Investment – Quarter ended 31 March 2019
The commentary features contributions from AMP Capital. The views expressed are not necessarily the views of the Board of Trustees of the National Provident Fund.
A weaker global economic backdrop (particularly in Europe and China) led the US Federal Reserve (the Fed) to pause its tightening cycle, while the European Central Bank(ECB)also moved to a more dovish policy stance. In New Zealand,the Reserve Bank of New Zealand (RBNZ) also signalled potential rate cuts, primarily due to the weaker global outlook.
Inflation stayed below target in most global markets.The Fed has signalled an indefinite pause in its prior track of raising interest rates,and has also indicated it will retain a higher overall balance sheet than previously expected. This, combined with new discounted lending to banks from the ECB and domestic security purchases continuing from the Bank of Japan, keeps monetary conditions stimulatory around the world. The resumed dovishness in monetary policy was a clear change of position by monetary authorities,which had through 2018 appeared committed to using the relative strength in the world economy to gradually remove the extraordinary stimulus dating from the Global Financial Crisis a decade ago.
As it has turned out, the market volatility experienced in the December quarter, coupled with a clear slowing in Chinese growth (which hits European exports) and the unclear US trade policy position, were enough to unnerve central bankers. The March quarter therefore saw a renewed underwriting of growth assets through removing the incremental upward interest rate pressure that had been building through 2018.
The top level macro environment was softer,and many of the issues keeping markets unsettled persisted.
- While top line global growth was relatively stable, the stability in developed market growth belied some underlying shift in momentum.Having been stronger in the United States thanks to late cycle fiscal stimulus,first quarter economic activity was subdued by the US government shutdown. Europe and Japan could not offset the US dip.
- President Trump’s trade war with China continued. However, more recent positive news suggests the US will want to bring this to a conclusion sooner rather than later.
- Growth slowed in China, but no more than expected. However, the trade war raised concerns about a more precipitous decline. China’s government has responded by removing some restriction on lending introduced earlier in the year for prudential reasons. Chinese producers remain very cautious as trade issues are still unresolved.
- President Trump’s political woes may have entered hiatus as the Mueller enquiry wrapped up without recommending any Presidential indictment. The Republican’s loss in the House of Representatives in the November mid-term elections means policy-making is more confrontational, and easy growth-boosting measures like tax cuts are unlikely.
- Politics in Europe were messy as France was unsettled by riots triggered by the government’s economic reform agenda. President Macron’s approval rating hit a fresh low,leading the government to commence a two-month ‘consultation’ process with the voters, involving surveying their discontents in some detail at the town/region level.
- The shambles of Brexit became even more shambolic,threatening Theresa May’s hold on the Conservative party leadership and raising the spectre of fresh UK elections. The March 29 exit deadline was missed and no alternative has yet attracted a House of Commons majority. It is now unclear whether Brexit will in fact happen at all.
- Much lower US interest rates, which rallied particularly strongly in the March month, eased pressure on emerging markets, especially those with on going structural weaknesses and/or high levels of US dollar denominated debt.
- Many growth and cyclical assets were lifted by the monetary tightening pause,with West Texa sIntermediate (WTI) oil rallying by 32%.
While international equity markets recovered a large proportion of the December quarter weakness, the gains are quite fragile as they depend on major economies stabilising in 2019 rather than slowing further.
We continue to expect the uncertainty to give way to the reality that while global growth may have passed its peak, it will remain solid and no recession will arrive unexpectedly this year. Furthermore, inflation is expected to remain low and monetary policy easy by historical standards. In New Zealand we expect growth to improve slightly on the back of fiscal stimulus, but for inflation to remain benign and the RBNZ to either stay on hold or introduce a precautionary interest rate reduction later this year. That decision may depend on whether Australian rates are lowered, as a higher NZD/AUD exchange rate would negatively affect exporters and the local economy.
Global share markets are now expected to consolidate sideways,and even yet achieve final highs for this cycle. Returns from cash and fixed interest are expected to remain low. Given the more moderate interest rate track that we expect, it seems likely that listed real assets such as property and infrastructure can build on their recent strength compared to broader equity markets,also benefiting from their more defensive qualities in uncertain times.
New Zealand assets still look robust compared to their international counter parts, though New Zealand equities could be challenged in retaining their record-high valuation level ,if domestic growth and hence earnings are softer than investors currently expect.
Commodities strength may gradually broaden beyond the oil price and some industrial metals. However, greater clarity on global growth is needed before any sustained improvement in commodity prices gets underway.
Ongoing and unresolved US-China trade negotiations continue to impart uncertainty to the markets, with recent short-term swings between a ‘risk-on’ and ‘risk-off’ bias. Therefore, until some semblance of longer-term stability supports global markets, shares will likely remain susceptible to volatility, especially following the rally from falls at the end of 2018. The US Federal Reserve has also changed tack, indicating from recent communications that further interest rate rises will not occur until 2020 and that it will halt the shrinking of its balance sheet by September 2019.
European tensions remain high, particularly from Brexit uncertainty and the fast approaching exit date. Eurozone GDP remains anaemic, and with the German economy approaching technical recessionary territory, the European Commission has revised growth estimates down and implemented stimulatory measures, with more likely to come.
Emerging market economies continue to experience some outflows. Emerging market shares, in particular, remain vulnerable to the persistently strong US dollar which is keeping funding costs elevated. Asian data remains mixed, with both Japan and China continuing to be accommodative.
Low, though rising, sovereign bond yields point to low medium- term returns. The abatement of deflationary pressures, the gradual reduction in spare capacity and a shift in policy focus from monetary to fiscal stimulus, primarily in the US, indicate yields are likely to steadily trend higher, although the pace of change is likely to moderate in the shorter-term.
Australian shares remain exposed to a global slowdown, particularly in the resources segment. Banking profitability is also likely to be constrained by increased macro-prudential regulation, capital-holding requirements and a shifting banking structural landscape. Credit will likely continue to be subdued as banks tighten lending standards and business confidence pulls back. Economic uncertainty could also amplify market volatility as Australia approaches the general election in 2019 and the respective parties stake-out their economic plans for the future.
In New Zealand, GDP growth has shifted down a gear, reflecting a moderation in global growth and slower population growth that will flow through into a moderation in consumption growth, which will help alleviate demand and supply imbalances in the housing market. Rising capacity constraints will also continue to have a moderating influence on growth in activity. We expect employment growth to slow an wage pressure to build. At the same time, monetary policy remains highly stimulatory. The economy is now growing at a rate that is closer to the economy’s potential growth. What impact that now has on the unemployment rate and wage growth will be a key determinant of the next move in interest rates.
CASH AND FIXED INCOME
The OCR remained unchanged at 1.75%, although the RBNZ signalled that the “more likely direction of its next OCR moves was down” following its OCR review on 27 March.
90 day bank bill rates were down 12 basis points (bps) in the three months to March, ending the quarter at record lows. Further falls are expected with the market pricing in OCR cuts by year-end.
Government bond rates fell across all maturities, with long-end yields down almost 50 bps on the quarter and outperforming falls in shorter-end yields. New Zealand 10 year government bond rates outperformed US 10 year bond rates, which fell around 30 bps over the same period.
Swap rates were lower across all maturities with the yield curve flattening in line with global moves. Swap spreads tightened around 7 bps at the short-end as government bonds under performed. However, the 10 year swap spread widened 4 bps on the quarter as demand for long-end government bonds increased.
Break even inflation rates were lower by 7 bps as Australian and a number of other inflation-linked bonds under performed government bonds.
Global government bond yields fell in January amid a rebound in risk assets. Led by the US, market expectations pivoted to a pause in US Fed rate hikes after the central bank signalled a more dovish tone. Yields were largely range bound in February, with geopolitical influences such as improved confidence of a positive resolution to the US-China trade conflict appearing to outweigh largely poor economic data releases and further economic growth forecast downgrades by central banks.
March saw a significant bond market rally, with fears of a global growth slowdown gaining further traction as softer economic data releases on balance were accompanied by a shift to a more dovish tone from key central banks. Notably, markets saw an inversion of the 3-month to 10-year US Treasury yield curve late in the period, an event which can sometimes be a signal for recession. The US 10-year bond yield ended the quarter at 2.41%, while the German 10-year bond yield and its Japanese counterpart ended at -0.07% and -0.08% respectively.
Global credit markets performed well during the March quarter, with investment grade credit spreads tightening to recover most of the widening experienced during the prior quarter. Credit markets benefited from improved sentiment from early in the quarter as risk assets generally rebounded, with a key trigger being the US Federal Reserve signalling a more accommodative tone with regard to monetary policy in late January. Credit markets continued their push tighter, with investment grade credit spreads continuing to tighten in particular during March in an environment of sharply lower interest rates across the major markets and dovish messages from the Fed and ECB. The latter part of the quarter saw some market bifurcation as concerns for lower prospective global economic growth were felt, primarily through the under performance of high yield credit.
After heavy falls in the December quarter, global share markets posted extremely strong gains over the March quarter. Markets around the globe remain optimistic on the back of reasonably good global economic growth, a somewhat dovish US Federal Reserve, improving US trade relationships, strong resource prices and Chinese economic stimulus. However, this is being balanced by some caution creeping in around an inverting US yield curve, softening (but still reasonable) US growth, and relatively high price/earnings ratios, particularly in the US.
Chinese shares were the clear standout over the period, as the CITIC 300 index soared 27.63% on the back of positive trade talks with the US and stimulus measures introduced by the Chinese government. Most other major markets saw returns near or beyond double-digits for the period, as a wave of optimism seemed to make the falls of late 2019 a distant memory. Despite the markets’ rise, broader risks to global growth have arguably not appreciably changed over the quarter, leading many commentators to urge caution, after the strong price rises.
Emerging markets were also strong over the period, with the MSCI Emerging Markets index returning 9.84%. Resource prices rose and the positive sentiment from developed markets spilled over, despite ongoing currency and debt issues that many developing economies continue to face. (All returns quoted in local terms unless otherwise stated.)
NEW ZEALAND DOLLAR
The New Zealand dollar (NZD) was marginally stronger over the March quarter, gaining 0.6% against the Trade Weighted Index.
The US federal funds target rate is above the New Zealand Official Cash Rate, which is a negative differential in the US favour and no longer supportive of the NZ dollar. This differential is likely to remain for some time, as both country’s central banks are likely to remain on hold for the near-term.