29 October 2017
Themes For October
October was another good month for risk assets with most global share markets posting healthy gains. The combination of strong profit results, improving economic growth, low inflation and easy monetary conditions have been a powerful tonic for shares. The Australian market had a return to form posting a strong rise of 4% with the All Ordinaries index finally reaching the 6000 point level. The local bourse shrugged off a potential political crisis for the government as a High Court ruling on dual citizenship threatened their slim majority in the lower house. The best market sectors for the month were Information Technology +9.3%, Energy +5.8%, Healthcare +5.5% and Consumer Staples +5.5%. The US was 2.3% higher on strong earnings from large tech companies such as Amazon, Microsoft and Twitter together with growing confidence that growth boosting tax cuts would be negotiated through Congress by years’ end. The economic environment in Europe continues to improve with cyclical industries showing a strong rebound prompting the ECB to announce a EUR 30billion per month scale back of its QE program in early 2018. European stocks were 2.3% firmer led by the export laden German market, which finished 3.1% higher. Japan improved 5.5% based on a strong Tankan business conditions survey and optimism of continued economic reform by the Abe government, which was returned to power during the month. The $A continued its slide against the $US and has now shed close to 4 cents since mid-September. This would be welcome relief for the RBA keen to provide some stimulus to the struggling local economy without cutting interest rates. Australian bond yields fell a bit over the month as the market continued to price out any near term rate hike by the RBA, now unlikely to occur before mid-2018 at the earliest.

Share markets shrug off the ghosts of October

Historically October has been a poor month for share markets with some of the most dramatic market events occurring during that month. This October marked the 30th anniversary of the 1987 share market crash and 88 years since the original 1929 crash that led to the Great Depression in the 1930’s. While the failure of Lehmann Brothers in mid-September 2007 was a pivotal event in the GFC saga, the US market peaked in October 2007 subsequently falling 50% to its lows in March 2009. With global share markets on average now close to 200% higher since then, many market commentators are now speculating the market rally has run out of steam and is vulnerable to a correction.

The 1987 market crash was a rather unique event that followed a spectacular market run up over the preceding 12 months driven by excessive optimism and high levels of junk bond financed corporate activity. Economic growth was actually quite strong at the time and while there was some risk of higher interest rates from rising inflation, the crash was not so much driven by the fear of a possible recession, but more from market euphoria leading to excessive valuations. The severity of the fall however was exacerbated by the prevalence of automated “portfolio insurance” trading activity that triggered more selling as the market fell which subsequently prompted the advent of “circuit breaker” trading rules.

The GFC was a much more significant economic event that precipitated a sharp global recession prompting the introduction of emergency monetary and liquidity measures that are still being felt today. The genesis of the GFC centered on aggressively sold low quality (sub-prime) home loans funded by securitised mortgage backed securities. An insatiable appetite for this kind of high-risk asset spurred huge origination programs by investment banks, which quickly permeated though the global financial system. Many of these securities became worthless following a spate of mortgage defaults as foreclosures promoted a sharp decline in the US residential property market. Faced with a severe liquidity crisis that threatened the viability of the global banking system, the US Federal Reserve led the way by introducing unprecedented bail out measures to ensure that banks were able to continue to provide liquidity to the financial system. Subsequent to this, savage cuts to interest rates to zero (and below in some cases) together with Quantitative Easing measures were introduced to limit the severity of the recession and revive economic activity. The seriousness of the GFC is underlined by the fact that ten years later, the global economy is only now starting to show signs of strengthening to levels that allows some reduction in the emergency accommodation measures.

So what’s different now?

The old adage that “bull markets don’t die of old age” has never been more relevant than in the current market situation. The fact that we have seen a prolonged period of good performance from shares does not in itself mean we are facing an imminent correction.

In a typical investment cycle, strong rates of growth lead to inflation from a lack of capacity and a tight labour market which pushes wages higher. As a consequence, central banks raise short-term interest rates to subdue inflation, which is generally negative for shares. Following 10 years of sub-trend growth, there is still plenty of spare capacity in the global economy. As a consequence of this, there has been a dearth of investment in productive capacity especially in Australia post the mining boom. In addition to this, despite reasonably full employment, wages growth has been tepid so in aggregate, global inflation is well and truly subdued.

As mentioned in last month’s report, global monetary conditions remain very easy and conducive to rising asset prices, especially shares. While the US has raised cash rates incrementally on several occasions (from abnormally low levels), it will be some time before most other major central banks follow suit. In terms of QE, while the US discontinued their program late last year, the ECB will continue a scaled down form of QE well into 2018 and Japan has given no indication of any wind-back of its version of QE.

While a simple analysis of share market PE ratios may indicate that valuations are becoming expensive relative to history, if you adjust for low bond yields and inflation levels, shares are still reasonably priced at current levels, with global shares a touch cheaper than in Australia.

Share market

With interest rates expected to only rise gradually from here, the primary driver of future share market performance will be profit growth. To this end, in the US and increasingly in Europe and Japan, profit results recently have exceeded expectations and are being driven more so by revenue growth than artificially boosted by buy-backs and other financial engineering measures. As a rule of thumb, market appreciation from here should approximately track the level of earnings growth as P/E valuations should hold reasonably firm at current levels. While market sentiment is quite positive (for good reason), there is not the “irrational exuberance” or “excessive euphoria” normally associated with the last gasp of bull market phases.

So our conclusion is that while a smallish correction of up to 5% is always possible due to profit taking, the medium term outlook for shares remains positive. In the current environment, a significant market correction of around 10% is more likely to be driven by a geopolitical (North Korea) or political (Trump impeachment) type event. While these cannot be fully discounted, in our opinion remain unlikely outcomes.

Investment Outlook

Our medium term view of financial markets has not changed over the month and hence we have maintained our asset allocation strategy stance. We continue to hold a growth asset bias in multi-asset portfolios with a preference for global shares (especially Europe) compared to Australian shares. Despite the recent decline in the $A, we would expect further falls from here as the interest rate differential with the US closes which will enhance the return from global shares. We remain cautious on the outlook for fixed interest especially sovereign bonds whose returns will be subdued by the gradual reduction in monetary accommodation measures.