The global Purchasing Managers’ Index (PMI) has been in decline since 2017. Combined with the heightened risk of a prolonged US-China trade war; this has caused global interest rates to decline and for the US Federal Reserve to halt any further tightening of monetary policy. This has resulted in a significantly more dovish outlook for global economic growth and policy settings.
Related to this trend is a continued reduction in the rate of growth in global earnings per share (EPS). By the end of 2019, the current trend in global earnings may result in negative EPS growth, supporting the very low level of interest rates.
Against this backdrop, cental banks, including the Reserve Bank of Australia, have had no choice but to adopt an easing bias with interest rates, and the RBA has recently started to ease policy again, cutting the cash rate to an historic low of 1.25 per cent in early June.
A stabilisation in the global PMI (as compared to further deterioration) is now a critical point. Improved trade negotiations between the US and China that have recently been reported will be positive for equities and the global PMI. For Australia, the stimulus from tax cuts, interest rate cuts, an easing in financial conditions for residential lending and improved consumer and business sentiment, coupled with an improved PMI, should be very supportive for equities.
Australian Equities supported by Lower Interest Rates
The reduction in the Australian cash rate to a record low of 1.25 per cent is positive for investment in the Australian equity market. Given that the yield spread for Australia equities to the best rate term deposit or the 10-year bond is now at a post-GFC high, we expect investors to continue to favour assets such as Australian equities that will help deliver required income with the appropriate level of risk.
The expected franked yield for the Martin Currie Australia Equity Income strategy, at 7.1 per cent, is also well above the broader equity market due to its focus on high quality businesses, with solid track records of paying sustainable dividends throughout the business cycle.
Investment opportunities in Income and Cyclicals
We believe that the best opportunities are currently income generating assets with strong free cash flows and reasonable return on invested capital. These tend to be real assets such as utilities, infrastructure and retail shopping centres. Real assets are defensive, generally provide essential services and often are very dominant in their respective markets. This industry structure is typical in Australia and New Zealand.
Companies in the consumer staples and discretionary sectors should also benefit from the combined stimulus from the RBA’s rate cuts, the government’s tax cuts and measures to stimulate housing demand. This also extends to building material companies which are leveraged to growing infrastructure spend and an expected recovery in housing construction once the current housing market stabilises and the easing of credit flows through to first and new home buyers.
Geopolitical risk will undoubtedly be an important and ongoing focus for the market in the months ahead. This will, in our view, centre around two key areas: first, U.S.-China trade tensions, and second, Brexit visibility (and the ongoing uncertainty of its outcome). The former will feed into the longer-term outlook for Chinese and U.S. economic momentum, and by extension, drivers of global economic growth. Although Chinese authorities have continued to take action this year to avoid a hard landing for their economy, there is the ongoing risk of a weakening of momentum at this stage.
This will in turn lead to a secondary focus for the market on the macro front, namely the need to assess monetary policy actions across the regions. The U.S. Federal Reserve has been more vocal
about the potential need for interest rate cuts, as has the European Central Bank, so a more accommodative monetary stance is likely to be a theme for the rest of the year and beyond.
On the economic growth front, leading indicators are weak across all regions, which highlights downside risk to GDP estimates and earnings forecasts. In our view, equity valuations are relatively more supportive in Asia and Europe than they are in the U.S., although the backdrop of weakening economic momentum means that monetary policy assessment has become an important aspect to consider when assessing both direction and style leadership in the market.
Impact of Tariffs
We believe that the current impasse over tariffs has minimal potential to affect the long-term outlook for equity markets. Our view on the long term has not changed – we continue to see a lack of inflationary pressures, and in fact, strong underlying deflationary currents brought by technological disruptions. In this environment, we continue to focus our fundamental research work on finding undervalued companies with attractive, sustainable returns, good growth profiles, and strong balance sheets, as well as those that offer good compounding characteristics over the long term.
The Emerging market opportunity
On a 10-year view, looking at current basic price-to-book (P/B) value versus history, emerging markets in aggregate (as measured by the MSCI EM Index) are at a wide valuation discount compared with world equities as a whole (as measured by the MSCI World Index. This is despite the fact that the EM equities offer very similar profitability and better aggregate profit growth potential. In our mind, this presents a compelling opportunity for long-term investors. What’s more, the EM
market opportunity (as measured by the EM index) has also undergone a powerful shift in nature, becoming materially less weighted to resources and more weighted to the information technology and consumer sectors over the last 10 years.
Looking regionally, there is reason to be positive about China. Valuations are reflecting much of the uncertainty about the trade situation, and longer-term secular growth opportunities are now being mispriced. Indonesia should benefit from more accommodative monetary policy globally; consumer sectors are cycling through the difficult growth environment and the outlook is improving.
Meanwhile, in Hong Kong, while the local economy is more sensitive than most to problems in the overall trade environment, we believe the stock market includes companies with really attractive long-term secular growth characteristics. Apart from the obvious impact of money flows that will be needed to avoid unwanted deviations from benchmarks, we see the inclusion of A shares in major indexes as likely to drive the Chinese equity market forward in terms of corporate governance and a greater focus on ESG factors. We also see further inclusion as likely to drive a further reform and liberalisation of capital markets.