Investment – Quarter ended 30 September 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.
Political issues remained front and centre in the September quarter as the trade dispute between the United States and China continued to escalate, fears rose of the United Kingdom leaving the European Union in March 2019 without a deal, and the deadline approached for new populist government in Italy to pull their 2019 budget together.
Trade wars continue to present the greatest threat to the global economic outlook. Tensions rose further over the quarter, though new tariffs implemented towards the end of the period were less than feared. Furthermore, there have been reports that China is planning a broad cut to its tariffs, which provides scope for a negotiated settlement.
The risk of a ‘hard Brexit’ rose over September as the European Union rejected the British Government’s latest Brexit plan, with the “four freedoms” and the Irish border the key sticking points. A hard ‘Brexit’ risks throwing the UK into a recession and time is running out.
Fiscal policy is again a key focus in Europe as the new populist government in Italy attempted to pull a Budget together that delivers on their election promises but stays within EU-determined Budget limits. This simply serves to highlight again the need for a Eurozone-wide fiscal framework.
Economic data among the key developed economies has been generally positive over the quarter. That said, we continue to believe that Europe and Japan are past the peaks of their respective growth cycle, but that growth will remain sufficiently robust to absorb spare capacity in their economies and put upward pressure on inflation. Activity in the UK economy continues to suffer from the uncertainty around the Brexit process.
The European Central Bank has signalled it will end its quantitative easing (asset purchase) programme at the end of 2018. However, they have also signalled that any move higher in interest rates is unlikely until the second half of 2019. In the UK, the Bank of England has been raising interest rates in response to the tighter labour market, but are now likely on hold until Brexit uncertainty diminishes. The Bank of Japan continues to ease aggressively.
Growth remains most robust in the United States where late cycle fiscal stimulus is continuing to support activity. The labour market continues to tighten and wage growth continues to move higher. The US Federal Reserve delivered its eighth interest rate hike of this cycle in September and signalled a continuation of the gradual approach to further interest rate increases. We expect their next move in December.
As US monetary policy has tightened and the US dollar has risen, emerging markets have come under pressure. As a whole, emerging markets are better placed than they have been during previous periods of market stress. In particular, growth is higher, inflation is lower and external imbalances are in better shape. However, some countries such as Argentina and Turkey have poor structural settings that have seen their financial markets punished during the last few months.
Concerns about the slowdown in China resurfaced over the quarter. We have been expecting China to continue slowing and we believe the downside risks in the economy are manageable. The authorities have shown they have the willingness and resources to support the economy should it be needed.
Australian GDP growth has been on a rising trajectory over the last 12 months. Annual growth now sits at 3.4% following a better than expected June quarter result and upward revisions to earlier data. However, we expect growth to soften again over the period ahead given the current debilitating drought and the slowdown in the housing market that will constrain consumer spending.
After spending the first half of 2018 in an uncertain mode, global share markets managed a vigorous rebound in the third quarter, gaining 4.5% in US dollar terms over the three month period. Gains were paced by the US market, which rallied 7.2% as corporate earnings continue to be strong, lifted by healthy domestic demand and corporate tax cuts. However, Europe and emerging markets were weaker, with Europe rising by just 0.3% and emerging markets ending the period unchanged.
We remain moderately cautious regarding the more expensive asset classes and market sectors. 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, although the last quarter saw the rally broadening to the healthcare and industrials sectors, which both outperformed technology. The Japanese index’ gain unusually exceeded that of the US, with yen softness supporting an 8.1% quarterly gain in local currency terms.
In New Zealand, which has outperformed, much momentum relies currently on our commodity exporters and on sectors benefiting from a weaker New Zealand dollar (NZD).We currently see no catalysts for a significant NZD rebound, given divergent interest rate paths, so New Zealand equities may continue their resilience for some months despite slowing growth and record-high valuations. A dovish monetary policy update from the RBNZ at the end of the quarter accompanied by a move lower in New Zealand bond yields reinforced the perception that domestic equities still face no threat from the direction of New Zealand interest rates. However, valuations remain stretched considering the slowing domestic economy, which will begin impacting earnings before long.
In global fixed interest, in contrast to New Zealand continued weakness in major country bonds’ performance is particularly notable. The willingness of investors to switch in to longer-duration 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. The US 10 year bond yield has again risen above 3.0%, and returns from US corporate credit also remain subdued.
We expect the final quarter of 2018 to see a resumption of volatility, as geopolitical (tariff and US electoral) risks add to tightening global monetary conditions as a challenge to equities. European issues may again come to the fore, with Brexit complications rising and the Italian fiscal picture deteriorating. However, because other developed market economies remain strong and inflation is gradually turning upwards, we expect limited diversification benefits from global bonds and continue to prefer cash. For New Zealand bonds the outlook is better with softer growth ahead and a decoupling from US bond yields persisting, allowing us to restore more neutral weightings to domestic bonds in order to access their interest rate advantage over cash.
The NZD fell -2.2% against the US dollar over the third quarter, enhancing returns from global equities somewhat. We think that the NZD correction phase will now pause for a period, but may resume in the event of any sharp deterioration in international equity markets, bad news from China, or weakening in agricultural commodity prices.
CASH AND FIXED INCOME
There was no change in the Official Cash Rate (OCR) as expected as the RBNZ continues with its “on hold” message. The RBNZ continues to have a balanced view on whether the next move will be up or down, but the market has reduced its expectations of a cut.
90 day bank bill rates were down 9 basis points (bps) in the last three months, falling back nearer to the lows experienced at the start of the year after initially bouncing back above 2%.
Government bond rates decreased for all maturities and there was a flattening of the government bond curve. New Zealand government bond rates outperformed global government bond rates, with the US 10 year rate increasing by 20 bps over the same period.
Swap rates were lower for all maturities. This was against the move in US markets and other global markets, which saw swap rates widen as growth in the US continues to strengthen.
Swap spreads widened for longer dated maturities as the flattening of the New Zealand government bond curve was not reflected in the New Zealand swap curve.
Break even inflation rates were lower by 4 bps, which was in line with Australia and Japan markets, but under performed relative to the US and UK.
Global government bond yields drifted higher for the majority of July, with trade tensions continuing to influence financial markets. In August, global bonds experienced a moderate rally across most markets, as geopolitical factors appeared to supersede economic data during the period, with trade negotiations between the US and Mexico, ongoing trade friction between the US and China and emerging market risks dominating headlines.
September saw global bond yields rise as bond markets sold off on the back of positive economic data releases which outweighed geopolitical influences, in particular ongoing trade tensions which continued to occupy the attention of market participants. The US 10-year bond yield ended the quarter at 3.06%, while the German 10-year bond yield and its Japanese counterpart ended at 0.47% and 0.13% respectively.
Global shares, particularly those in developed markets, were up strongly in the September quarter. The MSCI World ex Australia Net Index finished the period higher by 5.39%.
In the US, decidedly positive sentiment lingered from good corporate earnings growth, combined with continued strong economic growth and low unemployment. The S&P 500 total return index ended the period up a scorching 7.71%, touching record highs in the process. Trade-related developments, while providing a source of volatility (both on the positive and negative side) were again a feature. While there was much negative media surrounding the war of words leading up to the thrashing out of new deals, most developed markets seemed not overly concerned.
There was also a marked change in top-performing sectors. Technology stocks came under some pressure, while some of the more traditionally defensive segments of the market, such as REITs, did well, which was perhaps a little surprising given rising bond yields.
Some emerging markets struggled during the quarter, as the strong US dollar fanned currency outflows from markets such as Turkey, where inflation was recently estimated to be running at over 100% on an annual basis. Commodity prices, however, provided some support to many emerging markets and the MSCI Emerging Markets total return index finished down by just 0.04%. (All figures quoted in local currency terms.)
NEW ZEALAND DOLLAR
The New Zealand dollar (NZD) was weaker over the September quarter.
The US federal funds target rate is now above the New Zealand Official Cash Rate, meaning the positive interest rate differential which has supported the NZD has now reversed into a negative differential in the United States’ favour. The RBNZ has signalled that it is unlikely to lift domestic interest rates until 2020, while the US Federal Reserve could potentially raise rates by over 1% within that timeframe.