The Financial Year that was
Equities rallied to new highs by early January…
As far as financial markets were concerned, FY20 was “one for the ages”. The financial year started with equities struggling to make headway from July to September in the face of US-China trade tensions and an associated manufacturing slowdown. However, late 2019 saw equities rally as central banks enacted a ‘U-turn’ on monetary policy and US-China trade tensions eased, triggering a global manufacturing recovery. The rally received further fuel in early January when the US and China negotiated a ‘Phase 1’ trade deal, seemingly reducing the risk of a trade war.
…then came COVID-19…
Global equity markets initially brushed off the threat of COVID-19, which initially appeared in China in late 2019, with many markets reaching new highs by late February.
However, as COVID-19 escalated into a global pandemic, risk assets began selling off sharply starting in late February. The month of March saw the sell-off become a rout as the pandemic saw one country after another effectively shut down large parts of their economy with lockdowns in order to contain the virus. Risk aversion measures skyrocketed to levels not seen since the Global Financial Crisis.
Politicians & central bankers responded with ‘whatever it takes’…
Governments and central banks responded with unprecedented fiscal and monetary measures: Governments announced several rounds of progressively larger fiscal spending initiatives and central banks enacted Quantitative Easing measures and sharply slashed policy rates: From 30th June 2019 to 30th June 2020 the RBA official cash rate fell from 1.25% to 0.25% and the Fed Funds rate fell from 2.25-2:50% to 0.00-0.25%.
…& markets eventually stabilised then rallied…
The measures eventually appeared to ‘staunch the bleeding’ and restore some semblance of confidence in the economy and financial system. Equities bottomed in late March and then began a very sharp rally that gathered momentum as the intensity of the virus dissipated and economies opened-up as lockdowns eased.
…before losing steam in the face of a ‘second wave’
However, the rally lost steam in June as a ‘second wave’ of the virus, particularly in many U.S. states, prompted reversals of lockdowns, prompting questions about whether the much hoped-for ‘V-shaped’ recovery would be under threat.
…& renewed political risk
Late in the financial year political risk flared up again after China approved a national security law for Hong Kong and the United States began revoking the special treatment extended by law to Hong Kong.
Australia weathered the virus storm relatively well
Like other Western countries, Australia felt the impact of COVID-19 as it imposed lockdowns and travel bans. However, the progression of the virus was relatively well contained in Australia, which meant that the Australian economy, while not unscathed, was hit relatively less than other major Western economies. Additionally, the Australian government’s fiscal response as a % of GDP was one of the largest in the world, helping to ease the pain on the economy.
Big differentials in equity performance…
The ‘roller coaster’ ride for equities through the financial year resulted in stark differential in performance at both a market and sector level.
…at the market level...
World equities posted an aggregate total return of around 4% in local currency. However, US equities (+7.5%) substantially outperformed other major markets, some of which (Eurozone -4.5% and UK -13.8%) underperformed heavily.
…& sector level
There was massive dispersion in sector returns. Generally defensive sectors outperformed cyclical ones. The best performing sector (Information Technology) rose around 30% while the worst performing (Energy) fell around 30%. Financials (i.e. Banks) and REITs also performed poorly, REITs weighed down by closures of retail malls and office buildings.
Australian equities underperformed
Australian equities (-7.7%) substantially underperformed despite a relatively less severe progression of the virus. Australia’s underperformance was to a large extent a function of its sector mix – heavily overweight underperforming Banks and underweight the outperforming Tech sector.
Thematically, ‘growth’ beat ‘value’…
Thematically, ‘growth’ continued to outperform ‘value’, continuing a trend that had been going on for years. Growth stocks with relatively ‘defensive’ earnings streams found favour over value stocks whose earnings were more linked to the economic cycle.
…& dividends were slashed
Additionally, ‘high dividend yield’ stocks heavily underperformed as the COVID-19 induced economic shutdown hit the cashflows of companies and forced them to slash dividends. This was keenly felt in Australia, where investors had traditionally shown a strong appetite for dividends: Dividend expectations for Australian Banks have been cut over 40% since late February.
US$ Rises, AUD on a roller-coaster ride
The big currency story of the year was the rise in the US Dollar on safe-haven buying. The Australian Dollar traded for much of the year on risk-aversion, plummeting to a 17-year low of US$0.57 in March before recovering to finish the financial year at US$0.69 – approximately where it had started the year.
Government bond yields fell…
The deteriorating economic situation beginning in February, as well as the slashing of policy rates and enactment of Quantitative Easing by central banks, saw global government bond yields fall during the year. However, at the height of the crisis in March, central banks had to intervene as signs of stress in fixed income markets saw government bond yields spike sharply, albeit temporarily. During FY20 the Australian 10-year government bond yield fell from 1.32% to 0.87% and the US 10-year Treasury yield fell from 2.00% to 0.65% with both touching lows in March of 0.61% and 0.50% respectively.
…though credit spreads spiked
The sharp rise in risk aversion in March saw credit spreads skyrocket to levels not seen since the GFC. This prompted the Fed to expand its purchases of corporate debt to include categories of non-investment grade debt. This announcement, as well as other measures, helped stabilise the corporate debt market and saw credit spreads begin to fall back to more normal levels.
Commodities
Oil: The big commodity story of the year was the collapse in the oil price (down ~30%), particularly in March on lockdown-induced demand destruction. A headline-grabbing event was the collapse in a WTI futures contract price to negative $37.63 a barrel – the first negative oil futures settlement in history. However, an agreement in April between oil producers on production cuts, as well as easing lockdowns, kicked off a sharp rally in the oil price for the rest of the financial year.
Gold: The gold price rallied (~25%) on QE and falling interest rates.
Iron Ore: The iron ore price (down ~6%) was relatively unscathed (at least compared to other commodities) as problems in big producer Brazil curtailed supply.
Looking Forward
While the short-term outlook has become increasingly cloudy and the momentum of the recent rally is likely to fade, we do not think the cyclical recovery is at threat.
Put differently, downside risks are more likely to slow the recovery rather than put the recovery at threat. This could lead to a more drawn out rebound, but if economic growth and corporate earnings continue a path back to trend, then in combination with record low interest rates this will be sufficient to propel markets higher.
In addition, while valuations for equity markets are not overly appealing, they are even worse for the bond market with yields not far from their lower bound and as a result bonds continue to give away a substantial yield premium to equities.
Investors should be prepared for the risk rally to slow and for the equity market to consolidate rather than undergo a major (>10%) correction. Further COVID-19 outbreaks are troublesome but will be dealt with differently to the first wave and in a less economically disruptive way. Any rise in bond yields will be capped by the need to keep financial conditions accommodative which will continue to support equity valuations. The cyclical recovery may slow but remains on track despite fears to the contrary and this supports a growth over defensive strategy.
This article was finalised on the 2nd of July and was originally produced by Macquarie Wealth Management.
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Source: https://www.macquarie.com/au/en/disclosures.html