Market commentary October 2019
Global share markets higher
Global share markets rose in October, albeit modestly. Much of the gains were driven by increasing optimism surrounding US-China trade negotiations after the two countries announced a partial trade deal that was viewed as a significant step toward ending their 15-month-long dispute. Stocks also benefited from the US Federal Reserve (Fed)'s decision to cut interest rates for a third time this year; the Fed lowering its target range by a further 0.25% to between 1.50% and 1.75% as it looks to offset global risks to the US economy and subdued inflation. The central bank also hinted that the move may be its last for some time after it dropped from its policy statement the line that it "will act as appropriate to sustain the (economic) expansion". This earlier language had been interpreted by investors as a sign of more rate cuts to come. Sentiment was further buoyed by news US consumer spending, which accounts for around 70% of all US economic activity, increased in September and some encouraging US earnings updates, with the likes of JPMorgan Chase, Johnson & Johnson and Microsoft all beating analysts' expectations. In saying that, there were some notable misses, including Amazon, Caterpillar and Google parent, Alphabet. Limiting the advance was news both the US and Chinese economies slowed in the third quarter, ongoing Brexit uncertainty and the International Monetary Fund's decision to cut its 2019 global growth forecast to 3.0% in August; the institution's lowest forecast since 2009.
At the country level, US stocks hit further record highs in October, while Japan rose to its highest level in a year. Share markets were also stronger in China and Europe but fell in the UK and New Zealand.
Australian shares lagged their global counterparts over the period thanks to weakness across the major banks and miners; which together represent a large part of the index. The 'Big Four' banks were all lower for the month amid concerns declining interest rates and heightened regulatory scrutiny within the banking sector will impact profitability, while mining heavyweights BHP Billiton and Rio Tinto fell on the back of disappointing production updates. Limiting the decline was the Reserve Bank of Australia (RBA)'s decision to cut interest rates, easing US-China trade frictions and some encouraging domestic economic data, including third-quarter inflation figures which printed in line with expectations and a drop in the unemployment rate to 5.2% in September.
RBA cuts interest rates
The RBA cut interest rates by a further 0.25% in October; taking the official cash rate to a new low of just 0.75%. It was the Bank's third rate cut this year. In its post-meeting statement, the RBA noted that even though domestic growth had softened, a gentle turning point appeared to have been reached with economic growth a little higher over the first half of this year than over the second half of 2018. Further, officials believe that low interest rates, recent tax cuts, ongoing spending on infrastructure, signs of stabilisation in some established housing markets and a brighter outlook for the resources sector should all support growth. The Bank's main domestic uncertainty remains the outlook for consumption, with the sustained period of only modest increases in household disposable income continuing to weigh on consumer spending. Meanwhile, the Bank noted that employment is likely to slow from its recent fast pace and that inflation pressures remain subdued, with both headline and underlying inflation expected to be a little under 2.0% over 2020 and a little above 2.0% over 2021.
At Russell Investments, we've been of the view that the RBA would likely cut interest rates twice from their 1.00% level. We saw the first of these rate cuts at the Bank's October meeting and we continue to believe another cut is coming; most likely in the first half of 2020. The risk of the cut coming earlier has abated given the more positive direction of trade negotiations and reduced expectations of easier monetary policy globally.
Australian dollar strengthens
The Australian dollar (AUD) rose for a second consecutive month in October; the local currency benefiting from encouraging US-China trade developments, stronger commodity prices and general US dollar (USD) weakness. Better-than-expected inflation and employment data also provided some support. Limiting the AUD's gains was the RBA's decision to cut interest rates and a series of mixed domestic earnings updates.
The AUD gained 3.5% against the Japanese yen, 2.6% against the USD and 0.5% against the euro. It fell 2.4% against the British pound, while the broader Australian Trade-Weighted Index1 closed the month 1.4% higher.
Global markets continue to add to their strong 2019 performance. However, recession risks are rising as trade tensions depress global manufacturing and the inverted US yield curve signals danger. We're cautious for now, though the combination of central bank easing, a possible trade truce and Chinese stimulus could brighten the outlook.
The upcoming 2020 US presidential election makes de-escalation of the US-China trade war more likely. But a combination of unpredictability on both sides and the damage already done keeps us cautious. We have an underweight preference for US equities, driven by expensive valuation and cycle concerns around the trade war escalation, fading fiscal stimulus and yield curve inversion. We're broadly neutral on non-US developed equities. Both Japan and Europe should benefit from China policy stimulus, which would help bolster export demand. Whilst emerging markets remain attractive from a value standpoint, tailwinds from Chinese stimulus and dovish global central banks have been countered by negative impacts caused by global trade uncertainty.
For fixed income assets, we see government bonds as universally expensive. As of mid-August, around 30% of global developed government bonds on issue were trading at a negative yield. US Treasuries offer the most attractive relative value. However, the concern is that central banks have limited ammunition to fight a downturn. Interest rates are already at zero or negative in Japan and Europe. The Fed has more scope to ease, but it also faces the zero-lower bound constraint. We anticipated the Fed's interest rate cuts in September and October. With downside risks to economic growth and muted inflationary pressures, trade discussions between the US and China continue to be the swing factor that may increase or decrease the number of cuts needed in the near term. In credit markets, we believe high-yield bonds are still slightly expensive given the risks from slowing corporate profit growth. 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 despite this year's rally and has attractive 'safe haven' properties if the trade war escalates. A resolution to the trade war could see the USD weaken, given its counter-cyclical tendency. In Australia, the RBA has hinted at further rate cuts to support the economy, which is being dragged down by falling housing construction and heavily indebted households. We expect a further two rate cuts by the middle of 2020. The AUD is likely to continue to be impacted by monetary policy, geopolitical risks involving China and other emerging markets and commodity price movements.
Recession risks are rising and we expect late-cycle risks to increase. However, the current economic expansion could extend further, supported by additional central bank stimulus and a potential easing of US-China trade tensions; even if only temporarily. If we see the clouds of uncertainty removed by year's end, the global economy has a chance to reaccelerate. But a failure in US-China trade talks and further escalation of tariffs could easily tip the US and global economies into recession. We remain alert to downside risks of further selloffs given uncertainty over central bank policy and changes to global trade policies. Importantly, we believe this is an environment that will favour our active management approach.
1 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.