The past month has seen a significant outperformance in domestic assets following the surprise election result and Reserve Bank of Australia’s (RBA) decision to cut rates to 1.25%. The S&P/ASX 200 was up 3.45% over the past month and 15.6% year to date, outpacing the rest of the world.
Other markets did not fare as well. In the U.S., there was more volatility and markets pulled back before staging a strong rebound at the start of June and is little changed over the past four weeks. The Euro Stoxx 50 gained by 0.76%, whilst China’s CSI 300 index fell 1.22%. Commodities continued to turn lower as global economic growth indicators pointed to further deterioration.
Defensive assets continued to rally despite a rebound in risky assets as the U.S. 10-year yield fell 32 basis points (0.32%) as traders priced in rate cuts by the end of the year. Australians fully expected the RBA cut as yields fell 0.25% prior to the decision, and has been little changed since.
The Australian Dollar continues to hover around 70 US cents.
As the world continues to grapple with the implications of rising trade tensions between the U.S. and the rest of the world, the Australian economic outlook seemed to have turned more positive in the past month, albeit from a low bar as Q1 GDP showed that Australia was already in recession on a per-capita basis as immigration drove a 1.8% annualised rate of growth. The polls got it wrong once again as has been the case for the past several years, wrongly predicting the outcomes of Brexit and the U.S. election, and now wrongly predicting a Labor win. From an unbiased perspective, the Coalition retaining leadership is positive for domestic equities and risk assets as it removes the threat of government policies that were wholly negative for equities and properties.
Following this outcome, APRA reduced lending requirements on new mortgages by relaxing the serviceability measures which will lead to increased borrowing capacity and can be seen as a form of liquidity injection. Borrowers were assessed on the ability to repay a loan at 7% but the regulator now proposes a gap of 2.5% on the prevailing lending rate which means the current serviceability check would be at 6%-6.5% in the current environment. Furthermore, RBA decided to cut rates by 0.25% to 1.25% at the start of June and the market is pricing another cut before the end of the year. These factors have shored up sentiment domestically as housing sales enjoyed a bump in recent weeks, and business confidence has bounced strongly in the latest reading.
The U.S. activity indicators showed further signs of slowing momentum but remain firmly in growth territory, while the latest employment figures were much weaker than expected. European and Chinese activity indicators continue to be show contraction on the manufacturing side but the services side is still propping up both economies. Faced with mixed data, central banks were quick in their efforts to reassure markets and businesses with the U.S. Federal Reserve (Fed) and European Central Bank (ECB) both providing dovish comments. Jerome Powell, the Fed Chairman, signalled that they were monitoring the risks of the trade war on economic growth and are prepared to cut rates, sending U.S. yields lower, whilst the ECB promised to keep rates on hold until at least 2020.
Tariffs and trade continue to be front and centre for market sentiment as Trump threatened tariffs on Mexican imports to the U.S. before subsequently announcing that they had come to an agreement on immigration shortly after. India was also removed from the U.S. list of developing nations which means that a wide array of Indian imports are no longer tariff exempt. U.S. and China continues to be the main event, and all eyes are currently on the G-20 summit at the end of June where a meeting between Trump and Xi on trade issues could occur.
Trade war or power struggle?
The trade war continues to escalate but there are questions on the true intentions of the U.S., is this truly about trade, or is this really a power struggle for the U.S. to retain its crown as the world’s most prominent superpower?
The real question for long-term investors may well be, can China and the U.S. escape Thucydides’ Trap? Thucydides is a Greek historian who opined that a ruling power will not quietly roll over for a rising power, and such situations tend to culminate in war or some form of it, and the results are generally quite negative for all involved. Examples include Athens and Sparta in ancient Greece, or Germany and Britain in World War 1, or Russia and the U.S. cold war.
There are two key areas that China is currently challenging the U.S. on, economic size and technological prowess. On one measure (Gross Domestic Product on a Purchasing Power Parity basis), China’s economy is already larger than the U.S., however, in absolute terms and on a per capita basis, the U.S. retains the lead. The most common measure is in absolute terms as shown below. Projections are for China to surpass the U.S. on this basis in 2026.
Trump himself said, “Our economy has been fantastic. Because they were catching us, they were going to be bigger than us. If Hillary Clinton became president, China would have been a much bigger economy than us by the end of her term. And now it’s not even going to be close.”
Technological prowess is not as easy to gauge. China already files a much larger number of patents than the U.S. but the U.S. houses all of the world’s largest tech companies. In 2015, China announced the Made in China 2025 strategy to focus on building technological capabilities such as artificial intelligence, robotics and electric vehicles and in Huawei, China houses the company that currently has the most complete 5G capability in the world. This prompted the U.S. think tank, Council on Foreign Relations to state that Made in China 2025 is a "real existential threat to U.S. technological leadership". Since then, China has dialled down its rhetoric on the strategy, and the U.S. imposed sanctions on Huawei earlier this year, whilst putting several other Chinese companies on a watchlist for sanctions as well as pushing for allies to boycott Huawei.
We have seen all of this before. The cold war between the U.S. and Russia provides a strong historical reference. At that time, it was a technological war focussed on nuclear power and satellites which took forty years to resolve. The likelihood of actual military warfare between U.S. and China is unlikely in this day and age as information is more readily available and the populace has little appetite for violence. A new cold war scenario is the most likely culmination of this power struggle.
Market headlines remain focussed on the daily updates surrounding the trade war and whether an agreement is forthcoming. Whilst consensus is generally optimistic on an agreement eventually being reached, expectations should be tempered as the animosity between U.S. and China will likely remain. Even if an agreement is reached, it may not result in all tariffs and sanctions being rolled back. Furthermore, there will likely flare-ups through trade and various other avenues for decades to come.
This does not mean that investors should shun risky assets. Indeed, the cold war period continued to produce good returns for long-term investors and arguably spurred a period of strong innovation that may not have occurred otherwise. Instead, investors should be cognisant of the underlying issues that manifested into a trade war and look to take advantage of opportunities it might bring in the bouts of volatility that will likely occur as tensions ebb and flow.
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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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