Themes For February

Calendar 2018 has so far produced a roller coaster ride for financial markets with the strength seen in January offset by the sharp sell-off in February. While it was comforting to see markets rally off the lows reached early in the month, share markets around the world recorded sharp losses led by the US market down 4%, Europe 6%, the UK 4%, Japan 4.5% and both Hong Kong and mainland China 6% weaker also. The Australian market (which underperformed in January) staged an impressive comeback in the second half of the month to be down just 0.4% overall, buoyed by strong earnings results especially in the health care sector.

While the catalyst for the equity market sell-off centered on inflation concerns spooking the bond market, moves in yields were surprisingly modest with Australian 10 year bond yields flat at 2.81% while US 10 year bonds rose a modest 16bp to 2.86%. For the first time in many years the US 10 year yield is now in excess of Australia’s which doesn’t bode well for the medium term direction for the AUD. Currency market flows tended to support safe haven currencies such as the USD and JPY at the expense of “risk on” currencies such as the AUD, which fell 3.6% against the USD and 5.9% against the JPY.

The inverse relationship between the USD and commodity prices saw most base metals lower, oil down 4.8% and somewhat surprisingly, the normally safe haven of gold fell 1.8%. The exception was iron ore, which continued its recent strength rising 8.3% which gave some support for the AUD and Australian resources share prices.

Sifting through the market smoke and haze

It’s worth reflecting that the turmoil in financial markets seen in February was instigated by a single piece of economic data that was only marginally worse than expected. While the 2.9% annual wages growth reflected in the January US employment report was higher than expected, it was hardly the harbinger of a sharp break out in wages or inflation. Shortly after this release, the Fed’s preferred measure of inflation came in at just 1.5%, well below their target level of 2%. Dire predictions for inflation citing a weak USD, rising budget deficit, and the impact of US tax cuts all spread panic through financial markets. Parallels to 1994, where US bond yields rose 200bp and Australian yields rose 400bp, are simply not valid and underline the panic that can quickly invade the market psyche. It’s no surprise that US cash rates are set to rise this year. The Fed has publically stated that it intends to increase cash rates by at least 3 times this year as a pre-emptive measure to contain inflation before it becomes a problem. If the fiscal stimulus in the US prompts the Fed to raise rates by an additional 0.25%, it’s hardly a cause for calamity. The market’s volatile behaviour was more a reflection of strong recent performance and complacency about risk more than any substantial change to underlying fundamentals driving financial markets.

While the recent focus has understandably been on the US, it’s worth re-iterating that elsewhere in the world, it is the absence of inflation that is of greater concern to major central banks. While ECB President Mario Draghi would like to commence a wind back of the EUR 30 billion per month net asset purchases, his efforts are hampered by persistently low inflation of around 1%. The situation in Japan is even more sanguine, with recently reappointed BOJ Governor Kuroda recommitting to their easy policy settings for the foreseeable future with any scale back of their QE program not expected until 2019 at the earliest.

Profits are the key for share market returns

The flip side to the outlook for possibly higher inflation, is the impact of the improving macro backdrop on the outlook for corporate profits. The chart below shows that the IMF has recently upgraded their forecasts for global growth for 2018 whereas past years were characterised by negative revisions. While interest rates and inflation have an influence over the multiple of earnings that investors are willing to pay for shares, it is earnings that are the dominant driver of prices over a market cycle. To this end, the improving and increasingly synchronised macro outlook is providing a strengthening tail wind for corporate profits.

The IMF

In Australia, while the reporting season was somewhat of a mixed bag with some high profile disappointments from Telstra, Commonwealth Bank and RIO Tinto, overall 46% of results exceeded expectations, slightly higher than has been the recent norm. The market now expects FY18 earnings growth of around 7% with resource sector profits upgraded to around 16%. In the US, the profit outlook is much rosier boosted by a stronger underlying economy, large corporate and personal tax cuts, infrastructure spending and a lower regulatory burden faced by businesses. The recent US reporting season for Q4 2017, showed earnings growth of 16% for the calendar year with expectations now at 21% for 2018. Notwithstanding the adverse impact of higher interest rates on share valuations, the stronger earnings outlook is likely to be the more dominant influence on markets over the next 12 months.

Investment Outlook

In times like these, the importance of a strategic approach to managing asset allocation comes to the fore. It is important not to be too distracted by extremes of sentiment, which can distort long-term decisions making. This highlights the need to maintain sensible levels of diversification while emphasizing asset classes with the best risk and return prospects. Based on our medium term forecasts we still expect shares to offer the best returns over the next 12 months, with unhedged international shares more attractive than Australia. We acknowledge however, that the tailwind of very easy monetary policy is starting to moderate so shares are unlikely to match the generous returns delivered in the past few years. Our strategic approach is flexible to accommodate whatever market scenarios we are presented with to balance the desire to capture upside while protecting capital where risks become unacceptable.

 

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