Market commentary: annual update

Global shares

Global share markets made good gains over the past 12 months, returning 6.6%1 in local currency terms. In unhedged Australian dollar (AUD) terms, stocks returned 11.9%2.

Share markets began the year well, rising on the back of some positive earnings results from the likes of Apple, Walmart, PepsiCo and Amazon.com; all of which beat analysts' expectations. Stocks also benefited from some positive European and Japanese earnings, an upward revision to already-strong June quarter US growth figures and some encouraging rhetoric from US Federal Reserve (Fed) chair Jerome Powell, who reiterated his optimism in the country's growth outlook. Sentiment was further boosted by some solid German and Japanese growth data and news the US had finally agreed a deal with Mexico to address key parts of the North American Free Trade Agreement. However, investors were made to exercise some caution as US-China trade frictions rose and concerns over Brexit negotiations mounted.

Share markets fell sharply in the December quarter, driven largely by a series of softer-than-expected European economic data and ongoing US-China trade uncertainty; though a truce between the two in early December did fuel hopes of a near-term resolution. Stocks were also impacted around this time by increasing fears over Brexit, the Fed's decision to raise interest rates again in December, and further evidence that growth in China was slowing; the latter suggesting the country's standoff with the US was beginning to bite. Sentiment was further impacted by softer manufacturing activity in the US and Europe, as well as further US political uncertainty, including the impasse between top democrats and President Donald Trump over funding for Trump's Mexico border wall; which ultimately led to a partial shutdown of the US government.

Optimism returned to share markets in the first quarter of 2019, thanks largely to promising US-China trade talks and some positive rhetoric from the Fed's Powell, who reaffirmed the bank's “patient” approach to interest rates. Share markets were also supported by another round of encouraging US earnings updates, some better-than-expected US jobs and consumer confidence data, and fresh stimulus measures in China. However, investors turned more cautious in March as fears global growth was slowing intensified after both the Fed and the European Central Bank (ECB) turned more dovish. The Fed, who only in January adopted a 'wait and see' approach to interest rates, went one step further in March and effectively ruled out any rate hikes this year, while the ECB pushed back their own guidance for rate increases. Compounding investors' growth concerns was a brief inversion of the US yield curve which has, in the past, signalled an impending recession.

Stocks finished the year on a positive note as global central banks maintained their dovish tilt in the face of rising global growth fears, falling bond yields and heightened geopolitical risks; notably an escalation in the war of words between Washington and Beijing. Both the Fed and the ECB signalled a willingness to adjust monetary policy to boost growth should it be needed, while the Reserve Bank of New Zealand and the Reserve Bank of Australia (RBA) went further and lowered their respective cash rates to record lows. Share markets also benefited from yet another round of encouraging US earnings results, further Chinese stimulus and late hopes that a meeting between Trump and Chinese president Xi Jinping at the G-20 Summit in Japan might lead to a resumption in trade talks. [Note: following their meeting, Trump and Xi announced that they had agreed to renew talks to resolve their trade dispute.]

At the regional level, stocks in China (9.0%3) and the US (8.2%4) posted some of the strongest gains for the year. Share markets in Europe (2.3%5) were also positive, while stocks in Japan (-4.6%6) and the UK (-2.8% 7) struggled.

Australian shares

The Australian share market performed well over the period, with the S&P/ASX 300 Accumulation Index closing the year 11.4% higher. Much of the local market's gains came in the second half of the year, driven by an increasingly dovish RBA (and subsequent rate cut in June), and strong gains across the 'Big Four' banks and major miners. Stocks also benefited from the Coalition's surprise election win in May, an increase in domestic corporate activity and a dovish shift in Fed and ECB rhetoric. Limiting the advance were some mixed earnings results and disappointing growth data, with gross domestic product for the 12 months ended 31 March 2019 coming in at just 1.8%; the economy's worst yearly performance since the global financial crisis. Stocks were also impacted by renewed global growth concerns and ongoing geopolitical uncertainty.

At the sector level, communication services (30.9%), information technology (24.6%) and industrials (19.5%) posted the biggest gains over the period. Materials (18.0%) and property trusts (14.1%) were also stronger for the year, while energy (-6.1%) was the only sector to record a loss; the latter driven by a 21% decline in oil prices.

In terms of central bank activity, the RBA cut the official cash rate from 1.50% to a new low of just 1.25% in June. The widely anticipated move came after the Bank conceded stimulus was needed to combat softer employment, wages and inflation. In making its decision, the RBA acknowledged that there had been little further inroads into the spare capacity in the labour market and that recent inflation outcomes had been lower than expected, pointing to subdued inflationary pressures across much of the economy. The Bank concluded its June meeting by saying that a lower cash rate would help make further inroads into the spare capacity in the economy. The move was also expected to assist with faster progress in reducing unemployment and achieve more assured progress toward the inflation target. [Note: the RBA went on to lower the cash rate to an all-time low of just 1.00% in early July.]

At Russell Investments, we believe the RBA will keep interest rates on hold for a couple of months while it waits to see how economic data evolves; most notably labour market data. In saying that, any deterioration in near-term key economic data may see the Bank move sooner.

Real estate investment trusts

Australian real estate investment trusts (A-REITs) performed very well over the past 12 months, closing the period up 19.4%8. Local property stocks gained as investors sought higher-yielding assets in the face of declining interest rates, with long-term domestic bond yields falling to record lows late in the year. A-REITs also benefited from ongoing corporate activity within the sector, as well as their traditionally defensive characteristics in the face of fresh global and domestic growth concerns and heightened geopolitical uncertainty. Global REITs (7.7%9) were also positive for the year. Like their Australian counterparts, global REITs benefited in large part from declining bond yields and the asset class's perceived 'safe haven' qualities.

Bonds and cash

Global bonds made good gains for the year, returning 7.2%10 . Major long-term bond yields fell sharply over the period as investors favoured the asset class's traditionally defensive properties amid renewed global growth fears and heightened political and trade risks. Australian bonds outperformed their global counterparts over the year, gaining 9.6%11. The yield on domestic 10-year government debt fell 131 basis points over the period, hitting a series of record lows in the process. Like Australian shares, much of the domestic bond market's gains came in the second half of the year as the growth outlook softened and the RBA adopted a more dovish stance on interest rates. Meanwhile, both global and Australian credit markets strengthened over the year with spreads narrowing as investors, for the most part, adopted a 'risk on' mentality.

Cash returned 2.0%12 over the past 12 months, underperforming all the other major asset classes.

Australian dollar

The AUD closed the year lower, thanks to the RBA's decision to cut interest rates (and expectations for more to come), softer domestic growth and a further widening in the yield differential between Australian and US government debt. The currency was also impacted by lingering global trade and political uncertainties and some mixed domestic earnings results. Limiting the decline was a surge in iron ore prices, an uptick in local merger and acquisition activity and a strong, albeit short-lived, bounce in the wake of the Coalition's surprise election win.

The AUD fell 7.7% against the Japanese yen, 5.1% against the US dollar (USD), 2.7% against the euro and 1.8% against the British pound. Meanwhile, the broader Australian Trade-Weighted Index13 closed the period down 4.0%.

Where to from here?

Global markets have rallied in 2019, supported by central banks turning dovish and Chinese authorities announcing stronger-than-expected stimulus measures. However, yield curve inversion, trade war uncertainty and weakness in global macroeconomic data are pointing to elevated late-cycle risks. Whilst there's a case for lower US interest rates, further Chinese stimulus and a possible US-China trade deal to support another leg higher for risk assets, we remain cautious as we feel downside risks to equity markets outweigh the upside.

We have shifted to a small underweight view on global equities overall, driven by an underweight to the US where we believe valuations are expensive. In other major equity markets, we see Europe and Japan as fairly valued. Whilst emerging markets remain attractive from a value standpoint, tailwinds from Chinese stimulus and dovish global central banks have been countered by global trade uncertainty.

For fixed income assets, we're now forecasting the Fed to cut interest rates in July and September due to subdued inflation and downside risks to both US and global growth. However, we believe current market pricing of three to four rate cuts is too aggressive, unless the headwinds for the US economy intensify. Whilst we think all major bond markets are expensive, there is cycle support for bonds that's being driven by the dovish shift by global central banks and delayed inflation pressures. In credit markets, we believe high-yield debt is still expensive; though this is typical late in the cycle when profit growth slows and concerns over defaults rise.

In terms of currencies, we maintain a preference for the Japanese yen. We believe the yen is undervalued, has attractive 'safe haven' properties due to its strong, negative correlations with global equity returns, and is under-owned from a market positioning standpoint. We hold a neutral view on the USD, while the AUD is likely to continue to be impacted by monetary policy, commodity price movements and geopolitical risks involving China and other emerging markets.

Although we expect late-cycle risks to rise further, we nonetheless expect the current US expansion to continue through 2019. In saying that, we see increasing risks for a US recession in late 2020 or early 2021. Overall, we expect global growth to remain modestly positive. Whilst markets have rebounded impressively so far this year, we remain alert to downside risks of further selloffs given uncertainty over US monetary policy and changes to global trade policies.

1 Global shares measured by the MSCI World ex Australia Net Accumulation Index in LC
2 Global shares measured by the MSCI World ex Australia Net Accumulation Index in AUD
3 Chinese shares measured by the Shanghai Shenzhen CSI 300 Index
4 US shares measured by the S&P 500 Index
5 European shares measured by the Dow Jones EuroStoxx 50 Index
6 Japanese shares measured by the TOPIX Index
7 UK shares measured by the FTSE 100 Index
8 Australian REITs measured by the S&P/ASX 300 Property Accumulation Index
9 Global REITs measured by the FTSE EPRA/NAREIT Developed Real Estate Index Net TRI (hedged to AUD)
10 Global bonds measured by the Barclays Global Aggregate Bond Index (hedged to AUD)
11 Australian bonds measured by the Bloomberg AusBond Composite 0+ Year Index
12 Cash measured by the Bloomberg AusBond Bank Bill Index
13 The trade-weighted index for the AUD is an indicator of movements in the average value of the AUD against the currencies of our trading partners.

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