Economic and Investment Update - July 2016
by Lonsec Research
Summary of Key Views Brexit:
Where to now?
Much of the recent market news has been dominated by ‘Brexit’ and what it all means. Post the UK’s decision to leave the EU equity markets and the Pound Sterling pulled back aggressively as markets had largely priced in that the ‘remain’ vote would win, conversely ‘safe havens’ like gold and defensive sectors such as utilities rallied. Since that time markets have recovered (although the Pound remains at multi-decade lows), however it is still unclear what it all means for the UK and more broadly the EU.
In order to get the exit process going the UK will need to enact Article 50 of the Lisbon Treaty, which is basically a letter notifying the EU that a member state is withdrawing from the EU. This follows a negotiation period (up to two years) whereby an ‘exit’ is negotiated between the UK and the EU. Lonsec’s view is that it remains unclear on how the exit will shape up, however the main risk is that other key EU member states follow a similar path to the UK placing the future longevity of the EU into question. Our expectation is that we may see ongoing bouts of volatility in markets as more information comes to hand as to how the ‘Brexit’ will occur. This supports our medium term view that we are in a period of increased periods of volatility.
Our view on market fundamentals has not materially changed since last quarter. We continue to believe that we are entering a low return environment, company earnings are generally subdued and valuations on key equity markets are at fair value or overpriced. Our medium term asset allocation remains defensively positioned preferring cash and alternative assets over equities. We continue to hold a neutral allocation to listed property and infrastructure despite rich valuations, noting that such assets may continue to perform in a low yield environment and in a market where we may see some downward pressure. We continue to monitor market prices and valuations and, should there be earnings support, would be looking to increase our allocation to equities if we saw markets at around the 4800 mark for Australian equities and pull back of 10% to 20% for global equities.
Market developments during June 2016 included:
Australian shares took a dive in June as fallout from the Brexit referendum sent the S&P/ASX 200 Index to a low of 5051.00 points, 4.35% lower from the pre-Brexit close. Returns on Australian equities, as measured by the S&P/ASX 200 Accumulation Index, were -2.45% in June, with large falls in the Information Technology (-7.82%), Financial (-4.23%) and Consumer Staples (-4.08%) sectors. The Utilities sector was the best performing, returning 6.22% in June and 25.54% over 12 months.
The Financial sector saw large declines in shares with direct UK exposure, including Henderson Group (-31.20%), CYBG (-28.23%) and BT Investment Management (-21.44%), as well as QBE Insurance Group (-16.16) amid fears it would be forced to revise its business approach in the UK and Europe. Likewise, Information Technology sector shares Computershare (-14.62%) and IRESS (-12.67%) took the brunt of the post-Brexit blow. Australian small cap shares outperformed in June, with the S&P/ASX Small Ordinaries Accumulation Index returning -1.31%, continuing its run of outperformance over one- and three-year periods.
Market drawdowns in the wake of the Brexit vote meant global TR index returns were significantly negative in June, with the UK market the hardest hit. Price return indices have, for the most part, already recovered, and the FTSE 100 Index even posted a positive return of 4.39% for the month, after falling -3.15% on the Friday following the vote, and a further -2.55% on the Monday.
Funds with significant UK holdings were able to take advantage of recent strength in the GBP to partially hedge their exposure. However, the need to ensure adequate defence against a Brexit had to be balanced against the risks inherent in a remain vote, which would have given rise to further strength in risk assets. Funds overweight shares such as Royal Dutch Shell, BP, Anglo American and Rio Tinto were well placed to defend against losses, while the banks (RBS, Lloyds and Barclays) suffered, as did major property builders.
The S&P 500 TG Index returned -2.45%, while the MSCI Emerging Markets NR Index held firm, returning 1.18%, with any flow-on effects from Brexit so far contained to developed market economies. The German DAX, which measures the performance of Germany’s top 30 listed shares, fell -6.82% on the day after the vote to close the month down -5.68%. In Asian markets, the Nikkei 225 Index fell -9.63% in June, while the Shenzhen CSI 300 Index was steady, falling -0.49%.
Australian bonds returned 1.33% in June, with Brexit pushing the Australian 10-year Treasury yield to a low of 1.98%, following a pre-Brexit close of 2.25%. Australian government bonds returned 1.54% during the month, while Australian corporate bonds were hampered by the flight to safety, returning only 0.73%. Globally, government bond yields underwent further compression in June, benefitting from a Brexit induced flight to quality. Bond markets are also anticipating more accommodative monetary policy from central banks. The US 10-year Treasury yield fell from 1.85% to 1.47%, while the German 10-year Bund yield was the latest to turn negative, falling from 0.14% to -0.13%.
Japanese yields moved further into negative territory, with the 10-year yield dropping from -0.12% to -0.22%. Global bonds, as measured by the Barclays Global Aggregate TR Index, returned 1.98% in June (in AUD hedged terms), while the return on global corporate investment grade bonds were 1.91%. Credit spreads were a casualty of the risk off behaviour in markets with the Bank of America Merrill Lynch US High Yield Option-Adjusted Spread widening from 5.97% to end the month at 6.21%.
A number of managers expressed their intention to extend the duration of their portfolios in the lead up to the Brexit referendum and took steps to hedge their positions, including through short positions in the GBP and long positions in UK Gilts. Based on reportable results, Australian Fixed Interest funds gained on the Friday as referendum results hit the newswires, while global Fixed Interest funds were steady, recording small positive gains on average, especially the more UScentric funds.
REITs (listed property securities)
The S&P/ASX 200 A-REIT Accumulation Index returned 3.54% in June, with expected further easing from central banks likely to prop up the yield trade for some time yet. Concerns remain about excessive gearing and overpricing in some cases, driven by persistently low interest rates. In the UK, investors pulled money from open-ended property funds on fears that office values could plummet as a result of businesses leaving London. So far seven funds have moved to curb redemptions. Globally, REITs returned 4.02% in June (in AUD hedged terms), while the FTSE EPRA/NAREIT Developed NR Index gained 2.99%. In the US, REITs returned 6.15% (in USD terms) – clear Brexit winners.
Dividends remain high, especially in sectors such as health care, and are far outpacing yields on Treasuries. Globally, REITs are positioned to gain from Brexit, with 10-year yields forced down further as a result, and they are likely to continue to appeal to investors looking for cover as any effects on the global economy are felt.
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