30 December 2018
Investment Outlook 2019
The final months of 2018 were certainly forgettable with share markets experiencing sharp declines in the final quarter of the year. For investors there was really no place to hide with all major asset classes except for cash and government bonds posting negative returns for the year. Sentiment turned decidedly negative and markets climbed a “wall of worry” over a multitude of concerns including a slowdown in the Chinese economy, interest rate hikes in the US, the trade war between the US and China, uncertainty surrounding the UK’s “Brexit” from the EU and political turmoil in the US which culminated in a shutdown of 25% of the government late in the year. In Australia, falling house prices in major capital cities as a result of tighter lending conditions raised concerns of a spill over into consumer spending which accounts for around two thirds of economic growth. While the market always grapples with risk and uncertainty, over the short term, it can be heavily driven by sentiment.  When pessimism becomes the driving force, an unrealistically high probability is attached to negative scenarios when the reality is that not all fears will be realised.

Some positive news to kick off 2019

The good news is that two of the major factors on the 2018 worry list have turned for the better in early January 2019. Firstly, and most importantly, US Federal Reserve Chairman Jerome Powell has articulated a more dovish tone concerning future rate rises in 2019 much to the market’s relief. The concern was that the Fed had become tone deaf to the message that financial markets were sending them about the state of the economy and that they might err by hiking rates too aggressively. As the US has been the shining light in the global economy, a slowdown there would possibly induce a global recession. In 2018 the Fed had created the expectation of up to four 25 basis point increases in 2019, raising concern that that US economy could not handle such an adjustment especially while liquidity was being reduced by running off balance sheet assets bought following the GFC. Fortunately, Chairman Powell’s words provided the comfort markets were looking for by stating they would be “patient and flexible” with respect to future moves. This was interpreted to mean that the Fed would likely pause rates hikes for the time being. In our view, with inflation remarkably stable around the Fed’s 2% target level, and with the global economy slowing producing a strong deflationary effect, there is simply no imperative for the Fed to increase rates in the immediate future. While the Fed will naturally review data, especially relating to inflationary pressures such as wages growth, we expect a period of rate stability at least for the next few months, which will be positive for share prices.

The second major positive development has been reports of good progress towards resolving the trade dispute between the US and China that saw “tit for tat” tariffs imposed by both countries. Since their meeting at the G20 summit in Buenos Aires in late November, both countries have met on several occasions to hammer out a mutually acceptable resolution. With the Chinese economy slowing for domestic reasons and President Trump under increasing political pressure in the US, both sides have strong motivation to make a positive announcement inside the 90-day window established in Argentina. While the longer-term structural issues concerning protection of intellectual property and the forced transfer of technology from US companies investing in China will take some time to resolve, at a minimum expect to see both sides remove their tariffs and China commit to buying more US goods, especially agricultural products. The lowering of trade barriers between the world’s two largest economies will be good news for the global economy.


So where to from here?

Fortunately, 2019 has started on a much brighter note with share markets sharply higher so far this month. For example, the pivotal US share market is up 10% from its December lows and has adopted a decidedly more upbeat tone. Now the 2018 dust has settled, it is clear that markets were overly pessimistic in the latter stages of the year. As a consequence, part of the rebound has been a correction from an over-sold position but also reflects the positive developments referred to above. Even factoring in the recent bounce, shares are now much more reasonably priced than 12 months ago with PE ratios now trading around 14 times earnings down from 18 times at the beginning of 2018. With the market only expecting modest earnings growth of around 5% this year, there is a substantial valuation buffer to protect against further falls of the magnitude that we saw in the December quarter last year.

There is no doubt that there will be some challenging times for the market over the course of 2019 and that volatility will be the norm not the exception. Rather than be reactive to volatility, we look through the noise to long term fundamentals to make sound investment decisions. Our focus is always on the need to balance risks and opportunities in designing the optimal portfolio. Over the course of 2018, in response to rising risks, we reduced exposure to listed equities in diversified portfolios in favour of more defensive assets such as corporate and government bonds to provide greater downside protection. Rest assured, portfolios that we manage and advise upon are under continual review and adjustments are made where circumstances warrant.

On balance, we expect 2019 to be a much better year for portfolio returns than 2018.  We remain confident that shares will deliver good returns for investors based on more reasonable valuations, sound earnings growth and a less hostile interest rate environment. We are also cognisant of the need to provide sound portfolio diversification to reduce the volatility of returns. While returns from listed real assets, government bonds, corporate debt and cash are likely to be lower than shares, they provide valuable diversification benefits to smooth portfolio returns. With the AUD likely to decline further this year, we also recommend a healthy exposure to foreign currencies via international shares and USD cash, which provides a useful risk buffer in volatile markets.