Market Outlook – July 2019

The Australian equities market is closing in on record highs, aided 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 now close to zero—the worst outcome since FY16 (with the only exception being Resources which is exhibiting double-digit growth).

The upcoming reporting season will see the market turn its focus to FY20 earnings. The market is currently forecasting EPS growth of circa 10%, which seems a little high given the current macroeconomic backdrop that is challenging at best. New government policy should help, with a combination of interest rate cuts, likely tax cuts and increased stimulus through both Federal and State government spending on infrastructure.

Confession season has started with a bang, marked by a litany of downgrades in domestic cyclicals—particularly those exposed to consumer spending—but also others such as Caltex, Incitec Pivot, Star Entertainment and Adelaide Brighton which are impacted by more stock-specific issues. The poor sentiment over the past six months, given both local and global uncertainty, has certainly kept operating conditions subdued in many sectors.

Reporting season is not just about the past (which we already know is not great) but, more importantly, about the outlook and trading conditions going forward. The market will be looking for any green shoots given the election is behind us, two rate cuts have been announced and we are likely to get some fiscal stimulus. However, political stress points such as the US-China trade war, Brexit and US-Iran remain, and may be larger drivers of the market (both positive and negative) than the reporting season itself.

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, the risks remain.

This 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. Furthermore, within equity markets, this flight to safety has also continued with defensive and yield sensitive sectors continuing to outperform.

Essentially, markets are pricing that this impasse will have significant implications for global growth and corporate profitability. The inversion of the US yield curve is read as implying a 40% probability of recession. These moves reflect a growing belief that Presidents Trump and Xi will need to see significant economic pain before any compromise is sought, let alone achieved.

Investors are now 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 further, 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 normalize. As a result, we are reluctant to further add to our exposure to the more economically sensitive parts of the market.

Source: Brad Potter, Nikko Asset Management