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Over the past few months, we have entered a troubling time for the world. Lives are being lost, and most countries have entered varying degrees of lockdown. Most don’t have enough hospital beds, ventilators or medical professionals to deal with the pandemic and any spike in cases. The world as we know it has changed and the economic impacts are significant and difficult to quantify.
We know that the world has entered a recession, but we don’t know the magnitude or extent. Economists are forecasting unemployment rates around the world will hit 10-20% over the next few quarters. The US has seen jobless claims rise to over 20 million, which implies an unemployment rate of 16%.
Fortunately, governments are stepping in with fiscal policies to provide varying degrees of unemployment benefits and wage support to companies, where employees are furloughed (forced leave). This will lead to a surge in government debt as trillions of dollars are spent, which will one day need to be paid back by taxpayers. In Australia, the government has announced $320 billion of support, representing 16.4% of annual GDP, while the US is providing a US$2 to US$3 trillion relief package.
The last time global economies looked this weak was in 1938. If you had asked me a few months ago how much would I expect the stock market to be down under this scenario, I would have expected a lot more than the current 11% decline in the S&P500 year-to-date.
Let’s not forget that the US market was trading at elevated valuation multiples before these declines. European markets have been some of the hardest hit, with the French CAC down 25% year to date, and the UK FTSE down 23%. Australia’s All Ordinaries Index is in the middle of the pack down about 18% this calendar year.
The varying degrees of performance has more to do with the mix of sectors and stocks in each index than the economic impacts of the pandemic. The S&P500 is now more concentrated than ever with the top five companies representing 21% of the index. Microsoft, Amazon, Apple, Alphabet and Facebook have performed incredibly well over the past few months.
Many of these companies benefit from the current situation of people staying indoors. Ecommerce is accelerating, benefiting Amazon, while Microsoft Teams and the growth of the cloud are supporting Microsoft’s businesses. Alphabet’s and Facebook’s businesses will be tested as it is hard to see advertising spend holding up in the current environment.
The difference between the current GCC (global consumer crisis) and the GFC (global financial crisis) is that the consumer represents a bigger proportion of GDP than banks and the financial industry did. So, when people stay inside and stop spending, this has a larger impact on incomes and GDP.
The second large difference is that while central bank rates were above 4% prior to the GFC, most central banks have started this recession around 2%. Central banks have shot every bullet they have in the past month, with the Federal Reserve cutting the fed funds rate to zero and announcing a plan to provide up to $2.3 trillion in loans to support the economy. They are purchasing $700 billion in US treasuries and mortgage-backed securities. This has flooded financial markets with liquidity, which has quickly found its way into equity markets.
Other central banks have taken similar steps with the Reserve Bank of Australia following Europe and Japan into a path of quantitative easing. So, we are at a crossroads where money is free and while fundamentals appear to be deteriorating the stock market is rejoicing in this new flow of funds and declining discount rates.
A few weeks ago, we suggested it may be time to invest in global stocks while hedging the currency back to Australian dollars. The Australian dollar had dipped below 60c to the US dollar but the interest rate differential between Australia and the US had disappeared. Furthermore, Australia has dealt with the pandemic exceptionally well over the past six weeks.
The issue we have in Australia is that we don’t have a deep pool of stocks in a variety of sectors. We have been adding to existing positions and buying stocks in essential service sectors. These stocks include technology stocks like Alibaba, which is the leading e-commerce and payments company in China, as well as the leader in the cloud. They are China’s equivalent of Amazon, but Alibaba trades on valuation levels that are half of Amazon. While most people have only heard of US large-cap tech stocks, we think the opportunity to buy high quality businesses trading at a discount to fair value is much greater outside the US.
Consumer staples stocks are also winners in the current environment. Woolworths and Coles are doing well. This phenomenon is similar all around the world. Proctor & Gamble recently posted its biggest US sales increase in decades, with US sales up 10% for the March quarter. In the months of March and April, packaged food sales around the world have been growing at a double digit pace.
The largest position in the fund I manage is Nomad Foods. It is a leader in frozen foods in Europe, with over 15% market share of the UK frozen foods market with brands such as Birds Eye and Aunt Bessie’s. They have also seen double-digit sales growth over the past few months as people eat at home more. Both Nomad foods and Alibaba also fit our criteria of companies with leading goods or services, managed by owner managers.
Healthcare is another sector that will continue to do well, irrespective of how the economy goes over the next year or two. Companies like United Health, a leading health insurer and technology provider to the US healthcare system, and Fresenius Medical, a leading provider of dialysis equipment and services for patients with chronic kidney failure, continue to deliver a steady stream of earnings and cashflow.
It’s important to accumulate stocks over the long term and buy when others are fearful. A month ago, there was a lot of fear and valuations were attractive. Now we see more greed despite economic fundamentals that are still deteriorating.
I think the biggest bounce will come from cyclical companies when we exit this recession, although it is not clear exactly when we will exit this recession. For the time being, the best plan of attack is to continue to accumulate quality companies in essential services, that are trading at attractive valuations. Investors should keep some powder dry for a reporting season in three months’ time, which will reveal how weak the economy really is.
Charlie Munger, Vice Chairman of Berkshire Hathaway Inc. and Warren Buffett’s long-time business partner, likes to say that one of the keys to great investing results is “sitting on your ass.” That means doing nothing the vast majority of the time but buying with aggression when bargains abound.
Berkshire Hathaway is also one of our biggest positions, and Buffett hasn’t really deployed the significant pile of cash on the balance sheet, which represents about 20% of their portfolio of companies and stocks. Munger was recently quoted in the Wall Street Journal as saying:
“Of course we’re having a recession. The only question is how big it’s going to be and how long it’s going to last. I think we do know that this will pass. But how much damage, and how much recession, and how long it will last, nobody knows."
First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.