Investment & Economic Review January 2020
Stock markets displayed their unpredictability in 2019, striding surprisingly and steadily higher after
shaking off the volatility of the prior year. Low interest rates and generally benevolent economic and
profit conditions provided the catalyst.
Interest rates, and their future direction and economic implication, need particularly careful attention in
2020. The Reserve Bank of Australia (RBA) adopted a rate-reduction approach in 2019 to keep the dollar
weak and thwart some economic downturn risks. Their aggressive policy, whilst surprising, was done
because they could, that is the lack of inflationary risks and very low rates overseas meant there was very
little danger in engineering interest rates lower – at least for a while. I doubt that conditions will be quite
so conducive this coming year, and any further rate reduction would have questionable economic benefit
and may coincide with a period of increasing asset price volatility.
2020 is likely to witness an array of opportunities and threats. Geopolitically, it is a year of significance
as the United States embarks on what could be the most fractious election campaign in recent history.
Britain, having secured popular (i.e. exhausted) support to proceed with Brexit, must now get on with it,
and the Hong Kong legislative election in September might represent a focus date for change in China’s
Special Administrative Region policies. Economic activity has waned globally, exacerbated by trade
disputes between the United States, China and others. A failure to resolve these issues could lead to
weaker trade and economic activity in 2020.
Meanwhile, global debt continues to spiral higher due to
supportive credit conditions, ultra-low interest rates and
an inclination by governments, including China, to
support further credit expansion. The quantum of debt
is less important when rates are really low, so in a sense
it doesn’t matter till it does matter - by which time of
belated recognition it is usually too late to prevent a
financial catastrophe of some sort. This is an issue of
utmost importance to financial markets in 2020 and
beyond.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, was almost unchanged in the
December quarter, though a multitude of dividend payments provided some positive cash returns. For
the 2019 year the market was up by a staggering 18.4%, plus dividends, its best year since the 2009 GFC
recovery bounce. Dividends in 2019 were higher than usual as some large companies chose to make oneoff special payments or distribute franking credits via share buybacks. It’s likely that the usual market
dividend yield of 3.5% to 4% will prevail in 2020.
Corporate profitability in Australia has been satisfactory, but mixed. Some sectors suffered poor results,
including the agricultural sector due to worsening climatic conditions, the banks due to their misdeed
provisioning and lower margins, and some retailers. Mining companies, particularly the iron ore miners,
had strong results, as did some of the consumer, real estate and technology companies. More of the
same can be expected in 2020 with little impetus for above-average growth, but generally stable
conditions, nonetheless.
A primary market valuation factor in 2020 is the extent to which shares have been benefiting from the
lower dollar and interest rate tailwind, rather than the core fundamentals of profit or economic
improvements. A higher Australian dollar this year is possible, particularly if our export commodities stay
strong, and the RBA pause their rate reduction policy. Short term interest rates won’t likely rise, but any
sign of inflation could cause some stress in bond prices and affect share prices.
With a new decade starting, it’s interesting to look back on the longer-term performance of share returns,
combining both capital growth and dividend income. It’s clear, and unsurprising, that average stock
returns have waned as interest rates and inflation have fallen. The average market return for the last
decade was 7.9% compared to 8.8% in the 2000’s, 10.6% in the 1990’s and 17.7% in the 1980’s. As interest
rates represent the risk-free benchmark, and are currently at their cycle low, it’s reasonable to expect a
market return of 6% to 8% per annum in the coming decade, with probably seven positive return years
and three negatives.
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In the 1980’s the compound return was 17.7% per annum. The market was down in four years
and up in six, so very volatile, but the up years were considerable, leading to a very strong decade
overall.
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The 1990’s delivered 10.6% per annum, affected by a poor start to the decade (Australia’s most
recent recession), but the latter half of the decade was much stronger.
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The 2000’s had a compound return of 8.8%, lower than the two preceding decades, and affected
by the GFC.
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The 2010’s had a lower return again, just 7.9% per annum. Market volatility was lower with only
two years down and eight up.
Within our list of preferred stocks and managed portfolio the shares of Santos, CSL, Wesfarmers, BHP,
Sonic Healthcare and Macquarie performed very well in 2019, whilst Link Administration, Boral and more
recently Westpac were the laggards. Of late, we’ve been buying the shares of Costa Group, a poorly
performing horticultural company share, currently drought affected.
Global Shares
Global share prices performed very well in 2019, the sharp decline in the December 2018 quarter
quickly fading to history. US shares benefited from steady economic growth, lower tax rates and most
particularly the decision by their Federal Reserve to reverse course on interest rates. European shares
were also strong, especially Germany and France which recovered strongly from a period of relative
underperformance. Britain struggled with Brexit but rallied towards year-end following their general
election. In Asia, shares in China and Hong Kong mostly underperformed their global counterparts, held
back by concerns about the timing and content of trade disputes and agreements with the United States.
Japanese shares performed well due to their generally steady economy and persistently low interest
rates.
The Australian dollar had a remarkably steady year, beginning and ending 2019 at close to 70c against
the US dollar. Against the Euro and Yen, the dollar was also largely unchanged, and it was only the
British Pound, surprising given their Brexit issues, that strengthened meaningfully. The outlook for the
Australian dollar is for more of the same for a while, as the weakening trend caused by our falling
interest rates is offset by strong export commodity prices. It will probably take a significant fall in
mineral and agricultural commodity prices, especially iron ore, for the Australian dollar to weaken
appreciably in 2020.
Looking forward, there are, as usual, a multitude of positive and negative issues to consider. In the US
the forthcoming election campaign will likely be testy with policy pronouncements in abundance
causing some market movements. There is also the impeachment hearing of the President to contend
with and increasing anti-trust scrutiny of the mega-tech companies (which represent the largest stocks
on the market). In Asia, the primary issues emanate from China, as their expansionist ‘Belt and Road’
initiative continues unabated, yet largely funded by spiraling, but difficult to quantify debt, at a time
when their stock prices appear relatively cheap. There are few obvious concerns in Europe, though
their lack of economic impetus could stall the recent rally in their share markets.
Generally, with the Australian dollar no longer providing an obvious return enhancement, investment
in international shares should be a little more modest, particularly US shares, some of which appear to
be fully priced. We should also remember that the US bond yield-curve flattened and briefly inverted
last year, usually a precursor of weaker economic activity. Consequently, our global share portfolios
are underinvested, retaining tactical capacity for future investment, which we expect to occur this year.
Property Securities
The property sector of the stock market, commonly known as Real Estate Investment Trusts (REIT’s),
performed well in 2019 delivering an overall capital return of 14%. Distributions were also strong, adding
a further 5% to the return.
Curiously, all of 2019’s performance of REIT’s came in the first half of the year – the second half being a
negative 2.3% in capital
prices, thankfully offset
by a similar amount of
positive cash
distributions. Clearly,
the tailwind of falling
interest rates – a
primary catalyst to real
estate price
performance – ran out
of puff when long-term
interest rates stopped
falling in August.
Most of the major
REIT’s reported similar operational themes, that being solid new leasing and high levels of occupancy, ongoing capital
refurbishments assisted by supportive credit conditions, good demand in industrial and some commercial
markets, but a competitive and weaker outlook for retail.
Within the sector the large-cap REITs such as Dexus, Goodman and GPT had weaker performance, largely
due to their stock market valuations being stretched rather than any operational problems. REIT’s with
residential exposure including Mirvac and Stockland performed better, partly buoyed by the upsurge in
dwelling prices in the larger capital cities. The retail-based REITs, Scentre Group (Westfield) and Vicinity
Centres have largely traded sideways, but their capacity to retain large anchor tenants has remained
sound, so their distributions have been maintained at over 5.5%.
The outlook for the REIT sector remains satisfactory due to their distribution yields, which remain
attractive relative to prevailing interest rates. However, the decline in capital prices in the latter part of
2019 suggests a fullness of valuation and with some risks to rental growth, this sector may struggle to
generate high returns for a while.
Interest Rates
After nearly three years steady at 1.5%, the Reserve Bank of Australia (RBA) reduced the local cash rate
three times in 2019, to 1.25% in June, then to 1% in July and to 0.75% in October. The RBA continues to
evaluate the global economic and inflationary outlook, and has seemingly determined that domestic
inflationary risks remain low, allowing them to more assertively act with this lower rate stimulus. It is our
expectation that the RBA will retain the 0.75% rate for at least the first quarter of 2020 and evaluate their
monetary settings thereafter.
The Australian core inflation rate remains stubbornly below 2%, and as the RBA has a 2% to 3% inflation
target, they can and will hold rates very, very low until they see unambiguous signs of the reemergence of
inflation.
Interest bearing portfolios typically contains a diverse mixture of assets within the cash and fixed interest
investment sectors, generally within four broad asset types:
- Cash. Deposit rates remain historically low, but security of capital is high.
-
Term deposits. Banks have lowered their deposit rates such that the returns are now lower than
inflation
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Corporate and government bonds. These are generally held via managed structures and have
performed well due to the capital appreciation effect of falling yields. Running yields are now very
low, and capital risks exist should interest rates rise
-
Listed income securities. These are mostly bank issued securities or listed pooled lending structures
that generally have a higher yield and higher risk than other fixed income styled investments.
When we dwell on the last decade, one of the most astonishing reflections is the extraordinary low level of
interest rates – not just a fleeting collapse in the cash rate as in previous economic cycles, but a deep and
lasting period of very low rates, both short term and long term around the world, and persistently negative
real interest rates, causing them to be lower than the prevailing inflation rate, thereby generating no real
return for depositors and investors.
The Global Financial Crisis (GFC) of 2008 has been blamed as the accelerator of the decline in rates, yet
twelve years later the interest rate on 5-year government bonds in the European Union and Japan is still
negative, and the comparable rate in Australia is a historical low 0.85%. Investors seeking a risk-free return
from government bonds are now confronted by really low running yields - considerably less than inflation
- but can no longer comfortably rely on capital appreciation (rates falling further) to generate an acceptable
return. Consequently, returns from fixed income investments are going to remain very low for a bit longer,
but rates have bottomed (they are unlikely to go much lower), so a real risk of bond market capital loss
exists when the cycle turns upwards.
Outlook
The outlook for 2020 is only satisfactory. Economically, Australia enters its 28th year of uninterrupted
economic growth, though the pace of growth has diminished somewhat, and the economic consequences
of drought and bushfires are yet to be fully assessed. Furthermore, the adoption of economic
responsiveness to the twin themes of climate change and societal inequality needs to be accelerated in
2020, which may lead to policy changes in the government, corporate and private sectors.
The stock market is due a quieter year, not necessarily calamitously, but rather a consequence of
relatively full valuation. Any especially negative extraneous event, such as an escalation of trade disputes,
an economic retraction in China, a sharp fall in export commodity prices or a disorderly disruption in the
astonishing monetary/interest rate environment – all of which are possible – could trigger a market fall
and diminish investor returns. Geopolitical anxieties aren’t easy to predict, but the US election campaign,
disharmony in Hong Kong/Taiwan/China relations, and tensions in the Middle East stand as events to
keep a watchful eye on.
We are maintaining our preferred lower allocation to risk assets in early 2020, this being a 20% to 30%
cash portfolio weight for growth biased investors, held for tactical reinvestment in due course. More
conservative investment profiles should maintain even greater liquidity.
To conclude, Australians have about $700bn
invested in bank deposits, the interest rate upon
which has declined to a miserly 1.5% for term
deposits and even less for cash. The temptation,
and compulsion, is for investors to reallocate
these funds to investments with a higher interest
rate or potential return. This question has been
raised by many of our clients recently, so we urge
and encourage investors to give careful
consideration to the risks of alternative
investments before proceeding, and one’s
tolerance to risk should not be impulsively
abandoned.
Yours sincerely,
Malcolm Palmer
Joseph Palmer & Sons
Disclaimer General Advice Warning
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