Quarterly Economic Outlook

By Chief Investment Officer, James Cook

Overview

With a significant global downtrend in growth well under way, financial assets continued to benefit from major central banks’ effort to reflate economies. This has resulted in the cutting of cash rates to record low levels and resumed quantitative easing programs to boost liquidity throughout the economies. Key risks in the form of economic softening, Brexit uncertainty, Trump tweets, trade wars and tariff sanctions, Middle East proxy wars and the future implications of untested economic experimentation abound.

However, two positive signals are evident amongst the doom and gloom.

  1. The central bank stimulatory efforts are alive and well. This has previously been tested and offered clear support for financial assets such as property and equity – implications for wealth disparity aside.
  2. The negative news is now well baked into news and financial thinking and news/information channels. The downside, unless matters amount to a severe crises type event, must be close to being factored into asset prices.

Our defensive strategy has softened towards a neutral stance. We recently cut the Growth Portfolio’s underweight position to equities to a neutral stance on belief that much of the bad news ahead had already been discounted in asset prices. Within the portfolio, we carry an overweight position in international equities and property trusts funded by an underweight position in Australian equities. We are neutral in cash.

The bear case

One of the more simplistic but fundamentally sound measurements of the relative attraction of equities is the oft cited Warren Buffet approach measuring the S&P 500 market capitalisation/GDP ratio which effectively measures the implied worth of listed equities over the size of the economy. While currently falling short of the red flag raised prior to the dotcom crash, it has exceed the elevated levels recorded at the time of the GFC. The flipside is that it does not look to provide a precise timing signal so it might remain at such levels for some months or even years. It is enough for Buffet’s Berkshire Hathaway to move to a very defensive 60% cash – a cool $122 billion.

The other often-cited bearish indicator is the now inverted US Treasury yield curve where long term interest rates (US 10 year Treasury bonds) are lower than short term cash rates (3 month Treasury bills). This has been a consistent but not foolproof indicator of a pending recession and a likely downturn in corporate profits. With Australia’s open external economy, a US-led downturn would only propel the current global downtrend impacting Australia’ growth prospects.

It is also interesting to note Australia’s increasing exposure to China’s fortunes as our share of exports to China continues to grow. China’s stimulatory measures remain critical to the health of Australia’s national accounts, its wealth, business confidence and investment and ultimately, household wellbeing and consumption.

What risk does this all pose to corporate earnings and market direction? An earnings slide in the face of an economic downturn would leave the market exposed to a sustained sell-off. While justified on a relative basis when measured against low risk free rates, price earnings ratios (PERs) stand vulnerable against potential earnings downgrades. Countering this is that little of this is fresh news. Markets have had some time to adjust to this and with the stimulatory efforts from central banks in paly, we believe the risks are now more balanced.

Conclusion

We are currently slightly defensive with an overweight international equities position funded through an underweight Australian equities position in our Growth portfolio. We are cautious within our Australian and international equities with both carrying an allocation of ~6% cash.

With economic momentum falling and the level of uncertainty so high, a high degree of caution should be maintained. Equity valuations are not extreme, although high, while bond valuations arguably are. Traditional correlations between major asset classes have fallen over so diversification does not look to be the same robust defence it once was. Economic momentum, as measured by leading economic indicators, is indicating a recession across a significant tract of the global economy. Geopolitical risk and social discontent is as high as ever.

The contrary argument is mounting. The one key mitigation to the doom is sentiment. Many scribes have been echoing a degree of caution, if not rash, alarm. Press and financial headlines are skewed to the negative and portfolio cash holdings are high. Fear is perhaps dominating greed. Central intervention is very much back in play which has proven telling since the GFC in supporting financial asset markets, if not economic growth!

We may be at an inflection point that could go either way. Reflecting a twelve month outlook and in absence of high conviction signals, we believe risks are now more balanced.

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