31 May 2018
Themes For May
Markets defied the old adage of “sell in May and go away” by posting modest gains over the month of May. The US market recorded a healthy 2.2% return driven by a recovery in technology stocks such as Facebook which bounced back strongly from the negative sentiment associated with the data protection scandal that dogged the company in April. Elsewhere, the UK also posted a 2.2% gain however, across the channel, markets in the EU were rocked by political events in Italy raising concerns about its financial stability. The Italian market fell by 9.2% dragging the Eurozone down by 4% only mitigated by the stability of the pivotal German market, which held steady. The Australian market scratched out a small 0.5% gain building on the strong gains in April. Healthcare and consumer discretionary stocks led the way with CSL up 9.1% reflecting its phenomenal unbroken run of profit growth. On the downside Telstra fell 12% after disappointing the market with earnings guidance raising fears of further dividend cuts. The REIT sector was up 3% as local investors cashed out of Westfield following the successful completion of the takeover by Unibail-Rodamco and reinvested in other stocks in the sector. The US bond market was fairly resilient with 10 year treasuries falling 9bp to 2.86% as annual wages growth remained steady at 2.6% despite strong employment numbers which saw the unemployment rate fall to just 3.9%. It now appears fairly certain the US Federal Reserve will raise rates by 0.25% in June and possibly twice more before the end of the year. Australian 10 year bonds followed in lock-step falling 9bp to finish at 2.67%. The turmoil in Italy saw bond spreads against German bunds widen but to nowhere near the level seen during the European sovereign debt crisis in 2012, as can be seen in the chart below. There was a mixed bag amongst commodities with the oil price pushing through $US 70 per barrel during the month after the US decided to pull out of the nuclear deal with Iran and re-impose sanctions on OPEC’s third largest oil producer. Iron ore fell marginally by 1.2%, however base metals were a standout with nickel up 11.3% on anticipated supply deficits based on strong forecast demand for stainless steel. In currency markets, the US dollar was stronger against major cross rates reflecting its safe haven status in the wake of the turmoil in Italy as well as in emerging markets, such as Argentina, where interest rates were raised to a staggering 40% in an attempt to support the flagging peso. The AUD was 2.4% firmer against the EUR but flat against the USD.

Some good news for Australia from the Federal Budget and National Accounts

The Australian government released its budget for 2018/19 during the month and forecast a surplus of A$2.2 billion in 2019/20, returning to the black a year earlier than expected. If achieved, Australia’s fiscal position would be the envy of most other developed economies. The improvement in the budget position has not been the result of deep cuts to government spending, but rather a consequence of higher revenues from bracket creep as rising nominal incomes have pushed individuals into higher tax brackets. This is evidenced by the fact that personal tax revenues increased from 9.5% of GDP to 11.2% over the past seven years. To redress what is effectively a tax hike by stealth, the government has announced a plan to reduce personal taxes in three stages over a seven-year period to augment the reduction in corporate taxes already announced. If successfully implemented, this would be a fillip for our economy, which has struggled to rebalance following the end of the mining boom largely due to the lack of purchasing power by consumers burdened by stagnant growth in real wages and high levels of housing debt.

The March quarter National Accounts saw Australian GDP print at a surprising 1% to bring the annual rate to 3.1%, up from 2.4% from the previous quarter. Strong contributions from net exports added 0.5% to growth with household spending adding 0.3%. The outcome exceeded the market’s expectation as well as the government’s budget assumption and RBA forecasts. The inflation measures embedded in the National Accounts were also well behaved and as a consequence the RBA will be in no hurry to raise cash rates anytime soon.

Investment Outlook

The fundamentals supporting risk assets such as shares remain sound and in line with our forecasts. A synchronised global economic recovery is underway which is providing a solid platform for profit growth and the opportunity for central banks to gradually reduce the level of monetary accommodation by unwinding the emergency measures imposed following the GFC. Despite strong employment gains in most economies, wages growth remains subdued which is keeping inflation under control and moderating the pace of interest rates rises.

It has to be acknowledged however that the elevated level of market volatility we have witnessed is a consequence of rising risks such as the threat to the global economy from trade protectionism, possible EU fragmentation and geopolitical issues in North Korea and Iran. Investing is a blend of art and science that seeks a balance between risk and return. In times of rising uncertainty, the need to preserve capital assumes greater significance. As a consequence of this, we plan to use periods of market strength to gradually de-risk portfolios by incrementally reducing allocations to equity markets in favour of more defensive assets such as cash and shorted dated fixed interest.