Stock markets continued to rally in February to recover most of the losses from late 2018, at the same time Australian government bonds have continued to price a slowing Australian economy which led to a strong performance from all of our portfolios. International +5.3%, Tactical Growth +3.4% and Tactical Foundation +2.0% were the best performers. We have been using the strength in markets to take further profits on our equity holdings – we are now at the minimum weight for Australian shares across all tactical portfolios, including zero-weight in Tactical Income. We are decidedly conservative and defensive across all tactical portfolios. One remaining sentiment positive event is a trade deal between China and the US – we expect some sort of announcement shortly which could spur stock markets higher, but we believe: a comprehensive deal is unlikely, the announcement is likely to be more style than substance, and any stock market gains will be short-lived.
The other major risk is our bet against the lucky country. Australia rolled from a mining boom into a housing boom, all the time building up more and more debt at the household level to world-leading levels. Concurrently, at government levels, one-off gains from mining and housing booms have been funnelled into recurring expenditure and tax cuts. The conditions for a reckoning have been in place for many years, but Australia has managed to avoid the reckoning through a mix of:
- External good fortune: a massive increase in debt-fuelled Chinese building sparking demand for iron ore and coal
- The good fortune of gas discoveries: gas discoveries created a historically huge level of capital expenditure on gas infrastructure and LNG plants, turning Australia (soon) into the world’s largest exporter of LNG
- The good (?) fortune of lax regulation: poor regulatory oversight allowed Australian consumers to borrow far beyond their means, pushing an otherwise ordinary housing cycle into a housing boom
Rather than use the booms to re-engineer the Australian economy to rebalance to a more sustainable footing, Australia has doubled down each time: spending the proceeds of the booms on tax cuts / increased government spending, allowing the gas giants to dictate policy so that gas royalties are reduced to levels far below other countries while domestic gas prices soar to be among the highest in the world, allowing a higher Australian dollar and higher gas prices to hollow-out non-resource industries. At each step of the way, short term gains have been taken at the expense of long term gains, often at the urging of vested interests.
Each of these factors seems to have come to an end. The gas capital expenditure, which added well over 10% to Australia GDP over a number of years is largely finished. The production phase of the major projects has little effect on the Australian economy as the projects are largely owned by foreign entities who pay minimal royalties and have enough tax losses to avoid income tax for many years. While China may continue to build at record levels, there is downside risk rather than upside. Finally, the royal commission into the banks has raised the prospect that the banks have been involved in predatory lending – this has led to a sharp contraction in the amount of lending which in turn accelerated the fall in house prices.
We may be wrong and Australia might get lucky again. Just recently another mining accident in (key competitor) Brazil has curtailed iron ore production – to the benefit of Australian producers, maybe more of these events will emerge. Maybe a comprehensive trade deal between the US and China will spur the global economy. The odds are though that the run of good fortune is over, and with the Australian stockmarket at a 10% premium to world markets, on far worse earnings growth, we believe the current run-up in stock markets is giving Australian investors one more chance to position their portfolios.
For most of 2018, we grappled with the dilemma of how to get enough exposure to the final leg of the bull market while maintaining downside protection in case markets unravelled earlier than expected. We are not expecting much positive news for stocks and so 2019 will be about how to get downside protection.
A resolution to the US/China trade war is one possible positive catalyst, however, we believe the intrinsic issues between China and the US run so deep that any announcement in the next few months is likely to be made to appease the egos of the leaders rather than as a long term solution. If this were to occur, our instinct would be to take further profits on shares and increase our bond/cash holdings further.
For the most part, we expect 2019 to be about avoiding accidents. Brexit, the rise of extremist parties in Europe, slowing growth plus too much debt in China, trade wars, emerging market crises and a slow-motion Australian housing crash will all present their challenges. If every accident is avoided then the stock market could eke out reasonable returns – but our base case is that the best returns are likely early in 2019 before slowing global growth (particularly in China) becomes apparent.
Tactical Asset Allocation Portfolio Positioning
In our tactical portfolios, we own cash, bonds, international shares and Australian shares. We tend to blend these portfolios for clients so that each investor receives an exposure tailored to their own risk and income requirements.
The broad sweep of our asset allocation over the last 18 months was to ride the Trump Boom, winding back on equities as share markets advanced and topping up when they fell but maintaining an underweight position in shares. Now, it is about an appropriate level of protection as the current business cycle draws to a close.
We have positioned our portfolios to be underweight shares (and significantly underweight Australian shares), overweight bonds and overweight cash.
Over / Underweight positions by portfolio
In summary, our view continues to be that Australian investors should continue to hold minimum weights for Australian shares at this point in the cycle. Our intention is that our portfolio is positioned to take advantage of our key themes but minimise risk in the event that our themes take longer than expected to resolve themselves.
We retain large cash and bond balances to hedge against volatility and in the expectation that capital protection will be important during 2019. If markets continue to be rally then we will likely sell more shares. Our key focus is Chinese growth, gauging the extent of the slow down and the policy response.
Damien Klassen is Head of Investments at the Macrobusiness Fund, which is powered by Nucleus Wealth.
The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.