16 August 2019.

Overview

Equity markets posted exceptionally strong returns across the June quarter fuelled by prospects of stimulatory action from major central banks, with the Peoples Bank of China and the Federal Reserve weighing in heavily to influence investors.

The price action saw bonds move once again to record lows in Australia on the back of weaker lead economic indicators and the wave of uncertainty from global trade-wars and punitive tariffs between the US and China saw business confidence dented. With the prospects of lower interest rates, the relative attraction of dividend yields saw buyers push equity markets into record territory.

The current scenario highlights the dilemma facing investors; lower yields and interest rates are signalling a major economic slowdown – hardly positive news for corporate earnings. However, with the savings rate now less than 1%, investors are turning to equity investments in search of higher yields, despite the inevitably slowing earnings outlook. The current scenario highlights the embedded risks that are now confronting investors across the globe at this point.

Growth waning globally and domestically

The US economy has been growing at an above-trend pace and the unemployment rate is below most estimates of full employment. However, the US outlook has been in contrast to its global counterparts where growth is in a definite downtrend with inflationary expectations well below Central Bank targets. This will ultimately influence Australia’s open economy although recent tax cuts and infrastructure spending may well cushion the full extent.

Australian equity downgrades slowed to a trickle in July after major revisions in May and June. As we enter the company reporting season for 2H FY19, we see domestic industrials’ earnings per share (EPS) estimates fall to -10.2%, while FY20 estimates are suggesting a flat outcome. There have been plenty of reasons for downgrades including tighter credit, weak consumption, unseasonal and extreme weather events, softer China growth, Brexit concerns and heightened geopolitical risks around global hotspots, particularly in Hong Kong. This is in stark contrast to the resources sector that has been enjoying high iron ore and gold prices to generate growth estimates for FY19 earnings per share at 27% and 22% for FY20.

Could this time really be different?

Major global economies are now facing negative bond yields – a situation where investors actually pay the central bank for the right to hold their bond in anticipation that they will at least enjoy repayment of their capital at the maturity of the bond. In essence, it highlights the sober outlook across the global economy where there is little incentive to take on risk and enjoy a positive return for doing so. It is currently all about return of capital rather than return on capital.

The weaker economic outlook comes at a time where levels of debt have risen dramatically since the Global Financial Crises. Public purses have been opened to fund various efforts to stimulate while tax cuts, which weaken fiscal receipts, have also contributed to a deterioration of national balance sheets. However, new theories such as Modern Monetary Theory argue this time it is different. Simply put, the latter argument suggests that while a country is able to successfully issue debt in its own currency to fund its deficits, the global economy can continue to ‘kick the can’ and defer the major market upheavals which have been the traditional results of structural imbalances across economic systems.

This time around, things really are different when we take stock of the magnitude of interventions we have seen by way of record low interest rates, quantitative easing and helicopter money - not to mention the ongoing acceptance of unprecedented levels of debt!

Aside from the ability to keep financing stimulus from issuing same-currency debt, the old cynic in me suggests that the forces measured by absolute interest rate levels and levels of debt appear close to spent.

Our strategy

We adopted a defensive position at the beginning of the December 2018 quarter in anticipation of the last legs of excessive growth preceding an inflation breakout and a non-market-friendly ratcheting up of interest rates worldwide. Such a typical cycle has usually led to slower growth, if not outright recession.

The surprising outcome, which ambushed most investors at the beginning of 2019, was that the growth projection halted quite dramatically. The resulting pivotal turn by almost all G10 central banks has proven a game changer as they unilaterally reversed intentions to continue to tighten interest rates to ‘normal’ levels—to today’s situation where we are seeing negative returns on instruments of monetary policy. Continued easier financial conditions have upped the demand for equities and allowed markets to climb the “wall of worry”.

While we may have been wrong-footed in the first half of 2019, we believe our defensive positioning remains appropriate for a medium-term view. This is due to concerns over a weakening global economic outlook and the risk of central banks exhausting the ability to stimulate through lower interest rates. The ongoing trade wars and punitive tariff responses from global counterparties coupled with ever-present geo-political risks also warrants some caution given the potential disruption to global growth—all factors which challenge Australia’s very open economy.

We remain underweight Australian equities in our growth portfolio and defensively positioned within all our portfolios across equities, cash and fixed income. We note that our rather sober outlook recognises that financial markets and economic trends are not always correlated – especially at inflection points. Should equity markets suitably discount the anaemic growth outlook, we will begin to sharpen our pencils to restore our exposures to equity markets at more comfortable valuations.