Outlook for investment markets
Written and accurate as at: Jun 29, 2018 Current Stats & Facts
The world economic expansion is still trucking along, although it has become a bit more dependent than previously on the U.S. economy, and should support some further equity gains, although against a background of rising political risks—especially the risk of trade wars. Fixed interest and other income-oriented asset classes continue to be challenged by the prospect of rising inflation and tighter monetary policy. In Australia, there have been some promising signs that the pace of business activity is picking up, although the benefits for growth assets are being held back by the ongoing weakness of the financial stocks.
Here is the current outlook for some of the key asset classes.
Australian Cash and Fixed Interest
Short-term interest rates are very likely to remain around current levels over the next year. The RBA has said the next move is more likely up than down, but has given no signals about when it might start raising rates. Forecasters typically expect it will not be for some time with a general expectation of a 0.25% increase sometime in the second half of next year, though it could be later again. For example, Westpac thinks there will be no change before March 2020. Low rates on cash in the bank will be a feature of the local investing landscape for some time yet.
Bond yields look likely to head higher. Inflation is likely to be a little higher over the next year, with forecasters typically seeing it around 2.0%-2.5%, which means bond yields will have to rise to maintain the same real (after inflation) return. And while the relationship has not held exactly this year, there is also likely to be some impact from higher U.S. bond yields. Forecasters on average see the local bond yield around 3.5% in a year's time.
Currencies reflect a wide range of factors which often point in different directions, but at the moment, there is one factor, a particularly obvious divergence between the likely path of U.S. and domestic monetary policies, which is likely to dominate. The U.S. policy rate is already above the local rate, with the target U.S. federal-funds rate at a range of 1.75% to 2.0%, compared with the RBA’s cash rate of 1.5%, and the gap is likely to widen further as the Fed raises rates again later this year while the RBA holds rates steady. While other factors could intervene—there could be a pickup in overseas portfolio investment into the equity or property markets, which would tend to support the Australian dollar, and the Commonwealth Bank, for example, sees the U.S. exchange rate rising to USD 80 cents in a year’s time—at the moment, the forecasters picking a lower Australian dollar look to be taking the more realistic view. The ANZ Bank and Westpac, for example, see the dollar down in a year’s time from its current USD 74.3 cents, with ANZ picking USD 70 cents and Westpac USD 72 cents.
Australian and International Property
The operating outlook for property (ex retail) is solid, particularly in Sydney and Melbourne. In the office sector, for example, there are tight supply/demand conditions in the CBDs of both cities, which are having knock-on benefits for the wider metropolitan (outside the CBD) office markets. As Colliers’ first half of the year review of metropolitan offices found: “Some metro markets, such as Parramatta and the Melbourne City Fringe, are even more tightly occupied than the Sydney and Melbourne CBDs, and we expect them to stay this way until new supply starts completing around 2019/20.”
Industrial property is also performing strongly with high demand but limited supply, largely but not exclusively driven by online shopping logistics. Colliers’ half-year review said: “Although investment choices in logistic-type assets will remain dominant, particularly as e-commerce
continues its exponential growth path, other industrial sectors have experienced positive employment growth over the past five years.” Retail is the laggard, although the high end of the market, for example, large “destination” malls, appears to have better prospects against the online challenge than lower-tier shopping outlets.
A good operating outlook, improved by recent evidence that the pace of the economy has kicked on a gear, has not, however, appeared to offer a compelling proposition to investors who have been getting better capital gains from the wider market, and without sacrificing much yield. The A-REITs offer 4.6% compared with the overall market’s 4.2% (on Standard & Poor’s calculations). The prospect of rising bond yields is also an ongoing challenge. Further underperformance looks the most likely prospect.
Overseas, the key market is the U.S., which accounts for 45% of the benchmark FTSE/NAREIT index. On the plus side, the U.S. economy has been performing strongly, and while retail remains under the global shadow of e-commerce—U.S. retail-focused REITs are down 4.8% year to date, with shopping centres down 7.5%—other sectors have been doing well, particularly industrial (up 3.8%). Colliers’ latest report on the industrial sector said: “The national industrial vacancy rate remained at an all-time low of 5.1% for the second consecutive quarter despite nearly 53 million square feet of new supply completing in the first quarter of 2018;” rents have risen by 5% to a new record high; and “growth in investor demand for industrial properties continues to surpass all other property types.”
On the down side, however, the U.S. market is also the market most exposed to higher bond yields as American monetary policy tightens faster than in other major regions. So far, the contest between improving rental income and the prospect of lower capital values as interest rates rise has not worked out well for investors, and although there are some very strong property markets outside the U.S., overall listed property outcomes are likely to remain on the disappointing side until U.S. bond yields peak.
Australian shares
While there has been a prolonged period of subpar performance by both the economy and the equity market, recent data suggests a modest turn for the better. The economy grew at a faster-than-expected 3.1% annual rate in the year to March. The official data on company profits showed they also had a good March quarter, and were up 5.3% on a year earlier. The labour market continues to improve, with the unemployment rate dropping on its latest reading from 5.6% to 5.4%, which is the lowest rate since late 2012.
The latest business surveys have also been encouraging. The latest (May) business survey by National Australia Bank, or NAB, was somewhat down from the very strong results in April, but as NAB commented: “Despite the easing in conditions, the survey continues to suggest a broad-based strength across industries and most states. Both business conditions and leading indicators continue to suggest a pick-up in economic growth and that, over time, jobs growth should see the unemployment rate fall towards 5%.” Other business surveys show the same picture. The latest (June) Australian Chamber–Westpac
quarterly Survey of Industrial Trends, for example, found that: “Expectations are positive, centred on new orders, output, backlog, overtime as well as renewed expansion in employment.”
The probability is that the economy is heading into a better period of business performance with the RBA, for example, saying at its latest policy decision that it expects “GDP growth to pick up, to average a bit above 3 per cent in 2018 and 2019.” It is not a certainty, particularly given the still-cautious behaviour of households. Westpac, for example, commented on its latest Westpac–Melbourne Institute consumer confidence survey that confidence “remains well below the levels typically associated with a robust consumer,” and expects GDP growth to fall short of the RBA’s expectations.
But overall there is enough in the recent data to suggest that, outside the financial sector and parts of retailing, other sectors of the equity market may finally to start to benefit from the long-awaited pickup in business activity. While profit outcomes this year are likely to be somewhat exaggerated by the ongoing turnaround in the miners’ fortunes, nonetheless, the likelihood is that other sectors will also see some of the benefit from faster GDP growth flowing through to improved equity performance.
International shares
The world economy is still enjoying a largely synchronised business expansion. Virtually every sector is growing, according to the IHS Markit Purchasing Managers Index (PMI) measure which is based on aggregated single country PMIs. In May, it showed that all seven broad sectors it monitors were doing well, led by the industrials and technology, and nearly all of the 22 subsectors were also expanding, with the sole exception of mining.
It is a similar picture when the world economy is looked at regionally, although there have been some recent shifts in relative performance. The May JP Morgan Global Composite performance index, also based on the same country PMIs, “signalled a further uptick in the rate of global economic growth ... Robust inflows of new work, rising employment and positive business sentiment should all support further output growth during the coming months.”
The latest uptick, however, owed a lot to the U.S., where faster growth has made up for steady growth in China and slower growth in the eurozone, Japan, India, and Russia. In the U.S., the latest data showed the unemployment rate dropped to a new low of 3.8% in May, and the economy generated rather more new jobs (223,000) than forecasters had expected. Share analysts believe the
strength of the U.S. economy will translate into substantial rises in U.S. corporate profits. On the latest analyst forecasts collated by data company FactSet, profits for the S&P500 companies are expected to rise by very nearly 20% this year, and by a further 10% next year.
The new relative pecking order has not gone unnoticed by fund managers. As the June BAML survey showed, they have moved to a slight overweight allocation to U.S. equities for the first time since March 2017. The increased allocation has been funded by less overweight allocations to the eurozone (where economic data have been on the weaker side of expectations) and to emerging markets (where as noted earlier, risks have risen in a number of developing economies).
The economic fundamentals are still supportive of equity price gains, especially in the U.S. The analysts polled by FactSet think the S&P500 will reach 3,090 in a year’s time, a gain of some 11%, while the fund managers surveyed by BAML see the index peaking at around 3,040, which would be a gain of around 9%.
But there is no denying that the global expansion is now getting on in years, and the odds of an interruption to the expansion at some point in the next year or two are rising. In the BAML survey, for example, respondents were evenly split over whether or not the world economy will be stronger in a year’s time.
As well, the risks are rising and mutating. At the time of writing, the trade dispute between the U.S. and China had worsened, with President Trump threatening to impose tariffs on an additional USD 200 billion worth of Chinese goods, on top of the USD 50 billion previously targeted (and to which China had responded with a similar-size tariff package of its own). Confrontational protectionist policies raise a real risk of disruption to the global economy, and the BAML managers now rate trade wars as the single most worrying risk, ahead of a monetary policy mistake by either the Fed or the ECB, and the risk of a eurozone financial crisis.
If the economics prevail, world equities should be able to make further gains. But protectionism, in particular, and the potential for other policy mistakes and geopolitical shocks, mean that gains, if they come to hand, will be achieved in choppy markets, and the volatility seen year to date is likely to remain a feature of the markets.
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