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2019 was an exceptional year for stocks at home and abroad, with both the Aussie and US markets hitting all-time highs. It was also the 11th year of the current bull market – one of the longest on records.
So it is hard not to approach 2020 without some degree of trepidation, more so because the outlook seems to come down to the actions of the erratic and unpredictable President Donald Trump. If the trade war between the two largest economies, China and the USA, continues or escalates again, that has to be bad for stocks. And if the US market sinks, the aussie market will follow and probably fall further.
Conversely, a positive trade outcome will be supportive for the market. It may not propel the market that much higher as this is the “expected” outcome, but it will at least remove the biggest negative overhanging it.
We know that President Trump is very attuned to the market and that facing an election in November, he will want a strong economy, high consumer confidence, low interest rates and full employment. The absolute last thing he wants is a stockmarket in retreat.
From a risk/reward point of view, taking a more defensive orientation due to the unpredictability of the President seems prudent. A big drop if he can’t pull off an acceptable trade deal, probably a smaller rise if he can get it done.
The odds do, however, favour a deal so its not time to quit the market. Also, the “trend is your friend” and despite the tenure of the bull market, the direction is still firmly up.
More confidently, we can assume that interest rates are going to stay low – very low – for some time. Ultra-low interest rates are a function of low economic growth and lack of pricing power by businesses, the latter mainly due to disruption by technology, and I can’t see this changing in 2020.
In fact the cheer squad is already calling for RBA Governor Dr Phillip Lowe to cut the cash rate by a further 0.25% in February. Some are saying that it will hit 0.25% by June, and then the RBA will embark on “non-traditional” methods.
I hope that employment holds firm and that the RBA doesn’t cut the cash rate, because I fear that these cuts will do more harm than good by hitting consumer confidence. However, I do sense that they will bow to the pressure again. This means that “expensive defensive” stocks such as Transurban, Sydney Airport and the A-REITs are set to become even more expensive as investors chase secure yield. The aussie dollar will also remain under downward pressure.
Another trend that is likely to continue in 2020 is that the quality stocks with both top and bottom line growth will get even more expensive. With so many of the major companies seemingly “growthless”, there is a paucity of companies of the calibre of CSL, Ramsay, REA or Seek. These stocks are going to stay in very high demand.
Summing this up a strategic level:
Now let’s look at the composition of the portfolio by company size and industry sector.
In 2019, both big and small cap stocks have moderately underperformed compared to the overall market. As the table below shows, the top 20 stocks, which make up about 45% of the total market capitalization, have returned (on a total return basis including dividends) 23.4%. On a relative basis, this is 2.7% worse than the broader market’s (S&P/ASX 200 ) total return of 26.1% and is mainly due to the performance of the major banks and insurance companies.
Small caps, as evidenced by the Small Ordinaries index which tracks stocks ranked 101st to 300th by market capitalization, also underperformed with a return of 21.7%. This index tends to be overweight resource companies and is the second consecutive year of underperformance.
Larger mid-caps, stocks ranked between 21st and 50th by market capitalization, outperformed in 2019.
Mean reversion, that is the tendency for prices and returns to revert to the long-run average level of the entire dataset, is always something to consider when making assessments on how markets may perform. I can’t see much in this data to help one way or the other. I do, however feel that in an environment of lower growth and softer commodity prices, small caps may struggle. Further, I think the big banks could do a little better so my inclination is to maintain a bias towards larger cap stocks.
The table below lists the 11 industry sectors for the Australian sharemarket according to the GICS classification methodology. It shows the sector weighting as a proportion of the S&P/ASX 200, the return (including dividends) for 2019 and the returns for calendar 2018, 2017 and 2016.
Two matters stand out. Firstly, the variability of the returns. Although all sectors are positive in 2019, the gap between the best performing sector (healthcare at 47.4%) and worst performing (financials at 15.4%) is quite material. Secondly, the lack of consistency from year to year. So, getting the view right on each sector, in terms of whether you should be over-weight, under-weight or neutral (index-weight), can have a pretty big impact on portfolio performance.
What will be the best and worst performing sectors in 2020? Here is my take on each sector (in descending order of market capitalization).
a) Financials – Index-weight
The major banks have been laggards and the sector has underperformed for the last four years. While mean reversion is a possibility, it is hard to see the market wanting to re-rate the sector in the short term while earnings are under pressure. And with interest rates staying so low and credit growth relatively anaemic, opportunities to grow earnings look more likely to come from the cost line rather than the revenue line.
But, capital pressures have abated and fully franked dividend yields in the range of 5.5% to 6.5% will look very attractive to some investors. I don’t think it is a sector to be short (underweight), but I can’t quite bring myself to going over-weight.
b) Materials – Under-weight
Brazilian miner Vale resuming full production should act as a cap on iron ore prices. This will limit the opportunities for major miners BHP, Rio and Fortescue, who have now taken the easy wins on productivity .
With world economic growth softening and the potential for a stronger US dollar, commodity prices look set to remain in a softer cycle. While gold and some other precious minerals were big winners in 2019, with the US Federal Reserve now appearing to be on hold and trade tensions easing, I would be surprised if they continue to rally in 2020.
Non mining material companies, such as Amcor, Bluescope or Orora have appeal, but they will be pressured if growth in the USA slows or a trade deal is not done.
c) Health Care – Over-weight
The best performing sector on the ASX in 2019, 2018, 2017 and over the last 5 years and the last decade, not a sector to be short as the tailwinds of an ageing population, increasing demand for health services and increasing expenditure by government keep blowing. Some of the stocks are very expensive but the risk is that they could get even more expensive.
A risky call, but my hunch is to stay overweight.
d) Industrials – Index-weight
This sector is arguably misnamed, because some of the leaders (such as toll road operator Transurban and Sydney Airport) aren’t really industrials in the classic sense. Qantas is also in this category.
Because of the variety of companies that the sector covers, it is largely a stock by stock proposition.
e) Real Estate – Index weight
With interest rates staying low and demand for east coast office and industrial property strong, investor interest in trusts focussed on these sub-sectors will be fairly resilient. Caution around trusts trading at significant premium to NTA and shopping centre (retail) trusts.
f) Consumer Discretionary – Over-weight
Largely a stock by stock proposition, but one of the better performing sectors in 2019 and one that should benefit from very low interest rates, an improving housing market and hopefully, an uptick in consumer confidence.
g) Consumer Staples –Under-weight
This sector surprised in 2019 with strong performances by leaders Woolworths, Coles, Coca-Cola and a2 Milk. Although a defensive sector, it does look very pricey and for the major supermarkets, the earnings trajectory is weak. Moderately under-weight.
h) Energy – Index-weight
Over the last couple of years, OPEC has been remarkably successful at “managing” the production of oil from OPEC and some non-OPEC nations. Accordingly, the price hasn’t been able to break down below US$50 per barrel. Notwithstanding that the global growth outlook is somewhat subdued, I am inclined to play this sector in the expectation that the $50 price level will hold and that the returns for Australia’s energy companies should be largely ok. Index-weight.
i) Communication Services – Index-weight
Telstra’s rebound caused this sector to be one of the better performers in 2019. It came after three very tough years. While pressure on mobile pricing appears to be easing, it will be difficult for the incumbents to grow earnings while customers are switching to the NBN. 5G could be an upside. Index-weight.
j) Information Technology – Index-weight
Very much a “stock by stock” proposition. The macro drivers say that this is a sector to be overweight, but the paucity of Australian IT companies means that many of the sector leaders are hideously expensive.
k) Utilities – Under-weight
This sector underperformed in 2019, and despite ultra-low interest rates, downward pressure on wholesale electricity prices will make it hard for the sector leaders.
This is how I think you play the sharemarket in 2020:
Health Care Over-weight
Real Estate Index weight
Consumer Discretionary Over-weight
Consumer Staples Under-weight
Communication Services Index weight
Information Technology Index weight