Written by David Walker, Senior Equities Analyst, StocksInValue
At the start of the year we said monetary policy divergence globally would be a dominant theme this year, and the divergent performance of equity markets in the first quarter reflected this theme.
Figure 1. Sharemarket Performance, March Quarter 2015
The ASX rose more than 9% in the March quarter, driven mainly by the Reserve Bank’s February rate cut, the likelihood of another one in coming months (despite the decision not to change this Tuesday), and falling Australian bond yields supporting equity valuations.
More than a dozen other central banks cut rates in the quarter in attempts to devalue their currencies while the European Central Bank began its 1.1 trillion euro money printing program and Japan continued with its massive program. So the Nikkei was up more than 11% over the quarter while Germany’s DAX and France’s CAC respectively appreciated 23% and 19%. The Euro Stoxx, a broad measure of European stocks, rose 18% and the Shanghai Composite rose 17% after China loosened monetary policy.
In contrast key US indexes were dull in the March quarter, with the Dow and S&P 500 up only 1% and the Nasdaq 5%. This reflected expectations for the Fed’s first monetary tightening since 2006, as well as pressure on corporate profits from the strong US$. Also oil majors were weak in line with the soft oil price.
So, six years on from the global financial crisis we’re still in a market where the promise of cheap money from central banks can drive shares higher. Printed money should continue to find its way to Eurozone and Japanese equities, where we expect further modest gains hence the small positions in European and Japanese equities ETFs in the model portfolio. Small for two reasons: 1) because these ETFs are unhedged for currency and we don’t desire to take on any more currency risk in case the Euro and the Yen depreciate against the Australian dollar, and 2) these equity markets have already had strong quantitative easing-driven rallies so the upside is less than it was. At some point Eurozone growth and inflation will accelerate, when the boost to equities from QE will decline.
In Australia we expect the ASX to remain volatile on key Chinese and US data, especially as the Fed has chosen to be data-dependent. You can see this volatility in the market running hot and cold in recent days. But the market should grind higher on Australian dollar depreciation and also support for yield stocks, with the already dire situation for investors living off fixed interest about to get even worse as the Reserve Bank signals its bias towards another rate cut in coming months. In advance of the expected cut(s), banks continue to reduce bonus interest rates on deposits.
So why would the RBA consider future cut(s) when low interest rates will further inflate the frothy Sydney property market and there are many warnings this is increasing systemic risk? For four reasons:
- The dovish US Federal Reserve might defer its inaugural hike, which will inflate our US$ exchange rate for longer, but the RBA is desperately seeking depreciation to compensate for the slump in our terms of trade.
- The deterioration in business capital spending intentions, which was worse than the central assumed.
- The ongoing alarming fall in the iron ore prices, with the US dollar price of iron ore now down around 18% since the RBA’s board last met. This has not been neutralised by a commensurate decline in the Aussie dollar, which is trading at US76 cents and only off 1.5% or so over the same period.
- The RBA has admitted interest rate cuts are not as effective at boosting demand and confidence as they were, reflecting historically high household gearing, suggesting it will have to cut more to have the same effect.
The white-hot Sydney property market is of concern to the Reserve Bank but, as demonstrated by their February rate cut, not an impediment to easing because there is not yet the combination of excessive and broadly spread growth in bank-funded leverage in property markets. Debt levels are manageable with interest rates at current levels. Debt metrics will come back to haunt us at some point, but not in the near term.
Harder prudential limits and more transparency by APRA are required. The Reserve Bank is counting on regulatory constraints on bank lending to avoid a build-up of risky loans, so we were surprised at APRA’s suggestion last month such measures would be done in secret. Surely they’d want to shout from the rooftops they will impose tougher capital requirements on banks that grow investor lending too quickly.
The Reserve Bank remains hostage to global forces, in particular by US economic data, the US dollar, US treasury yields and by any decisions made or not made by the Federal Reserve. Australian dollar depreciation towards 70 US cents, especially if it were accompanied by a substantial fall in the trade-weighted index, would stay the RBA’s hand; indeed these are the intended outcomes of its rate cuts. Faster, deeper A$ depreciation would be inflationary and would tend to elevate domestic bond yields, which would be negative for equity valuations except where the boost to earnings from the stimulus outweighs this effect. Slower, shallower depreciation would keep the pressure on the RBA to cut and would see less upwards pressure on bond yields.
Worsening fixed interest returns should continue to force income investors into higher-yielding equities. This market dynamic is overwhelming, it should sustain into the June quarter and it should also continue to disproportionately benefit large-caps like the big four banks, Telstra, utilities and infrastructure stocks, whose yields remain superior to fixed interest. Refugees from fixed interest markets want fixed interest-style yields and they perceive higher-yielding, large-cap stocks as defensive.
It’s interesting to note ASX large-caps have substantially outperformed small-caps. This is because the greater liquidity of large-caps makes them more attractive during uncertainty about global central bank actions. There’s a premium for being close to the exit! This doesn’t mean ruling out small-caps as new investments but to outperform they must have secular growth or the right sensitivity to the structural and cyclical changes in the economy.
The most feared enemy of all of the above would be an unexpected come-back of inflation, forcing the Fed and financial markets to suddenly adjust to a much steeper trajectory for global interest rates. No sign of such reversal seems on the horizon for as far as the eye can see but we are watchful.
So let’s finish by previewing one of the most important data releases in the world this week: March US non-farm payrolls, to be released on Friday night our time. This monthly data series is pivotal to when the data-dependant Fed lifts rates and it directly drives volatility on markets. March payroll employment probably did not sustain the torrid pace of the previous four months, which averaged a 322,000 gain per month. Consensus is 249,000 with an unemployment rate of 5.5% but the main data point of interest to us will be wages because so far, persistent soft wages growth suggests the headline unemployment rate is not a good gauge of slack in the labour market. This is because the US still has many millions of workers, thrown out of work in their Great Recession, who are yet to return to the official labour force data. This is one of the main reasons the Fed is waiting so long to tighten despite the impressive improvement in the headline figures. Janet Yellen has affirmed interest rate normalisation will begin only when incoming data suggest inflation will rise to the Fed’s 2% target. We think uncertainty about the outlook for inflation and GDP growth will keep US monetary policy normalisation shallow and protracted.
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