Everybody Loves TINA
Summary: Equities continue to march higher and the ASX 200 has rocketed through 7000 for the first time as the signing of the long awaited Phase 1 trade deal emboldened risk sentiment.
The ASX 200 has broken through the psychologically important 7000 level, a big, round number, and making a new record high. The Aussie index is on course to take the crown as the world's top performing index this month, having gained more than 5% this year already. Although this is likely partly due to the underperformance in December.
Momentum is strong and there is a growing consensus that the raft of rate cuts throughout the last year and ongoing expansion of central bank balance sheets will reignite global economic growth. Geopolitical fractures which generated an increasing amount of anxiety over the last 18 months have been pushed to the sidelines as focus shifts to vote winning tactics. Political risk premium has been significantly reduced with less Brexit and trade uncertainty. Combined, these factors present further upside for risk assets throughout Q1 2020 as investor confidence is restored. Further into the year, the key test will then be whether reality is in line with market expectations. Will much heralded green shoots actually translate into a return to trend growth, and will the narrative of receding geopolitical risks be maintained. We are sceptical on both fronts.
The prior year’s gains on the ASX have been driven almost exclusively by multiple expansion and the market is looking past realities of languishing economic growth and lacklustre corporate earnings to better times ahead. As positioning continues to turn more bullish, the present environment risks a return to the euphoric sentiment, or melt up scenarios that have previously ended in tears.
By historical standards valuations look incredibly stretched, more than 2 standard deviations from historical averages. But countering that we also have global interest rates which have moved in the opposite direction and are also at historic lows. And rate hikes/”normalisation” of monetary policy comes with an increasingly high bar. As investors re-calibrate long term interest rate expectations at current levels, large amounts of capital is enticed up the risk spectrum. Lower rates also feed into valuation models, justifying higher multiples, and fuelling asset price inflation. The equity dividend yield premium of the ASX relative to Australian government bonds is hovering around decade highs which lures investors up the risk spectrum, a dynamic that is set to persist into 2020 as the RBA continue to ease monetary policy, favouring equity allocation.
However, the sharp upwards move along with increasingly stretched valuations leave the market frothy and somewhat vulnerable to shocks, and there are plenty of catalysts for potential drawdown, geopolitical, economic, policy or otherwise. The upcoming earnings season could also be one of those catalysts and come February market performance and economic realities may be forced to converge once more.
Aussie stocks are on track for some uninspiring profit growth, battling a cautious consumer and a weak domestic economy, notwithstanding an unprecedented bushfire season that only reinforces those soft conditions. The damaging disruption to tourism, regional trade, construction activity, agricultural productivity and retail/eating out, against the backdrop of an already cautious consumer, will not only hit those areas most affected, but also major East Coast cities engulfed by thick smoke. This presents problems for a raft of Australian companies. Retailers who have already been doing it tough have to contend with an already anaemic consumption spend, distressed further by the devastating bushfires. The dampened confidence along with a reluctance to spend whilst the nation is in crisis will have hit retailers in what is seasonally a busy period. Tourism and travel will also feel the pinch as mass evacuations along the east coast, thick smoke, and raging fires impacts travel plans and business operations. Lower rates also present profit headwinds for the for the banks, which make up a large portion of the index, not to mention a mountain of scandals and misconduct charges which also add to the patchy earnings picture.
But as we wrote yesterday, for long term investors, these headwinds should not deter. Monetary policy remains a powerful determinant of asset prices, and as we progress through the year, continued central bank liquidity injections will lend underlying support to equity markets. With liquidity being pumped and low yields forcing risk seeking behaviour, dip buyers are there on the sidelines ready to step in as valuations correct which lends an underlying support to global markets. Monetary policymakers have already exhibited their willingness to intervene with added stimulus measures in an attempt to extend the cycle, so, for as long as investors feel like central banks have their back and policy rates remain low there will be upside for equities.
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