The past month has delivered little resolution to the key questions plaguing investors as the cycle matures. Can strong global growth be sustained beyond this year, and inflation and wage pressures stay benign, allowing risk markets to grind ever higher?
Alternatively, will tightening jobs markets foster an unexpected lift in inflation, or will global growth fail under the weight of a persistent trade war and other geo-political risks?
Despite the ebb and flow of largely ‘Trump-centric’ trade war headlines, and a new financial crisis in Turkey that seemed to dissipate as fast as it emerged, risk markets have continued to move higher through August. Geo-political risk and benign inflation globally have also continued to keep fixed income markets rangebound.
At his Parliamentary Testimony earlier this month, Reserve Bank of Australia (RBA) Governor, Dr Philip Lowe, noted that “the Australian economy has continued to move in the right direction … the economy looks to have grown strongly over the first half of 2018”. Indeed, Q2 growth in Australia accelerated from last year’s average pace of 2.2 per cent to 3.4 per cent (above its historic trend).
Australian fixed income markets remain attractive and we continue to expect further near-term interest rate increases in the US. Interest rates are also expected to rise through 2019 in Europe and Japan, as global quantitative easing (QE) begins to unwind. In contrast, given ‘at-trend’ growth, a slowing housing and credit cycle, and inflation below the RBA’s target, expectations for any upward hike in Australian rates is focused on late 2019 or even 2020.
For Australian government bonds, yields are likely to trend higher from here as the global outlook remains favourable and global central banks normalise policy. However, we expect any increase to be more muted than globally. Indeed, Australian 10-year yields have recently traded well below those of the US, a trend we expect can continue.
For Australian corporate debt, we remain supportive of investment grade, where demand is driven by attractive real yields and strong issuer credit relative to global alternatives. While funding pressures for Australian banks saw senior unsecured spreads widen earlier in the year, the recent rally in bond yields has led to a stabilisation in spreads.
The Australian equity market remains a modest underweight. This is in part due to its higher sector weightings in structurally slower-growing sectors, and in part due to a less ‘above average’ growth outlook than elsewhere in the world. Our end-year target for the Australian dollar of US$ 0.72 also supports our preference for unhedged international equity positions, though less so than earlier in the year when the exchange rate was over US$ 0.80.
The reporting season in Australia looks to have mirrored many aspects of the recent US Q2 reporting season with ‘in-line’ results the norm. More than half of companies produced results that were in keeping with consensus, while ‘beats’ versus ‘misses’ were relatively evenly split.
Nonetheless, as always, there were some key trends that are worth noting. While 2018 results were typically in line, FY19 guidance proved modestly weaker than expected. According to UBS, “negative FY19 earnings revisions outweighed positive revisions by around two to one”.
For those companies that did deliver earnings upgrades, they were concentrated outside the top-100 in the S&P/ASX 300 index and driven by higher-than-expected cash flow (not cost out). Costs broadly surprised to the upside, suggesting the past few years of aggressive cost out has largely been exhausted. Capital management stayed focused with more positive than negative dividend surprises and significant new on-market buy-backs and extensions of current plans announced.
Otherwise, tariffs and trade war concerns were of little focus. According to UBS, some of the industry-specific themes were around a partial recovery in mining exploration and strong east coast infrastructure that aided mining services and contractors. Additionally, lower electricity prices led to energy retailer downgrades.
High quality offshore earners (notably in healthcare) outperformed domestically-exposed stocks. Finally, growth remained in favour, as the market was willing to pay up for high multiple stocks, while punishing premium stocks that missed earnings or guidance.
Looking ahead, with the broader ASX industrials (ex-financials) trading just shy of 22 times forward P/E, higher than the pre-GFC peak, style and sector selection is becoming increasingly important. We favour themes, such as seeking value in domestic companies with exposure to offshore high-growth markets; being cognisant of the market’s high level of dispersion towards growth and the risk that, at some point, there may be a rotation back to more value-orientated companies; and consistent with the above, investing cautiously in sectors that appear crowded.
Scott Haslem, chief investment office, Crestone Wealth Management
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