Macro and Australian equity strategist, Macro Strategy Advisors

Shane Lee

Macro and Australian equity strategist

Macro Strategy Advisors

Thematic (Sector/Industry)

Stay Overweight Global and Domestic Cyclicals. A key assumption underpinning our Aussie equity market outlook in 2018 is that global growth remains strong and synchronised, while domestic growth strengthens and longer-term interest rates rise further, but don’t overshoot.  Our model portfolio is detailed in our recently published 2018 Aussie market outlook (“Aussie Equities 2018: In a Sweet Spot” – December 2017).  The US yield curve is still steep enough to support our view, even if it continues to flatten steadily during the year.  Furthermore, history shows that an inverted US yield curve doesn’t normally signal an imminent equity market downturn.  The curve can be inverted for several months before the equity market peaks. Beware of Sharp US Yield Curve Flattening. We remain comfortable with our outlook, but a sharply flatter yield curve is a risk that would lead us to a material change of tact.  One of our key concerns is that our positive outlook for the Australian equities becomes knee-capped by rapid curve flattening in the US.  The term premium component of US 10-year yields remains below zero, with the rise in yields over the past month due solely to expectations of higher average interest rates over the term period.  A rise in the term premium could be positive for equities and lead to some curve steepening that prolongs the equity market rally.Avoid Interest Rate Sensitive Sectors: Global long rates should rise, but not overshoot.  Data shows the decline in the term premium component of US 10-year yields to below zero began as the ECB ramped up its asset purchase program in 2015.  However, it’s now cutting the size of its monthly asset purchases by 50% until September with prospects of no further purchases beyond that month.  ECB balance sheet stability should ultimately put upward pressure on the term premium of global long rates even if interest rate expectations remain anchored.  The tapering of growth in the BoJ balance sheet doesn’t appear to have had a noticeable impact on US yields.Buy Australia over the US:  Another one of our key calls for 2018 is that Australia outperforms the US.  The US valuation premium to Australia is now at excessive levels that normally deliver Australian outperformance of around 10%pts in the 12 months ahead.  A weaker AUD could drive even more outperformance if the recent bout of USD weakness reverses.  A stronger US dollar not only makes Aussie equities more attractive to offshore investors; it also boosts domestic financial conditions and earnings.  Another factor adding to downward pressure on the AUD this year is the fact that other major central banks are likely to either raise policy rates or reduce the size of asset purchases.  This leaves the RBA isolated unless domestic wages growth lifts.

Stay Overweight Global and Domestic Cyclicals. A key assumption underpinning our Aussie equity market outlook in 2018 is that global growth remains strong and synchronised, while domestic growth strengthens and longer-term interest rates rise further, but don’t overshoot.  Our model portfolio is detailed in our recently published 2018 Aussie market outlook (“Aussie Equities 2018: In a Sweet Spot” – December 2017).  The US yield curve is still steep enough to support our view, even if it continues to flatten steadily during the year.  Furthermore, history shows that an inverted US yield curve doesn’t normally signal an imminent equity market downturn.  The curve can be inverted for several months before the equity market peaks. Beware of Sharp US Yield Curve Flattening. We remain comfortable with our outlook, but a sharply flatter yield curve is a risk that would lead us to a material change of tact.  One of our key concerns is that our positive outlook for the Australian equities becomes knee-capped by rapid curve flattening in the US.  The term premium component of US 10-year yields remains below zero, with the rise in yields over the past month due solely to expectations of higher average interest rates over the term period.  A rise in the term premium could be positive for equities and lead to some curve steepening that prolongs the equity market rally.Avoid Interest Rate Sensitive Sectors: Global long rates should rise, but not overshoot.  Data shows the decline in the term premium component of US 10-year yields to below zero began as the ECB ramped up its asset purchase program in 2015.  However, it’s now cutting the size of its monthly asset purchases by 50% until September with prospects of no further purchases beyond that month.  ECB balance sheet stability should ultimately put upward pressure on the term premium of global long rates even if interest rate expectations remain anchored.  The tapering of growth in the BoJ balance sheet doesn’t appear to have had a noticeable impact on US yields.Buy Australia over the US:  Another one of our key calls for 2018 is that Australia outperforms the US.  The US valuation premium to Australia is now at excessive levels that normally deliver Australian outperformance of around 10%pts in the 12 months ahead.  A weaker AUD could drive even more outperformance if the recent bout of USD weakness reverses.  A stronger US dollar not only makes Aussie equities more attractive to offshore investors; it also boosts domestic financial conditions and earnings.  Another factor adding to downward pressure on the AUD this year is the fact that other major central banks are likely to either raise policy rates or reduce the size of asset purchases.  This leaves the RBA isolated unless domestic wages growth lifts.

The US Yield Curve Threat to Aussie Equities