Market Commentary

The S&P/ASX 200 Accumulation Index returned -2.4% during the month.

The Australian market finally ended its winning streak in August following a mostly disappointing results season and weak performance in the Materials sector dragging down performance. Globally equity markets were also weaker, with developed markets marginally outperforming emerging markets. In major global developed markets, the DJ Euro Stoxx 50 was down 1.1%. The S&P 500 was down 1.6%, while Japan’s Nikkei 225 was down 3.7%. The UK’s FTSE 100 was the worst performer, down 4.1%.

The Reserve Bank of Australia (RBA) maintained the cash rate at the record low level of 1.00%. The RBA noted that it is reasonable to expect an extended period of low interest rates in order to make progress in reducing unemployment and achieve more assured progress towards the inflation target.

Domestic economic data releases were mixed in August. Employment growth rose a higher than expected 41,500 positions in July, while the unemployment rate remained steady at 5.2%. Retail sales exceeded expectations, rising 0.4% in June. The NAB Business Conditions index fell by 2 points to +2 in July. In contrast, Business Confidence rose to +4 from +2. National CoreLogic dwelling prices rose 0.08% in August, with strong gains in Sydney and Melbourne.

The August results season disappointed, with more misses than beats. Guidance was also softer, with FY20 earnings for large cap stocks revised lower by around 2.5%. The main positive surprise from the results was the broad-based increase in dividends. Sectorally, there were some positives to come out of the retail sector from names such as JB Hi-Fi and Super Retail Group. Meanwhile the resources sector struggled, with the miners facing wage and capex cost pressures.

The majority of sector returns were negative in August, with only four sectors managing to achieve positive returns. The best performing sector was Healthcare (3.6%) which was followed by Real Estate (2.3%), Information Technology (0.3%) and Consumer Discretionary (0.2%). Consumer Staples (-0.1%), Industrials (-2.5%), Financials (-2.6%), Utilities (-3.0%), Communication Services (-3.1%) and Energy (-5.6%) all posted negative returns. Materials (-7.5%) was again the worst performing sector for the month.

The Healthcare sector was the strongest performer this month with sector heavyweights CSL (4.9%) and ResMed (8.7%) the key contributors. CSL reported a result that was in-line with expectations and provided guidance that was above expectations as CSL is expected to take market share from a competitor who is struggling to keep up with product demand. The intention to open an additional 40 collection centres also illustrates the company’s confidence it is growth outlook.

The Real Estate sector also posted positive returns with key contributors including Lendlease (19.4%) and Scentre Group (4.2%). Lendlease outperformed after announcing it had several parties undertaking due diligence on its engineering unit, raising expectations of the long awaited sale of the troubled business unit. Lendlease also confirmed it has AUD 100 billion in projects in the pipeline. Scentre Group reported results that were in-line with expectations.

The Information Technology also outperformed the broader market with Wisetech Global (15.6%) and Afterpay Touch (15.9%) the key contributors to performance.

Communication Services underperformed the broader market, weighed down by sector heavyweight Telstra (-4.3%) which reported a 40% fall in its full year profit.

The Energy sector underperformed with oil prices falling during the month. Woodside Petroleum (-5.8%) was the key detractor. The stock was weighed down by the lower oil price and higher production costs.

The worst performing sector was Materials. Sector heavyweights BHP (-11.0%), Rio Tinto (-8.3%), and South32 (-15.9%) were the key detractors from performance as iron ore prices took a tumble during the month. Furthermore, the August results for all three stocks fell short of consensus expectations.

Market 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 outcome since FY16 (with the only exception being Resources which has exhibited double digit growth).

The August 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 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 President’s 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.