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The Outlook for Equity Markets

Although equities, overseas and at home, have been recovering from their sell-offs in October, they are still well below their previous peaks. Looking ahead, the global economy looks like continuing its already long post-GFC expansion into 2019, which should be supportive for growth assets, but equities remain over dependent on the performance of American shares and the American economy, and there are risks (notably around trade wars and potential mistakes from accidentally overtightening monetary policy) which could derail this outlook.

In New Zealand, the economy appears to be better poised than downbeat business surveys might suggest, but a variety of cost pressures on businesses suggests a growing economy in 2019 may not translate into strong corporate profit outcomes.

The significant sell-off of New Zealand equities in October bottomed out on 26 Oct, at which point the S&P/NZX50 index had dropped by 9.5% from its peak on 29 Aug. More recently, New Zealand shares, following the global pattern, have been recovering, though the index is still 5.4% below its previous peak level. Year to date, the index has delivered a modest capital gain of 3.5% and an overall return including dividend income of 6.7%.

It has been a very similar story in Australia, with a 10.8% decline in the S&P/ASX 200 index between 29 Aug and 26 Oct followed by a modest recovery since. Year to date, the index is down 2.0% in capital value, although dividend income takes the overall return into positive territory, for a small 1.7% total return.

New Zealand business surveys continue to show that businesses are not in a great place—while firms' assessment of their own situation has levelled out after earlier sharp falls, it has stabilised at a low level by historical standards.

Despite the current business caution, forecasters expect that the economic outlook will pick up into 2019. Economic data has certainly been stronger than the business surveys would have suggested, notably the unexpectedly sharp fall in the unemployment rate in the September quarter. Forecasters had been picking a 4.4% rate, whereas the actual number was 3.9%. While quarterly data can be erratic, and the true picture might not actually be as buoyant as the numbers painted, the news nonetheless added to the earlier impression left by stronger than expected 1.0% GDP growth in the June quarter that the business outlook may be more solid than
some of the surveys might suggest.

The RBNZ, for example, said that "GDP growth is expected to pick up over 2019. Monetary stimulus and population growth underpin household spending and business investment. Government spending on infrastructure and housing also supports domestic demand. The level of the New Zealand dollar exchange rate will support export earnings."

In Australia there is still a widespread divergence of views on the outlook for business performance. The RBA's latest quarterly monetary policy statement was right down the upbeat end of the spectrum with the bank lifting its forecasts for economic growth and lowered its forecasts for unemployment. On GDP growth, it now
thinks the Australian economy will grow by 3.25% this year (it had previously picked 3.0%), and it expects the unemployment rate will be 5.0% at the end of next year (previously 5.25%), and lower again (4.75%) in 2020.

Given the mixed views on the business outlook, more of the same modest profit growth looks the most likely outcome, although equity performance could surprise on the upside if the RBA's more upbeat scenario were to come to hand.

World shares have struggled to regain the ground lost since the sharp sell-off in October. At its current level, the MSCI World index of developed markets in U.S. dollars is still 7.8% below its recent peak on 27 Sept, and is 9.8% below its all-time high back on 26 Jan. Year to date, the index is down 3.6% in capital value and by 1.9%
adding in taxed dividend income, though local investors holding the index would have experienced a small gain thanks to the 5.0% depreciation of the New Zealand dollar against the U.S. dollar. The overall outcome has continued to depend disproportionately on the U.S. market, where the S&P500 index is up 2.0% year to date: ex the U.S. the MSCI World index is down by a substantial 11.3% in capital value. Japanese shares have been least bad, with a 2.2% fall in the Nikkei index, but European shares have been weak, with the FTSEurofirst 300 index down 6.9%. German shares have been among the weaker of the major European markets, with the DAX index down 12.3%. The U.K. has also struggled, with the FTSE100 index down 8.3%, although at time of writing there were some potentially hopeful signs that the Brexit negotiations might be reaching a negotiated conclusion rather than the "hard" Brexit that has been worrying the U.K. equity market.

The dependence of the overall asset class on U.S. performance has been understandable: profits have been booming in the U.S. but have been harder to come by elsewhere. There is still no clear indication the U.S. economy has run out of profit-generating steam. Profit growth in 2019, is expected to be 9.2%. The analysts believe
this will be enough to carry the S&P500 up to 3,181 in a year's time, which would be a 16.7% rise from current levels.

While there are reasonable grounds to expect the U.S. economy and its equity market will hold up well. There are risks: the current fiscal stimulus will progressively run down (and will not be renewed with now-divided control of Congress between Democrats and Republicans); there are more questions being asked of the prospects for the big tech stocks, which up to now have been a disproportionate source of U.S. equity gains; and the recent sharp drop in world oil prices brings the expected profits of the U.S. "fracking" industry under a new spotlight. But all that said, there is a reasonable prospect of U.S. gains supporting the outlook for the asset class.

Elsewhere, the good news is that the global economy looks set for ongoing expansion, but the bad news is that the rate of growth looks like slowing down. J.P Morgan said "The start of the final quarter saw a modest improvement in the rate of expansion of global economic output, as a stronger performing service sector offset the ongoing slowdown at manufacturers."

It is somewhat more likely, that 2019 will not be quite as good a year for global business activity as 2018. But (absent unpredicted geopolitical shocks) there is still a  reasonable chance that the ongoing world business cycle will muddle through over the coming year, and provide some fundamental economic support for better
equity performance.

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