Equities were mixed as the US S&P 500 pushed about 2% higher in the past month on the back of a tech resurgence.
The domestic S&P/ASX 200 was largely flat as banks and financials continued to trend lower, offset by rises in healthcare and exporters on the back of a lower Australian Dollar. Meanwhile, the European Stoxx 600 was also largely flat despite volatility around the Italian election.
Emerging markets was the poor performer as the US Dollar continued to strengthen and escalating trade tensions weighed on stocks in the region, with China’s CSI 300 Index down over 5% despite mainland Chinese equities being inducted into the global MSCI indices.
Yields on US 10-year bonds fell to around 2.9% despite the US Federal Reserve raising rates by another 0.25% as risk-off sentiment prevailed. Meanwhile, the gap between the Australian 10-year bond yields, currently around 2.6%, widened to almost 30 basis points or 0.3%.
The Australian Dollar continues to fall and is hovering just above the 74 US cents mark.
Trump headlines dominated the month once again as he vacillated on trade policies and political relationships. First came the ‘agreement’ with China to refrain from implementing $50 billion in tariffs as China would reduce the US trade deficit by buying ‘significantly more’ US products over the next few years. Then came the expiry of steel and aluminium tariff exceptions for Canada, Mexico and Europe which are historically the closest allies of the US, followed by Trump agreeing to back a unified G-7 statement to a commitment to free-trade which Trump then backpedalled only hours later via his favoured media outlet, Twitter, as Canada held its ground that it would respond to US tariffs. Europe and Mexico have also signalled that it will look to hit back at US tariffs and Europe has maintained its stance that it will not negotiate on trade until Trump rescinds the steel and aluminium tariffs on European products indefinitely. Trump then reinstated a commitment to implement the $50 billion China tariffs, with China following up the next day by implementing $34 billion in tariffs on US agriculture products and signalling that it is reluctant but prepared to impose further restrictions in retaliation to any further sanctions from the US.
Past the headlines, Australia has shown economic improvement over the past few months as GDP beat estimates, coming in at 3.1% for the first quarter of 2018. Retail sales and consumer sentiment both showed improvement, but this positivity was offset by weaker business confidence and a continued weakening of employment conditions. The Reserve Bank of Australia (RBA) held rates once again as widely expected and the consensus view is that the RBA will remain on hold for the rest of 2018.
The US economy continues to show strength as employment figures, wages and retail sales were better than expected, while core inflation was at 2.2%, slightly above the US Federal Reserve (Fed) target of 2%. The Fed raised the official interest rate to 1.75%-2% and also raised expectations from a total of three hikes this year to four.
Economic data in Europe was largely in-line with expectations, indicating that despite the issues around the viability of the European Union, it is continuing to show a broad-based recovery, albeit off a very low base. This prompted the European Central Bank (ECB) to announce that it will formally end its quantitative easing (QE) program by the end of this year, although the caveat was that it does not foresee a rate rise until at least mid-2019.
Chinese data was solid but there has been signs of more restrictive liquidity conditions as it continues to balance debt reduction with its growth targets. Meanwhile, Japan disappointed as it had weak results on nearly everything from GDP to industrial production and personal expenditure.
Moving forward, trade issues will likely continue to dominate headlines in the near term but the key issue that markets will face in the medium term is the gradual reduction of liquidity as the Fed gradually unwinds its balance sheet and central banks continue to hike rates.
What liquidity means to markets
Liquidity has several aspects. One is the time to convert an asset to cash, for example, selling a stock on the ASX takes two additional business days to settle or T+2, some managed funds take one week, some one month, and others that invest in private equity can take several years and the underlying cost to convert the asset to cash, for example, buy/sell spreads paid on managed funds or bid-ask spreads paid to exchange currencies. Another, which forms the basis of this article, is referring to the market’s monetary conditions. Whilst the former is generally fixed (funds can close or restrict redemptions depending on what’s laid out in the agreements), the latter tends to change over time and largely depends on monetary conditions and market sentiment.
When liquidity dries up as the market becomes a net seller, it is likely that the market falls as a result. For example, significant monthly net outflows from the S&P/ASX 200 is likely (though not always as there are other factors that drive markets such as earnings) to mean that the S&P/ASX 200 had negative returns. The chart below illustrates this relationship.
Central banks are draining the liquidity
For many years post the Global Financial Crisis, central banks have pumped liquidity into the market by reducing interest rates to record lows and even negative in some areas, in conjunction with massive QE programs. Through interest rate policies, central banks basically incentivise savers to spend and even borrow as interest costs become cheap, resulting in money pouring into assets such as real estate and equities. The perceived cost of risk also falls in such instances, resulting in multiples expansion such as higher P/E ratios for stocks, or lower yields for real estate and bonds, driving up prices that investors are willing to pay. In addition, the massive QE programs are basically the central banks printing money and providing even more liquidity. As central banks reverse their actions to normalise their respective monetary policies, they are draining the liquidity from markets.
The Fed has already raised interest rates significantly, although it is not yet at a restrictive level. The unwinding of the Fed’s balance sheet is basically taking cash out of markets but was initially offset by the ECB and Bank of Japan continuing to buy assets at a greater pace. Central bank bond buying is set to turn net negative as the ECB tapers and ends its QE program, and will start to drain liquidity from markets. However, we generally see a liquidity crunch only after liquidity growth bottoms as the chart below shows.
The Rothbard/Salerno True Money Supply
Liquidity levels remain well above previous levels that triggered crises but the downward trend is likely to pressure all markets so the focus shifts more to earnings growth for equities, and balance sheet strength and cashflow for fixed income. We have recently seen earnings growth comfortably beat estimates with many companies upgrading guidance, while corporate balance sheets generally remain in good health, while central banks have, thus far, been cautious in their approach, carefully laying roadmaps early on and indicating their willingness to tolerate above-target inflation. If they manage this transitionary phase well, they may be able to stave off a liquidity crunch for some time to come, but investors should be vigilant for signs of liquidity conditions deteriorating to dangerous levels.
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This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Partners Wealth Group we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
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