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F Palmer & ME Palmer
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Investment & Economic Review January 2020

Stock markets displayed their unpredictability in 2019, striding surprisingly and steadily higher after shaking off the volatility of the prior year. Low interest rates and generally benevolent economic and profit conditions provided the catalyst.

Interest rates, and their future direction and economic implication, need particularly careful attention in 2020. The Reserve Bank of Australia (RBA) adopted a rate-reduction approach in 2019 to keep the dollar weak and thwart some economic downturn risks. Their aggressive policy, whilst surprising, was done because they could, that is the lack of inflationary risks and very low rates overseas meant there was very little danger in engineering interest rates lower – at least for a while. I doubt that conditions will be quite so conducive this coming year, and any further rate reduction would have questionable economic benefit and may coincide with a period of increasing asset price volatility.

2020 is likely to witness an array of opportunities and threats. Geopolitically, it is a year of significance as the United States embarks on what could be the most fractious election campaign in recent history. Britain, having secured popular (i.e. exhausted) support to proceed with Brexit, must now get on with it, and the Hong Kong legislative election in September might represent a focus date for change in China’s Special Administrative Region policies. Economic activity has waned globally, exacerbated by trade disputes between the United States, China and others. A failure to resolve these issues could lead to weaker trade and economic activity in 2020.

Meanwhile, global debt continues to spiral higher due to supportive credit conditions, ultra-low interest rates and an inclination by governments, including China, to support further credit expansion. The quantum of debt is less important when rates are really low, so in a sense it doesn’t matter till it does matter - by which time of belated recognition it is usually too late to prevent a financial catastrophe of some sort. This is an issue of utmost importance to financial markets in 2020 and beyond.

Australian Shares

The Australian stock market, as measured by the S&P ASX200 Index, was almost unchanged in the December quarter, though a multitude of dividend payments provided some positive cash returns. For the 2019 year the market was up by a staggering 18.4%, plus dividends, its best year since the 2009 GFC recovery bounce. Dividends in 2019 were higher than usual as some large companies chose to make oneoff special payments or distribute franking credits via share buybacks. It’s likely that the usual market dividend yield of 3.5% to 4% will prevail in 2020.

Corporate profitability in Australia has been satisfactory, but mixed. Some sectors suffered poor results, including the agricultural sector due to worsening climatic conditions, the banks due to their misdeed provisioning and lower margins, and some retailers. Mining companies, particularly the iron ore miners, had strong results, as did some of the consumer, real estate and technology companies. More of the same can be expected in 2020 with little impetus for above-average growth, but generally stable conditions, nonetheless.

A primary market valuation factor in 2020 is the extent to which shares have been benefiting from the lower dollar and interest rate tailwind, rather than the core fundamentals of profit or economic improvements. A higher Australian dollar this year is possible, particularly if our export commodities stay strong, and the RBA pause their rate reduction policy. Short term interest rates won’t likely rise, but any sign of inflation could cause some stress in bond prices and affect share prices.

With a new decade starting, it’s interesting to look back on the longer-term performance of share returns, combining both capital growth and dividend income. It’s clear, and unsurprising, that average stock returns have waned as interest rates and inflation have fallen. The average market return for the last decade was 7.9% compared to 8.8% in the 2000’s, 10.6% in the 1990’s and 17.7% in the 1980’s. As interest rates represent the risk-free benchmark, and are currently at their cycle low, it’s reasonable to expect a market return of 6% to 8% per annum in the coming decade, with probably seven positive return years and three negatives.

  • In the 1980’s the compound return was 17.7% per annum. The market was down in four years and up in six, so very volatile, but the up years were considerable, leading to a very strong decade overall.
  • The 1990’s delivered 10.6% per annum, affected by a poor start to the decade (Australia’s most recent recession), but the latter half of the decade was much stronger.
  • The 2000’s had a compound return of 8.8%, lower than the two preceding decades, and affected by the GFC.
  • The 2010’s had a lower return again, just 7.9% per annum. Market volatility was lower with only two years down and eight up.

Within our list of preferred stocks and managed portfolio the shares of Santos, CSL, Wesfarmers, BHP, Sonic Healthcare and Macquarie performed very well in 2019, whilst Link Administration, Boral and more recently Westpac were the laggards. Of late, we’ve been buying the shares of Costa Group, a poorly performing horticultural company share, currently drought affected.

Global Shares

Global share prices performed very well in 2019, the sharp decline in the December 2018 quarter quickly fading to history. US shares benefited from steady economic growth, lower tax rates and most particularly the decision by their Federal Reserve to reverse course on interest rates. European shares were also strong, especially Germany and France which recovered strongly from a period of relative underperformance. Britain struggled with Brexit but rallied towards year-end following their general election. In Asia, shares in China and Hong Kong mostly underperformed their global counterparts, held back by concerns about the timing and content of trade disputes and agreements with the United States. Japanese shares performed well due to their generally steady economy and persistently low interest rates.

The Australian dollar had a remarkably steady year, beginning and ending 2019 at close to 70c against the US dollar. Against the Euro and Yen, the dollar was also largely unchanged, and it was only the British Pound, surprising given their Brexit issues, that strengthened meaningfully. The outlook for the Australian dollar is for more of the same for a while, as the weakening trend caused by our falling interest rates is offset by strong export commodity prices. It will probably take a significant fall in mineral and agricultural commodity prices, especially iron ore, for the Australian dollar to weaken appreciably in 2020.

Looking forward, there are, as usual, a multitude of positive and negative issues to consider. In the US the forthcoming election campaign will likely be testy with policy pronouncements in abundance causing some market movements. There is also the impeachment hearing of the President to contend with and increasing anti-trust scrutiny of the mega-tech companies (which represent the largest stocks on the market). In Asia, the primary issues emanate from China, as their expansionist ‘Belt and Road’ initiative continues unabated, yet largely funded by spiraling, but difficult to quantify debt, at a time when their stock prices appear relatively cheap. There are few obvious concerns in Europe, though their lack of economic impetus could stall the recent rally in their share markets.

Generally, with the Australian dollar no longer providing an obvious return enhancement, investment in international shares should be a little more modest, particularly US shares, some of which appear to be fully priced. We should also remember that the US bond yield-curve flattened and briefly inverted last year, usually a precursor of weaker economic activity. Consequently, our global share portfolios are underinvested, retaining tactical capacity for future investment, which we expect to occur this year.

Property Securities

The property sector of the stock market, commonly known as Real Estate Investment Trusts (REIT’s), performed well in 2019 delivering an overall capital return of 14%. Distributions were also strong, adding a further 5% to the return.

Curiously, all of 2019’s performance of REIT’s came in the first half of the year – the second half being a negative 2.3% in capital prices, thankfully offset by a similar amount of positive cash distributions. Clearly, the tailwind of falling interest rates – a primary catalyst to real estate price performance – ran out of puff when long-term interest rates stopped falling in August.

Most of the major REIT’s reported similar operational themes, that being solid new leasing and high levels of occupancy, ongoing capital refurbishments assisted by supportive credit conditions, good demand in industrial and some commercial markets, but a competitive and weaker outlook for retail.

Within the sector the large-cap REITs such as Dexus, Goodman and GPT had weaker performance, largely due to their stock market valuations being stretched rather than any operational problems. REIT’s with residential exposure including Mirvac and Stockland performed better, partly buoyed by the upsurge in dwelling prices in the larger capital cities. The retail-based REITs, Scentre Group (Westfield) and Vicinity Centres have largely traded sideways, but their capacity to retain large anchor tenants has remained sound, so their distributions have been maintained at over 5.5%.

The outlook for the REIT sector remains satisfactory due to their distribution yields, which remain attractive relative to prevailing interest rates. However, the decline in capital prices in the latter part of 2019 suggests a fullness of valuation and with some risks to rental growth, this sector may struggle to generate high returns for a while.

Interest Rates

After nearly three years steady at 1.5%, the Reserve Bank of Australia (RBA) reduced the local cash rate three times in 2019, to 1.25% in June, then to 1% in July and to 0.75% in October. The RBA continues to evaluate the global economic and inflationary outlook, and has seemingly determined that domestic inflationary risks remain low, allowing them to more assertively act with this lower rate stimulus. It is our expectation that the RBA will retain the 0.75% rate for at least the first quarter of 2020 and evaluate their monetary settings thereafter.

The Australian core inflation rate remains stubbornly below 2%, and as the RBA has a 2% to 3% inflation target, they can and will hold rates very, very low until they see unambiguous signs of the reemergence of inflation.

Interest bearing portfolios typically contains a diverse mixture of assets within the cash and fixed interest investment sectors, generally within four broad asset types:

  • Cash. Deposit rates remain historically low, but security of capital is high.
  • Term deposits. Banks have lowered their deposit rates such that the returns are now lower than inflation
  • Corporate and government bonds. These are generally held via managed structures and have performed well due to the capital appreciation effect of falling yields. Running yields are now very low, and capital risks exist should interest rates rise
  • Listed income securities. These are mostly bank issued securities or listed pooled lending structures that generally have a higher yield and higher risk than other fixed income styled investments.

When we dwell on the last decade, one of the most astonishing reflections is the extraordinary low level of interest rates – not just a fleeting collapse in the cash rate as in previous economic cycles, but a deep and lasting period of very low rates, both short term and long term around the world, and persistently negative real interest rates, causing them to be lower than the prevailing inflation rate, thereby generating no real return for depositors and investors.

The Global Financial Crisis (GFC) of 2008 has been blamed as the accelerator of the decline in rates, yet twelve years later the interest rate on 5-year government bonds in the European Union and Japan is still negative, and the comparable rate in Australia is a historical low 0.85%. Investors seeking a risk-free return from government bonds are now confronted by really low running yields - considerably less than inflation - but can no longer comfortably rely on capital appreciation (rates falling further) to generate an acceptable return. Consequently, returns from fixed income investments are going to remain very low for a bit longer, but rates have bottomed (they are unlikely to go much lower), so a real risk of bond market capital loss exists when the cycle turns upwards.

Outlook

The outlook for 2020 is only satisfactory. Economically, Australia enters its 28th year of uninterrupted economic growth, though the pace of growth has diminished somewhat, and the economic consequences of drought and bushfires are yet to be fully assessed. Furthermore, the adoption of economic responsiveness to the twin themes of climate change and societal inequality needs to be accelerated in 2020, which may lead to policy changes in the government, corporate and private sectors.

The stock market is due a quieter year, not necessarily calamitously, but rather a consequence of relatively full valuation. Any especially negative extraneous event, such as an escalation of trade disputes, an economic retraction in China, a sharp fall in export commodity prices or a disorderly disruption in the astonishing monetary/interest rate environment – all of which are possible – could trigger a market fall and diminish investor returns. Geopolitical anxieties aren’t easy to predict, but the US election campaign, disharmony in Hong Kong/Taiwan/China relations, and tensions in the Middle East stand as events to keep a watchful eye on.

We are maintaining our preferred lower allocation to risk assets in early 2020, this being a 20% to 30% cash portfolio weight for growth biased investors, held for tactical reinvestment in due course. More conservative investment profiles should maintain even greater liquidity.

To conclude, Australians have about $700bn invested in bank deposits, the interest rate upon which has declined to a miserly 1.5% for term deposits and even less for cash. The temptation, and compulsion, is for investors to reallocate these funds to investments with a higher interest rate or potential return. This question has been raised by many of our clients recently, so we urge and encourage investors to give careful consideration to the risks of alternative investments before proceeding, and one’s tolerance to risk should not be impulsively abandoned.


Yours sincerely,

Malcolm Palmer
Joseph Palmer & Sons

Disclaimer General Advice Warning

This publication has been prepared by Joseph Palmer Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer Sons as at the date of publication and may change without notice. Joseph Palmer Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.

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