Investment & Economic Review July 2019
The turnaround in markets that began in January has continued for much of 2019 to date, such that share prices are generally now at or near historic highs. The strength of the rise, Australian shares are up about 20% in 2019 including dividends, is surprising, but so too was the abruptness of the market decline in the last quarter of 2018. Part of the recent strong performance is merely the reversal of this prior period.
Of most significance this year is the recommencement of the downward trend in Australian interest rates, after a long and low but stable period. The Reserve Bank’s recent dual actions are provoking much discussion and consternation, as it seems that their act in belatedly making this dramatic policy change is suggestive of their increasing concern about deteriorating economic activity.
Some extraordinary market circumstances have followed. Australia’s first ever negative interest rate bond, an inflation linked real return variety, has just been issued; our yield curve has become almost flat; real interest rates of all duration have turned negative; and the long term interest rate less the long term inflation expectation is also negative, a phenomenon that rarely occurs.
In the coming months markets will need to decide whether the negative economic signals and yield curve warning will cause a correction in risk asset prices, or whether the more positive effect of the consequential low interest rates will continue to prevail. Investors also need to keep a cautious watch on emerging economic trends, and the corporate profit season numbers when released in August.
The Australian stock market, as measured by the S&P ASX200 Index, rose by a further 7.1% in the June quarter, and was up by 6.8% for the financial year. With dividends included, the returns were 8% and 11.5% respectively. Dividends were a feature of the year past, as multiple companies made higher or special payouts or buybacks, some seeking to do so prior to the federal election, in case a change of government restricted future benefits of franking credits.
The recently strong market was enjoyed by most sectors, but particularly solid in those areas that stood to benefit from lower interest rates, and some specific sectors that rallied after the surprising federal election result.
Within our managed share portfolios some of the core traditional stocks, notably Telstra, Westpac and Commonwealth Bank enjoyed strong gains. Telstra’s recovery is particularly noteworthy, returning over 50% for the financial year, represented by their ordinary and special dividends, plus their considerable price rise. We’ve been gradually diversifying our preferred Australian equity portfolio by introducing some new stocks, including InvoCare, Link Administration, and Costa Group, and reducing our holdings in more mature industries such as retail and banking. Our portfolio structure strategy remains an approximately equal mix between economically cyclical ‘value’ stocks, and faster growing, but often more expensive ‘growth’ stocks, all selected from within the top 200 as usual.
Australian share prices have been well supported by very low and indeed declining interest rates. To date in 2019 stock markets have ignored the weakening economic data and bond market warnings, choosing instead to price shares higher in a hunt for yield. It is unreasonable to expect this to continue, and it is our expectation that share prices, which are now modestly overpriced, will suffer a downturn at some point in the second half of 2019. Consequently, towards the end of June we initiated a tactical change, by reducing some stock holdings broadly across our managed portfolios and increasing our cash position.
Global share prices all hit a weak spot in the final quarter of 2018, bottoming in late December, but have mostly enjoyed a solid revival since. US shares have recovered best, benefitting from last years’ tax cuts, and an about-turn on interest rate policy by the Federal Reserve. Asian and European markets have been more volatile, partly due to the trade and tariff disputes that are dominating global geo-politics.
The decision by the US Fed to change policy is the momentous moment of the year. US interest rates were being engineered higher last year, the resolution being to reduce or taper the significant quantitative easing/money printing/bond buying programs that had hitherto prevailed, and to try to normalise interest rates. The primary purpose of normalised rates is to provide a monetary tool to mitigate the next economic slowdown. Regrettably this process didn’t last long, and by backing off so soon the United States Federal Reserve has illustrated their heightened concern about the economic outlook, not dissimilar to the apprehensions shown by the Reserve Bank of Australia.
So much of 2019’s stock market gains have been driven by lower interest rates, rather than economic or profit growth, that it is hard to now find good value markets. However, there are some sectors, regions and stocks that are appealing, particularly in some of the European and Asian markets that appear to have been unreasonably harshly punished by fears about trade wars.
The Australian dollar has been trending downwards for a few years, and the Reserve Bank’s recent interest rate reductions have provided further downside pressure. The lower dollar has helped Australian investors in overseas shares. However, commodity prices, particularly iron ore, have risen strongly of late, which usually leads to an upwards trend for the Australian dollar. These competing forces probably mean that investors won’t receive as great a currency benefit next year.
The stock market listed property securities (REIT’s) sector has had a remarkably good year, driven by strong investor demand for yield and solid commercial property values. Market prices of REIT’s tend to trade counter to the direction of bond yields, so the considerable decline in yields recently has provided a significant boost. The performance in recent months has finally seen the stock market REIT index exceed its pre-GFC high point.
There is growing concern about the direction of prices and demand for residential real estate in Australia’s largest cities. House prices have fallen steadily, oversupply is looming and in multiple instances construction quality has fallen short of standards. It is likely that prices for medium and higher density real estate generally will remain under pressure for a while, till oversupply starts to wane.
As REIT prices rise, many have taken advantage by raising fresh equity from existing and new investors. Placements of stock, Security Purchase Plans and rights issues have become commonplace. This is an unsurprising occurrence as the management of these organisations take the opportunity to strengthen their balance sheets and provide capital opportunities for the future.
The office, industrial and diversified property sectors have performed best, notably Goodman, GPT, Charter Hall and Dexus. Conversely, retail mall owners have lagged considerably, dragged down by lackluster rental and tenancy and increasing penetration of e-commerce. Governments, with the availability of very cheap debt, have increased their fiscal spending, particularly in public sector infrastructure. This will likely benefit parts of the construction, engineering and materials sectors in the years ahead.
REIT valuations are mostly high, and consequently we have generally been reducing our investment exposure to this sector.
The Reserve Bank of Australia recently made two preemptive interest rate cuts, in June and July. This was counter to most prior predictions and signaled an abrupt change from their long-lasting sit-on-hands policy. The RBA cash rate is now just 1%, 3-year bonds 0.95%, and 5-year bonds just 1%. The yield curve is almost flat.
Meanwhile, inflation and inflationary expectations have fallen below the RBA’s mandated minimum target, thereby creating this unusual phenomenon of zero or even negative real interest rates. This is very rare in a pro-cyclical economy such as Australia is, and bears watching and careful consideration as to the economic and broader market effects in the coming months. Bond prices, which act opposite to interest rates, are very high. Investors need to be very careful about understanding the mark-to-market capital risks that come with long duration securities should an unexpected rise in rates occur at a time when running yields are historically low.
Credit spreads have largely been calm and market price conditions for higher risk income securities such as hybrids have been very good. As commercial rates fall there has been a flood of money into hybrids, hunting their higher yield and sometimes franking credits. This asset class is dominated by the four large banks, and their improved capital structures have helped mitigate some of the concerns. However, all investment requires adequate compensation for the risks taken, and in some instances these types of assets no longer provide the potential return to justify the risks.
An oft asked question is where to now for rates? The RBA has commenced an easing policy and already cut rates twice. Perhaps they’ll continue, and reduce to zero, then shift to a money printing stimulus. If this happens the economic outlook would be very bleak indeed. Our assessment is that the RBA will soon pause, and evaluate the benefits of the existing stimulus, before determining their next course of action in 2020.
2019 has been a very good year for stock markets and bond markets, leading to generally pleasing investment returns. Share dividends increased dramatically, partly via one-off payments and buy-backs. This will revert to normal next year. The stock market is fully priced, though if interest rates keep falling shares will continue to be attractive on a relative yield basis. Inevitably, after a strong market period there’ll be a market correction, which we expect in the second half of 2019. We encourage investors to hold a tactically defensive investment approach in anticipation.
Whilst the markets are rallying the economy is weakening. We hope that economic activity doesn’t decline, but some of the signals, weak retail sales, little inflation, underemployment trends, the flat yield curve and negative real interest rates paint a worrying picture. Geopolitical matters and tariff disputes further cloud the outlook.
We urge investors to be cautious.
Joseph Palmer & Sons
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