Market Commentary
The S&P/ASX 200 Accumulation Index returned -0.4% during the month. Global equity markets posted positive returns in October, with Australian equities lagging major developed markets. Emerging markets outperformed developed markets for the first time since January. In major global developed markets, Japan’s Nikkei 225 was up 5.4%, followed by the S&P 500, which rose 2.2%. The DJ Euro Stoxx 50 gained 1.1% while the UK’s FTSE 100 was the laggard, falling 1.9% as Brexit again came to a head.
The Reserve Bank of Australia (RBA) cut the cash rate by 0.25% to a new record low of 0.75% at its 1 October meeting. The RBA reiterated that they would ease monetary policy further if needed “to support sustainable growth in the economy, full employment and the achievement of the inflation target over time”. We note that the RBA kept rates on hold in November with an easing bias.
Domestic economic data releases were mixed in October. Employment increased by 14,700 positions in September, which was broadly in line with expectations. The unemployment rate edged back down to 5.2%. Retail sales missed expectations slightly, recording a 0.4% gain in August. The NAB Business Conditions index rose by 1 point to +2 in September while Business Confidence fell to 0 from +1. Both readings remain below their long run average. National CoreLogic dwelling prices continued to rise, increasing by 1.2% in October, the fourth consecutive month of gains. On the inflation front, the CPI rose 0.5% during the third quarter, while the annual rate was 1.7%. Both results were in-line with consensus.
In company specific news, IOOF was up 15.5% during the month following the news that the ANZ Wealth transaction would proceed, and at a lower price. CYBG was a strong performer during the month, up 24.5%, having gained regulatory approval to combine the acquired Virgin Money business with its existing CYBG operations and as optimism grew that a hard Brexit would be avoided. Orora sold its Australian fibre business to Nippon Paper for a very attractive enterprise value of AUD 1.7 billion that implied transaction multiples that are well in excess to the multiples that Orora was trading on. The company expects to return AUD 1.2 billion to shareholders.
Sector returns were mixed in October. The best performing sector was Healthcare (7.6%), followed by Industrials (3.0%) and Utilities (1.4%). Real Estate (1.2%), Consumer Discretionary (0.9%) and Energy (0.5%) were also positive. Communication Services (-1.5%), Materials (-1.9%), Consumer Staples (-2.2%) and Financials (-2.8%) posted negative returns. Information Technology (-3.9%) was the worst performing sector for the month.
In the Healthcare sector, the strongest performer in October, sector heavyweight CSL (9.6%) was the key driver of outperformance as the market raised consensus earnings expectations for the stock.
The Industrials sector outperformed the broader market. Stocks that contributed to sector performance included Sydney Airport (9.3%) and Brambles (7.7%).
The Utilities sector was also positive as investors continue to chase yield. Key drivers included AGL Energy (3.3%) and APA Group (1.7%).
The Consumer Staples sector underperformed. Key detractors included Treasury Wine Estate (-5.4%) and Coles (-2.7%). Treasury Wine underperformed following news that CEO Michael Clarke will retire, which negatively impacted sentiment towards the stock.
The Financials sector fell in October. Key drivers of the underperformance were the ‘big four’ banks: ANZ Bank (-6.2%), Westpac (-4.8%), National Australia Bank (-3.7%) and Commonwealth Bank (-2.7%). The recent bank AGMs have shown that compliance costs remain an issue and pressure on net interest margins continues, as low interest rates hurt the returns on deposits. Proposed changes to capital requirements by the regulator also negatively impacted the major banks.
Information Technology was the worst performing sector in October, led by falls in Afterpay Touch (-19.5%) and WiseTech Global (-24.6%). WiseTech was negatively impacted by a report making numerous allegations with regards to the company’s earnings quality. Afterpay moved lower following renewed concerns regarding sector regulation.
Market Outlook
Potential resolutions to the US-China trade dispute and Brexit are looking outlooks a little rosier, as the markets start to price in a slow return to stability. However, we remain a long way from ‘normal’ and it appears we have been in this situation before over the past 12-18 months, with little relief in geopolitical tensions.
Geopolitics has been one of the largest drivers of the slump in global growth and corporate profits over the past year. Therefore, less stress could be a powerful catalyst for a cyclical revival. Compounding this are the cheap valuations and extreme positioning of the market that has the potential for violent rotations into the value end of the market.
The divergence in valuations between the defensive and low volatility parts of the market and riskier sectors is still at heightened levels. This relative valuation bubble between value/cyclical stocks versus low volatility/defensive stocks is at a level that even exceeds the dot.com valuations of the late 1990s. We believe this reflects concerns around global growth, which has been exacerbated by geopolitical issues such as the US-China trade war, Brexit and slowing global growth. In our view, the market’s concerns are overdone.
The US economy remains around trend and the Federal Reserve has pivoted from tightening to an easing bias that may help steepen the yield curve. The Chinese deleveraging that was a feature of 2018 has ended and stimulatory measures are now showing their effect in activity levels. As the market gains comfort that the global economy is slowing, but not collapsing, we believe valuation parameters will normalise.
Further, any resolution or partial resolution of the key geopolitical risks will reduce the downside risk of further deceleration in growth due to elevated uncertainty. The recent dialogue between the US and China and hopes of a deal regarding trade negotiations is a significant step in the right direction.
We remain positioned to take advantage of the global economy moving away from outright bearishness and risk-off to a more moderate growth environment. The defensive bond-sensitive and quality names remain in 'bubble' territory and they would be expected to correct heavily when the market moves into more rational territory. As seen during September, reversion trades in favour of value stocks can happen quickly and aggressively. Despite a strong move in September, the valuation divergence is such that there is significant further upside potential in the portfolio as and when the market valuations normalise.
