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Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

• Federal Reserve disrupts markets
• Recession fears overblown
• Australian data mixed

The Big Picture

If they’d blown the final whistle at three-quarter time for 2018, we would have been looking back on an impressive year for both domestic and foreign equities. Instead we have to work out what really happened in this last quarter.

The consensus opinion, with which concur, is that the Chairman of the US Federal Reserve (the “Fed”), Jay Powell, started the sell-off with his comments that rate hikes had a long way to go. This was out of line with market expectations.

Trump and Powell have been jousting and we are the ones that got the raw deal. Economic fundamentals have hardly changed. While most agree what started the October rout, there are two camps of opinion concerning the future. One group is fearful that the Fed will push up interest rates too far and cause a recession in the US with consequences for the world.

We are in the other group. We believe that there will be at most one hike in 2019 (and not the two they flagged) and the Fed might even start to ease towards the end of 2019. They are charged with maintaining a stable economy and the wolves will be at their door if they fail.

Towards the end of 2018, there were a few stellar days up on Wall Street and quite a few down. Fund managers and others tend to ‘square’ their books at the end of the year – also managing capital gains and losses for tax planning. Until we are a few weeks into January, and reporting season in the US has started, we will not have a clear picture of what might follow.

We strongly believe – like many others – that both the ASX 200 and the S&P 500 are undervalued – by as much as 5% – 15%. With consensus brokers still predicting above average earnings growth, 2019 should look good.

It would be imprudent not to add a caveat. If companies reporting in the US materially downgrade their expectations in January, then we must follow suit. But, whichever way these predictions point, we do not see a recession in the US in 2019 at least. The bull run is far from finished. As they used to say in the old Western movies, “it’s only a flesh wound” best describes quarter 4 (“Q4”) of 2018.

There have been many other complex forces affecting short-term movements in markets. Oil prices took a battering in December – about 10% down (or 40% on the year) as OPEC and others tried to negotiate price stability. Iron ore prices were flat on the year but up 10% in December.

With Trump’s imposition of new tariffs, China has probably been rescheduling its international trade transactions to pre-empt the expected tariff hikes. Therefore, we cannot interpret China economic statistics in the usual way.

Australian GDP did come in a bit light on in Q3 but the labour force data has been quite impressive in recent months. At last the RBA has started to hint that they might have to cut rates at some point – a view we have expressed for the last two years. We are not in economic trouble but a helping hand should get us over the line.

We are not worried about average Australian property prices. Time and time again they follow the pattern of strong growth followed by a little pull back and then flat prices for an extended period. Nothing yet suggests that this pattern has ended.

If any lucky investors happened to have gone to cash in late September, they should thank their lucky stars and try to get back into the markets. For the rest of us, just buying and holding is still the mantra. Selling now could prove very costly.

Asset Classes
Australian Equities

In spite of all of the commentary, the ASX 200 was slightly down in December but only down by nearly 7% on the year. Over 2018, this index outperformed the London FTSE, the German DAX and Japan’s Nikkei. It moved broadly in line with Wall Street.

Financials and Telcos were the worst performing sectors hurting many retirement funds. Healthcare was the stand-out sector.

If Financials can maintain their expected dividend stream, the yield will be about over 8% plus franking credits! Telcos are looking at a yield of more like 5% plus franking credits.

We have the ASX 200 under-priced by around 5% with the forecast underlying capital gains for 2019 around trend at 5%.

Foreign Equities

The S&P 500 lost around 7% on the year but it fell nearly 20% from its October peak to the close on Christmas Eve. That was enough for commentators to call it a bear market. However, a post-Christmas rally of over 5% eroded some of those losses.

We have the S&P 500 under-priced by around 15% post the decline, with underlying capital gains forecast to be above trend at 7%.

Bonds and Interest Rates

The Fed raised its Fed Funds Rate by 0.25% at its December meeting (to a range of 2.25% to 2.5%) but pencilled in only two rate hikes (rather than previously three) for 2019. The market is only pricing in a weighted average of 1.2 hikes. Markets fell on the Fed news thinking the Fed is being too aggressive.

The Reserve Bank of Australia (RBA) kept rates on hold at 1.5% and it does not meet again until February.

Other Assets

The price of oil fell sharply in December but the price of iron ore rose. Copper was weaker. The Australian dollar (against the US) slipped.

Regional Analysis
Australia

Q3 GDP growth came in at 2.8% for the year while the RBA was holding on to expectations of 3.5% for both 2019 and 2020. Our household savings’ ratio is still falling – but close to zero – so this source of assistance for economic growth is near its end.

Unemployment did go up one notch to 5.1% but this figure is still reasonable – but not great. In official trend terms, 19,300 new full-time jobs were created.

APRA has lifted the cap on interest-only residential home loans. That should ease downward pressure on house prices.

Official house price statistics show that the falls from their peaks for Sydney and Melbourne are 5.6% and 4.0%, respectively. These moves are not out of line with the aftermath to previous growth spurts.

China

China’s trade statistics in December missed expectations but this pull back could be due to a ‘bring forward’ move designed to avert the possible (but since withdrawn) hikes in tariffs to 25% on January 1.

However, the drop in the China manufacturing PMI (Purchasing Managers’ Index) to 49.4 is a little disturbing. The services version did rise to 53.8.

Since the PMI indexes are measures of managers’ expectations, some of the fall to a sub ‘50 level’ could be due to lack of progress in the trade negotiations with the US.

China has agreed to buy US soybeans in a move to placate Trump. It has also agreed to buying US rice but that is less likely to have much effect on US farmers. At this point, we believe that some inroads in trade talks during January would be sufficient to avert further worries.

US

Just when some were thinking the US economy could be slowing down, Christmas retail sales came in at a six-year high. Q3 GDP growth was revised down but only by 0.1% to a well-above trend 3.4%. Growth in Q2 was 4.2%.

The US labour market data remain very strong. Indeed, it is hard to find out what statistics the naysayers are looking at. If growth slips back to 2% to 2.5% from 3.4% that is still trend growth, or above – and not the start of a recession.

Of course, the common pastime of “shutting down the government” is going on again. Trump is now flexible on whether they call it a “wall” or a “fence” so long as he gets his $5bn deal.

Trump is claiming that talks with China are bearing fruit and Putin has spoken of his desire to meet with US over a range of matters.

Europe

The European Union (EU) and Italy struck a crucial deal on budget repair. A re-appearance of the “PIGS” crises is not imminent.

Of course, Britain is still in trouble with the Brexit negotiations. The end of March was the date for the final solution. As we have written before, any fall-out from a bad deal to Australia should be well contained.

Rest of the World

New Zealand missed expectations on economic growth. They achieved only 0.3% for the quarter rather than the expected 0.6%.

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

US Fed gives markets renewed hope!

– Fed chair changes his tune on rate hikes
– Brexit is getting messier
– Australian labour market strengthens further

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact us.

The Big Picture

For the last two months, stock markets having been reeling on a roller coaster ride. It’s almost all been due to the evolving best guesses of what the US Fed might be thinking.

When the official interest rate is above the “neutral rate”, monetary policy is tightening in an attempt to slow down the economy. High interest rates are usually the precursor to a recession.

At the start of October, Fed chair, Jay Powell, stated that rates were “a long way from neutral”. That is, there were likely to be many more rate hikes in the pipeline and markets corrected sharply. Other Fed members started to soften this view and markets settled somewhat. At the end of November Jay Powell reversed his stance by stating rates were “just below neutral” even though the official rate hadn’t changed in the intervening period! Wall Street jumped 2% on the news and 4.8% over the last week.

The Fed minutes (of the “FOMC”) also supported this softer view but they are still pointing towards a hike on December 19th. That hike would take the official rate to be in the range 2.25% to 2.5%. With most experts thinking that the neutral rate is somewhere in the range 2.5% to 3.5% there is now a feeling that the Fed might slow down its hiking programme for 2019 – or even pause it for a while.

The so-called ‘dot plots’ that indicate Fed members’ expectations of rates for the next year or two will be published at the December meeting. At that point markets will have a much clearer view of what may happen in 2019 and markets should settle down further. If those plots show a reduction from the three or four 2019 hikes that seemed to be in the Fed pipeline, markets should rally. It is hard to see any real downside from the December 19th meeting.

The other current key market driver is the status of the US-China trade talks. The G-20 meeting in Buenos Aires, which ended on December 1, should start to clarify much – particularly as Trump had dinner with President Xi that evening. It appears that the tariff war is now on hold for 90 days with no new tariffs to follow after January 1st.

Early December is also the time that UK prime minister, Theresa May, will attempt to get her Brexit deal through the House of Commons. It is expected that there will be some rebellion from both sides of the House. However, the spill-over of any outcome on the rest of the world is thought to be minimal.

The British government’s recent official analysis of Brexit is stated to be a 4% reduction in UK GDP – but spread over 15 years! That doesn’t seem to be a big issue for Australian trade or our economy.

The Australian economy again posted some strong data during November. The unemployment rate stayed at an acceptably low 5.0% and jobs growth was very strong. Even wage inflation at last showed some strength with a 2.3% gain over 12 months.

Of course, there are always some patches of gloom in the media to navigate. UBS has a forecast out that Australian house prices could fall by up to 30% and Goldman Sachs is predicting no gains on Wall Street in the next 12 months.

We see Australian house prices being largely flat for a few years – as is customary after a strong growth spurt. We see further growth in our stock market and on Wall Street. However, we have noted that earnings expectations having been slowing a little over the past two months. A lot of attention will be paid to upcoming reports of US earnings from early January and Australia in February.

Earnings have been performing quite well in 2018 but outlook statements of late have been a little soft. By the start of next year, we will have an opportunity to assess whether companies over-reacted to the Trump trade war chatter!

Our view is to hold the line on investment strategy until mid-December and then consider putting any excess cash to work in the markets if the Fed predicts only one or two rate hikes in 2019.

Asset Classes
Australian Equities

Our ASX 200 was down firmly ( 2.8%) over November. With commodity prices against us and trade wars in motion, our resources and growth stocks did not fare well. For example, the energy sector was down by over 10% but the Financials sector was up a fraction.

With the G-20 events in Buenos Aires and the expectations for the December 19 Fed meeting, we see our market starting to play catch-up to world markets towards the end of the year. This rally, if it transpires, will be due to our perception of current under-pricing of the ASX 200 rather than anything to do with Santa.

Market volatility is only a little above average and we have our market as under-priced so it is a sit and wait situation in our opinion.

If the Fed meeting goes well, it might be a case of putting more cash to work in the markets.

Foreign Equities

The S&P 500 gained +4.8% in the last week of November as the Fed declared its softer stance. Indeed, the Dow Jones index had its best week since Trump was elected two years ago.

We noted a slight softening of broker expectations for US company earnings over the last two months. That softening seems to have halted or, at least, paused. The key to 2019 is whether the Q4 earnings reports back this gloomier view or carry on the great performance of the last few years. We lean towards the latter view.

If, as expected, the Fed does pause on rate hikes in 2019, market volatility might get back to normal as fears of a contraction or worse in the US economy dissipate.

Bonds and Interest Rates

There is a current market-based probability of over 80% that the US Fed will raise rates on December 19th so the Fed would be silly not to lock this one in. The main focus will be in how many rate hikes are being predicted for 2019. For over a year, the Fed has expected much more than the market. This meeting could result in an alignment between such expectations.

The Reserve Bank of Australia and that of New Zealand were again on hold.

Other Assets

The price of oil dropped strongly in November ( 21%) and the price of iron ore fell by  15%.

The price of copper, however, rose modestly (+3.5%). The Australian dollar firmed (+3.3%) against the US dollar.

Regional Review
Australia

The RBA kept rates on hold for yet another month. The jobs report was strong but not strong enough to cause inflation problems. There were 42,300 new full-time jobs created in the latest month and the unemployment rate held at 5.0%.

Retail sales growth was slightly below expectations at +0.2% for the month. GDP growth is to be published in the first week of December to complete the picture. We do not expect much market reaction to that data print.

We do not attach much credibility to those who are predicting house price collapses. It would take a massive switch in bank lending practices to cause such a crash and there is no evidence of any such behaviour emerging. Rather, we see flat, or only slightly falling, prices in the foreseeable future.

China

November’s data drop for China was slightly positive. Retail sales at 8.6% missed the expected 9.1%. Factory output was 5.9%, being up from the previous month’s 5.8% and the consensus forecast of 5.7%. Fixed asset investment was 5.7%, being up from the previous month’s 5.4% and the consensus expectation of 5.5%.
The Purchasing Manufacturers’ Index (PMI) was 50.0 and below the expected 50.2. Below 50 would have indicated slowing growth expectations.

There have not yet been any strong visible signs of Trump’s tariffs causing any major headaches for China growth. If Trump and Xi can continue to make progress after their talks in Buenos Aires, the past 12 months of gloom should start to dissipate.

US

The US mid-term elections did not produce the ‘blue wave’ of Democrat support that some expected or hoped for. The Republicans did lose control of the House but they kept the Senate. These split Congresses are common and we do not expect any negative impact on our expectations of strong US economic growth through 2019.

Dr El-Erian, the highly respected economist who ran the world’s largest bond fund (PIMCO) for many years, stated in a CNBC interview last month that he thinks there is “no chance of a [US] recession within 18-24 months”. We concur.

The US jobs’ report was again a blockbuster. There were 250,000 new jobs added and unemployment stayed at the historically low rate of 3.7%. There was even some modest wage growth of 3.1% which is the best since 2009.

Europe

Theresa May at last struck a deal with the EU over Brexit. Many MPs from both sides have problems with the deal but the EU does not look like renegotiating. Therefore, it looks like this deal or no deal. The latter outcome would be particularly bad for the UK.

The EU economy is not doing particularly well at the moment and is part of the softening of global growth about which some people are talking.

Rest of the World

Japan GDP growth for the 12 months ending in quarter three missed expectations at  1.2% but a contraction of  1.0% was the consensus expectation. The APEC meeting in Indonesia did not result in any communique! Neither did Australia manage to get the trade deal with China it had hoped for. The G-20 meeting in Buenos Aires produced some agreement between China and the US but Trump cancelled his meeting with Putin. It is still early days for the US-China trade talks but there is some optimism among market analysts.

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

US rally ended with a thump

– Are fears of US rate hikes justified?
– Global growth still has strong prospects
– Australian unemployment rate falls but inflation stays low

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

Six consecutive months of capital gains on Wall Street were ended with a correction in October – eradicating all of the gains made in 2018. It is important to note that this correction could not have been precipitated by gloomy economic data. There wasn’t any!

While everyone is entitled to nominate reasons for the correction, it is not possible to attribute it to various causes with any degree of certainty. The best we can do is focus on what hit the headlines – and then look through the noise at the fundamentals.

The downturn did start within hours of US Fed chairman, Jay Powell, making a very strong statement about being able to be aggressive on rate hikes. And he made no soothing comments even as the market fell by up to 10%.

Of course, Trump was never far from the spotlight. His repeated ‘upping the ante’ in the trade war couldn’t have helped. The latest is that he is reportedly planning even more tariffs for China trade if China does not make progress at the table.

The US mid-term elections are due on November 6th. Pundits are forecasting the Republicans likely to keep control of the Senate but lose control of the lower house. But both reported probabilities are sufficiently woolly to allow for an upset. If Trump loses even control of just the house, his presidency will lack the support he needs for further reform.

When we look at the new economic data reported in October, we see a glowing score-card for the US. Economic growth came in at 3.5% after a 4.2% in quarter two. The IMF just reported its US forecast for 2018 of 2.5% which is already now overwhelmingly seen as far too pessimistic. Three percent plus is on the cards.

The Fed’s preferred inflation measure came in at 1.6% which is well down from 2.1% in the previous quarter and the 2% Fed target. There are no apparent inflation pressures bubbling under that might require sharp rate hikes. Indeed, very gradual increases in rates seem the way to go!

The US bond market did react pushing the 10-year rate well above 3% but markets can jump at shadows. When the Fed likely raises the rate in December the key information sought from the Fed press conference by analysts will be the so-called “dot plots” indicating the most likely course of action in 2019. Given the economic data, we feel that markets and the Fed will settle by then.

Even earlier, Trump may seal a deal with China over trade. It is said by many that he wins votes from both sides of politics by looking tough with China. Whether the race is won or lost after the mid-terms, Trump can then settle the trade talks before real harm is done to the US economy, hence we remain positive in relation to US stocks in the near term.

The IMF did forecast world growth of 3.7% for each of 2018 and 2019. These forecasts are now the same as those from the OECD. China reported growth of 6.5%, which was a slight miss, but very good producer and consumer inflation statistics were posted.

The Australian unemployment rate fell from 5.3% to 5.0% for the latest month. Full-time jobs growth was also strong.

At times like these, it is important to remember that when people sell shares someone else is buying them! We think that those who bought in October might look very good in months to come. Reporting season for the US banks has been very strong but there were some notable misses in the rest of the company reports.

In the long run, market prices reflect the underlying strength of the economic fundamentals, for which we remain optimistic. However, in the short run, fear or hubris can take markets almost anywhere, the middle weeks of October being an example.

Asset Classes
Australian Equities

Our ASX 200 had another down month in October ( 6.1%). All sectors experiencing meaningful losses but perhaps the biggest losers were those stocks that were priced (“to perfection”) for strong growth. However, the rally at the end of October saw recovery in those same stocks.

The banking sector has projected dividends of 8.5% plus franking credits because stock prices have been sold down so strongly. With the sector proposing to divest wealth management business, capital gains for the sector are harder to predict. There is the prospect that this very large sector might soon end its poor run over recent years and start to recover – which in turn could boost the ASX 200.

Foreign Equities

The longest run of consecutive months of capital gains in recorded history for Wall Street ended with a thump in October ( 6.9%). We think it is far too early for a slow-down in the US economy to be on the cards. Rather, we think October represented a case of the jitters after the US Fed chairman spoke out of turn.

Most major global markets and regions experienced declines in the magnitude of 5% to 10% over the month as the same macro-economic and geopolitical factors affecting the US market, namely rising interest rates and trade tension between the US and China came to bear. Encouragingly the last week of the month saw markets take a breather and consolidate in the short term.

Bonds and Interest Rates

The US 10-year treasuries’ yield continued its rally from September, the yield at the start of October being 3.06% and peaking mid-month at 3.21%, this in conjunction with statement by Federal Reserve Chair Powell and ongoing concerns in relation to the ‘Trade War’ possibly helped put equities into a spin.

In Australia the Reserve Bank of Australia again left official rates ‘on hold’ at 1.5% with no apparent impetus to move in either direction, similarly the Australian 10 Year Government bond yield remained little changed as it has done since late 2016. Hence, we do not expect Australian Official rates to change in the near term.

Talks of trade war between the US and China, Australia’s largest trading partner, and US interest now being higher than ours saw the $A continue to experience softness against the $US and finish the month just above $US0.70. The interest rate differential could act to hold the $A around current levels relative to the $US in the absence of a greater stimulus in either direction e.g. changes to resource commodity prices.

Other Assets

The price of oil dropped strongly in October ( 8.2%) but the price of iron ore rose by +10.1%.

The price of copper ( 3.0%) and the Australian dollar, against the US, ( 1.9%) both fell in October.

Regional Review

Australia

The Wentworth by-election has put the government in a precarious position but economic data were quite strong.

Retail sales rose by 0.3% for the latest month and the unemployment rate fell to 5.0%. 20,300 full-time jobs were created.

Our CPI came in at under 2% whichever variant is used. The trimmed mean of 1.8% is below the RBA’s target range of 2% to 3%.

China

October’s data drop for China was slightly weaker. GDP growth missed expectations at 6.5%. Retail sales were 9.2%, factory output was 5.8% and fixed asset investment was 5.4%. The Purchasing Manufacturers’ Index (PMI) was 50.2 and below the expected 50.6

While these numbers were slightly worse than expected they are still big numbers! Providing China and the US come to terms on trade soon, there seems little to impede the world’s second biggest economy from continuing to grow.

US

The US recorded growth of 3.5% for the third quarter making the last two quarters as having produced the best two-quarter growth in four years.

The PCE inflation measure, preferred by the Fed, fell from 2.1% to 1.6%. With the target rate at 2%, there is plenty of wiggle room for the Fed in considering future rate hikes. The CPI inflation measure came in at 2.3% from 2.7% and the CORE inflation rate that strips out food and energy was 2.2%.

The US unemployment rate came in at 3.7% which is the lowest since 1969 when man first walked on the moon!

Europe

After 13 years at the helm, Germany’s Chancellor, Angela Merkel, has announced she will not continue in politics after her term expires in 2022. She has been under intense social pressure owing to her immigration policy – particularly with regard to taking in refugees. However, she has been considered a major stabilizing influence in Europe.

EU growth slowed to 0.2% in the latest quarter and Italy came in at 0.0%!

The Brexit negotiations hit another speed bump in October. There has been a reported surge in Irish passport applications because of the way the Eire / Northern Ireland border might be handled.

Rest of the World

Brazil elected a new president in October which might help stabilize its economy.

The NAFTA trade agreement between the US, Mexico and Canada was completed. After all of the fuss, the changes are minimal in the new USMCA variant. The US is better off by only about $70m!