Global shares

Global share markets struggled over the past 12 months, returning -7.5%1in local currency terms. In unhedged Australian dollar (AUD) terms, stocks returned -7.6%2.

Share markets began the year well, with stocks rising in January as investors responded positively to more encouraging US earnings results and further evidence economic activity globally was gathering momentum. However, share markets moved sharply lower in early February as US bond yields shot to a four-year high following the release of stronger-than-expected wages data; the surprising outcome sparking fears the Fed may accelerate its rate hike agenda. Helping accentuate the decline was a rapid unwinding of so-called ‘short volatility’ trades as volatility spiked sharply higher in the wake of the release.

Whilst stocks did recover somewhat toward the end of February as investors bet the selloff was nothing more than an overdue correction following an extended period of gains, this optimism proved to be short-lived after 13 Russian nationals were indicted for allegedly interfering in the 2016 US presidential election. Share markets were also impacted by further US political uncertainty, including Trump’s sacking of his Secretary of State, Rex Tillerson, and the threat of a potential US-China trade war after Trump slapped around USD50 billion in tariffs on Chinese imports.

Optimism returned to share markets in the second quarter thanks to yet another round of encouraging US earnings results, improving US jobs data and stronger commodity prices. Sentiment was further buoyed by news the European Central Bank expected to leave interest rates on hold until at least midway through 2019, and some encouraging Chinese economic growth; the world’s second-biggest economy expanding 6.8% in the March quarter.

However, this optimism was tested by rising geopolitical risks, including an escalation in US-China trade tensions and Donald Trump’s decision to quit an international deal with Iran aimed at preventing the country from acquiring nuclear weapons. Stocks were further impacted by the US Federal Reserve (Fed)’s decision in June to accelerate its rate hike agenda and some softer-than-expected Japanese growth data; the latter’s economy contracting 0.2% in the first quarter and ending a run of eight consecutive quarterly expansions.

The third quarter saw further share market gains, with investors responding positively to better-than-expected earnings results from the likes of Apple, Walmart and 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 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 escalated and concerns over Brexit negotiations mounted.

Share markets ended the year on a sour note, with stocks falling sharply on the back of 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 by increasing fears over Brexit, the Fed’s decision to raise interest rates yet again in December, and further evidence that growth in China is slowing; the latter suggesting the country’s standoff with the US is 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.

At the regional level, stocks in China (-25.3%3), Japan (-17.8%4), Europe (-14.3%5), the UK (-12.5%6) and the US (-6.2%7) were all significantly lower for the year.

Australian shares

The Australian share market was also weaker in 2018, with the S&P/ASX 300 Accumulation Index closing the year 3.1% lower. The local market traded higher for much of the period, benefiting from some positive earnings updates, some encouraging economic data – notably declining unemployment – and further merger and acquisition activity; the latter including takeover bids for Healthscope and Investa Office Fund, as well as the proposed merger between TPG Telecom and Vodafone. However, the market ultimately struggled to hold onto these gains as commodity prices tumbled, US-China trade tensions escalated and the latest domestic growth reading disappointed. We also saw the ‘Big Four’ banks, which together comprise a large part of the index, weaken amid the ongoing fallout from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. The local market was further impacted by heightened political uncertainty in Canberra following the removal of Malcolm Turnbull as Prime Minister.

At the sector level, communication services (-14.8%), financials (-9.8%) and energy (-8.6%) posted the biggest losses over the period. Utilities (-4.9%) and consumer discretionary (-4.0%) were also weaker for the year, while healthcare (17.7%) and information technology (10.0%) recorded the strongest gains.

In terms of central bank activity, the Reserve Bank of Australia (RBA) left the official cash rate on hold at a record low 1.50% throughout the year. In its latest (December) post-meeting statement, the bank said it expects domestic growth to average around 3.5% this year and next, before slowing in 2020. Officials also noted that the labour market remains positive and that inflation, which is at the lower end of the RBA’s 2-3% target range, is expected to pick up over the next couple of years, with the pick-up likely to be gradual. Meanwhile, the outlook for household consumption remains a concern, with growth in household income low and debt levels high. The RBA concluded its latest meeting by saying that "taking account of the available information, the Board judged that holding the stance of monetary policy unchanged… would be consistent with sustainable growth in the economy and achieving the inflation target over time."

We still see a chance that the RBA will raise interest rates to 1.75% in the second half of 2019 as wage and price inflation rises further. However, in recent months, consensus expectations for the 2019 year-end cash rate have fallen from 1.75% to the current level of 1.50%. Moreover, market pricing at the beginning of January 2019 points to a significant chance of a rate cut by December 2019. In fact, there is much uncertainty surrounding the domestic interest rate outlook, with June 2020 cash rate forecasts by leading economists ranging from 0.75% to 2.25%.

Real estate investment trusts

Australian real estate investment trusts (REITs) performed relatively well over the past 12 months, closing the period up 3.3%8. Local property stocks benefited from lower long-term bond yields, some encouraging domestic earnings updates and some notable corporate deals; including US firm Blackstone’s bid for Investa Office Fund and Unibail-Rodamco’s massive USD32 billion play for Westfield. Australian REITs were also supported by expectations domestic interest rates will likely remain lower for longer.

Global REITs (-4.0%9) underperformed their Australian counterparts over the year. Global REITs were impacted by rising US interest rates, higher US and Italian bond yields, and renewed concerns toward the end of the period that global growth may be moderating.

Bonds and cash

Global bonds made only modest gains for the year, returning 1.7%10. Most major global long-term bond yields fell over the period as investors favoured the asset class’s traditionally defensive characteristics in the face of heightened political and trade uncertainties. US and Italian yields were notable exceptions; the former rising after the Fed raised interest rates four times throughout the year.

Australian bonds outperformed their global counterparts over the period, rising 4.5%11. The yield on domestic 10-year government debt fell 31 basis points over the past 12 months; though much of the decline came in the final quarter as investors shunned risk assets amid fresh global growth concerns and elevated geopolitical risks.

Meanwhile, both global and Australian credit markets weakened over the year as spreads widened in response to escalating geopolitical risks and renewed fears regarding the global growth outlook.

Cash returned 1.9%12 over the past 12 months, outperforming global and domestic shares, global REITs and global bonds, but underperforming Australian bonds and Australian REITs.

Australian dollar

The AUD ended the year lower, thanks in part to rising US interest rates, heightened geopolitical risks and expectations softer inflation and wages data will force the RBA to keep interest rates on hold for longer. The local currency was also impacted by a widening in the yield differential between Australian and US government bonds, weaker commodity prices and evidence that Chinese growth is slowing. Limiting the decline were some encouraging domestic earnings results and some upbeat rhetoric from RBA officials regarding the domestic growth outlook.

The AUD fell 11.4% against the Japanese yen, 9.5% against the US dollar (USD), 5.4% against the euro and 4.0% against the British pound. Meanwhile, the broader Australian Trade-Weighted Index13 closed the period down 6.5%.

Where to from here?

Volatility returned in 2018 and will likely continue in 2019. As late-cycle risks rise, there are several issues which remain on investors’ minds, including tightening US monetary policy, global trade war escalation, budget conflict between Italy and the European Union, and uncertainty over Brexit. To add further complexity, it’s likely both economic and corporate earnings growth will slow in the US.

In a volatile equity market environment, we have a neutral view on global equities overall. We believe that Europe and Japan still represent better relative value compared to the US. For Europe, we believe consensus expectations have become too pessimistic. Our base case is for the negative risks associated with Italy’s budget, Brexit and global trade uncertainty to fade in 2019, and for European corporate earnings and economic growth to improve. We continue to like valuations for emerging markets equities, particularly given their attractiveness relative to developed markets. However, the threat of trade wars, slowing economic growth in China and a stronger USD temper our view.

For fixed income assets, we see the cycle as a headwind for bond markets, given the risk of rising inflation pressures and tighter monetary policy from major global central banks. We feel bonds remain expensive, especially given the US labour market is tight. Any selloff in bonds could be amplified if the Fed decides to raise interest rates at a faster pace than expected, and if global central banks shift further away from accommodative monetary policy stances. We believe high-yield credit remains expensive, which is typical late in the cycle when profit growth slows and concerns over defaults rise.

In terms of currencies, the Japanese yen remains our preferred currency. 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 also think the USD has modest upside potential, driven by interest rate differentials between the US and the rest of the G10. The strength of US growth relative to the rest of the world will continue to have implications on USD movements. With the RBA unlikely to shift monetary policy, we think the AUD will continue to be impacted by the US-Australian bond yield differential, geopolitical risks involving China and other emerging markets, and commodity price movements.

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 2020. Overall, we expect global growth to remain modestly positive, with volatile equity markets to deliver mid-single-digit returns. Downside risks of further selloffs remain, 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 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 Japanese shares measured by the TOPIX Index
5 European shares measured by the Dow Jones EuroStoxx 50 Index
6 UK shares measured by the FTSE 100 Index
7 US shares measured by the S&P 500 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.