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Investment – Quarter ended 30 June 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.

ECONOMIC SUMMARY

GLOBAL ECONOMY

A softer global economic situation, particularly in Europe and China, led the US Federal Reserve (the Fed) to pause its tightening cycle and saw the European Central Bank (ECB) move to a more dovish policy stance earlier this year. This has now been felt in Australasia, with interest rate cuts from both the Australian and New Zealand central banks. In New Zealand, the Reserve Bank of New Zealand (RBNZ) reduced the Official Cash Rate in May by 0.25% to 1.5%, and the Reserve Bank of Australia also trimmed the policy rate 0.25% to 1.25%. New Zealand’s central bank demurred from a further cut when it met at the end of June, but signalled an additional easing due to the weaker global outlook and slower domestic activity.

Re-emergence of trade tensions during the June quarter lowered the prospects of a recovery in global growth in the second half of 2019. The G-20 meeting in Japan in the closing days of June was looked to by investors worldwide to provide some clarity, and by optimists to signal some form of compromise between the USA and China. Otherwise, with trade tensions remaining in an escalatory cycle, risks to the global outlook are still skewed to the downside.

Inflation stayed below target in most global markets. The Fed has not merely signalled an indefinite pause in its prior track of raising interest rates, but has hinted that a rate reduction from the current 2.5% level may be desirable in the near-term. It will retain a higher overall balance sheet than previously expected. This, combined with 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 has, by and large, been rewarded with an upward trend in global growth asset classes such as equities alongside gains in the value of bonds. However, equities endured a difficult May month, with a sharp reversal in confidence as the US government stepped back from a conclusive trade agreement with China and suggested more tariffs were likely, also potentially being applied to other nations as a lever of foreign policy influence. This disappointment hit equities and generated a sharp demand for the perceived safe haven of US and other developed market government bonds.

Central bankers appear increasingly unwilling to allow extended bouts of weakness in asset markets. Nor do they wish to run the risk of stalling their economies, preferring to wither ease policy or make comments calculated to lower their domestic currencies and thus spur growth through the export channels. The June quarter therefore saw a renewed support to growth assets delivered by more accommodative future interest rate paths, and consequently lower sovereign bond yields. However, markets recognizing greater risks to corporate profitably pushed lower-rated corporate bond yields higher in response.

The top level macro environment was uncertain, and many of the issues keeping markets unsettled have persisted.

  1. President Trump’s trade war with China escalated. However, more recent positive news suggests the US will want to bring this to a conclusion sooner rather than later.
  2. 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 cautious as trade issues are still unresolved.
  3. President Trump’s political woes may have entered hiatus but issues could re-appear as the campaigning towards the November 2020 election begins. The Republican’s loss in the House of Representatives means policy-making is more confrontational, and easy growth-boosting measures like tax cuts are unlikely.
  4. Politics in Europe were messy as European parliamentary elections saw a surge in support for non-traditional ‘populist’ parties in several countries. Centre-left and centre-right parties saw losses, while Eurosceptic, nationalistic and environmentalist parties achieved gains in support. This complicates the policy outlook given the impending retirement of two pillars of EU stability: the ECB’s Mario Draghi in October and Germany’s Angela Merkel in 2021.
  5. The shambles of Brexit became even more shambolic. Theresa May lost control of the Conservative party leadership and has indicated a departure from the Prime Ministership after the party selects a new leader. May’s successor is unresolved but could well be Boris Johnson. Fresh UK elections seem unlikely as Johnson has spoken against them. The extension of the exit deadline to 31 October is still the formal target for a resolution, though it is unclear whether Brexit will in fact be viable if no acceptable deal is achieved.
  6. Much lower US interest rates, which rallied particularly strongly in the May month, eased pressure on emerging markets, especially those with ongoing structural weaknesses and/or high levels of US dollar denominated debt.

International equity markets recovered a large proportion of the May month weakness and several key markets (eg the US S&P 500) achieved new all-time highs in June. However, the gains are quite fragile as they depend on major economies stabilising in 2019 rather than slowing further, on a resolution of trade and geopolitical friction, and monetary easing continuing.

We continue to expect the uncertainty to give way to the reality that while global growth has clearly passed its peak, it will remain tolerable (if tepid) and no recession will arrive unexpectedly this year. Nevertheless, a period of supressed investment growth is looking more likely given political uncertainties. Inflation is expected to remain low and monetary policy easy by historical standards.

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, 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.

Commodities’ strength has again proved transitory, with the oil price declining 11% from its April high to the end of June. Much greater clarity on global trade and final demand is needed before any sustained improvement in broad commodity prices gets underway, and that now seems unlikely to develop in 2019.

LOOKING AHEAD

Despite the general rise in share prices since the beginning of the year, looking ahead elevated valuations and a currently unresolved US-China trade dispute present an asymmetric risk exposure, with an increased risk of a correction. The current environment of uncertainty has the potential to provide periods of heightened volatility as we enter the September quarter.

The downside risk will likely be exacerbated by geopolitical risks, including the potential for an escalation in the conflict between the US and Iran.

In Europe, a weakening economy and political upheaval, including Brexit and internal European Union disagreements, will likely increase risks. Furthermore, with the German economy remaining susceptible to a further slowdown and the European Commission having revised down its economic growth estimates, any instability at the union’s core will mean there will be little to mask any fragility within peripheral economies. Thus, further stimulatory measures are to be expected.

During the current turbulent period and given high valuations, quality companies with solid defensive properties should benefit the most.

Low sovereign bond yields and increasing global economic uncertainty point to low short to medium-term returns from global sovereign bonds. Within a generally benign inflationary environment, an unresolved US-China trade dispute causing a flight to safety, and a recent increased bias from central banks towards more accommodative stances; any upward pressure on bond yields is now likely to be subdued for the time being – at least until the global economic environment shows signs of improved sentiment, momentum and visibility.

Australian shares remain exposed to global economic uncertainty, despite the greater visibility imparted by the recent return of the Liberal Coalition to government. Much of this uncertainty is outside the Australian government’s control. The Reserve Bank of Australia cut the cash rate to an historically low 1.25% in early June, with communications suggesting further likely reductions, which is positive for equites and should feed into earnings. However, looking ahead, generally higher valuations and increased global economic uncertainty have increased the shorter term downside risk. However, this does not mean momentum cannot carry the market higher.

Modest global growth, supported by historically low interest rates, is an environment in which global listed real estate is expected to deliver reasonably solid medium-term returns. When there is a fall in the risk-free rate because central banks around the world are loosening their monetary policy, investors often turn to listed real estate as a reliable alternative for yield and a defensive asset class. Opportunities to acquire individual companies at attractive valuation levels may also arise as geopolitical developments lead to heightened volatility and diverging stock performance.

New Zealand’s economy registered GDP growth of 0.6% in the first quarter to be up 2.5% in the year to March. While the RBNZ is looking for a rebound towards 3% in the next 12 months, more timely data suggests the economy has downshifted to a lower run-rate of nearer 2.0-2.5%. Construction, government spending and lower mortgage rates continue to support the economy, while slowing net migration and a weaker global backdrop provide headwinds.

CASH AND FIXED INCOME

The Official Cash Rate (OCR) was cut 25 basis points (bps) to 1.50% in May. Market pricing signals an 85% chance of a follow up cut in August, with a third rate cut to 1% all but priced for early 2020. 90 day bank bill rates fell 21 bps on the quarter to 1.64%.

Government bond yields were 23-30 bps lower across the June quarter as global bonds benefited from safe-haven demand amid rising geopolitical risks. US 10 year Treasury yields fell 40 bps to 2.00% over the same period.

New Zealand swap rates fell by an even greater extent, down 27-37 bps in the June quarter. This led to a compression in swap spreads as the global reach for yield led to increased receiving at the long-end of the New Zealand swap curve. Underperformance from government bonds saw the 10 year swap spread tighten 14 bps to 22 bps in the June quarter, while short-end swap spreads were little changed.

The 2 year-10 year swap curve flattened by 10 bps over the quarter in response to long-end receive flow.

Breakeven inflation rates were little changed in the June quarter.

GLOBAL BONDS

Global government bond yields mostly moved higher in April, amid generally favourable economic data releases. In the US, gross domestic product rose at a stronger than expected rate over the March quarter as contributions from trade and inventory offset slower growth in consumer spending and investment. Yields subsequently reversed direction over the remainder of the June quarter as a lowering of regional growth forecasts stoked expectations of co-ordinated easier monetary policy on the part of major central banks.

A mix of dovish pivots by the US Federal Reserve and the European Central Bank, generally soft data releases and geopolitical uncertainty in relation to US-China trade negotiations and escalations in US-Iran tensions helped drive global rates to fresh lows and record-low levels in some countries. The US 10-year bond yield ended the quarter at 2.01%, while the German 10-year bond yield and its Japanese counterpart ended at -0.33% and -0.16% respectively.

Global credit spreads tightened in April as the continuation of accommodative monetary policies fuelled an ongoing inflow of investment funds into credit and broader fixed income investments. Subsequent market unease in May, amid concerns related to global trade, gave way to renewed optimism in June. This followed the US move to suspend tariffs on Mexico, with President Trump saying that Mexico would soon make “large” agricultural purchases from the US. Sentiment was further boosted by a positive outcome to the G20 meeting of world leaders in Osaka at which the President announced that he would hold off on imposing planned tariffs on US$300 billion of Chinese goods.

GLOBAL SHARES

The MSCI World index rose over the June quarter. Global shares were strong early in the period, amid a mostly positive US reporting season. Upbeat sentiment around the globe was further supported by a relatively dovish US central bank, sound levels of economic growth, strong resource prices and optimism about a US-China trade deal. Markets subsequently took back some of these gains mid-quarter. An escalating US-China trade dispute was the major culprit, along with the US flagging the possibility of increasing tariffs more broadly. Markets then powered ahead in June, with some even breaking record-highs, as dovish central bank policies drove market sentiment. European shares, particularly Germany’s share market, were very strong as expectations of further easing from the European Central Bank rose.

Emerging markets shares, while positive, couldn’t match their developed counterparts’ performance over the quarter and the MSCI Emerging Markets index finished the period up modestly, despite mostly strong resource prices and broadly positive sentiment

NEW ZEALAND DOLLAR

The New Zealand dollar (NZD) was marginally weaker over the second quarter, losing 0.9% against the Trade Weighted Index.

Interest rate cuts by the RBNZ increased the differential in favour of the US and is no longer supportive of the NZ dollar. This differential is likely to remain for some time.