Economic and Investment Update - October 2018
by Lonsec Research
Summary of Key Views
Portfolio diversification in volatile markets
Markets have continued to experience volatility over the month. The US market in particular has experienced significant volatility with technology stocks facing the brunt of the turbulence. Until recently the tech sector was a significant driver of US market returns, making up over 20% of the S&P 500 Index.
Over the last five years, stocks such as Facebook have seen their share price rise phenomenally from around US $48 in November 2014 to over US $200 in July this year. Since then, the stock price for Facebook has declined due to stock specific issues, as well as momentum turning negative on tech stocks generally. We expect market volatility to continue as the market digests the prospect of possible lower growth in the US economy in the future, and the potential for further interest rate rises.
In such an environment, portfolio diversification becomes increasingly important. We believe we are at the later stages of the cycle, with economic indicators such as global PMIs declining, however overall growth still remains positive.
Market developments during October 2018 included:
The S&P/ASX 200 Index returned -6.1% through October as local markets reacted to selling on Wall Street and growth shares came under pressure. Sectors that have enjoyed a relatively robust earnings trajectory in recent months, such as Health Care (-7.0%) and Information Technology (-11.2%), were hit hard as investors backed away from elevated valuations. Returns for ‘bond proxy’ sectors such as Utilities (-4.0%) and A-REITs (-3.1%) were the least negative during the month but continue to be buffeted by moves in the US bond market, which has seen yields push higher as investors raise their inflation expectations in response to the strength and duration of the current US economic cycle. Some of Australia’s own growth darlings came under pressure, including fintech player Afterpay Touch (-30.4%) and global logistics software provider WiseTech (-27.3%), but both were still trading at around 50x FY20 earnings by month-end. Within the Energy sector (-10.5%), Worley Parsons (-24.7%) saw the biggest drop, with investors cautious about the price paid for its $4.6 billion acquisition of Texas-based Jacobs Engineering’s energy, chemicals and resources business.
In the US, the market rally gave way to a rolling bear market in October, with debate raging about whether the selloff was predominately technical or driven by fundamentals. Global shares, measured by the MSCI World Ex Australia Index, returned -5.2% in Australian dollar terms, while small cap shares fared even worse, returning -8.0%. While systematic flows may have exacerbated the drawdown, there are signs of slowing earnings momentum in the US and companies missing EBIT margin estimates for 2019, while liquidity and Fed tightening remain overarching concerns. The S&P 500 Index returned -6.8% in US dollar terms, and in price terms the index surrendered all of its year-to-date gains in just three weeks. Losses were concentrated in the areas of the market where fund managers have relatively higher levels of exposure, including IT (- 8.1%), Consumer Discretionary (-11.3%), Energy (- 11.3%) and Industrials (-10.9%). The STOXX Europe 600 Index lost 5.3% in October with the largest falls coming from Industrial Goods and Services (-9.3%), Technology (-8.7%), and Banks (-9.3%). Chinese equities and the yuan remained under pressure over the past month as investors fretted over the ongoing slowdown in growth and the potential negative impact from the escalating trade war with the US.
Global bonds, measured by the Barclays Global Aggregate Index, returned 1.0% in October in AUD terms and -0.2% in AUD hedged terms. October was dominated by the sharp rise in US bond yields and the accompanying downturn in global equity markets, with the US 10-year yield pushing to a high of 3.26%, while the S&P 500 suffered a 9.9% drop from its record high in September to its October low. Ongoing strength in the US economy and a readjustment in inflation expectations was the obvious culprit, although loose guidance from the US Fed may also have been a contributing factor. The market lifted its expectation for the Fed funds rate, factoring in a December move and two further hikes in 2019 to 2.875% but with a low probability of further action. Yields eased through the end of October and early November as the market came under pressure from record volumes of longer-dated US government debt supply, which saw the 10-year yield slip to 3.18%, while the US Dollar index fell below 96. Australian bonds returned 0.5% in October and it was rocky ride for the Australian 10-year yield as well, which hit a high of 2.78% in October before falling to low of 2.57% late in the month, only to shoot back above 2.75% by the second week of November.
REITs (listed property securities)
The S&P/ASX 200 A-REIT Index returned -3.1% in October but was the top performing sector, with solid gains from Shopping Centres Australasia (+7.1%) and BWP Trust (+3.6%). Australia remains reasonably attractive in terms of commercial property yield spreads to bonds (around 3.0% compared to the long-term average of 3.5%) and the fall in the Australian dollar through 2018 has made property cheaper to foreign investors. Corporate activity in the sector has also picked up recently, with Oxford Properties Group winning the race to take over Investa Office Fund (+0.5%) with a $3.4 billion cash offer. The residential property market is reporting signs of reduced auction clearance rates and easing prices, particularly at the top end of secondary market transactions, and the high-rise apartment market is showing some signs of retreat with developers delaying projects. The residential sector still faces some uncertainty as to the impact of recent bank lending curbs, lifts in foreign investor charges, plus the speed of interest rates increases. US REITs continued their slide in October, although results were mixed. The Bloomberg US REIT Index was down 2.8%, with falls in Hotels (-9.9%) and Offices (-5.2%) while Single Tenant property (+3.6%) and Storage REITs (+2.1%) led the gains.
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