Global share markets stronger
Global share markets made strong gains in the third quarter, benefiting in part from another round of positive US earnings results, with the likes of Apple, Walmart, PepsiCo and Amazon.com all beating analysts’ expectations. In saying that, there were some notable misses, including Netflix and Facebook; the latter falling sharply after management surprised investors by downgrading the company’s short-term growth outlook.
Stocks also benefited from some encouraging European and Japanese earnings, an upward revision to already-strong US June quarter growth figures, and some encouraging rhetoric from US Federal Reserve (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, improving US jobs and consumer confidence figures, and news the US had agreed a deal with Mexico to address key parts of the North American Free Trade Agreement; or NAFTA as it’s more commonly known.
Limiting the gains was an escalation in the trade dispute between the US and China, weaker commodity prices and ongoing concerns surrounding Britain’s exit from the European Union. Stocks were also impacted by renewed political uncertainty in Italy and fears that fresh economic crises in emerging markets like Turkey and Argentina could spread to other countries.
At the country level, US stocks hit further record highs as they recorded their best quarterly performance since the fourth quarter of 2013. Share markets in Japan and Europe were also higher, while the UK and China both struggled.
Australian shares were stronger over the period; the local market gaining on the back of some positive domestic earnings updates, a drop in the unemployment rate to a near six-year low and news the local economy expanded at its fastest pace in six years in the June quarter. Stocks also benefited from further corporate activity—notably the merger between TPG Telecom and Vodafone—and evidence that China’s economy is holding up after second-quarter gross domestic product (GDP) data printed in line with expectations
Limiting the advance were mixed performances from the ‘Big Four’ banks as financials generally struggled amid the ongoing fallout from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Stocks were also impacted by another soft inflation reading, weaker commodity prices and heightened political uncertainty in Canberra after Malcolm Turnbull was ousted as Prime Minister.
RBA leaves interest rates on hold
The Reserve Bank of Australia (RBA) left the official cash rate on hold at a record low 1.50% throughout the period, 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 household income growing slowly and debt levels still 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 70% chance of a rate hike by the end of 2019.
Domestic economy expands
The Australian economy continued its expansion in the second quarter of 2018, with GDP for the three months ended 30 June coming in at 0.9%. Most economists had anticipated growth of 0.7%. Stronger domestic demand contributed the most to the outcome; accounting for more than half of all growth over the period. The result means the local economy remains firmly on track to make it 27 straight years without a recession, especially given current low levels of interest rates and increased government spending on infrastructure.
On an annual basis, the economy grew 3.4%; its fastest pace in almost six years and up on the revised 3.2% growth recorded in the 12 months ended 31 March.
Australian dollar falls
The Australian dollar (AUD) was weaker in the third quarter; the local unit falling as trade tensions between the US and China escalated, commodity prices tumbled and the yield differential between US and Australian government debt widened. The AUD was also impacted by fresh economic crises in emerging markets and speculation domestic interest rates will remain lower for longer following another disappointing inflation reading.
Limiting the currency’s decline were a series of encouraging domestic earnings updates, better-than-expected GDP growth data and further merger and acquisition activity.
The AUD fell 2.3% against both the euro and the US dollar (USD), and 2.0% against the British pound. It rose 0.2% against the Japanese yen, while the broader Australian Trade-Weighted Index1 closed the quarter 0.6% lower.
We expect volatility to continue into 2019, 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.
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.