31 July 2018
Themes For July
The influential US equity market once again provided a positive lead for the rest of the world by posting an impressive 4.7% gain for the month brushing aside concerns about a possible trade war, preferring to focus on the positive earnings environment. European markets were also strong with Germany up 4.1% and France 3.5% firmer while across the channel the UK market improved only 1.8% as it continues to labor through the difficulties of extracting itself from the EU. Mainland China edged marginally higher but struggled under the cloud of the potential economic impact of trade sanctions from the US while the Australian market added 1.4% consolidating its strong gains in June. Fixed interest markets were very subdued with US 10-year treasuries 10bp higher to 2.96% and Australian 10-year bonds just 2bp higher finishing at 2.65%. The AUD rose marginally against the USD to close around the US 74 cent mark. Commodities were a mixed bag with iron ore 4.8% higher whereas with oil was down 7.3% and base metals were all weaker on concerns about the impact on demand of a potential trade war.

US economy building up a head of steam

We have held for some time that the US economy will lift the global economy into a more broad-based recovery. The strength of the world’s largest economy was confirmed late in the month with the annualised rate of GDP growth for Q2 printing at a healthy 4.1%, the fastest pace since 2014. While the contribution from net exports was boosted by forward sales of soybean exports ahead of a potential tariff from China, the result confirmed the underlying strength of the US economy. This prompted the US Fed to label the US economy as “strong’ for the first time since May 2006 and while they did not raise rates in July, it is widely expected they will in September and December. Despite the growth outlook, the Fed’s preferred inflation measure remains close to its target level of 2% while annual wages growth remains well behaved at 2.7% despite unemployment reaching the historic low of 3.9%. There is no doubt the impact of the tax cuts implemented earlier in the year is having a beneficial impact on both consumer and business behaviour in addition to the roll-back of many corporate regulations.

As mentioned in previous months, the US market is now strongly driven by corporate earnings rather than liquidity, which has now turned from being a strong tail wind to a mild head wind. While daily market commentary focussed on the “tit for tat” trade spat between the US and China, second quarter US earnings continued to impress with 85% of results from S&P 500 companies exceeding expectations by 3% on average. With roughly 80% of companies reporting, profits have improved 23.5% on revenue gains of 9.2%. While there is no doubt the impact of a corporate tax cut from 35% to 21% has been a strong driver behind these numbers, the second round effects of investment and spending decisions have resulted in forecasts for S&P 500 earnings next year to have increased to 7.6 per cent. This gives us confidence that the earnings-driven rally has not yet run out of steam.

Investment Outlook

While still being constructive on the outlook for risk assets such as equities, we believe it is now prudent to adopt a slightly more defensive asset allocation posture in multi-asset portfolios. While investment fundamentals remain sound, we have to acknowledge potential risks such as tightening global liquidity and the risk to global growth from protectionist trade policies. While valuations are sound, they are not as attractive as they have been in the recent past. As a consequence, towards the end of the month we decided to modestly reduce the weighting to Australian and International shares in favour of Australian corporate debt and cash. Given our strong conviction that the AUD is likely to weaken further against the USD, we have decided to maintain exposure to the USD by holding the realised proceeds from the sale of US shares in USD cash. In addition to these measures, recently we also sold holdings in Westfield into the Unibail-Rodamco takeover bid without reinvesting the proceeds into the listed real assets sector. Should we experience further market strength in coming months, it is likely that we would continue this de-risking process by further reducing equities exposure.