The big movement for the April was the pullback in bond prices following a stellar few months, although bond prices have been rising again in May. Indeed, the largest issue facing investors at the moment is the distinct divergence in government bond pricing vs the pricing for stocks. The stock market is pricing in attractive economic growth, the bond market is pricing in economic misery – they can’t both be right. We have been carrying elevated cash levels for the past few months with the view that the answer lies somewhere in the middle.
Stock markets continued to rise in April although May has been considerably more volatile. In particular, we are noting that our preferred strategies of Value stocks and Quality stocks have underperformed over the last six weeks, while Growth stocks have outperformed. While it is possible that the world is about to suddenly solve all of the low growth and low inflation issues it is facing, we consider this unlikely outcome and so we are sticking with our preferred value and growth exposures.
Trade war
In recent weeks the US/China trade war has once again hit the front pages. It would be a mistake to consider the trade war to be a minor issue that will be solved by a single deal. Our assessment is that there is a significant reset in geopolitical relations happening globally, and while Trump has been the driving force he does have the support of both Democrats and Republicans in the US and many developed democracies globally.
Not only have tariffs increased but now there are Chinese companies being excluded from using US technology on a security basis – Chinese company Huawei is the poster child with a number of bans being threatened and/or implemented. There will likely be a range of retaliatory measures in China, although we expect many of these to be unofficial like the ban of Australian coal which was denied officially but enforced practically.
This has significant implications for companies – for many global companies, it means assessing whether reduced competitive threats from Chinese companies (as they are locked out of US and other developed markets) are more important than reduced opportunities to sell products to the Chinese consumer and short term economic issues. We looked at this issue in considerable depth in our latest podcast.
Australian Election
Politicians have far less effect than many think on the performance of stock markets and economies. This is partly because there is less difference between the policies of the different political parties than the politicians want you to believe, and partly because they have only limited effect on economic outcomes – central bank decisions are more important in most countries.
This is more true for Australia than most, as a small open economy Australia is highly dependent on global commodity prices which political leaders have even less effect on.
So, don’t overplay the effect of elections in general. Having said that, I do expect a positive short-term effect and a negative medium-term effect from the surprise re-election of the Coalition.
Short-term effect
The Labor party had policies that would have been negative for house prices which would have increased the possibility of house price declines sharpening. That crisis has not been completely averted, but the chance of a negative tail risk event has decreased. Our expectation is that Morrison will also be more aggressive in trying to bail out the housing sector as house prices continue to weaken.
Medium-term effect
One of the structural problems with many global economies is a lack of demand and what is being termed “secular stagnation”. Our assessment is that much of the secular stagnation is due to inequality and stagnant wage growth. Labor had a number of policies to address those risks in Australia, the Coalition does not. We expect low wage growth and secular stagnation to continue to be a feature of the Australian economy.
Chinese growth
Our core thesis over the past ten years has been that China’s growth is, in the words of its own Premier, unstable, unbalanced, uncoordinated and unsustainable. China is running a Gerschenkron economic growth model, which has been run by many countries in the last 50 years including Russia, Japan, South Korea and a number of Latin American countries. The model works like this:
- By repressing consumption China increased their savings rate
- This savings was diverted into investment
- Most of the investment was centrally managed infrastructure spending (as the private sector is not good at that kind of investment)
- China also kept interest rates low (below inflation for many years) which penalized savers and benefitted companies and governments
- At first, the investment earned great returns (as China was in dire need of investment) and was hugely successful at increasing wealth for everyone
- As time went on, the investment projects generated lower and lower returns
- Finally, the return on investment fell below the return on debt and the debt burden began to grow
- At this point, you would think that a new growth model would need to be created – but in every other country that has followed this growth model, they have stuck to the old growth model and kept increasing the debt until some form of crisis forced a change.
China spends around 50% of its GDP on capital expenditure, mostly housing and infrastructure, which is far in excess of other countries, even those like Japan or South Korea that followed a similar growth model.
So, our view is that China will structurally try to manage away from this growth model as the debt burden required to maintain that model increases every year.
However, vested interests made a fortune from the rise of China, and they don’t want the party to stop. More bridges, more apartments, more airports and more train lines. China’s growth model was unsustainable in 2010 and is less sustainable now. But there is still scope for the model to be pursued for a considerable period of time – with less and less of an effect every year.
We expect Chinese growth to grind lower, where minor measures will be attempted to improve growth (with little effect) until growth slows enough or vested interest bleating becomes loud enough for another round of stimulus.
The aggregate of these factors means that while the effect will be positive for Australian growth, just not as large as prior episodes. The initial Chinese debt boom had the largest effect on Australian growth but each subsequent echo boom is having less and less of an impact.
Individual Stock performance
April saw Growth stocks continue to soar with technology companies the key leaders. European stocks lagged as did some of our Value stocks.
Domestically stocks with strong overseas earnings were favoured with the decline in the AUD a key contributing factor. Domestic defensives were the main detractors.
Epilogue
Both Australia and China have imbalances that will eventually be resolved. The influx of another round of Chinese stimulus will delay the resolution for both countries, and make the eventual resolution more problematic. However, in the short term, we expect the impact of the latest round of Chinese stimulus to be similar to prior episodes. This more positive outlook hasn’t been enough to convince us to significantly change our weight to Australian shares – Australian shares are still considerably more expensive than most international comparisons with poorer growth expected.
We retain large cash and bond balances to hedge against volatility and in the expectation that capital protection will be important during 2019. Our key focus is Chinese growth, gauging the extent of the slow down and the policy response.
Damien Klassen is Head of Investments at 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.
