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Skip Navigation Links-Economic-update-Home-and-away—plenty-of-plot-twists-but-a-satisfying-conclusion Economic update: Home and away—plenty of plot twists but a satisfying conclusion

Economic update: Home and away—plenty of plot twists but a satisfying conclusion
James Cook

​​​​​With all the drama surrounding geopolitical events, volatility across financial markets duly jumped. The December quarter saw a large selloff across equity markets with falls of up to 20 per cent—the threshold required to officially register a ‘bear’ market. The start of 2019 saw much of those falls reversed as central banks have made ‘dovish’ statements indicating more supportive financial conditions. We held a defensive stance through the December quarter as projected economic indicators signalled a slowdown across the global economy. Our equity portfolios looked to unwind some of our exposures to more highly priced growth stocks that had performed so well through the year and we increased our cash holdings. This helped soften the full extent of the downturn although the market reacted savagely to downgrades to some of our key holdings in Lend Lease, Boral and Bingo—reflecting the sensitivity of the market to negative news. The Australian equity market has now rebounded to recover most of the losses experienced across December while USA benchmark indices are still down 1-2 per cent but have also risen markedly from the December lows. 

Why all the drama?

Volatility is usually the result of high uncertainty. Heading into the December quarter, sentiment indicators suggested high degrees of confidence through business and consumer sentiment indicators. Equity markets had enjoyed tremendous returns while economic growth figures looked robust. But there were geopolitical storm clouds looming. President Trump went into overdrive on Twitter issuing missives around withdrawing military support from Syria while continuing to use the government shutdown to force through his election pledge to build the wall along the US and Mexico border. The US–China trade dispute dominated headlines while Europe saw civil unrest in France. Concerns over the state of the Italian economy and the ongoing Brexit shambles also weighed heavily on investor sentiment. There is now a recognition the global economic cycle has peaked albeit with US wage growth beginning to accelerate. This contrast was particularly evident with a warning signal that the Federal Reserve’s policy of continuing to tighten financial conditions through higher interest rates was intact. The message to global investors was clear: tighter financial conditions at a time when the economy and corporate earnings looked to be rolling over. The resulting sell-off quickly reverberated around global stock markets with significant falls. Australia was not spared, particularly with its exposure to China which continued to experience a noticeable slowdown in its own growth. With widely reported falls in house prices, particularly in Sydney and Melbourne, the negative wealth effect contributed to investors’ jitters and the subsequent selling of equities in a distinctly ‘risk off’ environment.

Another plot twist? 

In a complete turnaround, the markets have seemingly dismissed concerns as Trump’s Tweets of positive progress in USChina trade talks have seemingly calmed nerves. We have either come a long way in our financial market sophistication or regressed considerably! At the same time, the US Federal Reserve and the Reserve Bank of Australia have both made soothing sounds in the face of rising uncertainty. The Federal Reserve suggested that the pace of tightening in financial conditions may ease off while the Australian counterpart even suggested that rate cuts and other stimulatory measures could be drawn upon if needed.

Chart 1: V-Shaped Recovery 

S&P ASX 200 - Price (Aust)
S&P 500 - Price (USA)​

​Source: FACTSET

Returning to Australia, the prospect of Labor returning to government in 2019 will heighten domestic risks if touted tax reforms are introduced, which may reduce equity market returns. Economic growth forecasts are now being pared back at a time when the property market threatens to derail confidence throughout the economy. While the market no longer looks excessively overvalued, the rebound in the ‘big four’ banks lifted overall valuations after the banking royal commission findings. This suggests that their operating environment and profitability will not be as negatively impacted as originally thought. 

A cliff hanger or a happy ending? 

Equity and bond markets remain elevated reflecting a generally positive sentiment towards economic and financial conditions. However, talk of further central bank interventions (quantitative easing) is increasing the sense that a greater than expected downturn lies in the wings. With interest rates still at historically low levels in many countries, quantitative easing to introduce more liquidity to the system will need to be a finely tuned exercise given that central bank balance sheets are already bloated from prior efforts to pump up economies. We will target a return to a more neutral position when we see evidence of companies being able to confidently invest capital at a profitable rate of return that compensates for the risk in doing so. We would also prefer evidence that the growth in the Australian economy can be sustained through a more secure outlook from major trading partners. Australian households would need to address their record levels of indebtedness and also see meaningful rises in wage levels to offset the rises in the real cost of living.​