(Merlea Market Outlook – October 2016)
Political influence on markets has risen; both directly through economic policy and indirectly through uncertainty and shifting electoral values. A clear and long term structural change towards anti-globalisation and protectionism is occurring as indicated by Brexit, the US elections and an increase in Nationalists popularity right here at home as well.
Over the quarter financial markets remained focused on interest-rate movements and monetary policy. Equity and bond returns are becoming more correlated and could fall in tandem, while rising long-term yields are a tail risk that could cause an unwanted tightening of financial conditions.
Markets recovered from the initial shock of the late-June U.K. referendum vote to leave the European Union, as lower bond yields, expectations of additional monetary accommodation, and stable global economic data soothed investor concerns.
Long-term government bond yields remained low around the world, and were helped by extremely low policy rates—even negative rates—in Europe and Japan. In the U.S., the Federal Reserve kept rates unchanged, but the Fed continued to express an expectation to lift them later this year. So while the low-yield/low inflation global environment still exists, yields actually ticked up during the past month, and this modest upward move in yields caused prices of ‘bond proxy’ stocks to fall. Ultimately, the outlook for interest rates depends on the growth and inflation outlook for the U.S. and global economies. For that reason, we think the odds are good for a Fed rate hike in December 2016.
Most of the developed world is in the mid-to-late stages of economic expansion and China’s improved cyclical trajectory has helped boost many emerging economies. The global economic expansion continues at a slow, yet steady pace. The odds of global recession remain low, although the overall global trend can be characterised as relatively mature.
Asset prices have been particularly sensitive to changes in bond yields over the past year, especially the performance of bond-proxy equity sectors such as utilities, REITs, and some consumer staples. Benefiting from their attractiveness in a low yield environment, the relative valuations of these high-dividend payers have reached extreme levels on a historical basis. We have reduce positions where prices have moved beyond fundamentals (examples are bonds and bond-proxies such as utility stocks). Investors should be looking to rotate low yield, low volume stocks and move to more cyclical stocks such as mining with the outlook for commodity prices rising due to Chinese demand driven by the prevailing policies of the Chinese government towards infrastructure investments and supply curtailment.
Economic analysis (Australian Update)
The Australian dollar (AUD) rose 1.5% against the US dollar in September due to higher commodity prices (notably coal and oil) and the Fed once again delaying higher US interest rates. The AUD rose by 2.4% against the British pound given Brexit concerns. Australia is relying on record-low interest rates and a (now) below-its long-term-average Australian dollar to support economic growth. But non-mining investment is much weaker-than-expected. The RBA has highlighted the reluctance of Australian companies to lower their expected rate of return on investment. This seems at odds with low interest rate environment.
While the RBA did not say which way it would be likely to adjust rates, if the RBA were to move interest rates in the near term, the most likely direction would be down. President elect, Donald Trump’s polices are expansionary. Increased spending in the US will drive the Australian Dollar higher, further influencing another rate cut. Some analysts are calling for a further two interest rate cuts but commodity prices lifting will push inflation locally, reducing the RBA’s capacity for additional easing.
Australian GDP growth accelerated to 3.3%/yr Q2 16 –Q3 16 looks to be holding up well. Q2 16 growth was driven by public investment (contributing +0.7%), government consumption (+0.3%) and inventories (+0.3%), business investment remains a drag on growth. Income growth picked up significantly in Q2 16 thanks to the improvement in the terms of trade and some pick-up in profit growth. Softness in non-mining capex reflects growth in Services sector (less capital intense) and concerns over a lack of structural economic reform and the relative low cost of labour.
Economic activity was solid with a rise in job vacancies and the unemployment rate edging down to 5.6%, which is the lowest in the past three years. The National Australia Bank’s business survey and consumer sentiment surveys also show favourable results. Positive comments from the new Reserve Bank of Australia Governor, Dr Philip Lowe, that the Australian economy was “adjusting reasonably well” after the end of the mining boom were also supportive.
October saw the S&P/ASX300 Accumulation Index return -2.17 per cent, while the MSCI World Net Total Return Index, in Australian dollars, declined by -1.38 per cent. In addition, Australian Real Estate Investment Trusts (A-REITs) fell sharply by 4.3% in September given their sensitivity to higher bond yields.
Oil prices rebounded by 7% in September following the announcement from the Organization of the Petroleum Exporting Countries (OPEC) that it will be making production cuts.
Contracting global oil production could potentially bring greater supply-demand balance (and higher prices) for oil going forward. With core inflation in the U.S. already firm, a continued stabilisation in energy prices will begin to push headline inflation higher on a year-over-year basis, even without a powerful rebound in growth or commodity prices.
Australian Real Estate Investment Trusts (A-REITs) fell sharply by 4.3% in September given their sensitivity to higher bond yields.
We think that the valuation of the AREIT sector is quite expensive, this reflects how sought after AREITs are as an income asset class. The biggest risk to the sustainability of dividend yields, from our point of view, is a potential increase in interest rates. Now that’s not the market’s thinking at the moment. In fact, the market thinks the opposite; that interest rates are set to continue to fall in Australia, and that might well be the case in the short to medium term. We think the really important thing for investors is not to get too complacent, in the current low rate interest environment. The recommended portfolios below have been designed with a larger selection of property trusts available, giving investors more choice and a greater spread across the sector.
Most of the developed world is in the mid-to-late stages of economic expansion, and China’s improved cyclical trajectory has helped boost many emerging economies, such as Brazil. The global economic expansion continues at a slow, yet steady pace. The odds of global recession remain low, although the overall global trend can be characterised as relatively mature.
Migration fears are now at record levels across the UK, US and Europe. These migration fears are playing into the hands of the Nationalist politicians, as evidenced by Brexit and the US Presidential election. We are also seeing this in Australia with the return of Pauline Hanson.
Major central banks in Japan and Europe have enacted negative policy rates, but each rate-cut into negative territory was immediately followed by a decline in bank stock prices. In fact, the real-world impact of negative policy rates may run counter to several of their intended goals, and the BOJ and ECB opted not to reduce policy rates further during Q3.
Europe’s economy, including the U.K., appears resilient in the wake of Brexit, with surveys of manufacturing activity surprising to the upside. However, the picture remains mixed, as political uncertainty weighs on sentiment indicators. Many European economies remain solidly in the mid-cycle phase, but growth remains tepid.
The pound surged to a three-week high in the wake of a court decision that the U.K. must hold a vote in Parliament before activating ‘Article 50’, enacting the two-year countdown to Brexit. 60% of the U.K. parliament sits within the ‘stay’ camp, creating further uncertainty over the future relationship between the U.K. and EU. There have been significant political ramifications in the UK, with Theresa May taking over as Prime Minister. Business and consumer confidence initially declined but has recovered somewhat with the timely easing by BoE dampening the immediate economic impact.
China remains more central to the globe than Brexit, especially so for Australia. Near-term China risks have receded amid gradual currency depreciation and a pick-up in Asia’s export machine along with expectations for interest rate cuts.
The International Monetary Fund recently held their GDP growth forecasts for China unchanged at 6.6% for 2016 and 6.2% for 2017, a modest slowdown from estimated growth of 6.9% in 2015. China’s economy appears to be successfully transitioning from a predominantly export-focused economy to one with more emphasis placed on domestic demand and services growth.
Donald Trump has won the US presidential election and the equity markets have reacted adversely, at least during the first day as the count took place. The Trump victory was built on a strategy of being a disruptor and not accepting the rules of the game as politics is practiced in the USA. Donald Trump is to politics as Steve Jobs was to the music industry and Sergei Brin, Larry Page and Mark Zuckerberg have been to the advertising industry. They have not played by the accepted rules and they have appealed directly to customers. This resonated directly with the target market of millions of middle and working class people who have not shared in the growth in wealth and income that has flowed from the economic and monetary policies of the last thirty years.
In his direct appeals to voters Trump has been light on policy detail but has said that he will:
- Cut corporate taxes
- Spend big on infrastructure
- Renegotiate foreign trade arrangements
If Trump carries through with just these, there will be many winners and many losers. He is likely to carry through with the help of a Republican party that controls both houses of Congress.
The medium term consequences are likely to include:
- Bigger Federal deficits over the next four to six years and much more issuance of US long term bonds leading to yields being higher than they would otherwise be.
- Faster economic growth and higher inflation.
- Faster growth in earnings per share of US domestically oriented companies.
- Slower growth in world trade with adverse impacts on countries such as China and eventually Australia as well as on earnings growth of multinational firms including those based in the USA. Exports from China to the USA represent 20% of Chinese exports and 4% of Chinese GDP. A reduction in trade would be significant but not devastating to China, although it would exacerbate its already difficult task of avoiding a hard landing as it seeks to reorient its economy.
- China may seek to offset the effects of any global trade slowdown via increased infrastructure spending that in turn may boost iron ore and coal prices.
The world economy still faces many uncertainties and is grappling with low growth while central banks have attempted to stimulate economies by lowering interest rates. Indeed, the duration of the current low-rate cycle can only be matched by the period following the Great Depression in the 1930s. In Australia, the Reserve Bank has reduced the official cash rate to 1.50% and our 10-year bond yields have fallen to the lowest levels on record.
We’ve also been highlighting the rising volatility of investment markets over the past year. If the past is any indication, uncertainty surrounding Brexit could fog the global outlook for months to come. While the Brexit will have a minimal direct impact on Australia and Australian companies (China is still Australia’s number one trading partner) global growth and stability will be impacted and Australia would feel the effects of this.
Given this the current lower return environment is set to continue throughout 2016. But the current volatility will give investors the opportunity to purchase stocks that have previously been out of range. We believe that any stabilisation in China should be supportive of risk assets. However, at this point in the cycle, there may be more limited upside for returns, and therefore smaller bets are warranted.
Global interest rates are likely to stay low for longer reducing the appeal of cash, and we have a large part of the population placing a higher importance on sustainable – predictable income. This year, as was the case last year, dividend yields will play an important role in supporting total return. But investors do need to be mindful when pursuing returns via equity dividends. Share dividends are attractive compared to current bond rates but low or negative interest rates will not last forever. Portfolio’s currently hold higher allocations to cash than normal but this asset allocation decision of not being fully invested is warranted as we have been unable to find attractive assets.
Investors should focus their attention on ensuring that their overall portfolio is suitable for their risk tolerance, their lifestyle needs and their long term return requirements. Market performance is difficult to predict, particularly over the short term but putting together an appropriate mix of Australian and international equities, fixed interest, property, cash and alternative investments is more likely to achieve an investor’s long term goals compared to reacting to market events without the benefit of a plan.
Diversified portfolios with a mix of asset classes have managed to post acceptable returns over longer term frames of 5 or 10 years despite market volatility. This reflects the short-term nature of many of the equity market declines, together with the other asset classes being influenced by different drivers, and therefore providing an offset when equities perform poorly.
Given recent volatility some stocks/sectors that have been discounted are now within buying range. There have been several new additions to the portfolio investment models as we find value in stocks that were previously unattainable. While yield is likely to remain a focus, in time, as economic activity is stimulated by low interest rates and accelerates, we expect our models to broaden to a wider range of companies that will deliver capital growth as well as income.
Merlea Investments recommended portfolios are generally designed to diversify assets across a range of asset classes to obtain low volatility given a stated return goal. The actual goal, or targeted return, from a portfolio is perhaps the most important influence in a portfolio as once a goal is stated the ability to assign asset allocations becomes a matter of maths. We will always prefer to gain as much return as possible from cash and defensive type assets and then augment this return with the higher risk/higher return possibilities from growth assets.
We aim to continue to accumulate stocks upon further weakness in the market but investors will need to be patient and wait for opportunities to arise. To find additional growth opportunities the models now have more stocks outside the Top ASX200.