International shares returned a slight negative return in February, down -0.9% (fully hedged) due to disappointing US economic data, rising inflation and poor investor sentiment around President Trump’s economic plans. The Trump administration has imposed a 25% tariff on steel and aluminium imports. Currently, 25% of steel consumed in the US is imported, with the three largest exporting countries being Canada, Brazil and Mexico. President Trump announced that the next steps in his tariff plan will be reciprocal tariffs on all trading partners. These tariffs would be customised for each country and will match other countries’ tariffs on the US, as well as address any non-tariff barriers believed to disadvantage the US. U.S Consumer Price Index (CPI) for January was higher than expected. The increases were widespread and not driven by housing, unlike previous months.
Australian shares performed worse than their global counterparts, down -3.8%. This underperformance was mainly due to disappointing earnings results from large cap shares in the banking sector. International REITS returned 2.0% in February and Australian REITs were down -6.1% due to some significant capital raising in the Australian REIT sector.
International sovereign bonds were up 1.0% in February, as bond yields fell over the month driven by softer-than-expected US economic data. The Bank of England cut interest rates by 0.25% in February, noting significant progress in reducing inflation over the past two years. Domestic inflationary pressures remain somewhat elevated, and UK economic growth has weakened.
Australian sovereign bonds were up 0.9% in February, as RBA comments cautioning expectations for additional interest rates cuts caused bond yields in Australia to stay elevated compared to international yields.
The Australian dollar (AUD) fell slightly and experienced greater volatility over the month trading in a wide range of $0.61 to $0.64 in February as the RBA cut interest rates for the first time since late 2020. This cut was widely expected, as the RBA noted that “inflationary pressures are easing a little more quickly than expected”. However, the RBA cautioned against expecting further rate cuts as labour market conditions remain relatively tight, evidenced by limited labour supply and stagnant productivity growth.
In our last monthly Economic review, we warned of our concerns that Trump policies may have on inflation expectations and the subsequent impact on financial markets. After the volatility experienced in December, markets have again been particularly weak from late February to early March. Our outlook statement has retained this caution and we remain vigilant about the implications for investors.
OUTLOOK
The key Trump policies that are likely to come into play and consequently influence markets in 2025 are: Tariffs on imported goods (particularly Chinese goods), Deportation of illegal immigrants, and tax cuts . These are all considered inflationary and pose a new risk to our current view that inflation will abate, and interest rates will fall further. On the flip side, these policies are stimulatory for the US economy and positive for corporate earnings.
However, rising inflationary concerns may cause markets to reassess the current expected trajectory of interest rate cuts and limit further gains in stock prices. On balance we expect that potential inflation from the Trump policies, may cause the FED to materially change the trajectory of its current interest rate cutting strategy. Should interest rates cuts ultimately fall short of current expectations, then we would expect to see interest rate sensitive assets such as bonds, property, and infrastructure underperform. However, the fillip provided from the Trump policies will likely see a broad-based expansion to corporate earnings and support equity prices. In such an environment we favour small and mid-cap stocks over the larger tech stocks.
Another thematic from interest rates not falling to current expectations, is a stronger US$. This has already started to play out and we favour adopting an increased unhedged exposure to international stocks. Further, there is a strong negative correlation between a strong $US and the relative performance of Emerging market equities. We would advise an underweight to Emerging market equities at this stage of the cycle.
Domestically, While the RBA cut rates at their February meeting, the labour market is likely stronger than the RBA would prefer. Therefore, we do not expect the RBA to rush into further rate cuts. Further easing will likely depend on sustained signs of a loosening labour market and/or weakening wage growth. While unemployment remains low, both wage growth and job vacancies continue to fall, which suggests we should see the labour market begin to soften and a modest rise in unemployment in 2025. We continue to expect growth to remain weak, as higher interest rates and cost-of-living pressures are likely to keep consumption suppressed. Consequently, we are cautious on Australian cyclical stocks and prefer defensive stocks with relative earnings certainty. In addition, we favour Australian sovereign bonds over cash, with interest rates likely to have peaked this cycle. Lastly, Japanese equities offer an interesting play on corporate restructure. Shareholder activism and a range of reforms are encouraging Japanese corporates to increase their focus on greater capital efficiency and liberate cash idly sitting on balance sheets. Japanese equity prices remain relatively inexpensive and are likely to re-rate higher if these reforms are successfully adopted.