Markets Fall, Economies Shrink

Monthly Market and Economic Update –  10th September 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

Is that a tech correction I see!?

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: 

  • Markets sell off, why?
  • Interest rates remain low, how does that affect share markets?
  • Does the world need China?
  • Coronavirus continues to spread around the world.
  • How is America tracking?  What does that mean for us all?
  • Australia’s biggest economic contraction ever.
  • What does New Zealand’s elections mean for investors?
  •  

Markets correct downward, with the Dow Jones losing over 800 points on Thursday, September 03 2020. That looks like the biggest one day decline since March this year. 

More interesting, I think, is the fact that if we look at the S&P 500 hovering around all-time highs, only 16% of stocks have actually been driving that index up (a similar story to the Dow Jones) but if we look at the average stock within the index, the average stock is actually 28% below its all-time high. 

I mention that because it tells a different story to the overall index.  Just as interesting is the fact that 46% of S&P stocks have actually made no gains over the last two years – believe it or not. 

Whilst at the time of preparing this newsletter, we are in the midst of the correction, by the time you read this, we will all know what has actually transpired; however, across the markets, there are a number of commentators comparing this mini correction with some of the ratios and numbers that were seen just prior to the 2000 tech wreck. 

Yes, that was when markets sold off significantly as the excess pricing of tech related companies became too much for the market and strong selling action suddenly erupted. 

Back to September 2020, apart from the fact that the trading prices of a number of tech companies are well above standard valuation metrics, there is an increasing amount of money playing in the futures and options space with those same companies that we invest in, taking positions for and against market direction.  The bottom line here is that when those positions become out of the money, they must sell and sell in a hurry. 

It might be that we can expect to see more of this type of activity and therefore more of this type of volatility in the future.  Reasonably long periods of stability and then a sudden eruption of market activity on either the buy or the sell side.  The point here is that synthetic instruments (e.g. futures and options) are creating some of the sharp swings in trading prices.   

 

Can you trust the market?  What do you think?

The real question right now on everyone’s minds is (Monday, 7 September 2020), are we done yet … has this mini correction finished? 

What we know is, at the moment the top five stocks on the US market represent 18% of the S&P index, which is more than the bottom 300 stocks which represent 17% of the index. 

What we can see is that those largest stocks by capitalisation (the likes of Tesla, Apple, Facebook and Alphabet) are strongly followed and as one commentator put it, ‘very crowded’.  When you have a large chunk of the market chasing a very small number of stocks, then it is inevitable that those stocks will rise strongly.  Guess what else is possible at some point? 

Well … as for you and I, we are investing in the business rather than speculating on the stock – agree?   

Our fortunes do not lie in the current trading price of each of those stocks today, but rather in the underlying quality of each business in the long term.

 

Should we buy on weakness?

 Very carefully is my thinking.  That is because lower prices at the moment do not necessarily mean cheap, just less expensive. 

Does this mean there is no investing opportunity then?  No.

How you and I go about investing is strongly correlated to our Investment Strategy.  Those with a more balanced approach or shall we say, a less advanced approach to investing will simply ride through this type of volatility. 

Those perhaps that are more advanced may seek selective opportunity.  In other words, it could be a chance to add another business at a price that, whilst not cheap is better buying than it was a few days ago. That is a more advanced approach for an investor with a more advanced Investment Strategy

Different investors invest differently. 

Ideally, they follow the value / eco-Investing guidelines, investing with the strategy that is suitable for them.  You invest in a way that is suitable for you.  Part of my job, by the way, to ensure that happens. 

 

Interest Rates – America

The above chart shows the decline in interest rates since 1995. By the way, that is 25 years with some ups and downs in the middle but a trend of declining interest rates. 

Usually, an interest rate chart would be included under the economic section of The Market and Economic Update. I include it here because ever-declining interest rates over the last 25 years or so and ongoing low interest rates are a driver of higher trading prices. 

Markets take the view that if they can invest in bonds or term deposits in the bank and achieve a reasonable return, then that would be the market’s preference rather than investing in volatile assets, even though these volatile assets grow, even though they will make more money in the long run in those volatile assets.  

Do you ever wonder, if interest rates start to rise what impact that might have on the cash-up value of your portfolio?

A meaningful interest rate increase would see the cash-up value of our portfolios decline in a meaningful way. 

For those who play the markets (most investors by the way, but not our style), this would be a concern. For us, whilst the cash-up value of portfolios may decline in this situation, we will likely have cash available but better still, we will be investing in quality businesses that will continue to grow, even as interest rates rise. 

To be clear, just because hundreds of thousands of analysts around the world carry out discounted cashflow analysis, increase the interest rate that they use to determine the risk, which in turn significantly reduces the theoretical long-term value of an asset, does not mean that good businesses will not grow. 

It does mean that because the market believes these businesses may not grow as fast because of rising interest rates, that the market may sell down some assets, causing trading prices to decline. 

If you have invested for more than 10 years, you will have seen this in the past, where interest rates rise and markets sell off. 

There have been numerous cases over the years.  1994 is one that sticks in my mind.  Back then, from memory, the markets declined for three consecutive quarters.  It was a great time to average down and build more growth into investment portfolios. 

 

European Share Market

The above chart shows the movement of the European share market over the last 12 months.

Looking at the European share market chart above, note the correction in the market over February and March and then note the correction underway at the moment on the right hand side of the chart.  In simple terms, European markets often follow the lead from the US market. 

The above chart indicates the level of computer device exports for each country around the world.

Interestingly, China is the largest exporter of computer devices, with Mexico coming in second.  Although the US is also a significant exporter, its level of exports around the world are much less than China. 

 

The top 10 largest computer device exporters in the world

Country

Exports 2019

Market share as a percentage

China

$148 billion

40.3%

Mexico

$32 billion

8.7%

Netherlands

$28 billion

7.7%

USA

$26 billion

7.0%

Hong Kong

$21 billion

5.7%

Germany

$15 billion

4.0%

Czech Republic

$13 billion

3.5%

Thailand

$12 billion

3.2%

Taiwan

$9 billion

2.4%

Singapore

$8 billion

2.1%

 

Obviously, there are many different types of companies that make computers, smart phones and other componentry.  A good many also source their microchips from China, including the likes of Apple and others. 

China’s figure, by the way, does not include separate totals from other Asian manufacturing countries, like Hong Kong ($21 billion) and Taiwan ($9 billion).

In short, the world relies quite heavily on Asia to build and export its computers, smart phones and other componentry.  This means that there are a lot of levers that different countries can pull when they are having a squabble, like the US and China are at the moment. 

It is a double edged sword though and it also demonstrates the point that, squabble all you like, the fact is if you are China and America, you rely to some degree on each other. 

Another point worth mentioning here is the fact that trade imbalances, disagreements and trade wars might be news but can also become a distraction for us as investors if we are not careful. 

As value/eco-Investors, we are well served by remaining focused on the quality of the business. 

  

THE GLOBAL ECONOMY

The above chart from John Hopkins University shows the global cases of the Coronavirus.

 

The United States of America

Unemployment – America

The above chart shows the unemployment rate in America.

Unemployment in America spiked dramatically from 4.4% in March this year to a significant 14.7% in April and has since eased back to around 8.4%.  Notably, the trend of declining unemployment appears to be continuing, although is linked somewhat to the spread of the Coronavirus. 

High unemployment is a significant headwind for any economy; however, up until the Coronavirus, unemployment in America had been tracking at historic lows.  Still, whilst the graph above provides us with a general overview, these official figures may not necessarily reflect total reality because of the way people are being classified as being employed, even though they are absent from work. 

It does not seem that long ago that I was focused on the lack of wages growth and now we are back to focusing on unemployment, a long way from wages growth! 

The chart on the left shows housing starts in the US. The chart on the right tracks existing home sales.

As the chart on the left shows, new housing starts took a serious hit in the midst of the spread of the Coronavirus but have recovered strongly to levels seen over January and February this year. 

Similarly, existing home sales declined in the midst of the Coronavirus but have rebounded strongly as Americans chose to move out of the city into more provincial areas or even fringe city in order to escape the pressures of the Coronavirus.  This is an interesting trend, although it is probably too early to use the word trend.  It is likely more of an adjustment to prevailing conditions.  We will see whether it continues. 

We have all read various comments that this is the beginning of the end for big cities.  In my view, it is way too early to make those types of comments.  It may well be that there are some changes and in this particular instance, whilst some people move out of the city and will stay out, there may be others that move back in. 

We know that for example, the experience with Christchurch earthquakes was that many people did move out.  There was an 8% decline in the population, which is typically the case for earthquakes.  What we are now seeing is some of those that fled have returned and others are coming to Christchurch to live.

The point here is that in some areas, property is undergoing a mini boom, which of course is helping to keep things ticking over to some extent in certain parts of the American economy.  Interestingly, mortgage applications are reasonably flat and indeed have declined slightly as a result of the Coronavirus.

 

US Core Inflation Rate

The above chart measures the inflation rate in America.

Inflation is one of those key indicators that the US Federal Reserve continues to watch.  At a recent meeting, the Fed stated that they are looking to arrange their policy settings in order to accommodate inflation at a rate above 2.0% for a foreseeable period of time in the future.  In short, they need more inflation to help boost prices and the economy.  

That means interest rates may remain low and accommodative for some time to come.  That means that share markets may continue to rise. 

 

The Euro Area

Economic Growth – Euro Area

The above graph tracks economic growth (or should I say contraction) in the Euro area economy.

Unsurprisingly, economic activity has shrunk by a significant 15% recently.  In short, this means ongoing fiscal stimulus in the Euro area.  The contraction of 15.0% over the second quarter of 2020 is the biggest on record.

 

Coronavirus Spread – Europe

The above chart shows the spread of the Coronavirus across a number of European countries.

As the chart above shows, the Coronavirus continues to spread across Europe, although at varying speeds from one country to another.  Like every other country in the world, Europe keenly awaits the completion of stage three trials and the announcement of a vaccine that at least can help contain the virus. 

  

Australia

 Economic Activity – Australia

The above chart shows economic activity in Australia.

The Australian economy declined by 7% in the June quarter, which is the largest decline on record according to the Australian Bureau of Statistics.  This decline followed a 0.3% fall in the March quarter of 2020. 

Like many other countries around the world, Australia has seen declining economic activity and like other countries around the world, generally the most impacted are those at the margins, who are the most vulnerable.

Businesses that were struggling prior to COVID-19 may find this makes things even more difficult.  In some cases, it may be non-survivable.  Likewise, for individuals and families that are not well-placed, the Coronavirus may see them struggle even more than they have in the past. 

That said, Australia would not be the worst country in the world to be impacted strongly by the Coronavirus – not by a long way. 

 

Interest Rates – Australia

The above chart tracks interest rate movement in Australia from prior to 2000.

Like most countries around the world, interest rates in Australia are at historic lows.  The Reserve Bank of Australia kept the cash rate unchanged, at a record low of 0.25% during its September meeting. 

Interestingly, the Reserve Bank of Australia stated that the recovery from the COVID-19 crisis is now underway in most of Australia; however, we have the uneven and bumpy recovery with the outbreak in Victoria having a noticeable effect on the Australian economy.

 

COVID-19 Across Oceania

The above chart shows the spread of the Coronavirus around the Pacific Islands, including Australia and New Zealand. 

Despite the outbreak of COVID-19 across Victoria, overall the Australian economy is getting on top of it and will be well-positioned in due course to recover from the Coronavirus.  However, they are currently embroiled in a squabble with China, which is not ideal. 

Without boring you with the details, there is a growing list of issues in contention between Australia and China.  It appears to have started with Australia backing America on the investigation into the origins of the Coronavirus.  China claimed that this hurt China’s feelings and they started pushing back.

The short of it is, this may continue for a while yet and could be seriously damaging to Australia, although as important and large as China is, they are not the only country in the world that Australia trades with.  Here is a quick list of the top five:

  1. China: US$89 billion                                                    32.7%
  2. Japan: US$24.4 billion                                                 9.0%
  3. South Korea: US$13.6 billion                                     5.0%
  4. United Kingdom: US$10.4 billion                              3.8%
  5. United States of America: US$10 billion                 3.7%

By the way, New Zealand trades with Australia as well.  From an Australian perspective, this represents $7.1 billion and only 2.6% of their exports.  New Zealand is not that important to Australia from a trade perspective compared to other options. 

 

New Zealand

The above charts show the movement in the GDT (Global Dairy Trade) price index.

GDT prices declined by 3.2% in August, which took back about half of the gain from July.  Skim milk powder prices actually rose; however, this was offset by weakening prices in butter, cheese and milk powder during the month.  Interesting when we think that tourism, depending on how you measure it, was the number one or number two driver of economic activity in NZ up until COVID-19 and now we rely once again on the farmers.

The above chart shows the price movement in residential property prices across New Zealand over the last 12 months.

The above chart shows the difference in selling prices between the rateable value and the actual selling price.

The blue chart above is quite interesting because it shows the margin between the sale price or the market price and the rateable valueAs you know, the rateable value is for rating purposes and does not actually reflect the underlying intrinsic value of the property.  As a broad blunt measure however, the market often refers to it as a reference point. 

If you look at the numbers since January, you can see that the provincial areas in some cases have shown a wider margin between the market price and the rateable value.  The likes of Gisborne and perhaps Hawkes Bay are notable examples of a wider margin, as is Southland and to a slightly lesser extent, the Marlborough district. 

So, are properties in those aforementioned areas better than in other areas? 

As we know, the market determines the price and the demand is one of those factors (along with other variables) that helps the market determine the price. 

It will be interesting to see, once we get through COVID-19, what moves property prices and whether they will remain in the flat zone for quite some time longer or whether tourism sparks back into life, immigration is born again and we have a repeat of what we have seen over the last 15 to 20 years or so.  Or will tougher lending conditions and increased regulation for landlords impact?  What do you think?

 

To Summarise

China and America continue to squabble and now Australia is also at odds with China.  We have seen some significant economic contraction around the world and central banks taking strong action to stabilise their respective economies.  It is fair to say this has worked so far. 

I know, it is not over yet. 

Still, a number of economies around the world are seeing green shoots appear as unemployment rebounds and some people are getting back to a more ‘normal’ type of work environment – but not everybody. 

Here in New Zealand some of the support that has existed throughout the spread of the Coronavirus is about to end. 

The NZ government maintains that there are other options for people that need help, although at a different level than has been the case in the past.  The short of it is, if this starts impacting on the economy or becomes politically unfavourable, then the government I imagine, will take quick steps to put things right, given the election is almost upon us. 

As you probably know, both Labour and National hover around the centre.  Sometimes it is hard to know whose policies are whose, as they attempt to steal the march on the opposition.  According to some, the election is Labour’s not to lose.  I am not sure where that leaves National?  

Of course, given the political structure in New Zealand, the Greens, New Zealand First and the Act party may have a say as well.  Anyway, for us as investors, I suspect it will make minimal difference and it will be business as usual for us. The upcoming US election might have more impact if Joe Biden wins.

The markets were in the midst of a minor correction at the time of finalising this paper, so by now we will know how that has unfolded.  Certainly, there was room for some downside, which was not unexpected.  After all, how can we obtain favourable buy prices if markets simply keep tracking up without any volatility!? 

As you may have read elsewhere, I reckon there is the possibility of third stage vaccine trials finishing in some cases as early as the end of 2020. 

This suggests, if all goes well there could be the announcement about some sort of vaccine towards the end of this year or beginning of 2021. 

That would truly be a fantastic achievement, if that is the case.  From there, it would likely take to the third and fourth quarters of 2021 to roll the vaccine out, which could provide COVID-19 containment by say, early 2022, even if it is not a cure. 

As I have also mentioned elsewhere, the markets may not wait until early 2022 before it decides that everything is looking good again …

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