Investor Insight

July 2019

Ian Gillies talks to John Green and Kane Baranow about the second quarter of the 2019 calendar year.

They also discuss our approach towards markets for the remainder of the calendar year and why.


Ian Gillies 0:10
Hello and welcome. I’m Ian Gillies and welcome to the Hamilton Wealth Management podcast number 29 for July 2019. I’m joined today by John Green in Canberra now. John will discuss recent markets and fixed interest and Kane will talk about equity property alternatives and John will finally comment on our outlook. Market volatility has formed over the last quarter of central banks globally striking accommodating tone, clearly putting the likelihood of further monetary policy easing back on the agenda. John, how do we see this possibility playing out market context?

John Green 0:46
Thanks Ian. Look, despite the calmer markets, there’s no doubt that uncertainty does remain particularly with respect to the ongoing US China trade dispute. And this remains a market risk. The Trump Xi meeting at the G20 gathering and the saga being an important next step and the negotiations. Bond markets are continuing to rally reflecting continued low inflation expectations and concern over the outlook for global economic growth. For now, equity markets are not reflecting this growth concern and they’ve continued to rally also encouraged by the promise from the central bank’s that they will do what they can to keep their economies moving. We often talk about the views of our Economic Advisers Capital Economics in London, who Will visted in June. Capital Economics are not forecasting recession but they are forecasting a significant slowdown in US growth and accounting the Fed funds rate in the US later in the second half of this calendar year. We do need to discuss the impact of the tariff wars. President Trump has been gleefully saying that the US has been receiving billions of dollars in tariffs. But this is patently incorrect. The tariff is actually a tax on imported goods and therefore is being paid by the US importers, not the Chinese exporters, and therefore these are going to result in higher prices for the US consumer. The US has also spent most of the tariffs revenue on agricultural subsidies, effectively ensuring that these tariffs are fiscally neutral. There’s also talk that substitution is now taking place the US buying from countries other than China but at a higher price than the pre tariff imported goods. Capital Economics estimates that the tariffs are directly reduce China’s GDP by point 3%. The US by point 2%, and global GDP by point 1%. Capital Economics also argues that there is an indirect cost of the tariffs, that being deferral of investment decisions tied to credit conditions and reduce business confidence. They believe this will shade and additional 2 points from global GDP. Therefore, whenever with the direct impact, the trade was affected global growth by point 3 points with the global GDP overall having fallen from around 4% to 3% over the last year. The risk of course in Capital Economics views is that the US economy remains stronger than they anticipate. And while this is always possible, it could only occur on the back of productivity improvements. The market remains optimistic on earnings and if they disappoint the equity markets will come under pressure. The further melt up in equity markets would not surprise us in the near term. But we do continue to support the Capital Economics view of a decrease in corporate earnings, which is greater than that anticipated, as growth slows in the US economy. This will lead to move down in equity markets later in 2019. Early in 2020. Capital Economics has revised their end of 2019 target for the S&P 500 up from 2300 to 2500. But listeners should know that this is still nearly 15% below current levels. We will therefore continue to fade equity market.

Ian Gillies 4:01
Thanks, John. Would you like to comment on the outlook for fixed income?

John Green 4:05
Sure. US Federal Reserve Governor Powell’s comments over the last month have signaled that the current rate hike cycle in the US is definitely over. And that rate cuts are back on the agenda provided the economic data warrants them. The market on the Fed Funds rate is pricing in a 100% likelihood of a Fed funds rate cut in July. And it’s also assuming two more cuts by year end. Weaker data at the end of June suggests that US Treasury bond yields can fall further yet. 10 year US treasury bonds started the quarter at 2.5% and ending the quarter at around 2%. Which should also be noted that the US cash to 10 year yield curve remains inverted suggesting the likelihood of recession or at least a notable slowdown within the next year. In Australia RBA governor Lowe has also taken a more dovish stance given no sign of domestic inflation pressures and some early signs of awakening in the labor market. As a result, in June, we saw our first RBA interest rate cut in nearly three years from 1.5% 1.25%. They seem certain there will be another cut in July or August and some commentators expected further cut to by year end. 10 year Australian Government bond yields started the quarter at 1.8%. And they’re ending the quarter around 1.3%. And this is a very significant move. Arguably it’s got ahead of the equity markets and in Australia, we think it’s difficult to see yields falling much further, unless inflation expectations also fall further.

Ian Gillies 5:42
Thank you John. Now to you Kane, how did equity markets progress?

Kane 5:48
Thanks Ian equity markets have been quite strong they continue to rally on the back of further reductions in interest rate expectations and not because of stronger company fundamentals such as earnings growth. This was most profound in the domestic landscape with ASX 200 rallying approximately 7.6% over the quarter, the RBA signalled that their revised estimate for the non accelerating inflation rate of unemployment known as Nehru is closer to 4.5% than 5%. Now this has led to board members signaling that lower interest rates would be required to reach this lower rate of unemployment and to bring inflation back within the bank’s target range of 2 to 3%. The surprise was out from the federal election so investors returned to equity markets, with banks leaving the gains and as investors bid up high yielding equities and embark in an environment of continually lower interest rate expectations. Global equity markets switched focus over the quarter with less attention paid to trade negotiations between China and the US and more movements been attributed to Central Bank guidance. The US Federal Reserve acknowledge that more uncertain economic outlook would keep them data dependent. while adjusting interest rates and European Central Bank governor Mario Draghi reiterated his whatever it takes comments in response to supporting the Eurozone. In in the face of again falling inflation rates. Emerging markets were mostly flat over the June quarter with trade tensions causing sharp declines in major indices during May only have this recover over June as lower Us rate expectations took the shine off the US dollar and saw flows head back into emerging markets. So we’re true to word with respect to fading the equity market rallies over the June quarter and continued to reduce exposure to small and mid cap Australian equities. Our overall exposure to Australian equities is now neutral. Our view around interest rates means that we prefer equities over fixed income in the short term and shrinking bond yields reinforces argument towards equities.

Ian Gillies 7:54
That’s okay. How have REITs performed recently?

Kane 7:59
REITs are quite strong in quarter one and this continued into quarter two as lower interest rates domestically and expectations of lower rates globally and lower and valuations higher. The sector has seen an increase in capital raisings over the quarter with firms looking to take advantage of the strong run up in share prices as an opportunity to pay down debt and provide liquidity for development and acquisition opportunities. Those a rates with large residential exposure benefited towards the end of the quarter due to optimism that followed the federal election result which saw labor’s proposed changes to negative gearing dismissed an app was proposed regulatory changes to lower lending service ability buffers along with the RBA cash rate as the main positive drivers. As rate valuations have improved in relative terms and are now attractive compared to real bond yields. Although there was still neutral they are still neutral on a price to book basis. Macro and policy indicators are broadly positive and suggests that a rates could extend their rally further given recent moves in bond yields. Demand for direct property continues to be strong as investors appear to chase anything with a solid yield. I’ve been surprised with the speed at which deals are closing and the level of oversubscription that is occuring. We will continue to be selective and assessing deals and partner with quality groups to provide client exposure to direct real estate. Over the quarter we moved from a small underweight position in property to now being neutral.

Ian Gillies 9:33
Thanks Kane.

Regarding alternative assets, what comments do you have on those?

Kane 9:39
Well, we commenced discussions with clients late in the quarter on our asset allocation calls for alternatives. We have seen an increase in client allocations towards high quality illiquid assets with these assets having previously been allocated towards one alternatives bucket. So we spent many months working with our asset allocation consultants Heuristic Investment Services, establishing where appropriate for a client the allocations within alternative towards each private equity, direct property, diversified credit and infrastructure. While this is not appropriate for all clients, establishing allocations for each of these alternative asset classes, under their own risk category ensures client allocations for each are appropriate rather than being combined under one risk category. As with all asset classes at tactical asset allocation approach has been implemented, which does consider existing valuations. So, we’ll continue to discuss this approach alternative assets with clients in the new quarter.

Ian Gillies 10:39
Thank you Kane. John, would you like to comment on where we see markets going in the foreseeable future?

John 10:47
Yes, look, there’s really two main forces driving markets and they’re going to continue to drive them for some time, certainly for the end of this year. Cyclical forces, namely, slowing growth and accommodative central banks and structural forces, the US China trade dispute, and the imposition of tariffs. Eventually, both of these are likely to lead to the return of inflation and an unwinding of the bond markets we currently find ourselves in. As a result will continue to fight the rallies and we encourage our clients to maintain their appropriate asset allocations.

Ian Gillies 11:21
Thanks, John. Thank you to John and Kane for today’s podcast. As always, if you have any questions or would like a copy of our insight, please call us on 03 9275 8888, I am Ian Gillies and thank you for listening.