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.
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
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.
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
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.
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.