29 November 2018
Themes For November
Following the sharp declines recorded in October, markets began the month strongly only to weaken through the month which saw mixed results across developed markets around the world. The US market was volatile but managed to close 2.1% firmer, although gains in the tech sector were more subdued with the NASDAQ edging only 0.5% higher. The UK and European markets were beset by their own home-grown difficulties as the tedious Brexit negotiations labored on, the stand-off between the European Commission and Italy over their budget continued and civil unrest emerged in France in protest to higher taxes and low wages. The UK was down 1.6% while Germany and France were both 1.7% weaker. Across Asian markets, Japan recorded a solid 2% return however the beleaguered Chinese market fell 3.3% to bring its decline over the past 12 months to 22% due to a slowdown from excessive debt levels and concerns its export sector would be hard hit by a protracted trade dispute with the US. The Australian market fell 2.2% with the resource sector hardest hit due to sharply lower prices for iron ore and oil. Bond markets reasserted their defensive characteristics with the US 10-year bond yield 13bp lower to nudge under the psychologically important 3% level while Australian 10-year bonds were a touch firmer to close the month at 2.59%. The AUD was 2.5% firmer against a USD that was broadly flat against EUR and JPY but firmer against the struggling GBP.

Key Market Considerations

As we move to the end of the calendar year, financial markets are climbing a wall of worry threatening the traditionally strong end to the year better known as the “Santa Claus Rally”. There is growing concern that the global economy is slowing more than official data is suggesting. Most recently, the 2 to 5-year part of the US yield curve inverted, giving rise to speculation of a looming recession in the next 12 months. This is somewhat at odds with official data, which is still suggesting solid economic growth in the US with little prospect of a recession anytime soon. The principle concern lies outside the US where the UK, Europe and China in particular are all experiencing a moderation in their growth outlook. Federal Reserve chairman Jay Powell recently hinted that the Fed might pause their trajectory of rate rises in 2019 principally due to concerns about the global impact on the US. While a December rate hike still looks likely, the Fed will be cautious not to kill off the benefits of their carefully crafted monetary stimulus with a ham-fisted approach to rate hikes next year. Powell’s comments precipitated a rally in the US Treasury market and a re-pricing of US equities in line with a lower growth outlook.

Similarly, in Australia disappointing third quarter GDP growth of just 0.3% (half the rate forecast) has also prompted a revision to the interest rate outlook for Australia. With inflation subdued, some slack in the labour market, falling house prices and sluggish credit growth, there is little prospect of a rate rise here. With the global economy slowing especially in China, a rate cut in 2019 is now much more likely. It’s worth remembering that, due to the cushioning effect of the commodities boom, Australia never cut rates to the same degree as other countries and never engaged in quantitative easing measures, so there was never the same imperative to raise rates from emergency low levels.

The on-going trade dispute between the US and China is casting a long shadow over the global economy. Put simply, tariffs discourage trade, disrupt supply chains, raise prices and reduce global growth. Leading into their meeting during the G20 meeting in Buenos Aires, there were high expectations of progress between the two economic super powers. The market initially rallied due to positive commentary immediately post the meeting from the US. In subsequent days however, confusion reigned on both sides as to what was actually agreed upon leading to a sharp sell-off in equity markets. The situation was further complicated by the arrest of Meng Wanzhou, a senior Huawei executive and daughter of its founder, in Canada for violating the US trade embargo on Iran and facing extradition to the US. This arrest brought an angry rebuke from China and threatened to de-rail the trade talks even though on the surface it appeared unrelated to the trade dispute. According to the US, there is a 90-day tariff moratorium (expiring March 1st, 2019) after which they will increase existing tariffs to 25% and potentially extend the range of Chinese imports covered by a further $250 billion. Central to US concerns are issues of forced technology transfers from US companies investing in China via joint ventures with State owned enterprises, intellectual property theft and flat out cyber espionage sponsored by the Chinese government. These are complex issues to resolve within 90 days so there is a risk the trade war will escalate before it is resolved.



While slower world growth from the trade dispute will also impact the UK and Europe, they are battling to come to terms with unique issues. The economic performance of the EU is hamstrung by a rolling series of issues amongst member countries preventing the region from achieving its potential. Just in the last 6 years we have seen the serious sovereign debt crisis in 2012 engulfing Portugal, Spain, Italy and Greece, the threat of a Greek exit from the EUR in 2015, the rise of populist “leave EU” movements in France, Holland and Italy, to the latest civil unrest in France over high taxes and poor wages conditions. While the mess that has ensued following the UK’s “Brexit” vote to leave the EU in 2016 was not of Europe’s making, it naturally will have a major impact on its economic interactions with the UK. In many ways the problems in Europe expose the structural weakness of the whole Eurozone concept; a common currency, a single central bank setting a uniform monetary policy, but with fragmented fiscal policy settings in member countries, and little enforceable governance from the European Commission. While valuations and investment potential always look appealing, it seems unlikely to ever deliver on its potential.

Investment Outlook

It is often said that investment is a blend of “art and science”. This has never been more relevant than in current circumstances. The optimal mix of assets in a diversified portfolio represents a trade-off between risks and opportunities. At different stage of the investment cycle our strategy will shift focus from return seeking to capital protection. For many years now, the equity risk premium has paid-off handsomely as shares have risen strongly due to strong tailwinds provided by very easy liquidity conditions. In many ways, central banks provided markets with a free “put option” and share returns were a one-way bet.

In the current environment, we believe it is prudent to improve the downside protection qualities of portfolios by lowering the exposure to risk assets such as shares. With cash rates unlikely to rise in Australia and with the Federal budget moving into surplus, the investment fundamentals for Australian bonds have improved. Australian sovereign debt offers the highest available credit rating with a fixed coupon income stream providing a good complement to other defensive assets such as floating rate corporate credit securities and hybrids.