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Investment & Economic Review October 2018

A notable economic feature of late is the inexorable rise in US interest rates, and its consequential effect on rates elsewhere, and market valuations. Equally notable is the escalation of trade disputes, most particularly between the United States and China. This shift towards greater protectionism by the United States could, if not mitigated, trigger more dramatic retaliatory actions, possibly including currency devaluations, and stands as a primary market risk as we look to the remainder of 2018 and into 2019.

In Australia, economic conditions remain benign. Economic activity and inflation have risen modestly, interest rates have remained largely steady this year, and shares were trending higher till a recent sharp sell-off. Much of the growth in consumer consumption has come from a draw-down in savings. As household debt remains extremely elevated and savings diminish, there is not much margin for error should interest rates rise.

The Australian dollar has been under pressure, falling to multi-year lows against the Euro and $US, primarily due to a capital exodus to the higher interest rate US Dollar. The Reserve Bank’s inclination to keep interest rates very low might keep the currency weak, but this could be counterbalanced by the improved energy and iron ore commodity prices.

Australian Shares

The Australian stock market, as measured by the S&P ASX200 Index, rose by just 0.2% in the September quarter, and 2% since the beginning of 2018. With dividends included, the returns were 1.5% and 5.5% respectively. The domestic market did have a positive surge in July and August, retreated somewhat in September then took a sharp dive in October following a similar decline in the US. The steady interest rates and more positive economic conditions have assisted corporate profit growth and made share valuations (though not prices!) a bit less unpredictable than usual.

Our analysis from both company earnings and macro-economic perspectives suggests more of the same ahead – that is, satisfactory profits and dividends, low prevailing interest rates, an inclination to high dividend payouts and a stock market that encounters occasional periods of sharp volatility but doesn’t contain risks that are too precipitous.

We have maintained an elevated cash weighting within our managed shares portfolios for all this year, preferring to persevere with a relatively cautious approach. However, we assess the overall stock market to represent acceptable value when below the 6000-point level, so the recent market decline has resulted in some better-priced investment opportunities. We recently added the shares of AGL Energy to our Australian share managed portfolio, and we’ve been inclined to increase our investment in some other stocks, including Amcor, InvoCare, and Ramsay Healthcare. We’re also happy to add to client positions in bank shares, due to their prices generally being below our assessment of their long-term intrinsic fair value. We have also been reducing some share positions, including taking some profit from CSL, and paring back some portfolio exposures to Wesfarmers and Santos.

Within our managed portfolios the shares of Telstra, Brambles, Santos, Qube and Woodside performed well in the September quarter, whilst the laggards included ANZ, Amcor, CBA, InvoCare and Westpac.

Australian shares for the remainder of this year will be subject to the vagaries of international events, namely the escalation (or not) of the international trade squabble, any fallout from the forthcoming US mid-term elections and the risks associated with interest rate volatility. Looking further ahead to 2019, it’s likely that the fundamentally solid base of the Australian economy, and decent corporate earnings and dividends will support modestly higher share prices, though we’ll be moving into the latter phase of the economic cycle.

Global Shares

The United States’ stock market, the world’s largest, has generally performed well in 2018, but skidded sharply recently as their interest rates began to rise. Japanese shares rallied well in recent months, but other markets have fared poorly this year, the Germany stock market being down 7.5% in 2018, Britain down 6% and China negative by a staggering 17%. Some of this relative performance is attributable to the ongoing tariff and trade row, which from a short-term stock market perspective has so far favoured the United States.

Our analytical approach to the international stock markets includes numerous macro and market-based indicators including GDP growth, inflation forecasts, earnings growth and yield, and risk-based factors such as currency sensitivity, interest rate spreads and sovereign security. Our assessment at present is that the share markets of Asia and Europe have become relatively good value and are likely to outperform the broad-based US markets in the coming year or two.

On a like-for like basis, the cyclically adjusted PE ratio indicates more prospective investment valuations from German and Japanese shares, relative to the United States.

Property Securities

The stock market prices of listed property securities (REIT’s) are susceptible to variations in interest rates, so it is no surprise that some REIT prices fell sharply recently, in the immediate wake of rising US bond yields. This retraction in prices also reflects the heightened valuations of some underlying real estate assets, and the possibility of a slower rate of appreciation ahead. Corporate activity continues, notably the contested offer for the Investa Office Fund – the competing acquirers both having foreign backing, and probably benefitting from the low $A.

The development cycle in the Sydney and Melbourne CBD’s remains very strong, particularly in Sydney where the Metro rail project has created multiple new commercial sites, in addition to the already significant pipeline. Consequently, oversupply risks are likely to arise as many of these projects complete in 2020/21.

Residential real estate prices are falling in much of Australia, reversing a period of strong growth. Tighter credit criteria, concerns about elevated houshold debt, a waning of foreign investment and pockets of oversupply are responsible. The outlook is subdued, with some areas likely to suffer further demand and price decline, before stabilising.

Interest Rates

The Reserve Bank of Australia (RBA) is persevering with its stable 1.5% cash interest rate setting, a position it has held since August 2016. Consequently, the RBA has allowed the interest rate differential with the US to widen, (US rates are rising whilst ours are steady), and this has led to a weaker Australian dollar, a premeditated strategy that has helped support export related economic activity.

Long dated Australian bonds have been remarkably steady, exhibiting a very narrow range of 2.5% to 2.9% for nearly two years. The lack of perceived inflation risk, stubbornly low wage growth and inactivity by the RBA have contributed to this stability in rates. Similarly, credit spreads have remained fairly narrow, meaning that the availability and cost of finance have both been satisfactory. However, in recent months, credit assessment conditions for household mortgages has tightened, driven by prudence, economic necessity and more stringent regulatory settings. Such conditions might exacerbate an already weakening housing market, which in turn may lead to a softening of economic activity – circumstances that the RBA would see as justification for maintaining their 1.5% policy setting well into 2019.

Meanwhile, the US Federal Reserve’s well-advertised program of rate increases continues, now with a bit more fanfare as the prospect for higher rates is causing some market angst. The Fed has indicated the likelihood of a further 0.25% rise in December, and another three such increases in 2019. US rates are now higher than comparable Australian rates, and this widening differential is likely to cause the Australian dollar to remain relatively weak.

The stable interest rate conditions in Australia have allowed hybrid prices, credit spreads and trading margins to temporarily shed some volatility. Interest bearing investments that carry risk, such as hybrids, have performed well, but investors need to be aware that such instruments can suffer sharp market price volatility when credit conditions deteriorate.

Outlook

The final quarter of 2018 has started badly due to a fall in bond and share markets in the US, a rout in emerging market asset prices and some disquiet over some global trade and political policy settings. Bouts of volatility are likely to continue, so investors should remain vigilant.

Much of the market risk and volatility is originating from outside of Australia. We aren’t economically immune from global events, particularly if our major export destinations such as China have falling demand. However, our domestic economy is performing relatively well, and there are not many indicators of a sharp retraction, so long-term investors should consider periods of stock market weakness as buying opportunities.

Disclaimer General Advice Warning

This publication has been prepared by Joseph Palmer Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer Sons as at the date of publication and may change without notice. Joseph Palmer Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.

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