Economic Update – September 2019

by Infocus Author

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe. The key summary points are as follows:

• Global share markets retreat from all-time highs
• US consumers still leading the way
• Currencies becoming the focus as trade tensions rise
• The Australian jobs market holding firm

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

The ASX 200 and the S&P 500 reached all-time highs in July. Since then most major markets sold off by around 5%. Arguably, the catalyst for the sell-offs was a series of Trump tweets on tariffs and counter threats by China.

The trade war is causing market volatility but without any real progress on Trump’s demands. With the US presidential elections a little over a year away, Trump needs to get on top of this skirmish if he doesn’t want it to negatively impact his prospects of re-election in 2020.

Few in the Western world would disagree with Trump’s claims about China needing to respect intellectual property rights and the like. But Trump seemingly also has another agenda based on the strength of the US dollar. If a country’s currency depreciates, its exports get cheaper and imports get more expensive. Such a move typically helps trade balances.

While currency forecasting to any reasonable degree of accuracy is all but impossible, economists largely agree on the fundamental factors that drive currency movements in the longer term.

“Purchasing Power Parity” (PPP) is a theory that postulates that a currency moves to equate prices of goods that are traded between two countries. With inflation hardly a problem anywhere at the moment, PPP is currently not the main game in town.

The other major macro-theory is interest rate parity. If a country cuts its interest rate relative to another, its currency might be expected to depreciate as capital flows between countries. So, if two countries both cut by the same amount, the currency impact is neutralised! Hence the expression, “race to the bottom” as countries engage in ‘tit for tat’ rate cuts.

Speculation and expectations play such a major part in moving currencies, analysis can very much be clouded – and even thwarted – by other factors in the short and medium terms. Trump has stated that he wants the US Fed to cut its rate by a full 1% – even though the Fed is meant to be independent from political pressures. The US economy is currently quite strong – particularly in the consumption sector. US inflation is just above target and the unemployment rate is all but at a 50-year low at 3.7%. So, Trump’s call for a rate cut has more to do with wanting to weaken the US dollar for trade purposes rather than stimulating business investment at home.

Trump recently called China out as a “currency manipulator”. While interest rate policies could be thought of as being part of a manipulation process, economists are usually referring to a country using its foreign reserves to stabilise a currency by buying or selling its currency. This is not unique to China, many countries have done this previously, Australia did it in the late 1980s following then Prime Minster Keating’s ‘Banana Republic’ comment about our economy.

China does set its exchange rate each day; it is not a freely floating currency. But China could not sustain an artificially low currency for an extended period as it would eventually run out of foreign currency reserves. Indeed, many argue that any manipulation China is currently engaged in, is more likely helping to keep the currency stronger rather than weaker! In the case of Australia’s currency, it is usually also thought that commodity prices are a major determinant.

With iron ore prices historically high owing to supply problems in South America, there would seem to be more downside than upside risk in iron ore prices and hence our currency. Indeed, this view is supported by iron ore prices having fallen already by around 30% in August. While trying to trade on predicted currency movements can result in major losses, prudent long-term investors do need to consider possible currency risks. Investors can completely insulate themselves from any currency movements by using “fully currency-hedged” foreign assets.

On the other hand, by taking a completely unhedged position, an investor can take all exchange rate risk head on. As a result, many prudent investors will blend hedged and unhedged assets in a portfolio as deemed to be appropriate at the time. Australian jobs are holding up well however, while the Reserve Bank of Australia (RBA) seems to have a bias to reducing the official cash rate further it chose to leave rates unchanged at its September board meeting. The US Fed, on the other hand, is seemingly reluctant to cut rates by as much as Trump would like. That might put downward pressure on our dollar. Accordingly, some currency exposure in our foreign investments might be worthwhile. Perhaps a moderate leaning towards unhedged exposure might be appropriate. But, with bonds and cash not being a particularly viable alternative in portfolio construction, both domestic and foreign equities offer short to medium term investment opportunities.

Asset Classes

Australian Equities

After reaching an all-time high in July, the ASX 200 retreated somewhat in August on trade war and recession fears. Many Australian companies have reported well in this earnings’ season but we find that earnings’ forecasts from here (provided by brokers) are a fraction lower than they were before the August reporting season started. Unsurprisingly, defensive sectors fared a bit better than the cyclicals over August. With dividend yield expected to remain at about the average 4.5% over the next twelve months (with franking credits taking that “grossed-up” yield to just short of 5.8% (assuming an average 70% franking level) we think Australian equities remain relatively attractive all things considered.