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Our Investment Team’s economic and investment market update for 2018

December 2018

The key points

  • Investment markets experienced several bouts of volatility during 2018.
  • The last few months have been particularly volatile and have negatively impacted returns.
  • Despite slowing down in recent months, the economic backdrop remains generally supportive for investment markets.
  • Risks remain around deteriorating political conditions which are affecting the outlook for economic growth.
  • Political interference is often much harder to factor into investment decisions, and this has led to a more complicated investment environment.

A summary of the market

The year started off well with most major share markets posting very strong gains as the global economy got a boost from the Trump tax cuts (see Figure 1 below).

Figure 1

Figure 1: Comparative performance between the S&P500 Index (US – Black Line) and the ASX200 Index (Aust – gold line) from 1 January 2018 to 13 December 2018. Source: Bloomberg

This was followed by a short but very sharp sell-off in February as investors started to question whether the impact from these tax cuts would cause the economy to overheat, and the announcement of tariffs on Chinese imports into the United States (US).

Markets then stabilised, posting steady gains from April to September as global growth strengthened, company profitability continued to improve, and talk of tariffs stabilised.

October then saw another bout of volatility on concerns over proposed interest rate increases in the US and a hardening in US–China relations. Markets are yet to stabilise post this latest downturn.

A summary of the economy

The global economy has been remarkably stable over 2018, continuing a long run of consistent growth since the Global Financial Crisis (see Figure 2 below).

However, the global growth figures do mask some differences between economies – the US economy has seen very strong growth over the last 12 to 18 months thanks to the series of tax cuts pushed through by President Trump in late 2017. This has effectively balanced out a corresponding slowdown in growth in the Eurozone and Japan (see Figure 3 below).

Figure 2

Figure 2: Global economic growth

Figure 3

Figure 3: Economic growth – Advanced Economies

Chinese economic growth has also continued to slow as the Government seeks to contain some of the financial risks that have been building in the non-bank financial sector, though it still remains high by world standards.

Here in Australia, economic conditions could best be described as steady, rather than spectacular.

Economic growth remains just below its longer term average as the impact of falling house prices works its way through the economy. While economic growth has been strong enough to bring the unemployment rate down to 5%, the tightening in the labour market has yet to translate into any meaningful increases in wages. This has resulted in inflation remaining subdued.

The impact of the end of the mining boom also continues to be felt, with most of the major projects now complete or very close to completion. With production due to ramp up, the drag from this will recede and will turn into a tailwind of support for the economy.

The economic backdrop and market impacts

Throughout 2018, there have been three main economic concerns that have flowed into markets. To some extent they are all interrelated, and have each impacted returns:

  1. The outlook for US interest rates.
  2. The slowing of global economic growth, particularly outside the US.
  3. The impact of trade wars and other geopolitical concerns on economic growth.
US interest rates

For the last few years, the US Federal Reserve (the US equivalent of the Reserve Bank of Australia) has been watching the US economy improve.

As conditions have improved and the unemployment rate in the US has come down to a multi-decade low of 3.7%, inflationary pressures have started to build, forcing the ‘Fed’ to gradually lift interest rates from near on 0% to their current level of around 2.25–2.50% (after another 0.25% increase in the last few days).

Of much greater significance to investors is the outlook for the future path of interest rates. This is due to the fact that investors across virtually all asset classes – bonds, equities, unlisted assets, foreign currency – use interest rate settings to feed into valuations in some way. Fortunately for investors, the Fed publishes quarterly forecasts of where it sees interest rates heading over the next few years.

For the last two years, the Fed has indicated it will be embarking on a series of aggressive rate increases over the next three years, ultimately expecting the target rate to peak at 3.5% in 2020.

Investors have been much more optimistic about this, with market pricing indicating the Fed will only be able to lift rates to around 2.5% to 3% (refer to Figure 4 below).

The Fed (along with the Bank of Canada) is the only major central bank still raising rates, with most other major central banks forecast to remain on hold from lifting interest rates for the next 12 months.

Figure 3

Figure 3: US Interest rate policy – actual and projected

Figure 4

Figure 4: Current and expected interest rate policy of selected advanced economies

Investor calmness was interrupted in late September 2018 when the Federal Reserve Chair Jerome Powell indicated in a speech that US interest rates remain ‘a long way from neutral’ (a reference to the fact that they ultimately expect interest rates to rise well above current market expectations).

This triggered a significant re-think among investors globally that the Fed may actually keep rapidly lifting interest rates in the face of slowing economic growth. These comments almost perfectly coincided with the latest step down in the share market sell-off throughout October.

Interestingly, in another speech in early December (and following the significant volatility in share markets triggered by his earlier comments), Chair Powell indicated he now saw current interest rates ‘just below’ the rate seen to be near a neutral level.

The fact that the Fed appears to have adopted a ‘wait-and-see’ position on economic conditions rather than boldly lifting interest rates provided some comfort. It should also help to reduce the most significant threat to investors: that the Fed would lift interest rates too far too quickly, and kill off the economic recovery.

Slowing economic growth

The global economy is just about to enter its tenth year of uninterrupted economic expansion and this has continued well into 2018. To some extent this has been due to the influence of the very supportive conditions in the US, which received a boost from the Trump fiscal stimulus package.

It’s been a somewhat different story in emerging markets where the combination of the China trade tariffs and tightening US interest rates have combined to negatively impact growth.

On top of this, China (now the world’s second largest economy) has been looking to slow the rate of local debt issuance, particularly outside of the main financial sectors, which has in turn limited economic expansion domestically (see Figure 5 below).

When viewed as a whole, to date the impact of all these factors on global growth has been muted. The economic backdrop still appears positive, and is likely to remain positive in the near term.

Looking further into the future, the outlook is a bit more uncertain as the Trump tax cuts are forecast to turn into a mild drag on growth in 2020. While the Fed has indicated they’re open to slowing down the pace and number of further interest rate increases, any future rate hike will also place a drag on growth with the impact of these likely to be felt around 2020.

Finally, there’s the number of geopolitical issues that remain unresolved, which is also placing an elevated amount of uncertainty around the outlook for economic growth.

All of these factors are weighing on investors, particularly after such a sustained period of economic expansion. The longer these expansionary phases continue, the higher the chance that risks build up within the economy and eventually lead to an event that prompts an economic downturn.

As most economic data continues to remain elevated and supportive, there’s no immediate concern. Importantly, unemployment remains low globally (refer Figure 6 below), and while some data points are showing a slowdown, the levels recorded are still well above long term averages.

As share markets are more forward looking, however, volatility is likely to remain until the economic data stabilises.

Figure 5

Figure 5: Chinese financing conditions and lending rates

Figure 6

Figure 6: Unemployment rate and wage growth – advanced economies

Trade wars and the political environment

Trade wars have been the most significant and rapidly evolving political story of 2018.

The initial mention of tariffs being placed on China by the Trump administration was met with doubt and scepticism by investors. As the year progressed, and the rhetoric between the two sides intensified, investor tension became more and more apparent.

While the economic impact of the announced and imposed tariffs have been modest to date (outside of certain emerging markets), the wider ramifications of the dispute and where it may ultimately lead have been playing on investors’ minds.

Some progress was made recently following a meeting between Presidents Trump and Xi; however, the story remains volatile and the outcome uncertain. This means markets are also expected to remain volatile.

The other political event causing concern among investors globally is Brexit. This is because it’s reflective of the fraught political environment that now seems the norm among the major democratic powers.

This environment is not just contained to the UK; similar processes are playing out in countries like Italy and France. A general deterioration in the political situation increases the risks for policy missteps as politicians clamour for votes, which ultimately flows over into the broader economy. Investors then have the difficult task of trying to factor the political process into their investment decisions.

Energy Super and investment markets

Achieving the Fund’s long term investment return expectations typically requires some exposure to growth assets as these provide greater potential for strong returns.

To date, the majority of the market volatility has been contained to listed equities. As long term investors, Energy Super expects bouts of volatility to occur in share markets from time to time. This risk is managed through diversification – both to a range of assets and asset classes (see Figures 9 and 10 below), and it’s not a deterrent so long as the economic backdrop remains supportive.

Figure 9

Figure 9: Long run real returns of various asset classes

Figure 10

Figure 10: Long run annual return of equity investments across various regions

The Energy Super Board continues to take a long term view into its decision making process.

As such, no significant changes have been made to the asset allocations across all of the investment options throughout 2018. The Board constantly reviews and evaluates future investment opportunities, particularly in light of the current market volatility.

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