After several months of historic calm, stocks sold off sharply this quarter. Rising interest rates in the US and trade war fears were cited as the spark that caused the sell-off. From 1st September to the time of writing, the Australian All Ordinaries dropped from approximately 6,400 to 5,700 points, almost 11%. Concerns about corporate profit margins peaking and a potentially overcrowded tech trade also likely played a role in upsetting a market that had been extraordinarily calm.
We do not think this warrants that investors flee for the equity exits, we also remain in the camp of recommending that investors have no more than their normal long-term allocation to equities. Historically we’ve seen that the best stock returns tend to come when economic data is weaker, not stronger—remember the stock market is a forward-looking mechanism. Stocks have an uncanny ability to figure out when the data is at or near its peak and just beginning to roll over (i.e., stocks tend to discount inflection points). Stocks rarely “wait” for the data to deteriorate meaningfully.
Solid economic growth and strong corporate results, particularly in the U.S., boosted global equity markets. Tax cuts provided support, but the policy environment is becoming less positive as the Federal Reserve continues to hike interest rates and U.S.–China trade escalation exacerbates late-cycle pressures. In Europe, fears of a ‘no-deal’ Brexit persist, less stimulatory monetary policy from the European Central Bank and uncertainty regarding to the political environment in Italy are leading to weaker confidence toward the outlook for the region.
Economic analysis (Australian Update)
As expected, the RBA left the official cash rate (OCR) unchanged at its latest policy meeting on 6 Nov. Bond yields have been volatile in recent weeks though with little net overall change, and the 10-year Commonwealth bond yield of 2.72% is close to where it was a month ago. The Australian dollar has fallen in value this year, partly reflecting the global strength of the U.S. dollar. In overall trade-weighted value, the Australian dollar is down 3.1%, due mainly to its depreciation against the U.S. dollar (down 7.4%) and the Japanese yen (down 6.3%).
In its latest (9 Nov) quarterly monetary policy statement, the RBA said it “is expecting further progress in reducing unemployment and ensuring inflation is consistent with the target. If that progress is made, higher interest rates are likely to be appropriate at some point. However, given the expected gradual nature of that progress, the Board does not see a strong case to adjust the cash rate in the near term.”
On current pricing, the futures market is interpreting the RBA’s “at some point” to mean a 0.25% increase in the cash rate sometime in late 2019 or early 2020. Inflation is likely to gradually move up into the RBA’s 2%- 3% target range, with the RBA expecting inflation will be running at 2.0% to 2.25% next year and will continue at 2.25% throughout 2020. Higher inflation means it is likely bond yields will also have to head higher to preserve investors’ “real” (above-inflation) returns. Another factor suggesting higher local yields is the likely rise in U.S. bond yields, as although the relationship appears to have become uncoupled in recent months, longer-term trends still suggest higher U.S. yields will have some local impact.
The financials led the market down during its recent fall, under scrutiny from the Royal Banking Commission. As of 15th November, they were down 9.7% in capital value while consumer discretionary stocks were down 2.7%. More positively, the IT sector has been strong (up 13.2%), while consumer staples (up 6.4%) and the miners (up 3.6%) are also ahead. The industrials have shown little net change (formally down 0.3%).
The RBA believes GDP in the Australian economy will grow by 3.25% this year (it had previously picked 3.0%), and it expects the unemployment rate will be 5.0% at the end of next year (previously 5.25%), and lower again (4.75%) in 2020. Overall, the labour market remains healthy, growth is solid, but wage and price pressure remains subdued in the economy more broadly. When we consider history, one of the standout messages for this stage of the cycle is to be extremely careful paying up for growth i.e. We want GARP (growth at reasonable price) not GAAP (growth at any price).
Although headwinds persist in the form of an uncertain global economic outlook, we expect that global commodity prices will post solid year-on-year gains in Q4 2018. The increase will largely reflect the boost in prices observed in the first half of the year, especially for coal, nickel, oil and its derivatives, palladium and U.S. steel. Next year, global commodity prices will expand at a slower rate as a broader preference for cleaner energy and increased oil supply will lead energy prices to decline.
Recently, we’ve seen a discount develop on the back of massive builds in US Crude Oil inventory to the tune of 6.49mln barrels. In addition to increased inventory in the US that may be showing demand is waning, traders are concerned that a tightening Fed will hurt demand while trade wars may have impacted China. Chinese GDP missed expectations when it came in at 6.5% vs. 6.6% and signs are emerging that Saudi Arabia is increasing production to more than make up for pending Iranian sanctions and depleting in Venezuela. While concerns remain about US monetary policy, global economic growth, and now crude oil supply, the historical pattern of rotational leadership in capital markets tends to see commodities lead the final charge before a recession takes place as inflationary concerns and growth see its final light of day. JPMorgan noted that they see more than a 60% chance that the US will tip into a recession over the next 24-months based on a slew of macroeconomic data.
BASE METALS – Australia
The combined effect of a weaker exchange rate outlook and persistent strength in the price of some resource and energy commodities — particularly thermal coal and oil, which affects LNG prices — has led us to revise up our resource and energy export forecasts. We now expect Australia’s resources and energy export earnings in 2018–19 to reach a new high of more than a quarter of a trillion dollars. Nickel is used in the production of stainless steel, but it is not only improving demand there that has driven up the price of nickel. Nickel has become a key ingredient in the booming demand for more and better lithium-ion batteries to charge our electronic devices and now the electric vehicles (EV) of the future.
Listed property has proved to be a usually defensive asset through the past month’s equity volatility. Although the absolute return has not been especially impressive, with the S&P/ASX 200 A-REITs index marginally down (by 0.2%) in capital value, and providing a modest 3.0% total return, the sector has outperformed the 1.7% return from the overall share market. The outcome flatters the sector to a degree, as there was a burst of merger and acquisitions activity that somewhat fortuitously boosted the prices of the target A-REITs
There is a strong negative correlation between the A-REIT sector’s share price performance and changes in long term bond yields. Going forward, we believe local bond yields will continue to be influenced by rising global rates creating value in individual stocks.
Until this year, the global economy had been characterised by three years of strong, synchronised growth with subdued inflation—the “not too hot, not too cold” characteristics of a “Goldilocks” economy. Inflation risk is clearly on the rise, driven by high commodity prices and tight labour markets.
The outlook for the global economy is currently clouded by a series of deadlocks on key issues.
• Since September’s Salzburg summit, the Brexit negotiation process has turned from bad to worse.
• U.S. tariffs on $200 billion of Chinese imports and China’s retaliatory tariffs on $60 billion of U.S. goods have contributed to elevated global trade concerns.
• Italy’s high deficit target will lead to a face-off with the European Union (EU).
Though we are still cautiously optimistic about global prospects, there is a clear growing unease over the handling of these important issues. Hopefully, economics and politics will align to reach productive resolutions.
Emerging markets face headwinds from China’s industrial slowdown, looming trade uncertainties, and global monetary tightening. Europe has experienced the most significant slowdown among developed regions.
Global manufacturing activity continues to expand, but the pace of improvement has slowed meaningfully. Manufacturing PMIs in 88% of the world’s largest economies are in expansionary territory; however, only 20% of them are improving on a six-month basis. Manufacturing trends offer evidence of slowing global momentum and, along with elevated trade risks, remain a headwind for export-oriented economies.
The British economy is heading for its worst year in almost a decade amid the growing risks from no-deal Brexit, according to a leading economic forecaster.
After official figures revealed zero growth in GDP in August, forecast growth of 1.3% for the whole of 2018, down from a previous estimate of 1.4%. This would be the worst annual period for growth since the financial crisis. It also downgraded the outlook for the second quarter running. Economists have said failure to reach such a deal could significantly harm the UK economy, with the International Monetary Fund warning of “dire consequences” for growth.
The government’s economic forecaster, the Office for Budget Responsibility, raised the prospect of a no-deal scenario triggering border delays, companies and consumers stockpiling food and other supplies, and aircraft being unable to fly in and out of Britain. Inflation is forecast to fall from about 2.7% to 2.3% by the end of the year, above the Bank of England’s target rate. Consumer spending growth is estimated to remain limited as a consequence, as UK households remain under pressure from weak wage growth and relatively high levels of inflation.
While we consider the greatest risks to European equities to be largely external, local political developments will warrant close attention. For instance, the Italian government’s recent submission of its 2019 budget plan has sparked a war of words. The European Commission is expected to say that Italy’s budget is in breach of EU fiscal rules. Italy has so far refused to yield to demands from Brussels on its targets for a 2.4 percent budget deficit and 1.5 percent growth. The European Union is a high-trust society, requiring all countries to do what is in the best interests of the Union. Italy would rather spend to stimulate its economy and reduce unemployment than force more austerity to reduce debt.
Fidelity’s proprietary Industrial Production Diffusion Index continues to signal significant weakness in China, and during Q3 China acknowledged the slowdown by fully shifting toward an easing stance. Policymakers there face a delicate balance of trying to ease conditions while, at the same time, not adding to elevated debt levels, a task made more difficult by an external sector no longer in surplus and facing rising U.S. trade.
The performance of Shanghai Composite Index is lagging the US market by a massive 30% so far this year. This divergence is extreme when compared to the ‘economic reality’ of the trade tariffs.
What’s next for China?
Increased infrastructure spending
The NDRC, the agency that oversees plans for infrastructure investment, announced plans to 1) front load some projects planned for the next couple of years; and 2) accelerate preparatory work for public projects to ensure steady flow of new projects and investment.
Increased export tax rebate and improved trade facilitation
China announced a 2ppts increase (weighted average) in the VAT tax rebate for exports worth about $300 bn (in 2016) effective September 15. The government also plans to reduce customs fees and approval procedures to facilitate trade.
Lower import tariffs and increase market access
Premier Li stated that China is considering lowering import tariffs on imports from a wide range of economies.
More tax cuts likely
On top of the planned RMB 1.1 trillion in tax and fee cuts announced in March, which include an estimated >RMB300 bn personal income tax cut, China has also announced increases and extensions of tax waivers for micro and small businesses in the past few weeks.
Boost domestic consumption
The State Council released on September 20 a general guidance to promote domestic consumption. The government plans to increase spending on public services, including by building related hard and soft infrastructure to facilitate consumption in health care, old age care, tourism, education and sports. It also promises to further open these sectors to private investment including by improving land access and business approvals.
While the official consumer price index rose at just half of policymakers’ 2% target in the latest reading, less-watched gauges suggest cost pressures are building. Prices paid by services companies are climbing the most since the early 1990s, as is worker compensation. Rents are accelerating in major cities, led by Tokyo. As companies start passing those costs along, and generalised inflation takes hold, investor attention could pick up. While Japanese stocks have been caught in the global sell-off that hit equities, the Nikkei 225 stock average at the start of October touched its highest level since 1991. This confirms the record profits among the nation’s companies and an investment-driven rebound in growth that’s helped pull unemployment down to the lowest in more than a quarter century this year. Companies have become more focused on improving profit margins and gradually increasing shareholder returns. Consumers were less pessimistic about their confidence in income growth as well as their willingness to buy durable goods. The Bank of Japan (BoJ) expects the economy will expand between 1.3% and 1.5% in the 2018 fiscal year, which ends in March 2019. In the subsequent fiscal year, the BoJ sees GDP growth at between 0.7% and 0.9%.
A trade war between the US and China has been heating up for much of this year, and it could have huge impacts on the US economy. President Donald Trump’s administration has levied tariffs on a total of $US250 billion of imported goods from China. That represents about half of all imports from China. China has retaliated by announcing tariffs on $US110 billion of US exports. The most recent set of tariffs against Chinese imports, which went into effect at the end of September, targeted around $US200 billion of goods with a 10% tax scheduled to increase to 25% on January 1, 2019. Unlike earlier rounds of tariffs that mostly targeted materials and intermediate goods, about a quarter of the new tariffs target consumer goods directly. As such, these tariffs could have an even more direct impact on Americans’ wallets. Some of the goods that are likely to be hardest hit by the newer tariffs include computers and computer parts, furniture, and tires.
Although an exceptionally tight labour market (unemployment below 4%) will likely continue to support consumer spending in coming months, ongoing rate hikes from the Federal Reserve should significantly dampen the momentum over time. Federal reserve officials unanimously voted to increase the federal funds rate by 0.25 percent. This will be the third such rate hike this year, lifting the benchmark rate above 2 percent for the first time since the Fed’s intervention following the credit crisis. Fed officials also hinted at one more rate hike before the year ends, while reaffirming their positive view of the U.S. economy.
Against a favourable fundamental backdrop, market declines present attractive buying opportunities. Eventually we will hit a recession, but in our view, economic underpinnings make that unlikely in the coming year, supporting further increases in corporate profits – a historically successful recipe for the stock market. It is certainly possible this sell-off gets worse before it gets better, our belief is that it is unlikely to develop into a bear market. The focus of markets will be on the earnings season which will be crucial in providing overall direction in the months ahead.
Investors can rebalance the property component of their portfolio to their full AREIT weighting as per the current Merlea Models. REITs are traditionally a defensive asset class, so rising rates have led some investors to rotate away into less defensive shares. But, the direct impact of rising interest rates on A-REITs’ profits is more gradual as many of the A-REITs have investments in commercial real estate with long term contracts in place, which are linked to inflation (so can be a hedge to rising rates). Structurally, at least, the sector is in good shape and balance sheets are generally healthy, with sector gearing of 26.8% on average. Furthermore, distribution pay-out ratios are also conservative and sustainable, at 82.2% on a weighted average basis. A-REITs with higher gearing will feel the pain more from rising rates.
Investors should focus their attention on ensuring that their overall portfolio is suitable for their risk tolerance, their lifestyle needs and their long-term return requirements. Market performance is difficult to predict, particularly over the short term but putting together an appropriate mix of Australian and international equities, fixed interest, property, cash and alternative investments is more likely to achieve an investor’s long-term goals compared to reacting to market events without the benefit of a plan.
Diversified portfolios with a mix of asset classes have managed to post acceptable returns over longer time frames of 5 or 10 years despite market volatility. This reflects the short-term nature of many of the equity market declines, together with the other asset classes being influenced by different drivers, and therefore providing an offset when equities perform poorly.
Given recent volatility some stocks/sectors that have been discounted are now within buying range. There have been several new additions to our investment models as we find value in stocks that were previously unattainable. While yield is likely to remain a focus, in time, as economic activity is stimulated by low interest rates and accelerates, we expect our models to broaden to a wider range of companies that will deliver capital growth, as well as income.
We recommended portfolios are generally designed to diversify assets across a range of asset classes to obtain low volatility given a stated return goal. The actual goal, or targeted return, from a portfolio is perhaps the most important influence in a portfolio as once a goal is stated the ability to assign asset allocations becomes a matter of maths. We will always prefer to gain as much return as possible from cash and defensive type assets and then augment this return with the higher risk/higher return possibilities from growth assets.
Opportunities are presenting themselves to accumulate stocks given the current market weakness, however, to find additional growth opportunities the models now have more stocks outside the Top ASX200.
Disclaimer – This document has been prepared for the general information of investors and not having regard to any particular person’s investment objectives financial situation and particular needs. Accordingly, no recipient should rely on any recommendations (whether express or implied) contained in this document without having obtained specific advice from their adviser. Jayne Graving, Arch Financial Planners and Financial Planners Alliance Pty Ltd make no representation give no warranty and do not accept responsibility for the accuracy or completeness of any recommendation, information or advice contained herein and Jayne Graving, Arch Financial Planners and Financial Planners Alliance Pty Ltd will not be liable to the recipient or any other persons in contract in tort for negligence or otherwise for any loss or damage arising as a result of the recipient or any other person acting or refraining from acting in reliance on any recommendation information or advice herein except insofar as any statutory liability cannot be excluded Under Section 849 of the Corporations Law.