International equities continue to push higher as the US earnings season and the French elections have been safely navigated. The US earnings season has been positive, with average profit growth beating expectations.
Locally, the S&P/ASX 200 has been slightly weaker following a continued pullback in commodities, and financials are starting to fall after strong gains over the past year, on the back of weaker than expected bank results. Net interest margins were particularly disappointing, despite the out of cycle rate hikes. This was somewhat offset but strong capital ratios and low bad and doubtful debt charges.
Oil has fallen amid continued worries that OPEC cuts will not be sufficient to reduce inventories, and the possibility that OPEC does not extend cuts. Along with oil, industrial metals also suffered with iron ore back in the US$60s as China continues to tighten conditions and stockpiles remain at highs.
The Australian Dollar has also posted a decent fall to below 74 US cents amid weak commodities, worries around the AAA rating, and a continued budget deficit.
Economic overview
The world looks to be in a period of synchronised growth which has led the International Monetary Fund to upgrade global growth forecasts this month, despite weaker than expected US GDP data and activity indicators. Offsetting this were strong US employment figures providing hope that wage gains will start to pick up and feed through to their consumer dominated economy.
The European economy has been a bright spot, with both inflation and growth picking up, while activity indicators have been stronger than expected. Political risk is also alleviating as polls were right this time in predicting a Macron victory for the French elections. This was a positive for markets given his pro-Euro and pro-business stance, but without a party behind him, it could prove difficult to implement any major reforms.
Meanwhile, Chinese growth continues to be stable at 6.9% GDP despite the implementation of various tightening measures since the turn of the year which is partly to blame for derailing the commodity rebound in recent months.
Locally, last month’s employment figures were encouraging as the economy added more jobs than expected, and the underlying data was even more impressive due to the number of full time jobs added. However it remains to be seen if it is sustainable as the construction leg of the economy is showing weakness. Building approvals declined by 13.4% in March, far more than expected, which could weaken the employment outlook as construction is the third biggest contributor to employment in Australia.
The Reserve Bank of Australia (RBA) continues to keep rates and their outlook for an improving economy unchanged despite inflation figures for the first quarter of the year coming in weaker than expected; however, weak consumer spending was flagged as a possible downside risk. This proved to be prescient as the retail sales figures released a week later were much weaker than expected, falling 0.1% in March versus a forecasted 0.3% growth.
The Australian budget was also released this month, you can view our full analysis of the proposed changes here.
A volatile period for oil
Oil is one of the most important commodities in the world due to its use in various daily activities. This was certainly reflected in the investment markets in the 2014 – 16 commodity bust as oil prices tanked from over US$100 per barrel to under US$30 per barrel, exacerbating volatility in the equity and bond markets.
The 2014 – 16 crash was caused by a conflux of factors ranging from:
• The advent of shale oil leading to oversupply
• Stockpiles reaching unsustainably high levels
• The Organisation of Petroleum Exporting Countries (OPEC) employing a pump-at-will approach
• Worries about slowing global growth
Fast forward to 2017:
• Oil has recovered slightly to around US$50 per barrel
• Many shale oil rigs have been shut down due to unprofitability at the current oil price
• Stockpiles are starting to fall
• OPEC and a group of other major producers have cut production in an attempt to reduce stockpiles and boost prices
• Global growth concerns have abated with the world entering a period of synchronised growth.
Despite the better environment, oil prices remain prone to jitters as participants remain wary after recent crashes and these stabilising factors remain feeble. As shown below, the early months of OPEC’s production cut did not stop rising stockpiles. It was only in the past few months as OPEC continued to deepen cuts when stockpiles finally started to draw down.
Meanwhile participants continue to fret on the sustainability of the drawdown, primarily as:
• OPEC and the external parties involved consider extending the production cut agreement to the second half of 2017
• The number of operational US oil rigs have rebounded strongly since prices rebounded above US$40 per barrel about a year ago, leading to volatility in the oil price over the last month.
In recent days various participants of the production cut agreement have backed the continuation for production cuts as inventories have only just started to fall. Given this noise markets are expecting the OPEC meeting in two weeks to result in an extension of production cuts. Should an extension be announced, one would expect oil prices to rise, but given the expectations, there would likely be a steep fall in oil prices if the production cuts were not extended.
Oil price implications
While iron ore remains Australia’s largest commodity export, oil is growing in importance due to the oil price-linked nature of natural gas. In recent years, various companies have invested into large liquefied natural gas (LNG) projects in Australia. These projects are just starting to come online, with Santos’ Gladstone LNG and Origin’s Asia Pacific LNG being prime examples. The significant investment has resulted in a massive uplift in production leading to projections that Australia will surpass Qatar as the largest exporter of LNG in the world in 2018.
Given this backdrop, oil prices will have a growing influence on Australia’s trade balance and budget, which will inadvertently impact the Australian Dollar. As investors would have experienced over the past few years, the oil price will also impact heavily on the ASX-listed energy producers, with the stocks and bonds of Origin (ORG) and Santos (STO) heavily hit in the last few years.
However, the oil price volatility in May has not fed through to these investments as strongly as they would have a year ago, implying the correlation with oil prices has weakened. This is likely a result of better balance sheets following recent capital raisings and asset divestments, and importantly, the commencement of operational production in their respective massive LNG projects leading to positive cash flows.
Looking broader, equities and other risky assets have also experienced a much more subdued correlation with oil prices in 2017, a far-cry from 2015 and 2016 where oil prices (along with other commodity prices) seemed to be a primary driver for the movement of risky assets. Much of this can be attributed to better growth and a more optimistic outlook for economies around the world, and marks the end of a period of significant stress in the energy market, where commodity pricing undoubtedly exhibited irrational behaviour. This decoupling is also a positive for investors as falling correlations also imply higher diversification benefits for clients with diversified portfolios through lower overall portfolio volatility.
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This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Bentleys Wealth Advisors we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
