The slowing global and domestic economy over the past year continues to create challenges for the Reserve Bank of Australia (RBA) and the Government. Policy makers will need to remain alert and deliver additional effective and timely stimulus to address the challenges ahead. This creates opportunities for investors as they reflect on their return expectations across the various asset classes and their risk tolerance. In short, investors will need to anticipate even lower yields in the year ahead including dividend cuts.
The International Monetary Fund (IMF) has consistently downgraded global growth for calendar year 2019 from 3.7% over a year ago to 3% earlier this month. This will be the slowest economic pace since 2008-2009 creating challenges for investors.
The ongoing slowing global economic activity is not being helped by the trade war between the US and China, the largest and second largest respective economies globally. The supply chain disruption has impacted trade flows and it can always escalate further whereby slowing global trade even further. Globally, these trade tensions and geo-political events impact business conditions and sentiment. Further, the ongoing Brexit drama will impact both the UK and EU economy. This uncertainty looks set to continue for now despite the many fatigued Brexit watchers. Hence, global central banks will continue to deliver even further accommodative stimulatory policy to help cushion the downside risks to global growth.
Slowing global trade is not ideal for the Australian economy which is effectively a resource (bulks, metals), energy and food exporter. However, the services part of the Australian economy has been expanding over the past decade whereby education, tourism and financial services are becoming significant parts of the economy and should hold up well with a lower AUD.
Also, some of the past private sector investment is also helping in a number of ways. The very large CAPEX investment in our resource sector over the past decade was a very significant stimulus to the domestic economy at the time and while the resource investment boom is behind us, the export orientated resource sector will benefit from this investment for decades to come. The dividend for this investment will continue for some time. Further, the government will benefit from the corporate profits that are increasingly derived from this investment.
The housing construction boom that followed the resources boom is now well behind us. The sharp fall in dwelling investment over the past three years has been driven in part by tighter credit conditions for investors (prudential regulation), broader tighter mortgage lending conditions post the Banking Royal Commission and household confidence to name a few. Going forward, there will be some additional stimulus measures that will be required to cushion the downside risks.
The recent recovery in median house prices in the major Melbourne and Sydney markets are welcomed to help sentiment recover following recent rate cuts, however house prices have come off very elevated levels. While house prices are a very emotive topic, the fall in median prices from the highs seen a few years ago has partly addressed some of the extreme housing debt liabilities ratios that the Australian market has been known for by global investors.
On the fiscal side, the tax cuts have been the single largest household income boost for some time. It is effectively higher incomes with immediate effect. Interestingly, it appears that most of this tax cut has not flowed through to retail sales, as household have preferred to retire debt and increase savings. Additional targeted fiscal stimulus would be required in the year ahead and one would anticipate some announcement post the Federal Budget in May 2020.
Further, the independent Fair Work Commission increase of the minimum wage to 3.0% annually earlier this year (following the 3.3% and 3.5% increases the following two years) were timely. These cumulative increases in recent years are significantly larger than inflation and will transfer into the broader economy. It would be expected that these “greater than CPI” increases will continue in 2020.
Also, the boom in government supported infrastructure spending (both at the federal and state level) will continue to absorb some of the softening housing for some time. With the 10-year government bond yield now just below 1.15%, bond yields are broadly around historical lows to fund future projects. Clearly, the current low rate bond environment requires fiscal discipline at all times, which is monitored by the various global rating agencies.
On the monetary policy front the RBA looks set to drive the cash rate even lower from the current historical low of 0.75% to 0.5%. Many commentator point out that the marginal benefits of lower rates diminish. This is a valid point however the stimulus is still required and Australia is finally catching up to challenges that other key economies have been dealing with. The lower rates will support the labour market and help encourage further investment. It will also support the current long standing SMSF investments in equities for the dividend (that will be cut) and the very precious imputation credit. The subdued inflation conditions and slowing global growth allow for even lower rates going forward. This will be additional relief for households with existing mortgages who are effectively pre-paying their debt at a faster rate. A further boost for household savings.
In summary, a combination of household income growth (tax cuts, wage rises above inflation rate), the ongoing large scale infrastructure programs, even lower cash rates and a lower AUD all combine to help cushion the global slowdown and help drive investment and confidence going forward. Risk assets (equities, sub investment grade bonds, hedge fund alternatives) have delivered very strong returns year-to-date (circa 20%). Investors have effectively received two years return in the first ten months of the year. A lower return expectation is advisable and some profit taking is prudent. Dividends will be cut and volatility will become more elevated unless global policy stimulus is even more pre-emptive and aggressive. With higher volatility anticipated your reaction to your investment portfolio is behavioural. For the long term investor (greater than five year time horizon) they will still need to be invested through the cycle ahead despite some challenges ahead.
CIO | Atlas Capital
Director | Salter Brothers Asset Management (SBAM)