Economic and Investment Update - February 2016
by Lonsec Research
Summary of Key Views
In the eye of the storm
Lonsec has remained cautious on markets, increasing our underweight position to equities in favour of cash and alternative assets at the last investment committee meeting. The move reflects our expectation of ongoing market volatility, uncertainty around the strength in earnings growth for many companies and, to a lesser extent, the risk of a possible escalation in geopolitical risk, particularly around the tense situation in the Middle East and a breakdown of the EU with a possible ‘Brexit’.
The beginning of 2016 has been marked with a continuation of volatility in equity markets which has picked up since August last year. If we observe at the VIX index, which measures the implied volatility of index options, over the last 12 months the market has been characterised by two halves. Prior August 2015 the VIX was relatively benign, partly due to accommodative monetary policy by the major economies via their Quantitative Easing (QE) programs, which drove interest rates down and buoyed markets. Since August expected volatility has picked up, triggered by a steep fall in the oil price, along with uncertainty as to the direction (or more the magnitude) the Fed would take on rates and growing concern over a slowdown in Chinese economic growth. In the shorter term we expect volatility to remain a feature of the market.
Lonsec remains cautious on Australian equities amidst depressed commodity prices and a slowdown in the Chinese economy, which has forced Australia into a transitionary economic phase, shifting away from a commodity driven economy towards growth sectors such as education and tourism. From a global perspective, while the US economy has seen improvement in areas such as housing and a fall in the unemployment rate, we are yet to see wage price growth come through and it is still uncertain as to what the impact the roll back of QE will have on markets. We are also watching earnings growth numbers, as share prices have risen well in excess of EPS expected growth for many segments of the market. Our cautious view on equities is mirrored in emerging markets, where valuations appear attractive, but where headwinds remain for commodity driven economies such as Brazil and Russia and China looks to transition from an export based economy to a domestic consumer driven economy, which will take time.
Fixed interest markets remain challenging, as it is widely expected that bond yields will rise at some point from their current low levels, the question is when? We remain focused on shorter duration assets and have a bias towards investment grade credit, although we are cognisant that liquidity in credit markets has fallen as regulatory changes have resulted in many market makers pulling out of the market.
Our cautious stance on the market comes on the back of a period of strong double digit returns across most asset classes, which has been a positive for investors’ retirement savings and superannuation balances. These returns have been well in excess of Lonsec’s long term expected asset class returns, and our expectation is that the next few years will be characterised by single digit returns.
Market developments during January 2016 included:
The Australian equity market, as measured by the S&P/ASX 300 Accumulation Index, experienced a volatile start to 2016 and finished January down -5.5%. Global market weakness was the key driver with Australia following the results from offshore. Commodities markets once again resumed their loss leadership with Materials and Energy falling -9.1% and -6.5% respectively, as concerns around Chinese growth intensified. The result saw defensives favoured with outperformance only in Telecommunications (+0.7%) and Utilities (+0.7%) sectors.
Growth fears were confirmed via a decline in Australia 10-year bond yields from 2.9% to 2.6% and the Australian dollar falling to a low of AUDUSD 0.683 during the month. At its worst point in January, the S&P/ASX 300 was down by ~10%.
Global share markets were dominated by threats of slower growth in China and a precipitous drop in oil which saw inventory write-downs of US$7.8T in the first two weeks of January. Volatility and caution remained the overarching themes this month; however, shares globally came off their lows towards the end of the month on hopes the Federal Reserve will slow the pace of future interest rate hikes. Characterised by a retreat from risky assets, the S&P500 Index finished down -2.3%, similar to the MSCI World ex Australia NR Index which lost -3.2%.
Key Asian markets were also down as news from China heightened fears the economy was slowing and attempts to prevent market wide panic failed. The Shanghai Shenzhen CSI Index (-21.0%), NIKKEI 225 Index (-8.0%) and Hong Kong Hang Seng (-10.2%) all lost significant ground. Consecutive substantial devaluations of the Yuan saw the Shanghai Composite close early, twice in one week, after hitting the daily -7% threshold. China factory activity shrank for the tenth straight month and a ban on share sales by major shareholders was put in place.
In January, a sharp decline in risk appetite led to high levels of market volatility and weakness in risk assets. Global bond markets saw perceived safe havens rally with Treasury, gilt and Bund yields declining. As such, high grade corporate bonds were stable and high yield bond indices sold off. The 10-year Treasury yield fell sharply from 2.27% to 1.92%, as the equivalent gilt yield fell 0.40% to 1.56%. The 10-year Bund yield dropped from 0.63% to 0.33%, shrugging off investor disappointment from December in light of renewed global growth concerns.
The investment grade Bank of America Merrill Lynch Global Corporate Index generated a return of 0.48% as the high yield equivalent fell -1.44%. The dispersion of returns across US dollar, sterling and euro markets was relatively narrow. Investment grade corporate bonds in all three currencies ended the month with positive returns, while all the high yield indices declined.
The final trading day of the month stunned the market when the Bank of Japan went against its prior view of being against negative interest rates by adopting a negative -0.1% interest rate for bank reserves. The Japanese government 10-year bond yield finished January at an all-time low of 0.11%.
REITs (listed property securities)
The S&P/ASX 300 Property Accumulation Index retuned 1.0% in January, outperforming the S&P/ASX 300 Index, which returned -5.5%. Astro Japan Property Group saw the largest gains in the Index up 4.1% during the month; conversely Generation Healthcare REIT lost - 7.7%. Domestic REITs have reported strong portfolio revaluations and cap rate compressions to December 2015, reflecting the fundamentals of the direct market over the past 12 months. This was apparent in Dexus Property Group, Investa Office Fund, Stockland, Vicinity Centres and BWP Trust.
Globally, REITs returned -4.3% over the month of January in USD terms. Similarly, the FTSE EPRA/NAREIT Developed NR Index (A$ Hedged) lost - 3.6%. Australia was the top performing region in USD terms (-1.5%), followed by Japan (-2.6%), Continental Europe (-3.4%) and the United States (-3.5%).
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