It has been a poor 10 weeks for investors, with the S&P/ASX 200 giving up all the gains for the year by dropping 10%. Over the same period, the S&P 500 is down 7% and the Euro STOXX is down 6%. A relief rally at the start of November proved short-lived as tech and oil dragged global equities lower. Bonds offered no respite either, providing negative total returns as yields rose over the period.
The Australian 10-year bond yield remains around 2.75% as markets continue to expect the Reserve Bank of Australia to remain on hold in the short term. US 10-year bond yields pulled back a little following the huge run-up in September and October, currently trading around 3.15%.
The Australian Dollar has firmed up as the US Dollar weakened and is now trading around 72.7 US cents.
Market bulls are hoping there is some resolution between Xi and Trump during their meeting scheduled late November at the G20 Summit. Whilst this is unlikely given the differences between the US demands and the concessions that China is willing to cede, Trump has shown previously that he is happy to sign high-level agreements with little detail, like the one signed with Kim Jong Un. This is likely to be a key driver for market sentiment in the near-term.
Economic data has remained resilient in the face of higher trade tensions up to now. However, the third largest economy, Japan, and the largest European economy, Germany, both contracted in the third quarter. Granted, Japan was impacted by multiple natural disasters, but cracks are starting to emerge and trade tensions are likely the big factor in deterring economic activity.
Australia continues to face its own challenges with the royal commission inquiries spreading to other lenders and the deflating of property prices. Despite this, the economy is not showing signs of a meaningful slowdown. Employment remains robust, with wages growing at 0.6% for the third quarter and unemployment falling 0.1% to 5%, primarily driven by full-time positions. The Reserve Bank of Australia is unlikely to raise rates anytime soon though, as other economic data is still weak and inflation remains well below the target, coming in at 1.9%.
Markets remain concerned on China, with the latest figures showing the manufacturing and industrial production sectors holding up well in the face of US tariffs but the Chinese consumer has taken the foot off the gas as consumer activity data was slightly weaker than expected but continues to indicate good growth. The data was from October, so maybe Chinese consumers were just saving for Alibaba’s Singles Day sales on 11 November (11/11) which hit another record at US$30.8 billion in sales in one day, up from US$25.3 billion despite a 5% fall in the Chinese RMB. Meanwhile, trade data continues to improve despite tariffs. Imports and exports both rose more than expected and the US trade deficit with China continues to rise as the weaker yuan offsets some tariff costs and strong US consumer sentiment translates to higher demand.
Meanwhile, the US economy continues to impress, with the Federal Reserve reiterating their rate hike path with no mention of the recent moves in investment markets. Everything from consumer confidence to manufacturing and services activity data continue to show a strong US economy. Employment blew past expectations again and unemployment held at 3.7% as more people joined the workforce. Hourly earnings rose 3.1% over the past year and labour costs rose 1.2% in the last quarter. This puts further pressure on the Federal Reserve to raise rates which leads to higher bond yields as markets price this in. Bond yields still imply that bond investors do not believe the Fed, while the recent equity correction suggests that equity investors are concerned over this. This means that investors should keep an eye on interest rates and bond yields.
Earnings, yields and valuations
In stark contrast to market movements, third-quarter earnings have been good globally. Most US companies have reported and the S&P 500 earnings growth is tracking at 25.5%, well ahead of expectations of 20% growth at the start of earnings season. Europe is about halfway through their reporting season and has so far posted earnings growth of 11% versus expectations of 10% at the start of earnings season. There are no third-quarter earnings for Australia, but the results from the big banks were positive relative to expectations given the backdrop of slowing mortgage demand and the royal commission. In addition to strong earnings, even an easing of tariff concerns from company outlooks as shown below, could not alleviate the sell-off.
So what is the reason for the selloff? Rising bond yields which have led to yields above inflation for the first time in several years could have been the key trigger. Bond yields are a key factor in valuations as they are generally used to comprise part of the discount rate when valuing future cash flows such as dividends, free cash flows or earnings. Therefore, as bond yields rise, the future cash flows get discounted at a higher rate which translates to lower present values. The chart below shows this relationship has generally held true. The S&P 500 Earnings Yield in red is the inverse of a P/E ratio, or Earnings/Price.
This relationship means that if earnings don’t grow, both traditional bond and equity investors would both lose money as yields rise. In reality, rising yields often occur in periods of good economic growth and higher inflation, so earnings tend to show strong growth, especially in the early stages of a rate hike cycle. This can be seen in the current cycle where adjusted for tax cuts, share buybacks and currency, the earnings growth for the S&P 500 is estimated to be 15% for the third quarter for the 90% of companies that have reported. However, as we reach the latter stages of the rate hike cycle, higher borrowing costs begin to bite, hurting earnings growth and economic growth. The question that investors are currently grappling with is whether we have moved to the latter stages. So far, bottom-up analysts are still forecasting healthy earnings growth for 2019 at this stage and earnings results have indicated that we are not yet at the tipping point, so this could just be a healthy correction.
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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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