30 June 2018
Themes For June
The Australian share market finished the financial year on a strong note posting a healthy gain of 3%, outperforming most other global markets during June. For the financial year the local market recorded a gain of 13% including dividends. It appears that the weaker local currency prompted renewed foreign interest in our market. The AUD fell 2.2% against the USD based on a widening interest rate differential following a 25bp hike in the Fed funds rate and concerns about the health of the Chinese economy. Commentary by the RBA has further pushed out expectations for a hike in interest rates to the end of 2019. The energy sector was the stand-out, advancing 7.7% boosted by the sharp 10.6% rise in the crude oil price. Overseas markets were mixed as concerns about the potential onset of a global trade war elevated volatility and risk aversion. The VIX index which is a barometer of market volatility, rose 19% for the month. The US scratched out a small 0.5% gain, as did Japan, while Europe was 0.9% lower on concerns that the pace of growth has recently slowed. The headline story for the month however was the sharp decline in the Chinese share market with Shanghai off 8% and Hong Kong down 5% based on concerns on the state of the Chinese economy and the potential for the adverse impact of US tariffs on their export sector. Bond markets were fairly subdued with the US yield curve flattening as 2-year treasuries rose 10bp to 2.53%, while 10-year notes were flat at 2.86%. Australian bonds fell across the curve with 10-year bonds 4bp lower to 2.63% and 3-year bonds 3bp lower at 2.06%. The spread between the US and Australian 10-year bond yields is now the highest recorded this century reflecting the divergence in monetary policy settings between the two countries, a harbinger for future AUD weakness.

China slowdown or meltdown?

The rapid growth in the Chinese economy over the past decade has propelled it to become the world’s second largest economy. Double-digit growth rates during the 2000’s was a boon to the Australian economy due to the demand for our iron ore and coal to meet their high levels of steel production which cushioned our economy through the GFC. While these growth rates are a thing of the past in China, the government has so far managed an orderly moderation in the pace of growth to a more sustainable level of around 6.5% in their attempt to rebalance the economy from being investment led to more consumer oriented. It is important to remember however that China is not a western-style open market economy. The communist government exerts control of many financial market variables that are usually determined by market forces such as interest rates, currency levels and capital flows. During the share market sell off in 2015, the government instructed state owned enterprises not to sell to moderate the extent of the market’s decline. Official data releases in China suspiciously fall bang in line with expectations and are therefore treated with some skepticism.
As our major trading partner, the Australian economy is inextricably linked to China. As a consequence, the economic prospects for China have a direct impact on our economy, currency and share market. Overseas investors often use the AUD as a proxy for both commodity prices and Chinese growth.

China faces a number of economic challenges raising concern in financial markets. First of all, its rapid expansion over the past decade has largely been financed by debt, much of which has been sourced from outside the regulated banking system by the so called “shadow banking” sector. In the event of an economic downturn, excessive debt levels elevate the risk of the damaging impact of bad debt impairment. As the world’s biggest creditor nation however, most of the debt is locally sourced cushioning the economy from a potential foreign currency crisis.

Secondly, the property market has been slowing lately raising concerns that this may turn into a more serious slump. There has been concern about property over supply in China for many years, much of which has been absorbed by the migration of labor from rural to urban areas.

Lastly, the potential impact of a prolonged trade war with the US could be damaging to China’s export led economy. With the US economy powering along and with key US mid-term elections coming up in November, President Trump has picked his time to take on China in a trade fight.

Our conclusion is that while the risks in China need to be carefully monitored, especially the trade risk, these will be manageable especially given that the Chinese government has numerous mechanisms available to avert any meaningful slowdown.

Investment Outlook 

We continue to remain comfortable with the outlook for the global economy, led by a robust US economy. Inflation remains well contained and markets are coping well with the reality that monetary stimulus is slowly being drained from the financial system. While share markets have done well over the past few years, valuations still remain reasonable, especially when factoring in anticipated levels of corporate earnings growth. We continue to expect shares to outperform other asset classes but by a smaller margin than has been the case in the past few years. On the flip side, risks to the market outlook are on the rise especially in relation to US inflation, a potential global trade war, on-going difficulties with the Brexit process and the risk of further EU instability in the wake of the Italian election.

At this stage of the investment cycle our focus shifts towards the need to preserve capital as opposed to squeezing every last drop out of the equity market rally. As a consequence, we will shortly commence the process of gradually reducing the level of equity risk in portfolios by selling a modest position in international and Australian shares. We will exercise discretion with respect to the timing of this move as it is our preference to sell into strength rather than weakness. The up-coming US earnings season, which promises some strong results, looks to be the ideal opportunity to commence this process. Part of our strategy will be to maintain the level of foreign currency exposure in portfolios as USD strength is a high conviction position that has paid dividends in the past few months as the AUD has fallen around 9%, providing a wind fall gain from foreign currency assets.