Market Commentary
The S&P/ASX 200 Accumulation Index returned -7.7% during the month. Australian equities marginally outperformed global equity markets in February, as the spread of the coronavirus saw global markets sell off sharply. Emerging markets outperformed developed markets, ironically thanks to China’s relative outperformance during the month as new virus cases slowed within the country. In major global developed markets, the S&P 500 was down 8.2%, the DJ Euro Stoxx 50 was down 8.4%, Japan’s Nikkei 225 was down 8.8%, and the UK’s FTSE 100 was down 9.0%.
The cash rate remained unchanged during February at a record low of 0.75%. The Reserve Bank of Australia (RBA) acknowledged the uncertainty being created by the coronavirus and reiterated that they would ease monetary policy further if needed “to support sustainable growth in the economy, full employment and the achievement of the inflation target over time”.
Domestic economic data releases were mixed in February. Employment rose by 13,500 positions in January which exceeded expectations. The unemployment rate jumped to 5.3% from 5.1%. The NAB Survey of Business Conditions was steady in January at +3 points and business confidence remained negative at -1. December retail sales were lower than expected, falling 0.5%. National CoreLogic dwelling prices continued to post gains, rising 1.0% in February.
While the reporting season should have been the main focus in February, it was overshadowed by the coronavirus. Companies reported various impacts, including but not limited to, the impact of travel restrictions (airlines/travel/leisure stocks), lower commodity prices (resources ex gold stocks) and the impact on supply chains (retail/manufacturing stocks). This means the hopes for an earnings recovery in FY20 have now been pushed out again. Offshore earners may fare better however, as the falling Australian dollar should cushion the impact. Overall during reporting season, downgrades dominated with three times the number of FY20 earnings downgrades, than upgrades. Sector wise, real estate and industrials delivered the best results, while financials, consumer discretionary, communications and health care had more earnings misses, than beats for the period.
All sector returns were negative in February. The best performing sector was utilities (-3.6%), followed by health care (-3.7%) and real estate (-4.6%). These were followed by financials (-4.9%) and consumer staples (-7.1%) which also outperformed the broader market. Sectors that lagged included industrials (-8.2%), communication services (-8.6%), consumer discretionary (-8.6%), materials (-11.7%) and energy (-17.2%). Information technology (-17.3%) was the worst performing sector.
The utilities sector was the best performer locally, as investors sought refuge in defensive stocks. Both APA Group (-5.2%) and AGL Energy (-1.8%) outperformed the broader market.
The health care sector benefitted from solid results in key stocks such as CSL (-0.8%) and ResMed (-2.2%). Meanwhile Cochlear (-13.9%) underperformed the market, with the coronavirus expected to impact FY20 earnings.
The real estate sector benefitted from solid results and modest EPS upgrades during reporting season. Some of the best performing names included Goodman Group (0.6%), Lendlease (-1.1%), GPT Group (-3.7%) and Dexus (-4.4%).
The materials sector lagged in February as global risk-off sentiment continued to take its toll on commodities. Key detractors included BHP (-14.7%), Rio Tinto (-11.6%), Newcrest Mining (-10.6%), South32 (-15.9%) and Fortescue Metals (-11.5%).
The energy sector also underperformed the broader market due to the fall in oil prices and LNG supply contract risk escalated. Key detractors included Woodside Petroleum (-17.5%), Santos (-20.6%) and Oil Search (-24.2%).
Information technology was the worst performing sector. Key detractors included Wisetech Global (-39.7%), Xero (-13.9%), Computershare (-13.7%) and Link Administration (-30.9%).
Market Outlook
Although the global economy had ended on a weak note in 2019, both manufacturing and services survey data was suggesting a rebound was underway. It is now clear that the recovery has been put on hold by the coronavirus outbreak.
Prior to the weekend of 21-22 February, risk asset markets were near all-time highs, both the US and Australian markets were pricing in little to zero chance of rate cuts as markets seemed to be treating the virus as a China-only supply chain story.
Circumstances changed dramatically over that weekend as news on the Italian contagion set the risk- off wheels into motion. The news flow progressively worsened during the week as numbers of infected patients rapidly rose in South Korea, Japan and Iran. By the end of the week almost every country in the EU had reported cases, schools were shut in Japan, large gatherings were banned in France and there was a run on hand sanitizers in most US cities and toilet paper in Australia. The bottom line being, the coronavirus situation had changed, had gone global and the markets savagely reacted. The situation has changed from a large supply shock to a potential global aggregate demand shock as well. GDP will and has been materially impacted–particularly in China, but the shockwaves are being felt globally. GDP in China will likely contract in 1Q20, the first time in modern history.
In the first week of March both the RBA and US Federal Reserve (Fed) reduced rates, with the Fed reducing by 50 bps out of cycle. Both central banks indicated they were prepared for further action that may include qualitative easing.
The combination of the coordinated central bank stimulus and some positive news on the containment of the coronavirus are the keys to turning the global economy around. Previous similar episodes have resulted in a short and sharp economic impact followed by a “v” shaped recovery. However, given the huge uncertainty at present, and the actions from governments in trying to reduce the spread of the virus, it is difficult to have a firm conclusion on the length of any downturn.
The February reporting season was one of the weakest since the global financial crisis and that does not include the likely impact to earnings from the coronavirus. Many companies commented that it was likely to adversely impact but had little visibility on the quantum as yet. Revenue was the area called out as most at risk whereas very few had experienced supply chain disruptions yet. The risks around supply chain disruptions out of China may be starting to alleviate given workers are returning to work and factories are starting back up.
The economic impact of spread of the coronavirus beyond China to the rest of the world and the subsequent coordinated central bank responses to lower interest rates to ease financial conditions magnifies the relative attractiveness of defensive and otherwise coronavirus-isolated names.
The Portfolio is positioned to take advantage of the global economy moving away from outright bearishness and risk-off, to a more “normal” environment. The defensive bond-sensitive and quality names remain in “bubble” territory and would be expected to correct heavily when the market moves into more rational territory. The valuation divergence is illustrated by the gap between high and low PE names, which remains extreme and as such there is significant further upside potential in the Portfolio as and when market valuations correct to more appropriate levels.
