As 2024 progresses, so too does financial market confidence improve, such that some asset prices have been increasingly robust. Buoyant enthusiasm is welcome but seems at odds with some of the more pressing issues of the world.
Few will complain, as investment portfolio and superannuation returns have been good, helping alleviate some of the financial pressures on Australian households. But I wonder whether there isn’t a degree of illusion in some asset prices. US shares, for example, are currently priced close to the highest ever multiple of their profits. This infers either a fabulous corporate profit/economic outlook, or an improvement in valuation metrics, specifically a meaningfully lower risk-free rate. Neither seem likely.
Market volatility was surprisingly quiet, till early August, when the Japanese TOPIX stock market index lost 12% in a single day, causing the VIX volatility index to spike to levels not seen since the COVID-19 pandemic. The Bank of Japan had raised interest rates from zero to 0.25%, marking a significant change in its long-standing monetary policy. This precipitated the rapid unwind in an investment strategy called the yen ‘’carry trade’’, essentially investors borrowing in yen (with its ultra-low interest rate) to invest in shares. Whilst this bout of volatility quickly eased it should serve as a reminder that markets are finely priced, without much margin for error.
The Australian economy is facing a period of subdued growth as it navigates high inflation and interest rates. Our major export commodities have suffered from an economic slowdown in China, but a gradual improvement is anticipated when inflationary pressures ease, perhaps the latter half of 2025.
The Peoples Bank of China, (their Central Bank), announced an extraordinary package of stimulus measures designed to turn around their languid economy. The package included a cut to the bank reserve requirement ratio (freeing up liquidity), cuts to policy and mortgage interest rates and, most unusually, a facility for corporations and institutional investors to access liquidity to buy stocks. This unsurprisingly, lit a fuse under the Chinese stock market, sending it significantly higher (by as much as 30%) within a few days.
Arresting the slump in the Chinese economy is enormously important for world growth, including Australia, as China is the destination for more than 30% of our exports. Chinese demand (or lack of it) dictates the prices of our three largest export items – coal, iron ore and liquified gas. The Chinese stimulus package had the effect of reversing the slumping iron ore price from about US$90t to over US$100t.
Central bank stimulus has become the default policy globally when economic trends deteriorate. A sugar hit helps, but it’s not without a cost, usually in the form of higher sovereign indebtedness, or an artificial expansion of money supply. There is a reckoning date looming when loose fiscal policies and massive indebtedness can no longer be sustained or tolerated. Let’s hope, for the sake of financial market stability, that this reckoning is not too soon.
Meanwhile, the global economy seems to have averted the oft-predicted recession, thanks largely to better-than-expected economic activity in the United States. The US resilience is underpinned by sustained employment growth, and their global leadership of technological advancements in machine learning and computing.
The US economy will probably soften a bit in 2025, whilst Europe and Japan, which both suffered recent downturns, will likely exhibit a better growth dynamic next year. The Australian economy has delivered only moderately above zero growth thanks to generational high government investment and expenditure, higher than trend immigration and resilience in our terms of trade, primarily mineral, energy and agricultural exports. On a per capita basis the Australian economy is weak, having suffered sequential quarters of negative growth. Domestic inflation has not abated at the pace enjoyed overseas, so the Reserve Bank has not yet observed sufficient dampening data to initiate a policy interest rate reduction. 2025 looks to be another weak economic year domestically, with rising unemployment and persistent consumer cost pressures.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, rose by 6.5% in the September quarter, notwithstanding a sharp but very temporary fall in early August. Many companies reported dividends during the quarter, which added to market investor returns. Recent performance of the market was bolstered by the significant Chinese stimulus package, further rises in US large-cap stocks and central bank policy interest rate reductions in Europe and the United States.
There was the usual variation in returns within the market sectors in the September quarter. Energy shares were relatively weak, a little surprising given the conflict in the Middle East. Stocks such as Woodside and Santos have significant upside potential, but they do incur very heavy project and exploration capital costs, which can weigh on their profit and share price potential. Mining shares received a big boost from the China stimulus and bounced sharply in September.
Bank shares have performed very strongly this year, which is a bit at odds with the cyclical nature of their business, and the prospect of rising loan defaults. The Australian stock market has become more concentrated (fewer new listings) such that the bank sector now accounts for more than a quarter of the entire market and the steady growth of superannuation contributions has led to super funds collectively owning a quarter of all bank shares – with every contribution to Super more bank shares get bought, irrespective of whether they are cheap or expensive. Bank shares therefore are trading at the highest ever multiples of their projected profits, all OK whilst positive investment flows continue but watch out for the downside risk when the inevitable reversal of fund flow commences.
Consumer staple businesses are dealing with soft demand, a symptom of cost pressures on households, and some rigorous regulatory investigations into pricing patterns and market concentration. Stocks in this sector are typically defensive, due to their resilient cashflow, and represent investment opportunity in a weak economic time. These include retail businesses Coles, Woolworths, Metcash and Endeavour.
The Australian stock market is relatively high, our reasoning being an inadequate projected return when compared to low-risk assets such as term deposits or government bonds. This could lead to a period of sub-par returns, so investors need to be conscious of moderating risk exposures. But there are pockets of good value amongst Australian shares, and increased volatility will shake out some more bargains, so investors can be watchful for opportunities.
Global Shares
In the September quarter the MSCI world stock market rose by a further 6%, continuing a strong and above-trend phase that commenced in November last year. US shares, particular mega-cap technology related led the surge, and the stimulus inspired rally in Chinese stocks helped. For the 2023/24 financial year this index rose by 18.3%, approximately twice its long-term average.
The 2024 year-to-date market performance has been truly rewarding for global share investors – the US market is up by 21%, Asia up 20%, and Europe up 11%. Australian investors have missed a bit of this due to our moderately appreciating currency in the second half of 2024.
Global stock market valuations appear stretched. Nearly all markets are trading well above their 20-year average of price to projected profits, in some cases, notably India and the United States, at close to the very peak of their long-term valuation range.
This leads to the obvious questions of why, and what’s next? On the former, markets are primed for perfection, pleased with the soft but not cataclysmic global economy, happy to price up risk due to the expectation of central bank interest rate reductions and riding the herd of positive investment flows. But this can’t last – it never does. Markets have a habit of surprising, often for the most innocuous of reasons and without much warning. Inevitably there will be a reversion to historic multiples, this being a combination of market price declines in some overpriced stocks and sectors, and a probable continuation of better-than-expected corporate profit growth (which has the effect of improving market multiple ratios). An exogenous event, or a worsening of the crises in the Middle East and Ukraine, or a credit spread spike could upend the apple cart and provide the next phase of better buying conditions.
Politics and elections are not usually materially influential on stock market prices, unless there is a dramatic and unexpected shift, or unusual alterations to policy status quo. The imminent US election will be accompanied by a cacophony of noise, but shouldn’t markedly affect financial markets in the near term. However, the trend towards more populist and nationalistic policies such as higher tariffs and embargoes suggests an era of more significant policy change, some of which may alter economic and market trends in unexpected ways.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) rose by 13.8% in the September quarter, a sterling recovery from the previous quarter’s selloff. The Chinese stimulus and some interest rate cuts overseas helped, as did some recognition that the sector’s market pricing had become unreasonably bearish.
The notable feature of the quarter was the rapid recovery in the prices of some laggards following their financial result announcements, such as Stockland and GPT, and the waning of the relative performance of Goodman, the sector leader.
Stockland, a residential, retail and commercial diversified REIT, announced funds from operations of 35.4c per security for the 23/24 financial year, being the top of their guidance range and slightly better than market expectation. They have a $50bn development pipeline including 15 new residential communities. Stockland (and other residential developers such as Mirvac) are clearly well positioned to participate in the requisite increase in housing supply.
In the commercial sector Dexus and others have struggled to maintain office occupancy, and as rent incentives have risen, cash funds from operations have not meaningfully increased. Dexus has changed its capital management policy, now choosing to distribute 80% to 100% of adjusted funds from operations, the effect if which is a projected decline in annual distributions from 48c to 37c. Whilst this policy change reduces the distribution yield to securityholders, it does retain more capital within the business, allowing Dexus to better plan for developments, acquisitions, refurbishments and other growth projects.
The three large retail property REITS, Scentre (Westfield), Vicinity and BWP (Bunnings) are all enjoying good operating conditions. Scentre Group occupancy is 99.3%, and they collected $1.37bn in rent for the six months to June 30. BWP reported 99.1% of space leased as they have successfully repurposed some properties vacated by Bunnings.
Goodman Group is the largest listed Australian REIT and has proved recently to be the most successful. They develop industrial projects, often with external partnership funding in the logistics and warehouse sector. Of late, they have focused on data centres, such that these developments now represent 40% of their $13bn work in progress. Goodman’s securities are highly priced, reflecting their success, and perhaps some premium for their involvement in the data/AI space.
Goodman’s operational and structural characteristic serves as a reminder that REITs are not just property trusts. Most operate as stapled securities, essentially stapling a trust structure with an operating business, usually being a development or property management business. In Goodman’s case the staple comprises an ordinary share in Goodman Ltd, a unit in Goodman Industrial Trust and a share in Goodman Logistics (HK). The point is, investors need to remember that REIT investments can behave like shares, and exhibit share like volatility rather than the traditional high income and price stability of pure trusts. REIT distribution yields can also be very low, as they can choose to retain earnings due to their stapled security structure, as Goodman does, and as Dexus is moving towards.
Interest Rates
Short term interest rates are being cut in many countries and zones. But not in Australia (yet). Our Reserve Bank has been wrestling with stubborn inflation and economic data, whilst understanding that tight policy can be unreasonably, and perhaps unnecessarily, constrictive.
The RBA has an unenviable task. They are required by charter to promote financial stability and to target sustainably low inflation, in the 2% to 3% range, so their prognostications have been focused on the middle ground – keep fighting inflation but in doing so don’t let the economy fall off a cliff.
Overseas, the US Federal Reserve cut their Federal Funds rate in September by 0.5% to 5%, whilst central banks in Europe, China, Canada, New Zealand and elsewhere have all initiated rate reductions. All have referenced the abatement of inflation and the waning of demand as reasons for the reductions. In other words, they consider their higher rate policies of recent years to have been effective.
So, it’s the Reserve Bank’s turn to reduce rates, now a matter of when rather than if. Their recent commentaries and press statement suggest a hold and wait policy for a while longer, so perhaps a modest reduction on 18th February. They do meet twice before then (4/5 November and 9/10 December) and might be tempted to initiate a pre-emptive reduction should an event or circumstance create some risk to stability, for example a significant worsening of the Middle East conflicts.
Longer date bond interest rates have been more volatile, oscillating between 3.6% and 4.5% recently in the United States and between 3.9% and 4.5% here. The recent sharp selloff in bonds (rising rates) contrasts starkly with the Central Banks’ objective of rate reduction.
There are some messages in the bond market volatility. Firstly, markets are becoming more concerned about fiscal looseness and sovereign indebtedness, such that bond yields are pricing in greater risk. The International Monetary Fund produced a major paper on this in October, warning in no uncertain terms, that surging government indebtedness cannot continue, or else a significant system shock could follow. The second message is the economic trend uncertainty that prevails – yes, global economic activity is generally better than expected, but anecdotes suggest a slowdown.
Bank AT1 hybrid securities have been a popular investment choice, but the banking regulator (APRA) has decided to ban future issuance to retail investors. This is a shame on the one hand, but understandable as many investors were ill-informed of the risk contained within loss-absorbing bank credit securities. We’ll be reviewing and recommending other fixed interest securities as alternatives to hybrids.
Outlook
There’s a bit happening in the next eight weeks – including the US election, developments in the ongoing crises in the Middle East and Ukraine, more central bank interest rate reductions, two RBA meetings and the ongoing efforts by Chinese authorities to stimulate their moribund economy.
This has and will lead to more volatility, which inevitably means higher risk and creates investment opportunity. We’ve seen some better priced opportunities arise already. Investors should expect volatility and be on the lookout for good-value investment opportunities as they arise.
Yours sincerely,
Malcolm Palmer
Joseph Palmer & Sons
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