The Market Correction in Perspective
It’s never good news to see such as sharp market pull back as we witnessed in October. As mentioned in previous monthly reports, we had become cautious about equity markets and as a consequence reduced equity exposure in late July in favour of more defensive securities while also increasing the portfolios’ foreign exchange holdings via a US dollar position. Despite this, it was difficult to predict the timing and severity of the correction as the sell-off was not triggered by any specific event or data release.
During the month, the market became gripped by negative sentiment and heightened risk aversion, climbing a wall of worry about what might happen, rather than what is likely to happen on key issues such as the path of US interest rates and the trade dispute between the US and China. It is not unusual to see market corrections in the order of 10%, we have seen several moves of this magnitude in the past few years that have not interrupted the broader upward market trend. The key consideration for investors is whether the October sell-off represented a correction in an otherwise upward trend or whether the market is forewarning of an economic recession and a bear market in shares. As the chart below shows, equity market corrections historically have not been a reliable indicator of an upcoming bear market, the last of which occurred in the wake of the GFC.
Cutting through all the market noise and distraction, there are two key issues confronting global financial markets. As mentioned in previous reports, the major consideration is the strength of the pivotal US economy and the pace at which the Federal Reserve will increase short-term interest rates.
By any measure, the US economy is performing well. Economic growth in the third quarter showed an annualised GDP growth rate of 3.5%, consumer confidence is at an 18-year high and the unemployment rate of 3.7% represents a 49-year low. After a long period of stagnation, wages growth is now around 3% annually, providing a healthy environment for consumer spending which accounts for around 2/3rds of GDP. Fiscal stimulus from personal and corporate tax cuts have added fuel to the economy and boosted company profits, which grew in excess of 20% in Q3. While the rate of earnings growth is sure to slow in 2019, the US market is now trading on a much more reasonable PE ratio of around 15 times forward earnings compared to 18 times at the beginning of the year. In response to such a positive report card, it is logical that the Fed has been gradually reducing the level of monetary accommodation by steadily increasing cash rates. Rather than being cause for concern, this is the sign of a healthy economy. While the Fed is likely to further increase rates by 25 basis points in December, inflation is close to the Fed’s 2% target and real cash rates of around zero are nowhere the level that would push the economy into recession. In summary, while the pace of growth in the US may slow a little in 2019, there is little prospect of a recession in the next 2 years.
The second issue concerns the potential impact on the global economy from the trade dispute between the US and China. In our opinion, the risk of this having a material impact is relatively small and substantially overblown in the market’s psyche. While both sides have engaged in posturing and brinkmanship and further short-term escalation can’t be discounted, there is a bilateral motivation to reach a compromise, which would avert major damage to global growth or inflation. It is worth remembering that only 12% of US imports have been subject to a 15% tariff from China, which represents an average tariff of just 1.8% across all US imports. Remember that following their repudiation of global trade treaties, the US has successfully renegotiated trade deals with South Korea and Canada/Mexico and is currently negotiating with Europe and Japan.
Following the disappointment of October, it has been pleasing to see some market stability so far in early November. With the US mid-term elections now out of the way confirming the forecast of a split Congress, the market can refocus on the supportive medium-term fundamentals. Having reduced equity positions a few months ago, we remain comfortable with current portfolio risk settings. In the event of further falls in the near term, we would be encouraged to buy back the positions recently sold, as valuations are now the cheapest they have been for many months.
We continue to favour unhedged global markets over Australia which is now starting to focus on the likelihood of a change of government next year with policies concerning franking credit refunds and negative gearing not likely to be well received by the market. In addition to this, the continued decline in the residential property market and the fallout for major banks from the Hayne Royal Commission continues to weigh on the local market. The European equity position we hold as part of the international equity weighting is currently under review as the region continues to lurch from one set back to the next. Most recently, the new Italian government proposed a budget not acceptable to the European Commission, which expects more austerity than currently proposed. Leading indicators of growth in the region have disappointed in recent months so while the markets there look to be cheaper than other regions, this may reflect inferior growth prospects. The ECB are due to wind up their QE program next month so we will be closely monitoring market events in Europe as we close out the year.