Themes For April

30 April 2019

Markets continued their impressive run in April to the point where most have now recovered all losses sustained in the correction late last year. Equity returns across the globe were fairly consistent with the US up 2.7% led by gains in heavyweight names such as Amazon 8.2%, Microsoft 10.7% and Facebook 16%.

The Eurozone improved 3.8% driven largely by Germany up 5.6%, as the manufacturing power house showed signs of life, while the UK was up just 1.9% still languishing in the mire of Brexit uncertainty.

Across Asia, Japan led the way up 5% while China fell 1.5% following its recent strong performance. In Australia, the market advanced a respectable 2.3%, pushed higher by IT and consumer stocks while weakness in the big miners BHP and RIO dampened the overall market.

The benign March quarter CPI saw market pundits sharply revise their interest rate expectations which fueled a 10 basis point rally in 10 year bonds and a 1 cent decline in the $A against the $US.

Commodity markets were a mixed bag with base metals weaker across the board, however, supply disruptions saw the oil price up 7% and iron ore 9% firmer.

Markets at All Time Highs – Time to sell?

The past 6 months have been a wild ride for share markets around the world. As the chart above depicts, the US market is now at an all-time high having exceeded its previous peak set in late September last year and is now 25% higher that the low reached on Christmas Eve in 2018. Hindsight always provides perfect clarity in financial markets and it is now evident that fears of a global recession last year have been assuaged by the sharp about face in central bank policy led by the US Federal Reserve. In October last year the Fed communicated expectations of four 25 basis point rate hikes in 2019, whereas now they are on hold and may even cut rates later in the year. They have also decided to scale down their quantitative tightening (QT) program (i.e. no reinvestment of maturing bonds held) in May this year and will discontinue this altogether in September. The net result of these actions is that liquidity conditions have become more accommodative and pushed both equity and bond prices sharply higher.

Economic data released this year has also printed stronger than expected especially in the two largest economies, the US and China. Growing optimism that the 12 month long trade war between these economic powerhouses will be resolved by the end of May would also be a fillip for the global economy.

The good news for the interest rate outlook is that despite relatively strong labour markets, inflation continues to trend downwards, especially in Australia and the US. With inflation targeting the primary objective of monetary policy, it is very difficult to see liquidity conditions tighten for the rest of 2019. In Australia, at least one and probably two 25 basis point rate cuts are almost certain now with the only question being the timing, given the Federal election on May 18th and the RBA’s historic reluctance to move rates during an election campaign. Rate cuts here are much needed to boost the local economy weighed down by the property sector where house prices in Sydney and Melbourne continue to fall.

In the US, the economy grew at a surprising 3.2% annualised rate in the March Quarter, however, the Fed’s preferred measure of inflation actually fell to 1.6%, well below their target of 2%. Despite the very low unemployment rate of just 3.6%, it is not implausible that the Fed may cut rates later this year if inflation continues to fall. Deflation rather than inflation may in fact to turn out to be the greater policy challenge for the Fed.

Despite the strong rise this year we believe it is incorrect to conclude that the market is overpriced. While expectations of full year profit growth of just 5% is not demanding, especially in an expanding economy, the sharp fall in bond yields has a major impact on the valuation of shares. Put simply, the lower the bond yield, the higher the Price to Earnings ratio the equity market will trade at. Using these valuation metrics, the market is actually cheaper now than it was in September last year.

Another way to look at this is depicted in the chart below, which shows the difference between the yield from Australian share dividends and the 10-year government bond yield. This “yield gap” is now at a 25 year high, which means the demand for Australian shares will be underpinned by their income in such a low interest rate environment.

Investment Outlook

In recent months, the fundamentals for risk markets such as equities have improved and asset prices have responded accordingly. Despite record highs being achieved in many share markets, we do not believe this is a signal that they are expensive in light of the concurrent rally in bonds. Low interest rates and easy monetary conditions are now likely to prevail for the rest of this year which will provide good valuation support for shares and keep bond yields low. The key to a more sustained rally in shares is the prospect of positive revisions to earnings growth which is yet to materialise but is becoming more realistic as data continues to print stronger than expected in the US and China. We believe our strategy for multi-asset portfolios is well positioned for the outlook ahead and provides a good balance between risks and opportunities.