Market commentary: quarterly update

Global share markets rise

Stocks performed well in the second quarter. Much of the gains came after central banks turned more dovish in the face of rising global growth concerns. Growth fears intensified throughout the period, driven largely by heightened geopolitical risks, softer global macroeconomic data and falling bond yields.

In terms of geopolitical risks, these centred mainly on US-China trade frictions as the war of words between Washington and Beijing escalated after US president Donald Trump raised the tariffs on USD200 billion of Chinese goods from 10% to 25% in May. Tensions rose further after China retaliated with tariff increases of their own and Trump moved to blacklist the country’s top telco, Huawei.

Investors also had to contend with further Brexit uncertainty following British prime minister Theresa May’s decision to resign as leader of the Conservative Party, and renewed US-Iran tensions after the US accused Iran of attacking two oil tankers just outside the Persian Gulf. In response, both the US Federal Reserve (Fed) and the European Central Bank (ECB) signalled their willingness to adjust monetary policy to boost growth should it be needed, while the Reserve Bank of New Zealand (RBNZ) and the Reserve Bank of Australia (RBA) actually went one step further and lowered their respective cash rates to record lows. In fact, the RBNZ became the first of the world’s major central banks to start loosening monetary policy this cycle.

More broadly, stocks also benefited from some encouraging US earnings results, fresh Chinese stimulus and late hopes that a meeting between Trump and Chinese president Xi Jinping on the sidelines of 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 country level, US stocks hit a series of record highs during the quarter. Share markets were also positive in Europe, the UK and Japan but fell in China as escalating trade tensions with the US weighed on sentiment.

Australian shares made strong gains over the period, driven largely by mounting speculation softer economic data would force the RBA to cut interest rates; which it ultimately did in June. The local market also benefited from the Coalition’s surprise election win, further domestic corporate activity and good gains across the ‘Big Four’ banks and major miners. Sentiment was further buoyed by dovish Fed and ECB rhetoric and a positive lead from major overseas markets. Limiting the gains was softer domestic growth, some mixed earnings updates and heightened geopolitical uncertainty.

RBA cuts interest rates

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 its post-meeting statement, the RBA said that while employment growth had been strong, there’d been little further inroads into the spare capacity in the labour market of late.
• It also noted that recent inflation outcomes had been lower than expected, pointing to subdued inflationary pressures across much of the economy.
• However, the Bank said it still expected the local economy to grow by around 2.75% this year and next, supported by increased investment in infrastructure and a pick-up in activity within the resources sector.
• In concluding its June meeting, the RBA said lowering the 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 July. The Bank said it will continue to monitor developments in the labour market closely and adjust monetary policy if needed to support sustainable growth in the economy and the achievement of the inflation target over time.]

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.

Domestic growth continues to disappoint

Australia’s economy continued to slow in the first quarter of 2019, with gross domestic product for the three months ended 31 March coming in at just 0.4%. Whilst the outcome was double the 0.2% growth recorded in the final quarter of last year, it was nonetheless below the 0.5% most economists had been expecting.

Underpinning the softer result was weaker household spending, which contributed just 0.1% to the overall outcome as households cut back on discretionary purchases. Growth was also impacted by weaker construction activity, while commodity exports and government spending on things like aged care, health and disability services helped prop up the result.

On an annual basis, the economy grew just 1.8%; down on the 2.3% growth recorded in the 12 months ended 31 December. It also marked the economy’s worst yearly performance since the global financial crisis.

Australian dollar weaker

The Australian dollar (AUD) was weaker in the second quarter, falling to levels not seen since early 2016. The local unit fell on the back of 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 AUD was also impacted by some mixed earnings updates and ongoing US-China trade frictions. Limiting the decline were stronger iron ore prices and a strong, albeit short-lived, bounce in the wake of the Coalition’s surprise election win.

The AUD fell 3.8% against the Japanese yen, 2.2% against the euro and 1.0% against the US dollar (USD). It rose 2.1% against the British pound, while the broader Australian Trade-Weighted Index¹ closed the quarter 0.7% lower.

Looking ahead

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. 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.