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In this update we examine why markets where so strong, factors driving the rebound, and the outlook for the year ahead.
Why Markets Boomed in a Year of Human Misery
The New York Times recently published a very interesting article providing some further insight into why equity markets were so strong in 2020. It was not just the US Federal Reserve cutting interest rates or government stimulus. The rise in savings among white-collar workers created a tide lifting nearly all financial assets.
Chart 1 – A combination of soaring income and falling spending pushed the US savings rate through the roof.
Source: US Bureau of Economic Analysis
From March through to November, personal savings was $1.56 trillion higher than in 2019, a rise of 173 percent. The savings rate spiked to 33.7 percent in April, its highest level on record dating to 1959. Even as millions of individuals faced great financial hardship this year, Americans in aggregate were building savings at a startling rate. As Chart 2 shows Australian personal savings rates are also highly elevated.
Chart 2 – Australia experienced a similar combination of rising household cashflow and falling spending pushing the savings rate to record levels.
These savings had to go somewhere. In an ultra-low interest rate world, it is only natural that shares attracted some of these funds.
Factors Driving the Cyclical Rebound and Trends Supporting Commodities
In our previous Market Commentary, we highlighted a rebound in Leading Indicators were pointing to a stronger economic recovery than initially expected. As the quarter evolved, the data increasingly supported the case for a strong recovery in late 2020 and into 2021. Overall economic activity has held up better than expected. This likely reflects greater flexibility within services based, digitised economies. The rebound has been supported by early approval and release of several vaccines across the globe.
Based on this we have been increasing exposure to cyclical stocks on a selective basis. What we did not anticipate was the strength of the rebound. With cyclical stocks such as REA returning more than 34% over the quarter, BHP returned 20%, Fortescue 43%, James Hardie and Aristocrat more than 13% (despite a 10% increase in the $A). More stunning was the very strong rally in Bank stocks, admittedly after a long period of underperformance. ANZ increased 34% for the quarter, CBA 29% and Westpac up 17%.
One of the early beneficiaries of the Cyclical upturn has been commodities. The combination of strengthening demand against a backdrop of low levels of investment in exploration and new capacity is likely to remain supportive of prices.
Political Fog Clears in the USA, Thickens in China
Resolution finally as the US elections has been settled with a clean sweep to the Democrats. This is now the first time since 2010, that one party has controlled the White House, Senate and Congress. Markets have responded positively to this outcome, reflecting increased stimulus in the short term, supporting the already strong recovery during 2021. The longer-term negative of rising taxes, increased regulation may well be partly offset by increased spending finally on infrastructure and renewable energy.
In contrast, political risks have ramped up in China. While enjoying a mild impact from COVID-19 and a strong economic recovery, there appears to have been a change in the political landscape. Events such as the crackdown on Hong Kong, stopping the Ant Financial IPO and a multitude of trade spats with several countries including Australia are concerning. From an investment perspective none of the companies we are holding have been directly impacted to date.
Australian Outlook Favourable but a Strong Dollar is a Headwind
From the depths of the recession experienced in the March and June quarters of 2020, the Australian economy returned to growth in the September quarter. Since then, it appears that momentum has continued to build. Consumption spending has been very strong as travel budgets have been re-allocated to domestic consumption.
There has been a strong recovery in housing approvals, setting the stage for an increase in construction activity through 2021. Infrastructure spending remains at historic highs, with a large backlog of work to be done. Commodity prices have been strong, especially iron ore. The rural sector has seen the drought and bushfires of a year ago turn into a bountiful grain harvest, and recovery in pastural land with La-Nina delivering high rainfall.
Australian employment rose 29,000 in February, with the unemployment rate falling to 6.4%. The outcome supports the view that Australia’s labour market can recover rapidly as economic activity normalises. Australian consumer sentiment rose +4.1% to 112pts in December, reaching its highest level since 2010. The increase was supported by positive news around vaccine development, as well as Australia’s stronger-than-expected 3Q2020 GDP.
As the COVID-19 vaccine is rolled out during 2021, some of the laggard sectors such as tourism and education should begin to see some recovery. In summary, Australia is entering 2021 in good economic health.
Major risks include the possibility of a stronger $A, and a further deterioration in relations with major trading partner China. Having touched a low of $0.57 in March 2020, the $A recently traded above $0.78, up 37% and up over 10% in the December quarter. Such a rebound in the $A is unhelpful for companies with significant overseas earnings.
Investment Outlook
As we enter 2021, the outlook for equities appears favourable. Interest rates are anchored at near zero or lower in most of the developed world. Resolution of the US election provides the first opportunity in a decade for an administration to get things done, although acknowledge a very polarised country. The financial system is full of liquidity. Consumer savings rates are at record highs, suggesting significant pent-up demand. 2021 forecasts see global growth of more than 5% in 2020, paving the way for strong growth in corporate earnings.
While we expect a solid start to 2021, how the year evolves will be highly dependent on some of the factors such as longer-term interest rates, inflation and trends in liquidity being provided by Central Banks and Governments. The three most obvious risks in our view are rising interest rates, rising inflation, and reducing levels of liquidity being provided by Central Banks and Governments.
Globally, most Central Banks have committed to holding short/medium term interest rates at close to zero for the next 1-2 years. The RBA again re-affirmed that they do not expect to be increasing the cash rate for at least three years.
Low and stable inflation have been supportive of financial markets over the long term. Trends towards De-Globalisation, rising cost of capital, higher commodity prices and potentially higher wage costs could reverse some of these historically favourable trends.
