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Markets such as the one we're experiencing now show that we can't be agnostic about what's happening in the wider world. So, when I think about macro conditions and where markets might go, I always use a really simple way to break it down into three factors:
If we've got good earnings growth, reasonable valuations, and abundant liquidity, then markets are more likely to go up. And vice versa. So, let's break it down.
As we all know, we're in the midst of a pandemic which is bringing economic conditions that we haven't seen for a hundred years. If we look at the US, Gross Domestic Product (GDP) is probably going to be down 35% quarter on quarter for the second quarter.
Take the example of the energy sector. It is facing a triple whammy of excess supply, absent demand, and no access to capital markets to cushion the blow.
So, what we saw in March and April was the first half of the storm, the human cost, but soon we’ll begin to see the economic toll. One of the research providers that we talk to uses an analogy of dynamite fishing - where you blow up some dynamite beneath the water and then the fish start to rise to the surface. The first ones to rise are the little ones and then over time the bigger and bigger ones begin to rise.
This is the kind of process that will happen now. It takes a while for companies to experience financial distress and then actually go through to insolvency or bankruptcy. There's a lot of companies doing it tough now and we'll only see the ultimate impact as time goes by. So, we know the news will get worse from here but we don't know how bad it will be relative to our expectations.
Valuations are not cheap. When you have periods of big volatility, predicting what earnings will look like becomes challenging and particularly hard because more than half of the companies on the Australian stock market have withdrawn guidance. Any kind of interim earnings estimate is really just a guess. But if you make some kind of a guess and then look at the price, we're actually back up to mid-term highs on PEs, although more so in the US market than here.
Australia’s price to book value is a better measure because it's more stable, but still moving around because there will be some write downs that will have to come out of this.
What’s impacting valuations on the other side though, is that we moved from a lower-for-longer expectation for interest rates to a lower-for-forever or lower-for-the-vast-foreseeable-future. And that is also putting a floor under valuations.
I think Australia and the US will have different fundamental outcomes but I think our valuation parameters are likely to be set by what happens in the US market. Lower rates or high valuation metrics in the US will boost us. If the US has challenging outcomes and their valuation parameters go back down, that will likely drag us back down too.
So that leads us to a really interesting question. What timeframe is the market currently discounting? Because we know that for maybe the next six months at least, economic outcomes will be very negative. So, either markets are looking through that and discounting all the way out - saying, “Well, I know this is going to be bad, but there's also the stimulus. And so, okay, I'll look through that.” And that's why share prices have bounced back up. Or markets are just not discounting at all.
How would that be?
We know markets are supposed to be discounting machines. They're supposed to look ahead and price every factor in to the value of stocks. We've had an unprecedented shift towards algorithmic and quantitative trading. I’ve been talking about this for a while and the shift of market participants from those that are trying to arbitrage price to fair value versus those in their trading on other proxies of outperformance.
It's possible now that the marginal buyer of markets is a bot or an algorithm that doesn't actually hear rumours, only published data. That old function - "I'll buy the rumour and sell the fact" or vice versa is not actually working anymore. Markets are not discounting the negative picture of the next six months. So, they've either lost a lot of the discounting capability and are just looking at the benign conditions that are currently on paper, or markets are looking all the way through to the end of this, even though we really don't even know how far in the future that is.
In March, we had a massive dislocation with very leveraged players, highly exposed to equity markets. As they exited positions, it created an enormously painful and rapid downdraft in share prices.
We've had enormous multi-trillion dollar Fed flows to the rescue and that put a floor under the panic and closed a lot of the arbitrage gaps that had opened up. But positioning in equity markets is now more fearful rather than risk-taking, so there's more money on the sidelines.
On the Australian side of the equation, the really interesting part now is superannuation. Super is an enormously-wonderful factor in the Australian economy, but right now we're asking a lot of it. We're asking for super to be the corporate re-capper. We've had a tonne of recapitalisations and they keep coming every single day. So we want superannuation money there to front up and buy these new issues.
And we now have a new role for super. We want it to be the household piggy bank. If a person has a cashflow problem now, they go to the ATO website and withdraw $10,000, and then again in July.
We now also want superannuation to abstain from dividends if companies cut or halve or restrict their dividends. And this is new for them because these superannuation funds have relied on very high dividend flows from their equity holdings. The Government is also asking super providers to step up and fund infrastructure and contribute to nation-building projects.
That’s all a big ask on superannuation and it's definitely a change from 2008 when super just stood there as a re-capping vehicle.
So, what does that all mean? We know that the fundamentals will get worse from here, but there's excess liquidity and the lower-forever impact of interest rates is currently putting a floor under valuations. Over the next few months, as we move from the eye of the storm to the economically-devastating bit, we'll see if low rates and high liquidity are still enough to support markets.
We’ll find out if markets were looking way out ahead or actually not even as far as their noses.
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