Economic Update Dec 2020 to Jan 2021 – ‘Island Life’

I think I can safely say that 2020 did not go as originally planned. 2019 had seen equity markets rise and was one of the best performing years in decades. I noted on many occasions that valuations were stretched, resulting in overweight cash positions for many portfolios in the lead up to 2020. It was frustrating, but no one was expecting 2020 to turn out the way it did. Several records were broken in 2020, new market peaks were achieved early in the year; the fastest bear market in history in March, followed by the fastest time to a bull market; and we are rounding out the year with an exceptionally strong November and new all-time highs being registered in US markets. 2020 was a year of challenges that often tested our patience but, as I reiterated at our Smart Investor Market Update in early December, those who can stick to their long-term investment strategy were ultimately relived and rewarded by staying invested and prudently deploying cash that had built up during 2019.

The spread of Covid-19 (the pandemic) around the world and its arrival in Australia early in 2020 has had a significant and dramatic impact on the economy, investment markets and our lives. Australia’s effort to control the pandemic has been impressive. While there was a serious second wave in Victoria and some hiccups in Adelaide and now Sydney, Australia has by and large done an exemplary job. Being an island has its benefits.

In response to the pandemic governments have deployed extraordinary fiscal and monetary policy support. In Australia, with this support and the role of the Australian banking system, the economic impact of the pandemic has been far less severe than originally expected. Although, it did end Australia’s stellar 30yr run without a recession. An unemployment rate of 7.5% is good in terms of the expected outcomes from earlier in the year, but the human toll of such a fast rise in the unemployment rate is very real.

The onset of the pandemic and the ‘stay at home’ orders enforced rapid change in our lives and the economy. Technology has been embraced like never before. We are all now experts at online meetings via Microsoft Teams and Zoom, and we are all much happier to purchase almost anything online and have it delivered to our homes.  For many economists, they have seen a sharp increase in their use of ‘high-frequency’ (internally) generated data. This data has now been firmly integrated into their practices to provide better, more up-to-date information than ever before, no longer relying on Australian Bureau of Statistics (ABS) data to be released 5-6 weeks after the fact.  Banks for example can use data from income flowing into bank accounts such as JobSeeker, JobKeeper and wages, and see those funds flowing into savings. Credit Card data can then be used to see where the funds are being spent.

The data has told us that income growth has been very strong through the pandemic with more income flowing into bank accounts than before the pandemic. This income has however primarily come from the government via JobSeeker and JobKeeper. Private sector wage payments are also starting to rise helped by the bringing forward of income tax cuts and an improving jobs market.  The CBA noted that total income flowing into CBA accounts was up circa 1.5% for the year to 11 December. Household income is growing at a rate vastly above wages growth and a large part of that is being saved. This savings pool will provide support to the consumer and the economy in 2021.  The result of this is that Australia will have one of the shallowest recessions of all major economies in 2020.

Looking forward to 2021 the economy will be supported by the ongoing re-opening of the economy (including state borders), further improvements in consumer confidence, tapering of government support offset by draw down on savings accrued during 2020, improvement in the housing market, and a pick-up in domestic tourism.  The Mid-Year Economic and Fiscal Outlook has already revealed the better-than-expected economic outlook and those higher commodity prices should see the budget deficit come in lower than forecast. For our exporters, the AUD$ is likely to continue its rise throughout 2021.

The better-than-expected economic and budget outlook means that government debt will accumulate at a slower rate. While some may be concerned about the sheer size of the debt, it should be noted that the interest cost of the increased debt will be very low. The Reserve Bank of Australia (RBA) is now holing interest rates at 0.10%. The economic benefit from the increase in Commonwealth debt will far exceed interest costs.

The RBA will continue to support government borrowing with the cash rate target expected to remain at 0.10% for at least 3 years. The RBA has also entered a Quantitative Easing program and is buying Commonwealth and State government bonds. Having entered unconventional monetary policy, it will take some time before the RBA can unwind the strategy.

Globally, 2020 is likely to be the weakest gross domestic product (GDP) print since WWII. As I write, unfortunately, Europe, the UK and other northern hemisphere countries move back into lockdowns to try and stop the exponential growth of the second wave of the pandemic. A new strain in the UK has forced PM Boris Johnstone to change tack and what was looking like a Christmas with a small group of family and/or friends has been scuttled. The UK, Europe and to a lesser extent the US, are at risk of a double-dip recession.

On top of the pandemic, Europe continues to have other general economic issues (a bit of a hangover from the GFC) and BREXIT (due to be signed-off on 31 Dec) still has a few issues notably, fishing rights for the French in UK waters and state-based aid for corporates, the latter possibly being a deliberate bargaining chip implanted by Boris Johnstone. It seems both parties are far apart, only time will tell. For now, we see it as a short-term risk.

In the US, Joe Biden has been confirmed as the President Elect but there remain several political risks ahead of the 20 January inauguration. President Trump has been heard speaking of imposing military rule and re-running the election…..to say that Trump could say or do anything between now and inauguration would be an understatement. Fortunately, his party seems to be distancing themselves.

Joe Biden in our view is highly probable to be sworn in on 20 January and we anticipate that he and his team will focus immediately on, controlling the virus, implementing a fiscal stimulus package, reviewing health care, trade policy, tax reform and infrastructure. Joe Biden continues to build a solid team around him and has recently appointed former Federal Reserve (FED) chairperson, Janet Yellen, as Treasury Secretary.

Again, as I write, I am reading that the US government has approved a $900b fiscal package. This is a good step forward, but a few issues remain. The FED has extended its stimulus ‘until substantial further progress has been made towards maximum employment and price stability goals’.  Full employment and inflation (exceed initial target of 2%) are to be achieved before any change to the current policy. The monetary policy of mantra of central banks around the world can be heard loud and clear – ‘lower for longer’.

China is in contrast with most of the rest of the world. GDP is expected to be positive for 2020 and Authorities are focused on expanding industrial production and investment. They have released their 14th 5yr plan which has included the Dual Circulation Policy (DCP). The DCP lifts the focus of the domestic market or internal circulation. It is a strategic blueprint for the country and its economy to adapt to increasing instability and hostility in the global environment. Replacing high-speed growth with high-quality growth is on the agenda. This suggests a reduced focus on infrastructure and export growth and a refocus on internal growth. The outsized spending on infrastructure has resulted in diminishing returns in real economic terms in more recent times. It is possible we may witness peak demand for iron ore and metallurgical coal from China in 2021.

To date this has been good news for Australia. Iron ore prices have sky rocketed and in fact the value of iron ore exports reached a high of AUD$10.9b in October…..much to the displeasure of China. There are of course growing concerns over the Australia-China diplomatic freeze. So far this has resulted in tariffs and the outright ban of some of Australia’s exports to China. A substantial reduction in exports to China poses a downside risk for the Australian economy in the years ahead and suggest that a more diversified export base is needed. This is a warning from China to other nations and for Australia it is a wake-up call that we have become overly reliant on the export market to China.

The new year for investment markets will launch from an elevated position, if not overvalued, if you measure valuation purely on PE ratios. US indices are at record highs and the expectations for investors are also high, valuations continue to rise and become exposed to disappointment. We are all familiar with the term FOMO (fear of missing out), but 2021 may be the year of TINA (there is no alternative). Bond yields remain corralled at ultra-low levels and while they do TINA will prevail, but it wont last forever. Central banks are aware of the longer-term problems they are creating in underwriting underperforming companies and that current monetary policy ultimately delivers diminishing returns in terms of economic activity and job creation.

2019 closed on a high, and surprisingly equity markets will finish 2020 on a high note too. Being an island nation, Australia has had a much better chance at containing the Covid-19 pandemic and as we enter summer we seem to be in a good position (despite the current outbreak in Sydney) both with the virus and the economy. Lockdowns in Sydney do have the potential to derail Australia’s recovery, but we will have much better data and confidence in any vaccine that is released to the public before winter sets in. A double dip recession in Europe and BREXIT hang over us along with China-Australia diplomatic tensions but a politically stable and predicable US Presidency should provide support. 2021 is likely to be a rollercoaster but we are predicting for a smooth finish to the year as vaccines are rolled out and international boarder re-openings become a reality.

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