Over the last two weeks we have seen a correction in the tech sector which has dragged markets down. The ASX, S&P 500 and tech heavy NASDAQ are down 1.6%, 3.9% and 7.8% over the period since our last release. The pullback in the US was concentrated in a few names in growth such as Tesla (-20.4%), Amazon (-15.4%), and Apple (-9.7%), but big tech names in Australia like Afterpay (-12%) were not spared. These are all great companies still with amazing growth prospects, but all were at record highs before the drop. We have not seen a change in indicators or central bank policy that would see the fall continue. A consolidation period for the top names, and the broader market catching up is a good thing.
A CONCILIATORY NOTE ON FEDERAL DEBT
As you may have heard in the news, Australia has been ramping up fiscal
stimulus in the wake of coronavirus; with our debt increasing by over $180
billion so far. This has raised debt to GDP from ~25% to ~42.5%, the
trajectory is for total debt to reach 50% of GDP in the next year. A total
of $1 trillion!
These numbers sound alarming, and have been portrayed as such in the
media. This is part and parcel with Australian political culture, which is
traditionally very "anti-debt", with much focus on "getting back in black".
When you look at the opinions of economists and even comparable statistics from
around the world, it is obvious that the picture painted of sovereign debt is
not a simple analogy to the "household budget".
We believe current debt levels in Australia are not troublesome and the benefits
of fiscal stimulus outweigh the cost of increasing the already low amount
of relative debt that Australia currently has. To look more deeply into this subject we
will observe two popular trains of economic thought, Debt Dynamics and Modern
Monetary Theory.
DEBT DYNAMICS
In traditional economics, the study of sovereign debt falls under the field of
"Debt Dynamics". While a complicated and nuanced field, its fundamental
equation describing the change in government debt boils down to three
inputs:
Yearly Deficit (or yearly government expenses - yearly taxes) or how much debt will have to be raised
Interest rate on the debt [r]
Country GDP Growth [g]
The theory is debt should be used if the GDP of the nation is greater than its
cost of debt (interest rate) as over time this debt will more then pay for
itself. Imagine a business: if a financed project has a return greater
than the cost of financing, it makes a profit overall.
Given the average interest rate of debt raised by the Aussie government this
year is 0.83%, and that over the long term Australia has grown at ~2-3%, it
makes sense to raise debt if it can stimulate the economy. When you plug
those numbers into the equation, you'll see that the interest-growth
differential is negative, implying that despite increasing debt in the short
term, it will naturally pay itself off overtime.
MODERN MONETARY THEORY (MMT)
The "new kid on the block" in economics is Modern Monetary Theory (MMT). A
relatively recent form of thinking, that challenges many of the fundamentals in 'classical economics'.
The theory creates differentiation between countries that have full
control of their currency through their central bank (e.g. Australia, NZ,
Japan, US, UK etc.) vs others that share a central bank with other nations and
do not have control of their currency (e.g. EU Nations: Greece, Italy,
Germany & Dollarized countries: Zimbabwe). This may not seem like a significant
detail, but it points out a key feature of MMT: that governments with their own
central bank are unable to become insolvent. To demonstrate this we need
only look to the recent example of Greece.
In the Greek debt crisis, there was a downward spiral: creditors worried that
Greece would default, likewise Greek bonds saw their rates increase, ultimately making it more
expensive for Greece to pay new debt, which in turn increased the risk of actual default.
Imagine instead, that instead of using the Euro, Greece controlled its own currency, then creditors are assured
that come what may, Greece can cover its interest with printed money,
preventing the downward spiral from manifesting. That printed money never makes its way into the real economy, as its trapped in bank reserves, so inflation is kept in check. This is no better
demonstrated than in Japan, where government debt is at over 230% and has been
for over 10 years, with record low interest rates, no inflation, an A+ credit
rating and continued ability to issue debt to fund stimulus.
This is a very small snippet of MMT and its implications, if you would like to
understand more, this article
written by Chris Bedingfield - one of
the real estate managers we use at TFM - goes into much more depth and will
give you a better perspective of what economists in institutions and government
use to make decisions.
What to draw from this is that the level of Australian debt is not something to
worry about. Compared to other nations like the US (~150% debt to GDP), UK(~100% debt to GDP) and
Japan, we have a low level of relative debt. As a nation we need to ensure that we can
use this stimulus headroom to stimulate our economy and come out ahead of COVID19, as we
did in the GFC.
UPDATING OUR CHECKLIST:
Valuation: ASX & S&P500 levels:" The froth being blown off the latte" the last few weeks has seen forward P/E valuations on the ASX and S&P 500 retreat to 21.6x and 25.9x respectively. Both are at levels far above their 10yr averages and not seen since 1998-2000. Unprecedented fiscal and monetary stimulus is fuelling this charge, compared to an overheated tech sector in the late 90's. Earnings will have to catch up to prices eventually.
With a TINA – There Is No Alternative – attitude building in markets, because of low bond yields, we could see elevated forward valuations for some time. As an example the current dividend yield on the S&P 500 is 1.6%, compared to a US 10yr Treasury note that yields 0.68%, over the next decade that the bond is held by an investor, the S&P would have to drop 9% to have a similar return. Accounting for inflation of 2% over that period, the equity market would have to drop 25%. The alternatives to equities are not pretty, as governments continue to run the printing presses.
Global PMIs: PMIs are released at the beginning of the month, so there is not much news on this front we did not cover two weeks ago. As a recap key figures in China, the US and Europe, continued to show expansion for August. Interestingly Brazil is climbing back hard after plummeting manufacturing figures in April/May, the country did not see a peak in infections until August 2020.
Downgrades on guidance: We are in the sweet spot between quarters, where financial news is light. Companies with a calendar year end are in midst of budget planning for next year, so a lot of "strategy", or "investor" updates come out during September. Of note Macquarie Bank recently released their outlook for the short and medium term. The bank expects profits to be down 35% in their base case, with $1.4bn in loan losses. MQG's share price has been on a tear since March, setting new highs. The bank offered no new guidance, but the new economic outlooks were enough to trim the share price back. Banks are conservative by nature, so the fact that the spread between the worst and best case for losses was $700m was comforting, as it says that the bank has a handle on their projections.
Infection rates to slow globally: Infection rates that we track through mortality has come down from the latest spike in infections. Lockdowns in Melbourne are persisting, but regional Victoria could see easing as early as this week. In vaccine news the leading candidate from the University of Oxford/AstraZeneca had its phase III trial suspended temporarily as a subject was experiencing severe side effects. The trial was resumed in some regions of the world after an investigation and the blessing of regulators. These stoppages are common during trials, they just usually do not have the world's focus upon them when they occur. Markets are beginning to shift towards discussion of a rollout strategy, so the mentality around the virus is moving.
Monetary and Fiscal stimulus announcements globally: In the US we continue to expect a deal between Congress, the White House and the Senate to extend benefits. Jobless claims, both continuing and initial are still trending downwards, but consumer confidence is low. For a consumer led economy like the US, this is troubling. In Australia, the fiscal budget is set to be released in October. Leaks have been infrequent, but we'll continue to scour headlines looking for ideas that the Morrison government are floating. We do expect infrastructure spending still.
The recent "tech wreck" over the last two weeks is a good time to reflect. For a few weeks a value over growth tilt has emerged in the finance world. Personally, we favour a barbell approach, playing value through select names that still spend on R&D, or through infrastructure and REITs that have heavily sold off. In the broader market the rotation is driven by a narrow market recovery and rising bond yields. A few high-flying names have led the recovery in shares, pushing the market (e.g.: Amazon, Facebook, etc), while the bulk of the index lags.
With regards to rising bond yields this causes future profits to be discounted more heavily than profits from this year and next year. The effect is companies with big growth expected 5yrs down the road and little profit now, will sell off in favour of established brands that are currently profitable, but are trapped in a sector with average growth prospects and locked in market share.
We feel this rotation is a bit misplaced since spiking bond yields, that plunge growth stocks also hurt value stocks, and the overall trend is down, but value gets a burst of outperformance. If this trend were to continue the net result is a collapse in the aggregate stock market. When the market collapses, this unleashes a new move down in bond yields as they are bought up in a "risk off" environment, likely to a new low. Ultimately, we again find ourselves in a low rate environment that is perfect for growth. With the business cycle in the early stages of a recovery, and no better alternative to equities for return, odds are against a market collapse. We remind ourselves just because it rhymes, it does not make it true regarding the latest "tech wreck". Avoiding these bumps in the road is why your advisor has setup a long-term plan for your financial goals.
Finally, we have a new contributor to introduce to "A View from the Top End", as Declan Sullivan helped for this edition. Declan has been with us for a little over a year now as he finishes off his studies at UQ, and we would like to congratulate him on his first piece.
Gareth Jakeman Chief Investment Officer
Nirav Patel, CFA Investment Analyst
Kyle Schlachter, CFA Investment Analyst
Declan Sullivan Junior Investment Analyst
(Territory Funds Management Pty Ltd is sub advisor to Mason Stevens for the Territory Active Goals SMA’s).
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