The Australian equities market has been buoyed by a now dovish RBA, elevated iron ore prices and a Coalition victory at the Federal Election that was largely unexpected. The one important factor currently missing is earnings growth. This will be required for the market to sustain its trajectory. FY19 earnings growth for the market is currently close to zero – the worst outcome since FY16 (with the only exception being Resources which has exhibited double digit growth).
The August/September reporting season saw the market turn its focus to FY20 earnings. At the start of the season, the market was forecasting EPS growth of circa 10%, which seemed a little high to us given a macroeconomic backdrop that is challenging at best. Sure enough, downward revisions to earnings during August now have the market expecting EPS growth closer to 6% in FY20. Given the uncertain geopolitical outlook that is impacting business confidence, together with cost pressures that seem to be across multiple sectors, further downward revisions are likely.
The escalation in the US-China trade war, including the export restrictions placed on Huawei and technology sharing by US companies, has led to a now-consensus view that as well as correcting trade imbalances, the US administration is seeking to constrain the rise of China. If accurate, this portends a more protracted and divisive trade war with a permanent constraint on technology transfers. While a trade war ceasefire was declared at the G20 Summit at the end of June, it was short-lived, with China announcing retaliatory tariffs on USD 75 billion of US goods in August, and President Trump announcing a 15% tariff on USD300 billion worth of Chinese imports that had previously been spared.
The trade war has seen a significant ‘risk-off’ trade and flight to safety, which has seen bond yields fall precipitously. Equally, gold has rallied and growth sensitive commodities, such as oil and copper, have seen large price corrections. Equity markets have not avoided this de-risking event, with global markets selling off sharply in May, then recovering in June and July. Furthermore, within equity markets, this flight to safety also continued with defensive and yield sensitive sectors having outperformed.
The underperformance of value versus low-volatility and momentum is the largest divergence seen in history. The extreme positioning and divergence saw a massive reversion in the month of September that resulted in the largest three-day factor rotation witnessed in 30 years. Extreme factor positioning has been the catalyst for the rotation, with better economic news and perhaps some stabilization in the trade dispute required for the value rally to be maintained.
Despite the recent rally in value, investors are still paying a record premium for safety, which reflects the inherent uncertainty of a potential paradigm shift in the global economic framework, with Trump unilaterally dismantling the rules-based, free-trade system that has been built since the Second World War.
We have previously noted that the recent premium paid for safety is largely unprecedented and has never been sustained at such levels. While this remains the case, the change in the environment leaves us cautious in regard to how and when this premium will normalise.
Brad Potter, Head of Australian Equities – Nikko Asset Management
