Economic and Investment Update - October 2016
by Lonsec Research
Summary of Key Views
The monetary policy endgame
Since the global financial crisis 8 years ago we have been in a world where markets are heavily influenced by central bank policy. We have witnessed key central banks around the global undertake aggressive ‘unconventional monetary policy’, notably quantitative easing and rate cuts, whereby some countries are currently in negative rates territory. It is questionable whether this policy has stimulated real economic growth with measures such as the velocity of money (number of time a dollar is spent to buy goods and services) falling off a cliff and economic data being mixed as some countries grapple with deflation, while others seek to transition their economies away from exports to domestic consumption. What has occurred is that global equity markets have rallied as investors, particularly retirees, have flocked to equities in the hope of generating a return greater than cash. The so called ‘defensive bond proxy’ sectors such as REITs and listed infrastructure have rallied significantly, assisted by low bond yields. However, in many instances company earnings have not kept pace with the rise in asset prices and overall volatility in markets has been relatively low. Such a dynamic typically does not persist for extended periods of time, however much will depend on the direction central banks take on rates.
Increasingly, dialogue has focused on the possibility of moving away from quantitative easing and accommodative monetary policies towards fiscal policy. In September the European Central Bank (ECB) held off further monetary policy stimulus, resulting in a decline in markets. Conversely, the much anticipated rate rise by the US Federal Reserve didn’t eventuate, further fuelling equity markets. A shift towards fiscal stimulus will require political will and it is uncertain whether the will is there. Much of the political dialogue has been focused on repairing national balanced sheets rather than spending more.
Politics is also increasingly impacting markets with events such as ‘Brexit’ and the upcoming US election contributing to market volatility. While markets rebounded following the initial fall post the UK referendum we are yet to understand how the ‘separation’ will take place and the possible implications not only of the UK, but for other EU member states. While in the US official polls have Democrat candidate Hilary Clinton in the lead the rise of Republican candidate Donald Trump is symptomatic of growing global disaffection with the mainstream political elites and a widening gap between rich and poor.
What does this all mean? We continue to experience the flow-on effects of the financial crisis of 2008. Unconventional monetary policy was designed to stabilise global economies and markets, however eight years on the side effect has been an increased imbalance in markets, where market fundamentals have been overshadowed by central bank policy and it remains unclear how markets will wean themselves off this drug.
Amid this backdrop we have remained defensive in our overall asset allocation positioning with a bias to alternative assets as a source of uncorrelated returns and downside management. We also continue to hold more cash with a view of deploying the cash allocation on the back of a material market pull back.
Market developments during September 2016 included:
The Australian market continued its slide into the start of September, before recovering strongly in the second half of the month, led by gains in the Materials sector. The S&P/ASX 200 Index finished the month higher at 5435.90, looking poised to test its July and August highs. Returns on Australian shares, measured by the S&P/ASX 200 Accumulation Index, were a modest 0.48%, supported by large gains in mining shares, as well as the OPEC oil deal, which had a significant impact on energy market sentiment.
Telecommunications and Utilities were a drag on the index, with weak earnings from TPG sending the share price down more than 30%. The largest gains came from BHP spinoff South32, as well as risk and compliance company SAI Global, which agreed to a $1 billion takeover bid from Hong Kong private equity firm Baring Asia. The Financial sector was affected by Europe’s banking woes later in the month, with Magellan Financial Group, Henderson Group and QBE Insurance suffering, while the major banks recovered strongly from early losses.
Smalls cap returns, measured by the S&P/ASX Small Ordinaries Accumulation Index, were 1.53% in September, taking the 12 month return to 29.16%.
Global indices were down in September as volatility made a brief comeback, driven in large part by monetary policy uncertainty. Global shares, measured by the MSCI World TR Index, returned -1.22% in AUD terms. The S&P 500 TG Index returned -1.77% despite strong gains from oil and gas sectors.
Market reaction to the first debate between presidential nominees Hillary Clinton and Donald Trump saw the Mexican peso rally 2.0% against the US dollar, while US equity futures gained 0.6% and gold retreated.
In Europe, the Euro Stoxx 50 Index was down -0.69%, while the German DAX fell -0.77%. Europe’s problem child, Deutsche Bank, fell -12.41% on capital adequacy fears and even talk of a possible bailout as several major hedge funds were reported to have pulled ISSUE DATE: 26-10-2016 P 2-3 September 2016 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. their investments. Earlier in the month, NYSE listed agrochemical giant Monsanto accepted a US $66 billion takeover bid from Germany’s Bayer, which is set to be the largest all-cash transaction on record.
Markets reacted positively to the Bank of Japan’s announcement that it would seek to target long-term yields, with strong gains from Japanese banks, but this could not be sustained, with the Nikkei 225 finishing the month down -2.59%. In other Asian markets, the Shenzhen CSI 300 fell -2.24%, while Hong Kong’s Hang Seng gained 1.39%.
Global bonds, measured by the Barclays Global Aggregate TR Index, returned a meagre 0.07% in September (in AUD hedged terms), with long-term yields easing from their mid-month highs. Early in the month, investors might have had every reason to anticipate a Fed rate hike as committee members adopted a distinctly hawkish tone. Come 21 September, there were enough excuses to leave the funds rate on hold, although the Fed’s statement reiterated that the case for a hike has strengthened. Significantly, three dissenting policymakers voted to lift the target range.
The US 10-year Treasury yield rose from 1.58% to 1.60% over the month, hitting an intra-month high of 1.73%. The return on corporate investment grade bonds was -0.25%, while US high yield debt returned 0.65%, continuing to benefit from ultra-low rates. Remarkably, credit spreads were further compressed following a brief Brexit spike in June, with the Bank of America Merrill Lynch US High Yield Option-Adjusted Spread falling from 5.10% to 4.97%.
Australian bonds returned -0.22% in September, with returns on Australian corporate bonds a modest 0.12%. Australian government bonds returned -0.31% as the 10- year yield pushed higher from 1.82% to 1.91%, hitting a mid-month high of 2.17%. Brexit has had a sustained impact on Britain’s long-term rates. The UK 10-year Gilt yield began to claw its way higher in September, from 0.64% to 0.75%, compared to its pre-Brexit high of 1.37%. The German 10-year Bund fell from -0.07% to -0.12%, while the Japanese 10-year yield fell slightly from -0.071% to -0.094%, briefly hitting positive territory following the Bank of Japan’s announcement that it would begin targeting the yield curve.
Brexit has had a sustained impact on British yields, with the UK 10-year Gilt yield moving lower in August, from 0.68% to 0.64%, with a mid-month low of 0.52%. This is compared to the pre-Brexit high of 1.37%. Outside of the UK, sovereign markets are beginning to see a gradual lift in yields, with markets again countenancing the possibility of an early rate hike from the Fed. The US 10- year Treasury yield rose from 1.45% to 1.58%, and the German 10-year Bund rose from -0.12% to -0.07%, making its way slowly back towards positive territory. Japanese 10-year yields lifted slightly from -0.195 to - 0.071, heading into its sixth month of negative yields, following an unprecedented low of -0.295% in July.
REITs (listed property securities)
The S&P/ASX 300 A-REIT Accumulation Index entered a second month in the red, returning -4.31% in September, dragged down by rising bond yields. Charter Hall fared the worst, with property mogul John Gandel offloading a 19.18% stake worth $488 million. Despite current headwinds, including a dip in retail sales, rising rate expectations globally, and a potential slowing in residential property, A-REITs generally appear well positioned, supported by office portfolios and successful new industrial developments, such as Dexus’s Drive Industrial Estate in Brisbane.
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