2019 has been a great year for investors with all asset classes delivering returns well above long term averages. For the year to November 30th Australian equities are up by 26% and International equities by 23.6%. Both our market and the US market are pulling back from record highs as I write but returns for calendar year 2019, even with a pullback will be well above long term averages and the highest for a decade. Listed property has also had a stellar year with the Australian A-REITS (Real Estate Investment Trusts) delivering a 12 month return to November 30th of 27% and Global REITS 16.6%.
With hindsight 2019 will likely prove to be an outlier. Returns at these elevated levels are not sustainable. Over the decade Australian equities have delivered an average annual return of 8.5% or within striking distance of its 100-year average of just over 9%. International equities have delivered a higher 12.8% over the decade skewed mainly by the stellar performance of the US market and its dominance in the ‘Information Age’ technology stocks which have created more wealth than any other sector in recent history.
The issue over the last 12 months has been the disconnect between earnings growth and share prices. Share prices have climbed higher while earnings growth in most markets, including our own has stalled. In Australia this is accentuated by the large size of our banking sector. The outlook for bank earnings discussed in last month’s update is expected to weigh heavily on the earnings and dividend growth for our market in the short to medium term. The value of listed companies is now 25% higher than 12 months ago without any increase in earnings. Price to earnings multiples (the most used valuation metric) have increased and are now at levels some 35% above long-term averages.
Shares and property valuations are being supported and pushed higher by a period of falling and historically low interest rates, high levels of liquidity and credit availability. The bulls argue that lower for longer interest rates can justify higher valuations for equities and property relative to history. This time it is different they say. We disagree. As Sir John Templeton so famously said – “the four most dangerous words in investing are: this time its different.” This is not to say markets cannot go higher from here. Some would argue the US market is entering the final phase of one of the longest bull markets in history and that the irrational exuberance that rears its ugly head during this phase is yet to play out. Trump may even promote this in an election year and pull every lever available to keep the economy and markets buoyant. Certainly, the US economy is in better shape than most with continued strong growth in consumer spending, unemployment at record lows and real wages growth. Should this occur it could take our market along for the ride.
More probable is returns across most asset classes and particularly equities will be significantly lower in calendar 2020. The disconnect between the real economy and stock markets cannot continue for long. Over the medium to long term share markets follow earnings growth and if the economy is struggling so too are earnings.
Our economy remains stuck in the slow lane. Growth for the year to June was 1.9% down from 2.8% in 2017/2018 and well below the forecasts of most economists for 2018/19 of 3-3.5%. September quarterly economic data released on December 4th showed our economic growth slowed to 0.4% down from 0.6% in the June quarter. Annualised growth for the year was 1.7%, up slightly on the annualised rate of 1.6% in the June quarter but despite the upbeat commentary from our Treasurer Josh Frydenberg there was little to celebrate. We may have entered our 29th year of expansion without a recession but consumer and business confidence remain low. Consumers are not spending, and businesses are not investing. Households remain cautious with the quarterly data showing the boost to household disposable incomes from tax cuts flowed into savings and paying down debt. Government consumption expenditure and the continued strong performance of our export sector (mainly mining and energy) were the only sectors delivering any growth of note in the quarter. Of greater concern was the release of productivity numbers by the Australian Bureau of Statistics on December 2nd which showed a sharp fall in productivity in 2018/19 and the weakest labour productivity numbers in 25 years. If you want an explanation of why real wage growth has stalled, look no further than these numbers. Stimulating the economy through monetary and fiscal policy is one thing but equally, if not more important is supply side reform. It is productivity growth (i.e. producing more output for a given level of inputs whether that be labour or capital) that ultimately drives real wages and living standards.
We remain cautious about the outlook for our economy without serious economic reform across taxation, industrial relations, the public sector and energy. Unfortunately, it is universal truth that governments will only tackle major reform when forced. While our economy continues to muddle along with no clear direction or momentum so too will governments. What the trigger for serious reform will be is anybody’s guess but through our eyes both the domestic and global economy feels vulnerable to any major external shock be it geopolitical or economic.
Monetary policy has been the weapon of choice in response to slowing economic growth domestically and internationally in 2019. As noted in previous updates we believe monetary policy has moved from ineffective to counterproductive and is now adding more risks via asset price inflation, rising debt levels along with leaving many countries with little fire power to respond if economic conditions do not improve in 2020 or deteriorate further. Pleasingly, the US Federal Reserve kept rates on hold this month and stated they see no reason to justify further cuts in 2020. Our Reserve Bank also left interest rates on hold this month, but most have pencilled in a further rate cut in February.
Internationally key risk factors include high and rising debt levels globally and the potential for wage inflation and inflation led interest rate increases in the US. Debt levels globally are now above those that caused the last crisis and its management is dependent on interest rates remaining low. Other risk factors include an escalation in the trade and currency wars between the US and China, its spread beyond the US and China and the worldwide ramifications of a slowdown in the Chinese economy. Many already believe economic growth in China to be well below the official line of 6%. China is also trying to deleverage its economy, but this is seeing a spike in private sector default rates. According to ratings agency Fitch, default rates for Chinese private enterprises increased from 0.6% in 2014 to 4.9% for the year to November 2019. China is also experiencing a sharp spike in inflation which could increase pressure for inflation led interest rate increases.
Economic forecasters remain hopeful. The International Monetary Fund forecasts global economic growth of 3.4% in 2020 up from an expected 3.1% in 2019. This assumes an orderly Brexit and some resolution of the US China trade war. The Reserve Bank in its December commentary also stated they believe the Australian economy has reached a gentle turning point after the soft patch in the second half of calendar 2019 and expects economic growth to be about 3% in 2020. Economic growth may be stronger, but we believe the level of uncertainly globally is likely to remain elevated. Despite Boris Johnson’s clear victory, the Brexit transition will be difficult and Trump may yet get another term.
As your investment adviser we monitor the short-term macro issues to manage risk and make tactical changes across and within asset classes. It does not alter our investment philosophy, or our long-term strategy and it should not alter yours. Short term forecasting is notoriously difficult, and most get it wrong. What we can be confident about is that a well-balanced diversified portfolio across asset classes will deliver real returns above inflation over the next decade and in line with the last 100 years equities will be the best performing asset class. Human ingenuity will continue to invent and innovate, start new businesses and provide us with a plethora of investment opportunities.
So, to end on an optimistic note. As the clock ticks over to the start of a new decade our advice is as follows:
- Ignore the doomsayers. The have been predicting global catastrophe for hundreds of years but the sun keeps rising, the world keeps turning and living standards keep improving.
- Stay the course. Sticking to your investment strategy over the long term is the best way to build long term wealth.
- Be grateful for what you have. For all its faults we live in a great and lucky country. Warren Buffett often says he won the lottery by being born in America. We can all say the same.
We wish you all a wonderful and safe Christmas and look
forward to helping you preserve and build your wealth in 2020.
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Sources: Commbank Global Markets Research, RBA, Morningstar.