(Gary Gleeson)
Key short-term issues
- US COVID trends: Continue to improve, with falling hospitalisations.
- US earnings season: Continues to surprise on the upside, albeit off a very low base of expectations.
- Vaccine & other therapeutics: Novavax trial reports positive, raising possibility of an alternative vaccine platform.
- US policy: A continued stalemate on fiscal package. Progress is expected this week; if not the market will start to worry.
- NSW and Victoria’s COVID trends: Victoria is showing early signs of stabilisation while NSW holds the line. Broadly in-line with expectations.
- Australian Policy: Federal government will make payments to support self-isolating Victorians unable to earn an income. Emphasises approach of policy plugging economic gaps.
- Australian earnings season: Mixed results, but too early for discernible trends. ResMed (RMD, -11.4%) was negative; REA Group (REA, +4.6%) was positive; Insurance Australia Group (IAG, -1.2%) was in-line.
COVID-19 update
New daily cases are falling in response to Victoria’s lockdown measures. NSW continues to hold the line at about 10 daily cases on a seven-day moving average.
The economic impact is starting to make itself felt in real-time data. Retail foot traffic has declined from about 90% of its year-start level to about 60%. The data suggests this is not just from the Victorian lockdown – there is more cautious behaviour among Sydneysiders as well.
US trends are generally positive. Test numbers are falling — but not as much as case numbers, so the ratio of positive results is falling. There is some evidence that base levels of immunity are helping in the worst-hit states.
More importantly hospitalisations are falling. This is helped by a younger age skew, better adherence to safety protocols and possibly the weather. Even in the hotspot states hospitals have been coping and pressure is now being relieved.
This has fed through to a much better outcome in terms of mortality. Deaths reached half the rate of the April peak and are now falling. This is likely due to age skew and protocols. But it’s also due to a wider geographic spread of cases, allowing the healthcare system to cope better — with more experience and better treatments.
At this point we are likely to see a Sweden-like model in the US, where cases remain persistently high. If the community believes a third major surge can be avoided under this model — and acute cases are better managed — activity will start ramping up again, supporting markets.
This is a very different situation to Australia. Here we are prepared to accept more short-term economic damage in exchange for effective elimination. The key risk in the US is children returning to school at the end of August. This will be a key swing factor moving into September.
Economic update
The US remains in a holding pattern. Mobility data and outlook surveys are all trending sideways. Employment data was better than expected, but still a material step down from improvements in June.
Elsewhere around the world the Institute of Supply Management (ISM) survey data suggests good momentum on improving growth from June, albeit off a low base.
Vaccine update
The development of a viable vaccine remains the most important medium-term issue for the economy and markets.
The result of the Novavax trial was encouraging, but not a silver bullet. Its platform is based on introducing a protein rather than the current approach of using a genetic message to prompt the immune system to produce the required protein.
This is important because it offers an alternative route for vaccine development and increases the overall chances of success. The method of vaccination also has a better history of success.
Consensus expectations among experts about the likelihood of developing a vaccine for delivery in material amounts next year have increased markedly in recent weeks.
Gold
Gold has run hard in recent weeks and become the hot topic in financial commentary.
Traditional measures of sentiment suggest it may have over-heated near term. The RSI, for example, has reached its highest point in over a decade.
This suggests near-term consolidation may be likely, particularly if we see more positive news on the vaccine front.
Nevertheless, we continue to see this as a buying opportunity. In our view gold plays an important role in the portfolio, protecting against two key issues (outlined below) and risks facing investors:
The decline in real rates
As we’ve noted before, the Fed has clearly signalled it will allow inflation to rise through the target range rather than pre-emptively tightening. They are taking the view that avoiding structural economic deterioration and potential social consequences is paramount. So we are likely to see the use of their balance sheet and other tools to hold nominal yields, even as inflation expectations rise.
This should support economic growth. But there is also an imperative to hold rates down given the explosion in debt — much of it short duration — with which the US treasury has been funding itself. Even a small increase in rates could see a massive increase in interest expenses, which the US budget would struggle to accommodate.
The outcome is likely to be long-term suppression of real rates, which in turn is driving a lower USD, lower credit spreads, lower equity risk premiums — and a higher gold price.
It also has a significant effect on performance within the market, as referenced last week. It is more nuanced than a simple rotation to value. Value does not necessarily outperform, given this could be a headwind for financials. But it will help certain industrials. Growth stocks are okay in this environment, but they lose the tail wind they have had for 10 years.
Outside of equities, low real rates are beneficial for other real assets. This has constructive implications for housing. Mortgage affordability in the US is rising and history suggests low real rates are good for house prices.
It is worth putting some perspective around moves in the USD, given its relationship to this issue and to gold. It, too, looks oversold in the near term. Some are pointing to the fact that it is back to a reasonable historical range when measured by the DXY (US Dollar Index).
However, the latter is dominated by value versus the Euro (58% of the measure). On a trade-weighted basis (TWI) the USD remains very strong compared to history. It has room to fall further once the near-term move has consolidated.
US-China relations
The second driver of a gold position is the deterioration in US China relations, which is unlikely to look any better ahead of the election.
While the tension remains largely rhetorical at this point, there have been material moves that elevated risks and risk premiums in the market.
The US has acted against Chinese companies such as Tik Tok and WeChat. It has also sanctioned politicians, increased carrier group activity in the South China Sea and sent the US health secretary on a visit to Taiwan. China has responded via moves in Hong Kong, increased activity in the disputed regions of the South China Sea and dragging its feet on a phase one trade deal.
With the US and China using this friction for domestic purposes, this situation is unlikely to disappear in the near term. Heightened tension is prompting investors to allocate more to gold for portfolio insurance.
Markets
The US reporting season has so far yielded the largest ever quarterly decline in earnings and the largest upside surprise to expectations.
US earnings are down 35%. This is far better than consensus expectations, which have obviously re-based too low. This has helped the market offset the negative effects of the COVID second wave and stalled fiscal negotiations.
The Australian earnings season has yielded mixed, but on a net basis a slightly positive outcome.
There were positive updates from:
- Treasury Wine (TWE, +17.6%). The best performer in the ASX 100, with the market latching onto signs that Chinese demand is showing signs of recovery.
- QBE Insurance (QBE, +10.5%). Results had been pre-announced, but management emphasised supportive trends on premium pricing which are underpinning higher insurance margins.
- Commonwealth Bank (CBA, +0.34%). No deterioration in bad and doubtful debts or net interest margins from the previous quarterly update – and a slightly better position on capital – meant a well-received result which was reflected more in the other bank stock prices.
- Xero (XRO, +3.4%). Management’s AGM update revealed the latest subscriber trends remain positive. Policy support is staving off a feared surge in insolvencies. Business formation rates are stronger than usual.
- AMP (AMP, +10.3%). Announced a special dividend and buy-back, equating to 10% of its market cap. This provided short-term relief for shareholders and went straight onto the share price.
- Goodman Group (GMG, +4.8%). A stronger-than-expected order book of new developments demonstrates the current bifurcation in the REITs sector. While malls face challenges from foot traffic, soaring online sales are a stiff tailwind for GMG.
- James Hardie (JHX, +1.5%). Its quarterly update confirmed that strong trends continue in new US housing. However, it also showed the remaining parts of its business are back to growth as well. Strong cost control means margins are in a sweet spot.
These companies had poorly received updates:
- AGL Energy (AGL, -8.8%). The worst performer in the ASX 100 outside of NST. Management downgraded earnings based on weaker forward-pricing trends for electricity. This is likely to be an ongoing issue.
- Telstra (TLS, -7.7%). Hit its FY20 numbers but gave a disappointing outlook. There are two issues. First, losses associated with the rump of its fixed line business, which the market expected to hit in FY22, are now likely to come through earlier, leading to a downgrade in FY21. Second, and more importantly, management has cut the return on capital target for FY23 from 10% to 7%. While consensus had not factored in a 10% return, this shift is seen as a signal that the environment will be tougher than management had previously indicated. We think the dividend is unlikely to be cut – and the degree of yield in the current environment should see the stock remain supported. However, it also may mean the implied upside case is now smaller.
- Seek (SEK, -8.6%). Outlined a potential scenario for FY21 in which, if the environment remains as it is now, it will barely make a profit. This demonstrates the challenge for some of the recovery stocks where, having run hard from the rebound, it may transpire they have run ahead of themselves.
There were mixed updates from:
- Evolution Mining (EVN, -0.3%). Short-term capex guidance came in at the higher end of consensus expectations – and production volumes at the lower end. There was some offset as management upgraded the expected size of resource at the new Red Lake mine in Canada.
- Downer (DOW, +6.9%). The result was in-line with guidance from its recent capital raising. While parts of the business continue to face challenges, management seems focused on a restructure which will see it withdraw from these businesses and focus on its core urban service franchise.
- Transurban (TCL, +0.7%). While traffic has had a good rebound from the pothole of April, the more recent trends have been softer, leading to some risk around the size of the FY21 distribution.
- Sydney Airport (SYD, +2.0%). The $2bn entitlement raising demonstrates the scale of the issues facing SYD. However, it removed an overhang of doubt about when and how much the company would be forced to raise.
Elsewhere iron ore gained another 8% to reach US$118 per tonne. This level is unsustainable, but a likely increase in steel demand outside China in coming months will probably keep the iron ore price at elevated levels and the miners in an upgrade cycle.
Crude oil rose 2.5%. There were early signs of a correction in copper and gold.
Yours faithfully,
Gary Gleeson
BBus(Ec&Fin), MAppFin, CFP®, SSATM
Principal | MFM Group
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