Q1 Outlook: Getting defensive on Australia

After the previous quarter’s mayhem, there is no shortage of concern heading into 2019. Although it is hard to pick a single culprit for the Q4 sell-off, arguably the most important is the culmination of several factors leading to tightening of global liquidity, but others include:

The shift from quantitative easing to quantitative tightening as central bank balance sheets shrink and drain liquidity – a task never achieved on such a scale by any central bank in history.

• Decelerating global growth with the narrative of “synchronised global growth” now firmly switched to a synchronised global slowdown.
• Seizures in corporate credit markets.
• The rising price of money, with the question being whether the Fed is simply tweaking its message or balking and pausing on rate hikes.

GETTING DEFENSIVE ON AUSTRALIA

“Lucky” Australia’s luck may be running out and China’s economic slowdown only adds to the country’s woes, giving investors good reason to take a cautious stance. Going into the first quarter, we are focused on wealth preservation and a defensive risk allocation. Against the backdrop of falling house prices and tightening credit, the central bank’s next move could be a cut rather than a hike.

Adding to the melting pot, we see trade wars reversing decades of economic globalisation, rising geopolitical uncertainty and the resurgence of nationalism with whispers of civil insurrection. This combined with a continued undermining of international frameworks and supine political institutions, and we have a host of challenges that will only serve to heighten volatility in 2019.

However, the last quarter’s pessimism seems to have evaporated, and equities are off to a positive start in the new year as the US Federal Reserve has flipped to capitulation mode, counselling a wait-and-see approach to policy adjustments. While glimmers of a trade deal surface and China announces further policy easing, a bounce is warranted. But despite the U-turn from Fed policymakers and investor sentiment alike, it remains likely that panic capitulation still lies ahead, and it would be premature to sound the all-clear.

A rally off the back of any quantifiable trade deal would be called into question as the earnings cycle turns and it becomes clear that a cyclical peak in corporate profits has passed, with forward earnings guidance trending lower. Further vulnerability to such a rally could stem from incoming real economic indicators (global PMIs, manufacturing ISM, et cetera) highlighting deterioration in global growth, not to mention if any one of the aforementioned risks rears its ugly head. Then policymakers’ pirouettes will need to become more than just rhetoric, and a trade détente won’t save the turning cycle. Markets will remain choppy and volatile, and for now it seems more likely than not that the December lows will be retested.

Australia has been recession-free since the early 1990s, but it seems the country’s luck may be drying up. Investors in Australia face a raft of domestic problems in addition to the myriad global troubles. The deceleration in the housing market is gaining pace, and a potential change of leadership brings uncertainty with federal elections due to be held by May 2019. Opinion polls indicate a Labour government is increasingly likely. This brings an element of policy uncertainty, with proposals to restrict negative gearing, cap private health insurance premium increases and abolish cash rebates when franking credits are greater than the taxes paid. Throw into this mix China’s slowing growth momentum, and the outlook for the Aussie market this year should also be viewed with a degree of caution.

Heading into the first quarter of 2019, we focus on wealth preservation and playing defence with a conservative allocation to risk assets unless global policymakers capitulate and move to boost liquidity. Based purely on where we are in the current economic cycle, the risk-reward ratio for equity investment is skewed to the downside, while investors can secure an almost 2-3% return over the year in Treasuries. The second half of 2019 could be different if we see the global economic slowdown lead policymakers towards stimulus in a bid to catch the dip. A few months ago, this scenario seemed far-fetched, but recent messages from the Fed indicate a more flexible policy approach and that a pause in QT could be in the pipeline if deemed necessary.

In terms of ASX 200 sector performance, there is scope for returns from high-quality stocks in the healthcare sector, with defensive, quality cashflows adding resilience to portfolios. In volatile times, another way to slice and dice the equity market and add defensiveness to a portfolio is to look at style/factor exposure rather than sectors. We look to maintain exposure to low beta/minimum volatility and quality in terms of factor exposure as an indirect portfolio hedge, while staying clear of momentum and high beta factor exposure. We also look to bond proxy stocks in the year ahead to provide reliable cashflows and predictable returns adding to portfolio defence.

CHINA TROUBLES

We expect growth stabilisation to be a top policy priority for China this year – with fiscal and momentary stimulus playing key roles – so the mining sector in Australia could benefit if infrastructure spending is ramped up. However, be aware that stimulus measures will take several more months to feed through to the real economy. Recent Chinese data suggest the economy has not yet bottomed out, and early 2019 could see data deteriorating and a deeper slowdown before easing policies take effect.

Almost every Chinese indicator in the last few months has come in below expectations, most significantly November’s industrial production and December’s manufacturing PMIs. Although deleveraging plans have fallen by the wayside, local governments are expediting new bond issuance and the reserve requirement ratio has been cut for a fifth time in a year, these new stimulus measures fall on a weaker economy saturated with debt where the marginal impact of such measures will be less than in previous episodes of stimulus. The scale of the stimulus package is also still falling short of the previous 2008-09 and 2014-15 packages. For Beijing’s growth targets to be met, larger stimulus measures cannot be avoided.

If, as we have long predicted, China pursues a growthat-all-costs strategy, resisting economic slowdown and kicking the can on financial stability, and implements the large stimulus package needed to counteract slowing growth momentum, then the second half of this year could look different as growth would eventually be stabilised. But larger stimulus or not, it is unlikely China will resume its role as the global growth wunderkind. At this stage, a “Shanghai Accord 2.0” seems unlikely, and markets will have to look elsewhere for a lifeline.

Chinese policymakers are also focusing on quality over quantity in terms of economic growth and switching from an export-driven economy to a consumption/ domestic demand-led economic growth model. Further stimulus measures are likely to focus primarily on boosting domestic demand as opposed to increased infrastructure spending, meaning the marginal benefit to Australian commodity exporters could be less than in previous bouts of stimulus.

We are cautious of Australian banks. Although the 9-11% gross dividend yield provides valuation support, it is difficult to see a catalyst for a broad sector upgrade. While the decline of the East Coast housing market continues to gather pace, the banks will remain victims to offshore selling and earnings headwinds will persist given their leverage to the housing market. If we see a Labour government, the proposed changes to franking credits will also weigh on valuations in 2019.

AUSSIE HOUSING MARKET

The latest statistics show that declines in the property market are gaining pace, with the CoreLogic December home value index down 1.1% month-on-month. The housing market is struggling, and weekly auction clearance rates continue to deteriorate, pointing to further declines ahead. The epicentre of the housing market downturn is in Sydney where an 11.1% drop in prices since the peak in July 2017 is outpacing the declines seen in the late 1980s during the last recession.

Looking forward into 2019, it is likely that the East Coast housing market will continue to slide as credit conditions continue to tighten with the banks’ self-regulating, thus weighing on the growth outlook for the year ahead. Banks will continue to tighten credit standards and serviceability measures in the wake of the banking royal commission. Tougher credit checks and verification of borrower income and expenses are in full swing already.

The Australian economy is now in reasonable health, growing at a steady pace with benign levels of inflation at 1.8%, consistently below the Reserve Bank of Australia’s target band of 2-3%. According to RBA deputy governor Guy Debelle, the country is in “uncharted territory” as house prices are falling while the labour market is strengthening, and unemployment rests at a modest 5.1%. The RBA expects that a strengthening labour market will offset the potential hit to consumption from declining house prices, thus securing a soft landing for the Australian economy.

The RBA is, however, becoming anxious that lending standards have tightened significantly, and that continued credit constriction may add fuel to the fire. RBA governor Philip Lowe met with the heads of Australia’s big four banks last month to warn against an over-restriction of credit inflicting harm on the economy. But the royal commission’s final report is due to be submitted in February 2019, and it is highly unlikely that credit standards will be loosened in the run-up to this event.

The RBA is treading a fine line after the banking royal commission exposed decades of bad behaviour by the banks, which has led to tighter lending standards, and the epic build-up of debt on household balance sheets from the property binge threatens long-term financial stability. But the hit to households and the economy from a housing market crash would be dire. Nevertheless, it could be argued that the unwinding of credit excesses is needed to reset the economy and fix the problems rather than keep inflating asset price bubbles.

The risks to the downside would become more severe if unemployment were to rise amid a hit to domestic growth, an exogenous shock, or if banks further tighten lending standards, resulting in lower loan supply and higher loan costs. A self-perpetuating feedback loop could then ensue as prices fall further and the loan supply remains tight, mortgage stress rises, and defaults rise particularly for those with less equity in their homes. Vulnerable borrowers could then no longer afford their mortgages and would be forced to sell their homes. A rise in unemployment would further perpetuate that vicious circle as those who lose their jobs would be forced to sell, sending prices spiralling further downwards. If this scenario were to unfold, the RBA would have no choice but to cut the cash rate and, depending on the severity of the slowdown, implement QE – a scenario outlined by Debelle in his December speech.

The recent strength in the labour market may offset the negative wealth effect and fall in consumer spending precipitated by the sliding housing market – at least that is what the RBA is relying on. But the risks are mounting, and the Australian economy has run out of steam over the last six months, as evidenced in the third-quarter 2018 GDP report where annual growth slowed to 2.8% from 3.1%.

Household spending stumbled in the report as well, weighing on growth. Household spending growth slowed to 0.3% in Q3 from 0.9% in Q2, against a declining household savings ratio. As house prices fall, heavily indebted households feel less comfortable with running down their savings and will trim spending, especially if wages are stagnant. Eventually, consumption takes a hit. In light of these developments, the RBA will likely need to lower its optimistic 3.5% annualised growth forecast for 2019 in its February update as the economy continues to lose momentum. The markets have also lost faith in the RBA’s stoic narrative that the next move in its cash rate will be up, and they have started to price in the growing chance of a rate cut over the past few weeks.

Given the uncertain global backdrop and concerns about the domestic economy, it seems likely that the RBA cash rate will not increase anytime soon, and the risk that the bank’s next move is a cut is ever increasing