In our last blog, our view was that "the best part of the cycle is behind us. This doesn't mean there will not be growth, but it will likely subside…we believe now is the time to focus on building defensive portfolio allocations in anticipation of more attractive opportunities".
We hadn't expected to be on the money so soon.
Since posting the article markets have notably weakened: global equities are down 6%, while Australian equities are about 5% weaker. In fact, both global and domestic equity markets are now about 6% below where they started 2018.
Similar to early 2018, volatility has returned: doubling (according to the VIX index) in the space of a week in early October. We note that outside short bouts of uncertainty, markets have experienced abnormally low levels of volatility for the past six years: something we have been warning clients about for some time.
So what has led to the recent uncertainty? The media is quick to call out:
- The continued trade dispute between China and the United States; and/or
- A perception that economic momentum is slowing, as evidenced by a minor slowdown in revenue growth amongst US technology (FAANG) stocks.
While not entirely discounting them, we believe there were other factors at play.
First, we began to see analysts refine their growth forecasts for 2019. In the context of a tight US labour market, rising global interest rates, further increases in the cost of raw materials and political uncertainty across the globe; growth forecasts were being reduced. By early January, we expect global earnings forecasts to have been reduced by 2% to 3% and settle at a growth rate of around 6% to 7% for the year ahead. To be clear: this remains a decent level of growth.
Secondly, we saw a rapid decline in the price of oil: down almost 30% in less than two months on the back of slowing demand (in response to the higher price) and rampant production growth from the US (now the world's largest oil producer). While we expect OPEC to act and stabilise oil markets, the recent movement comes as a double-edged sword for investors: Energy sector growth will be clearly impacted, yet the global economy receives a quasi-tax cut.
Consumers will see lower petrol prices, leaving them with more disposable income. Meanwhile for economies, the cost of energy (power and transportation) rapidly falls, assisting to reduce inflationary pressures. The latter could prove crucial for the US Federal Reserve which remains on a path of lifting interest rates. We may well see the Fed pause rate hikes sometime in 2019, providing a degree of support to equity markets.
With this in mind, our outlook for equity markets hasn't really shifted since our last update. The three key drivers - interest rates, profits and risks - remain neutral at best. However, what has improved are valuations.
Given recent share price movements have far outweighed analysts' earnings revisions, valuations have become far more attractive, particularly in international markets. We now have the opportunity to buy US equities, growing at 8% to 9%, at a very reasonable 15.6x next year's earnings. Unfortunately it remains a different story for Australian equity investors with our market (excluding banks and resources) continuing to trade at an elevated 22x multiple of next year's earnings (for a modest 4% to 5% growth).
We will remain opportunistic in our approach to portfolio management, looking to invest during times of weakness while ensuring our defensive allocations to Cash and Fixed Income remain solid.