YIN and YANG 2
Let’s see if we can make some sense of all the noise in the past month. July blog was written to coincide with the ASX All Ordinaries 500 index closing at a record high, having taken 12 years to beat the previous record in November 2007 (6853). The recovery continued until 30th July 2019 peaking at 6928.
The subsequent month has seen a fall of around 5% being 360 points to 6566. Given the negative geo-political news, it is hardly surprising that markets here and overseas have softened by 5%. In a generally trending upmarket, such retractions are more often than not buying opportunities. Our conclusion is that may not be the current scenario, so a number of investors may prefer to reduce risk and bank some of the capital gains, thus increasing cash to 10-20%.
Europe remains weak. Germany announced a quarter of negative growth, which shocked a number of commentators. While most of southern Europe was anticipated to be in recession in the current year, Germany as the powerhouse of Europe, has been weakened by falling exports to Asia of high end manufactured goods including electrical generation. Germany is conservative when it comes to fiscal policy i.e. government settings. Economist Krugman says Germany should take advantage of negative interest rates and borrow to replace its ailing German infrastructure and to provide fiscal stimulus. Australian companies are being impacted by Euro weakness. Brambles warned of a “broad slowdown in Europe and a possible wider contagion” this financial year.
Iluka noted weaker demand for Zircon used in ceramics in Europe and issued a warning that the 2019 outlook “remained dark”.
The United Kingdom also printed a quarter of negative growth, with Brexit uncertainty continuing amidst a change in Prime Minister to Boris Johnston and a fixed Brexit date of Halloween 31st October 2019.
The US/China Trade War has so far shown no signs of immediate positive resolution. The Chinese negotiators are due to visit the USA in early September. The pressure by world leaders at the recent G7 meeting together with two days of adverse movements in the USA stock market of over 800 and
600 points coinciding with a negative progress on Trade War negotiations perhaps sets a backdrop that may force the US and China to a sensible negotiation.
Meetings of central bank governors in Jackson Hole saw some push back against political interference in the interest rate setting process with three Federal Reserve governors indicating that given the strength of the US economy, they saw no immediate need to cut US rates further. The Australian Reserve Bank governor Lowe backtracked in response to criticism on his previous commentary concerning a hard inflation target of 2.5% and said it was necessary to be flexible given those targets were set in days of high inflation, whereas the current issue is that there is low inflation. Lowe noted, “Political shocks are now becoming economic shocks”.
This statement from Lowe is the nub of the current issue for investors i.e. markets have largely ignored the geopolitical factors up until now. But issues such as a hard Brexit and the increasing twitter yin & yang from the US President raise the question: Are the political shocks now becoming economic shocks resulting in reduced GDP and if so, then investors may wish to bank some of the gains from the last 3 years. Your diarist is in favour of this strategy.
Australian Reporting Season
The Australian Reporting Season was mixed, with around 50% of companies meeting earning expectations. While some companies exceeded expectations, the current view is that more companies disappointed, particularly with CEOs’ outlook statements. Brambles and Iluka are noted above. Wagners disappointed with a 48% decline in NPAT and axed the dividend. Fortunately Burrell largely avoided this IPO. Stockland spoke of tough times in retail and residential. Boral guided to a negative outlook with “NPAT 5-15% lower in FY2020”. Inghams downgraded due to margin pressure saying “this impact will be significant in FYr20”.
The Australian economy is receiving the fiscal stimulus from the personal income tax cuts. But evidence is that the downturn in residential and commercial construction is not being replaced quickly enough by infrastructure spending from a Commonwealth government reluctant to take steps that will impact on the budget surplus and state governments are constrained by high levels of state government debt.
The banks have continued to come under pressure in terms of remediation costs with their exits from the wealth management business proceeding apace and little real consideration of the legacy they are leaving the investment advisory industry. The Treasurer has announced the Australian Treasury will devote 75% of its resources to implementing the Hayne Royal Commission 76 recommendations. AMP has announced it will not serve ordinary Australians, adding to the long list of investment advisory firms that will only deal with high net worth firms/high net worth investors.
Fortunately Burrell will continue to keep our doors open to meet our social responsibility and financial literacy objectives. TR Burrell OBE held that clients have the right to proper investment and financial advice. If per chance they are unable to afford it, then that is our social responsibility.
So on the downside, there is much in the above to give the market pause. It would not be surprising to see these events create a catalyst whereby the Australian and US markets fell by 10-15%, rather than the current 5%.
The Argument for the Upside
The 10 year bond in Australia has continued to fall and is currently around 0.9% with a deputy governor of the Reserve Bank last night speculating, in your diarist’s view irresponsibly, that rates may settle between 0-0.5%. This means that once the geopolitical issues are cleared, the difference between dividend yield and the 10 year bond should see the TINA effect i.e. “there is no alternative”. Good quality companies listed on the Australian stock exchange and overseas should continue to see support from record low interest rates. Valuations of growth stocks increase in times of low interest rates, because the higher earnings in the forward years are discounted at a lower rate resulting in higher fair values (FVE) for growth stocks. Rather than growth stocks correcting, we’ve seen a number of growth stocks increase their price earnings valuations multiples. The risk in this valuation is that the growth rates are too optimistic and falls in growth rates will be harshly metred out by the market.
Value stocks that have disappointed have seen sharp corrections and some of these stocks appear attractive.
Thus the conclusion of this blog is as follows
- There is heightened geopolitical risk and the warning by the Reserve Bank Governor that the political shocks are now becoming economic shocks requires careful analysis of overvalued companies. It may be that some risk off is advisable and a cash holding of 10-20% is seen by some Burrell advisors as a useful target.
- There will be opportunities between now and Christmas 2019 as the market is dealing severely with any disappointments in earnings and outlook statements.
- There may also be buying opportunities around any new geopolitical events e.g. any further setbacks in the China/US Trade War negotiations or a no deal Brexit.
- Once the noise is absorbed by the market, the TINA effect should result in higher valuations for good companies with sound dividend yields, as the difference between those dividend yields and the ten year bond rate has expanded.
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