Sentiment across financial markets appears to have finally caught up with a not so sunny global outlook. Concerns over the economic cost of US-China trade/tariff wars have added to emerging US inflation concerns. Continued geo-political tensions and a weakening domestic housing market has added to uncertainty across Australian markets as well.
Global growth has now decelerated and become less synchronized, with accelerated economic momentum primarily restricted to the US. US wage pressures are beginning to grow at a faster rate, adding weight to expectations of further US Federal Reserve rate hikes. Global debt levels across both public and private sectors remain a concern, leaving many economies vulnerable in the face of an economic downturn and rising interest rates.
Source: BCA Research Inc. Monthly Portfolio update November 1 2018
On the upside, Australia posted GDP growth of 3.4 per cent in the last quarter. The positive tone was reflected by the RBA’s Assistant Governor Michele Bullock who noted both global and domestic structural drivers at work. In recognition of concerns over Australian household indebtedness and the elevated levels of the residential property market, she cited lower nominal interest rates - due to both lower inflation and more competition - and financial deregulation as indicators that the average household could service a larger loan. This was further bolstered by continued falls in unemployment.
"While unemployment continues to trend lower, we believe the serviceability of rentals and mortgage payments will hold up with the key risk to property markets being out of cycle interest rate increases, primarily borne from rising US interest rates" (Michele Bullock: The evolution of household sector risks).
Excessive debt is another cause of concern when assessing the sustainability of China’s growth trajectory – which remains important for Australia’s prosperity. In the face of slowing economic growth, China’s high levels of debt may magnify the extent of any global downturn, particularly in the materials sector which could dent Australia’s export receipts.
So while global economics point to increasing divergence, the Australian economic front looks benign with unemployment now at 5 per cent. With interest rates likely to remain unchanged, business confidence is largely supportive and the geo-political landscape is reasonably insulated from global machinations. However this is largely known news. Geo-politics and trade wars remain unpredictable and will only add to heightened volatility across financial markets.
Throughout most of 2018 we have targeted a neutral stance, recognising the prospect for a traditional late cycle run in equity markets while economic and earnings data top out.
Profit results to date have delivered positive surprises with two consecutive years of +20 per cent growth in the US. Australian earnings recently reported +8 – 10 per cent for the full year, slightly ahead of expectations. This was led by positive earnings in resources (+20 per cent) and industrials (+9 per cent), with financials, while still positive, slightly weaker (+2 per cent).
Previously, it had been enough to keep risk on the table, especially at a time when bond yields remain stubbornly low and inflation sits within targeted bands.
With the economic outlook looking so supportive, the major concern had been when to take risk off the table as the US Federal Reserve lifts interest rates, setting a higher demand for return across all asset classes.
Whilst economic growth and employment figures are so strong, it is seemingly obvious to continue to expect further gains from equities. History, however, tells us a different story. Equity markets will invariably start to anticipate an economic downturn through the early stages of a rising interest rate cycle as prospects of slower corporate earnings lead to a deterioration in investor sentiment.
These concerns were realized across October as global equity markets sold off, most from positions close to record highs, to levels that were around 10 per cent lower.
We had adopted a defensive stance early in October and are now decidedly overweight in cash in the UCA Growth Portfolio, with both Australian and international equity portfolios holding higher than normal levels of cash. After a long period of stellar returns, capital preservation now appears more prudent than chasing ever higher levels of growth.
Behavioural finance suggests we may well be approaching a period where despite the news being positive, it is no longer as positive as it had been and, more importantly, no longer as positive as the market expects. With rising rates, geo-political tensions and inflationary pressures now finally breaking free, prudence has won over valour.