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.
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.