2018 was a perplexing year for investment markets, having started apprehensively due to economic growth and rising interest rates concerns, which was then followed by a benign mid-year period of greater optimism and growth, that ended abruptly in the final quarter. By year-end markets of all types - stocks, bonds and currencies - were experiencing heightened investor agitation and volatility.
There are a host of clear-cut causes for the weaker state of markets. Firstly, there is a general sense that the durable global economic growth of recent years is beginning to wane, this being most apparent in the flattening of global interest rate curves – the falling long-term rates often being a leading indicator of a forthcoming weakening of economic activity. Secondly, the United States (the world’s largest economy) is pursuing more protectionist policies, while China (the second largest economy) is becoming more expansionist. These disparate policies are exacerbating already fractious trade relationships, and generally spooking the markets. It’s unlikely that either will give much ground, so their relationship will remain a key geopolitical factor for many years ahead.
The third issue afflicting markets is a little more subjective, being the heavier hand of regulation and policy change, combined with unusually volatile political trends. There is no doubt that the pronouncements, behaviours and policies of the US President and his administration are extreme – perhaps more so than in any previous peace-time administration. Consequently, it’s possible that political upheaval will be a prominent feature of 2019, as will market reactions to the forthcoming Australian federal election and the UK’s Brexit pathway.
The Australian stock market, as measured by the S&P ASX200 Index, fell by a significant 9% in the December quarter, and was down by 6.9% for the 2018 full year. With dividends included, the returns were negative 8.2% and negative 2.8% respectively. The domestic market decline was nearly all experienced in the final quarter, retracing the multi-year high point achieved in August. The poor recent performance of shares was exacerbated by an unusually large decline in the markets’ largest sector, banking and finance stocks, which fell on average by about 15%.
The 2018 year ended with more appealing Australian share valuations, which augers well for 2019. Dividends have largely been maintained, economic conditions are patchy, but satisfactory, and corporate profits likely to be reasonable. However, the timing and path to a market recovery will need to first overcome some obstacles, including the volatility of overseas markets, a clearer view of forward economic activity and a settling of the current downtrend in domestic real estate.
Within our managed share portfolios, the bank shares (ANZ, CBA and Westpac) had a poor year, though Macquarie proved to be a pleasing exception. We’ve added to our bank shareholdings of late, mostly by acquiring NAB shares. Other negative contributors for the year were Boral, which suffered an earnings downgrade in its construction materials business and InvoCare, which has embarked on a large-scale renovation program of its funeral homes. Positive contributions came from healthcare company CSL, which continued is stellar performance, BHP which benefitted from improved commodity prices and rewarded shareholders with increased dividends and share buybacks, and both Woolworths and Wesfarmers, the latter having recently demerged Coles into a separate listed company.
We maintained an elevated cash weighting within our managed shares portfolios for all last year but are inclined to invest with a little more confidence at the lower prices that now prevail.
Share prices skidded sharply in the United States in the latter months of 2018, leading to a full year decline of 6.2%. Other markets fared worse, suffering full-year declines of 11% in France, 12% in Japan, 12.5% in Britain, 13.6% in Hong Kong, 16.2% in Italy, 18.3% in Germany and 24.6% in China. Most of the falls occurred in the final quarter of 2018.
Our analytical system, known as RVA Global, covers the largest ten world markets. An assessment is made of a variety of factors, including market dividend and earnings ratios, the specific country GDP and inflation outlook and the pricing of shares relative to risk free bond rates. We also employ risk assessment factors, including country risks based on credit default rates, and a consideration of currency risk, a very important factor for Australian domiciled investors
By the end of 2018, with markets having had a sharp sell-off, all major world markets were deemed to be within a broad fair value range. There is unsurprisingly a variance in relative value, with those markets more affected by the geopolitical and trade war factors such as Japan, Germany and Hong Kong, representing modestly better value than shares in the United States and Australia. We have tilted the geographic mix in our managed portfolios accordingly.
There are some global impediments to overcome in 2019, specifically the intractable political environment in the United States (and the irascible President), the composition of the final Brexit outcome in Europe, an ongoing consideration of potential weakening economic trends, the movement in global interest rates, and the continuation of the global trade and tariff imbroglio. On this latter point, the so called trade war between the United States and China is unlikely to be solved any time soon, as each has an entirely contrary position – China seeking to be more internationally expansionist and the USA adopting a more protectionist approach.
The stock market performance of listed property securities (REIT’s) was satisfactory in 2018, the sector as a whole rising by 2.9% when distributions are included. REIT’s performed better than the overall stock market, which came as a mild surprise as some perceived negatives had prevailed early in 2018, namely the risk of higher interest rates and weaker property prices. As it turned out, Australian long-term interest rates did trend higher early in 2018, but ended the year considerably lower, whilst the weakness in real estate prices has mostly been limited to the residential sector, at least to date.
The long period of low interest rates and the consequential heightened real estate valuations have made some individual property acquisitions less appealing and has led to an increase in merger and takeover activity. Two such large deals occurred in 2018; being the acquisition of Westfield Corporation by the European based Unibail-Rodamco group, and the purchase of Investa Office Fund by the Canadian based Oxford Properties, having won a hotly contested bidding duel with the US based Blackstone group.
High priced corporate deals and strong commercial and office valuations - note for example Dexus’ year-end $405m valuation increase across 108 properties – are characteristic of a market high point. It’s difficult to foresee further outperformance of this sector in 2019 as interest rates won’t be supportive forever, and occupancy rates will wane should the economy soften at all.
It’s been a weaker year for the residential property market, caused by a confluence of factors, including the unsurprising emergence of oversupply, the curtailing of some foreign investment criteria and both the tightening of credit regulations, and some diminution of credit supply. Residential markets are unlikely to improve this year, as development completions will lead to further oversupply in the capital cities, but credit conditions are likely to stabilise and improve, probably in the second half of the year after the adoption of the main recommendations arising from the banking royal commission.
The Reserve Bank of Australia’s (RBA) perseverance with its stable 1.5% cash interest rate setting has exceeded two years, which is unprecedented. Logically, the long period of sustained economic growth in Australia would lead to inflationary pressures, and higher rates, but this has not been the case. Consequently, the RBA can continue with its extremely accommodating policy, thereby engineering a beneficial decline in the Australian Dollar (as they know that US rates are being raised).
The low rate policy is also a useful tool to counteract the potential negative that a slump in real estate prices might have on economic activity and constrain the effects of the disturbingly high level of Australia’s consumer indebtedness.
Long dated Australian bonds were remarkably steady in 2018, trading in a very narrow range of 2.5% to 2.9%, until a dramatic sell-off in the United Sates in November caused our ten-year rate to fall sharply to the year-end level of 2.3%. US rates, which had been rising steadily to peak at 3.2% retreated sharply to about 2.7%. The interest rate pundits had a difficult year, as the consensus was clearly for higher rates – indeed there were significant short positions in US bonds, which would have resulted in much angst and considerable losses when rates fell. The US Federal Reserve has indicated a preparedness to continue with their policy of raising short term rates, and reversing the quantitative easing program, though their pronouncements by year end were a little less assertive.
The low interest rate conditions in Australia have allowed hybrid securities and other higher risk fixed interest investments to perform satisfactorily. The higher regulatory capital requirements of the banks, and their inclination to shed balance sheet risk has had the positive effect of increasing the capital security buffer provided to hybrids and helped maintain some price stability. Credit spreads and trading margins have been reasonably steady.
2019 has started under a cloud of uncertainty, markets having endured significant declines in the December quarter. Investor consternation is widespread in both economic and political spheres. Locally, residential real estate prices are falling, causing concern about the potential consequences on economic consumption and bank profitability. Interest rates have started to fall, when they were expected to rise.
Despite all of this, investment opportunities are more favourable. Notwithstanding some dramatic and oft-reported headlines the clouds are not all that dark. Domestic economic activity is assisted by good tourism, infrastructure activity and commodity export markets, employment growth is good, and the low dollar is beneficial. Share prices have retreated to affordable levels, and after dealing with some of the short-term obstacles are expected to rise again beyond 6000 index points during 2019. Bouts of stock market and interest rate volatility are likely to continue, so investors should remain vigilant.
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