Disconnect between upbeat share markets and fragile economies

Never underestimate the volatility of investment markets.

Take the last couple of months for example. Despite share markets falling sharply in the first quarter of the year, due to economic shutdowns across the world, there was a strong rebound in the second quarter to June.

So, what drove this remarkable turnaround?
 

Concentration of returns

According to MLC Chief Investment Officer Jonathan Armitage, to put this volatility into context, it’s important to look at what’s been driving investment markets, particularly the US share market, as measured by the S&P 500 Index.

Since the start of 2015, the top five US stocks— Amazon, Google, Microsoft, Facebook, and Apple alone have added around $1 trillion more in market value than the other 495 companies on the S&P 500 Index combined!

To further illustrate this point, in the 6 months to the end of June, Amazon's market capitalisation increased by more than the combined total market capitalisation of Wells Fargo and JP Morgan— two of the US’s biggest banks.

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As such, Armitage says this period has been largely driven by the strength of a concentrated area of the share market.

“Particularly in the US, share markets have been very narrowly focussed. And by that we mean you've had a very small number of stocks, namely a handful of technology companies, driving index returns.

“These markets are therefore presenting real challenges for active investors, because if you didn't own those stocks, it's incredibly difficult to beat the market.”

Armitage also warns that historically this concentration of returns within share markets has been unsustainable.

“There have been other periods when similar things occurred but it's very difficult for that to be repeated for any length of time.”

Credit spreads

When it comes to credit markets (that is the corporate bond market), US, European and Australian corporates bonds showed very different returns.

As indicated in the graph below, there was a significant disruption to credit markets in March due to government policies shutting down parts of the economy—most notably in the US.

But according to Armitage, Australia performed relatively well, despite the market having liquidity challenges during that period, which played to the strength of MLC’s investment portfolios.
 

Government and central bank intervention

The scale and speed of the Australian government’s intervention for COVID-19, has caused the country’s budget balance to shift in an incredibly short period of time.

In May last year, the budget surplus was predicted to be about 0.4% of Gross Domestic Product (a measure of the value of the goods and services produced by Australia), however, according to the Treasurer's most recent comments, the deficit is likely to end this financial year about 10%.

But Armitage says it’s important to note that while it's clear the budget position has swung quite dramatically; Australia's position looks robust.

“In comparison to other developed and major economies, Australia's position is relatively healthy. Also, historically, we've seen periods of much higher government debt during serious economic dislocations”. By the end of World War II, following debt levels that built up during WWI, the Spanish Flu Pandemic, and the Great Depression, Australia’s debt rose to more than 150% of GDP.
 

Dealing with new risks

COVID-19 has added new risks for investors that may require them to make risk-reward trade-offs.
According to MLC Head of Investments Al Clark, there are now myriad risks that investors need to be prepared for.

“We need to accept that we don't know what the future is going to look like so we need to be positioned for a range of potential outcomes.

“We prefer the idea of participating in attractive opportunities but protecting our portfolios as we do so,” he says.
 

Playing defence is important

Clark says MLC uses a range of different techniques to help provide some protection in its portfolios which is necessary in this highly uncertain environment.

Diversification

When uncertainty is high, Clarks says his investment team reduces reliance on any single growth allocation.

“We've got equities, but we’re also looking at other growth drivers to diversify the way we’re receiving our returns.”

Defensive strategies

Defensive strategies are used to trade away some share market upside for downside protection, in the event of market falls.

Currency

Investing in less risky currencies like the US dollar or Japanese Yen, Clark believes lessens the impact on Australian investors when global share markets fall.

Gold

Clark believes gold may be a good defensive exposure against inflation risks as central banks keep a lid on interest rates.

Liquidity

“With all these uncertainties and changing conditions, we want to make sure we've got a liquid portfolio so we can adjust to these changing conditions,” he says.

 

Important information and disclaimer

This article has been prepared by NULIS Nominees (Australia) Limited ABN 80 008 515 633 AFSL 236465 (NULIS) as trustee of the MLC Super Fund ABN 70 732 426 024. The information in this article is current as at August 2020 and may be subject to change. This information may constitute general advice. The information in this article is factual in nature and does not take into account personal objectives, financial situation or needs. You should consider obtaining independent advice before making any financial decisions based on this information. You should not rely on this article to determine your personal tax obligations. Please consult a registered tax agent for this purpose. An investment with NULIS is not a deposit with, or liability of, and is not guaranteed by NAB or other members of the NAB Group. Opinions constitute our judgement at the time of issue. In some cases information has been provided to us by third parties and while that information is believed to be accurate and reliable, its accuracy is not guaranteed in any way. Subject to terms implied by law and which cannot be excluded, neither NULIS nor any member of the NAB Group accept responsibility for any loss or liability incurred by you in respect of any error, omission or misrepresentation in the information in this communication. Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.