Economic Update – May 2020

by Infocus Author

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

The recovery begins?

– Equities bounce back strongly in April as unprecedented fiscal and monetary stimulus applied
– Economies in early stages of starting to re-open as the COVID-19 rates of infection have slowed
– Oil prices face turbulent times and demand falls dramatically absorbing OPEC production cuts

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.

The Big Picture

After a really tough month for stock markets in March, the bounce back in April gave investors a chance to catch their breath. Of course, it is possible a new low will be formed at some time in the future but the news on COVID-19 is starting to get better.

It was quite rational for markets to have fallen as sharply as they did in March. After all, no one knew the extent of the devastation that the virus would cause. As soon as governments and central banks responded with stimuli, lock-downs and social distancing, markets realised that they had sold off too much.

We think the major markets are still cheap based on reported earnings but volatility and fear are elevated. As a result, the rate of price appreciation going forward over the longer term versus what we think of as fair pricing might be slower than what we experienced in April.

There have been so many stimulus packages and healthcare innovations, it is an impossible task to report all. And new changes are coming through with such speed that any attempted comprehensive report would rapidly be out of date. In the space of a month, global sentiment seems to have gone from doom and gloom in markets to ‘it’s not that bad’ after all.

We think the important take-away is that almost all major countries are rapidly responding to the challenges – unlike in the wake of the GFC in 2008 and 2009. Health authorities and scientists are seemingly working tirelessly to develop vaccines and provide cures. We think we are in safe hands! But Trump did take issue with the World Health Organisation (WHO) over their early responses (or lack thereof) to the onset of the crisis.

There are questions about whether or not people who have experienced a COVID-19 illness can be re-infected. As finance experts, we have nothing to offer on that question but we do take this uncertainty into account.

Many countries have already started to relax the lock-down restrictions – mostly in a phased fashion. It makes sense to respond in this fashion as it would be imprudent to run economies into the ground to ensure, like smallpox, the disease has been eradicated. That means that there will be future waves of infection in much the same way that there are usually weaker aftershocks following an earthquake. Because different regions are loosening restrictions in different ways there is a chance to learn from one another.

All economic data will likely be really bad for many weeks and possibly months – so there is no point in dwelling on them. If we look for a medical analogy, economies are experiencing ‘self-induced comas’ to allow doctors to deal with the patients’ needs in a timely fashion – rather than dealing with a recession-like trauma rapid-fire scenario in the ER.

Another point worth noting for less experienced readers is the bias that most forecasters put into some of their forecasts. It is well known that forecasters often indulge in so-called ‘rational cheating’ to use an academic term. It is often not in the best interests of the forecaster to publish their ‘honest’ best forecast but rather modify it in the light of the consequences of being wrong.

In the current situation, a forecaster who believes economies will be back to normal in short order would be well-advised not to say so. If the economy actually takes a longer time to recover, the optimistic forecaster is likely to be the object of much scorn. If the optimist is right, there are no particular prizes to win. On the other hand, a forecaster who overstates the time for recovery (at least by a little) will lose nothing if, indeed, it takes a long time. If a quick recovery happens, everyone is so happy that they ignore that the forecaster was, in fact, wrong.

With this bias in mind, we suggest that the consensus view for recovery that is published might be biased towards the longer run. Recall all of the eminent economists (including Nobel Laureates) who said, following the GFC, that a depression longer than the Great Depression was likely. How wrong they were – but can you now name them?

The impact of COVID-19 was more than enough for analysts to try and work through during April but oil prices also went into a tail spin! The timing of the two phenomena might be related as it is thought Saudi Arabia has been waiting for the opportunity to run the relatively new US shale-oil producers out of business. What better time is there to attempt such a price war than one in which people were already hurting?

There is always the incentive for independent oil producers to compete for market share – which is why OPEC was formed in 1973. Since Russia and the US are big oil producers that are not OPEC members, price control by OPEC is limited. In an attempt to become self-sufficient in oil, the US has turned to extracting oil from shale as well as oil wells. We ‘passed’ on such ‘fracking’ in Australia.

Shale oil is now such an important component of US production that its output had a depressing impact on global oil prices.

OPEC+ (i.e. including Russia and a few smaller independent players) agreed earlier in April to a material supply cut to start from May 1st. However, the massive lack of demand due to COVID-reduced travel on land, sea and air has made even that cut insufficient to stabilise markets.

The US has a massive underground oil storage facility in the centre of the country (Cushing, Oklahoma). It is nearly full so that there is nowhere for more US oil (known as WTI or West Texas Intermediate) to be stored. As a result, many players had to sell their forward contracts at negative prices to prevent being forced to take delivery! This is a phenomenon that is likely to recur monthly as each forward contract nears expiry (the next is due on May 19).

The global price of oil (known as Brent) has been more stable but it has still been impacted through interdependencies. The Saudis reportedly can withstand these price gyrations for many months if not longer. However, the newer shale-oil producers are less cost effective and the first bankruptcy proceedings have already started.

The oil price war is unlikely to have a major detrimental impact on the market in the longer term but these oil price spikes do seem to cause excess volatility in stock market indexes along the way.
With regard to COVID-19 and oil prices, we believe that the prudent investor who started the year with an appropriately diversified portfolio should probably stick with it. Even experienced fund managers find it difficult to pick the right time to buy and sell. And this suggestion brings us to the opportunity many people are now faced with in super funds as some are able to withdraw up to $20,000.

Super is a wonderful, tax-effective way to save and should be preserved if possible. For many people, $20,000 is a sizeable chunk of their savings. Assuming a balanced rate of return of 7% pa on investments with an inflation rate of 2.5% pa, a 30-year old person due to retire at 67 would be forgoing $244,472 at retirement (or $101,937 adjusted for inflation). Compound interest is a powerful force! Early exit can be massively expensive in the long run for the young.

Of course, some people might have no option but to withdraw the $20,000 or part thereof but it would be wise to look for alternative solutions first and, perhaps, not taking out the maximum amount even if alternatives are not available.