Slowdown yes, Recession no.
The ebb and flow of financial markets in recent times reflects growing uncertainty about the state of the global economy. While there is clear evidence of slowdown in the UK (Brexit related), Europe and China, the data in the US has been more resilient. While US business investment has fallen as a consequence of the trade war, the US economy is more reliant on domestic consumer activity which is being supported by a strong employment market and positive growth in real wages. There is growing evidence of a slowdown in China as the impact of US tariff policy is beginning to bite with export volumes to the US falling sharply.
In Europe, growth has been tepid for some time with the manufacturing hub in Germany close to recession already as the auto industry is caught in the global tariff crossfire. As a consequence, the European Central Bank is expected to soon announce a range of new measures to boost liquidity and stimulate growth in the region.
In Australia, the June quarter national accounts showed the annual pace of growth here slowing to just 1.4% which almost ensures the RBA will cut rates twice in coming months to bring the cash rate down to 0.5%. Our conclusion is that while a global slowdown is in train already, with little prospect of a recession in the world’s dominant economy, global growth should remain in positive territory. This economic scenario poses challenges for financial markets. On the one hand, slower growth will impinge on corporate profits, which is generally bad news for share prices. Indeed, profit growth in most developed markets is hovering in low single digit territory. On the other hand, lower interest rates and easy liquidity conditions have undoubtedly been supportive for equity prices since the GFC. This environment has been fertile ground for bond markets, which has seen global yields fall sharply and prices rise accordingly.
The cornerstone of our asset allocation process is to seek the appropriate balance between risk and opportunity. While our medium-term time frame will always ensure a healthy allocation to shares, at times our focus needs to be more directed to downside protection. While we remain optimistic about the long-term outlook, we do believe it is appropriate in the current environment to marginally reduce exposure to international shares in multi-asset portfolios, in favour of more secure US Treasury bonds.
While the US bond market has been strong over the last 12 months, it remains the global bellwether of security and offers much higher yields than Europe, Japan and even Australia. Persistently low inflation and the prospect of further rate cuts by the Fed will continue to offer good support for US Treasury bonds which will provide excellent risk mitigation in the event of a sharp equity downturn.
For Australian investors, exposure to foreign currency, especially the US dollar, also offers good protection in a risk off environment as the Australian dollar is usually seen as a proxy for risk, especially given our trade dependency on China. For this reason, the US Treasury bond holdings we have added to portfolios will be unhedged to maintain the foreign currency exposure across the portfolio.