Markets built on the strong 17% gains recorded in the first six months of the year to see the S&P ASX/200 Index rise a modest 1% for the quarter (2.35% including dividends).
The new financial year started strongly rising nearly 3% in the month of July (to hit fresh all-time highs) after the Reserve Bank of Australia (RBA) cut interest rates (by 0.25%) to a new record low of 1% (first back to back cuts since 2012) taking additional steps to support employment growth and lift inflation back towards medium-term target. The US Federal Reserve (Fed) followed suit cutting interest rates for the first time in nearly a decade lowering rates by 0.25% to a range of 2% to 2.25%. The Fed cited the move was a ‘mid-cycle adjustment’ or recalibration rather than being on a preset course for easing as the year-long US-China trade dispute continued to hurt growth and business investment. Often using the market as his political scoreboard ramping up trade talks when markets were at their highs and backtracking when markets fell US President Donald Trump (a frequent user of social media messaging app Twitter) tweeted his displeasure at Fed for not cutting interest rates further and to the slow progress of trade negotiations with China so threatened additional tariffs on Chinese imports.
Global markets sold off sharply in early August on the escalation in the trade war as China responded in kind by announcing new tariffs on US imports. The Chinese Renminbi fell to 11-year lows against the Greenback as increased trade tensions saw the world’s second-largest economy grow at its slowest pace in 27 years while political unrest (student protests) in neighbouring Hong Kong increased volatility to see Chinese shares lag falling 2.5% for the quarter while Hong Kong’s stocks plunged. Consequently, the local market fell by 3% in August (reversing July’s move) as global bonds rallied strongly on dovish central bank action that saw the yield curve invert again. The inverted yield curve a rare phenomenon where the long term yield (10 year) falls through the short term (2 year) – implies that an economy is approaching a recession within the next 18 months. Adding concern was a flattening or inverted yield curve has proceeded every US recession in the post-war era. As a result, investors chased safety buying typical safe-haven assets such as the US Dollar (US$) and Japanese Yen (¥) that rose to decade highs against the Australian Dollar (A$), Gold (rose to record highs in A$ terms) and Treasuries were bought at a record pace. By mid-August nearly 30% of global developed government bonds on issue were trading at negative yields an astonishing risk-off move (as investors were prepared to pay governments to keep their money safe i.e. lose money if held to maturity) and this was not lost on President Trump who yet again criticised The Fed calling for lower rates to boost economic growth and compete better with international peers.
The European Central Bank (ECB) joined the easing party in September as outgoing President Mario Draghi (Mr Whatever It Takes – a term coined by him in 2012 to preserve the Euro €) who retires in October turned to Mr ‘As long as it takes’ by cutting interest rates further into negative territory and re-establishing an indefinite Quantitative Easing (QE) program. At the heart of the concern is Europe’s biggest export-driven economy Germany that is on the brink of recession given its close ties to China and the UK that are both suffering trade and political uncertainty as the Brexit sideshow continues.
It’s clear to see the path of monetary normalisation has reversed sharply over the past quarter like many other developed and emerging economies respond by lowering interest rates or pledging accommodative action in the face of weaker global growth and benign inflation. The swift response has come as global growth looks to slow to decade lows around 2.5% (and below the 3% average of the last 5 years) and this slowdown has been most evident in global manufacturing readings that have contracted for a fifth straight month (longest negative streak since 2012) while inflation remains well below the targeted 2% level. These negative trends have overridden some clear positives being continued solid job growth and very strong service sector growth that shows that consumer confidence and optimism still remains high. By the middle of September, the US Fed bowed to some political pressure and mixed economic data enacting a second mid-cycle adjustment – taking interest rates to a range of 1.75% to 2%. This was enough for US markets to rally back to within 2% of their record highs as investors price in further central bank easing – a supportive backdrop for risk assets like equities. The timing of further easing will be largely dependent on global trade developments and high-level talks between the US and China are scheduled for mid-October so markets watch with bated breath.
For markets looser monetary policy and extra liquidity by central banks has seen continued downward pressure on bond yields. In Australia, the lower risk 10 Year Government Bonds continued to slide further (hitting a new record low of 0.86%) before closing at 1% as markets price in at least another interest rate cut (possibly two) before the end of the year. The weaker rate outlook has seen the A$ fall to US$0.675 (decade lows) and investors responded by buying overseas earners and stocks with higher yields given the average forecast yield for the market is more than 3% higher than bonds at 4.35% (albeit with higher capital risk) so cheaper money has promoted some greater risk-taking. This higher risk-taking was evident in the sectors that outperformed and this included technology stocks as well as small-cap and emerging stocks. The Emerging companies index (average market cap of ~$250m) rose by 5% for the quarter (30% for the year) outpacing the Technology sectors 4% higher move and the Small Ord’s (ASX100- 300 stocks) 3% lift. The ASX50 Midcap index (ASX 50-100 stocks) also rose by over 3% (including dividends) as investors chased higher growth among the blue chips. By the end of the quarter, markets had recovered strongly and rotation from growth to value was evident in the sectoral performance. We saw a switch back to less expensively priced macro-driven stocks in September such as Financials (Banks), Retailers (Supermarkets), Materials (Miners), and Energy (Oil) that dominates the ASX Top 20. The Banking sector finished the quarter strongly to rise by 5% in September, Retailers lifted 3%, and Resource improved 1.5% as major miners rebound on an improvement in the Iron Ore price. Meanwhile, the Energy sector spiked 4% as oil prices jumped mid-month on the back of the unprecedented drone attacks on Saudi production facilities and fears of a supply shock.
Looking at corporate earnings the August reporting season for Australian companies was difficult but better than feared as the second half was impacted by an uncertain election outcome that stymied investment. We saw a preference for flat dividends (as opposed to elevated payouts in February) as companies looked to invest further for growth. Companies that elected to pay higher dividends or conduct share buybacks were less rewarded this time
around. Clear winners of the reporting season were consumer stocks that have benefited from a series of interest rate cuts and a strong start to the new financial years trading as the first phase of fiscal stimulus (tax cuts) start to flow through. We saw some positive commentary and green shoots emerging from retailers and building companies as several leading housing developers suggested that the sector was near the bottom of the cycle in regards to volume and price. Given the expectations that interest rates will continue to fall this adds an earnings tailwind and positively the retail and construction sectors are among the economy’s biggest employers – so this is very encouraging.
Despite another positive quarter, the market volatility increased on weaker global manufacturing data and trade concerns and in the short term we have to expect more of the same as we head into October a month that traditionally has a reputation for some major market moves. A host of events will sway markets over the coming months and front on mind is the US-China trade war. Being a year out from the next US Election we are nearing an inflection point for trade and President Trump will want a win (even if it’s modest) to gain some traction with voters to claim he has delivered better deals for farmers and business. While investors aren’t predicting that a comprehensive trade deal will be reached as there are some complex issues to work through (intellectual property rights and enforcement) any view that we have passed the peak in trade frictions and more deals may come will be enough for markets to move higher. A further wildcard distraction is an Impeachment Inquiry into Trump’s alleged involvement and interference in the
2016 elections while in the UK the Brexit debacle is unresolved still 3 years on and must be reaching a crescendo.
While there always seems to be a wall of worry for markets to climb we remain cautiously optimistic that global central bank easing, economic stimulus in China and a trade war truce could underpin a rebound in the global economy heading into next year. As is stands markets have responded favourably to accommodative monetary policy to see Australian shares rally by over 20% so far this year put us on track to deliver the best yearly performance in over a decade. While cognisant that shares may pullback in the short term before an end of year rally we feel investors need to take heed to central bank commentary. RBA Governor Dr. Phillip Lowe has suggested that Australians should expect an extended period of lower interest rates. This “lower for longer” outlook for interest rates is likely to see bond yields remain around current depressed levels so investors will continue to seek higher alternate sources of income and this should bring about further buying support for Australian equities.