Themes For August

Equity markets took a breather in August with most major stock markets finishing in negative territory. Despite Fed Chairman Powell indicating rates would be on hold for now, the US market declined 1.8% and the NASDAQ fell 2.2% following the release of Q2 profit results which showed in aggregate that earnings had declined by 5% over the previous twelve months.

The Australian market fared slightly better, falling by just 0.8%, dragged lower by weakness in the mining sector, impacted by expectations of lower commodity prices due to a deteriorating economic outlook in China which saw its market fall by 8.3%. While the global economic focus usually centres around the US, the European economy is teetering on the verge of a recession while China is struggling under the burden of a debt laden property and infrastructure sector.

The negative outlook for China dragged the Australian dollar down by 4% against the US dollar to finish at 64.8 cents. Bond markets were a mixed bag with US 10-year treasury bonds increasing 14 basis points to finish at 4.1%, whereas the Australian market was more subdued with yields declining by two basis points to finish at 4%.

Australian Earnings

For example, in Australia forward year earnings are now 6% lower than they were at the start of the year and have been negatively revised for the past 3 months, predominantly in the mining sector. While it is fair to conclude that central banks will not raise interest rates much further, it is unlikely there will be any cuts in the foreseeable future given that unemployment remains very low and the risk of pipeline wages pressure is ever present. This means that the attractive interest rates currently on offer are likely to persist for some time meaning that investors can be patient before committing more capital to equities without being unduly penalised in the meantime.

Attractive yield is now a headwind for equities

In recent years ultra-low interest rates and abundant liquidity has made the opportunity cost of investing in shares as opposed to other interest-bearing securities very low. Investors really had no other alternatives than to buy shares given the extremely low cash and bond rates on offer. This led to the popular investment acronym of “TINA” (There Is No Alternative to shares). Following the post pandemic inflation outbreak which resulted in central banks aggressively increasing cash rates, attractive income yields now are freely available to investors for taking less risk than investing in equities. For example, in Australia investors can receive a 10-year risk-free rate of return of 4% by investing in government bonds, 12-month bank term deposits of 5% are freely available and for those willing to take slightly higher credit risk, yields on corporate debt can be as high as 7%. In the US where the yield curve is heavily inverted, investors receive 5.5% for investing in risk free 3-month Treasury bills. This means that more risk averse investors are being well rewarded for investing in high yielding, lower risk securities.

While it is true that inflation eats away some of this yield, with inflation now on the decline these interest-bearing securities are now starting to show a positive real rate of return. While this does not preclude share markets from advancing, it does mean that investors are not greatly penalised for not investing in equities. As we have been articulating for many months now, the key to the longer-term appreciation of equity markets is earnings growth. To this extent, the reporting seasons in both the US for Q2 and in Australia for the financial year ending June were less than inspiring with forward expectations for earnings continuing to be revised downwards.

Strategy and Outlook

The current outlook underlines the importance of having prudent diversification in a multi-asset portfolio. The primary consideration in portfolio construction is to make sure there is an appropriate trade-off between risk and return. While the long-term growth in portfolios will ultimately be delivered by cornerstone weightings to both Australian and international equities, in the short term it is hard to ignore the attractiveness of the yield from both corporate debt and government securities. To this end, our multi-asset portfolios have a healthy weighting to corporate floating rate debt and bonds as well as long term government paper. As we patiently wait for better earnings prospects to justify allocating more capital to equities, we are content with the positive real yields accruing from income bearing securities.

Gary Burke
Chief Investment Officer