30 September 2018
Themes For September
Markets were decidedly choppy over the month with mixed results posted around the world. Despite on-going trade tensions and a further hike in interest rates by the Fed, the US market scratched out a small gain of 0.8%. A fall of 0.9% in the NASDAQ however reflected weakness in the technology sector highlighted by the 7.6% fall in Facebook as a consequence of further data privacy concerns. The Japanese market was the standout rising 6% to a 27 year high following the re-election of the reformist Prime Minister Abe for a record 3rd term together with confirmation from the Bank of Japan that the massive liquidity support measures will continue for the foreseeable future. Europe was slightly firmer gaining 0.4% and the UK gained 0.9% despite on-going difficulties with the Brexit process. Mainland China bounced back from its recent trade related battering adding 3.5% while the Australian market fell 2.3% dogged by potential implications for the large financial services sector in the wake of the Hayne Royal Commission. Probably the most significant market move for the month was the 22 basis point rise in US bond yields to finish at 3.08%, a move that has continued on into early October. Australian 10-year bond yields followed suit rising 15bp to finish at 2.67%. Higher US interest rates buoyed the USD, which rose 7.9% against a weighted average of peer currencies, which has continued to place pressure on emerging market economies. The AUD received some support from a 5% rise in the iron ore price while the oil price rose 8% on fears that Saudi Arabia and Russia will not increase supply to offset lower Iranian shipments in the wake of new US sanctions.

Rising inflation, rising interest rates

Without doubt, the trajectory of both short and long term interest rates in the US is the biggest challenge facing equity markets. In response to a strong US economy with the very low unemployment rate of 3.7%, the US Federal Reserve will continue to increase cash rates to stay ahead of the inflation curve. While annual wages growth of 2.8% is not yet of great concern, further tightening in the labour market heightens the risk that inflation pressures will continue to build. While inflation rates across the world are still at reasonable levels, central banks will be pre-emptive in raising rates before the inflation genie gets out of the bottle.

Following the US rate hike in September there is likely to be a further 25 basis point rise in December as the Fed continues to move rates to a more neutral setting. In anticipation of this, US bond yields have continued to rise into the new month to be now around 3.2%. This is placing pressure on equity valuations, already quite full despite being supported by strong earnings growth.

The global growth outlook

The IMF has marginally downgraded their forecast for the global economy based on concerns that a prolonged trade war between the US and China will weigh on the global economy. With the growth outlook outside the US not as rosy and emerging market economies struggling in the wake of a strong USD, the IMF is concerned that any reduction in global trade will stifle the nascent recovery. Adding to this concern is the lack of progress in the Brexit negotiations between the UK and the EU, which has created uncertainty over trade within this important economic region. On the positive side, the US has successfully revamped the decades-old NAFTA trade agreement with Canada and Mexico to be now more beneficial to the US. The strong trade link between Australia and China, especially for the steel making bulk commodities iron ore and coal, leaves the local economy and AUD vulnerable to any slowdown in the Chinese economy.

Falling property prices

Weakening residential property prices especially in Sydney and Melbourne are of some concern to the RBA and may weigh on the future prospects for the local economy. Despite no increase in official cash rates, tighter lending conditions and higher funding costs have led to off-cycle increases in interest rates by some lenders. With consumers very leveraged to direct property, a further decline in prices will have a negative wealth effect which in combination with low wages growth and a low savings ratio could see a pull-back in consumer spending. This is one of the major factors that will keep the RBA on the sidelines for the foreseeable future.

Investment Outlook

While we remain confident on the primary drivers of equity markets, we acknowledge that risks are gradually rising. The medium-term outlook remains sound for shares which are supported by a robust profit outlook however there is a growing possibility of a short-term pull back if bond yields continue their current trajectory. A sharp increase in inflation is unlikely however, as pre-emptive action by the US Fed in particular will limit the negative inflationary impact on risk assets such as shares. With the AUD likely to weaken further in a risk-off environment, we are holding elevated levels of foreign exchange exposure as a form of risk mitigation. We are monitoring market events very closely and will implement further measures to protect capital if we deem necessary.