The coronavirus is not the only risk to consider this this year
Early indications from the start of 2020 suggest that investor confidence in share markets remains strong and resilient, despite some new challenges to the growth outlook. Domestically, the bushfire crisis has created significant personal loss and tragedy. Although not without long term consequence for investors and possibly the way the broader economy and environment is managed, the shorter to medium term impact of the fires on financial markets and the overall level of economic activity is relatively contained
The outbreak of the coronavirus, however, does threaten to have a material impact on the global macro-economic environment, which could disrupt financial markets. We can’t predict the seriousness of the epidemic nor its duration, although encouragingly the signs of stabilisation in new cases does suggest management of the crisis is having some beneficial effect.
None-the-less, the response to the virus has been substantial and the disruption caused to supply chains and activity levels will have a noticeable impact on broader economic measures - both within and outside China. Australia, with its extremely close economic ties to China, is more exposed than most.
Australian jobs will be lost, and Australian businesses will close as a result of the crisis. The following quote from the CEO of Queensland Tourism Industry, Daniel Gschwind, highlights the seriousness of the impact:
“I think this is the biggest crisis we have faced in a decade. The loss of business around Chinese New Year is irrevocable. It will come back, but when? Many businesses have been pushed to the absolute brink and possibly beyond”
Notwithstanding the seriousness of the current impact, past experience with viral outbreaks suggests economic recovery from the short-term effect can be swift. However, in the case of the coronavirus, it remains too early to draw any firm predictions.
On the whole, equity markets appear to be looking through the period of virus impact and focussing on the long term earnings of companies. Investors should generally take a similar approach. History suggests there is merit in maintaining adherence to longer term investment strategies in periods of uncertainty.
None-the-less, whilst maintaining exposure to risk assets may still be appropriate, there is perhaps some rationale for the coronavirus to prompt a reconsideration of portfolio risks and the ways in which risk could be potentially lowered without deviating too far from longer term strategies. An obvious strategy may be to lower exposure to any equity assets held specifically in China or the Asian region. However, there has already been some price response in these markets and, even prior to the outbreak of the virus, these markets were trading at substantial discounts in valuations to Australian and other developed economy markets.
This is shown on the accompanying chart, which compares to the PE ratio (the ratio share prices to annual earnings) of Asian markets to Australia and the broader global developed markets. With prices cheaper on a relative basis, Asian equity markets could rally strongly in response to news of a material subsidence in the virus. Hence, a strategy of exiting Asian equities may assist in protecting a portfolio against the impact of any further worsening of the virus; however, it may then be very difficult to execute the timing of a re-entry to Asian markets ahead of an expected sharp rally when the virus diminishes.
An alternative response would be to consider the allocation split between Australian and global equities more broadly. As mentioned above, the Australia’s economy is highly dependent on the Chinese economy in areas of commodity trade, tourism, education etc. As such, should the outcomes of the coronavirus be worse than markets are expecting, then Australian equities could be expected to underperform. As such, it could be argued that coronavirus related risks are more significant for Australian equities than for global equities. The potential role played by currency movements could further support this argument as it is more likely the $A would fall than rise in a scenario of a worsening virus impact. Any depreciation of the $A would then cushion the impact on global equities held on an unhedged basis.
Other risks presented by Australian equities
Even if one were to ignore the potential impact of the coronavirus, there are perhaps more fundamental reasons to be reconsidering the Australian/global equity market split. The current record high valuations on Australian and developed global equity markets can be justified by the combination of on ongoing low interest rates and a reasonable company earnings growth outlook. However, with the Australian economy operating on a lower growth trajectory than other developed markets, particularly the U.S., the opportunity for earnings growth here may be more muted. This disparity in earnings growth outlook is further entrenched by the industry mix available on the Australian share market, which has relatively few opportunities in the higher growth healthcare and Information Technology sectors.
Contributing to the risks associated with earnings growth in Australia is the banking sector, which accounts for approximately one quarter of the Australian share market. Although new lending has picked up, bank asset growth remains subdued and low interest rates have restricted earnings from interest margins. Regulatory risks remain elevated, with the risks of the current enquiry by the Australian Competition and Consumer Commission (ACCC) into home loan pricing potentially being underestimated by the broader market. As outlined in the following extract from the ACCC’s announcement of the enquiry last October, there will be a focus on the disparity in mortgage rates paid by borrowers. Any regulatory action to bring closer alignment of interest rates between banks’ historic “back book” of loans and that offered to new loan customers could have significant implications for bank profitability. Comparable regulatory action has taken place with electricity retailers, potentially setting a precedent for the banking sector.
“The inquiry will consider what prevents more consumers from switching to cheaper home loans. The ACCC will consider matters such as consumer decision-making and biases, information used by consumers and the extent to which suppliers may contribute to consumers paying more than they need to for home loans.”
As the chart above indicated, Australian equities are trading at similar valuations to other developed economy share markets. Given the arguably higher risks associated with Australian company earnings growth, it is perhaps more difficult to justify these Australian valuations.
Further risks to consider in 2020
Every period has its set of unique investment risks and there are always reasons the risk adverse can find to justify not investing. In addition to the coronavirus and Australian specific risks discussed above, 2020 presents some other potential events that may, or may not, end or pause what has been an exceptionally long bull market for equities. First and foremost, the bull market has been entrenched by the continued absence of global inflation and the exceedingly low interest rate environment this had facilitated. Any inflationary pressure, whether stemming from a tightening U.S. labour market or other source, would be a possible trigger for a correction on equity markets.
Towards the end of the year, the U.S. Presidential election may emerge as a key influencer on market sentiment and the direction of equity markets. Elections around the Western World have proved increasingly difficult to predict and the potential change in voter turnout patterns is one additional variable that needs to be considered in assessing the likely U.S. election result. Whether or not record high share market valuations can be maintained as the election date looms closer remains to be seen.
Holding equity investments in these periods of heightened uncertainty may feel uncomfortable. However, it is the presence of this uncertainty and risk that is the underlying reason why equity investments will produce higher returns than less risky asset classes over the longer term.