Global share markets tumble
Global share markets fell sharply in October, driven in part by a spike in bond yields early in the period, a series of softer-than-expected European economic data and heightened geopolitical uncertainty; most notably ongoing US-China trade frictions. Stocks were also hampered by some disappointing European earnings results, softer Chinese economic data and the prospect of higher interest rates as central banks move away from their post-GFC emergency policies. Share markets were further impacted by news the International Monetary Fund had downgraded its global growth forecast for this year, fears over emerging markets contagion and nervousness ahead of upcoming US midterm elections.
Limiting the decline was some encouraging rhetoric from European Central Bank president Mario Draghi, who remained unfazed by recent softer economic data in the region, and some positive earnings updates from the likes of Boeing, Microsoft and Facebook. In saying that, there were a few notable misses on the earnings front, including Amazon.com and Google parent, Alphabet.
Stocks also benefited from news Chinese policymakers intend to introduce additional measures aimed at boosting growth, speculation recent volatility could prompt the US Federal Reserve (Fed) to rethink the pace at which it raises interest rates, and some late bargain hunting as investors stepped in to pick up beaten-down names at a discount.
At the country level, stocks were significantly lower in the US, Japan, China, Europe and the UK. In the US, the benchmark S&P 500 Index recorded two separate six-day losing streaks for the first time in its history, while the tech-heavy NASDAQ posted its biggest monthly decline in almost a decade.
The Australian share market was also sharply lower in October, driven by weakness across the major miners and the ‘Big Four’ banks, lingering US-China trade tensions and a series of mixed shareholder updates. Sentiment was further impacted by another soft inflation reading and further domestic political uncertainty after Independent candidate Kerryn Phelps claimed victory in the Sydney electorate of Wentworth; a seat which was previously held by ousted prime minister, Malcolm Turnbull. Limiting the decline was a drop in the unemployment rate to just 5.0%, further merger and acquisition activity, and bargain hunting after stocks became technically oversold.
Interest rates on hold
The Reserve Bank of Australia (RBA) left the official cash rate on hold at a record low 1.50% in October, with officials remaining cautiously optimistic without showing any urgency to deviate from current policy.
In its latest post-meeting statement, the central bank said it expects domestic growth to average a bit above 3.0% this year and next, employment growth to continue to improve and inflation, which is at the lower end of the RBA’s 2-3% target range, to be higher in 2019 and 2020 than it is now. 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 expect the RBA will raise interest rates in the second half of next year, as wage and price inflation rises further. At the time of writing, the market is pricing in around a 40% chance of a rate hike by the end of 2019.
Australian dollar falls
The Australian dollar (AUD) was weaker in October; the local unit falling amid lingering trade and political uncertainties, a further widening in the yield differential between US and Australian government debt, and general US dollar (USD) strength. The currency was also impacted by weaker commodity prices and further domestic political upheaval.
The AUD fell 2.1% against the Japanese yen and 1.9% against the USD. It rose 1.0% against the British pound and 0.8% against the euro, while the broader Australian Trade-Weighted Index1 closed the month 0.5% lower.
We expect volatility to continue through the rest of 2018 and into next year, as investors contend with US policy agenda, potential further US rate hikes, higher bond yields and potential normalisation of monetary policy outside the US. Geopolitical uncertainty poses a further risk, with investors shifting their attention to the threat of trade wars. Acts of retaliation, particularly from China, already have had negative impacts on emerging markets. The spectre of trade war escalation and the potential impacts on global growth will need to be watched closely.
Relative to the US, we still believe other developed markets represent better value. Whilst Europe has significantly underperformed this year, we maintain the view that European equities are fairly valued. We note that European economic data surprise has shifted from deeply negative to more positive, which translates to an improved potential to beat scaled-back expectations. Risks from Italy, Turkey and Brexit still remain, however they appear less threatening than earlier this year. The risk of an escalating trade war must also be watched, as Europe has a significant trade exposure to emerging markets and could be hurt from automobile tariffs.
Emerging markets assets have weakened from a stronger USD and have reached oversold conditions recently. Momentum from positive corporate earnings has slowed, but resilient economic growth means they still offer attractive long-term value relative to their developed peers. Geopolitical risks still remain along with the threat of tighter US monetary policy, additional USD strength and further trade war escalation. Needless to say, with equity markets remaining expensive late-cycle, a cautious approach is warranted; particularly given the uncertainty around the pace of Fed rate hikes and global trade issues.
Our base case is for the Fed to raise interest rates once more in December, and a further three to four times in 2019. Our more hawkish outlook has been driven by a reacceleration of wage growth along with strong data from US business surveys that show healthy manufacturing confidence.
We feel bonds remain expensive and may face headwinds in the form of potential rising inflation and higher US yields, especially given that 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 away from their accommodative monetary policy stances.
We hold an unfavourable view on high-yield debt, as valuations have become stretched given the compression in credit spreads to near-historical lows. Conversely, we favour local currency emerging markets debt, with fundamentals remaining strong. However, we acknowledge that the prospect of tighter monetary policy may present increasing challenges across certain parts of the emerging markets complex, such as Mexico and Indonesia.
In terms of currencies, the USD has staged a recovery in 2018, 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. We observe signs that the current USD rally is stretched, given overall market positioning and the recent improvement in economic data in other G4 regions. Based on value metrics of real effective exchange rates, the USD is one of the most expensive currencies in the G10 universe. Our view is that the current rally is technical in nature rather than the beginnings of a renewed USD structural bull market.
We continue to hold a preference for the Japanese yen, given the solid economic data flow from Japan, including strong external demand and a tightening labour market. The yen is also attractive from a ‘safe haven’ perspective, as it is the currency most negatively correlated with global equity returns.
The AUD has suffered this year, driven by the widening US-Australian bond yield differential and the geopolitical risks negatively impacting China and other emerging markets. The future direction of the AUD is likely to continue to be influenced by these factors, along with commodity price movements.
Overall, we expect global growth to remain modestly positive into next year, with downside risks of further selloffs as markets continue to adjust to potentially higher levels of interest rates and changes to monetary and fiscal policy, especially in the US. Importantly, we believe financial markets will continue to provide further investment opportunities for our active management approach.
1The 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.