ASX Weekly Wrap 08/10 - 12/10

The XJO suffered its worst weekly loss since January 2016 as it fell 289.80 points or 4.69%. This was mainly on the back of rising rates in the US and trade tensions between US-China. This also saw us head into negative territory for the year with the XJO now off 2.79% for 2018. Our high was on Monday at 6,185.50 and our low was on Friday at 5,846.70. The XJO also now sits 7.2% below our recent closing high of 6,352.20 we set on 29/08. Of course the XJO is not the only market to be sold off hard the last few days with most global markets off substantially. For example the S&P 500, in the US, is down 6.87% from its highs as well.

Again it was a very quiet week for economic and corporate news, so rather than go through the usual formula I thought we would do things a little differently this week. I wanted to talk to you about the main catalysts behind market movements at the moment.

1. Rising Rates in the US

This is a subject I have touched up a bit over the last two years and was also part of the catalyst for our last aggressive sell off in February. It’s also probably the main reason for the selloff recently. As we all know the Fed in the US had been steadily lifting their official cash rate since December 2016 when it lifted it by 25bps to 0.50%. In September the Fed again lifted the rate by 25bps and it now stands at 2.25% with one more rise expected in December this year, three in 2019 and one in 2020. This would mean rates sit around 3.50% when all is said and done if things go to script.

Just over a week ago we had some very bullish sets of economic data come out for the US including its strongest ever manufacturing PMI data, strong US jobs growth, solid wages growth and some expectations by large institutions that the third quarter GDP would again print +4.2% in growth. This caused yields on US treasuries/bonds to spike to 7 year highs around 3.25%, and they still sit around 3.17% today. So why did this cause a selloff in stocks?

We have lived in a period where very low rates have been the norm, hence funds could not get a decent return from cash or bonds. Remember in July 2016 the 10 year bond rate was as low as 1.5%. This meant money piled into global share markets across the globe, including the US, to look for that investment return. It served its purpose with the US market entering into its ninth year without a major 20%+ correction. Now we are at a stage where rates are rising and the US 10 year bonds are offering 3%+, hence a decent return. Plus US bonds are considered one of the safest asset classes in the world hence if funds can get themselves an almost risk free 3%+, when there are major fears surrounding global growth etc., this is where they will look to park their money. This means allocating more funds into bonds and out of equities.

Finally rising US rates also have a flow on effects such as pushing the USD up against most currencies and increasing the cost of debt. The debt factor is a big one as most high growth stocks fuel this growth from a lot of debt. This means earnings may be impacted by higher debt costs, which means the markets have to readjust PE ratios by bringing them in. This is why you saw the NASDAQ sell off 9% from its highs vs the S&P 500’s 7% as a lot of high growth, debt laden companies reside within the NASDAQ.

We have already seen markets rebound a few percent this week as bond yields seem to have settled down a bit. This sell off has also been softer than the last in February, thus far, with US markets losing 12% at their worst in February vs 7% this time around. It may not be over yet but indicators seem to suggest it could be. This could mean equity markets are coming to terms with rising rates and they are closer to being fully factored in by markets. A good indicator as to when markets are at peace with it will be when bond yields spike and equity markets continue to rise. This was the case pre-GFC when rates rose aggressively between 2004-07 and yet we saw equity markets continue to climb.

2. US & China Tensions

The trade spat between the US & China has been well publicized and spent a lot of time in the headlines. It was only in September that Trump whacked a 10% tariff on $US200bill worth of Chinese goods on top of the $US60bill that was already in place. That 10% could increase to 25% by early 2019 if the conflict isn’t resolved. China has retaliated with $US60bill of its own, but also has started selling down its US treasuries reserves and devaluing its currency.

This has created fears that it could slow the Chinese economy faster than expected as less Chinese goods are imported and bought in the US. Since China made up an estimated 100bps of the +3.1% worth of growth in 2017 this is seen as a big deal. It also could have further flow on effects possibly causing debt defaults within China if it does indeed slow too much, due to lower earnings etc. There is a theory this is already starting to have an impact on the Chinese economy with manufacturing PMI falling to 50.8 from 51.3 earlier in the year. Having said that the PMI figures for 2018 seem to be trading within an acceptable range.

It is doubtful the tariffs will have much of an impact on China if any at all. China already devalued their currency to help combat the increased prices their goods will receive in the US. It is also likely the US & China will come to some sort of trade agreement; more than likely after the November mid-terms as they will not want to paint Trump in a good light with any positive agreement. The first quarter in 2019 could see an agreement occur. You also have to remember that these tariffs are being made via executive order and are not legislated, hence can be overturned very quickly. The new trade agreement between Canada, Mexico and the US shows that whilst Trump’s negotiation tactics may be harsh he can be negotiated with.

*Chart of the iShares Emerging Markets ETF listed on the XJO (ASX: IEM)

3. Emerging Markets

I only wrote about Emerging Markets (EM) a few weeks ago and the impact they were having on global markets. This of course all still ties in to recent events and mainly surrounding fears of a massive global slow down as a result. EM include countries such as China, India, Mexico, Turkey, Indonesia & Brazil and they made up 60% of the world’s growth in 2017, thus you can see why their performance is so important to continued growth. Now as I wrote about this, in depth, only a few weeks ago I will just skim over the important parts, but you can read my larger note surrounding EM here.

The ‘nuts and bolts’ of it is as rates rise in the US so does the US currency vs EM currency. Now most EM economies have fueled recent GDP growth with a lot of US denominated debt, hence if your currency is falling hard against the US, then effectively your debt grows as you need more of your local currency to pay it off than you did before. To combat this your local central bank lifts rates to help bolster the local currency but by lifting rates you are making debt within your country more expensive and unattractive to obtain hence your economy slows. This then puts global growth at risk plus increases the chance of defaulting on debt owed to other nations should your economy slow far. This is why we have seen massive falls in EM currencies and share markets for the last couple of months. As you can see from the chart above, the iShares EM ETF has fallen 14% from its highs indicating the trouble in this sector.

The consequences of EM slowing obviously is slower global growth, possible recession or worse another GFC style event fueled by the tremendous amounts of debt EM carry. This is obviously a big concern to financial markets and hence their role in the recent sell off.

4. Australian Housing

This is more a local issue which has not helped our own performance and probably why we have underperformed on any bounce thus far. The Australian housing market is in a bit of slump of late with house prices falling, on average, 4.3% over the last 12 months with Melbourne -4.6% and Sydney -4.4% being the main drag. Adelaide is currently +0.8% for the last 12 months. Building permits are also down -13.6% year on year (yoy), home loans are -2.1% (yoy), private sector credit is at +4.5% (long run avg. is +6%) and our construction PMI is now in contraction mode at 49.3. All of this points to a housing sector in decline. Of course this negatively effects our bank earnings and consumer confidence more than anything. The fear here is obviously a full blown crash, which still seems unlikely with such high immigration and solid jobs figures. If the world were to have another GFC style event I can see this being the straw that breaks the camel’s back and sends our property market into a crash. The first one since the early 90s.

The chart above shows the XJO Financials index (i.e. banks) and how badly this sector has performed over the last few months. Coming off the royal commission the banks have headed for some pretty soft housing conditions, thus it hasn’t been the best time to own bank stocks. It is not all doom and gloom because an economy can perform well even with a soft housing sector. The US and Canada have both had periods of a soft housing sector during the bull run over the last nine years and their economies have more than withstood this. It is likely that jobs will move across from housing construction into infrastructure if the sector doesn’t pick up in the near term.

The XJO does look quite weak here with a possible retracement back to 5,650 on the cards (green line). We are well below our 200dma and have broken below the recent upward trend (blue line). I will say we are up over 1.10% today which is not reflected on this chart, thus it is looking a tad healthier. On the up side we still remain in that longer term up trend that was established from our lows in 2009. When compared to the US markets we do look worse off. All of the US majors have respected their 200dma and trend lines and bounced accordingly. This may be what saves us and helps prop us up, but until the bank sector turns around I dare say we continue to underperform by some margin.

I hope you have enjoyed the slightly different wrap this week. My aim was to help you understand what is driving global markets at this point in time, so I hope I have been able to successfully do this. If you have any questions about what I have written above please feel free to ask via email, phone or social media. On a personal note we took advantage of the warm weather here in Adelaide over the weekend and spent our night at the beach Saturday. The kids loved it, building sandcastles and splashing in the water. Our eldest did not like the sand the first time we took him last time but he seemed much happier with it on Saturday. It was a very relaxing and enjoyable weekend. I hope you all have a wonderful and safe week ahead. I will speak to you all soon. Go Crows!

heath@hlminvestments.com.au

0413 799 315

Important Notice

Any advice in this article should be considered General Advice only and does not take into account your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate to you and whether you should act upon it. I am happy to assist you in this process. To do so, I will need to collect personal and financial details from you before providing my recommendations. Please note the author may own shares in the companies mentioned in the above blog.