Australian and global outlook for investment markets
Written and accurate as at: Sep 26, 2018 Current Stats & Facts
The world economy is still growing, which is a generally positive background for risk assets, but investment outcomes have become overdependent on ongoing gains from U.S. equities. The most likely outlook is ongoing global expansion, though trade wars, monetary policy mistakes, problems in some emerging markets, and geopolitical shocks are all real risks to monitor. Bond yields in the U.S. have headed higher and have contributed to weak performance by global fixed interest and by global income-oriented assets like property and infrastructure; Australasian property markets, however, have been performing rather better. In the Australian economy, it looks as if the pace of business activity may be moving into a slightly higher gear, although the ongoing drag of the financials sector remains a concern for equity performance.
Australian Cash & Fixed Interest
Forecasters have generally agreed with the RBA’s Statement on Monetary Policy in August that there is an interest-rate hike somewhere on the horizon but do not see eye to eye on when. For Westpac Bank, for example, the cash rate will be on hold all the way out to the end of 2020, and the current pricing in the financial futures market is broadly in the same camp, with a first rate hike not expected until late 2020. The other big banks, however, think the first rise will be earlier than that, most likely in the second half of next year. Either way, low rates on bank deposits will remain a fixture for some time yet.
The likelihood is that local inflation will gradually pick up more towards the middle of the RBA’s 2.0% to 3.0% target and that U.S. bond yields will continue to rise. Both factors should lead to some rise in local bond yields, though there is quite a variety of views on how large the rise might be. The latest bank forecasts suggest an increase to around the 3.2% to 3.3% mark in a year’s time. Rising yields will make it difficult for total returns from bonds to perform well.
Currency forecasting is a highly inexact science, and the latest forecasts from the banks consequently show a difference of views. Two of the banks (ANZ and Westpac) think the Aussie dollar in a year’s time will be a little lower than it is today, at around 70 US cents. The other two (the Commonwealth and NAB) see the Aussie dollar appreciating back up to the 75 – 76 U.S. cent area. There are good arguments on both sides: Widening interest-rate differentials against U.S. rates, for example, would argue for the lower number, but an upbeat view on Australia’s growth rate and world commodity prices would take you the other way. At least forecasters are, for now, reasonably agreed that further falls along the lines of earlier this year do not look likely.
Australian & International Property
The latest (September quarter) ANZ Bank / Property Council of Australia survey of commercial property, with two exceptions, generally painted an upbeat picture of the outlook for the property sector. The industrial, office, hotels, and retirement living sectors are all more optimistic than they were a year ago, and all of them have high expectations for capital gains, particularly retirement living (everywhere), industrial property (everywhere), and offices (mainly Melbourne and Sydney). The two exceptions are easily guessable. The retail sector has been under a cloud for some time, and although Colliers argues in its latest investment review of the sector that Australian retail is not as vulnerable to e-commerce as elsewhere–“The relatively low supplied retail market in Australia contributes to strong catchment engagement and high footfall in our shopping centres” compared with more at-risk operations overseas–investors remain wary of the sector. More recently, the housebuilders are finding it tougher going. The ANZ / PCA survey found a sharp fall in business confidence in the sector in the latest quarter, and respondents now expect falls in house prices in New South Wales (mainly) and Victoria (less so) over the next year.
Retail and house construction apart, there is enough in the economic outlook to support the operating prospects of property, expectations of bond yield increases are now more modest than they used to be, and REIT prices remain reasonable on a price to net tangible asset backing basis. It is probably optimistic to expect the A-REITs to go on outperforming the wider share market, but there is still the potential for some further gains.
Overseas, the ongoing global business expansion is generally helpful for property, although as with the wider equity market (discussed later) there is a clear distinction between the U.S. and everywhere else. Market conditions in Europe, for example, are nowhere near as strong as in America. Knight Frank’s latest quarterly review of European commercial property found that “The average European prime office rent fell by over 6% year-on-year, the steepest fall in ten years. The 30% rental increase in Berlin could not offset falls in Zurich, Geneva and Paris La Defense, where the current prime rent is below the 5-year average.” The large U.K. listed property market is also at significant risk from a poor Brexit negotiation outcome. Investment opportunities outside the U.S. are necessarily more selective and tactical (Knight Franks mentioned Madrid and Prague, for example), rather than riding a strong economic cycle.
Overall returns from the asset class consequently ride on the U.S. Cushman & Wakefield’s latest (September) macro forecast, which says that “By nearly every relevant metric, the economic backdrop pertaining to the property markets is in excellent shape.” The outlook for industrial property in particular is strong– “our forecast for overall industrial asking rents calls for a strong year in 2018, with a 6.5% growth rate and continued growth in 2019/20” - though retail is at the bottom of the totem pole, particularly lower-quality space. As Cushman & Wakefield colourfully put it, “The situation is increasingly dire for Class C properties, for many of which death spirals appear to be ramping up.”
The big issue is the threat from rising U.S. interest rates. Cushman & Wakefield argue that “The temptation is to say that if interest rates rise, then cap rates [used to value property] will rise—implying that values must fall. Although the higher cost of capital will put pressure on certain assets, the very fact that interest rates are rising signals that CRE [commercial real estate] values should go up, not down. Interest rates are rising because the economy is getting stronger. That means that all of the factors that drive net operating income (NOI)–those that lower vacancy, put pressure on rents, induce greater appetite for risk and debt - will support CRE values even in a rising interest rate environment.” Investors will have to hope the upbeat perspective is right: On the other hand, the recent decline in global REIT prices coincided with the U.S. 10-year bond yield getting back up to close to 3.0%. Investor sensitivity to bond yields may continue to outweigh the more positive economic fundamentals.
Australian Equities
Corporate profits have been doing well. The June reporting season was affected by some outliers–three big companies (BHP, Commonwealth Bank, and Telstra) reported lower profits–but overall, on broker CommSec’s estimates, profits were up 8.4% on a year ago. If you excluded the drag from the big three that went backwards, profits were up by a strong 20%, and for income-oriented investors a higher than usual proportion (90%) of companies paid a dividend, and in aggregate dividends rose by 13.6% on a year ago. There was also a pleasant surprise when the June quarter GDP data were released. The economy grew at a faster than expected 3.4% in the year to June, well above the 2.9% that forecasters had been predicting, and the news extended the already record-breaking economic expansion to a full 27 years.
One quarter’s data may be neither here nor there, and in any event the June outcome is already a bit dated. But it was an encouraging signal, and more recent data have generally confirmed that business activity is going well. The latest (September) business survey from National Australia Bank, for example, found that “Business conditions regained some of the ground lost in recent months and have been well above average for some time. In addition, the forward orders index saw a rebound as did capital expenditure. Capacity utilisation remains high and the profitability index remains well above average.”
The Commonwealth Bank’s performance indexes for August are not showing as strong a picture, especially for the services sector, but the bank reckons that the latest readings may be giving an overly pessimistic view of the true outlook: “…still high readings for business expectations about the year ahead suggest activity has hit a pothole rather than started a more serious decline.” In summary, the RBA may be right when it said at its September policy meeting that its “central forecast is for growth of the Australian economy to average a bit above 3 per cent in 2018 and 2019.” That would provide a supportive base for corporate profitability growth, although there is still the important issue of whether equity prices are expensive relative to what lies down the track.
As CommSec said in its reporting wrap-up, “The Australian sharemarket is no longer cheap with the price-earnings ratio at 17, above longer-term averages near 15.5.” (Standard & Poor’s came out with a very similar 16.8 ratio, also on a historic basis.) High valuations mean more-limited prospects for capital gains: CommSec expects the end-year S&P / ASX200 Index to be in the 6,150 to 6,550 range. Taking the 6,350 midpoint, that would translate into quite a modest gain of some 3% between now and the end of the year.
International Equities
The outlook for global shares continues to hang on the same handful of factors as previously: the performance of the U.S. economy, the wider performance of the global economy, the potential impact of trade wars, the tension between expensive share valuations (particularly in the U.S.) and rising bond yields, and the lurking risks of geopolitical issues.
In the U.S., corporate profits have been rising remarkably strongly. On data company FactSet’s calculations, profits for the S&P500 companies in the June quarter were 25% up on a year earlier, and on FactSet’s compilation of brokers’ forecasts U.S. companies are expected to record 20.6% growth in profit for 2018 as a whole. Analysts expect further good news for 2019, with profits expected to grow by a further 10.3%. While the numbers have benefited from some one-offs (rising energy prices, U.S. tax cuts) that will wane over time, this is nonetheless an impressive performance. The latest economic news has also continued to be reassuring. The key statistic is jobs: There were 205,000 more jobs in August, much as economists as expected, and the unemployment rate stayed at a low 3.9%. As noted earlier, wages started to grow rather more strongly during the month, at a 2.9% annual rate, the fastest rise in almost 10 years. Remarkably, there are now more job vacancies in the U.S. (6.94 million) than there are officially unemployed people (6.28 million), a situation that first emerged in March and has become more pronounced since then.
The rest of the world is nowhere near as buoyant but is also growing. The latest (September) consensus forecasts from the Economist magazine’s panel of international forecasters show that the eurozone is picked to grow by 1.8% next year, the U.K. by 1.4%, and Japan by 1.2%. These are self-evidently not tremendous growth rates, and they are vulnerable to even quite modest adverse shocks. But all going well, the major developed economies will continue to contribute to the ongoing post-GFC business expansion. Although the financial and other problems facing some emerging markets have dominated the news, it is also worth noting that all the key BRIC economies will be growing next year. In the case of the two biggest, growth is likely to be very strong, with India expected by the Economist panel to grow by a very substantial 7.3% and China not far behind with a strong 6.3%. Both Brazil and Russia have had their issues, but they, too, are expected to grow next year (Brazil 2.2%, Russia 1.7%).
The central scenario remains one of ongoing global growth. But it could be disrupted. The key issue (as revealed by recent surveys of large fund managers) is the threat of protectionism, largely driven by the U.S. against its trading partners, but there are also other potential trade-disrupting developments, notably Brexit. They may yet turn out to manageable. At time of writing, the U.S. appeared to be putting out feelers to China to try to prevent escalation of their tit-for-tat rounds of tariff increases, although there is less room for optimism around the omnishambles of the U.K.’s Brexit negotiations. Even if trade issues eventually become less alarming, however, it is worth bearing in mind that protectionist outcomes range from bad to less bad: All of them put barriers in the way of global trading growth.
There is also the slumbering issue of potential monetary policy mistakes. Faster-than-optimal normalisation of monetary policy could adversely affect economic growth and would also upset the relative valuations of equities and bonds at a time when equities, especially in the U.S., are expensive. The historic P/E ratio on the S&P500 is 24.2 times earnings, and the prospective ratio is 17.8 times. The equivalent ratios for the tech-oriented Nasdaq index are even higher, at 25.75 and 21.4. Valuations leave little room for earnings disappointment, valuation reassessment, or adverse shocks out of the blue.
There is also the risk that investors have once again become too relaxed about the true level of potential risk, especially when the tenor of much “tenth anniversary of the GFC” commentary has been that finance still has the potential to spring further unpleasant surprises. The VIX index of the volatility investors expect to encounter from holding the S&P500 has once again dropped back to low levels, consistent with investors seeing no especially worrying risks on the horizon. This does not ring especially true, considering the range of financial, economic, and geopolitical risks that might yet trip up the global economy. While risks abound, the post-GFC world economy and global equity markets have found a way to muddle through, and some further modest gains remain the most likely scenario.
Source: Morningstar
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