Market Commentary
The S&P/ASX 200 Accumulation Index returned 2.9% during the month. The Australian market delivered its seventh straight month of gains, outperforming global equity markets in July. Developed markets outperformed emerging markets. In major global developed markets, the UK’s FTSE 100 was up 2.2% and the S&P 500 was up 1.4%. Japan’s Nikkei 225 returned 1.2% while was the DJ Euro Stoxx 50 was down 0.1%.
The cash rate was cut by 0.25% in July to a new record low of 1.00%. Similarly to the previous rate cut, the Reserve Bank of Australia (RBA) noted that their decision was to “support employment growth and provide greater confidence that inflation will be consistent with the medium-term target”. This action was taken in the face of challenges from the ongoing US-China trade dispute and subsequent risks to global economic growth as well as subdued domestic consumption. Later in the month the RBA governor commented further that “…it is reasonable to expect an extended period of low interest rates”.
The latest domestic economic data releases were mixed in July. Second quarter CPI came in at 0.6% on quarter, with automotive fuel the key driver, rising markedly at 10.2% on quarter. Employment growth rose a lower-than-expected 500 positions in June, while the unemployment rate continued to remain steady at 5.2%. The NAB Business Conditions index rose by 2 points to +3 in June. In contrast, Business Confidence slumped to +2 from +7. National CoreLogic dwelling prices rose 0.04% in July, marking the end of a record downturn. Retail sales were weaker than expected again, rising just 0.1% in May.
In company specific news, Adelaide Brighton downgraded guidance on the last day of the month, which saw the stock fall by 18.1% on the day. The company cited competitive pressures in Queensland and South Australia, weaker-than-expected residential and civil construction markets, as well as higher raw material costs and one-off shipping costs associated with cancelled import orders. This result has led to caution regarding the outlook for domestic cyclicals during the August reporting season.
All sector returns were positive during July. The best performing sector was Consumer Staples (9.8%). This was followed by Healthcare (5.9%), Information Technology (5.0%), Consumer Discretionary (4.8%), Industrials (3.4%), Real Estate (3.2%), Communications (2.9%), Utilities (1.9%), Financials (1.7%) and Energy (1.7%). Materials (1.0%) was the worst performing sector for the month.
The Consumer Staples sector dominated in July, driven by strong performance from Woolworths (7.2%), A2 Milk (23.6%) and Treasury Wine Estates (18.6%). A2 Milk continued to rise on the back of retail price increases, which signals management confidence in its growth outlook and has led to earnings upgrades.
The Healthcare sector was also a strong performer this month with sector heavyweights CSL (6.8%), Cochlear (6.5%) and ResMed (10.7%) the key contributors. ResMed outperformed after reporting Q4 earnings that showed solid momentum in its Sleep and Respiratory Care division.
Information Technology also outperformed the broader market with Wisetech Global (15.3%) and Xero (8.3%) key contributors to performance.
The Financials sector underperformed the market in July, weighed down by sector heavyweights AMP (-15.6%), ANZ (-1.1%) and Commonwealth Bank (-0.6%). AMP was sold off following news that the sale of AMP Life is highly unlikely to proceed on the current terms as the deal did not receive approval from the Reserve Bank of New Zealand. The aftermath of the Royal Commission also continues to weigh on the sector more broadly.
The Energy sector underperformed with Brent Oil prices falling during the month. Woodside Petroleum (-4.6%) and Oil Search (0.6%) were the key detractors in July.
While still posting positive returns, the worst performing sector this month was Materials. Sector heavyweights Rio Tinto (-4.7%), Fortescue Metal Group (-7.7%) and BHP (-1.0%) detracted from performance. Despite another rise in iron ore prices during the month, Brazil’s Vale indicating it will be increasing supply saw the market take the view that iron ore prices will fall. This view on near-term prices saw iron ore miners underperform, particularly Fortescue.
Outlook
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 since FY16 (with the only exception being Resources, which is exhibiting double digit growth).
The August reporting season has seen 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, tax cuts and increased stimulus through both Federal and State government spending on infrastructure.
Confession season started with a bang, marked by a litany of downgrades in domestic cyclicals—particularly those exposed to consumer spending—while a handful of stocks have been impacted by more stock specific issues. The poor sentiment over the past six months, given both local and global uncertainty, has kept operating conditions subdued in many sectors.
Reporting season is not just about the past, but more importantly, about the outlook and trading conditions going forward. The market will be looking for any green shoots given the aforementioned stimulus measures. 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, in addition to 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 US President Trump recently announcing a 10% tariff on USD 300-billion worth of Chinese imports from September. China appears to have taken retaliatory steps by devaluing its currency and banning US agricultural products.
The trade war appears to have resulted in 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 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.
