slowed since the start of September in a number of major European economies.

For example in Israel, the second nationwide lockdown was implemented from mid-September through mid-October which saw credit card spending decline sharply.  The point here is that this and other sectors were already hard-hit and the second lockdown increased the risk of a higher level of unemployment and bankruptcy.

The chart on the left measures the change in inflation across those countries outlined in the chart.  The chart on the right measures the change in inflation expected across a number of other countries.

Inflation is generally expected to remain low for some time yet although as I have mentioned previously, the US Federal Reserve recently adjusted its inflation policy settings.  This means that inflation may run a bit hotter in the future which in theory would lead to an increase in interest rates in the US.  This could lead to increasing interest rates in other countries around the world.

The graph at the top measures how much fiscal policy is supporting real economic growth over those countries outlined.  The bottom chart measures projected contributions to household disposable income growth in 2020.  Two interesting charts when you study them closely.

The strong fiscal support for economies around the world has been swift and significant. 

That is because it is necessary to avoid a more damaging, longer lasting loss of economic market activity in the future.  The problem that could materialise in the future is whereby governments slow down or withdraw the support too soon.  I expect an ongoing “balancing act” that we have already seen in America when politics takes over and gets right in the way of what is needed.

The levels of debt for economies which includes business balance sheets and government debt to GDP ratios will expand.  On some estimates, the end of 2022 may show those debt levels increasing to circa 20% of GDP higher than in 2019.  This will see debt levels reach new highs over the next couple of years which is manageable given low levels of interest rates and the improving economic outlook for many economies.

 

The United States of America

Unemployment – USA

The above graph measures unemployment from prior to the spread of the Coronavirus up to now.

Hiring, or what is sometimes known as the reduction in unemployment in the US, has slowed and at its current pace it would take until around March 2024 for the job market to return to its February 2020 peak.  The US added approximately 145,000 jobs in November this year on a seasonally adjusted basis according to the Bureau of Labour Statics. 

This was approximately 224,000 less than economists were expecting and a noticeable slowdown from the 610,000 jobs added in October.  The unemployment rate has eased down to 6.7% from 6.9% in October but is looking slightly better because some workers have actually left the labour force in November.  Of the people who were not included in the labour force, approximately 3.9 million were prevented from looking for work because of COVID19.

 

Coronavirus Spread – USA

The top chart shows the spread of the Coronavirus currently. The bottom chart shows the position 3 months ago.

As the two charts above clearly demonstrate, the spread of the Coronavirus has increased and the position is worse than it was 3 months ago.  This is measured in this case by the Rt score.  A score greater than one means that the Coronavirus is spreading whereas a score less than one means that the spread is in decline and the virus is potentially controlled.

Joe Biden, the incoming President of United States has stated that his number one priority will be to target COVID19.  It will be interesting to see how he goes about it and how the American public respond to tougher measures regarding lockdown, tracing and quarantine restrictions. 

I wonder if, without the divisive narrative from Donald Trump, there might be a reasonable chance that Joe Biden may have greater success.  He has an advantage right at the outset because, he is actually making an effort, which is more than can be said for the outgoing president, Donald Trump.

 

China

The above diagram shows China as the number one economy by 2024

China has largely won the battle against the Coronavirus with COVID19 mostly contained right across China.  I see this as giving China a real edge in terms of economic power with its ability to get back on track with economic growth and therefore channel that additional productivity (that America continues to remain behind the 8-ball on) into initiatives that support its desire to support its aspirations of global dominance. 

Although not there yet, China is well on the way. 

For example they have already shown their ability to mobilise the population and to transform the economy from the rice fields into the cities as they gear up their economy through the education and intellectualisation of the people of China. 

The leadership of China, the Communist Party, have this interesting advantage to some degree over democracies in that they appear to be able to channel the will of the people in a single focussed direction for the greater good of China. 

America has enjoyed a unique position in the global economy as the most powerful by a number of measures.  The question is how long will that last?  The question then becomes, what does that mean for the global economy, global trade and the everyday lives of global citizens?

The top chart shows the previous/current global trade position.  The bottom chart shows the emerging trade situation as China pursues its reach and dominance of global trade.

China has developed the so-called “dual circulation policy” which is simply to focus more on the internal economy rather than rely on global trade. 

The US is still China’s largest trading partner for exports however the dual circulation policy aims to reduce its reliance on the US and other trading partners.  Interestingly the tariffs implemented by Donald Trump have seen the European Union take over the number one trading spot more recently according to Customs data recently released. 

Xi Jinping recently said in a speech “My country’s position in the world economy will continue to rise, and ties with the global economy will become closer and the market opportunity we offer to other countries will broaden.  We will also become a massive gravitational field for attracting international goods and key resources”.   

I wonder whether that means that instead of being the global benefactor they are going out to the world to look for resources that they need?  One thing I would see happening is that they are keen to reduce their reliance on United States of America and indeed to solidify their trading position in a way that excludes America.

Interestingly, despite the trade tensions particularly with the US, China is keen on foreign investment into China to help China continue to grow and develop.  Foreign direct investment in China grew a bit over 12% from last year to around $9.05 billion.  That is the fourth month in a row of an increase since the Coronavirus outbreak in February this year. 

Anyway, there is a clear focus by the Chinese government and companies within China on helping Chinese businesses adjust their focus to the domestic market.  It will take time and will not happen overnight.

Economic growth in China as measured by GDP contracted by 6.8% in the first quarter of this year and then there was the surprise 3.2% increase in the second quarter.  Retail sales in China still declined by 1.1% over July as the growth in online shopping was not quite enough to offset the overall decline.

Consumption will still not be the economic driver this year for China or even next year.  It remains to be seen but it looks as though investment and exports will still be those key drivers of the economy. 

As I have mentioned over the last few years, state owned enterprise reform remains key to the ongoing growth and development of the Chinese economy.  If China wants to become more inward with trade (making China great!) then income distribution will be required. 

What this means is that the poor farmers coming off the rice fields into the cities will need help to be able to earn more money so that they can in turn drive consumption and spending to boost economic growth in China.  This is particularly the case if they intend to reduce export reliance on the American economy. 

Although it is early days yet, Joe Biden has signalled that he will not be unwinding the current trade tariffs.  As China continues to pursue its “dual circulation” policy they will be looking to maintain a central role in the global supply chain, particularly as they attempt to reduce their reliance on United States of America.

 

Euro Area

The above diagram provides a variety of economic data.

Economic growth in the Euro area remains fragile.  Inflation remains low as do interest rates as their success in containing the Coronavirus remains patchy at best.

Lockdowns will be a feature of the European economy over the near term, at least until such time as controlled vaccines are developed and distributed. 

As we know, that is a 12 to 24 month timeframe although there will be some benefit even in the early days as those most at risk are given the opportunity for inoculation.

As an aside, I know there are some sections in the population who are not too keen on receiving vaccines in any form.  It will be interesting to see whether this particular group engineers some influence on the rollout process.

Anyway, the European Central Bank remains active and ready to provide more support as required.  Not much change in the Euro area.

 

Australia

China and Australia Argue

Australia is in the midst of a reasonably serious argument with China which could potentially be dangerous for them from a trading perspective.  China was quick to impose tariffs on Australia’s wine exports to China which will have a serious impact on the wine industry in Australia, especially if it drags on for too long.  Maybe that means cheap wine for Kiwi’s!

The above diagram shows to some degree how reliant Australia is with regards to its exports to China.

 

Retail Sales – Australia

The above graph measures retail activity in terms of both prices and volumes.

In the first quarter of this year, the value of retail sales jumped by 2.7% which included a 1.9% surge in prices and a more modest 0.7% rise in real sales, driven by panic buying and hoarding as the Coronavirus story unfolded. 

The second quarter sales fall by 2.3% with yet another jump in prices, up 1.2% with a 3.4% decline in turnover as Australia went into partial lockdown.

Over the third quarter sales more than recovered with the value of retailing increasing by a significant 6.8%.

The above graph measures the month-on-month change in residential property values in Australia.

In the 7 months since March this year, the Combined Capital Index for properties in the main cities has fallen by around 2.3% whereas regional dwelling values are actually up 1.7%.  There has been some comment that the popularity of working from the home since the spread of the Coronavirus is one factor that may be helping to support regional home prices. 

In general terms the core logic combined regionals index has seen relatively firm prices generally through the depth of the COVID19 related downturn.

The Australian economy like most other economies around the world has been stabilised through a solid effort from the Reserve Bank of Australia.  It will be interesting to see how the argument between Australia and China unfolds over the next couple of months or so.  It would also be interesting to see whether or not New Zealand becomes embroiled in it?

 

New Zealand

The above charts measure GDT Price Index activity over the last year (the top bar graph) and over the last 10 years (the bottom line graph).

As the above charts show, the latest dairy auction generated a 4.3% increase taking the average price to US$3,261, reasonably comfortably above the magic number of $3,000.

It is interesting to note that the warnings about dairy sector debt around January this year, whilst I imagine have not suddenly evaporated, nonetheless developed into serious trouble.  The dairy industry continues without significant signs of contraction due to over indebtedness.

The above graph measures job losses showing the sectors from which job losses came from.

With the loss of over 20,000 jobs, we can see from the chart above that the loss of jobs was not evenly spread across the economy. 

Part of the job of the Reserve Bank of New Zealand is to use monetary policy by lowering interest rates.  The effect is that low interest rates mean that households have increased income with debt servicing costs reducing.  People feel better off which is the so-called ‘wealth effect’ and they are inclined to invest, borrow more money or spend more money.  

This all adds up to economic activity which is what we want.  As an aside, it is a short-term fix and not a cure for an ailing economy.  What we really want is increased productivity but that is another story for another day.

With wholesale interest rates declining, this can have the impact of helping to reduce the New Zealand Dollar against other currencies which makes it easier for New Zealand exporters to export their goods and services to other countries. 

What we are all noticing though, is the one item that stands out above others and is getting most of the media attention – house prices.  Most economists including the Reserve Bank thought that house prices would be in a slumber or falling.  I am no economic expert however I wonder if they underestimate the fact that property in New Zealand is no longer a house to live in or even an investment but rather a religion (based on blind faith!).  Indeed, house prices have actually increased.

Last month I highlighted the funding for lending program (FLP) which basically is the Reserve Bank providing mainstream banks with a lump of money at the official cash rate (0.25%).  This is a cheaper source of funding for them as distinct from term deposits which may not be as favoured as they once were prior to low interest rates. 

The funding for lending program then is just another tool that the Reserve Bank is using to help stabilise the economy, to help reduce unemployment and to ultimately stimulate some economic activity.  Basically this means lower cost funding for banks which the New Zealand Reserve Bank is expecting to be handed on to consumers by way of lower interest rates.

The above graph shows the history of unemployment and some projections over 2021.

As the above graph also shows, the Reserve Bank of New Zealand is hopeful that unemployment will peak in the early to mid-part of 2021 and decline over 2021 and 2022. 

The challenges that America and Europe continue to face regarding control over COVID-19 will not be helping, but of course the rollout of the vaccine to help control the coronavirus may help to offset the current rate of spread over 2021. 

That therefore would support the idea that unemployment in New Zealand may decline as outlined in the chart above.  Time will tell. 

It would appear that there is still further to unfold in this area as some business owners decide whether or not to stay open or close and some employees decide whether to hold out in the hope that they can get back to work or indeed decide to retrain.  This of course may take them out of the workforce for a while as the retraining takes place.

One of the issues here is that there could be a sudden overhang of surplus jobs in some sectors where, without retraining they may find it very difficult to get work.  Also, different sectors in different parts of the country are affected differently.  Some may need to travel to other parts of the country to gain employment.

Whilst there was the wage subsidy and a scheme through the IRD that business owners could take advantage of, the reality is the criteria for being able to take advantage of those schemes was reasonably tight. 

They were certainly popular for those that could take advantage of them and without doubt they would have been helpful for those particular businesses. 

For a good many other businesses that fell outside of those criteria, there was little in the way of support and that remains the case now to a large degree. 

Perhaps overly simplistic, it would appear that the old formula of driving funding into housing whilst overlooking small business is being played out once again in New Zealand.  Short-sighted in my opinion because more business owners hire the very people that the government would like to see in work and contributing to the economy.  I regard this as a significant gap in the support program here in New Zealand.

Interest rates remain low in New Zealand, which on the one hand seems like a great idea if you are borrowing money but of course on the other hand it means that the economy is struggling.   Also those relying on term deposits for income (perhaps one day they can be more imaginative!) continue to remain challenged. 

Interest rates will start to increase in theory once economic growth returns and is well underway.  Although I would be keeping one eye on the 10-year treasuries in the US, it is difficult to see interest rates in New Zealand spiking upwards in the near future.  To put this another way, rising interest rates could be considered in some ways a good thing because, it means that economic activity is ramping up and the economy is growing at a faster pace.

 

When will the borders open in New Zealand?

It is difficult to gauge however the Reserve Bank of New Zealand have a working model based on 2022.  The idea is that if borders open early 2022, it may take between 6 and 12 months for migration and tourism to recover and to start impacting on the New Zealand economy.

For now though, the experience we are enjoying here in New Zealand with regards to COVID19 is very different to what many other countries around the world are experiencing right now.

The above graph tracks inflation as measured by CPI (Consumer Price Index)

In short, inflation has been lower than the Reserve Bank would prefer and it looks as though it will stay low over the next 2 to 3 years based on their projections. 

That ties in with interest rates potentially remaining lower for longer as well.  It is important though for us to keep an eye on external factors that could impact on the above projection.  The loosening of inflation settings in the US (as I have alluded to a number of times) is one of those factors to watch.

Negative interest rates have been discussed at some length around the marketplace. 

It looks as though at this point that there is a reduced likelihood of negative interest rates although risks can suddenly emerge which can change that view. 

For example, a community outbreak of COVID19 could see a resurgence of the spread of the virus which would see the good work done over the last several months reversed very quickly, increasing the need in that situation to possibly consider once again more seriously, negative interest rates.  This could mean that negative interest rates remain on the table depending on what significant risks emerge in the future.

 

What about residential property LVR’s

Loan to value ratios will be reintroduced in the early part of 2021 although a number of banks have pre-empted the introduction by imposing those restrictions now anyway.

 

To Summarise …

 Economic recovery is underway

The above graph highlights the economic recovery underway in China.

China has largely contained the Coronavirus without the use of a vaccine as far as we know.  They used a similar approach to New Zealand which involved lockdowns, strong tracing and quarantine measures that appear to have largely been successful.

On the other hand, the United States of America, Europe and a number of other countries around the world continue to battle with the Coronavirus. 

The point I am getting to here is that this can mean what I would refer to as “the sting in the tail” whereby some employees may need to retrain which will take time.  Some business owners may fail whilst others will be on the back foot for probably 2 or 3 years as they recover from this event.  I am over simplifying things however it all adds up to head winds, sluggish economic activity and that is without a resurgence.

Indeed what we will be seeing in some countries around the world such as the US, where a resurgence has simply set them back.  This set back is not allowing the economy to get back on track as they continue to allocate resource and more stimulus to support the economy rather than be in a position to allow economic productivity to drive growth. 

Australia and New Zealand have been relatively successful containing the virus although we all know how tricky COVID19 can be.  Our ongoing containment will rely heavily on successful quarantine arrangements and contact tracing, particularly if there is another community outbreak.

In short, whilst it is not over yet by far, the roll out of a containment vaccine is a strong next step, followed of course by ongoing support by central banks around the world.

Meanwhile back in New Zealand, residential property prices are definitely in a boom phase and so, rightly or wrongly this may help generate a wealth effect whereby kiwis feel financially robust and willing to go out and spend more money (and hopefully save and invest more money too!).

Despite the significant impact of COVID19, the global economy is stable and is slowly getting back on track.  Like always with these types of events, the impact on different sectors varies as it does from person to person across the economy.

From an investment point of view, it looks as though we are able to continue to focus on growth and to build on our positions for now. 

Meanwhile the quality of our investments will help our portfolios to grow, regardless of COVID-19 and the resulting short-term volatility.

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