Towards the end of the quarter, we saw the focus of financial markets move from trade wars and the Korean peninsula to the inevitable rise in inflation and likely central bank action. A review of the classic investment cycle provides a fair argument that global economies could face a decrease in spare capacity, an eventual push from wage demands, and cost pressures. It is expected all these factors will lead to a rise in global inflation.
The US economy has led the charge across developed markets, with global risk appetite remaining critical as a result of US monetary policy impacts. When determining our strategy for the next 12 to 24 months, we will need to grapple with how high Fed interest rate hikes go and if they will inevitably push the US (and ultimately the world) into recession. Despite this, current economic indicators continue to look very strong.
On 23 April, we witnessed the financial markets’ sensitivity to high interest rates. US 10-year treasury yields moved above 3 per cent, resulting in a boost to the US dollar. However, this caused the Aussie dollar to spiral downwards, while Wall Street’s S&P 500 Index also fell 1.3 per cent.
Domestically, the level of Australian household debt continues to be the major factor curtailing an otherwise glowing report card. The Reserve Bank of Australia (RBA) has noted that house price growth has eased somewhat, providing some relief to the housing market. Strength in the labour market has seen employment growth of 3.3 per cent over 2017, with the unemployment rate falling to 5.5 per cent. The RBA is more cautious about the outlook for employment growth in 2018. In its February meeting notes, the RBA described it slowing to “closer to growth in working age population” (approximately 1.6 per cent). With that result, the RBA has noted that “some spare capacity in the labour market would remain over the forecast period”.
As a result, we may see some wage pressure relief. This would be a boost to households who have been feeling the squeeze of long-term poor wage growth and rising living costs.
The key positives for the Australian economy are business conditions and the boost in construction, both non-residential and government infrastructure. However, the progress in lifting business investment has been limited.
Looking externally, the RBA is now more encouraged by the global economy. Commenting on the topic, the RBA stated in its February meeting: “The near-term outlook for Australia’s major trading partners had been revised up slightly since November … global growth could continue to surprise on the upside”. This would boost both growth and inflation in Australia. Although the RBA still expects commodity prices to fall over the next few years, the forecast terms-of-trade has been revised a little higher for the near-term. As evidenced by money market expectations, there appears to be little scope for the RBA to tighten monetary policy at this time.
Closer to home, the Banking Royal Commission appears to have had a greater impact on the financial sector than originally expected. The uncertainty and regulatory measures that are likely to be imposed as a consequence could offset any further relaxation in the Australian Prudential Regulation Authority’s lending restrictions. With high prices, challenged affordability and out-of-cycle mortgage rate increases, Australia’s housing market may weaken in 2019 and 2020. It’s even possible that by 2020, the Australian government will have limited negative gearing. The RBA will likely raise interest rates to compound the effect.
Our investment strategy reflects our view that the equity markets’ bull run (which began in March 2009) is now in the mature phase. Traditionally, this phase of the cycle has delivered strong returns for equity investors as it usually coincides with strong economic growth, rising corporate earnings and high levels of confidence. However, the balanced “goldilocks” scenario we have experienced recently will be challenged if the pace of inflation, most probably in the US, picks up at a greater rate than is currently anticipated. This could also lead to a material rise in bond yields and the cost of credit, especially at a time when the global economy is more highly geared than ever before.
While the macro outlook signals continued growth, there appears to be little room for disappointment in the pricing of equities and bonds. We are neutral in our exposure to equities in our growth portfolios. Our enhanced cash portfolios are also defensively positioned to take advantage of higher yields as they materialise.
For the moment, it is steady as she goes as we await clearer signals from economic indicators and Central Bank policy.