After the volatility and market turmoil caused by British referendum to leave the European Union (Brexit), markets rallied strongly in July based on the belief that further monetary easing, or at least a reduced tightening bias, was in the offing as central banks around the world assessed the likely impact of Brexit and weaker growth on their economies.
In Australia markets rallied strongly, up 6.3% for the month, as a Liberal party victory in the national elections combined with weaker than expected inflation numbers – with the Q2 inflation number of 0.4% resulting in the lowest annual reading in 17 years of 1.0% – supporting the expectation of further rate cuts. These came in the August Reserve Bank of Australia (RBA) meeting with a further cut to 1.5% which is a record low for the country. Given markets had largely anticipated this, the currency did not fall as a result, and markets are already pricing in a further rate cut later this year.
In Japan, an upper house election which strengthened the incumbent Abe government combined with a ¥13.5 trillion (?A$170bn) stimulus package have seen that market rally strongly in July, up 6.4%. This followed a poor June which was impacted by the Bank of Japan indicating it was reluctant to provide further stimulus.
In Europe, Gross Domestic Product (GDP) growth weakened slightly in Q2 up 1.6% year-on-year vs 1.7% year-on- year in Q1. Concern about Britain’s Brexit vote has faded somewhat although the UK has yet to start the formal withdrawal process. Both the European Central Bank and the Bank of England (BoE), did nothing at their respective July policy meetings, the BoE cut rates in its August meeting to a record low 0.25%. It also announced a bond buying programme for both government and corporate bonds and a schemed to encourage banks to lend to business.
The expectation of continued policy easing also saw European share markets to rally in July, but the EU remains at risk of further members leaving and indeed complete disintegration medium term. Other EU members will be keeping a close eye on the UK exit process, and the EU itself is therefore incentivised to be as tough on the UK as possible to dissuade further defections.
China growth continues to disappoint, with Q2 GDP coming in at 6.7% despite significant government stimulus over the past 12-18 moths as funds have been directed to underperforming state owned enterprises, limiting the efficiency of transmission to the broader economy.
In the US the Federal Reserve (the Fed) left rates on hold in July but the Fed has left the door open for a September rate rise amid conflicting signals. US Q2 GDP growth of 1.2% fell well short of the 2.6% expectations, however employment numbers surprised on the upside, with the non-farm payrolls report for July showing the US economy added 255,000 jobs in the month, beating economists’ expectations for growth of 180,000. Net-net however, the soft GDP growth profile in particular makes it unlikely, in our view, that the Federal Reserve will be able to hike rates at its next meeting in September.
Overall, while we see some green shoots of a recovery, we continue to believe that that recovery is fragile and overestimated given the relatively high earning expectations built into prices. As a consequence we continue see risks as to the downside in equity markets this reporting season as markets adjust their earnings outlook. Specifically, we continue to remain underweight the financial sector as we remain cautious on banks given the continuing risk around net interest margins for the banks while remaining overweight in the defensive healthcare sector, and the consumer discretionary sector. While the latter is not normally viewed as defensive, we have chosen companies with more significant barriers to entry or, in the case of REA, exposure to the real estate sector which is likely to remain buoyant on the back of continued low interest rates.