- US economy grows at an annualized rate of 4.1% in the second quarter, the fastest since 2014. Strong consumer spending, solid business investment and surging exports all contributed.
- US and the EU make a joint statement on trade, pledging to work together to reduce tariffs. However, similar progress between the US and China is yet to emerge.
- Earnings season in the US is well underway and overall earnings growth remains very robust at over 20%. However, market reaction if expectations are not met has been swift, with some notable stumbles.
- China’s State Council announces a series of policy loosening measures to keep economic growth on track.
- Locally, banks have recovered to some degree from the worst of their Royal Commission lows. The passage of the Coalition’s company tax cuts remains far from certain.
Global equity markets posted strong returns in Australian dollar terms for the second quarter with the positive run continuing through July. While there are emerging signs that synchronized global growth may now be waning, economic fundamentals in key economies largely remain constructive for equities. This has been further supported by the current quarterly earnings season, which is again posting very respectable growth. Having raised rates in June, the US Federal Reserve is expected to continue on its path of gradual hikes, with the market leaning towards 2 more rate rises by the end of the year. Geopolitics has featured more prominently in recent weeks, with promising signs of a de-escalation in tensions between the US and the EU. However, trade relations between the US and China have deteriorated with bi-lateral tariffs now in place. The market is hopeful that further escalation can be averted, though the situation remains mercurial. Signs that trade is starting to be affected by these ongoing uncertainties may be emerging. Given the high starting point of markets, sentiment remains vulnerable to any upsets.
USA: US equities in general have been buoyed by strong fundamentals as the current earnings season again surprises to the upside. However, there has been a potential shift in market leadership, with previous market darlings in the IT space being sold off. Led by Facebook’s 20% fall at the end of July, the FANG+ Index, which includes key technology giants, has posted a negative return in July and sharply underperformed the broader market’s positive move. Financial stocks are proving more resilient. For selected IT names, it is too early to confirm whether this is just a temporary setback or whether the market has to re-examine the growth drivers that are required to support lofty valuations.
China: While the absolute level of GDP growth continues to hold up well, second quarter GDP growth did tick lower to 6.7%. This, combined with the potential for the trade picture to become more challenging, appears to have prompted a series of policy loosening measures, including a less restrictive push for deleveraging, to support the overall economy. It should be noted that the quality of economic growth in China has been improving due to continuing reforms in State Owned Enterprises, rural areas and supply-side consumption along with environmental protection measures. Despite the recent market volatility, double-digit earnings growth and attractive valuations for Chinese equities broadly should provide support over the medium term.
Europe: With the actual Brexit date early next year rapidly approaching, and heightened uncertainty regarding a final Brexit deal, the opportunity for rate hikes in the UK appears to be shrinking fast and sterling has weakened accordingly. Developments in Italy have been more reassuring, with the new Prime Minister now showing positive engagement with the Euro and even a commitment to fiscal discipline. The local bourse has stabilized. The ECB’s rhetoric on rates has turned less hawkish with the acknowledgement that the euro area economy would continue to need ‘significant monetary policy stimulus’. The Euro has weakened from early 2018 highs. This, and some improvement in economic data, has allowed local markets to trade higher.
The Australian market added modestly to its strong return in second quarter when takeover activity and strength in the Energy sector saw the S&P/ASX300 Accumulation Index advance by 8.4%. In July, banks performed relatively well, helped by a shift to more defensive sectors as geopolitical concerns flared. ANZ has rebounded nearly 12% from its mid-June lows, as Royal Commission woes have eased and despite a relatively muted growth outlook.
A broader observation over the 12 months to the end of June has been the extreme relative outperformance of Growth style over Value in the Australian market, with some commentators noting the gap to be as much as 13%. While this trend has also been noticeable globally, in Australia it may have been more pronounced due to the poor performance of Financials, which feature prominently in the value bucket currently. One factor that investors should be mindful of is the relatively high valuations that some growth stocks have now reached. This is also apparent in Small Caps, where selected high PE and growth names have been stellar performers, but are now at challenging valuations.
A rotation towards cyclicals and value appears possible and should be supported by earnings growth in the more economically-sensitive sectors. The local earnings season bears monitoring closely.
Cash and Fixed Interest
The Reserve Bank of Australia left the cash rate unchanged at 1.50%, marking nearly 2 years at the current rate. While employment and broader economic data have been more positive recently, the RBA is also mindful of high household debt levels, heightened geopolitical risks and an inflation rate that continues to be subdued. Rates appear to be on hold for some time to come.
The US Federal Reserve is expected to increase interest rates for the third time in 2018 at its September meeting as it continues to normalize interest rate policy. US 10-yr yields had retreated on geopolitical concerns in early July, but looks set to re-test the 3% level that has been something of a ceiling. The gap with the Australian 10-yr equivalent is now at the widest since the early 1980’s and, at the margin, may exert some downward pressure on the Australian dollar. The yield curve in the US has flattened and bears monitoring.
Property – AREITs
AREITs surged in the June quarter, advancing nearly 10%. M&A has continued to be a strong theme, though returns have also been supported by defensive rotation and by Net Tangible Asset growth. While the pace of cap rate compression has slowed, some modest cap rate compression is still evident, even at these elevated levels.
At the sector level, ongoing rental growth and further reductions in vacancy rates are expected to support the Sydney and Melbourne office markets. Value is also becoming more apparent in quality retail names, where the market appears to be mispricing the longer term risk.
Whilst underlying property values are close to mature-cycle levels, the AREIT market is now trading at a small discount to NAV suggesting fair value. Nevertheless, the sector remains subject to moves in bond yields. We remain cautious on the long lease expiry stocks. Conversely, we continue to find reasonable valuations in select mall REITs.
Source: Written by Charles Stodart, Investment Specialist, Zurich Investments, August 2018