New highs on Wall Street
- Earnings season in US beats expectations, noting that expectations were lower due to COVID-19
- The US market buoyed by large Tech companies still leading the charge
- Australian jobs data show some strength but not out of the woods yet
The Big Picture
Wall Street’s second quarter (Q2) earnings reporting season, held mainly in August, provided a stronger result than expected on bottom line i.e. profits. Companies usually set a ‘low bar’ but this quarter’s ‘beat’ was much bigger than normal.
Admittedly, the main strength was in the tech sector – and mega-caps at that – but there were plenty of other good results. The Nasdaq (tech dominated) index made new all-time highs. The broader based S&P 500 also hit new all-time highs in August but the Russell 2000, representing smaller companies, did not fare so well.
Wall Street is on a roll but is it sustainable? Many argue that its success is largely due the Fed’s loose monetary policy. That is certainly true in part but it’s not the whole story.
Low yields on bonds and low rates on cash – which both come from the Fed’s policy stance – mean that equities are about the only place to earn income. However, massive improvements in technology and their impact on companies’ efficiencies are also at work.
That US earnings were largely under-predicted goes to the notion that many analysts’ views on over-valuation were partially misguided.
At home, our first-half company reports have also thrown up many upside surprises but our ASX 200 index has struggled to keep pace with Wall Street. Perhaps if we had a few Amazons, Netflix and Facebooks, things would be different. But we haven’t (yet?)! However, that doesn’t mean we can’t maintain growth in equities – but not necessarily at the same pace as Wall Street.
Our analysis shows us that only now does Wall Street start to look a little bit “toppy” but that does not mean a correction, or worse, is necessarily on the horizon. But it might mean the big short-term gains are behind us. In the long haul, we fully expect decent returns on Wall Street and at home. We do not think it is a time to sell – particularly when capital gains tax is included in the mix – but pausing between market entries with any excess cash, or dollar cost averaging, might be the way to go.
A lot is being talked about sector rotation and portfolio styles. Value portfolios (which are usually characterised by being cheaply priced relative to current earnings) have gone nowhere in recent years.
Growth portfolios (which are usually characterised by low dividends because companies prefer to re-invest earnings within the company rather than distribute them as income to the investors) have done well in recent years.
Apart from the relative performance in the steep market decline last March and the steep ascent since then, growth has beaten value by a country mile. However, our analysis suggests that these two aggregated sectors might be more on level-pegging terms in the year to come.
Diversification means that prudent investors shouldn’t take big bets on any stocks, sectors or styles. But prudent portfolio managers who have the flexibility in their mandates should try to anticipate changes in performance – but glide to a new position rather than lurch.
We think it is fair to say that much of the macroeconomic data has been corrupted by the impact of the sharp – but necessary – virus-related shut-downs and the consequent rush back to re-opening.
However, there have been a number of bright lights among the sea of data deluges. The US has witnessed some particularly positive housing data. China looks resilient. Indeed, the CEO of BHP just stated that ‘China is in a V-shaped recovery and looking good’.
The Fed held its big annual international central bank conference virtually rather than actually this year in Jackson Hole, Wyoming at the end of August. Nobody seemed to expect any big announcements this year. It was only going to be lower rates for longer but Fed Chairman, Jerome Powel, came up with a headline!
The ’old’ target for inflation of 2% was replaced by an ‘average inflation’ target of 2%’. The Fed had already baked in some wiggle room over slight breaches of 2% but this new target gives them even more room such that they could take a marching band with them!
The Fed does not want to stunt economic or market growth with a quick rate move. More importantly, it doesn’t want the market to try to second guess them so they’ve put this extra barrier around themselves.
In a previous meeting the Fed said they were ‘not even thinking about thinking about thinking about raising rates.’ Now they are not even thinking about the previous statement.We think we can reasonably conclude that the Fed will not upset the apple-cart again – as it did a few years ago when Powell hiked rates and then had to recant.
So, with rates low for a very long time, what should we fear? We think there is no reason to expect a pent-up inflation boom to build in the near term at least. The only big changes in inflation since WWII in the US followed the Korean war in the fifties and the OPEC oil prices hikes in the seventies.
And what if there is a boom in economic growth? We should applaud growth – unless it causes inflation. There seems to be reasonable evidence that low rates promote growth (greater than it would otherwise have been) but the link to inflation is tenuous.
Macroeconomics is an uncertain science at best – even compared to microeconomics and econometrics. The accepted linkage between growth and inflation is the so-called “Phillips curve”. In 1958, Kiwi Bill Phillips published a seminal academic paper on the relationship between unemployment and wages growth. He pushed the idea no further than that! But acolytes took this empirical study to the limits, even though new data did not support such a stable relationship.
In truth, academic economists and central bankers cannot find empirical evidence to support a stable relationship between unemployment and inflation and – by extension – between interest rates and inflation.
There has also been a growing following for Modern Monetary Theory (MMT). It didn’t exist a few years ago but the thesis of its proponents appears to be – grow the budget deficit with no consequences (unless inflation builds up). It’s interesting to note that academics who support this theory also seem to cover their tenure (i.e. a life-time job no matter what) which means that MMT proponents are safe from any come back if they are wrong!
So, where do we stand? We think we need a modicum of common sense when it comes to printing money and creating debt and that we are currently on a sensible path. Growth is building and is close to being sustainable without central banks.
We think it will be many years before any problems arising from Fed action surface – if at all – so we choose to think in terms of investing in a stable medium-term strategy.
Unlike in the US, our unemployment rate has not yet started to fall. But the last published increase was only from 7.4% to 7.5% and 114,700 jobs were created (of which 43,500 were full-time) in July. The participation rate continues to climb reflecting that people from outside the workforce are being encouraged to look for work.
James Bullard, president of the St Louis Fed, recently stated that the US growth for Q3 will likely come in at the biggest ever (largely because of the sharp fall in Q1/Q2) as we argued earlier in the year. If it does come in at around 20% (annualised) as Bullard suggests, that might be a big boost for Trump less than a week before the presidential election. Since most people probably don’t understand all of the important data and statistical issues it could be some ‘fake news’ that works in Trump’s favour!
The ASX 200 posted its fifth straight month of capital gains in August. However, our analysis does not suggest that it is significantly overvalued.
The Consumer Discretionary, Property and IT sectors were the strongest of the 11 sectors that make up the broader index during August. The Telco and Utilities sectors posted big capital losses in August.
The earnings reports for the first half of 2020 that have been posted so far have overall been better than many expected but there have been a number of quite poor results. This patchy success stresses the importance of appropriate diversification strategies.
The S&P 500 and the Nasdaq indexes broke all-time records on a number of days where new highs were reached during August. The S&P 500, like the ASX 200, posted its fifth consecutive month of gains but its August returns over-shadowed our (Australia’s) performance.
In contrast to our analysis of the ASX 200 we do find some evidence of the US market having run too fast. That does not mean that a correction is imminent, inevitable or even likely. Rather, the index might move sideways for a while until the fundamentals grow to catch up and erode any over-pricing.
There is increasing optimism on Wall Street that earnings in 2021 will be as big as, or even bigger than, those in 2019.
James Bullard, the St Louis Fed president, claims that the US recession only lasted two months and so its impact on earnings is likely much less than many anticipated at the start of the pandemic.
The world and emerging markets indexes have performed largely in line with the S&P 500 since the March lows.
Bonds and Interest Rates
The Fed’s contribution to the annual Jackson Hole meeting of central bankers was more interesting than normal – even if it was a virtual meeting. The Fed made it totally clear that it is not even worth thinking about when rates will go up. Indeed, they have even changed the definition of the inflation target to make the intent even clearer.
They are now targeting “average” inflation meaning that inflation above 2%, the current target, could be tolerated for an indeterminate period of time. Moreover, since the employment target will now focus on low and middle-income people, analysts are taking this to mean there is even more wiggle room for the Fed before it feels the need to raise rates.
The US 10-yr yield rose about 10 bps to around 0.65% and this caused the gap to the 2-yr yield (the so-called yield curve) to steepen.
Australia’s RBA is also ‘on hold’ and likely to be so for a similarly long time.
After some massive volatility in the prices of oil in the first half of 2020, there has been little change in either benchmark Brent or West Texas Intermediate (WTI) oil prices for several months.
The price of gold rose to above $US2,000 but then it retreated. The $A against the US dollar has continued its rise. Analysts are largely attributing this move to the weakness in the US dollar rather than in the strength of ours.
Importantly, iron ore and copper prices gained strength in August – possibly on the renewed strength of the China economy.
The June labour force data published in July stated that 210,800 new jobs were created but the number of full-time jobs was negative as COVID-19 restrictions changed the nature of business in Australia. In July, another 114,700 new jobs were announced but this time they included 43,500 full-time jobs. Perhaps solid economic recovery is underway. In normal times, only around 40,000 to 50,000 new jobs in a month (with half of that full-time) would be considered a big success.
The unemployment rate did go up one notch (0.1%) to 7.5%. Given that the participation rate – measuring the proportion of the relevant population actually in the workforce – was strongly up, an increase in unemployment from 7.4% to only 7.5% is particularly noteworthy. That is, people not either employed or classified as unemployed in the previous month were optimistic about joining the unemployment queue or got a job straight away.
The NAB and Westpac sentiment indexes painted a gloomy picture and the business indicators were sampled before the re-introduction of restrictions in Victoria. Nevertheless, retail sales were up 2.7% for the month of July.
We do not think the data are strong enough to conclude that the Australia economy has turned the corner and started to recover – but it does look that it might be in the process of recovering!
China exports grew at 7.2% in July and were much stronger than expected. The difference was largely explained by an unusual increase in medical supplies, no doubt related to COVID-19.
China auto sales were up 16.4% for the month which was the fourth consecutive month of growth.
The official China manufacturing purchasing managers’ index (PMI) came in as a slight miss at 51.0 – but that was well above the 50 mark that separates expansion from contraction. The services PMI at 55.2 was a big increase on the previous month’s 54.2.
Popular opinion among senior spokespeople for major financial institutions interviewed on business TV channels are calling a strong China recovery. In turn, that recovery has already helped Australia’s resources sector.
The US congress is struggling to find a solution to creating the next virus-related stimulus package. Both sides are in favour of a sizeable package but they cannot agree on how the money should be spent. The people who were getting the $600 supplements have received no more cash since the end of July.
If a solution is not found very soon, there will be no new payments until 2021. It is reasonable to conclude that much of the squabbling is due to politicking before the November election.
Trump was doing very badly in the polls a few months ago but he is coming back strongly – but he still has a long way to go. Democrats might well have fired all of their anti-Trump bullets but the Republicans seem to have some salvos in reserve. With a strong campaign and strong economic data (only because it was so bad before) Trump could make the election close.
It is not for us to take political sides or say which party would be better for the economy. One sage commentator on business TV pointed out that it is foolish to position one’s portfolio on the expectation of a particular candidate winning. Lots of proposed policies get lost after the election or defeated by the opposition. Punting on a candidate’s victory and subsequent policies is not a prudent investment strategy!
Non-farm payrolls were again up strongly in July – this time to 1.8m new jobs against an expectation of 1.6m. The unemployment rate fell from 11.1% to 10.2%.
The Citi surprise index – that measures the proportion of times consensus economic forecasts are beaten by the outcomes – continues to be very high. That is, forecasters in recent months were, in hindsight, far too pessimistic about the US economy.
Core inflation came in at 0.6% for July which is the largest number since 1991. However, as with our most recent CPI reads, there are possible statistical aberrations flowing from the impact of the virus (and the Fed need a lot more evidence of rising inflation to act on this reading anyway!)
News from Europe has largely been swamped by that from the US and Australia in our investing world. German exports did beat expectations but there were also many negative results – but not to the extent that they will impact in any major way on our market and Wall Street.
Rest of the World
Japan’s Prime Minister, Shinzo Abe, has resigned his office owing to health problems. He had brought stability to government after five years of instability during which five people had taken turns at the helm before his term.
Abe had built a policy, “Abenomics”, with three instruments – known as the three arrows. While it cannot be said that his policies have yet solved the problems of Japan’s economy, his presence on the global stage will no doubt be missed. We wish him well.