Global share markets tumble
Global share markets fell sharply in the fourth quarter. Stocks began the period on the back foot amid a series of softer-than-expected European economic data, some disappointing European earnings results and ongoing US-China trade uncertainty; though a truce between the two countries toward the end of the period did provide some hope of a near-term resolution. Stocks were also impacted early by the prospect of higher global interest rates as central banks move away from their post-GFC emergency policies.
However, much of the losses came in December, driven by the mess that is Brexit, the US Federal Reserve (Fed)'s decision to raise interest rates 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 soured 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 federal government.
Limiting the decline were expectations US interest rates are nearing what the Fed sees as a 'neutral' level, and some positive earnings updates from the likes of Boeing, Microsoft and Facebook; all of which beat analysts' expectations. In saying that, there were a few notable misses on the US earnings front, including Amazon.com and Google parent, Alphabet. Stocks also benefited from news Chinese policymakers had introduced additional measures aimed at boosting growth, and some late bargain hunting as investors stepped in to pick up beaten-down names at a discount.
At the country level, US stocks fell from their recent record highs. In fact, both the S&P 500 Index and the Dow Jones Industrial Average narrowly avoided entering a bear market late in December, while the tech-heavy Nasdaq wasn't so lucky. Share markets in Japan, Europe, the UK and China were also sharply lower for the quarter.
Like their global counterparts, Australian shares struggled over the period. The local market traded lower amid an early spike in bond yields, weakness across the major miners and the 'Big Four' banks, and lingering US-China trade uncertainty. Stocks were also hindered by a series of mixed shareholder updates, further evidence China's economy is slowing and some disappointing third-quarter growth data. Sentiment was further impacted by yet another tepid inflation reading, rising US interest rates and a poor lead from major overseas markets.
Limiting the decline was a drop in the unemployment rate to just 5.0% and the Reserve Bank of Australia (RBA)'s decision to maintain its improved growth forecasts despite the latest gross domestic product (GDP) figures. The market also benefited from further merger and acquisition activity, and some late bargain hunting.
RBA leaves interest rates on hold
The RBA left the official cash rate on hold at a record low 1.50% throughout the period, with December's meeting marking the 28th consecutive month without a move in either direction. In its latest post-meeting statement, the bank said it still 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."
At Russell Investments, 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%.
Domestic economy expands, albeit less than expected
The Australian economy continued its expansion in the third quarter of 2018, with GDP for the three months ended 30 September coming in at 0.3%. However, the outcome was the economy's weakest quarterly print in two years and well below the 0.6% growth that most economists had been expecting. The softer result was driven mainly by a sharp decline in mining investment and a slowdown in consumer spending. A slowdown in household consumption also impacted the outcome, while government spending and net exports both contributed positively to overall growth.
On an annual basis, the economy grew 2.8%; down on the revised 3.1% growth recorded in the 12 months ended 30 June.
Australian dollar falls
The Australian dollar (AUD) was weaker in the fourth quarter; the local unit falling amid ongoing trade and political uncertainties, some disappointing third-quarter growth data and another soft inflation reading. The currency was also impacted by further evidence Chinese growth is slowing, weaker commodity prices and general US dollar (USD) strength. Limiting the decline was the RBA's decision to maintain its improved growth forecasts despite the latest GDP reading, and further encouraging jobs data.
The AUD fell 4.9% against the Japanese yen, 2.3% against the USD and 0.4% against the euro. It rose 0.8% against the British pound, while the broader Australian Trade-Weighted Index1 closed the quarter 2.4% lower.
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 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.