Economic and Investment Update - February 2019

Summary of Key Views

Diversification in times of uncertainty

Equity markets have continued their upward trajectory, boosted by the Federal Reserve’s decision to place rate hikes on hold. But how long can markets remain placated? Despite the reprieve, key market risks remain, including a reduction in liquidity as central banks cease their quantitative easing programs, and tighter credit conditions, which have had a significant impact on those parts of the market supported by cheap debt and ample liquidity.

In uncertain market environments such as the one we find ourselves in, diversification becomes ever more critical to managing portfolio risk. Diversification across asset classes is key, but diversification across different investment strategies – such as absolute return and long-short equity strategies – is also essential.

There has been a lot of debate around whether bonds, which are traditionally seen as diversifiers to equities, can continue to deliver meaningful diversification benefits given the relatively low-yield world we are in. When we look at the correlation between equities and bonds over time it is clear that it is not static: there are periods of negative correlation but also periods of significant positive correlation.

Equity and bond correlations are influenced by a variety of factors. Rapid changes in real rates and inflation have tended to result in a positive correlation, an example being the ‘taper tantrum’ in 2013, which saw a surge in Treasury yields and a sell-off in equity markets. Conversely, growth shocks have tended to result in a negative correlation between equities and bonds as investors generally seek safe haven assets such as treasuries.

So, do bonds still have a role to play in portfolio diversification? In our view bonds continue to play a key diversification role despite the low yield environment, and indeed we have seen bonds act as a diversifier to equities in recent periods where there has been a flight to safety. However, it is important to recognise that correlations between asset classes can change, and under certain conditions they may become correlated when you don’t want them to.

Market developments during February 2019 included:

Australian Equities

Australian shares have been marching higher since the end of 2018, with the S&P/ASX 200 Index returning 10.1% over January and February, and in price terms now fully recovered since the start of the sell-off in October 2018. February’s gain of 6.0% was extended through the first week of March, with the Energy (+7.9%) and Information Technology (+7.6%) sectors once again performing strongly over the month. But it was the Financials sector (+9.1%) that was the real driver of returns, with the recovery in banks and insurance providers also offering a boost to asset managers. February’s earnings season was mixed but generally beat expectations.

There are signs that falling house prices and ongoing low wages growth are affecting retail businesses, with Coles Group (-9.4%) under pressure after reporting a 14% fall in half-year profit (despite the initial success of its Little Shop campaign in the first half). Blackmores (- 27.7%) was the hardest hit in the Consumer Staples sector (-1.5%), with investors clearly disappointed by the flat NPAT result, which was affected by Chinese market weakness. Meanwhile, Australia’s tech darlings have continued their inexorable rise, with Appen (+46.7%) thoroughly beating its earnings guidance and Afterpay Touch Group (+15.9%) likely to be largely unaffected by the Senate’s inquiry into the ‘buy now, pay later’ sector.

Global Equities

The global market rally continued apace in February and has extended into March, with the risk-on environment supported by a shift in central bank bias away from further tightening. While volatility remains elevated, it has eased significantly since December’s spike. China’s CSI 300 Index rose 14.6% in February on the back of stimulus efforts and an easing in trade tensions. While China was forced to cut its economic growth target, this did not come as a great shock to the market, although hopes still hinge on the efficacy of China’s stimulus measures.

The US S&P 500 Index rose 3.2% in February, with the biggest gains coming from the Information Technology (+6.6%) and Industrials (+6.1%) sectors. While there are still some areas of contention, including the treatment of intellectual property, progress appears to be made on a trade deal between the US and China, which has supported equities markets. However, German auto manufacturers are now the ones in the firing line, with President Trump threatening tariffs of up to 25% on German car imports. The UK’s FTSE 100 Index rose 2.3% in February but ended the month on shakier ground as uncertainty surrounding the Brexit outcome intensified ahead of the March deadline, with a number of moving parts making it difficult for markets to track the likely success of any new deal brought before parliament.

Fixed Interest

Even as equities have rallied, money has still flowed steadily into bond markets, with yields further compressed through February and early March. This is in contrast to the market dynamic at the end of 2018, in which growth shocks and fears over Fed tightening led to a flight to safety, with investors favouring defensive shares and bonds. Globally, bonds gained 1.9% in February in Australian dollar terms, while Australian bonds returned 0.9%. In Australia, the RBA’s more neutral stance saw markets price in a 25bp cut in the cash rate by November 2019. The Australian 10-year Treasury yield jumped to 2.19% ahead of the RBA’s March meeting before resuming its downward path and remains considerably lower compared to its November peak of 2.76%.

Similarly, a more dovish US Fed has resulted in yields trending down—the US 10-year Treasury yield rose from 2.72% to 2.63% in February but continued falling through March. Greece marked a milestone in early March as part of its long road to recovery, selling 10- year debt for the first time since March 2010. Japan’s 10- year yield fell to -0.05% in late February before rising back above zero in early March, while Germany’s 10- year Bund yield rose from 0.15% to 0.18% before heading south in March as caution set in ahead of the ECB’s meeting.

REITs (listed property securities)

The S&P/ASX 200 A-REIT Index returned 1.75% in February, building on January’s gains but underperforming most other ASX sectors. Amazon continues to be a boon for industrial REIT Goodman Group (+9.8%)—Amazon’s biggest landlord in Australia, Asia and Europe—which delivered stronger than expected earnings and lifted its full-year EPS guidance 9.5% to 51.1 cents per share. Themes such as a weaker housing sector, ongoing low wages growth, and the rise of Amazon continue to affect retail-exposed AREITs, including Vicinity Centres (-5.8%) and Scentre Group (-2.5%), which both fell after releasing earnings in February. Globally, REITs returned 15.3% in Australian dollar hedged terms over 2018, but in US dollar terms they were down 5.6%. The sector delivered modest gains as global growth and reflation expectations unwound through 2018 and investors sought defensive assets with resilient income streams. For US investors, global REITs are attractive given that they have been strongly negatively correlated with tech stocks, offering some protection from those feeling overexposed. February was a mixed month for US REITs— the Bloomberg US REITs Index returned 0.3% in US dollar terms, with gains from Hotels (+3.9%) and Manufactured Homes (+2.8%) and falls from Healthcare (-3.5%) and Self-Storage (-1.1%).