With Greece’s can of problems contained for the time being and persistent signs of low global inflation pushing down bond yields, equity markets rebounded in July – despite rich valuations and the threat of looming U.S. interest rates hikes.
With better U.S. growing conditions agricultural prices slumped back – along with prices for a range of other commodities, which in turn pushed the $A down further. As a result, unhedged U.S. equities performed best last month, though the local property sector also performed well in light of lower bonds yields.
All up, after a “pause for breath” in recent months, the global equity bull run appeared to regain momentum in July, helped by the fact that European and Chinese problems appear contained and bond yields continue to remain non-threatening to valuations.
Unhedged international equities, and specifically unhedged U.S. equities, along with local property have been the top performing asset classes of late, while Commodities have been the worst performers.
Market developments over July were favourable to our tactical asset allocation views. As we argued last month, the Greek problem appears to have been contained, with a new European financing deal now in the process of negotiation. China’s equity market also appears to be stablising after a major slump – without as yet much undue effect on the economy. Ample global spare capacity and rising commodity supply is also keeping global inflation in check, commodity prices under pressure, and bond yields low.
Accordingly, our broad medium-term asset allocation views remain in place. Against the backdrop of low inflation and a gradual global economic recovery, we continue to favour equities over bonds and cash, and remain underweight commodities. Within the equity space, moreover, we favour unhedged international equities (particularly U.S.) over Australian stocks.
That said, there remains the risk that as market attention begins to focus on higher U.S. official interest rates, global equity markets could still suffer a further moderate correction. We retain our view that the first Fed rate hike will come in September.
Above average price-to-earnings valuations in the U.S. are another market headwind, though relative to exceptionally low bond yields, equity prices are still attractive.
Low U.S. inflation, moreover, likely means the Fed will raise interest rates gradually, and in a manner that – as history suggests – does not overly disrupt the broader global equity market bull market that has been in place since 2009.
Closer to home, the unexpected stabilisation in the unemployment rate over recent months and further weakening in the Australian dollar has reduced the Reserve Bank’s inclination to cut official interest rates anytime soon. Our base case remains that the unemployment rate will rise further in coming months, however, and the RBA will still cut rates to 1.5% p.a. by mid-2016.
Our view remains that Australia’s sluggish economic growth and corporate earnings performance – together with a still high $A by historic standards – should mean the local equity market continues to underperform. Low interest rates and sluggish corporate earnings should continue to favour defensive high yielding sectors like property.