31 July 2016
Themes For July
It’s hard to believe that little over a month ago markets were thrown into turmoil following the UK Brexit referendum outcome. Share markets fell on the fear that the UK and Europe would be plunged into recession as a consequence of the UK’s decision to leave the European Union. As mentioned in last month’s report, it’s rarely a good idea to panic in these circumstances as markets typically overreact to such events by factoring in scenarios that are unlikely to eventuate. As has been the norm in recent years, Central Banks came to the rescue with soothing statements concerning further interest rate cuts and additional quantitative easing measures. One thing that we have learned since the Global Financial Crisis in 2008, both equity and bond prices greatly benefit from easy monetary conditions. The Australian share market was amongst the strongest for the month rising by 6.3% lead by consumer discretionary stocks which were up 8.9% and consumer staples, up by 8.5%. All major equity markets posted solid gains with the US up 3.7%, the UK 3.4% higher, and Europe a healthy 5.2% firmer. The Japanese market was 6.2% stronger on expectations of yet another stimulus package to attempt to revive their stagnant economy. Bond markets were fairly quiet over the month with the yield on both Australian and US government bonds modestly lower. Commodities were weak for the month led by a flagging oil price, which fell 14% weighed down by the prospect of supply overhang. The exception was iron ore which rose 9% on the expectation that further stimulus in China would boost steel demand. In the foreign exchange market, the $A was 2% firmer against the greenback which weakened on delayed expectations for the next increase in cash rates by the US Federal Reserve.

Australian Election, Inflation and Interest Rates

Early in the month, the Australian Federal Election was held and despite a close contest, the incumbent Coalition party was returned to power with a razor thin majority of just one seat in the House of Representatives. The Senate outcome however has seen a much greater representation from minor parties such as the Greens, the Nick Xenophon team and One Nation, which surprisingly rose from political oblivion to emerge with 4 senate seats. A positive for financial markets is that the Coalition can still govern in its own right, however it will take artful negotiation to ensure passage of legislation through the highly fragmented Senate. There is no doubt that the strategy of calling a double dissolution election backfired on Prime Minister Malcolm Turnbull, severely weakening his standing within his own party. Exposing the upper house to a full Senate election has produced a much more hostile composition than would have been the case had the parliament run its full term (only a few months later) which would have meant only half the Senate along with the full House of Representatives would have been elected. The Prime Minister is certainly on notice to produce decisive leadership and positive policy outcomes in the first year of the new parliament to maintain his grip on power.

During the month the CPI result of just 0.4% for Q2 and just 1.0% for the year, paved the way for the 0.25% interest rate cut delivered in early August by the RBA, bringing the official cash rate to 1.5%. This is still very high by international standards and with inflation still benign, there is further room for the RBA to reduce rates again before the end of the year. The likely narrowing of the spread between Australian and US cash rates over coming months is likely to put downward pressure on the $A which in itself will provide an additional source of financial stimulus to the Australian economy.

The cut

Mixed Signals from the US Economy

The month of July produced a mixed bag of results for the US economy. On the positive side the July non-farm payrolls data saw a healthy 255,000 new jobs created, much higher than expected indicating the economy is growing at a healthy clip. Average weekly earnings grew by a solid 2.6% over the 12 months, underpinning a positive outlook for consumer spending. On the flip side, US GDP for Q2 printed at a very weak annualised rate of just 1.2% with Q1 revised down to just 0.8% annualised. While a large negative contribution from inventories impacted these results, these numbers point to a tepid recovery in the US. As a consequence, the market has virtually discounted the prospect of a rate hike following the Fed’s meeting in September although we still believe a December rate hike in the US remains on the cards.



With the US share market trading on a healthy P/E multiple of 18 times forward earnings, the market needs company profit expectations to be delivered to justify this valuation. During the month, Q2 earnings for US S&P 500 companies saw 70% of companies exceeding earnings expectations and 54% exceeding sales expectations. It should be noted however that earnings have now declined year-on-year for the past 5 consecutive quarters.

Listed Real Assets

As a means of enhancing the asset allocation of diversified investment portfolios, we have recently introduced a newly defined asset class “Listed Real Assets” (LRA) to form part of our growth asset strategy.

The new LRA portfolio we have developed consists of a combination of both listed property trusts and listed infrastructure assets that trade on the Australian Stock Exchange (ASX). This portfolio will comprise a selection of high quality securities that cover the breadth of real asset sectors available in Australia. The difference between these types of securities and the shares of listed public companies, is that the income stream they produce is much more consistent and reliable than company dividends that are much more sensitive to the profit and business cycle. In addition to this, company boards have the discretion to retain profits for future expansion whereas listed real asset securities usually pay out all of their income in the form of distributions. As a consequence of this, listed real assets are a much more defensive type of growth asset, providing lower volatility and a high income yield with good diversification benefits.

Investment Outlook

As reported over the past few months, equity markets have rallied strongly as a consequence of the very easy liquidity conditions provided by Central Banks. In most countries other than the US, this policy shows little sign of abating given the complete absence of inflationary pressures. A prerequisite for markets to move substantially higher from here however is more tangible evidence that economic growth will be sufficient to drive sustainable profit growth. In light of this, we believe the time is right to marginally de-risk diversified portfolios as a means of both locking in returns and protecting capital. There are two ways we have implemented this strategy. Firstly, we have moved to a benchmark weight in the new LRA asset class funded by a commensurate reduction in the weight to Australian equities. While LRA are still listed securities, they have much more defensive characteristics than listed companies. In addition to this, we have taken the opportunity to write “out of the money” call options against specific stock positions to generate option premium income to cushion the impact of any decline in share prices. This is a risk-averse strategy as physical stock is only sold if share prices rally further from here at which point we would likely be sellers in any case.