27 February 2019
Themes For February
Financial markets continued the strong start to the calendar year by posting solid returns in February, regaining most of the lost ground from late 2018. The “pause” in interest rate hikes by the US Federal Reserve provided the positive momentum to propel US shares 3.2% higher for the month to be now a staggering 16% higher since the December lows. Similar gains for the month were recorded in both Europe and Japan however the Chinese market roared ahead by 12.3% as the government introduced a raft of stimulus measures to boost the local economy. The Australian share market has been a laggard compared to global peers in recent times however it returned to form in February recording a healthy 6% rise. The local market was boosted by a relief rally in banks as the Hayne Royal Commission findings were less punitive than feared and a strong resource sector buoyed by higher commodity prices led by iron ore up 7.8% and oil up 10%. With central banks around world joining the Fed to relax their stance on monetary policy, bond markets continued their rally as Australian 10-year bonds were 11 basis points firmer and US 10-year treasury yields declined 3 basis points. The Australian dollar fell 2% against a US dollar that was marginally stronger against the major cross rates.

Australian Economic Growth Grinds to a Halt

Weighed down by a slowdown in consumer spending and the downturn in the housing sector, the Australian economy recorded a paltry 0.2% growth in the December quarter of 2018. Following on from just 0.3% growth in the previous quarter, the annualised growth rate in the second half of 2018 was just 1%. The financial media jumped all over these poor results and declared a “per capita recession” on the basis that GDP per head of population has declined for the past 2 quarters. While much is made of the decline in property prices in Sydney and Melbourne, the sharp decline in building approvals will have a detrimental effect on home building activity in coming quarters. This will have a negative multiplier effect throughout the economy. With property prices likely to decline further given tight lending conditions, in aggregate the property sector is expected to detract between 1-1.5% from GDP over the next 12 months.

With business investment and public investment in infrastructure the major bright spots in the economic outlook, the Reserve Bank of Australia will be forced to cut short term interest rates, possibly twice before the end of the year, to stimulate private consumption demand. With inflation now trending below the RBA’s target range, there is simply no good reason not to cut rates. This will likely precipitate a further fall in the AUD, which will boost the contribution to growth from net exports. While the first “actual” recession here for 28 years is unlikely, growth of only around 2% for the next 12 months is likely to see unemployment rise and wage inflation fall providing ample room for the RBA to cut rates by up to 50 basis points. The banks will be under heavy pressure to pass on these cuts to reduce the mortgage interest burden faced by households and provide the capacity to increase expenditure.

Investment Outlook

Following the strong recovery in markets so far this year and with growing evidence that the global economy is slowing, some caution is warranted with respect to risk assets such as equities. In recent weeks, there has been a slew of negative revisions for growth in many of the world’s major economies suggesting a more constrained environment for profits and share prices. China has officially revised its forecast down from 6.5% previously to a range of 6-6.5%. Given the propensity of China to “window dress” their official data, this probably means the actual growth is more likely to be well below 6%. While the stagnant European economy is no revelation, the ECB has now revised its 2019 growth forecast for the European Union from 1.6% to just 1.1% and announced plans to boost liquidity by offering cheap loans to banks. We are somewhat more pessimistic for the EU as the manufacturing hub in Germany continues to flirt with recession so a zero growth outcome is more likely for the EU in 2019. In addition to this the messy divorce of the UK from the EU shows no clear signs of resolution as the clock ticks down towards the 29th March Brexit deadline.

Against this backdrop of a slowing global economy, the health of the US economy is critical as it has now become the principle source of global demand. Of some concern was the recent weak US Feb employment number where only 20,000 jobs were added, well below expectations and recent trends. While one swallow doesn’t make a summer, we are watching data carefully to assess if this may be an early warning that the US is slowing. While expectations have been high for some time of a successful resolution to the China US trade war, a positive outcome here is now assuming even more significance to provide a much needed boost to the global economy.

On the positive side of the equation, expectations for profit growth of around 5% in the US and a similar level in Australia are by no means demanding and Price to Earnings ratios of around 15 times are still reasonable. The change in central bank policy together with the rally in bonds will provide further support for equity markets. With interest rates likely to fall from here, we are looking for opportunities to add fixed coupon securities to portfolios where capital values will be enhanced as yields decline. In conclusion, markets are at an interesting juncture and the risk equation is finely balanced. In such an environment, we will be vigilant in our efforts to protect capital though prudent diversification.