Themes For April

30 April 2017

Global share markets brushed off geo-political threats in Syria and North Korea to post reasonable gains and continue their impressive run so far in 2017. European markets were the best performers advancing by 2.4% as markets were relieved with the outcome of the first round of the French Presidential election, which ultimately resulted in the landslide election of pro EU candidate Emmanuel Macron.

Asian markets were higher across the board led by Hong Kong and Korea both up 2.1% while Japan rose 1.5%. The US and Australian markets were more subdued but still nudged 1% higher. Our market’s advance was led by IT, healthcare, utilities and real estate investment trusts while the resource sector was weighted down by a sharply weaker iron ore price, which fell by 23%. In the US, the market is eagerly awaiting the drafting of tax reform legislation, the centerpiece of which is a cut to the corporate tax rate from 35% to 15%, which will boost corporate profits and business investment.

In currency markets, the GBP rallied 3% against the USD following the announcement of the UK election which the Conservative party led by Theresa May is expected to win comfortably giving her leverage to push forward with Brexit negotiations with the EU. The AUD fell 2% against the greenback as commodity prices fell. Bond yields continued their recent positive run with both Australian and US government bond yields falling slightly over the month.

Australian interest rates to be steady for some time

At the RBA meeting in early April the official cash rate was left on hold at 1.5% as expected. Their assessment is that the risks to the economy are finely balanced and we believe they are unlikely to raise cash rates until well into next year. As mentioned last month, there have been some calls to increase cash rates to cool the over-heated property markets in Melbourne and Sydney however this won’t happen as it would kill off the green shoots of recovery in other segments of the economy. The RBA believes the global economy will become increasingly supportive and while the domestic economy is yet to fully rebalance following the mining boom, they are confident of an improving growth outlook going forward.

The March quarter CPI showed a slight uptick in headline inflation to 2.1% however the preferred underlying measure is still below the lower end of the 2-3% target band. Of concern to the RBA would be the sluggish labor market including a high level of underemployment and tepid wages growth, which is likely to constrain private consumption. They are also concerned about the stubbornly high $A which despite its recent decline, is still constraining activity in the tradable goods and services sectors of the economy. The RBA has also raised concern about the level of household debt, which may leave consumers vulnerable in the event of rising interest rates and constrain future levels of consumption. As the chart below shows, we believe this concern is somewhat overblown as even though the aggregate level of household debt has risen, debt servicing as a percentage of household income has not been lower since 2003 and mortgage rates would have to rise by 2% to get this measure back to the peak level of 2011. Given the outlook for interest rates, this is unlikely to occur for several years at which time the economy is likely to be much stronger and incomes will be higher.

Medium term outlook for share markets is positive

In recent months we have discussed the possibility of a short-term correction in share markets given the strong rally we have seen since November last year. In the event that this occurs, we would consider this to be a short-term correction in a long term rising trend and should not be of great concern to long-term investors.

It’s worth considering the factors that are supportive of shares at the moment.

First and foremost the global economy is continuing to recover which will provide a supportive environment for corporate profits and therefore share prices. Reliable leading indicators of economic growth are the Purchasing Managers Indices (PMI’s) for both Manufacturing and Services. As the chart below shows these are undeniably pointing to a pick-up in global growth in the coming months. The IMF has also recently revised upwards its forecast for global growth to 3.5% for calendar 2017.

It must be remembered that global liquidity conditions are still very supportive for asset prices. While the US has begun to gradually increase interest rates, central bank policy in Europe and Japan remains very accommodative with quantitative easing programs still in place with interest rates close to zero. While this has proven to be very supportive of both equity and bond prices since the GFC, we are beginning to see these measures now gain traction in the real economy to promote growth.

While austerity measures especially across southern Europe in recent years have constrained the ability for governments to stimulate growth, fiscal policy is now being used as an additional tool to complement monetary policy. This is most evident in the US where the new administration is proposing substantial tax cuts and large infrastructure spending programs to reflate the economy out of its recent low growth trajectory. This is almost certain to result in a large increase in the US deficit from around 4% of GDP to possibly up to around 8% of GDP in the short term before the revenue benefits from stronger growth begin to close the deficit. While this is not likely to be well received in the bond market, corporate profits will receive a substantial boost from these measures.

At the end of the day the primary driver of share prices over the long term is corporate earnings. In recent reporting periods for most major markets, profit growth has met or exceeded the market’s expectations, which augurs well for future profits in a more supportive global economy. Valuations such as PE ratios at around 16 times are only marginally above long term averages and although not cheap in an absolute sense, offer much better value than other asset classes such as cash, term deposits, government bonds, and to a lesser extent property.

Investment Outlook

Our core assessment of financial markets has not substantially changed over the month. We continue to be surprised by the resilience of equity markets in the wake of a constant stream of electoral, policy and geo-political uncertainty. For reasons outlined earlier we remain constructive on the medium term outlook for shares and would use any short term correction to add to positions especially in international markets where a likely depreciation of the $A will augment returns. On the flip side, the outlook for fixed interest securities such as government bonds remains poor, as the economic cycle together with central bank and fiscal policy, will result in a gradual rise in bond yields, which will subdue future returns.