Economic and Investment Update - March 2016
by Lonsec Research
Summary of Key Views
It has been an interesting month, with rising iron ore prices supporting the Australian share market, coupled with a bounce in the AUD from 71 cents to 76 cents. The question is whether this is the start of a sustainable upward trend in markets? Lonsec has remained cautious, preferring to hold more cash and alternative assets over equities.
Our positioning continues to be driven by a mixed macro-economic backdrop, characterised by deflationary pressures in Europe and Japan, mixed growth in the US and continued concerns around a slowing China. This is coupled with more acute issues such as the outcome of the UK referendum on whether they remain within the EU or decide to exit the union – the so called ‘Brexit’ and the possible implications an exit may have on institutions and markets. Other issues which may spark volatility in markets include the impending outcome of the US federal elections and the growing refugee crisis in Europe, which is occupying much of the political discourse within the union.
From a bottom-up perspective, uncertainty remains as to the strength of future company earnings. We have seen BHP cut their dividends on the back of weakening earnings. It will be interesting to see whether other companies take a similar course of action in the future. Payout ratios across the market have been high compared to long term averages, in order for payout ratios to continue at current levels we need to see strength in company earnings.
Within fixed interested, we have remained cautious on government bonds with bond yields in low to negative territory. The ECB has continued to support its quantitative easing program, cutting deposit rates to minus 0.4%, Sweden and Japan are also in negative interest rate territory. Amidst this environment we have maintained our preference for cash and short duration investment grade corporate bonds over government bonds.
The catalyst for Lonsec increasing our allocation to growth assets will be dependent on more supportive equity valuations and increased comfort in the earnings outlook for companies coupled, with an improvement in macro-economic conditions.
Market developments during February 2016 included:
Australian equities were officially in bear market territory in February, with the S&P/ASX 200 Index down more than 20% since its April 2015 highs. Australian shares, as measured by the S&P/ASX 300 Accumulation Index, were down -1.72% in February, posting a month-end annual return of -13.5%. The main drags on the Index came from Telecommunications (-5.47), Information Technology (-5.46) and Financials (-5.32). Resources and Materials recovered ground in February, adding 7.52% and 9.12% respectively, following large declines in January. The Industrial sector continued its high performance run, adding 5.84% in February.
Growth fears continued to be reflected in Australia’s 10- year Treasury yield, which fell from 2.64% to 2.40% during the month. The Australian dollar strengthened only slightly to AUDUSD 0.714 after dropping below the 0.70 threshold earlier in the month.
Continued financial market volatility reflected a high degree of uncertainty in commodity markets, despite an apparent stabilisation in oil prices. Slowing growth in China and emerging market economies was again the main source of this uncertainty, with the focus on structural weaknesses and divergent economic cycles intensifying. China’s February manufacturing PMI figures were below expectations, with the official indicator dropping to 49.0 – below the median survey figure of 49.4. The People’s Bank of China (PBOC) resumed its easing cycle at the end of February, cutting the reserve requirement ratio for banks by 50bps to 17%, injecting an estimated US $100b in long-term cash into the economy.
Saudi Arabia, Russia, Venezuela and Qatar reached an historic agreement to cap oil production at mid-January levels, which helped to rally oil prices in mid-February. However, doubts remain about whether this will have a tangible or lasting impact on global oil production. Financial markets responded positively to the deal, with the S&P 500 Index gaining 5.34% during the week, although this was short-lived, with major indices remaining mostly flat to the end of the month.
The MSCI World ex Australia NR Index lost -1.70% in February, with European and Japanese shares the largest contributors to global equity falls. The S&P 500 Index finished down -0.41% as positive retail and manufacturing data helped to stem losses. In the UK, the FTSE 100 Index fell -2.41%, and in Europe the DAX tumbled -3.09% despite positive manufacturing and employment data at the start of the month.
In Asia, the Nikkei 225 Index fell -8.51% as Japan’s Q4 GDP returned to negative territory, shrinking -0.4% over the quarter and missing expectations. The Shanghai Shenzhen CSI 300 Index fell -2.33%, and the Hong Kong Hang Seng Index fell -2.90%.
The sharp decline in risk appetite at the start of 2016 has continued, with volatility in financial markets reflecting uncertainty in global growth and commodity prices. Softer economic growth forecasts have pushed out expectations for a Federal Reserve rate increase. Weakness in Europe has placed renewed pressure on the ECB to expand its asset purchase program and cut its deposit rate further into negative territory.
Volatility has benefited government bond investors, with the Barclays Capital Global Treasury TR Index up 1.40% in February in AUD terms. Monthly returns on global corporate and high yield debt were 0.70% and 0.78% respectively. The current attractiveness of government bonds must be weighed against the possibility of further monetary easing from central banks, including experimentation with negative rates. As pressure intensifies on monetary authorities, government bond yields may slide further. Around 27% of global government bonds are yielding below 0%, while 65% are yielding less than 1%. Government bond yields experienced further compression in February, with the US 10-year Treasury yield falling from 1.92% to 1.74%, the Australian 10-year Treasury yield falling from 2.64% to 2.40%, and the German 10-year Bund yield falling from 0.32% to 0.11%. Japan’s 10-year bond yield went negative in February following the adoption of negative interest rates at the end of January, with the Japanese 10-year Treasury yield falling from 0.10% to - 0.06%.
REITs (listed property securities)
The S&P/ASX 300 Property Accumulation Index retuned 2.81% in February, outperforming the S&P/ASX 300 Index, which returned -1.72%. Melbourne and Sydney have continued to drive earnings growth from offices, while residential real estate is slowing from record volumes, with prices flat in the two largest cities. Concerns remain among investors about the perceived risk associated with high A-REIT valuation multiples compared to the broader share market, which may be the result of yield chasing or rising valuations of underlying assets.
Globally, REITs returned 0.66% over the month of February in USD terms. Similarly, the FTSE EPRA/NAREIT Developed NR Index (AUD Hedged) lost -0.38%. In the US, REITs were down -0.29%, with positive performance in mortgage REITs largely offsetting decline in the equity REIT sector. US REIT performance is reflective of broader market behaviour, but could also signal a plateauing real estate investment market.
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