- The combination of slowing global growth, trade wars and higher interest rates proved to be toxic and sent markets sharply lower in Q4 2018.
- After the sharp correction in both equities and corporate credit, more compelling valuations and a more pro-growth stance from central banks facilitated a robust rebound in Q1 2019.
- Monetary authorities, especially in the U.S. and China, have adopted more accommodative stances in response to the loss of some growth momentum entering 2019. The moves should help the global economy regain some altitude and support investor confidence in the short term.
- China has entered a new cycle of policy easing. We expect this to stabilise Chinese growth in the short term.
- The Australian economy appears to be slowing with falling house prices beginning to weigh on consumer sentiment. We believe the RBA is likely to intervene post the Federal election to try to halt the slide in house prices.
- While we believe central bank intervention can elongate the current business cycle, we do not believe they can dispense with it.
- A contributing cause of the volatility late in 2018 was the withdrawal of liquidity from the financial system. Watching the tide of liquidity will be as important as any other variable in predicting the path of markets in the coming year.
- As we sit at the time of writing in early April 2019, we believe Australian and developed equity markets have returned to fair values and are no longer oversold.
- To sustain the current rally, global economic momentum will need to improve and translate into corporate earnings upgrades. We are cautiously optimistic, as more governments are adjusting their policies to keep this cycle going for as long as
- While near term we expect this rally to continue, eventually a slowdown will We believe Investors should use the current market strength to adopt a more defensive allocation—one that is more dependent on income- generating assets, such as Government bonds, high quality credit and high-dividend, defensive equities.
Investors have experienced a bumpy ride over the last 18 months. While financial markets are currently experiencing a risk on rally, we doubt that volatility is over. While experiencing volatility like we did before Christmas is clearly unnerving, it does provide us the opportunity to upgrade the quality of what we own. We cannot control the mood of markets, but when high quality assets/companies sell off alongside their not so great peers, we can control our own actions during that period. While the benefits of increasing the quality of the portfolio may take time to materialise, eventually it will bear fruit.
Let’s not sugar-coat things, the 4th Quarter of 2018 was ugly and painful (as demonstrated in the chart below). Amazingly 90% of all asset classes posted negative returns in 2018. This was the worst result since 1901 (yes in over 100 years!). 86% of Professional money managers under performed their benchmarks in 2018. The best of the best lost money in 2018. There was truly nowhere to hide, except cash. While things are looking more positive near term, unfortunately, we do expect more periods of volatility like December over the next year or so.
2018 Asset Class Returns
Having said that, we did not panic during the December selloff as we did believe the global economy was in better shape than what was being reported in financial media. Investors were pricing equities as though a US recession was imminent. We want to be clear that we do not believe a global recession will arrive in 2019. We absolutely acknowledge risks are rising as the current growth cycle has endured for a record length, but the growth slowdown we experienced late last year as worries over higher U.S. interest rates, accelerating wages growth (rising inflation), trade tension between the U.S. and China and a weakening global trade cycle that dampened business and consumer sentiment was actually expected and forecast by many economists.
So why have the markets bounced back in Q1 2019? The economic data is still sluggish. U.S. economic growth eased to 2.6% in Q4 2018, down from 3.4% in the third quarter. The Global Manufacturing Purchasing Managers’ Index (PMI) for February also fell, indicating that businesses have become more cautious. In China, consumer spending during the Lunar New Year holiday expanded at a slower pace compared with previous years. China’s economic growth fell to 6.4% in Q4 2018, below Beijing’s full-year target of 6.5%. In Europe, a drop in export momentum overshadowed stable domestic demand.
The answer, we believe, is Monetary authorities, especially in the U.S. and China, have adopted more accommodative stances in response to the loss of some growth momentum entering 2019. Their moves should help the global economy regain some altitude and support investor confidence in the short term.
We believe to sustain this rally though, global economic momentum will need to improve and translate into more earnings upgrades. We are cautiously optimistic, as more governments are adjusting their policies to try and extend this economic cycle for as long as possible.
Here are some of the positive developments that support the bull case for markets to keep grinding higher in 2019:
The US Fed will be patient- Clearly the US Federal reserve has been spooked by the market reaction in December and has backflipped its tightening bias and changed course. The Fed recently lowered its interest rate outlook to reflect zero rate hikes in 2019, down from its previous projection in December for two rate increases this year. This led some to speculate that rate cuts in 2019 were a strong possibility given the recent deterioration in certain US economic indicators alongside lower inflationary pressures due to energy price declines. Last year we had a more traditional Fed, determined to normalise policy. The risk, which we believe caused them to change course, was that the US credit bubble at some point in the near future was at risk of bursting due to higher interest rates.
It appears the Fed has decided it would rather deal with higher inflation than a bubble bursting. They have made it clear the Fed will be patient in normalizing interest rates, so they are going to allow inflation to tick up and continue to let asset prices reflate. We don’t think the Fed will actually cut rates unless things get worse in the economy, and actually still think there is some possibility the Fed could hike late this year, but only very reluctantly, when it is very clear the US economy is doing well, and if financial conditions are easier (driven by equity markets continuing to grind out this rally). So what of the risk of the credit bubble popping? We believe that the proverbial can will likely be kicked further down the road. The two catalysts for a credit problem to emerge are further Fed hikes, and a recession. The Fed’s new course of action clearly negates hikes, and also delays the next recession. Something else might happen to raise concerns of a recession, such as an escalation of a trade war, but without a rise in recession risk from an exogenous shock, we don’t see a near term catalyst for a credit event in the US. Nonetheless, the prospect of a bursting credit bubble, still lingers at some point in the next few years. We will discuss this risk further later.
The US Labour Market is the strongest it has been in Decades- with the Unemployment currently at 4% US job openings are at a record high of 7.3 million. There simply seems like there is too much activity in the domestic US economy for it to fall into a hole in the short term. The fully employed labour market is a cause for optimism as we are likely to see US wages growth grind higher and support consumer spending and confidence. This simply does not look like an economy that is ready to roll into recession just yet.
The disappointment in European growth is likely to be temporary- The European Central Bank (ECB) has pushed out the timing of its first post-crisis rate hike until 2020 at the earliest—after having previously signalled an interest rate hike towards the end of 2019. The ECB also lowered its growth and inflation forecasts out to 2021, noting that Europe’s slowdown was longer and deeper than first thought, and announced a fresh round of cheap, long-term loans to European banks to boost lending to the real economy. As a result, market participants pushed out expectations of an interest rate increase closer to the end of 2020, beyond that guided by the ECB. We believe EU Growth should stabilize in 2019 as the disruption from regulation changes on automobile manufacturing that caused industrial production to crater in 2018 normalise. While Brexit is a distraction, it is unlikely to cause a material slowdown in activity in 2019.
China is trying to put a floor under growth (again)- In order to stabilise the economy, China entered a new cycle of policy easing in mid-2018. As the PBoC adopts a more accommodative stance and local governments spend more on infrastructure projects, Chinese GDP growth will likely bottom out by the middle of 2019. Besides the conventional stimulus measures, a reduction in personal income tax and value-added tax (VAT) may further support growth and corporate earnings. These stimulus policies, together with a potential U.S.–China trade truce, would likely lead to stronger risk appetite and a continuation of the current momentum rally in A-shares. At the annual session of the National People’s Congress (NPC) in March, further supportive measures were announced to stabilise the economy. A GDP growth target ranging between 6.0% and 6.5% year- over-year was set for 2019 vs. a target of around 6.5% for 2018. The wider target range offers the government more flexibility in its policy implementation. A slowdown toward the lower end of the target range, that is 6.0% growth, could prompt even stronger supportive measures. Fiscal expenditure, supported by a higher fiscal deficit ratio of 2.8% of GDP (vs. 2.6% in 2018), and a quota of RMB 2.15 trillion for special local government bonds (vs. RMB 1.35trillion in 2018), are expected to deliver direct and instant support to investment growth.
Meanwhile on the policy front, “deleveraging” has been replaced by “stability of leverage.” The government did not set quantitative goals for the money supply or total social financing growth, but proposed keeping them “in line with nominal GDP growth.” Such changes suggest that monetary policy will remain accommodative in 2019, to support government and private investment. After the 100 basis point (bps) cut to the required reserve ratio (RRR) in January, an additional 200 bps of cuts are likely in 2019, to bring down financing costs. However, given high debt levels, monetary stimulus will be secondary to fiscal measures this year.
So with these positive developments supporting financial markets and the global economy so far in 2019, is there a case to become more bullish or aggressive with our portfolio strategy? Probably not, because for markets, the underlying problem is still there; the reversal of the post GFC liquidity. How do authorities withdraw 18 trillion dollars of support for bond markets, and raise interest rates, without causing a market rout? While the Fed has handled the immediate catalyst for the panic that was developing in Q4, and the market is likely to stay calm for now, eventually, the forces of supply and demand will emerge. The FED can extend the business cycle, but we do not believe they can conquer it. The US is leading the worlds business cycle and has entered the part where wages rise, inflation rises, interest rates approach neutral and purchasing power falls. Eventually rising wages, will force interest rates higher and corporate profitability to fall. It may take another year or two to transpire and to get the timing right is difficult, but we know it is coming, and that is why we remain cautious in this late cycle environment.
So what are the risks in the global economy that could eventually cause the next crisis?
The mix of cheap money and lower quality Corporate Debt- In just the last 10 years, the US triple-B bond market has exploded from $686 billion to $2.5 trillion—an all-time high. Presently 50% of the US investment-grade bond market now sits on this lowest rung of the investment grade quality ladder. The reason BBB-rated debt is so plentiful is because the period of ultra-low interest rates has incentivised companies to pile into the bond market. Corporate debt has surged to heights not seen since the global financial crisis as seen in the chart below:
Why the debt issuance is beginning to become an issue worth discussing is due to the fact that interest rates began to rise substantially in 2018. In fact, since July 2016, the interest rate on the 10-year Treasury note has doubled, and the value of corporate bonds is tied to government bonds.
When rates on government bonds rise making them more attractive, it makes existing investment-grade corporate bonds less attractive. This is especially true for bonds on the lower tiers such as BBB-rated bonds. This is how the bond market works: bonds sold today with a higher interest rate make yesterday’s lower-rate bonds lose value. So, if higher-rated bonds are a better deal for investors, that’s bad news for the companies issuing lower-rated bonds.
In a downturn, BBB-rated bonds are the most vulnerable of all investment-grade bonds. Former Federal Reserve Chair Janet Yellen thinks corporate debt levels are “quite high” in the US. She also thinks high corporate debt could prolong a downturn in the economy and lead to a rise in bankruptcies. This is what the Fed is worried about and we believe is part of the reason they have paused their normalisation of interest rates. We doubt this risk will re-emerge in the short term, but it is lingering on the horizon should the US economy slow or interest rates rise further.
Chinese Credit Growth- Chinese credit growth has slowed significantly since 2016. Chinese loan growth was running at over 30% pa in 2016. It has fallen to around 15%. If it stabilises around this level, that would be an ok result, as the money supply is still expanding, but if credit growth continues to fall, it is likely to have a negative effect on house prices. As we are currently seeing in Australia, falling house prices can weigh on consumer sentiment. As mentioned above, China appears to be loosening policy to support growth, but we will be keeping on eye on Chinese credit growth and M1 money supply data; any deterioration could become a worry for global economy.
Australia- The Federal budget was handed down last week with the aim of providing some fiscal stimulus in the face of slowing growth and get the Government re-elected in a Federal election likely to be in mid-May. The upside of their strategy is the household sector will receive a boost just at the time it needs it due to falling house prices and rising unemployment. The negative being the tax cut boost will be small at about 0.6% of GDP in 2019-20. The fact there is an election looming where the opposition is a red hot favourite means we have greater uncertainty about whether and when the stimulus will actually be delivered.
Regardless of who is elected to Govern, we believe the Australian economy is slowing and financial markets are now pricing in further cuts to interest rates. The market now prices one cut by August, and a 50% chance of another cut by February 2020. The RBA has explicitly linked any rate cut to the state of employment market. ANZ job ads have started to fall (year over year), and if we see unemployment increase, we believe they will cut. GDP is weak, consumption is very weak. And as we all know housing is very weak, arguably the weakest since the early 80’s. The RBA are clearly very reluctant to cut, but we think a rise in unemployment later this year will force their hand.
The housing market is unquestionably the major factor in the slowdown. RBA Governor Lowe takes comfort at the current 9% decline being “not unprecedented”. Well yes, it isn’t unprecedented in terms of magnitude. But it is unprecedented in terms of what is driving the fall. This is the only time that house price falls have not been due to higher interest rates. Rather, it is due to collision of special factors.
1) A surge in population growth driving a much delayed and ill-timed surge in dwelling stock.
2) The disappearance of the Chinese buyer. Approvals to purchase domestic property by offshore investors averaged 0.2% of the housing stock from the early 1990s until 2011 before surging by a factor of 10 through 2015 and 2016, and then plummeting back to 0.5% in 2018. Not all of this investment came from China , yet the surge and then retreat in foreign investment in Australian property does correlate closely with the surge and then retreat in private sector capital outflow from China over same period. Australia wasn’t the only destination of its capital, but it did unquestionably have an impact on the housing market and the perception of the sustainability of house price gains.
The “problem” with falling house prices is the impact it is having on the consumer. The RBA finds the wealth effect from falling housing is relatively contained, impacting predominantly cars, and to a lesser extend home furnishings, clothing and utilities. YoY Auto sales are presently approaching recessionary levels. Levels incidentally that normally illicit a sizeable response from the RBA.
Right now the problem for the RBA and the economy is there is presently no sign of a bottom in the housing market price decline. Yes, 0.9% decline in Feb is better than the prior 3 months. But we would be reluctant to call it a bottom without a reason, like a rate cut, particularly with an election looming and Labor planning changes to tax concessions. With the “perception” building that house prices continue to fall, one has to wonder if that becomes self-fulfilling? Changing perceptions is why we believe the RBA will shortly pursue the policy of least regret. That is likely to be a rate cut shortly after the Federal election.
Consequences for Asset Allocation and Portfolio Construction
While we expect the share market rally to continue as sentiment has improved largely driven by the central bank policy response in the short term, eventually a slowdown will occur. We believe those investors who felt overexposed to risk assets during the December sell-off should use the current market strength to rebalance and adopt a more defensive allocation.
In our view, valuations remain fair given it is unlikely we will see substantially higher global interest rates in the next few years. If rates were higher, absolutely, assets would look expensive and need to be reset lower, but central banks caving to the markets in Q4 2018 as interest rates were rising gives us the distinct impression that materially higher interest rates which would force a reset to discount rates are very unlikely in the medium term. Global growth is expected to improve moderately into the second half of the year, monetary and fiscal policy has become more supportive of markets and the trade war threat is receding. All of the above factors should support risk assets through the majority of 2019. How long the current cycle can endure for however, remains uncertain, but we do believe the Fed has chosen the lesser of 2 evils and will extend the current cycle.
Unfortunately absolute portfolio returns are likely to remain low.
- Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate further this year.
- Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier and bond yields could still fall further if global growth slows. We expect Australian bonds to outperform global bonds, particularly if the RBA follows through and cuts later this year.
- Commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is particularly likely to be the case for Australian retail property, given the difficulty in our domestic economy.
- In Australian equities, our longer term models are forecasting mid to high single digit returns. We do not think PE multiples can expand any further, so your return is likely to be the dividend yield, plus modest growth in line with GDP of 1.5- 2% pa. While 6-7% total returns hardly seem worth the effort, this is likely to be 6-7 times the Australian cash rate which we believe will be 1% within the next year.
- National capital city house prices are expected to fall another 5-10% into 2020 on the back of tight credit, rising supply, reduced foreign demand, price falls feeding on themselves and uncertainty around the impact of tax changes under a Labor Government.
- We believe the A$ is likely to fall into the US$0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates. Being short the A$ and holding unhedged $USD assets remains a good hedge against things going wrong globally.
- We have been absolutely disappointed with how some of our alternative managers performed in the volatile periods over the last 12 months. While tempting to remove them completely, we are reluctant to do so late in the cycle. We have replaced some of the managers in the line-up, but will persist with uncorrelated strategies given we believe diversification will be our best defence as the cycle matures.
In summary, we do not think this is the time to have extreme conviction in any asset class and diversification makes sense until valuations become more compelling.
Sources: JP Morgan Asset Management, Ellerston Capital, Jonathan Pain, Lazard Asset Management