27 Jun 2018
Markets and economics are somewhat at crossroads at present. I say this from the perspective that right now I can make an equally compelling case from both a positive and negative perspective.
Markets are traveling along reasonably well following some jitters earlier in the year. The environment remains supportive for equities, however, less so than it did a year ago, given rising US rates and with valuations appearing stretched in some areas of the market. More recently US tech stocks have come under some pressure following concerns that the US government may impose some regulations to curb their power. Also of late, there has been some pressure on emerging market stocks in light of a rising US dollar and rising oil prices, and the potential for escalation in trade disputes.
From an earnings growth perspective, we’ve seen extremely strong growth from US corporates supported by US tax cuts and rising profit margins. We are seeing rising upward momentum in earnings growth in Europe, Japan, and Emerging Markets. Corporate earnings growth in Australia, whilst positive, isn’t broad enough at present with the majority expected to come from the very cyclical resources/energy sector and the already very expensive healthcare sector.
From a valuation perspective, the US equity market remains the most expensive, but has the best earnings growth prospects. European, Japanese, and Emerging Market valuations look much more appealing with many of these markets trading at or just above their average historical valuation levels, with the prospect of rising earnings growth ahead. The Australia equity market is trading around fair value, but that provides a misleading assessment when you look under the bonnet. The cheapest sectors are the unloved - the banks, resources, and telecoms. Healthcare and technology are the most expensive, but do have strong earnings growth outlooks, whilst industrials also look expensive but have very little earnings growth to support those valuation levels. Listed property and infrastructure / utility stock prices have come back from more expensive levels given concerns around rising bond yields.
The environment is less supportive for bonds as the US Fed continues on their rate rising path. There’s also expectations that the European Central Bank will begin to reign in their stimulus at some time in the next 12 months. Whilst credit defaults remain low, credit spreads remain very tight, with little to no margin of safety at present, especially considering how long in the cycle we are. In saying that, we don’t expect central banks to rush to the exits in terms of reigning in their very stimulative policies. All will be slow and very measured, whilst clearly articulating and telegraphing their response paths. However, we can’t rule out a policy mishap along the way given plenty of moving parts.
From an economic perspective, the global economic upswing continues, however, some data has begun to show signs of waning as the potential for trade wars and rising geopolitical tensions looks to be sapping confidence and sentiment at both the consumer and business level. Unemployment rates globally continue to fall whilst we are seeing a tick up in inflation in most jurisdictions given rising input costs and some upward pressure on employment costs. Unemployment rates in some countries are at all time historical lows, but this hasn’t necessarily translated into strong wage increases, which has perplexed many. The reasons for this are varied, but centre on demographics (aging population), still reasonable levels of underemployment, the long term unemployed only recently re-joining the workforce (ie. lag effect), and the potential threat of technological substitution for labour. Housing, manufacturing, and trade data remains supportive to a continued economic growth upswing.
Whilst the US economy is performing well, boosted by recent personal and corporate tax cuts, the government is heavily indebted and debt levels are continuing to rise at an unhealthy pace. The tax cuts only made this position worse. The risk here is that the US Fed is raising rates and removing stimulus at the same time the government continues to rack up more debt. The potential for a mistake here is real, with many believing the potential for a US recession is now closer than previously expected. Rising debt levels, rising debt costs, and the US Fed removing stimulus form emergency levels aren’t the best combination. The Fed’s job has only gotten more difficult.
From an Australian perspective, the economy is performing reasonably well in that economic growth is positive (circa 2%), unemployment reasonably low, and inflation remains in check. However, that assessment masks some reasonable to significant issues at the underlying level. Business investment remains too low. The household budget remains squeezed and looks to be getting worse. A couple of out of cycle rate rises by the banks, in light if increases in their overseas funding costs, will only accelerate that. This translates into lacklustre retail sales and pressure on consumer confidence and sentiment. Wages growth is desperately needed, but we don’t see that any time soon. The mining boom has finished, the housing boom has come to an end, which leaves us with a mini infrastructure boom of sorts, with the hope that it carries the economy through the next couple of years. Plenty of spare capacity in the employment market, as we now have one of the highest unemployment rates in the developed world. Concerning is the continued divergence between the unemployment rate and the underemployment rate. As such, the RBA remains firmly on hold for this year and most of next year (possibly all of next year).
All in all, plenty to get both optimistic and concerned about. That means a somewhat neutral stance / setting is likely to permeate through portfolios we advise on. Diversification is key, unnecessary risk taking won’t be rewarded going forward, and selective security / investment selection is of the utmost importance.
- Chris Lioutas
Chief Investment Officer