What to expect from asset markets in 2019

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Via the excellent Bill Evans at Westpac today:

What do our economic forecasts for 2019 mean for Investors? Our key economic themes are: Australian economy and markets

• Growth in the Australian economy will slow in 2019 under the weight of political uncertainty; falling house prices; a contraction in residential construction; global volatility; and a softening labour market.

• Australia’s commodity price Index will fall as China softens its anti-pollution policies; supply lifts; and China’s economy slows.

• Housing affordability in Sydney and Melbourne is still stretched and further adjustments to affordability are necessary. With limited scope to rely on the adjustment factors of previous downturns (interest rates and strong household income growth) residential prices are set to fall further in Sydney and Melbourne through the year .

• Credit conditions are unlikely to ease significantly representing further complications. Even if prices adjust sufficiently to stabilise affordability and attract new buyers funding difficulties will complicate the recovery. In markets where affordability is not stretched credit tightening will still weaken conditions.

• The Reserve Bank is likely to keep the cash rate on hold through the year further widening the yield differential with the US.

• Lower commodity prices; deteriorating yield differentials; wide spread scepticism around the housing market will weigh on the AUD with a target of USD 0.68 seeming reasonable.

US economy and markets

• The bond markets are underestimating the momentum in the US economy particularly around the consumer and the resulting commitment of the Federal Reserve to higher rates.

• The federal funds rate is likely to peak at 3.125% by September (four more hikes) rather than the 2.5% which is currently factored into the market implying a potential Fed pause as early as March next year.

• The momentum of the US economy and the flexibility of the Federal Reserve to pause when growth is still around 2% and employment growth has eased to 1% leads us to expect a “soft landing” for the US economy with growth settling around 2% in 2020, from 2.5% in 2019.

• With recession and an early pause for the Fed unlikely there is going to be another wave of increases in the 10 year bond rate with a likely trough to peak move from the current 2.90% to 3.4% by September quarter next year.

• There is likely to be an extension of the fiscal spending initiatives from last year well into 2020, the Presidential election year.

• This sustained growth momentum ; a more aggressive Federal Reserve; and higher bond rates will further boost the USD which is expected to lift by a further 3% through the first half of 2019.

China and markets

• Authorities will stay the course of deleveraging; antipollution, although at a slower pace; and rebalancing the economy towards services.

• Further constraints on capital outflows will be enforced as US interest rates pressure investors.

• It seems unlikely that the Chinese authorities will be prepared to make the specific changes to their industry and trade policy that would specifically satisfy the US needs.

• These would include changes to forced technology transfer, intellectual property protection, non-tariff barriers, forced joint venture investment, cyber intrusions and government industry subsidies.

Investments

It is firstly important to note that our December Westpac Melbourne Institute Consumer Sentiment survey showed that respondents are increasingly risk averse.

The proportion of respondents who nominated real estate as the wisest place for savings was 10% –the lowest proportion since the first survey in 1974. Equities were down to 6%, the lowest since 2012, and the sum of equites and real estate was a record low.

Preferences for bank deposits and “pay down debt” dominated while the “don’t know” category, printed a record high at 7%.

USD Cash

Australian investors are expected to receive a reasonable return by investing in USD cash. With the federal funds rate forecast to average 2.6% over the next 9 months an anticipated fall in the AUD/ USD from 0.72 to 0.68 by September investors would receive an annualised cash return in AUD of “around” 10%.

That would compare with around 1- 2% in AUD cash.

Given the current mood of risk aversion such an option might be attractive. Of course the return is dependent on one of the key themes in our economic forecasts – a rising USD relative to the AUD.

Equities

Here the outlook is much more complex and the economic/ market environment which we forecast on balance sends a signal to be cautious until the second half of 2019.

Our best view is that equity strategies should recognise two separate phases. Currently, valuations are not stretched (as noted by Chairman Powell) as they were at the beginning of 2018 where forward PE ratios (S and P. 500) averaged nearly 19.

They are now down to around 16.0 (around average over previous cycles). These valuations are based on quite solid forward earnings estimates and the risk is always that earnings estimates prove to be overly optimistic.

The markets’ expectations for bond rates are quite different to our own views. An increase in the 10 year bond rate over the first nine months of 2019 from the current 2.9% to our target 3.4% and a rising USD could weigh on equity prices.

Markets are also basing the current outlook on prospects for a sharp slowdown through end 2019 and into 2020, (signalled by the current low bond rates and flattening of the US yield curve).

Our current expectation is that growth in the US will hold around 2% through 2020. With the Federal Reserve expected to be on hold after September next year; bond rates falling, and a lower USD, earnings can be expected to hold up.

Other developed equity markets are likely to reflect the US market and, indeed, likely to underperform as US economic and earnings growth continues to exceed growth in those markets. Consider 2018 where a flat US market outperformed Europe (– 12%); Japan (–5%) and Australia (–5%).

However, once the USD and US interest rates fall in response to the “on hold” Federal Reserve we would expect the US market to lift and provide a solid boost to other markets.

Our economic forecasts envisage the US economy settling into a stable growth environment supported by a lower currency and lower bond rates.

In summary, the best alternative seems to be to restrict most exposure to the cash option until it is clear (we expect around September) that the federal funds rate has peaked.

Property

Residential property prices are already falling in Sydney and Melbourne and with limited flexibility or desire to cut rates by the RBA there is likely to be a full year in 2019 of house prices falling further particularly in Sydney and Melbourne.

Westpac’s “Time to Buy” index from its Consumer Sentiment survey has recently lifted indicating some recovery in interest from owner occupiers but, as discussed, only 10% of respondents in the survey nominate real estate as the “wisest place for savings” – the lowest proportion since 1974. Investors are clearly cautious about residential housing.

For the US the housing market is at a very different stage in the cycle. Robert Shiller, using his highly regarded Case – Shiller Index, estimates that prices have lifted by 53% in the current boom (2012 to present) exceeded only by the pre GFC (1997– 2006) boom (76%) and the post war (1942–1947) boom (60%).

The “Time to Buy” Index from the Michigan survey has turned negative, and with our profile for the Federal Reserve policy and the outlook for bond rates a significant turning point in the US housing market seems very likely.

That will provide the Federal Reserve with additional reason to pause. However, the US banking system is well capitalised and it seems highly unlikely that the economy will be impacted by the highly leveraged liquidity crunch which under-pinned the GFC.

Nevertheless, residential housing in the US seems a very unattractive prospect if we are correct about the Fed’s interest rate policies.

Very good but a I disagree on a couple of points:

  • the Fed is going to pause sooner as it looks towards the H2 fiscal cliff, oil patch and housing slowdown;
  • China is going to have a growth scare in H1 and be forced despite incremental easing to revert to kitchen sink stimulus;
  • there’s a rising bullish risk of a short-term US-China trade deal. Nothing like the end of it but a can kick;
  • the RBA will be forced to cut by mid-2019 as the Australian economy stalls under pressure from the housing bust and falling commodities;
  • that will help stabilise house price short term despite credit remaining tight in H2;
  • the outlook for bonds, especially Aussie, is bullish;
  • equities are already reasonably priced but will likely see a choppy year;
  • the Aussie dollar drops further than 0.68 cents, at least until China blinks.

Leith and I will release our full Xmas special report next week.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.