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19 November 2019 | Newsletters

October 2019 Newsletter

October was certainly an eventful month and while the Australian share market (S&P 200 Index) fell 0.37% over the month its probably fair to say it was a relatively benign outcome.

Against such a volatile and unpredictable environment we are pleased to report that our IMP models outperformed their respective benchmarks by an average of 31bps during the month. Our YMP model also enjoyed a modest 18bps win versus its pure equities benchmark, no doubt assisted by a slightly negative market return.

Market Commentary and Outlook

As noted earlier, October proved to be largely positive for investor sentiment. At one point we were down by more than 3% amidst a litany of global risk events. While the US and China failed to deliver the trade deal investors had hoped for at the start of the month, the outcome proved sufficient to alleviate near term downside risk from the trade war and prompt a rebound in risk assets – at least for the rest of October and into early November.

Similarly, despite the failure to deliver a Brexit deal or exit the bloc on an already twice delayed deadline, the UK/EU situation actually appeared to improve with British lawmakers accepting for the first time (in principle) a Brexit plan.

On the corporate front as we moved into the US reporting season, the US companies appear to have once again eclipsed very low expectations during their current quarterly earnings season. The profit across the largest 500 companies looks like it could still decline (year on year) for the first time since 2016 the drop is likely to be less than 1% – not the 4% plunge expected just a month ago. Forward earnings revisions have remained negative and clearly some of the decline has been pushed back into FY20 estimates, but for now investors and the market have been spared a major earnings recessions helping to maintain support for the current elevated market multiple.

Finally, central banks largely continued to support risk assets with the Reserve Bank of Australia cutting its Official Cash Rate for a third time in the cycle at the beginning of the month, matched at month’s end by a rate cut from the US Federal Reserve alongside renewed QE. All of the aforementioned factors are fluid and could change in the weeks ahead but for October at least they proved better than feared and indeed Wall Street struck new all time highs (with European markets and Global indices achieving that marker in early November).

Australia’s market remains around 3% below its record set on 30th July.

We remain relatively constructive on the near term market outlook. We are heading into a historically bullish period of the Calendar (with last year as a notable exception) and any sort of a US/China deal may be sufficient to prompt a Santa Claus rally into late January. Momentum is positive in most regions with US/EU having broken out to new highs, while monetary policy for now remains supportive to equity markets. The apparent easing in US/China tensions has reduced the risk of sustained global economic slowdown and recession – for now. The two nation’s will arguably need to deliver something tangible before Christmas for improved sentiment to translate into improved activity and there remains a risk of a back down from either side. As we have previously discussed we do believe it is in both countries interests to reduce the economic impact of the trade war and at the same time the issues underlying the matter are unlikely to be fully resolved in the foreseeable future. For political reasons there is an inverse relationship between market conditions and pressure to reach an agreement. As data has revealed, and the markets presaged, in September there were growing fears of recession and clearly pressure mounted on both the US and China to reduce the negative impact the trade war was having on businesses and markets. Fast forward 6 weeks and Wall St is back to new record highs – and we have seen some solid data (particularly on US consumer front however global PMI’s have also improved from very low levels in the past month) and arguably pressure on Washington and Beijing is much lower than it was in late September/early October. This does raise the risk of setbacks in current negotiations. It is difficult to predict what path the talks will take however we feel a phase 1 largely aesthetic agreement is likely and it may bring some reprieve with delayed tariffs however we also feel there will likely be renewed tensions at some point thereafter if not before).

Brexit remains somewhat uncertain with the added unknown of a snap Election in mid-December. However it appears both major parties are committed to exiting the bloc and with lawmakers principally agreeing to a plan it does seem the risk of a no-deal Brexit has reduced (note that markets have virtually discounted the chance so there is risk in that). For the most part however, Brexit has not proven to be a global market influence anywhere near the extent the US/China trade war has and as such the latter remains more important.

Locally we have experienced a very negative AGM/Quarterly Update/Bank reporting season and it has weighed on our market (hence it is lagging global peers to hit fresh highs). A month ago Financial Year 2020 the Earnings Per Share (EPS) growth was slated at 6.7% and following the recent domestic earnings update season it is difficult to believe this is not now 5% or lower (given that ANZ and WBC have both missed estimates and many other firms have lowered guidance). This leaves the 12 month forward Price to Earnings Ratio (P/E) of the ASX 200 at an eye watering 17.5 times (virtually equal to its highest level in the past 15 years);

We have certainly seen a ‘gentle turning point’ as the RBA has put it. The market appears to be optimistic that improved global economic conditions linked to trade war detente and lower interest rates, combined with the effects of three RBA rate cuts domestically will signal improved macro conditions in 2020 and with it an uptick in earnings in 2021. This is certainly possible and of course we note the US presidential Election is now effectively one year away – Election years have historically been associated with strong market returns. But it is also fairly short sighted; the expansion cycle remains aging and following the ‘mid-cycle’ adjustment (which may just add a little sugar rebound in the next two quarters) there is relatively little monetary policy ammunition left to add incremental support to its duration. Recession for 2020 may have been avoided but it will of course eventually occur, and arguably the longer it is deferred the worse it may be. With markets trading in relatively optimistic sentiment, on high P/e’s with falling earnings expectations and little likelihood of further major monetary policy support near term we are not entirely bullish and will certainly consider taking profits on any end of year/early 2020 rally through to new highs should it occur.

It is worthwhile noting the shift in bond yields. The Australian 10 year bond yield broken recent highs yesterday following the RBA’s November statement and further near term upside it possible. This is adding to the cyclical/value rotation we have witnessed in October. A clear technical break on the chart could easily signal a move back to ~ 1.6% to 1.8% , which is 50% higher than current levels and double the lows struck in September!

In addition to company specific issues (WTC short report, APT fees inquiry etc) this appears to be driving continued underperformance across the ultra-high growth and P/E cohort. Meanwhile cyclical names in the materials sector have enjoyed very solid performance despite negative earnings news. While some improvement has been seen in Australian housing indicators (building Approvals much better than expected last month, Auction clearance rates in Sydney & Melbourne back >70%, house prices stabilising on annual observations while rising month on month in Eastern states), other data (retail sales, capex etc) has been deteriorating. Consequently we think the current view that FY20 represents the trough may be somewhat optimistic. Arguably, the same can be said for Agriculture too ; we note our crop conditions continue to deteriorate heading into a third year of drought…it will break of course but that seems like hope as a trading strategy at present! (at least for short/medium term investors in companies with debt). What is clear however is that investors are positioning away from high growth (and to a far lesser extent high yield) and rotating to cyclical value – the above chart suggests this may have further to run so long as global macro-conditions are conducive (ie trade talks do not fail). That being said we have actually added selectively to our exposure in high growth companies amidst the significant pull back (>30% from highs for many names) as we do believe that in the medium term global growth is unlikely to accelerate too far and lead to rate hikes, and that growth will again be attractive. Similarly we have maintained and even added to some quality high yield positions on the same belief too. Pleasingly, we entered the rotation with underweight exposure to these segments and significant exposure to cyclical/value – one of the reasons we have enjoyed outperformance in the past few months. At the same time we have reduced some cyclical/value exposure amidst the rebound and should the trend continue into the New Year period we will no doubt consider further reductions given the above.

Finally, from a technical perspective our market remains in a very strong medium and long term uptrend but is constrained by the all time high and the top of this trend channel suggesting limited upside. While a clear break of the all time high would normally be taken as a strong positive signal for short term upside, and the trend channel places resistance again at ~7050 implying +5% from current levels (just 2% from the break).