Economic Update March 2020 “Going Viral”

Last month we were cautiously optimistic about the prospects for stronger global and domestic economic growth in 2020 after the disruption caused by Brexit and the trade war in 2019.  This was predicated on the assumption that the recently discovered Coronavirus outbreak in China like its predecessor SARS would be quickly contained. The economic impact would be minor, and it would be limited to the first quarter of calendar 2020.   

Clearly, we were too optimistic and risks that we flagged last month in relation to the Chinese economy and our dependence on it have escalated.  As I write the death toll of the virus stands at over 3200 and it has now spread to over 50 countries.  What has been underestimated is the disruption to global supply chains and company earnings.  Over the last two decades and mostly post the SARS virus in 2003, China has become the world’s factory and has more than doubled its share of global GDP.  We have all benefited economically from China’s rise as global and ‘just in time’ supply chains delivered ongoing deflation in the cost of so many goods from the basics such as clothing and footwear through to high end electrical and electronic items.  But as many of the world’s companies have now discovered any supply chain is only as strong as its weakest link.  The shutdown of major manufacturing centres in China and the impact of many workers not allowed to or choosing not to return to work after the Chinese New Year has seen a raft of profit warnings across a broad range of companies and sectors nationally and internationally.  It is not only China’s impact as a producer but also as a consumer. Consumer confidence and consumer spending in China is also taking a hit.  Companies like Apple for example are being hit from supply chain disruptions at the manufacturing end and at the retail end through the closure and reduced foot traffic in many of their stores in China and potentially other countries as the virus spreads.

China’s official manufacturing purchasing managers’ index (PMI) contracted to an all-time low of 35.7 in February from 50 in January.  This is below the low point reached during the Global Financial Crisis.  The OECD expects economic growth in China to be impacted by 0.8% falling to an annual growth rate of 4.9% for the calendar year.  The Chinese government is unlikely to acknowledge an annualised growth rate of below 5% and monetary and fiscal stimulus has been announced. However, rebooting the economy already weakened by the trade war is likely to be tougher this time round.  It is now inevitable that global growth will be revised downwards for calendar 2020.

Governments are responding with further interest rate cuts.  The US Federal Reserve announced an emergency rate cut on March 3rd reducing the federal funds rate by 50 basis points to a range of 1.00-1.25 percent.  The Reserve Bank of Australia announced a further lowering of the cash rate by 25 basis point on the first Tuesday in March to 0.50% to ‘support the economy as it responds to the global coronavirus outbreak.’  With rates already at record lows we remain sceptical about the ability of such actions to support the economy, stabilise markets and improve consumer confidence.  Domestic consumer confidence already below average and trending downwards following the bush fires, is expected to fall further due to the escalating fear around the Coronavirus. This will impact spending.  

More worrying, many Governments, particularly in Europe have very little fire power left to respond to any further deterioration in the global economy through either monetary or fiscal stimulus.  Australia is better placed than most in this regard with its budget and current account surpluses.  This should allow strong fiscal action and stimulus if required.

China is our largest trading partner and the disruption to both production and consumption in China will impact our economy more than most. 

Domestically we have just finished reporting season.  It was mixed with 51% of companies reporting an increase in profits for the half below the long-term average of 60%.  The impact of the virus was most evident in the company outlook statements and has already spread well beyond the tourism and travel sectors.  The ABS quarterly profits survey released on March 2nd for the December quarter and before any impact from the Coronavirus showed trend company profits declined by 0.9% for the quarter and in seasonally adjusted terms by -3.5%.  It now appears almost certain company profits domestically and globally will at best be flat in CY2020 and negative in the most impacted sectors.

As noted in our recent flash note and previous updates, we have been mindful of the increasing disconnect between earnings growth and share price growth for some time and company valuations rising to well above long term averages.  The likelihood of earnings growth playing catch up in 2020 has all but evaporated.  One rarely knows what the catalyst will be for markets to correct and rebase to more sustainable valuation multiples, but there always is one.  This time tragically it is a health crisis and the impact has been swift.  The US markets and our market fell 13% and 10% respectively in a week and we are now officially in correction territory.  How long the disruption will last is still too early to call.  Until we see reductions in the spread of the virus and infection rates further falls appear likely.  

As always economies and markets will recover but it does appear that for now our long run of economic growth without a recession is under threat.  The probability of a global recession defined as two quarters of negative world GDP growth is also increasing.  

Strategically we will not be changing our overweight position to equities in our asset allocation. With another fall in interest rates, in our view the risk reward trade-off still favours equities.  Our cash holdings have been above our target weight for some time now as we have struggled to find value in our market.  The current correction is bringing several companies on our target list back to our fair value price range and we will be capitalising on these opportunities as they arise.

Disclaimer:

Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

This publication is confidential and intended only for current clients and prospective clients of Royston Capital and their professional institutional advisors only and is not to be provided to other persons.

This publication does not constitute an offer to sell, or the solicitation of an offer to buy, any securities or any interests in investment funds advised by, or the advisory services of, Royston Capital. This publication contains general information only and does not consider your personal objectives, financial situation or needs and so you should consider its appropriateness having regard to these factors before acting on it.

No legal or tax advice is provided. Any taxation position described in this publication should be used as a guide only and is not tax advice. You should consult a registered tax agent for specific tax advice on your circumstances. Recipients should independently evaluate specific investments and trading strategies.

By accepting receipt of this publication, the recipient agrees not to distribute, offer or sell this presentation or copies of it and agrees not to make use of the publication other than for its own general information purposes.

The views expressed in this publication represent the opinions of the persons responsible for it as at its date and should not be construed as guarantees of performance with respect to any investment. Royston Capital has taken reasonable care to ensure that the information contained in this publication has been obtained from reliable sources, but no representation or warranty, express or implied, is provided in relation to the accuracy, completeness or reliability of such information. Royston Capital does not undertake and is under no obligation to update or keep current the information or content contained in this publication for future events.

Past performance is not necessarily indicative of future results.  In addition, the price and/or value of and income derived from any investment may vary because of changes in interest rates, foreign exchange rates, operational or financial conditions.  Investors may therefore get back less than originally invested.  Furthermore, these investments may not be eligible for sale in all jurisdictions or to certain categories of investors. Portfolio performance is based on a theoretical model portfolio, returns for individual investors may differ.

Royston Capital, nor its associates, does not accept any liability in negligence or otherwise for any loss or damage suffered by any party resulting from reliance on this publication.

© 2020 Royston Capital Pty Ltd.  All rights reserved.  No part of this publication may be reproduced by any means, whether graphically, electronically, mechanically or otherwise howsoever, including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission of Royston Capital Pty Ltd.

Sources:  Commbank Global Markets Research, RBA, Morningstar.Toggle panel: banner

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China’s official manufacturing purchasing managers’ index (PMI) contracted to an all-time low of 35.7 in February from 50 in January.  This is below the low point reached during the Global Financial Crisis.  The OECD expects economic growth in China to be impacted by 0.8% falling to an annual growth rate of 4.9% for the calendar year.  The Chinese government is unlikely to acknowledge an annualised growth rate of below 5% and monetary and fiscal stimulus has been announced. However, rebooting the economy already weakened by the trade war is likely to be tougher this time round.  It is now inevitable that global growth will be revised downwards for calendar 2020.

Governments are responding with further interest rate cuts.  The US Federal Reserve announced an emergency rate cut on March 3rd reducing the federal funds rate by 50 basis points to a range of 1.00-1.25 percent.  The Reserve Bank of Australia announced a further lowering of the cash rate by 25 basis point on the first Tuesday in March to 0.50% to ‘support the economy as it responds to the global coronavirus outbreak.’  With rates already at record lows we remain sceptical about the ability of such actions to support the economy, stabilise markets and improve consumer confidence.  Domestic consumer confidence already below average and trending downwards following the bush fires, is expected to fall further due to the escalating fear around the Coronavirus. This will impact spending.  

More worrying, many Governments, particularly in Europe have very little fire power left to respond to any further deterioration in the global economy through either monetary or fiscal stimulus.  Australia is better placed than most in this regard with its budget and current account surpluses.  This should allow strong fiscal action and stimulus if required.

China is our largest trading partner and the disruption to both production and consumption in China will impact our economy more than most. 

Domestically we have just finished reporting season.  It was mixed with 51% of companies reporting an increase in profits for the half below the long-term average of 60%.  The impact of the virus was most evident in the company outlook statements and has already spread well beyond the tourism and travel sectors.  The ABS quarterly profits survey released on March 2nd for the December quarter and before any impact from the Coronavirus showed trend company profits declined by 0.9% for the quarter and in seasonally adjusted terms by -3.5%.  It now appears almost certain company profits domestically and globally will at best be flat in CY2020 and negative in the most impacted sectors.

As noted in our recent flash note and previous updates, we have been mindful of the increasing disconnect between earnings growth and share price growth for some time and company valuations rising to well above long term averages.  The likelihood of earnings growth playing catch up in 2020 has all but evaporated.  One rarely knows what the catalyst will be for markets to correct and rebase to more sustainable valuation multiples, but there always is one.  This time tragically it is a health crisis and the impact has been swift.  The US markets and our market fell 13% and 10% respectively in a week and we are now officially in correction territory.  How long the disruption will last is still too early to call.  Until we see reductions in the spread of the virus and infection rates further falls appear likely.  

As always economies and markets will recover but it does appear that for now our long run of economic growth without a recession is under threat.  The probability of a global recession defined as two quarters of negative world GDP growth is also increasing.  

Strategically we will not be changing our overweight position to equities in our asset allocation. With another fall in interest rates, in our view the risk reward trade-off still favours equities.  Our cash holdings have been above our target weight for some time now as we have struggled to find value in our market.  The current correction is bringing several companies on our target list back to our fair value price range and we will be capitalising on these opportunities as they arise.

Disclaimer:

Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such.

This publication is confidential and intended only for current clients and prospective clients of Royston Capital and their professional institutional advisors only and is not to be provided to other persons.

This publication does not constitute an offer to sell, or the solicitation of an offer to buy, any securities or any interests in investment funds advised by, or the advisory services of, Royston Capital. This publication contains general information only and does not consider your personal objectives, financial situation or needs and so you should consider its appropriateness having regard to these factors before acting on it.

No legal or tax advice is provided. Any taxation position described in this publication should be used as a guide only and is not tax advice. You should consult a registered tax agent for specific tax advice on your circumstances. Recipients should independently evaluate specific investments and trading strategies.

By accepting receipt of this publication, the recipient agrees not to distribute, offer or sell this presentation or copies of it and agrees not to make use of the publication other than for its own general information purposes.

The views expressed in this publication represent the opinions of the persons responsible for it as at its date and should not be construed as guarantees of performance with respect to any investment. Royston Capital has taken reasonable care to ensure that the information contained in this publication has been obtained from reliable sources, but no representation or warranty, express or implied, is provided in relation to the accuracy, completeness or reliability of such information. Royston Capital does not undertake and is under no obligation to update or keep current the information or content contained in this publication for future events.

Past performance is not necessarily indicative of future results.  In addition, the price and/or value of and income derived from any investment may vary because of changes in interest rates, foreign exchange rates, operational or financial conditions.  Investors may therefore get back less than originally invested.  Furthermore, these investments may not be eligible for sale in all jurisdictions or to certain categories of investors. Portfolio performance is based on a theoretical model portfolio, returns for individual investors may differ.

Royston Capital, nor its associates, does not accept any liability in negligence or otherwise for any loss or damage suffered by any party resulting from reliance on this publication.

© 2020 Royston Capital Pty Ltd.  All rights reserved.  No part of this publication may be reproduced by any means, whether graphically, electronically, mechanically or otherwise howsoever, including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission of Royston Capital Pty Ltd.

Sources:  Commbank Global Markets Research, RBA, Morningstar.