Outlook for investment markets
Written and accurate as at: May 15, 2019 Current Stats & Facts
Both equities and bonds have continued to do well this year. Although U.S. - China trade tensions have weighed on equities in recent days which is a major risk and hard to call as the impact could be significant. At home, the business cycle has weakened as such the Reserve Bank is likely to respond with at least one interest-rate cut in the short term.
Interest rates
Forecasters had been split roughly 50:50 on whether the RBA would cut the cash rate at its May decision. With hindsight, it was always somewhat unlikely, as the bank would not have wanted to buy into a political argument over rate changes in the middle of a general election campaign, and one month’s delay till the June decision avoided controversy. But at least one, and possibly two, 0.25% cuts now look likely in the second half of this year as the bank tries to boost a slowing economy and help get inflation up into its target 2% to 3% band. Savers will be receiving very low levels of bank deposit income for some considerable time to come.
The ongoing fall in bond yields to historic lows has one unexpectedly positive outcome: Bondholders have had some modest capital gains, with the S&P / ASX Index of government bonds up 4.5% for the year to date and the index of corporate bonds up 3.8%. It is possible that bond yields could fall even further again: The Reserve Bank of Australia, in its 10 May monetary policy statement, attributed the fall to very low short-term rates, lower inflationary expectations, less uncertainty about future interest rates, and the volume of bond buying from institutions such as pension funds which need to hold long-term assets. None of those factors looks like it is changing anytime soon: The plus is some further potential small capital gains, the negative is the increasingly low running yields, which will be upsetting the income expectations many investors had for their portfolios.
Australian dollar
The Australian dollar rose in the immediate aftermath of the RBA holding rates steady when a good proportion of forecasters had expected a cut, and, as the RBA commented in the latest monetary statement, it is possible that rising commodity prices (good for the dollar) will offset the downward effect of lower Australian bond yields and help keep the dollar around current levels. But the likelihood of a couple of cash rate cuts in the pipeline suggests that the Australian dollar has the potential for further modest weakness in coming months. All guesstimates, however, remain subject to the wild card in today’s financial markets: a good outcome from the U.S. – China trade talks would be likely to support the Australian dollar and conversely for a bad outcome.
Australian Listed Property
The economic fundamentals are not currently helpful for listed property. In National Australia Bank’s latest (March) quarterly survey of commercial property, overall respondents’ sentiment turned negative for the first time in four years, with particularly sharp falls in sentiment in the retail and central city hotel sectors.
While the office and industrial sectors are still doing well, they too showed falls from previous levels of confidence. Expectations for capital gains and rental increases are modest even in the better sectors and are outright pessimistic for the retail sector: Respondents expect retail rents to drop by 2.7% nationally over the next year. The NAB survey does not cover the housing-oriented REITs, but if it had the results would have been a bit glummer again.
But none of this may make much difference to investors’ ongoing appetite for A-REIT yields. With the 10-year Commonwealth bond yield now only 1.75%, the 4.6% yield on the A-REITs is likely to remain on investors’ radar.
Australian Shares
The most recent business indicators have been lacklustre. The Commonwealth Bank’s performance indexes for manufacturing and services in April showed that both sectors were barely growing. The very similar indexes compiled by Australian Industry Group showed much the same picture: Manufacturing may have picked up in April, but the (much larger) services sector was going backwards and the construction industry was worse again.
The latest official statistics on retail sales were also poor. In real (adjusted for inflation) terms, retail sales had been unchanged in the December quarter and dropped (by 0.1%) in the March quarter, the first decline since 2012. Household purse tightening is hardly surprising given the shock to family balance sheets from lower house prices. The rate at which prices are falling appears to be slowing down, but that is little comfort for homeowners in Sydney and Melbourne: On CoreLogic's April numbers, prices are down 10.9% on a year ago in Sydney and 10.0% in Melbourne.
The bottom for housing prices may not be too far away. A recent (10 May) market update from AMP Capital for example argued that “Our base case is for national capital city house prices to fall another 5% or so 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. An earlier rate cut could bring forward the bottom in house prices as in the last two cycles they bottomed four months or so after the first rate cut”. In the meantime, however, the direct and indirect ramifications of the weak housing market are contributing to a patch of slower than usual growth.
One consequence is that the RBA now thinks that 2019 will be a weaker year than it had earlier reckoned. It is picking gross domestic product growth of 2% this year, compared with the 2.75% it had expected when it last ran the numbers back in February. By macroeconomic forecasting standards this is a large adjustment of view in just three months.
It could be that the equity markets will look more to the prospect of stronger growth in 2020 – the RBA is forecasting a pickup to 2.75% growth – and there are other currents flowing that may also help keep the recent rally going, notably positive global equity sentiment and the increased attractiveness of equity dividends as interest rates continue to fall. But equally the downbeat outlook for domestic economic activity over the next six months, and the ongoing remediation required in the financials sector – exemplified most recently in early May by National Australia Bank cutting its interim dividend – mean there is a greater likelihood of corporate earnings disappointments than of pleasant surprises.
International Shares
The fundamental outlook is much the same. The year 2019 looks like it will not be as good a year as 2018 for global business activity. But the outlook remains for ongoing growth at a reasonable, though not strong, rate this year and next, with pronounced regional variations and considerable geopolitical uncertainty.
The most recent (April) reading from the J. P. Morgan Global Composite purchasing managers index, a gauge of world business activity, showed that the world economy is still growing, but at a slower rate than before, and continuing a pattern of gradual deceleration that extends back to early 2018. Some parts of the global economy are doing well: Notably, this is true for India and China, and the U.S. has been strong among the developed economies, with the unemployment rate falling to just 3.6%, the lowest in almost 50 years. Slower growth in other areas (notably the eurozone, Japan, and the U.K.) is constraining the overall outcome.
Other analysts have come to the same conclusion about a somewhat subpar 2019. The latest of the big international institutions to weigh in with its global forecasts is the European Commission. It has also taken a dimmer view of the prospects for this year: In this latest (Spring) set of forecasts, it thinks world GDP will grow by 3.2% in 2019, which is less than 2018’s 3.6% and also less than the 3.5% the EC had expected in its previous Autumn 2018 set of forecasts.
But it is optimistic that 2019 is the low spot for growth and that 2020 will be a bit better, with 3.5% growth pencilled in. In the commission’s view, “Over the course of 2019, a number of factors should help the global economy bottom out. Following the sharp tightening of financing conditions in the second half of 2018, the reappraisal of monetary policy by major central banks and the move towards a more accommodative monetary policy stance is expected to support a rebound in growth rates, especially across emerging market economies. In addition, significant policy stimulus has been deployed in China, which should help to stabilise activity in the country, while also supporting activity in Asia”.
The commission finished its assessment, however, with the proviso that “it is assumed that prospects for at least a temporary solution of US – China trade tensions have improved”. Unfortunately, this has not proved to be the case.
At time of writing, the prognostications for the trade outlook remained uncertain. The Financial Times in the U.K., for example, was pointing to some potential progress and the possibility that Trump would meet with Chinese President Xi Jinping at the G20 meeting next month to sign off on a deal. The Wall Street Journal also thought the meeting might be fruitful but was not overly optimistic given the track record so far: “Bridging the trade rift may ultimately depend on the personal chemistry between President Trump and President Xi and their willingness to push matters forward after months of negotiations that have been full of positive intentions but thwarted by miscalculations, accusations of backtracking and unfulfilled expectations”.
From the outside, it is impossible to know how the geopolitics will play out. If there is a good or semi-good outcome, equities will benefit; if not, then recent history shows that investor concerns about global growth can lead to ugly sell-offs, as in late 2018. Hopefully, the outcome will not be pigheaded enough to imperil the base scenario of ongoing global expansion, but with these levels of hard-to-read uncertainty, the best preparation is likely to be extensive portfolio diversification to limit the impact of whatever the politicians deal to us.