Investment – Quarter ended 30 June 2018
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.
Politics was to the fore over the June quarter as trade tensions between the US and a number of its trading partners rose, European immigration tensions simmered, including between government coalition partners in Germany, Italy formed a new populist government, Spain got a new Prime Minister, President Erdogan of Turkey won a snap election, the G7 held a fractious meeting in Canada, and US President Trump held a summit with North Korean leader Kim Jong Un in Singapore.
The most disruptive has been the mostly waxing, and only occasionally waning, of trade tensions, particularly between the United States and China. Both sides agreed in May a short-lived intention to negotiate a settlement, though by the end of the quarter there was only days to go before the US imposed tariffs on a broad range of Chinese imports into the US without agreement to a further round of talks. Tensions are also heightened between the US and its NAFTA (North American Free Trade Agreement) partners (Canada and Mexico) and the European Union, and were on show at the recent G7 meeting in Canada.
The political situation across Europe has become more complex. The latest European Union Summit at the end of June was the most intense in a while, with immigration a key issue. Immigration concerns had taken on renewed prominence with a disagreement between Angela Merkel’s CDU party and coalition partner CSU that threatened to bring the Government down and end Merkel’s reign as German Chancellor. A workable solution appeared to be agreed at the Summit though details were scant and the CSU leadership now seems to be grudgingly accepting Merkel’s efforts to craft a workable compromise.
In economic developments, it is the United States economy that has best maintained upward momentum in 2018. Most of the major economies suffered a degree of weakness in the March quarter for a variety of reasons but it is the US that has recovered best from that with renewed vigour. This is being helped by the tailwind from fiscal stimulus.
Europe and Japan are both expected to recover from weather-related disruptions in the March quarter, though of the three major economies only the US is expected to post stronger growth in 2018 than it did in 2017. That said, both Japan and Europe are expected to grow only modestly slower than 2017, and importantly still faster than their non-inflationary potential.
From a central bank perspective that means the US Federal Reserve (the Fed) will continue to raise interest rates. The Fed is now signalling a total of four interest rate increases (two more) in 2018 as well as the continued winding down of their balance sheet. The European Central Bank is on track to end its asset purchase programme by the end of this year, though interest rate increases are unlikely before late 2019. We don’t expect any change to the Bank of Japan’s aggressive easing stance any time soon.
In a development reminiscent of the 2013 ‘taper tantrums’, emerging market assets have come under some pressure recently as both US interest rates and the US dollar have headed higher. On average, the emerging economies are in better shape than they were in 2013: external imbalances are lower, growth is stronger, and inflation is under better control. But there are some emerging economies (Argentina, Turkey) with critical structural weaknesses that will still be punished in this environment.
World share markets have spent the first half of 2018 in an uncertain mode, with corrective down-moves followed by fragile partial rebounds. We are still cautious regarding the more expensive asset classes and market sectors, and are unsurprised that markets are finding it difficult to shake off their current sideways movement. In the key US equity market, while earnings growth has been supportive, periods of market strength have become more dependent on a narrow set of major global technology and energy companies.
In New Zealand, which has outperformed, much momentum relies currently on our commodity exporters and on sectors benefiting from a weaker New Zealand dollar. We currently see no catalysts for a significant New Zealand dollar rebound, given divergent interest rate paths, so New Zealand equities may continue their resilience for some months despite slowing growth and record-high valuations.
Alongside lower risk tolerance in the equity markets, the limited gains in bonds are particularly notable. The willingness of investors to switch into debt securities at times of turmoil has clearly diminished this year. Cash has been preferred as the safe-haven asset to hold immediately following market shocks, while awaiting clarification and re-building confidence in the continuing case for growth assets.
We expect the second half of 2018 to see continued nervousness and volatility, as geopolitical (trade and tariff) risks add to tightening global monetary conditions as a challenge to equities. However, because developed market economies remain strong and inflation is gradually turning upwards, we expect limited diversification benefits from bonds and prefer cash.
CASH AND FIXED INCOME
As expected, there was no change in the OCR as the RBNZ continues with its "on hold" messages.
The 90 day bank bill rate was up four basis points (bps) in the last three months.
Government bond rates decreased for all maturities except March 2019. The shape of the Government bond curve was largely unchanged.
Swap rates were lower for all maturities. This was in line with the UK and Europe markets, but against the move in the US market. Swap spreads tightened for all maturities except five year.
Breakeven inflation rates were higher by 11 bps. This was in line with the moves in the US.
Global government bonds yields moved higher in April, as markets regained their appetite for risk amid further evidence of strengthening economic conditions. In May, fears of a populist anti-European government coming to power in Italy prompted a sell-off in the debt of peripheral European nations and a flight to the quality of higher rated issuers. The US was one of the recipients of the shift in investment flows.
After trending upwards early in June, amid an easing of political uncertainty in Italy and optimistic economic commentary from central bankers in Europe and the US, yields subsequently reversed this momentum to fall amid escalating trade tensions. The US 10-year bond yield ended the quarter at 2.86%, while the German 10-year bond yield and the Japanese 10-year bond yield ended at 0.30% and 0.04% respectively.
Despite a number of global concerns for investors throughout the June quarter, most markets climbed the ‘wall of worries’ to rise strongly. The MSCI World ex Australia Net Index finished the period higher by 3.4% in local currency terms.
Concerns included negative US rhetoric towards Europe with the threat of tariffs on automotive imports, ongoing US/China counter-retaliatory tariff threats, early inflationary concerns in the US, currency concerns in emerging markets as the US dollar rose, and subsequent concerns around the increasing real debt levels of many emerging market companies which hold their debt in US dollars. The MSCI Emerging Markets total return index was consequently down by 3.5%. China’s market particularly suffered amid the US trade skirmishes, ending the period down by 10.6%.
Meanwhile, the US S&P 500 total return index ended the period up 3.4%, as companies continue to grow their earnings and economic growth remains strong. The UK’s FTSE 100 total return index was extremely strong and reached record-highs in the June quarter, up 9.6% as the Sterling fell (leading to a significant increase in earnings for many UK-based international businesses), commodity prices rose and the Bank of England remained a little less hawkish than expected.(All figures quoted in local currency terms.)
Emerging markets came under continuing pressure during the quarter, with the MSCI Emerging Markets Accumulation Index closing the month down by 3.5%. Both equities and currencies were impacted amid concerns that a strong US dollar will put pressure on emerging market funding requirements, with emerging market bonds seeing some significant outflows.
Asia was particularly weak over the period, especially China and Korea. China’s weak performance was predominantly driven by the ongoing trade disputes with the US. However, India, which is less affected by the ongoing trade disputes, fared better. The Europe, Middle East and Africa (EMEA) region also fared a little better, with Russia starting to benefit from constrained oil supply dynamics. Latin America had a more mixed quarter. Mexico was relatively strong in the lead up to the presidential election. However, Brazil exhibited weakness as economic activity became more subdued. If the US dollar remains strong, this could also cause some additional stress for energy-dependent emerging markets which will have to contend with both a higher dollar and a higher oil price. Emerging market currency stress saw particularly significant depreciation in the Turkish lira and Argentinian peso, with the Argentinian Government attempting to defend the peso by raising interest rates to 40%, prior to receiving a loan from the IMF.
NEW ZEALAND DOLLAR
The New Zealand dollar (NZD) was weaker over the quarter against all our major trading partners.
Core inflationary pressures remain subdued despite a tightening in the labour market. This means the Reserve Bank of New Zealand is likely to be on hold in 2018 with a first move to hike interest rates not likely until early 2019. This contrasts with the US Federal Reserve, which continues to increase interest rates in a gradual manner.