Half yearly investment update
26 August 2016
The first half of 2016 saw a significant increase in market volatility, initially driven by fears around the sustainability of China’s growth. At the end of 2015, the US Federal Reserve (“the Fed”) raised its policy from effectively zero, where it had remained since the height of the GFC, an unprecedented 8 year period of highly expansionary policy settings. Having been prepared well in advance of the interest rate hike, markets broadly took the 25 basis point hike in their stride, however as we highlighted in our December note, there was the potential for volatility to be seen not only across broader markets but within the emerging markets in particular.
Equity markets were slightly weaker for the first half of 2016, although the VIX volatility index (which is a measure of anticipated market volatility) at 15.6 perhaps understates the intra-period volatility, particularly in the first six weeks of the year when both the S&P 500 and ASX 200 fell in excess of 10%. For the full six month period, the S&P 500 returned 0.3%, the ASX200 was down 2.5%, and MSCI World (ex Australia) fell 1.2%. Offsetting these flat to negative equity market returns was a somewhat concerning rally (bond prices rising and yields falling) in major sovereign bond markets. From already low levels at the start of the year, ten year bond yields fell between 27 to 38 basis points across Australia, Germany and the US.
Global growth remains constrained as the major economies fail to provide sufficient demand, slowed by the ongoing post-GFC deleveraging and concern around political risks. It has been a constant theme for growth and inflation forecasts to start out high, then progressively get downgraded as any number of risks weighing on the global economy come to fruition. In this context, it is the US Federal Reserve Bank’s efforts to raise interest rates which will probably have the most significant impact on global markets and the global economy over the coming 12 – 24 months.
In the period immediately following the collapse of Lehman Brothers at the height of the Global Financial Crisis, the Fed lowered its cash rate to effectively zero (it actually specified a range of 0-25bps) a level at which it remained from December 2008 until the rate was finally hiked 25 basis points in December 2015. When the Fed raised the rate in 2015, it indicated that the members of the Committee on average expected four more raises of 25 basis points over the course of 2016. Half-way through 2016, they have not delivered any additional tightening, and markets are only partially pricing in a possibility of one 0.25% hike by the end of the year.
Admittedly there have been global factors which we discuss below playing on the mind of the Fed, such as the sharp slow-down in Chinese growth, the further easing in Japan and Europe where policy rates are now negative, and the June Brexit vote in the UK. However, more recently domestic factors have also been a factor in seeing expectations for higher US interest rates being pushed out further; as markets priced in a steady tightening of US interest rate policy. We have seen the US dollar strengthen over this period weighing on corporate earnings, and domestic economic data overall started to cool which was particularly evident in the very weak May non-farm payrolls. There has been no increase in underlying wage pressure and hence expectations for inflation have remained very low. As a result, members of the Fed started giving mixed signals with regard to the amount of tightening required (or possible) leading the interest rate markets to aggressively price out any move by the Fed.
Australia has not been immune to this macro-economic weakness. This underlying softness was most evident in late April and early May. Australia’s CPI inflation data for the first quarter was reported as very weak, and was a direct factor leading the Reserve Bank of Australia to cut rates to new record lows of 1.75% a few days later. The RBA downgraded further its medium term expectations for inflation, wage growth was also confirmed as weak, and markets then started to price further cuts into the overnight rate. The slowdown in Chinese growth which was really the trigger for equity selling in January and early February has further weighed on commodity prices, making the rebalancing within the Australian economy away from the mining sector more critical.
The Brexit vote of 23 June is worthy of special mention and certainly caused significant short term volatility on markets. It is somewhat reflective of growing discontent globally, where the majority of voters feel they have not been advantaged by post GFC policies, and are reflecting this in terms of political views. In the US it is otherwise difficult to explain the growth in support for Donald Trump into the November elections, but it also seems to have been a factor in the Brexit vote (and perhaps even in the lead up to Australian election). In the lead up to the UK vote, it seemed a highly likely result that voters would seek to remain in the European Union. However, as results of the vote started being tallied, it became apparent that this would not be the outcome and equities, the Pound and global bond yields in particular fell sharply. It seems fair to say that a review of the voting results shows that there were huge divisions amongst voters based on classification between white collar / blue collar, possession of a university degree, possession of a passport, weekly earnings and age clearly highlighting the divisions. Following the vote result, it has become apparent that many had not fully understood what they were voting for, and had rather been swayed by anti-Europe arguments as a perceived source of the unfairness.
In reality, the process to a break with the EU has not yet commenced; at some point Article 50 of the Lisbon Treaty will be invoked, leading to a two year deadline in which the terms of the UK’s departure from the EU are to be fully negotiated. Immediately post the result there were protests in Scotland in particular, who seemingly only voted to keep the British Pound in 2014 on the basis that it provided clear access to the EU at the time; a second vote seems a matter of time, and based on voting at the referendum it seems likely the Scots will choose to remain in the EU. This could be the start of the break-up of the United Kingdom.
The outcome of the Brexit process has seen a material uplift in uncertainty across a range of factors surrounding economic growth and capital flows within the UK and across broader Europe. It is difficult to see how corporates would be willing to make long term investment decisions (or hiring decisions) given this uncertainty, and it seems clear the BOE will be forced to cut rates in an attempt to stimulate growth and avoid recession.
The prospect of stalling economic growth had already seen Europe’s central bank (the ECB) push rates further negative ahead of Brexit at the start of March, and this had followed similar moves by the Bank of Japan in January. Somewhat concerning is that the move by the Bank of Japan (BOJ) was not taken well by markets and resulted in a rally of the Yen as a safe haven asset and a sharp fall in equity markets with the banking sector hit particularly hard. To us this is a clear sign that markets are beginning to become concerned that the monetary policy transmission mechanism is broken, and that systemic risks will start to mount as central banks ease further from already extreme settings.
The ECB’s move on deposit rates and buying programme of EUR-denominated corporate bonds has not been seen as delivering a sustainable long term positive impact on growth or inflation expectations across the Eurozone. Large negative output gaps, particularly in countries such as Italy, are seen as having more of a deflationary impact and outweighing any positive stimulus impacts that monetary policy is providing. It also closes the loop back on the banking sector and provides yet further reasons to reduce the already poor earnings outlook for European banks.
The rate of economic growth in the Chinese economy is also a key focus for markets and policy makers globally and is imposing its own risk on the global economy. In 2015 as the US dollar strengthened based on expectations that US economic growth was improving and the Fed would increase interest rates, a small devaluation in the Chinese currency (the Yuan) shocked markets on fears that China would export deflation globally thereby slowing economic growth. The weak economic growth signal from January 2016 in China again raised the prospect of further sharp downward moves in the Yuan given China’s reliance on exports. Since this time the Yuan has continued to weaken slightly, although a larger devaluation which would be deflationary to the rest of the globe has not as yet eventuated. Longer term there are certainly fears around the build-up of Chinese debt, much of which has been incurred post the December 2008 massive stimulus programme.
On the key matter of the US Federal Reserve, we believe rates will be raised at a faster pace than what is currently priced into markets, but at a slower pace than expected by the Fed itself. Given the lack of inflation, sluggish growth and global risks (which are all seemingly to the downside) there seems little reason to raise rates in a hurry. Under such a scenario, bond yields should begin to move slightly higher in the US, and as long as this results in an orderly increase in rates as opposed to an aggressive hiking cycle, equity markets can remain supported at levels slightly above historical averages. The US dollar should continue to rise driven by a better economic growth outlook and higher interest rates, and we expect the AUD would resume its depreciation into the high 60s. In recent years the portfolios have benefited materially from the AUD’s decline and as the currency approaches fair value, we may look to re-establish a partial (or full) currency hedge on our offshore assets.
The Reserve Bank of Australia is expected to cut further, driven more by international rather than purely domestic factors, although low inflation and wage growth will support this decision.
Returns on markets are likely to be subdued in the coming years given the low cash rates in major markets. In sovereign bond markets, we estimate a return of 2.2% in the US, and 2.4% in Australia in the coming 3 years. Credit will add to these returns slightly, where we hold a preference for Australian Investment Grade Credit over the US market, based on current spreads. Based on our analysis, on a 3 year basis, we expect excess returns from investment grade credit in Australia to be in the order of 1.7%, (above the long run average) and in the US 0.6% (below average).
Given valuations differences, we retain a slight preference for US (and global) equities over Australian equities, although we do not feel that prices in Europe warrant taking exposure given the risks to growth and the banking sector. However, with equity markets having made material gains in recent years and with valuations of markets sitting around or slightly above long term averages, the material benefit from stock selection generating returns above benchmarks becomes even more important.
Emerging markets need to be treated with caution as the Fed removes liquidity.
Liquid alternative assets will remain key diversifiers, and admittedly have been under pressure in the first half of 2016 as the above noted factors were difficult to trade (whether a trend-following strategy, a macro fund, or even equity long / short given the sharp reversal of lower quality equities during the half). We expect performance to improve for the alternatives managers, correlations with equity markets to remain very low (close to zero for managers in whom we invest), and a targeted net return of around 3% over cash looks attractive in the current low yield investment environment.
Real assets are attractive in a low return environment, and we will ensure that we are not driven into lower returning assets (at similar levels of risk), based purely on a short term view of low yields.
Overall, given the unprecedented levels of monetary stimulus and low growth, we believe that it is critical to maintain a diversified portfolio of exposures to a range of different risk factors, incorporating assets which can provide investors with positive returns and preservation attributes, irrespective of the broader market environment.
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