Tag Archives: Markets

Unintended consequences of Government COVID-19 Policies

By visual /May 13,2020/

For every action there is a reaction. And while we’re not criticising the government’s policy response to COVID-19, we recognise that such intervention often has unintended consequences. 

Take lower interest rates for instance. Central banks intended to make the cost of investment cheaper and be stimulatory. Instead, Australian households borrowed more money to buy bigger and better houses and US corporates levered up to buy back shares. Both actions have contributed to the economy’s current precarious situation.

One needs to think laterally when considering unintended consequences, something we apply our collective minds to. Why? Unintended consequences can impact the long-term prospects of companies and industries, both positively and negatively.

A costly decision

Providing a payment holiday seems like the right thing for banks to do given the unique circumstances. However, is it simply delaying the inevitable?

While a payment holiday means you don’t have to pay principal or interest over a six-month period, interest still accrues. In other words, after the payment holiday you have more debt. Imagine if the asset against that debt, maybe your family home or investment property, is worth less in six-12 months’ time. That leaves you with a higher liability and lower asset value.

If the servicer of the loan cannot find a job and is forced to sell in a depressed market, this becomes permanent financial damage. The unintended consequence of a payment holiday for SMEs and households could be a bigger problem down the track.

Credit rationing

Banks are experiencing significant demand for credit from existing customers. SMEs and households are getting payment holidays and larger corporates are drawing down any credit line they can. This is extremely capital consumptive for banks.

While the RBA is providing adequate liquidity and the government is providing motivation to extend credit to SMEs, there’s little motivation for banks to take on new customers, either consumers or SMEs. We believe credit rationing for new customers is likely, with non-bank lenders pulling back at the same time. This will provide a headwind for the economy, with a reduced number of business start-ups in the short to medium term.

Commercial property 

SMEs are most likely to use retail and office properties. To keep SMEs afloat, the government is addressing the two biggest costs, one of which is rent. The government has set up rules for a Mandatory Code of Conduct which helps tenants with turnover up to $50m. Essentially, the commercial landlord must take the same revenue hit as the tenant. At least half of this rent is waived completely, and the rest is deferred.

This is a smart move politically because there’s a perception that commercial landlords are rich, so there’s little sympathy from the public. However, unintended consequences are likely.

Commercial property is an attractive investment for two reasons; the stability of cashflows and the ability to borrow large sums of money against the asset. Landlords generally don’t get to participate in the upside when a tenant’s sales are going through the roof, but on the flip side, when the going’s not so good, they still get paid or can replace the tenant.

Banks traditionally liked lending to commercial property owners because of stable cashflows, the security of a hard asset and there wasn’t that operating leverage as is the case in most businesses. A precedent has now been now been set.

Commercial landlords now must cop the downside being felt by their tenants. There is even a six-month moratorium on evictions; so this asset, which was generating cash and servicing a debt, is generating no cash and there is nothing the landlord can do about it.

When the dust settles, banks are going to want more collateral and will likely lower loan to value ratios at a time when values could be under pressure. Given the importance of debt finance for most commercial property investors, this is likely to negatively impact valuations in the medium term.

The unintended consequences could include landlords hiking rents to take this new risk into consideration. If unable to increase rents, the result could be an accelerated downcycle in commercial property valuations, which would provide a further headwind for credit providers, which in turn could lead to further credit rationing.

Policies being implemented today have numerous unintended consequences that may impact the long-term prospects of many industries. This includes changes to supply chains from global just-in-time inventory systems to relying more on domestic supply chains. Immigration may slow to a trickle which, in turn, will impact economic growth.

Source: Perpetual

Geopolitical risks for the economy and investments

By visual /May 13,2020/

The world has always been challenged by the dynamics of geopolitics. The nature and magnitude of associated conflicts may transition and manifest across varying contexts but, broadly speaking, geopolitical risk is ever present.

The fierce competition between the powerhouses of the East and West has been watched closely by many. The trade war between the US and China, characterised by tit-for-tat tariffs, continues to disrupt major global supply chains with greater levels of exposure to the two while threatening to hinder global economic growth, albeit the extent to which is difficult to determine.

Numerous attempts to assess the impact and cost of the trade war between the US and China have been undertaken and recent research by the International Monetary Fund estimated the combined effect of the tariffs announced in 2018 and the recently announced tariffs this year could lower global GDP by 0.5% in 2020.

However, not all market participants are worse off as a result of the disputes between the US and China. While the impact of the trade war has affected the financial markets, primarily through its effect on investor sentiment, more broadly there could be opportunities for some nations to benefit from a potential diversion of trade, particularly for economies who have the competitive capacity to replace US and Chinese firms .

The open rivalry and strategic competition comes as China makes progress towards achieving its major long- term goal in becoming a “moderately prosperous country” by 2020. As part of this strategy, China aims to become a “global innovation power in science and technology” along with several other goals relating to sustainability of its growth.

Some of the actions China is alleged to have taken to achieve this, including allegations of inappropriate transfer of IP and technology, have raised concerns over national security for the US. This issue has been a driving force behind the protracted trade negotiations between the two countries with negotiations stalling on matters related to restrictions placed on some of China’s largest players in the tech industry. The tensions between the two nations are likely to remain while the possibility of a trade deal is still unknown.

Recently the People’s Bank of China (PBoC) let the yuan depreciate in its daily rate fixing, to be above the key USD/CNY 7 mark. Key reasons for the RMB depreciation is suggested to be in support of growth in light of the impact of US tariffs on China. Recent measures by China to combat US tariffs through a devalued yuan has soured the outlook for a trade deal.

While China is caught in a challenging set of negotiations with the US, it is facing unrest within its own country. In 1997, when the UK handed Hong Kong over to China, a One Country, Two Systems Framework was established which set out civic freedoms and a high level of autonomy, including judicial independence.

Recently proposed amendments to Hong Kong’s Fugitives Bill to allow extradition of fugitives not only to China, but to any jurisdiction in the world with which the territory has no existing formal agreement, has led to protests in the streets of Hong Kong over concerns and fears that the law could be abused by China for political or commercial reasons.

What began as a peaceful protest against an amendment to Hong Kong’s Fugitive Bill has now turned into the revival of a deeper-rooted issue reminiscent of the 2014 Umbrella Movement. While it is an example of China’s assertion of power within its own borders, it too is a demonstration of a clash of political ideology and symbolic of the gradual reclaim of power that has long been vested in the West.

Changing geopolitical relationships is also clear in the pending UK exit from the European Union (EU). The outcome remains more uncertain yet following the resignation of May only months before the Brexit deadline. Oxford Economics’ modelling of the economic implications assumes the base case as the UK continuing its EU membership.

In this model, all scenarios show a degree of trade destruction in which UK trade volumes decline as a share of GDP, reflecting the increased cost of trade between the regions, encouraging consumption of domestically produced goods instead. In the worst case scenario, compared to the base case, exports fall by as much as 8.8% and imports by up to 9.4%. The loss contributes to a 3.9% loss of GDP when factoring in events, such as a drop in labour productivity and foreign direct investment.

The rise of widespread geopolitical issues comes at a time when the world economy is slowing. The uncertain impact of potential US tariffs and the course of the UK’s pending divorce from the EU continues to introduce greater levels of volatility into the markets.

Source: BT

Economic Update

By visual /May 13,2020/

Market and Economic overview

Australia

The coronavirus ‘curve’ of known cases has flattened out, suggesting social distancing measures have been successful in slowing the spread of the disease.

The focus is now on a gradual easing of restrictions – people will gradually start returning to work as non-essential areas of the economy start to function again.

It will take time for conditions to normalise completely – borders remain closed to overseas visitors, for example, so tourism-related areas of the economy will continue to struggle.

It remains too early to say how significant the slowdown will be, but some observers have suggested the Australian economy could contract by approximately 5% in 2020. At the same time, consensus expectations suggest unemployment could double, from around 5% in February to perhaps 10% during the course of this year.

Job security is low and house prices appear likely to fall, which could further dampen sentiment. For now, credit card spending is running nearly -20% below the corresponding period a year ago, highlighting the current weakness in consumer confidence.

United States

By the end of April, more than 1 million people in the USA had been diagnosed with coronavirus.

Like other countries, the US had implemented various closures and restrictions. The ‘30 Days to Slow the Spread’ expired on 1 May 2020 and President Trump has suggested social distancing restrictions will not be extended.

Trump appears determined to reopen the economy as soon as possible, against the recommendations of some medical professionals. Ultimately, he wants the economy firing again in the run-up to the Presidential election in November.

The latest data showed the world’s largest economy shrank at an annual rate of -4.8% in the March quarter, even worse than consensus forecasts.

The downturn was due to economic disruptions in March. Data for the June quarter is expected to be worse still given more extensive closures during April, at least.

Europe

Much of Europe remains in lockdown, although numbers of cases vary quite markedly across the region. Germany – the largest economy in Europe – has much fewer cases than some other countries such as France, Italy, Spain and the UK. The economic impact might therefore differ between countries but will undoubtedly be significant overall.

Euro Area GDP growth declined at an annual rate of -3.3% in the March quarter and is expected to fall further in the June quarter.

Annual growth rates were lower still in some of the region’s major economies: France -5.4%; Italy -4.8%; and Spain -4.1%.

New Zealand

Restrictions have been eased in New Zealand; ‘Level 3’ measures are now in place – similar to those in Australia – after the more stringent ‘Level 4’ lockdown was no longer deemed necessary.

The Reserve Bank of New Zealand remains very active with its recently introduced asset purchase program. The Bank is buying large amounts of government and local authority bonds to ensure the smooth operation of the local fixed income market.

Asia

China’s economy shrank at an annual rate of -6.8% in the March quarter; a sharp slowdown from the 6.0% year-on-year growth seen in the December quarter of 2019.

The industrial sector was hardest hit by the near two-month shutdown of non-essential parts of the economy.

Whilst alarming, the short-term contraction will not impede China’s long-term growth trajectory, according to officials. That said, conditions could remain subdued in the foreseeable future.

Australian dollar

The Australian dollar clawed back all of its lost ground from March. The currency gained 7.0% against the US dollar, closing April at 65.5 US cents. Similar strength was seen against other currencies too.

Commodities

Most commodity prices finished the month of April stronger as demand uncertainty eased. Following sharp falls in March, copper (8.0%), nickel (8.0%) and zinc (3.4%) posted solid gains, although not enough to recover previous losses.

Iron ore (1.4%) reversed its downward trend on signs of a turnaround in Chinese manufacturing activity and reflecting China’s economic stimulus plans.

Oil prices (WTI Crude -26.6%) continued to fall, although stemmed losses towards month end on evidence of falling production.

The gold price (7.6%) again proved resilient against a backdrop of ongoing market uncertainty, while platinum (9.8%) and silver (10.1%) bounced back after March’s sharp falls.

Australian equities

The equity market recovery in the last week of March continued throughout April. The S&P/ASX 100 Accumulation Index rose 8.4%, registering its strongest monthly return since 1988.

Confidence was initially supported by the huge monetary and fiscal responses to the pandemic and later by encouragement that social distancing restrictions were proving effective.

The full impact of the virus remains unknown, however, and the shock to company earnings and balance sheets has placed additional pressure on dividend policies. At the same time, most companies have withdrawn earnings guidance.

Australia’s banks continued to underperform, as delays to mortgage payments and decreased property activity threaten earnings. The growing prospect of dividend cuts and the view that the banks will play a key role in supporting the economy has further dragged on investor sentiment.

Listed property

After plunging dramatically in March, global listed property markets rebounded in April. The COVID-19 situation continues to be the dominant driver of property securities. Due to virus containment measures globally, including widespread lockdowns, there are rising expectations for sweeping rent abatements across the sector, particularly in the most heavily hit sub-sectors such as discretionary retail. Many listed property securities globally have now withdrawn their earnings and dividend guidance due to the uncertainty.

 Global equities

Unprecedented levels of monetary and fiscal support helped global markets stage a remarkable recovery. The MSCI World Index bounced 10.6% in local currency returns in April – its strongest month since 1975. The appreciation of the Australian currency tempered global equity returns for domestic investors, with the MSCI World Index rising ‘only’ 3.7% in Australian dollar terms.

UK equities were the weakest performers in April, with oil giant Shell announcing a cut in its dividend. Financial stocks also weakened after Lloyds revealed a large drop in profits. Disappointing returns from energy and financials stocks have contributed to the underperformance of the MSCI World Value Index in recent months.

Global and Australian Fixed Income

Bond markets were substantially calmer in April compared to March as central bank support programs appeared to be having their desired effect.

The Reserve Bank of Australia, for example, has bought around $50 billion of government and state government bonds in the past few weeks. This has materially improved liquidity and helped steady the local bond market.

Benchmark 10-year US Treasury yields closed April just 0.03 percentage points lower, at 0.64%. Yields also declined in the UK, Germany and Japan, by 13 bps, 12 bps and 5 bps, respectively.

Australian yields moved in the opposite direction, though not significantly. The yield on 10-year Commonwealth Government bonds closed the month 13 bps higher, at 0.89%. This resulted in a modest negative return from the domestic bond market.

 Global credit

Like shares, corporate bonds were buoyed by an improvement in risk appetite globally. Credit spreads – the difference in yield between corporate bonds and comparable high-quality government bonds – narrowed substantially.

Companies looked to take advantage of improving risk appetite and strong inflows into the asset class by offering a substantial amount of new bonds. In some cases, this was to bolster their balance sheets to help cushion the impact of a more prolonged period of lower profitability.

 

Source: Colonial First State

Dividend cuts – what can investors expect?

By visual /May 13,2020/

Since the financial crisis more than a decade ago, investors have had to search much harder for income as savings rates have plunged.

Many have looked to the equity market to help them achieve better income returns, with large numbers of companies increasing dividend payments to shareholders as they have grown.

It is likely that equities will continue to provide a relatively attractive source of income for those comfortable with the risks of investing in the stock market. However, regrettably, dividend payments for most equity income investors are likely to be lower than in previous years for the foreseeable future as a result of the coronavirus crisis.

Here we explain why and give our views on the outlook for dividend payments over the medium and longer term.

The equity income fund model

Equity funds that have a focus on investing for income as well as the potential for capital growth are called equity income funds.

A dividend is an income payment from an investment. The dividends that investors receive from an equity income fund directly reflect the dividends received from companies that the fund holds shares in. This money is paid out to unit or shareholders in proportion to the size of their holdings.

One aim in managing an equity income fund can be to increase dividend payments to investors over time. A manager may aim to achieve this through focusing investment on successful businesses that have the potential to increase their dividend payments as they increase their profits. The income and capital value of an equity income fund can go down as well as up and investors may not get back the amount they invest.

How the coronavirus crisis has impacted companies’ dividend plans

The coronavirus crisis has blown the carefully laid plans of large numbers of companies around the world way off course.

For the time being, the revenue streams of many good businesses have been drastically reduced. And for some, in the most exposed sectors, they have effectively evaporated. All the while, there are costs that must still be met alongside obligations towards key stakeholders including employees, customers and suppliers.

As in any crisis, there are exceptions – some supermarkets, for example, have experienced a surge in sales during the lockdown period – but the management of a great many companies now have a single overriding focus: navigating their way through the current unprecedented conditions as best they can.

It should therefore come as no surprise that many companies have announced that they are reducing their dividend payments or in some cases, suspending them entirely. In most cases we believe this should be welcomed in the short term as it will provide necessary funds to shore up businesses, helping them to ensure their long-term viability once the immediate crisis has passed.

We expect to see more companies follow suit over the coming months, with many likely to err on the side of caution in setting their dividend policies, given the high degree of uncertainty we are all living with.

Companies that have been forced to accept Government assistance will find it difficult to continue paying dividends.  And in some countries, banks have been instructed not to pay to a dividend to preserve capital so that they can provide finance to companies that need it.

The knock-on impact on equity income funds

When investing in equities for income you are left with a choice between trying to maintain the level of your dividend income or accepting that it will fall.

Importantly, this does not have to mean abandoning an aim to grow your income over the long-term. This can sensibly remain a key consideration in your stock selection. Instead you may wish to consider each company on an individual basis, assessing how well they are positioned to come through the crisis without fundamental changes to their long-term business case, which will impact their ability to pay dividends going forward.

An insistence on maintaining the dividend of an equity income fund in the current environment would, in most cases, force you into investing in a narrow, less diversified range of stocks. Accepting a cut in the dividend on the other hand can allow you to maintain a focus on investing in the companies that are most likely to help you achieve your long-term objectives in both income and growth terms.

Bouncing back following a crisis

In the wake of crisis situations, companies that have cut their dividends to prioritise cash holdings that enable them to operate and trade effectively can often recover faster than those that have blindly pursued the maintenance of dividend targets set in a completely different environment.

When the economic environment improves, these companies have the potential to restore and grow their dividends again from a position of comparative strength. A look at past crises shows that the overall impact on the intrinsic value of a business from a temporary dividend cut is generally small and, for long-term investors, it is important not to lose track of that fact amid the short-term market noise.

The outlook for dividends and equity income investors over the medium and long term

The shape of the recovery from the coronavirus crisis remains far from clear. There are indications that the strict lockdown conditions in place in many countries could be relaxed reasonably soon, enabling some limited activity to resume.

Realistically however, we all face a long wait for anything approximating ‘business as normal’ to resume, given that the only route to achieving this appears to be the development and implementation of an effective vaccination programme on a global scale.

This is unlikely to come together until well into next year, even if one of the vaccines that have already begun human trials proves effective.

This means that dividend payments over the next three years or so are likely to remain well below levels seen in 2019. There is no precedent for the current crisis but estimates of the eventual cut in dividends for the UK market as a whole in 2020 have so far ranged from around 25% to as high as 50%.

Longer term, a return to ‘business as normal’ for the economy is likely to lead to a return to ‘business as normal’ for dividends and by extension equity income funds.

It is possible that we could begin to see more companies around the world adopt more conservative dividend policies along the lines of Asian businesses. However, the aftermath of past crises would suggest that while companies may change their behaviour for a couple of years, they often then revert to the way that things were before.

Source: Schroders.