Themes For April

30 April 2018

Despite on-going bouts of volatility, equity markets staged a reasonable recovery in April with most markets posting respectable gains for the month. The Australian market has been a laggard over the past year but returned to form by posting a healthy gain of 3.9% to be one of the better performing developed markets. The Royal Commission into banking misconduct subdued returns for the large financial services sector with AMP -19% in particular feeling the brunt. The strong oil price pushed the Energy sector 10.7% higher and a large number of corporate actions including takeover offers for Santos and Healthscope together with a $700m buyback for Scentre Group boosting the local market.

The US market finished only just in the black despite a bumper Q1 earnings led by high profile technology companies such as Facebook, Amazon, Apple and Alphabet (Google). European markets posted strong gains led by Germany up 4.3% as data showed the EU economy still on its recovery path with the ECB maintaining its expansionary monetary settings. The UK market recorded the strongest return of major developed markets recording a stellar +6.4% on positive signs of progress in negotiating trade arrangements with the EU as part of the Brexit negotiations.

A major talking point over the month was the US 10-year bond yield breaching 3% for the first time since October 2014 on rising concerns on the outlook for inflation. The Australian 10-year bond yield followed the US higher rising 17bp to 2.77% with the yield curve steepening as 3-year bonds rose 13bp to 2.18%. Subdued labor market and inflation readings will probably keep the RBA on the sidelines until late in 2019 with the widening interest rate differential with the US placing pressure on the AUD which fell 1.9% against the US but was marginally stronger against the JPY and EUR.

Assessing the Risks – Sifting through the Smoke and Haze

There is no doubt that the volatility that we have seen this year in equity markets reflects the reality that risks are on the rise. While the unprecedented level of monetary support in recent years has proved to be a strong tail wind for share prices, the argument for the continued outperformance of shares is now starting to be challenged. While some risks are real and need to be carefully assessed, in times of fragile sentiment there can be overreactions to factors that are of little long-term consequence. A key challenge for active investors is to differentiate between risks that are real compared to those that are illusory.

The major risks confronting financial markets are focused on the US share market and economy. Of primary concern is the risk that rising inflation will force the US Federal Reserve to aggressively ratchet up cash rates pre-emptively to stave off the risk of inflation before it gets out of hand. While we have already seen several rate rises in the US, it must be remembered that this is from an emergency base level, so the rises to date are merely the commencement of a normalisation process. A strengthening US economy, fuelled by tax cuts and government spending, has led to fears that in a tight labour market wages growth will lead to higher inflation and higher interest rates. This has a negative valuation impact on shares as company borrowing costs rise as do the discount rates used for share price valuations which pushes Price to Earnings ratios lower. More recently, higher oil prices have led to concerns that gasoline prices may further add to the inflation equation. It is no secret that the Fed is planning to incrementally increase interest rates either 2 or 3 times this year in 0.25% increments as long as data confirms this is necessary. It is also reasonable to assume that inflation measures will tick higher as the economy improves. The question is not whether rates are headed higher, but rather the pace of adjustment. The market will cope just fine with rates that grind higher in a measured fashion, however if the Fed has to push harder and more suddenly on the monetary brakes, as was the case in 1994, then markets would react adversely to this outcome. The evidence to date is that inflationary pressures are rising but in a steady fashion with the Fed’s preferred measure, the PCE deflator, is still just below their 2% target. Recent Fed commentary has also suggested that this target is “symmetric”, meaning that they may be comfortable letting it drift slightly above this level without hitting the monetary brakes too hard. While inflation concerns are often over-stated by many commentators, this is a genuine risk and something to be closely monitored.

Of lesser concern is the current fear around the impact on economic growth from a potential global trade war. It is becoming increasingly clear that this will be relatively quarantined between the US and China, with both sides likely to grant concessions to find a middle ground. Since the initial US announcement concerning tariffs on steel and aluminium imports, there have been numerous countries exempted from this proposal and a substantial walk back in the rhetoric concerning the breadth and scope of any further tariffs. More broadly, the US have recently showed renewed interest in re-joining the Trans Pacific Partnership regime initially shunned by President Trump upon taking office. Part of the trade negotiation between the US and China will no doubt include an obligation for China to assist in bringing North Korea to heal in the up-coming talks with the US to de-nuclearise the Korean Peninsula. China supplies the vast majority of North Korea’s imports and as such holds enormous economic leverage over their regime.

The on-going political circus in the US is an unwelcome distraction for markets but unlikely to see President Trump removed from office before the next Presidential election in 2020. It could however, have ramifications for the US mid-term elections in November this year which historically work against the sitting President. In President Obama’s 8-year tenure, the Democrats suffered heavy defeats in the 2010 and 2014 mid-term elections despite his personal popularity. If the Democrats win control of the House of Representatives, then it will become increasingly difficult for the President to pass meaningful legislation and there is the possibility that the Democrats may commence impeachment proceedings in the House. This is highly unlikely to be successful in removing the President from office however, as it requires a two thirds majority in the Senate, which in the absence of any crime, will be a very difficult hurdle to scale as was the case in the impeachment proceedings against former President Clinton.

On the positive side, the global macro environment is clearly improving providing the opportunity for central banks to gradually withdraw their monetary accommodation measures and providing a solid backdrop for growth in company profits. It’s important to emphasize that over the long run, profits are the dominant influence over share prices. Boosted by tax cuts and an improving economy, US corporate profits are booming with S&P 500 companies recording a massive 24% growth in Q1 earnings, well in excess of expectations.

Despite these stellar results, share prices barely moved during the reporting season based on scepticism about the on-going durability of earnings growth. We believe this is a short-sighted perspective which overlooks the fact that the underlying economy continues to improve and will be further strengthened as the impact of the tax cuts work through the economy. In addition to this, many companies will redeploy earnings into additional investment in productive capacity to enhance future earnings potential. While we may have seen the cyclical high in earnings growth, there is still likely to be positive earnings growth next year which will provide the impetus for higher share prices.

Investment Outlook

We remain constructive on the outlook for equities, believing that the current risk premium on offer is adequate compensation for the genuine risks to the market. Over the past year, our preference for unhedged international equities over Australia has paid dividends with global markets outperforming by a margin of over 7%. While we are maintaining the current mix between Australian and international shares in multi-asset portfolios, we are encouraged by the Australian Federal Government’s proposals for personal tax cuts to be unveiled in the upcoming May budget. This could provide a welcome boost to private consumption which has been suppressed by sluggish wages growth and high levels of household debt. In addition to the company tax cuts already announced, the fiscal stimulus from personal tax reform should provide a welcome boost to the earnings of local companies.