Themes For September

30 September 2016

Following the calm conditions experienced in financial markets in August, we saw volatility return in earnest during September with a series of sharp daily moves. In a net sense however, equity markets were relatively flat for the month. Australian shares were marginally higher, supported by a stronger resource sector buoyed by firmer commodity prices. In the US, shares were basically flat as was the case in Japan and Europe although the UK edged 1.8% higher on the back of promises of easier liquidity by the Bank of England to cushion the anticipated negative impact of the UK’s exit from the EU early in 2017. Bonds were a little weaker as Australian and US bond yields edged higher despite receiving some support later in the month when the US Fed chose not hike rates. The oil price received a boost with the surprise announcement that OPEC had decided in principal to curb production levels to support prices in the wake of soft global demand. The $A was firmer against the $US as the market pushed out expectations for the next US rate rise.

Monetary Policy – Now pushing on a piece of string?

There is a growing body of opinion in financial markets that the potency of monetary policy is diminishing and cannot be relied upon as the sole policy tool to revive the global economy. It is inarguable that emergency interest rate settings and the expansion of money supply by Central Bank bond buying programs, helped rescue the global economy from a deep recession. It has been 8 years now since the GFC however, and the economic impact of monetary stimulus appears to be ever diminishing. With economic growth rates still tepid in most developed economies, it is questionable whether further monetary stimulus from here, will have any material beneficial impact on economic growth and by extension, company profits.

What is clear is that equity and bond markets have benefitted enormously from these measures and have now become accustomed to the very easy liquidity measures that are maintaining prices at current levels. The problem that markets must confront over the next couple of years is that this level of stimulus cannot continue in perpetuity. Quantitative easing measures must first be gradually withdrawn, and then interest rates must eventually increase, albeit gradually. Both of these factors have commenced in the US and other countries will eventually follow suit. Central Banks in the UK, Europe and Japan are continuing apace with QE measures and interest rates are still falling in most western economies including Australia. While they are all lagging the US in terms of their timetable, it is inevitable that they will follow suit in coming years.

Is fiscal stimulus the answer?

A popular theme in the financial media is that governments should take advantage of the current low bond yields, and borrow to fund spending in areas such as infrastructure to stimulate economic growth. While this sounds intuitively appealing, governments historically have been terribly inefficient at managing these sort of programs, leaving them only more indebted and placing their budgets under more pressure to service future interest obligations. History tells us that governments are notoriously poor at making the tough decisions necessary to reduce budget deficits. In Australia, we saw the wasteful and ill fated “school halls” and “pink batts” programs while in the US, President Obama’s much heralded investment in “shovel ready projects” produced very little in terms of economic stimulus and escalated the level of government debt which now sits at $US 20 trillion. While monetary policy still has an important role to play, the solutions for governments are not politically easy

Storm clouds are gathering for Markets

The adjustment process to “normalise interest rates” could well be a painful one for markets as any increase in the risk free rate of return as represented by bond yields, will filter through to the valuation of all other financial assets including shares and property. To offset the impact of this, the market must be confident that profit growth will be sufficient to offset the negative valuation impact of higher bond yields to maintain equity prices at current levels. Therein lies the problem for equity markets; there has been a complete absence of profit growth in aggregate in recent times. For example, quarterly profits in the US have actually fallen for the past 2 years. While lower energy prices have contributed heavily to this outcome, the market is becoming increasingly impatient for actual profit growth delivery, especially from top line revenue expansion.

The over reliance on easy liquidity to maintain market valuations at current levels is becoming a concern for us. In the absence of tangible evidence of near term profit growth, markets are vulnerable to a correction before the end of the year. The volatility we saw in September is an indicator that market sentiment remains fragile and could easily be punctured by any number of uncertainties that are on the horizon. We saw evidence of this recently with the frenzy over Deutsche Bank’s financial health in the wake of a mooted $US14 billion settlement to the US Justice Department for their mortgage backed business practices prior to the GFC. Even though this figure was merely an opening ambit claim, and will be nowhere near the amount ultimately settled, the Deutsche Bank share price plummeted as a result, unsettling global equity markets in the process.

Known risks that lie ahead are firstly, the US Fed is almost certain to increase cash rates by 0.25% in December. While this would be no great surprise, it is not fully factored into market prices. Secondly, the US Presidential election on Nov 8th is looming and while Hillary Clinton maintains a lead in the polls, Republican candidate Donald Trump is close enough to pull off an unexpected victory. We only need to look back in recent history to the Brexit referendum which defied the pundits and produced a market shock. While Clinton’s policies are poorly defined in detail, the market would regard her election as “business as usual” and a continuation of the Obama agenda. A Trump victory on the other hand is more of an unknown quantity, although he would certainly be more pro-business as evidenced by his proposal to substantially cut company tax rates.

Thirdly, the issue of the UK’s exit from the EU has once again come into focus with Prime Minister Theresa May declaring she will formally invoke article 50 of the Lisbon treaty to exit the EU by March of 2017. With the UK likely to take a hard line on foreign worker access to its labour market, expect a tough trade agreement to be negotiated by hard line EU member states such as Germany, which will negatively impact the UK economy.

And finally, there is always the risk of an unforeseen or “Black Swan” event unsettling markets. This is particularly relevant during October, which has historically been a seasonally weak month for equity markets and witnessed many of the major market corrections through history.

Investment Outlook

As a consequence of the growing risk of a share market correction, we have decided to reduce the equity risk in portfolios by selling down holdings in Australian and international shares. While we remain positive on the medium term outlook for these markets, we believe it is prudent for the purposes of capital protection to increase defensive assets by way of short dated corporate paper as a buffer for any market pull back. Importantly, we do not hold any government bonds in portfolios which in our opinion are the most expensive asset class and likely to deliver poor, if not negative returns in coming years. In the event that markets do correct in the short term, we will use this new liquidity reserve to top up equity holding at cheaper prices to benefit longer term returns.