Economic backdrop: Housebound recession?

Aussies are living through extraordinary times. Our lives are currently being disrupted as governments and health authorities desperately attempt to contain the outbreak of the deadly coronavirus (COVID-19). The health crisis has the potential to impact the vulnerable – our parents, grandparents and the sick – with many of us already ‘social distancing’ and ‘self isolating’ by working from home. 

As we have already seen in China, the virus containment measures can have a huge impact on jobs, consumer spending, supply chains and business activity. In fact, retail spending, industrial production and fixed asset investment in the world’s second largest economy – and Australia’s largest trading partner - contracted by the most on record in the first two months of 2020.  

While restrictive measures appear to have worked in China, Singapore and South Korea – with a ‘flattening of the curve’ (number of new reported COVID-19 cases slowing) – the infection cycle has much further to go in the US, UK, Europe, Australia and other parts of the world. In fact, the US is not expecting a peak in infections until the end of the Northern Hemisphere summer – around July-August. And Australia is entering its peak winter influenza season.

In response to the virus outbreak, governments and health authorities around the world have reacted by encouraging their populations to reduce day-to-day activity. Travel bans have been enacted and borders closed. This will have severe implications for the global economy. While panic purchases of consumer staples will provide a front-loaded and temporary lift in consumer spending, broader discretionary spending on goods and services – especially on travel, motor vehicles, entertainment and recreation activities – will likely be hardest hit. Australia’s economy – for example – relies on consumer spending (around 55 per cent of GDP growth) to drive economic activity and growth. By staying at home for an extended period, outside of online purchases, Aussies will effectively reduce consumption – already growing at the weakest annual rate in a decade in late 2019. 

Initial economic data releases suggest that there is a high chance of a global recession. For example, the collapse in China’s manufacturing and services gauges saw a huge lift in unemployment. An estimated 5 million people lost their jobs - with the urban unemployment rate lifting to a record high of 6.2 per cent in February, according to the National Bureau of Statistics. While Bloomberg estimates that China’s economy is slowly returning to normal - capacity is now around 70 to 80 per cent – the US manufacturing sector is already contracting. In fact, the New York Empire State manufacturing gauge fell by the most on record in March. And the pillar of the US economy – the consumer – is already having its resilience tested with confidence levels waning from cycle highs and retail spending down 0.5 per cent in February.  

In Australia, key manufacturing and services sector gauges are also contracting. And the Westpac-Melbourne Institute Leading Index -  which indicates the likely pace of economic activity relative to trend three to nine months into the future - fell from -0.49 per cent in January to -0.96 per cent in February. Reserve Bank Governor, Philip Lowe, says he estimates the coronavirus will wipe at least 0.5 percentage points off the March quarter GDP, based on an estimated 10 per cent fall in tourism and education exports, and the bushfire tragedy will detract another 0.2 percentage points off growth. That means there's a high probability economic growth will contract in the March quarter. There is also a risk of another negative quarter of growth in June – implying a ‘technical’ recession – the first in almost 29 years. But massive government spending from April will hopefully ensure that this doesn’t eventuate.

Central banks across the globe have cut interest rates to historic lows. Official cash rates have been reduced to near zero as policymakers brace for a significant economic downturn due to COVID-19 containment measures by governments and businesses. The US has resumed its asset purchase program (that is, quantitative easing) and injected liquidity into stressed credit markets. And Bloomberg estimates that around US$1.15 trillion in fiscal support has already been pledged or is under consideration around the world to shore up businesses, jobs and financial markets. The Trump Administration is also discussing a plan that could amount to as much as US$1.2 trillion in additional fiscal initiatives.

The Reserve Bank of Australia appears ready to cut rates to a record low 0.25 per cent. Governor Philip Lowe said that, “The Bank will announce further policy measures to support the Australian economy on Thursday”. We also expect the Reserve Bank to announce details of an asset purchase program (that is, quantitative easing or QE) that will involve purchasing Australian government bonds and potentially state or semi-government bonds to reduce borrowing costs across the economy. The Bank is currently conducting repurchasing operations to provide liquidity to Australian financial markets, in addition to the $8.8 billion injected into markets on Friday.

But at some point, presumably within the next six months, the number of COVID-19 cases will peak globally. While a sharp recession is possible in the near term, it is conceivable that this unprecedented slowdown will be temporary and not long lasting. Once government policy is changed and the population is free to conduct normal activities again – combined with huge amounts of monetary and fiscal stimulus – there will potentially be a strong rebound in economic activity and data. An ‘I’ shaped recovery could even take shape in the second half of 2020, rather than the usual ‘V’ or ‘U’ shaped recoveries. Of course, much depends on policy efforts to contain unemployment and support businesses. 

Market volatility: At record highs

It’s a well-worn cliché, but financial markets and investors hate uncertainty. Historically, volatility (usually measured via an index or specific securities) of the range and speed of price movements – spikes during an economic or political crisis (i.e. war, 9/11 terror attack, trade disputes and ‘Brexit’). Financial markets are also sensitive to economic data releases, company earnings reports and changes in monetary or fiscal policies. This time around investor behaviour is being challenged by an unexpected event - the COVID-19 pandemic - arguably the biggest health crisis since the Spanish flu pandemic a century ago.

While investors typically invest in assets like individual company shares, a balanced superannuation portfolio/fund or even an index of listed companies (i.e. Exchange Traded Funds, ETFs) everyone’s appetite for risk differs. For instance risk appetite may depend on individual circumstances or their stage of life.

Investors or professional portfolio managers generally assess risk or volatility using an array of measures – such a reviewing metrics such as beta and standard deviation - which compares the risk-return and expected returns from the investment compared to the broader market.

A frequently-used gauge used to help investors predict or assess the volatility of their US investments is the Chicago Board Options Exchange (CBOE) Volatility Index – known as the ‘VIX’. On March 16, 2020 the VIX hit a record high (since records began in 1990) of 82.69 points. The 30-year high in US sharemarket volatility coincided with some of the biggest percentage moves on the Dow Jones Industrial Average, S&P500 and NASDAQ indexes. In fact, two of the Dow Jones’ largest one-day percentage drops – March 16 (-12.9 per cent) and March 12, 2020 (-10 per cent) – have occurred within the past week or so.

Similarly, Aussie investors have not been spared with our equivalent S&P/ASX200 VIX index hitting its highest level at around 31 points on March 18, 2020. Unsurprisingly, on March 16 the S&P/ASX200 index fell by 9.5 per cent (the biggest fall since October 1987), while also falling7.2 per cent on March 12 and falling7.4 per cent on March 9, 2020. The S&P/ASX 200 saw its third-largest trading day on record on March 16 with around $2.26b worth of Aussie shares changing hands.

The last time volatility spiked this high, it came after more than a year of a steadily escalating credit crisis in 2008/09. And since the S&P/ASX200 hit record highs of 7,197.2 points on February 20, 2020, shares have corrected sharply, down by around 29 per cent. The US Dow Jones index is down 28 per cent since its peak of 29,568.57 points on February 12, 2020. Like the last significant exogenous shock – the 9/11 terror attacks in the US – the COVID-19 health crisis has rattled investor confidence – as evidenced by wild swings in sharemarkets. As typical in a ‘bear market’ correction (declines in shares of more than 20 per cent), markets can rebound sharply too. For example, the ASX200 lifted by 5.8 per cent on March 17, 2020 – the biggest lift since October 1997 – and the Dow Jones surged by 9.4 per cent on March 13, 2020 – the biggest daily increase since October 2008.

In such difficult conditions, placing money in the sharemarket, or trying to estimate the best time to buy or sell shares, is incredibly challenging for professional investors, let alone retail investors. The rise of machine trading or algorithms is also exacerbating share price movements. And the overreaction, fear and panic pervading markets at the moment is evidenced by the ‘sell everything’ mentality as investors hoard cash and sell positions across all asset classes. Trying to evaluate company fundamentals – as their earnings get hit by the economic downturn – and determine prices for shares (known as ‘price discovery’) is almost impossible given the ongoing uncertainty.

But investors looking to exit the market should be very careful. Sharemarkets are likely to find a floor eventually as the health crisis is likely to be temporary demand shock to the economy. When it becomes clearer – via official government data - that the flow of new COVID-19 cases has plateaued or peaked – as we’ve seen in China – the ‘search for yield’ will resume, supported by unprecedented stimulus support.

While unnerving for investors, it is important to understand that superannuation is a long-term investment – normally for your entire working life of at least 20-30 years. Over the longer term, investment returns smooth out, increasing your overall savings, despite bouts of volatility. A superannuation fund which is diversified - including global and domestic shares, bonds, term deposits, infrastructure, commodities and property –offers wide exposure and shields investors from volatility and risk, mostly while boosting returns. For example, including downturns, the US S&P 500’s average annual return over all 10-year periods from 1937 to 2019 was 10.5 per cent. 

What should investors look at in a volatile market?

One of the ways that investors can tackle market volatility is through asset allocation and portfolio rebalancing.

For example, if you are risk-averse or approaching retirement, you may consider a conservative asset allocation designed to produce income (traditionally, this would mean a portfolio heavily weighted towards bonds and cash, rather than shares).

Alternatively, if your goals are geared toward longer-term growth, and you’re comfortable taking on more risk, you may consider a portfolio that is more heavily weighted towards shares. Selecting shares from different sectors is important, as smaller companies are considered more cyclical than blue chip companies.

Discovering growth opportunities

In the current environment, investors may favour quality companies that can demonstrate true earnings growth in a persistently slow-growth and low yield environment. Some investors may prefer companies that represent "good" value as valuations for growth-dependent shares may be considered to be ‘rich’, despite the correction last year.

If you’re looking for growth-orientated stocks, current volatility means that some companies are considered cheap or undervalued by the sharemarket. “Undervalued” means that the price per share is lower than what the estimated price should be based on the company’s earnings or total worth.

An ideal place to start your research if you’re looking for growth opportunities is by using the Stock Screener tool on the CommSec Adviser Services website.

Keeping an eye on your portfolio

It’s generally a good idea to check your portfolio at least once a year to ensure that your asset allocation still aligns with your financial circumstances, investment goals and risk tolerance. You may want to consider rebalancing if your goals or financial circumstances have changed.

Understanding the current economic climate is another way to keep tabs on your portfolio. There might be specific triggers – like changes in government policy or geo-political uncertainty – that prompt you to reassess. Knowing how you will respond in these situations, whether you adjust your portfolio allocation or sit tight, could help you reduce your risk over the long term.

Understanding the implications of withdrawing

Before you withdraw from an investment you should understand all the implications, risks and costs involved, including:

• Crystallising losses: If the value of your investment is falling, you are technically only making a loss on paper. A rise in prices could soon return your investment to profit without you doing anything. Selling your investment makes any losses real and irreversible.
• Incurring capital gains tax (CGT): Make sure you know what your CGT position will be before selling any asset.
• Losing the benefits of compounding: If you’re thinking about making a partial withdrawal from an investment, remember that it’s not just the withdrawal you lose, but all future earnings and interest on that amount.

The information presented on this page is an extract of a CommSec Economic Insights report. The full report is published on the CommSec website (under Market News > The Markets). The extract and full report are approved for distribution in Australia only and must not be directed or distributed to any person or entity outside Australia.