June was a very good month for financial markets, especially equities, in contrast to the poor performance seen in May. The US markets continued on to new highs while here in Australia we finally peaked back up around the GFC level for the first time (or did we?  It’s a bit different in ‘real’ terms – see story further down in the newsletter).  The key factor behind June’s results was not so much a change in the underlying economic conditions as a change in the central banks’ response to those conditions – read “interest rate cuts”.  The financial markets at present are all about interest rates.

For the past several months financial markets have been debating the need for central banks to cut interest rates, and in June, the central banks delivered. The Reserve Bank of Australia cut the cash rate to a new record low of 1.25%, and Governor Phillip Lowe subsequently made it clear that more rate cuts are on the way – he duly delivered in early July with a further cut to 1.0%. This, plus a disappointing set of Q1 GDP numbers and weaker readings on business conditions, reinforced the markets’ view that the cash rate will fall to 0.75% by the end of 2019, and potentially to 0.50% in 2020.  This is a complete turnaround from where we were a year ago (see Review, below).

It is a similar theme around the world: Futures markets are pricing 100 basis point of cuts in US cash rate over the coming year, from its 2.4% level at the moment. Elsewhere in the world, the Reserve Bank of India cut its cash rate and the ECB said it is ready to provide further, albeit limited, support to the Eurozone. The People’s Bank of China also flagged scope for further support to their economy.

Review:  2018/19 was an especially turbulent year for the global financial markets.

The year started with confidence about the global economy and expectations that central banks would continue to gradually move cash rates higher as circumstances allowed. However, markets were concerned the lack of inflation in the US meant the Fed was being too aggressive in its plans to lift the cash rate, and it all came to a head from October to December 2018 when global growth suddenly slowed much faster than expected and the markets started to worry about an imminent recession.

Equity markets fell sharply, with the US S&P500 Index posting its worst December return since 1931. The mood changed dramatically by Christmas, once the Fed signalled an end to lifting interest rates. Through the first half of 2019, as economic data around the world continued to slow and central banks moved further down the road of easing monetary policy, so bonds and equities continued to make further gains, albeit with bouts of volatility from time to time.

Looking ahead:  as we move into FY2019/20, the outlook is for interest rates to fall further, especially in Australia and the US, and to stay low for an extended period of time. Here in Australia the RBA dropped rates to an all-time low of 1.0% early in July and there is a very real chance the Reserve Bank will not be able to lift the cash rate again before 2021.   

Equity market valuations should be supported by the low inflation/low interest rate environment, but the challenge will be whether company earnings can hold up in a slowing global economy. The August reporting season coming up in the US and Australia will provide important data on this question. As markets balance these factors, equity markets should be able to cope as long as the feeling remains that Central Banks and their monetary policy levers can manage the slowing rate of growth.   

And volatility?  Regardless of the markets’ ability to ‘cope’, the significant geo-political risks we’ve been talking about for a very long time including the US/China trade dispute, Brexit, and tensions in the Middle East, will continue to distract investors and provoke periodic bouts of volatility. 

Sources:  CommSec, Quilla Consulting, RBA, Thomson Reuters, Bloomberg.