Economic and Investment Update - February 2017
by Lonsec Research
Summary of Key Views
Is up the new consensus?
Inflation appears to be back on the agenda, which highlights the extent to which things have changed compared to a year ago when talks of deflation and disinflation dominated discourse. Finally, no conference these days can be complete without pontificating on what a Trump presidency will bring from a geopolitical and economic standpoint. Is ‘up’ the new consensus?
Here are some thoughts:
Policy execution. Animal spirits have certainly taken effect, particularly post the Trump election result. The prospect of corporate tax cuts and reducing regulatory red tape for business, coupled with an increased focus on infrastructure spending, have the potential to provide a significant boost to the US economy. Positive sentiment may see markets continue their upward trajectory over the next six months or so, however we also believe that the market is factoring in high expectations on a Trump presidency successfully executing on these initiatives, and any shortfall may adversely impact markets.
Transition away from monetary policy. We are possibly seeing a move away from quantitative easing to more ‘conventional’ monetary policy. The market is factoring in rate rises in the US, and Europe has also signalled a pause in monetary stimulus. A rise in rates signals an improvement in economic strength and a subsequent rise in inflation. The key will be the extent to which rates rise. What we do know is that a rising rate environments is generally not positive for ratesensitive sectors such as government bonds, property and infrastructure.
Valuations. The adage of buying in the dips and selling at the highs is not a bad investment principle. However, assets can be expensive or cheap for a long time. At the moment most asset classes look to be priced at fair value to expensive. The S&P 500 has not batted an eyelid and continued its upward trajectory as momentum has driven asset prices higher. The longer asset prices continue their one-way street, the greater the risk of a mean reversion, which is usually driven by some unforeseen event.
Asset class dispersion. Correlations between asset classes have fallen to levels seen in 2002-03. This can be symptomatic of being at the late stage of an economic cycle, where the ‘macro’ factors that have dominated markets in recent years are beginning to play less of a role. We have also observed the significant dispersion in returns from managed funds in the same asset class. What this means is that investors will have to be more selective in their investment selection process as the days of rising ‘cheap’ directional beta may be coming to an end.
So, is up the new consensus? My view is that there is recognition that there are some material shifts taking place, notably a potential move away from ‘unconventional’ monetary policy, the prospect of rate rises and inflation, and ultimately a focus back on fundamentals. However, there is reason for caution, and is still unclear how effectively such a shift in economic and investment environments will be managed and executed. While economic data has improved across many metrics, which commenced prior to the US election results, we think some markets may have overshot in their exuberance post US elections.
Our dynamic asset allocation positioning reflects this caution. As communicated last month, we have reduced our underweight exposure to equities from an Underweight to a Slightly Underweight position, and trimmed our exposure to listed property and infrastructure. Our next Asset Allocation Investment Committee will be held in March, and we will keep you informed of any changes in our dynamic asset allocation positioning in subsequent editions of the Investment Outlook Report
Market developments during January 2017 included:
The Australian market had a sober start to 2017 following the highs late in 2016. The S&P/ASX 200 Accumulation Index lost -0.79% following December’s gain of 4.38%. Strong gains came from the Health Care sector, which gained 4.76%, led by heavyweight CSL, which recorded 11.84% after upgrading its full year earnings. Materials had another positive month, with the sector gaining 4.74%. Bluescope gained 20.80% in January, helped along by rising steel prices, a negotiated pay freeze, and payroll tax relief from the NSW government. Real Estate fared the worst in January, with the sector down 4.71% and all members losing, with the exception of global asset storage provider Iron Mountain. Industrials were also hit hard, down -4.72%, with logistics group Brambles losing -16.05% after issuing a profit warning, citing the longer time taken by customers in the fast moving consumer goods (FMCG) sector to commit to contracts. Small cap shares lost - 2.44% in January, with small industrials remaining under pressure.
In the US, markets were still pushing higher, although a weaker USD was negative for Australian investors, with the S&P 500 TG Index losing -2.81% in AUD terms. Earnings season is off to a solid start, with estimates for Q4 2016 showing growth of just under 5% for the S&P 500, and growth for the 2016 year in the 10–12% range. At the end of December 2016, estimated growth for Q4 was 3.1%. The upside surprise has been delivered courtesy of higher commodity prices, as well as climbing yields, which have benefited financials.
While the ‘Trump trade’ was a winner in December, the new year brought a slightly greater degree of scepticism ISSUE DATE: 2-03-2017 P 2-3 February 2017 Client Newsletter Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL No. 421445 This information must be read in conjunction with the warning, disclaimer, and disclosure at the end of this document. This report supersedes all prior reports. to bear on the new administration, with markets hungry for more detail on President Trump’s policies, especially with regard to tax, regulation and government spending. Sectors such as Information Technology (4.41%) and Health Care (2.25%) performed well in January, although the impact of potential regulatory changes remains difficult to evaluate. Materials (4.64%) continued to surge ahead as commodity prices rose. Globally, the MSCI World Net TR Index lost -2.29% in AUD terms. The Euro Stoxx 50 index fell -0.38% in EUR terms, in no small part to the return of political uncertainty, including the future state of trans-Atlantic trade. In the background, however, the European recovery appears to be slowly taking hold, and earnings for Q4 are better than expected. In the UK the FTSE 100 TR Index lost -3.44% in AUD terms. In Asian markets the Nikkei 225 Index lost -0.38% in local currency terms while the Shenzhen CSI 300 Index gained 2.35%.
Yields underwent some mild expansion through January, but have generally stabilised since the rapid moves seen in November last year and the continued rise in December. The prospect of higher inflation has been supported by recent CPI releases in both Europe and the US, which would be supportive of higher yields, but also returns on high yield debt due to the impact on company earnings. In January, the US 10-year Treasury yield finished only slightly higher at 2.45%, after reaching a high of 2.51%. The return on US corporate investment grade bonds was 0.30% in January, while US high yield debt returned 1.61%, still benefiting from a risk-on environment. Credit spreads were further compressed in January, with the BofA Merrill Lynch US High Yield OAS falling from 4.22% to 4.00%. Global bonds, measured by the Barclays Global Aggregate TR Index, returned 0.81% in January (in AUD hedged terms). Returns on Australian corporate bonds were 0.81% while government bonds returned 0.57%, with the yield on Australian 10-year Treasuries falling slightly from 2.77% to 2.71%, some 85 bps higher than its historic lows in August 2016. The UK 10-year Gilt yield rose from 1.24% to 1.42% in January and now appears to have normalised following the Brexit shock. The German 10-year Bund yield rose from 0.20% to 0.43%, while the 5-year Bund remains in negative territory, gaining from -0.54% to -0.31%. Since turning positive in November, Japanese 10-year yields continued to rise in January, moving from 0.04% to 0.08%
REITs (listed property securities)
The S&P/ASX 300 A-REIT Accumulation Index lost - 4.71% in January, following a strong gain of 6.75% in December. The index was finally pulled down by rising bond yields, despite a remarkable display of resilience in the final quarter of 2016. The largest losses came from GPT Group (-6.96%) and Dexus Property Group (- 6.65%), whose commercial property portfolios are most sensitive to rises in long-term bond yields. However, while rising yields will put pressure on ARIET values, the sector may continue to be a source of stability, especially if equity market volatility persists through 2017.
Globally, REITs were under pressure in January, with the S&P Global REIT NTR Index returning -0.86% (in AUD hedged terms), while the FTSE EPRA/NAREIT Developed NR Index was down -0.5%. In a rising rate environment, REITs will face additional pressure on cap rates and leasing spreads, but many investors still anticipate that rates will be ‘lower for longer’, meaning demand for yield-producing asset classes like REITs may be able to withstand current market movements.
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