Economic and Investment Update - July 2015
by Lonsec Research
Summary of Key Views
Volatility rears its ugly head
Last quarter we wrote how financial market conditions seemed not too hot, not too cold but just right for equities. Interest rates remain very low, inflation is low and growth is expected to remain moderate. We also pondered what could go wrong and identified the key risks as ‘inflation surprise’, ‘deflation grind’ or something relating to geo-political events in Europe (Greece, Ukraine) or the Middle-East.
As it turned out, it was events in Greece that have sparked increased volatility with the small European Union (EU) member on the verge of defaulting after many years of negotiations with ‘the Troika’ being the EU, International Monetary Fund (IMF) and European Central Bank (ECB). The leftist leaning Greek government seems fed up with austerity measures and is seeking some sort of debt write-down either by agreement or by default. A default would leave ‘the Troika’ with around €470bn in bad Greek government and bank debt. For Greece, it would probably mean expulsion from the EU and a major devaluation of any new currency and in turn, a major fall in the value of Greek assets and income.
While Greece is only a small economy, its default and expulsion from the EU could hurt confidence in other European countries, like Portugal and Spain, and indeed confidence in the European Union itself. It is too early to tell how the situation will unfold but it can be expected that the EU and ECB will move quickly to provide stability to the European financial system to mitigate any contagion risks. Lonsec also notes that given the Greek bad debt is mostly held by ‘the Troika’, and not the private sector, there seems little risk of a GFC type event; it is more likely to be a short term bout of volatility and uncertainty.
Turning to the global economy, conditions remain very diverse with the US closer to its first interest rate rise since the GFC, while Asia and Europe continue to ease monetary policy. It seems overall that the ‘deflation grind’ situation of overcapacity, increased competition and falling prices is a more likely situation than the ‘inflation surprise’ situation of growth and inflation surprising on the upside. Even in Australia, it is becoming evident that competition has increased markedly in many sectors including Finance, Retailing and Resources which make up around 60% of the local share market.
As we move into the September quarter, Lonsec has become a little more concerned about the potential for a correction in the US share market which has been quite resilient since January 2015. We are concerned that the outlook for a US interest rate hike in 2015, combined with increased uncertainty in Europe, could be enough for investors to take profits in the second half of 2015.
While the Australian market has already retreated around 9% since April 2015, it would still be vulnerable to a correction in the US, so we remain cautious on International and Australian equities, in the short term. We note however, that the Australian market would offer quite good value on a price/earnings and yield basis if it retreated further and this would most likely be a great long term buying opportunity.
Market developments during June 2015 included:
The Australian ‘broad cap’ equity market, as measured by the S&P/ASX 200 Accumulation Index, lost -5.30% in June as the market reacted to a raft of earnings downgrades as the financial year came to an end. Almost all Australian sectors underperformed their global counterparts with Consumer Discretionary leading the charge. Of the sub-sectors, Mining experienced the biggest loss over the month.
The S&P/ASX Small Ordinaries Accumulation Index underperformed its broad cap counterpart, down -7.77% in June. This trend extends over 12 months with the ‘small cap’ market materially lagging the broad cap index.
Global equity markets sold off heavily towards the end of the month as the drama of the Greek sovereign debt crisis played out, combined with a plunge in the Chinese stock market. This follows its astounding rally of greater than 150% over the 12 months to June. The Chinese authorities responded with interest rate cuts and an announcement that the country’s official pension funds would be permitted to invest in its own stocks for the first time – causing the Shanghai A Shares Index to rally 5.5% on the final day of the month. However the overall descending trend continued throughout Asia - Japan’s NIKKEI 225 down -1.17% and Hong Kong’s Hang Seng Index down -4.88% for the month.
The Australian fixed interest market, as measured by the Bloomberg AusBond Composite Index, was down -0.93%. Yields on long dated Australian bonds rose due to increasing confidence in the underlying global growth outlook and subsequent scope for offshore central banks to eventually normalise their cash rates. The Bloomberg AusBond Bank Bill Index, which comprises lower risk and shorter dated securities, finished 0.18% higher.
The Global Fixed Interest market, as measured by the Barclays Global Aggregate Index (Hedged A$), edged down -1.07%. Global bonds had another volatile month. Early in the month, the 10 year German bund tested the one percent yield level and experienced a 32 basis point sell off over two trading sessions (the largest two day move in 17 years). US payroll data was also stronger than expected. Large trading volumes and thin inventory of broker dealers seem to have exacerbated price moves in bond markets. Secondary market liquidity for bonds in the light of post GFC regulatory changes at Investment Banks continues to be a hot topic. Later in the month, as Greece began to dominate market attention, a flight to quality rally drove yields on bonds and treasuries lower (and prices higher) but prices of peripheral European bonds sold off.
REITs (listed property securities)
The S&P/ASX 300 A-REIT Accumulation Index lost - 3.97% in June while still outperforming general equities. However, across a broader time horizon, AREITs delivered a 20% return in FY15, largely driven by low interest rates and bond yields. Positive earnings surprises for many stocks, solid capital growth in asset values and mergers & acquisitions also aided returns.
The UBS Global Investors TR Hedged (A$) Index measuring the performance of the GREIT market ceased operating in May 2015. The FTSE EPRA/NAREIT Developed NR Index Hedged (A$) will be used going forward, down 4.4% in June.
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