Follow this link for a detailed summary of the proposals made in this year’s Federal Budget

Key points: 

• Australia capital city home prices fell -0.5% in May.
• Significant policy support & the earlier reopening of the economy have made our worst-case scenario for a 20% decline in average Australian house prices unlikely.
• However, our base case is for home prices to fall around 5-10%, as “true” unemployment will remain high, government support measures and the bank payment holiday end in September, immigration falls and new supply is likely to be boosted via government measures. 

Introduction 

Back on 19th March when we first looked at the impact of the intensifying shutdown of the Australian economy on the housing market we concluded that the impact would depend on how high unemployment rose. Our base case was a recession that saw unemployment rise to around 7.5% and would push average home prices down around 5%, but the risk was that a deeper downturn with say 10% unemployment could see a 20% fall in prices. Subsequent government support measures along with an earlier reopening of the economy have reduced the risk of worse case scenarios for home prices.

So far so good 

Since March property sales have slowed to a crawl.

The combination of the need for social distancing and the banning for a while of traditional on-site auctions led to a sharp decline in properties for sale. In addition to this, the Federal Government’s JobKeeper scheme keeping around 3.5 million people in paid employment and a doubling in unemployment benefits along with bank mortgage payment holidays, all of which are for the six months to September, have helped head off an increase in forced sales that might have occurred given the size of the hit to the economy. So, while property demand has fallen, it’s been matched by a collapse in supply, which has left the property market in a bit of a twilight zone.

While listings have started to pick up a bit lately, they are still very low and this has all helped soften the blow to house prices that would have otherwise occurred, but prices are still starting to fall. According to CoreLogic, after slowing to just 0.2% growth in April, average capital city home prices fell -0.5% in May. Prices fell in all cities except Adelaide, Hobart and Canberra, with Melbourne -0.9%, Sydney -0.4% and Perth -0.6%. This has seen the monthly change in capital city home prices collapse from a peak of 2% in November.

So where to from here?

The positives for the property outlook

There are basically five “positives” for property prices. 

• Mortgage rates have fallen to record lows with deals around 2 to 3%. This is keeping mortgage debt interest costs as a share of household income well below historic highs even though the ratio of household debt to income is at a record high of around 200%. Low mortgage costs also make the funding costs for an investment property very low.

• As noted above, while listings remain low.
• Government support measures have provided a huge boost to household income, supported businesses, supported employment for around 3.5 million workers, prevented a confidence zapping surge in measured unemployment & with bank mortgage payment holidays (which has seen around 440,000 mortgage deferrals) are preventing a sharp rise in mortgage delinquencies and hence forced sales.
• The shutdown, impacting mostly services jobs, has hit women and younger workers harder in contrast to past recessions which have hit male breadwinners harder and this may have helped keep down debt servicing problems.
• China is running 2-3 months ahead of Australia with respect to the coronavirus shock and its experience provides some guide. While property sales were near zero in the peak lockdown month of February average property price growth slowed but did not go negative and is now picking up a bit.

The negatives 

Against these positives, there are these big “negatives” for property prices flowing from the coronavirus shock. 

• High unemployment. We have long regarded the combination of high house prices and high household debt as Australia’s Achilles heel and so we feared back in March that a large rise in unemployment could trigger debt servicing problems, forced sales and so sharp falls in prices. As it’s turned out, measured unemployment is being suppressed and household incomes supported by stimulus measures. This is by design to help businesses, jobs and incomes hold up through the shutdown period. It’s likely headed off the worst case 20% decline in house prices scenario we saw in March. But once the support measures end later this year, measured unemployment will likely rise to around 8% and take a long time to fall back to the pre coronavirus levels around 5.2%. This in turn is likely to lead to some increase in mortgage defaults as bank payment holidays (for around 440,000 mortgages) end, boosting forced sales and act as a drag on property demand, albeit it’s unlikely to be anywhere near what would have occurred in the absence of support measures through the shutdown.
• A big drop in immigration. Thanks to travel bans, the Government expects net immigration to fall to just below 170,000 this financial year and to around 35,000 next financial year from 240,000 last financial year. This is a huge hit and if it occurs – the Government could always allow a faster return of immigration – it will take population growth over 2020-21 to just 0.7%, its lowest since 1917.

It will imply a hit to underlying dwelling demand of around 80,000 dwellings over the next 12 months taking it down to around 120,000 compared to underlying demand last year of around 200,000. This risks resulting in a significant oversupply of dwellings, reversing years of undersupply that has maintained very high house prices since mid-last decade. A cut to immigration is not something China has had to deal with, so its property market experience is not directly translatable to Australia.

• Falling rents and rising vacancy rates. Vacancy rates rose sharply in April and this plus rent relief is putting downwards pressure on rents. This will be further impacted by very low immigration. It will further weigh on investor demand and may cause problems for heavily geared property investors.

• Measures to boost housing construction. Faced with a big reduction in housing construction activity over the year ahead, governments appear to be working on plans to boost activity to protect home builders’ jobs via new home building grants and possibly the construction of social housing. Normally first home buyer grants provide a boost in overall demand. But if the focus is just on boosting supply at a time when underlying demand is very low reflecting lower immigration it could add to downwards pressure on average prices. (Proposed moves from stamp duty to land tax in some states could provide a short-term boost to home prices but should be long term neutral if the same revenue is raised and it’s unclear whether or when it will occur.)

Concluding comment 

Our worst-case scenario for a 20% decline in prices and those of others seeing 30% plus falls are unlikely thanks to support measures and the earlier reopening of the economy. To get these worst-case scenarios would require a “second wave” of coronavirus cases & so a renewed shutdown or another down leg in the economy in response to a surge in bankruptcies.

However, further falls in prices are still likely, as “true” unemployment (to become clear after September) remains high for several years, government support measures and the bank payment holiday end after September, immigration falls and likely government measures boost housing construction. Our base case is for national average prices to fall around 5-10% into next year. Sydney & Melbourne are likely to see 10% falls as they are more exposed to immigration and have higher debt levels whereas Adelaide, Brisbane, Perth & Hobart are only likely to see small falls and Canberra prices are likely to be flat.

This may be seen as a reasonable outcome in terms of making housing more affordable but without posing a big threat to the economy (via a downwards spiral of falling prices and negative wealth effects on consumer spending) at the same time.

Dr. Shane Oliver, Head of Investment Strategy and Economics and Chief Economist, AMP Capital

Key points:

• As we’ve seen recently growth assets like shares have periods of bad short-term performance versus bonds & cash. But they provide superior long-term returns which is essential to grow retirement savings. It makes sense for superannuation to have a high exposure to them.
• The best approach is to simply recognise that super and investing in shares is a long-term investment

Introduction 

This is an update of a note I wrote last November, but after the recent plunge in shares and the associated 10% or so loss in balanced growth superannuation funds through the March quarter, it’s particularly relevant now. When share markets plunge as they did into March the standard questions are: What caused the fall? What’s the outlook? And what does it mean for superannuation? The correct answer to the latter should be “nothing really, as super is a long-term investment and share market volatility is normal.” This may sound like marketing spin. But, except for those who are into trading or are close to or in retirement – shares and super really are long-term investments.

Super funds, growth assets & compound interest 

Superannuation is aimed (within reason) at providing maximum (risk-adjusted) funds for use in retirement. So typical Australian super funds have a bias towards shares and other growth assets that grow in value with the economy, particularly for younger members, and some exposure to defensive assets like bonds and cash to avoid excessive short-term volatility. These approaches aim to make the most of the power of compound interest which sees returns build on returns over time. The next chart shows the value of a $100 investment in Australian cash, bonds, shares and residential property from 1926 assuming any interest, dividends and rents is reinvested along the way.

As return series for commercial property and infrastructure only go back a few decades I have used residential property as a proxy. Over the period shown since 1926 cash has returned 5.4% per annum, bonds 6.9% pa, property 10.7% pa and shares 10.9% pa. Because shares and property provide higher returns over long periods the value of an investment in them compounds to a much higher amount over long periods. So, it makes sense to have a decent exposure to them when saving for retirement. The higher return from shares and growth assets reflects compensation for the greater risk in investing in them – in terms of capital loss, volatility and illiquidity.

But investors don’t have 90 years?

But while the above chart covered more than 90 years of returns, our natural tendency is to think very short term. Particularly so in times of uncertainty like now. And this is where the problem starts. On a day to day basis shares are down almost as much as they are up. See the next chart. So, day to day, it’s pretty much a coin toss as to whether you will get good news or bad on shares. But if you just look monthly and allow for dividends, the historical experience suggests you will only get bad news around a third of the time. If you go out to once a decade, positive returns have been seen 100% of the time for Australian shares and 82% for US shares. So while it’s hard given the bombardment of financial news these days it makes sense to look at your returns less because then you are more likely to get positive returns and less likely to make rash decisions based on short term bad news.

This can also be demonstrated in the following charts. On a rolling 12 month ended basis the returns from shares bounce around all over the place compared to the relative stability of cash (and bonds). See the next chart.

However, over rolling ten-year periods, shares have invariably outperformed, although there have been some periods where returns from bonds and cash have done better, albeit briefly.

Pushing the horizon out to rolling 20-year returns has almost always seen shares do even better, although a surge in cash and bond returns from the 1970s/1980s has seen the gap narrow. Over rolling 40-year periods – the working years of a typical person – shares have always done better.

This is all consistent with the basic proposition that higher short-term volatility from shares – often reflecting exposure to periods of falling profits and a risk that companies go bust – is rewarded over the long term with higher returns.

But why not try and time short-term market moves? 

The temptation to do this is immense. With the benefit of hindsight many swings in markets like the tech boom and bust, the GFC and maybe in the years ahead the current episode look inevitable and hence forecastable and so it’s natural to think “why not give it a go?” by switching between say cash and shares within your super to anticipate market moves. Fair enough if you have a process and put the effort in. But without a tried and tested market timing process, trying to time the market is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 8.5% pa (with dividends but not allowing for franking credits, tax and fees). 

If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 11.7% pa. And if you avoided the 40 worst days, it would have been boosted to 17.1% pa! But this is not easy as many investors only get out after the bad returns have occurred, just in time to miss some of the best days. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 6.3% pa. If you miss the 40 best days, it drops to just 1.9% pa.

The following chart shows the difficulties of short-term timing in another way. It shows the cumulative return of two portfolios.

• A fixed balanced mix of 70 per cent Australian equities, 25 per cent bonds and five per cent cash;
• A “switching portfolio” which starts off with the above but moves 100 per cent into cash after any negative calendar year in the balanced portfolio and doesn’t move back until after the balanced portfolio has a calendar year of positive returns. We have assumed a two-month lag.     

Over the long run the switching portfolio produces an average return of 8.6% pa versus 9.9% pa for the balanced mix. From a $100 investment in 1928 the switching portfolio would have grown to $185,869 compared to $595,510 for the constant mix.

Key messages 

First, while shares and other growth assets go through periods of short-term underperformance relative to bonds and cash, they provide superior returns over the long term. As such, it makes sense that superannuation has a high exposure to them.

Second, switching to cash after a bad patch is not the best strategy for maximising retirement savings and wealth over time as it locks in the loss with no hope of recovery.

Third, the less you look at your investments the less you will be disappointed. This reduces the chance of selling at the wrong time or adopting an overly cautious stance.

The best approach is to simply recognise that super and investing in shares is a long-term investment. The exceptions to this are if you are really into putting in the effort to getting short-term trading right and/or you are close to, or in, retirement.

Dr Shane Oliver, Head of Investment Strategy & Chief Economist 

Key points:

• After a strong rally, in the short-term shares are vulnerable to bleak economic and earnings news.
• However, positive news on the coronavirus outbreak is starting to get the upper hand – with evidence of curve flattening, an easing in lockdowns and massive policy stimulus pointing to a possible return to growth in the second half, which should ultimately underpin a rising trend in share markets beyond short-term uncertainties.

Introduction

The blanket coverage of coronavirus and its impact on the economy can lead to a lot of confusion right now. Some reports are hopeful of anti-viral drugs, others say a vaccine is at least a year away. There is talk of curve flattening but still rising cases and deaths. There is news of an easing in lockdowns but also worries about “second waves”. All this against a backdrop of collapsing economic data and surging unemployment. Some prognosticators say now is a great buying opportunity for investors whereas others see more financial pain ahead. This is a horrible time for humanity and particularly those directly affected by coronavirus, but I must say if ever there was a time to turn down the noise and listen to The Carpenters or Taylor Swift, this is it. Here is a summary of where we are currently at. First the bad news and then the good. I will keep it simple.

The bad news

• The reported number of coronavirus cases globally is still rising and has now gone through 2.5 million.
• The reported death rate is still rising and is now up to 6.9%.
• Many worry about a “second wave” of cases. This occurred in the 1918 Spanish flu outbreak, and Singapore and Japan which had been cited as models for containment are now cited as examples of this (although they really still seem to be in part of a first wave as their quarantining efforts failed).
• Most medical experts still say a vaccine may be a year or more away. I remember around 1984-85 constantly hearing a vaccine for HIV was a year away – but we are still waiting.
• In the absence of a vaccine some worry about coronavirus outbreaks every winter as it migrates around the world.
• Economic activity data is literally falling off a cliff. This was highlighted last week by the IMF’s forecast for a contraction in the global economy of 3% this year and in advanced economies of around 6%. And this masks a likely 10 to 15% slump in GDP centred on the June quarter. Falls of that magnitude have not been seen since the Great Depression. The collapse in economic activity in the US and Australia is highlighted by weekly economic activity trackers we have constructed based on data for things like restaurant bookings, energy usage, confidence, foot traffic and jobs.

• We are constantly hearing forecasts of unemployment going to 10%, 15% and maybe even 30% in the US (which does not have the benefit of Australian JobKeeper wage subsidies – if you are having a salary paid by JobKeeper then you will not be unemployed).
• This in turn is creating much consternation around whether there will be an economy left once the shutdowns end and/or how governments will get their debt down.
• Finally, the blame game is on. While partly politically motivated, US China tensions seem on the rise again.

The good news

• While the total number of coronavirus cases is rising, new cases appear to be levelling off or in decline.

• Numerous European countries, led by Italy, look to be following the same path as China which saw a blowout in new cases, a lockdown followed 2-3 weeks later by a peak in new cases and then falling new cases. Australia appears to have been very successful in following this path (with the peak coming faster) and the US now seems to be following the same path, albeit its yet to show a decent downtrend in new cases. Social distancing clearly works! (Just out of interest – with various countries following the same pattern China has reported it makes me think the Chinese data on new cases is roughly right despite emerging scepticism.)

• Following this, the focus is shifting towards an easing of lockdowns. Various European countries and New Zealand have already announced some easing, allowing some shops to open/activities to occur. The US has released guidelines for states to move through a three phased reopening if they meet various criteria (in terms of falling new cases & hospitals coping) before moving to each new phase.
• While Australia’s PM Scott Morrison has indicated that current restrictions will remain broadly in place for another few weeks, he has indicated three criteria for an easing in restrictions: better testing; better contact tracing; and confidence in containing outbreaks all of which makes sense given the risks Australia faces coming into winter. Of course, successful anti-virals and/or a vaccine would make it all a lot easier, but we can’t rely on either just yet.
• Most countries talking of easing are well aware of the risk of a second wave (although President Trump’s bravado about “liberating” states is worrying). Hence a focus on phased easing only once certain criteria – around testing, new cases and quarantining – have been met. This is very different to what happened in relation to Spanish influenza where there really wasn’t any testing. For Australia this is likely to mean a gradual opening up from May. In the absence of a vaccine, full international travel is likely to be the last thing to return. That’s not great but given that in net terms its worth less than 0.5% of GDP to the Australian economy, it’s trivial compared to the 10-15% hit that’s come from shutting or partially shutting about 25% of the economy as it would be this mainly domestically driven activity that would bounce back as the shutdown is eased.
• Fiscal and monetary stimulus has been ramped up to the point that they should help minimise second round effects on economies enabling them to bounce back faster. This is particularly the case in Australia where the focus has been on job subsidies to preserve jobs, support businesses and low-cost RBA funding has enabled banks to offer loan payment holidays. Yes, there may be longer term issues in paying down debt, but they are small compared to the cost of allowing a bigger and deeper hit to the economy from not protecting businesses and incomes through the shutdown.

If, as appears likely, an easing of the lockdowns becomes common place in May/June, then April or maybe May should be the low point in economic data much as February was in China. This does not mean that things will quickly bounce back to normal – some businesses will not reopen, uncertainty will linger, debt levels will be higher and business models will have to adapt to different ways of doing things around working and shopping. On our forecasts it will look like a deep V recovery in terms of growth rates, but looked at in terms of the level of economic activity it will take a lot longer to get back to normal and this will mean that it will take a while to get unemployment down – from a likely peak in Australia of around 10%. But at least growth will be able to return and spare capacity and high unemployment will mean that it will take a while for inflation to pick up and so low rates will be with us for a long time.

This is all very different to five or six weeks ago when there was talk of six-month lockdowns, no confidence as to whether they would work and the policy response was seen as inadequate.

What does it mean for investors?

From their high in February to their low around 23 March, global shares fell 34% and Australian shares lost 37% as all the news was bleak. Since that low to their recent high, shares have had a 20% plus rally helped by policy stimulus and signs of coronavirus curve flattening. But this strong rally has left them a bit vulnerable in the short term – particularly as we have now entered a period which is likely to be see very weak economic data and news on profits. The ongoing dislocation in oil prices – to a “record low” of -$40 a barrel for West Texas Intermediate – has added to this, although lower petrol prices are ultimately more of a help than a hindrance to a recovery in economic activity. So, the very short-term outlook for shares is uncertain and a re-test of the March low cannot be ruled out.

However, shares are likely to be higher on a 1-2 year horizon as evidence of curve flattening, easing shutdowns combined with policy stimulus ultimately see a return to growth against a background of still very low interest rates and bond yields.

From a fundamental investment point of view the historical experience that covers recessions, wars and even pandemics (in 1918) tells us that the long-term trend in shares and other growth assets is up and that trying to time bottoms is always very hard. No one will ring the bell at the bottom, which by definition will come at a time of maximum bearishness when all the news is horrible. Maybe the low was back in March, maybe it wasn’t. To borrow from John Kenneth Galbraith’s famous quote on forecasters I will admit that I know that I don’t know¹. So a good approach for long-term investors is to average into markets after bear market falls over several months.

 Dr. Shane Oliver, Head of Investment Strategy & Chief Economist 

Key points:

• While shares have rallied 15-20% from their March low and may have started a bottoming process, it’s still too early to say with confidence we have seen the low for this bear market.
• Key signposts to watch for are: signs that the virus can soon be contained (here the evidence is starting to look better); monetary & fiscal stimulus to minimise collateral damage to economies (this gets a tick); signs that collateral damage is being kept to a minimum and growth momentum is bottoming (it’s too early for this one – albeit this may partly be a lagging indicator); and technical signs of a market bottom (some tick off).

Introduction

After a roughly 35% plunge from their February high point to their lows around 23rd March, global and Australian shares have had a 15-20% rally. What’s more this rally has occurred despite increasingly bleak economic data ranging from plunges in business conditions surveys or PMIs (see the next chart) to a record 10 million surge over two weeks in claims for unemployment payments in the US. Volatility remains very high but at least we are seeing up and down volatility rather than all down as was the case into mid-March.

Markets usually lead and so may have already factored in the worst. And we have seen massive fiscal and monetary stimulus over the last few weeks to match the coronavirus threat to economies. So maybe we have already seen the low for shares? Or maybe not? There is still a lot of bad news ahead regarding the virus and the economic hit and we still don’t know how long the shutdown will be for and hence it’s hard to gauge the size and duration of the economic hit, when the recovery will come and what it will be like. What’s more past bear markets have often been interrupted by strong rallies, eg, October/November 2008 saw two 19% rallies in US shares followed by the ultimate low in March 2009. This could be the case here even if we have entered into a bottoming process.

So, what should investors look for in terms of when we can expect a bottom or be at least somewhat confident that the bottom has been reached? Not that anyone will ring a bell at the bottom or that investors will be bullish at the bottom.

The following are what we are looking for¹:

• confidence the coronavirus can soon be contained;
• measures to minimise collateral damage to the economy;
• confidence collateral damage is being kept to a minimum & signs that growth momentum is bottoming; &
• technical signs of a market bottom.

Confidence the coronavirus will soon be contained

This is important as it will give guidance as to the duration of the shutdowns and their severity and hence the first round hit to the economy. There are several key things to watch:

• The severity of suppression measures.After containment policies (quarantining & contact follow up) failed to control the virus (South Korea may be an exception), most countries have moved on to suppression, ie social distancing. This has been made necessary to allow hospital systems to cope without a blow out in deaths as in Italy. The question is are they being applied rigoursly. The evidence suggests that they are. Of 41 major countries nearly 80% now have severe restrictions in place, including Australia.

• Is suppression working?The best thing to watch for is a turn down in the number of new cases. Italy is a good one to watch as it went into national lockdown around 9 March and if they get it under control it gives other countries hope. And there are some positive signs here with a downtrend in new cases evident in Italy, Spain, Germany, the EU generally and Australia. In the US it’s too early to tell, but it’s New York epicentre is showing a decline in new cases.

• Based on China’s experience: 11-21 days after the lockdown new cases peak, and a month or so after that, the shutdown can start to be relaxed, which is why Chinese economic indicators started to improve in March. (While some question the reliability of China’s Covid19 case data, directionally it looks right and lines up with President Xi’s March 10 Wuhan visit & the restart of its economy.)
• This would suggest that the lockdown in Italy and maybe even Australia may be able to be relaxed later this month or in May, if the number of new cases continues to trend down.
• Of course, if the lockdown is eased too quickly this may risk a second wave of cases (as occurred in relation to the 1918 Spanish flu pandemic). To guard against this, quarantining of new cases and contact follow up will have to be aggressive and international travel bans would likely have to remain in place to prevent imported new cases (as China has found). There are two things that could short circuit this.
• Antibody tests. It’s likely the actual number of coronavirus cases is being significantly underestimated because those with mild or no symptoms are not showing up for testing, but mass testing for antibodies to Covid19 would reveal what proportion of the population have already been infected and recovered. They will likely no longer be transmitters of the virus and should be able to return to work. Some estimates suggest that it’s already 40-60% of the Italian and UK populations. If so, there would already be a degree of “herd immunity” making it easier to safely relax the shutdowns. Such testing may still be several months away though.
• Anti-virals or a vaccine. A vaccine may still be 12 months away but anti-virals are being rapidly tested.

The bottom line on this is that there are a lot of balls in the air but the decline in the number of new cases in several countries including Australia indicates that shutdowns are working which in turn holds out the hope that they can be relaxed in a month or so (providing containment measures are rigorous). International travel will likely be the last restriction to be lifted.

Policy measures to support the economy

The past month has seen a massive ramp up in monetary and fiscal measures globally and in Australia to support businesses, jobs and incomes through the shutdown period and to keep financial markets functioning properly. These are discussed here and here. Some (eg in Australia) are better than others (eg in the US) but with policy makers committed to doing whatever it takes they provide confidence that second round damage from the shutdowns will be kept to a minimum, which will enable economies to recover once the virus is under control. We rate this as positive, although more may still need to be done.

Collateral damage being kept to a minimum/growth indicators bottoming

There are a range of indicators to track on this front, including:

• Credit spreads. Corporate & government bond yield gaps need to narrow. They are off their highs, but above normal.
• Money market funding costs. As measured by the gap between 3 month borrowing rates and expected official rates these have narrowed in Australia but remain high in the US.
• Default rates up only slightly. This is important in terms of assessing whether public support & debt/rent payment holidays are working. It’s too early to tell in most countries.
• Daily activity indicators (eg, for energy production and traffic congestion) stabilising. This has been a good indicator in China, but it’s too early in developed countries.
• Business conditions PMIs stabilising/improving. They’ve improved in China but are still falling elsewhere.

Technical signs of a market bottom

Market bottoms usually come with a bunch of signs.

• Extreme oversold conditions. This got a tick in March.
• Apocalyptic investor sentiment. It’s very negative but maybe not apocalyptic yet.
• Signs of falling downwards momentum. This may only become apparent on a re-test of the March low.

Signpost table

The following provides a summary. The key ones are in blue.

Concluding comment

Many of these signposts tick off positively so we may have seen the low. But given the uncertainty around the length of the shutdown, risks of a second wave and very poor economic data to come it’s still too early to say that with confidence. Trying to time market bottoms is always very hard so a good approach for long term investors is to average in over several months.

Dr Shane Oliver, Head of Investment Strategy & Chief Economist

Key Points:

• Significant government support is essential to enable parts of the economy to successfully hibernate.
• This will be financed by borrowing and is affordable given Australia’s relatively low public debt and low borrowing rates.
• Central bank support to keep financial markets functioning properly is also essential and quantitative easing is part of this.
• We are more likely to see a U-shaped recovery than a V or L.

Introduction

Along with the horrible human consequences, the coronavirus pandemic is having a huge impact on the way we live and as a result investment markets. This has raised a whole bunch of questions: why does a big part of the economy have to go into “hibernation”? how long might it be for? how big will the hit to the economy be? what does it mean for unemployment? why is it so important for governments and central banks to protect businesses and workers? can we afford all this stimulus? This note provides a simple Q&A for most of the main issues from an economic & investment perspective. To the extent simple answers are possible in this environment!

Why do we need the shutdowns?

This is a medical issue, but it drives everything that follows. The answer is simple. Something like 15% of those who get coronavirus need hospitalisation and 5% need intensive care. And this is not just elderly people. And there is little to no community immunity to it. So, if a lot of people get it at once the hospital system can’t cope and the death rate shoots higher. Italy shows this with a death rate of 11.7%. So, unless we want to see the same surge in deaths as Italy we have to “flatten the curve” of new cases so the hospital system can cope. And to do this we have to practice social distancing which means meeting up with as few as people as possible which means staying at home wherever possible. This in turn means a big part of the economy gets shutdown.

Which Sectors of the economy are most impacted?

Roughly 25% of the economy is being severely impacted and this covers discretionary retailing, tourism, accommodation, cafes, clubs, bars and restaurants, property and various personal services. But there is also likely to be a flow on to construction and parts of manufacturing as uncertainty leads to less housing construction for example. Only about 20% of the economy – communications, healthcare and public administration – will really get a boost.

How big will the hit to the economy be?

It’s impossible to be precise, but if 25% of the economy contracts by 50% with other sectors offsetting each other, that will drive a 12.5% detraction in economic activity mainly in the June quarter which is basically what we are assuming. This will the biggest hit to the economy seen since the Great Depression. Of course, if this leads to collateral or second round effects as, for example, businesses and households default on their loans the impact could be much greater and longer.

But why all the talk of hibernation?

The hibernation concept is a good way to look at it. As a result of the shutdown many businesses are seeing a massive loss in their sales and some must partially, or in many cases fully, shutdown until the virus is contained and the shutdowns can end. But rather than shutdown forever the best outcome is for them and their employees to effectively go into “hibernation” for a period so they can go back into business and resume their normal lives once the virus is under control but without being encumbered with so much more debt and rent arrears, etc, that they go bust anyway.

Why the need for massive government support?

This is where government and central bank action comes in. Since coronavirus became a global pandemic last month and countries progressively ramped up social distancing policies, governments and central banks have swung into action to help economies weather this storm. This is absolutely necessary. Such support is unlikely to stop a recession or depression like contraction in the economy. But it’s needed to minimise the collateral or second round impacts of the shutdowns and enable the economy to start up again when the threat from the virus abates. Australia has announced three fiscal stimulus tranches now totalling around $200bn or 10% of GDP, which is nearly double that of the GFC stimulus. Other countries have also announced massive stimulus with the US just signing off on one package worth $US2 trillion and now talking of another. The policy response is now of a magnitude that it’s starting to tip the risk scales against some sort of long depression/recession.

How will it be paid for?

Simple, the Government will issue bonds & borrow the money.

But can we afford such a surge in the deficit and debt?

First, to stress it’s absolutely necessary. The hit to the economy from the shutdowns could be 10 to 15% of GDP. This requires a similarly sized stimulus program to offset it otherwise we risk immeasurable collateral damage to the economy and people’s lives (causing an even bigger budget deficit).

Second, it makes sense for the public sector to borrow from households and businesses at a time when they are stuck at home and can’t spend due to the shutdowns or won’t spend due to uncertainty and for the Government to give the borrowed funds to help those businesses and individuals that are directly impacted. Using the funds to subsidise wages is a particularly smart move as it keeps people employed and keeps them linked to their employer. The trick is to curtail the stimulus once the economy bounces back otherwise the competition for funds will boost interest rates and create problems for the economy. So, the support programs are set to end after 15 months.

Third, Australia’s public debt is relatively low. Net public debt as a share of GDP is a quarter of what it is in the US. So, Australia has far greater scope to do fiscal stimulus than other countries.

Fourth, the cost of borrowing for the Federal Government is very low at just 0.25% for three years and 0.75% for ten years.

Finally, the budget blowout may risk a downgrade in Australia’s AAA sovereign debt rating, but Australia’s public finances will still look better than others. And I would rather a rating downgrade than a deep depression/recession any day.

When the dust settles Australia will be left with higher net public debt at maybe around 45-50% of GDP. It will be the price we paid to (hopefully) minimise the loss of life from the virus and at the same time minimise the hit to people’s livelihoods from the shutdown. This may necessitate forgoing the next round of tax cuts or a new deficit levy. And it may put a burden on future generations as wartime spending did. But I reckon that’s a cost most Australians are prepared to wear.

Why is monetary stimulus necessary? Low interest rates won’t get us to spend when we are stuck at home

Yes, people can’t spend much now, but as with government stimulus much of the central bank easing has been aimed at “protecting” the economy. This has three key elements:

• lowering interest rates to make it easier for borrowers to service their loans – eg, the RBA has cut interest rates and targeted lower bond yields to cut long term borrowing costs;
• pumping money into financial markets to make sure they keep functioning. As the crisis intensified bond yields perversely started to rise (as fund managers had to sell their liquid winning assets to meet redemptions) and corporate borrowing rates surged as investors feared defaults so the Fed pumped money into the US bond and credit markets to push yields back down. The ECB has done something similar in Europe by buying Italian bonds; and
• ensuring cheap access to funds for borrowers – eg, the RBA has provided funding for banks for 3 years at 0.25% which has enabled the banks to cut rates and offer debt payment holidays. The Fed is even undertaking direct lending.

How does quantitative easing help the government stimulus measures? Won’t it cause inflation?

Quantitative easing – which the RBA has now joined the Fed, ECB and Bank of Japan in doing – involves using printed money to buy government bonds in order to help keep interest rates down. The central bank buys these bonds in the secondary market (eg from fund managers) so it’s not directly providing the money to the government and those bonds must still be paid back when they mature. So, it’s not really “helicopter money” – which would see the RBA print money and give it to the Government which it would then spend. But of course, it is aiding the government’s stimulus program by helping to keep bond yields down. In the meantime, the balance sheet of the RBA will rise as it holds more bonds, but this is not a major issue unless inflation starts to rise due to all the extra printed money in the system. The Fed, ECB and Bank of Japan have been doing QE for years with no rise in inflation, so the RBA has a long way to go before it becomes a problem. Put simply there is no magical right or wrong level for the RBA’s balance sheet so if you are worried about it, just ‘chillax’.

How high will unemployment go?

We see unemployment rising well above 10% in the US (possibly to even 25%). But in Australia, there is a good chance that the Government’s wage subsidy scheme will keep up to 6 million workers in the most affected parts of the economy in a job and this may contain unemployment to below 10% here. The decline in unemployment though will likely be slow though depending on the shape of the recovery.

Will the recovery in the level of economic activity look a V, a U or an L?

Much will depend on how long it takes to control the virus. An L shaped (or no real) recovery is unlikely given: evidence that shutdowns will slow down the number of new cases as occurred in China and may now be starting to occur in Italy; the chances of a medical breakthrough; and all the stimulus which should aid some sort of recovery. By the same token a quick V style recovery is unlikely given that absent a quick medical solution the shutdowns will be phased down only gradually (with international travel being perhaps the last restriction to be removed). This suggests a U-shaped recovery is most likely.

Could anti-virals or a vaccine improve the outlook?

Put simply yes. A study of past epidemics and the medical response to them by my colleague Brad Creighton shows an ability of governments working with scientists and the medical community to rapidly speed up the development and deployment of anti-virals and vaccines. There is now a massive global effort on this front and some drugs are promising. So, it’s not out the question that there is a breakthrough enabling a quicker relaxation of shutdowns.

When will shares recover?

The historical record of share markets through a long litany of crises tell us they will recover and resume their long-term rising trend. The massive global policy response to support economies in the face of coronavirus driven shutdowns is starting to tilt the risk scales against a long depression scenario. This is why share markets have started to get some footing over the last week or so after seemingly being in free fall for a month. Key things to watch for a sustained bottom are: signs the number of new cases is peaking – with positive signs emerging in Italy; the successful deployment of anti-virals; signs that corporate and household stress is being successfully kept to a minimum – too early to tell; signs that market liquidity is being maintained and supported as appropriate by authorities – this has improved; and extreme investor bearishness – investor panic is already evident but it can get worse.