The festive season is usually kind to equities. For the past 25 years, December has recorded the best monthly returns for both Australian and US equities at around a 2 per cent average gain. Furthermore, both markets have recorded gains in December more than 75pc of the time over this period.
The theory goes that lighter market volumes (due to market participants taking holidays) restrict the supply of equities for sale, making it easier for buyers to push up prices.
The market remains locked in a ‘Goldilocks’ scenario, where global synchronised growth and low volatility continues to buoy investor confidence while low inflation sees central banks in no hurry to accelerate interest rate normalisation.
Healthy growth puts the world in a better position to deal with the next downturn, but we are not ignorant of the risks and we remind investors to remain vigilant as these ideal conditions for equity markets are unlikely to continue through 2018.
Weighing up the geopolitical risks
A number of geopolitical risks could affect trade and market instability in 2018, including UK talks to leave the EU, political gridlock and instability in Washington, tensions over North Korea’s missile and nuclear program and increased trade protectionism.
While we don’t see a need for investors to be alarmed at this stage, investors should be prepared for at least some potential for an escalation of these risks. Leaving some cash on the sidelines is prudent at a time where significant risks stand on the doorstep.
A turning point for interest rates
In 2013 the mere hint that the US central bank (The Federal Reserve) would end its unprecedented emergency measures caused investors to throw a ‘taper tantrum’ devastating Emerging Markets.
Markets are currently pricing in a slower pace of interest rate rises and taking each increase in its stride. But this could all change if inflation surprises off very low expectations, unemployment rates around the globe have fallen where the US is now sitting at 4.1pc where many officials deem to be in full employment while capacity utilisation is back at pre-GFC levels.
Higher interest rates usually signal a close to a bull market, so investors should be prepared for a return to more normal levels of market volatility.
Australian market – needing an earnings catalyst
The equity market’s under-performance against its global peers still accurately reflects an economy that has failed to break decisively out of its post-mining slump. Low growth and low rate settings have made investing for yield a profitable strategy for much of the post-GFC period. We are starting to see limits to this well-worn strategy. ASX 200 Industrials ex-Financials earnings per share (EPS) growth is forecast (by Thomson Reuters I/B/E/S) between 4pc to 7pc over the next three years, falling well short of the 11pc average over the past 15 years. The market may continue to lag global peers until investors get a clearer read on a genuine acceleration in the business cycle. We think active stock selection will be key to returns in 2018.
What does it mean for 2018?
Australian shares are now trading about 3pc below our estimates of fair value. While the yield differential between bonds and equities still favours equities, we are cognisant of the potential for the risks above to trigger ongoing volatility. Several tactical considerations are worth noting in this environment:
- Moderate expectations of equity returns: Given the reality of below-average growth, investors need to caution against expectations of above-higher returns.
- Beware of complacent investing: Resist assuming higher risk in pursuit of diminishing returns. This includes large cap stalwarts.
- Follow conviction themes and stocks: Strong returns are achievable in Australian stocks, albeit in less traditional stocks and sectors.
- Diversify internationally: Capture relatively compelling growth dynamics and currency tailwinds offshore.
- Be opportunistic: Retain cash to protect capital and capture opportunities.
Strong returns are still achievable in this market, however this should not come at the expense of investors taking on excessive levels of risk.
- Boh Burima, Financial Adviser (Authorised Representative: 000341081) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410