Themes For November

11 December 2019

Markets continued their impressive run so far this calendar year with most major exchanges recording solid gains in November. It’s now clear that the briefly inverted yield curve earlier in the year was not the harbinger of a US recession as many feared. Strong employment and wages growth together with positive sentiment is fueling a consumption boom in the world’s largest economy. The US market gained 3.4% for the month to be up an impressive 25.3% so far this calendar year with the NASDAQ advancing 30.6% over the same period.

In Australia, our market was 2.6% higher despite some disappointment that the Reserve Bank did not cut rates on Melbourne Cup Day.

Elsewhere, Europe was up 2.5%, Japan 1.6% while the UK improved just 1.4% as the Brexit saga moves to its likely conclusion following the general election on the 12th of December.

It was no surprise that mainland China fell 1.5% struggling under the weight of US tariffs on top of an already slowing economy. This was exacerbated by negative sentiment associated with the civil unrest in Hong Kong, dragging its market down 2.1%.

Outside of equity markets, Australian 10-year government bond yields sold off after the RBA failed to cut rates but quickly recovered to finish the month 5 basis points lower at 1.05%. US ten-year bonds were 6 basis points firmer, ending the month at 1.78%.

Among commodities, the stand out was iron ore which advanced 2.2% to be a staggering 32.9% higher over the last year, largely due to supply disruption from Brazil. In currency markets, the USD was a touch stronger on the major cross-rates and improved 1.9% against the AUD which finished at 67.7 against the greenback.

Interest rates continue to drive the equity market

The global financial system is awash with liquidity as policy across all major central banks is aligned to make credit both cheap and freely available. While liquidity stimulus is at full throttle, central banks lament the lack of support from other arms of policy such as fiscal stimulus and productivity improvement measures. While both the US and Australia have cut taxes in recent times, the indebted balance sheets of most other developed economies prevent them from engaging in much needed fiscal expansion.

Low interest rates and easy liquidity have been a boon for both equity and bond prices as the yield on all financial assets has fallen pushing their prices commensurately higher. It is expected that these conditions will continue to prevail for at least the next 12 months as central banks will be mindful of the “mistake” made by the US Fed in 2018 which moved too quickly to tighten policy causing them to reverse their stance in 2019. As a direct consequence of this, it is likely policy will be kept lower for longer than otherwise would have been the case.

The Australian share market has performed strongly this year, but it has done so against the backdrop of a disappointing earnings environment especially in the non-mining sector. Consider the earnings profile for industrials in the chart below, which shows that for the past 6 years, earnings expectations have started each financial year optimistically, only to be negatively revised as the year unfolds. The red line shows that this financial year is only expected to deliver very modest single digit earnings growth, while the green line shows that optimism is rising for a double-digit recovery in earnings next year.

To deliver on this expectation, a general improvement in the macro-economic environment is necessary. There is some cause for optimism as depicted by the OECD’s leading indicators for growth which are pointing to a strengthening global growth profile as we move into 2020.

The elephant in the room is the ongoing trade dispute between the world’s two largest economies, the US and China, which has constrained international trade to the detriment of the global economy. While the constant chatter about “progress” towards achieving a phase one agreement is getting a little tiresome, it is fair to say that recent data confirms the US’s negotiating position is strengthening. It would be a gamble by China to continue to endure the economic pain that tariffs are inflicting in the hope of a more sympathetic negotiating partner after the Presidential election.

On the other side of the world, it appears that a resolution to the Brexit saga is close with the Conservative Government likely to prevail at the general election on the 12^th of December. This would give Prime Minister Boris Johnson a clear mandate for the UK parliament to approve the Brexit proposal already agreed to by the EU. The removal of this uncertainty which has hung over both sides of the English Channel for over three years now, will be a filip for both the UK and EU economies.

Investment Outlook

Markets are on track to cap off an outstanding year in 2019. This is in complete contrast to this time last year when prices were falling precipitously on the back of tighter Fed policy and an escalating trade war.

Looking out to 2020, low interest rates and easy liquidity should continue to provide support for asset prices but we will need to see the “whites of the eyes” of an improving earnings outlook before increasing our commitment to equities in multi-asset portfolios.

During the month we took advantage of the short-term weakness in the Australian bond market to lengthen the duration of the government bond position by switching shorter dated bonds into longer-term maturities. With the RBA likely to cut rates by up to 50 basis points next year and possibly even introduce a form a quantitative easing, we should see bond yields move lower and so a longer duration strategy will provide a greater capital gain in this scenario.