The United States' economy is firing on all cylinders: the labour market has reached full employment and recent corporate tax cuts have boosted growth. Global interest rates remain low by historical standards. Meanwhile the Australian economy is into its 27th year without a recession. Conditions couldn't be better to invest in equities… right?
Unfortunately we believe the best part of this cycle is behind us. This doesn't mean there will not be growth but it will likely subside. We need to consider this against the level of growth factored in by markets. We believe now is the time to focus on building defensive portfolio allocations in anticipation of more attractive opportunities.
We base this view on our assessment of the primary drivers for equity markets: interest rates, corporate profits and risk.
Global inflation has finally started to lift although it remains modest by historical levels. With the US economy surging, the Federal Reserve will most likely continue hiking interest rates well into 2020. Financial conditions in the country are also beginning to tighten and with housing affordability at a post-GFC low, the housing market may start to plateau.
This has seen rates on the benchmark 10 year bond in the US spike to their highest level since mid-2011 (refer chart below) and we expect there's more to come. With risk asset values commonly tied to bond yields, such moves will be a headwind to equity valuations.
Interest rates in Australia remain low with consensus expecting the Reserve Bank to remain on hold for at least another year. However Australians are not immune to rising rates. Events in the US have lifted the cost of funding for our major banks who are passing them onto consumers by hiking mortgage rates.
Notwithstanding the sugar hit from tax cuts, we also see headwinds for corporate earnings heading into 2019. Cost pressures are rising across a number of areas:
- Energy prices are clearly rising: just visit your nearest bowser. With oil prices at 4 year highs, there's unlikely to be any near-term respite particularly if the US places an embargo on Iran;
- Labour costs in the US are moving higher as a result of the economy operating at full employment;
- Tariffs (across timber, steel & aluminium) are impacting input costs for US homebuilders and manufacturers and will start to impact consumer prices before Christmas; and
- The strengthening US dollar will also act as a further headwind to many US-based companies. While the softening Australian dollar will support exporters, it will unfortunately increase the cost of internationally-sourced inputs.
While we do not expect corporate earnings to fall, we believe the scene is set for growth in profits to decelerate: a drag for share markets.
Markets have become complacent: the experience of January and February appears to have already been forgotten. There is a list of well-known uncertainties, each of which is continuing to slowly deteriorate.
Some of the key risks include:
- China, where the Communist Party must now manage the economy away from credit-fuelled investment to more sustainable growth drivers. The country's long-standing reliance on debt remains an area to watch. Meanwhile it's battling a US President determined to change their approach to global trade.
- Europe remains a constant source of uncertainty. The Brexit deal deadline is only 5 months away and both sides couldn't be further from agreeing to terms. Meanwhile the populist Italian government continues to challenge the EU's stance on exercising fiscal restraint.
- In Australia, there's a noticeable shift in political risk. The potential for goal posts to be materially shifted has risen substantially when one considers two Royal Commissions (Banking and Aged Care) along with the heightened scrutiny of energy retailers. A Federal Election also remains due for 2019…
For the bulk of the past two years, the drivers discussed above have been in the positive range. They are now all neutral at best, with the outlook for each pointing to further slippage in the year ahead. We continue to prefer international equities (over Australian) given the broader and more attractively valued set of opportunities found offshore. While we do not believe it appropriate to materially reduce equity weightings, we feel it is appropriate to be prepared for a tougher growth outlook.