Investment update - September 2018

The global economy continued to show signs of overall improvement, most notably with economic data in the US proving to be robust yet again. Nevertheless, political uncertainty continued to be plentiful across the globe, led by President Trump’s announcement of tariffs on an additional US$200 billion worth of Chinese imports. Rising tensions between the US and Turkey, paired with interest rate increases by the US Federal Reserve led to a massive currency depreciation in the Turkish lira in August, which spread to several other emerging market currencies. Uncertainty remains with respect to the political situation in Europe as the coalition government in Italy unveiled its budget, which includes a larger than expected deficit. Even Australia joined in on the political uncertainty, with a change of prime minister following a leadership spill in August.

It was a strong quarter for developed market equities, with continued positive economic data from the US helping support corporate earnings as the global economy continues to recover. Unhedged developed market equities were the best-performing asset class category for the September quarter, with the strengthening US dollar helping to further buoy returns to 7.4% for the quarter and 20.8% for the year.

Emerging markets equities were, by comparison, weak for the September quarter. The poor performance reflects continued geopolitical concerns relating to trade tensions between the US and China, as well as localised uncertainty in nations such as Turkey and Argentina.

Fixed interest markets were impacted by the increasingly optimistic US economic outlook, with the after-effects of President Trump’s tax cuts driving up both inflation and real GDP growth. As a result, the 10-year US Treasury yield breached the 3.0% mark in late September, before rising to a multi-year high of 3.2% in early October. The increase in yields led to broadly negative fixed interest returns over the month of September, and to some extent, the third quarter.

Australia

The Australian economy grew at an impressive rate of 0.9% over the second quarter of 2018, which led to an annual rate of 3.4% for the year, the highest annual rate in the past six years. The strong growth figure was largely on the back of higher than expected dwelling investment and export growth. Second quarter inflation came in at 2.1% year-on-year, representing just the second time in four years that the rate was within the RBA’s 2-3% target range for inflation. Meanwhile, the nation’s unemployment rate remained at a relatively low 5.3%, but perhaps more importantly, underemployment (the rate of people either unemployed or working less or at a lower level than they would prefer) fell by 0.3% to 8.1%.

The nation’s housing market continued to be a point of focus over the third quarter of 2018. House prices in several mainland cities have experienced notable declines, with the largest being felt in Sydney and Melbourne, marked by annual falls of 6.1% and 3.4% respectively for the year ending in September. The decline in house prices follows a tightening of credit standards by the nation’s major banks as well as rising wholesale funding costs, the latter of which led to several of the country’s retail banks raising lending rates out of cycle.

Unsurprisingly, the RBA kept rates unchanged throughout the quarter ending in September. Markets are currently not pricing in a hike as probable until early 2020, which means that the RBA’s cash rate will have remained static for over three and a half years if this eventuates. The bank’s meeting minutes continue to reflect optimism about both the local and global economies, however the bank remains concerned about the very high household debt levels.

United States

Economic data in the United States continued to prove to be robust. In the year ending in June, the US economy grew by 4.2% and corporate profits increased by an annual rate of 7.7%. US unemployment remained at 3.9%, with hourly earnings likely to continue to support inflation after reaching a decade-high annual rate of 2.9%, while jobless claims fell to their lowest level in nearly 50 years.

The US Federal Reserve stayed on course for up to four interest rate increases over the course of 2018 by implementing its third of the year at its September meeting. The 25-basis point rate hike brought the federal funds rate to the 2.00-2.25% range. While the ongoing trade tensions between China and the US have the potential to disrupt the US growth story, the stimulative effect of the tax reform implemented at the end of 2017 has allowed the Federal Reserve to continue on its monetary tightening path. The rate hikes from the Federal Reserve have led to US dollar strength, including versus the Australian dollar. Given that the RBA continues to be firmly on hold, the rising rates from the Fed have caused the interest rate differential between Australian interest rates and American interest rates to be the most negative in the past 25 years. This has made the US dollar relatively more attractive than the Australian dollar, leading to US dollar strength.

Europe

In contrast with the US, the European economy continued to underperform. Annual GDP growth for the eurozone came in at just 2.2% for the year ending in June, the slowest rate in over a year. Core inflation fell slightly to 1.0%. While the continent’s unemployment rate has continued to fall, it appears that the relatively tighter labour market has had limited impact on wage growth and inflation.

Italy continues to be a source of political controversy and uncertainty. The country’s populist coalition government announced a budget with an expected deficit of 2.4% of GDP. The deficit arises from the government’s plan to boost welfare spending, allow for partial amnesty on unpaid taxes and lower the retirement age. The EU has a ceiling in place on member budget deficits of 3.0%. While the Italian government’s proposal is well below the EU limit, investors are concerned because the Italian government is already highly indebted and there had been the expectation that the government would take measures to trim the deficit rather than increase it. The Italian bond market is the world’s fourth largest, and the fiscal positioning saw Italian ten-year government bond yields push out to over 3.5% in early October – the highest since early 2014.

The political landscape continues to be messy in the United Kingdom, with Brexit negotiations proving to be a very challenging task for Prime Minister Theresa May. The EU rejected May’s ‘Chequers plan’, which detailed her vision of the UK’s post-Brexit relationship with the EU, claiming that the plan did not come close to satisfying the needs of the EU. May’s plan also led to the resignation of two Brexit-supporting MPs, Boris Johnson and David Davis. The likelihood of an amicable agreement is looking increasingly unlikely, particularly in light of the looming 31 March 2019 deadline. Furthermore, given the discontent among British politicians in general, May’s position as Prime Minister looks to be precarious.

China

China’s economic growth slowed slightly to an annual rate of 6.7% for the year ending in June, down from 6.8% in March. The country continues to post impressive economic growth despite the ongoing challenges it is facing. On top of grappling with the implications of the tariffs implemented by the Trump administration, the Chinese government is also trying to deleverage its financial sector by reining in excessive debt growth, improve the quality of life in the country and tighten pollution controls.

After initially appearing to be unfazed by the trade tensions with the US, the announcement of tariffs on a further US$200 billion of Chinese imports in September appears to finally be hitting home for Chinese businesses. Sentiment gauges for both manufacturing and services have been creeping downwards closer to the 50-mark that delineates expansion from contraction. It appears as though the depreciating renminbi and the tariffs’ impact on the cost of raw materials have started to flow through to firms.

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