Economic Strategy: The current collapse
About the author:
- Author name:
- By Michael Knox
- Job title:
- Chief Economist and Director of Strategy
- Date posted:
- 19 March 2020, 3:25 PM
The current collapse in equity markets is not because of a collapse in fundamentals.
The physical infrastructure of the US economy, the Chinese economy and the Australian economy, are still the same.
The collapse instead, has been triggered by an attempt by these nations to avoid the excesses of mortality, previously associated with such a major international pandemic. The Australian Prime Minister, Scott Morrison, says that the current pandemic is similar in potential impact to the Spanish flu epidemic which struck Australia and the world at the end of the Great War.
The major effect of the Spanish Flu in Europe seems to have been in 1918 and 1919. Its major effect in Australia seems to have been in 1919 and 1920. All of these years saw enormous loss of life. This extreme loss of life, particularly in the United States, was primarily because the US president of the day, appeared to ignore the crisis in a situation, where he wanted to maximise the production of war material.
This time is different. Major economies are taking a significant hit in production early on, in order to keep the rate of growth of this contagion at a low enough level. At that lower level, the contagion can be handled by their existing health services. Their ability to achieve this objective will be the major measure by which they can successfully limit the death rates in their own countries from this epidemic.
Doctor Anthony S Fauci, the Director of the US National Institute of Allergy and Infectious Diseases, believes that the path of this disease in the US will likely run its course by the end of July. Should he be correct, then the current actions to restrict output, will come to an end. This will in turn generate a very rapid path of the recovery of both US manufacturing and services output in the second half of calendar 2020.
Most scenarios of the path of the US and Australian economies for 2020 see a slump in output in the second quarter, with growth accelerating rapidly in the third quarter and in the fourth quarter. Scenarios for the Chinese economy suggest that the major slump in output has already occurred in the first quarter of 2020. Output should recover modestly in the second quarter. Output should recover rapidly in the third and fourth quarters.
What is important to Australia?
Australia’s most essential export to China is iron ore. The steel industry in China, together with the coal industry provide a centrepiece to Communist Chinese policy of the expansion of output by government owned enterprise. In spite of the current slump in Chinese output elsewhere, it should be noted that the output of steel in China rose by 3.1% in the month of February.
This means that the demand for Australian iron ore in China is as strong as ever. The level of stocks of iron ore at Chinese ports, relative to consumption by Chinese steel mills, ended 2019 at close to the lowest levels since 2015. The supply of iron ore was relatively tight, compared to very strong iron ore demand.
Our model of the forecast level of Australian iron ore in $US terms, was at the end of 2019, showing a forecast price for 2020 in excess of $US110 a tonne. As we enter 2020, iron ore has been trading above $US90 per tonne. This is in spite of all the calamities that have been suffered by other commodities.
At the same time as $US iron ore prices held strong, the $A has fallen rapidly to below US60 cents. This means with Australian dollar export prices that are being received by iron ore exporters, are extremely strong. At the same time, the fall in the $A will generate an increase in import prices. The result should be that Australia should continue to maintain its very strong trade export surplus.
While the trade surplus should remain strong, the concern is the level of domestic demand. The major driver of cycles in the domestic demand in the Australian economy is the housing sector. In the short term the housing sector is primarily a function of the level of real interest rates. The lower housing loan interest rates fall relative to inflation, the stronger the demand for new and existing housing in Australia.
The Reserve Bank of Australia has embarked upon a path of aggressive monetary expansion. On 19 March, the RBA cut the cash rate to 0.25%; announced a program of quantitative easing to keep three year government bonds to a yield of 0.25%; announced a three year funding for lending facility for banks also at a rate of 0.25%, this last facility with funding of at least $90 billion.
Should the historical experience of other expansions be repeated, then this should generate an accelerated demand for new and existing housing. We understand that there may emerge supply chain difficulties in building materials, which will reduce the ability of the building industry to provide new housing. This will generate an exaggerated demand for existing housing.
Should the epidemic be coming to an end as expected in the second half of 2020, then this situation of limited supply and rapidly expanded demand could generate a dramatic acceleration of housing demand in Australia. This will support a powerful recovery of demand within the domestic Australian economy.
It is likely that the Australian economy will emerge from 2020, rapidly growing. It will not just be physically healthy, but economically healthy.
The current collapse in equity markets is not because of a collapse in fundamentals. The physical infrastructure of the US economy, the Chinese economy and the Australian economy, are still the same. We model equities markets on the basis of consensus estimates of operating earnings per share.
At the time of writing, there has been little downward revision of future estimates of operating earnings per share.
When they emerge, we think they will follow a pattern of a broader economic scenario. A weak second quarter will be followed by a strong third and fourth quarter.
The market has not been reacting to the fundamentals of earnings per share and bond yield that explain the overwhelming majority of stockmarket action. Instead, they have been responding to a one in a 100-year epidemic, the actual effects of which upon the economy are fundamentally unknown.
The ASX200 seems to be finding support around the area of 4800 points which was the support level in the selloff in 2016 and the peak of prices in 2011.
By falling to this area, the ASX200 is around 1000 points too cheap.
This is a slightly greater discount than was previously seen in the very worst periods of the financial crisis at the beginning of 2009. On a two-year view, or perhaps even a view to the end of calendar 2020, Australian equities are extraordinarily cheap.
It is a little over 100 years since the world has encountered an epidemic of the size which currently confronts us. Markets cannot comprehend the effect of something which previously happened so long ago. The result is that equity markets have fallen to levels of undervaluation, only previously seen in periods of the most extreme financial stress.
Our best available information is that this epidemic should run its course by the second half of 2020. By the second half of 2020, the Australian economy should again be healthy. We expect that Australian equities will be trading at much healthier levels as well.
More analysis on the effects of COVID-19
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