Investment & Economic Review April 2019
The first quarter of 2019 was distinctly different, and much improved, from the final quarter of last year. Stock markets which had slumped badly recovered just as quickly, erasing the losses of late-2018 within a few months.
The market turnaround was inspired by affirmation that corporate earnings were generally rising, and that the stimulus provided by Central Bank policy settings and low interest rates would remain. Indeed, Central Banks toned down their quest to normalise interest rates, thereby adding some fuel to the equity market turnaround, but equally raising consternation about the pace of economic activity. The accelerating downwards trend in global long-term interest rates caused a further flattening of the yield curve.
In Australia, reported economic statistics were mostly weaker, ignominiously the meagre 0.2% GDP growth for the December quarter and softer business and consumer confidence surveys, concurrent with a reduction is construction activity and housing values. The pace of economic growth is now considerably lower than both the Reserve Bank and Treasury’s forecast, meaning that downgrades are surely imminent, and the RBA will likely err towards a softening of policy settings, including possibly lowering interest rates. Further, population grew more quickly than GDP in the December half, causing GDP to be negative on a per capita basis. This will be offset, at least for a short while, by the economic benefits of stronger commodity prices and exports, particularly as the Australian dollar has remained low.
In the coming months markets will need to contend with the tortuous path of Brexit, ongoing fractiousness in US politics, and domestically, possible policy changes and pronouncements associated with the federal election. Investors will also be keeping an apprehensive watch on economic and profit reports.
The Australian stock market, as measured by the S&P ASX200 Index, rose by a significant 9.5% in the March quarter, and is up by 7.3% for the last twelve months. With dividends included, the returns were 10.9% and 12.1% respectively. The market recovery was broadly based but particularly strong in the commodity sectors which benefitted from improved raw material prices, and those areas such as utilities and real estate trusts that had their valuations enhanced by the effect of lower bond yields.
Within our managed share portfolios most stocks participated in the market recovery, most notably BHP, InvoCare and Santos, all of which rose significantly in the quarter. In the banking sector, we were inclined to add to holdings pre their Christmas dividends, but reduce holdings more recently as prices had rallied and the bank earnings outlook remains subdued.
Most corporations reported their half-year results in February, which were generally pleasing despite the lackluster economic environment and absence of inflation. Dividends were surprisingly strong, as many companies chose to increase payout ratios, citing strong balance sheets, and in some cases clearing excess franking credits ahead of possible policy changes.
Australian share prices remain well supported by the continuation of very low interest rates, but equally, upside potential is constrained by generally dull economic and profit growth. Stock market fair value can reasonably be assessed at about the current index level of 6000 to 6300 points, but the usual swings and trends could see it trade 5% higher or lower than this during the remainder of 2019.
Global share prices enjoyed a solid start to 2019, particularly in the US and China, which put aside their quarrel over tariffs and trade, at least temporarily. European shares rose less quickly as markets dwelt on stubbornly weak economic activity and the looming Brexit transition.
The large global technology stocks now represent the world’s largest share market components. Performance of this sector remains solid, but questions about single company market dominance and increased anti-trust scrutiny might crimp the pace of future growth. In the United States the phenomenon of share buybacks continued at a frantic pace, as companies took advantage of low interest rates, the easier repatriation of foreign cash and reductions in tax rates. This shopping spree accounted for the repurchase of 2.8% of all US shares on issue in 2018, more than the entirety of dividends paid. Share buybacks have helped underpin market prices by providing additional demand, and incrementally increasing future earnings per share. But there is a limit to their effectiveness, as funding to buy back the shares needs to be borrowed, or extracted from retained earnings, diverting capital that might otherwise be applied to operational growth. In 2019 the pace of buy backs is likely to wane, removing one of the stock market’s downside support mechanisms.
There remains a wide a variance in relative value, with markets in Japan, Germany, Hong Kong, and some of the emerging markets representing better value than shares in the United States and Australia. However, importantly the US dollar remains strong, and remains essentially the world’s reserve currency, so assets priced in USD provide diversification and risk mitigation benefits to Australian investors.
Some of the global impediments that we’ve previously referred to have now passed, but Brexit remains an issue for British and European markets and the subdued pace of global economic activity is emerging as the most important driver of forward market performance.
The stock market listed property securities (REIT’s) have enjoyed buoyant trading conditions in early 2019, hyped by falling interest rates. Market prices of REIT’s tend to trade counter to the direction of bond yields, so the considerable decline in yields recently has provided a significant boost.
Australian residential real estate’s purple patch is over, as the long period of undersupply has ended, and foreign investment is waning. Sydney and Melbourne house prices are now falling steadily, prompting the Reserve Bank to repeatedly warn of the perils of high household debt and shift to more cautious pronouncements and an easier interest rate policy position.
The office and industrial property sectors have performed well, benefitting from tight rental markets and solid demand for warehouse and logistic centres. Retail malls however are suffering weaker fundamentals, particularly the stubbornly difficult conditions for meaningful rental growth due to a generally subdued economy, lackluster consumer confidence and increasing penetration of e-commerce.
There remains considerable investment demand for commercial real estate, notwithstanding the rather uninspiring economic fundamentals. This is because of yield. When interest rates are very low (and staying low) the relative appeal of good rental yield from quality real estate is substantial. This is being reflected in valuations for larger commercial properties and the stock market listed property REIT sector, which is performing well, primarily because its attractive distribution yield. We anticipate that yield-based demand for this sector will continue, but investors should be more cautious due to the relatively high real estate and market valuations.
The Reserve Bank of Australia’s (RBA) stable 1.5% cash interest rate setting continues into its third year, but now with a surprising bias towards a lower rather than higher future rate. Disinflation remains prominent almost everywhere, causing anemic real economic growth and weighing on the pace of wage growth. In this environment longer term rates have slumped to a multi-decade low, and the shifting shape of the yield curve – flattening quickly as long-term rates decline – is serving as a forewarning that strong economic growth is nowhere close.
Elsewhere the same phenomenon prevails. In Europe long-term rates remain close to zero despite the financial crisis years passing into history. Similarly, Japanese bonds are zero, held there by unprecedented money printing/bond buying action by the Bank of Japan. In the United States the Federal Reserve has been running a program of gradual quantitative tightening by not reinvesting proceeds of bond maturities, and consequentially slowly easing their bloated balance sheet. The Fed has also been raising their short-term interest rate, seeking to normalise interest rate settings and build some ammunition for the next occasion their intervention is needed. In January however, the Fed made an unexpected about turn, indicating a softer approach, and it was this action more than anything else that caused the positive stock market turnaround.
Falling interest rates have caused bond prices to rise, adding capital to the performance of fixed interest portfolios. Australian hybrid securities whose distributions are linked to short-term bank bill rates have performed satisfactorily due to the increased regulated capital buffer the banks have been required to maintain, and the inclination towards higher interest margins for more recent new issues. Credit spreads and trading margins have been surprisingly calm but can quickly and unpredictably expand, so investors should be careful about some of the higher risk debt and credit instruments.
2019 has started well with excellent performance in equity and bond markets. Dividends have generally increased, share buybacks continue, and the economy has eked a small improvement in the March quarter, thanks to strong commodity prices and export volumes.
However, the Australian economy is unambiguously weakening, and for a long time now share and real estate prices have been supported by falling interest rates, which in turn are influenced by central bank actions. This tailwind can’t last forever. That interest rates are at their low point now, in 2019 and ten years from the financial crisis, is an extraordinary symptom of a long-lasting disinflationary and tepid economy – one in which corporations continue to prosper by borrowing, globalizing and automating, but the broad populace miss out. This time of increasing inequality and social dislocation, coupled with rapidly rising debt, fueled by central bank induced low interest rates is one in which investors have little choice but to hold some risk assets. But we caution against overinvesting, and we are keeping an increasingly vigilant and wary look over our shoulder for the emergence of market and financial obstacles.
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