18 February 2020.

Overview

• Global equities posted 4.3% gain for the December quarter capping an impressive 28.2% for the full twelve months

• Australian equities followed suite with gains of 0.7% and 23.8% over the same period

• Interest rates remain historically low supporting equities and property in contrast to both economic and corporate earnings growth which continue to track below long-term trends

• Strategy has been to reduce risk after the very firm quarter to re-position the Growth Portfolio to a mildly underweight equities position

It was a very good year... but will it last?

Stock market gains over 2019 have been well above long-term trends, ultimately pushed up by historically low interest rates. While this has been good news for equity investors, the question must be asked – how long can the good days last? Already there are numerous unprecedented happenings across financial markets, however, it is difficult to argue whether they are symptoms of an extended cyclical, debt fuelled bubble or results of a true shift in the nature of markets and the interaction of underlying players and influences.

The key player at present is the European Central Bank (ECB) and no longer the Federal Reserve as it conducts a regimented asset buying program, oblivious to underlying asset valuations. Once it stops we are likely to see volatility in asset prices jump and the premise of the underlying fundamentals for equity valuations challenged.

The current market cycle of ever rising company valuations against anaemic economic growth and sliding/flat corporate earnings will end, probably in spectacular fashion. The extent of the influence of environmental and social events on the value of securities remains to be seen. However, the trend up to the end of 2019 was very much in place and will have challenged many conventional value driven investment heads who have adopted defensive positions and fear the morning we wake up to a heavy stock market correction and ruefully mourn “it was so obvious…”. In the meantime, lack of extreme indicators and performance expectations keep most investors in the game and playing the game while enjoying impressive gains.

The momentum from positive investor sentiment, all reinforced by the financial reward of continued capital gains, has locked many investors in. Exchange Traded Funds and passive index funds have helped channel the trends so healthy positive gains from traditional riskier assets appear the norm.

Global economic growth expectations remain soft with little upside despite the continued support and accommodating monetary policy from global central banks.

The major concern surrounding macroeconomics centres on the potential duration of the ECB’s quantitative easing program which cannot last indefinitely and when the Fed eventually resumes its program to raise interest rates towards levels once considered normal.

We have the corporate earnings results season for Australian and US equities upon us which will provide a lead into how companies are positioned in the current regime of low growth. Market expectations are for subdued results however there is a degree of optimism on future earnings so the focus will be on management guidance as to what the outlook looks like and what shape the economy is in.

Ahead of the results there has also been a note of caution in analysts' previews, with factors such as trade/tariffs, wage inflation, politics and environmental and social issues remaining wildcards. Of recent concern has been the potential impact from the Coronavirus. While the headlines have been shocking with the number of deaths rising daily, the economic impact is still deemed to be negligible.

What will impact is if the infection rate is not contained and the levels of disruption to underlying economic activity is prolonged. To date the markets have largely adopted the stance that the outbreak is containable, even if the statistics surrounding the virus continue to deteriorate. Given China’s history of opaqueness surrounding negative news out of the country, we remain concerned that the outbreak may prove more serious than what is currently assumed.

After assessing all the factors mentioned above, we have started to reduce our exposure to risk and to shore up our defensive positions across our portfolios. Our objective is to seek insurance against any bout of surprisingly negative news, against which current valuations will offer limited resistance and to also lock in some of the tremendous returns realised through 2019.

Conclusion

The outlook for the Enhanced Cash Portfolio remains subdued as markets appear locked into a regime of lower rates for the foreseeable future. Equity markets have enjoyed a strong run, valuations continue to look expensive on all measures bar a yield relative to bonds comparison.

Momentum and the risk of any increase in disappointing news, renders global equities vulnerable to a significant pull back. If Wall Street were to fall, it would not take much for investors in Australian equities to reach for the bank vault after raising cash to store away their windfall equity gains of 2019.

The economic impost from the bushfires are a big concern for investors as is the human and economic impact of the emerging Coronavirus outbreak, and consequent shutting down of trade and tourism from China. Will these events signal a peak in investor optimism that may lead to a desire for the safer havens of cash? This will of course factor into our thinking over the next quarter.

The core strategy is to re-balance back to a slightly underweight equities (defensive) position after the heady start to 2020 which saw the Growth Portfolio slightly overweight equities.

Market Commentary Disclosure

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