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Investment – Quarter ended 30 September 2017

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

September quarter data was consistent with our expectation for higher global GDP growth in 2017. In the United States growth in activity has rebounded from the weak patch at the start of the year, supported by inventory accumulation, solid consumer spending, and a continuing recovery in investment spending. With US 2017 growth of around 2.2% and accelerating activity in Europe, Japan and the emerging markets, the increasingly synchronised global upswing is on track to deliver world GDP growth of 3.5% this year and 3.7% in 2018.

Economic conditions continue to improve in Europe with the likelihood that annualgrowth will exceed 2% in the near term, the first time it has done so since 2007.TheGerman unemployment rate has declined to 3.6%, which is its lowest level since1980.Across the European Union (EU), unemployment is down in all 28 memberstatescompared with one year ago. The still-supportive monetary and stimulus policiesfromthe European Central Bank (ECB), a healthy trend in exports and strongconsumerconfidence has supplanted earlier worries about mass migration andterrorismgenerating a sharp political swing towards Right-wing parties. Notwithstandingstronggrowth and employment trends, issues of social cohesion are still unresolved inEurope.The late-September German elections saw the CDU coalition led by Angela Merkelsufferweakened support, with the nationalist AfD and the free-market friendly FDP likely tobenecessary coalition partners for the centrist bloc.

Japan has also experienced an upturn in growth as business confidence has improved markedly, reflecting robust demand for exports, a weaker yen, and super-supportive monetary policy, with the Bank of Japan holding the 10 year bond yield down at 0.0% through continuing intervention. With business confidence at its highest level in a decade, consumer sentiment may improve toward year end. However, regional geopolitical threats such as North Korea, and Prime Minister Abe’s late-September announcement of a snap election on October 22, could keep consumers cautious until political and taxation uncertainties are better resolved.

In the United Kingdom, the rocky road of Brexit preparation continued, complicated by the weakened Conservative-led government needing to simultaneously manage negotiations with the EU, and to ward off claims from the resurgent Labour Party that the economy is fundamentally flawed and in need of radical policies like transport nationalisations. UK inflation has also moved higher in response to the persistently weak pound, raising the chances that the Bank of England may need to move interest rates up a little. These factors combine to give the UK a softer growth profile for the next two years, with 2017’s forecast GDP gain of 1.8% moving down to 1.6% next year and 1.5% in 2019.

Inflation continues to mostly undershoot expectations, especially in the US where core inflation is now tracking under2%, though the recent decline in the annual rate appears to be stabilising. Late in September, US Federal Reserve (the Fed)Chair Janet Yellen adopted a more hawkish tone, noting that it would not be prudent to wait for inflation to return to above 2% before additional interest rate increases. This restored the market’s expectation for another 25 basis points (bps) increase in the US target rate this year, almost certainly in December. The Fed also indicated that its bond repurchase programme (QE) will begin to be gently discontinued commencing in October, with maturing securities not being replaced on their balance sheet.

With core inflation ticking higher in the Eurozone and the better growth outlook, we expect the ECB to announce a tapering of its asset purchase programme for 2018. An announcement is expected by November at the latest. Central banks are becoming increasingly inclined to wind back their emergency easing or move to tighten monetary conditions. That reflects higher growth around the world that will likely accelerate the absorption of spare capacity, particularly in the labour market, making it prudent for central banks to start moving in anticipation of higher core inflation in the future. There is also a desire to normalise monetary conditions in the face of risks to financial stability from a prolonged period of ultra-easy monetary policy. This led to sharp rises in US bond yields in the latter part of September, which has partly flowed through to other developed bond markets.

Australian GDP rose by 0.8%in the June quarter and annual GDP growth was1.8%. Australian GDP growth has improved over 2017 and the increase has really been broad across themajor components–household spending was stronger, business investment is rising and export growth remains solid. The improvement in growth over 2017 means that annual GDP is moving towards 2.5-3.0% over 2017 and 2018, in line with Reserve Bank of Australia assumptions.

The New Zealand economy remains in good shape, with a rebound to 0.8% growth for the June quarter following 0.6%growth in the March quarter. Construction and mining activity were the weakest major sectors, while retail, manufacturing and transport expanded. On a year-on-year basis, the economy expanded by2.7%. From the Reserve Bank of New Zealand’s perspective, no change in interest rates is likely for the foreseeable future as inflation remains muted.

LOOKING AHEAD

Equity market valuations are fully priced, even allowing for improved corporate earnings. This makes further sustainable gains dependent on the other catalysts. In the US the Republican agenda has returned to attempting meaningful tax reform, which has led to renewed optimism recently.

Our economic view supports an expansionary phase ahead, although geopolitical risk has clearly risen in the Korea situation. There is a greater awareness that low interest rates and supportive central bank asset purchases will be phased out in most major markets (albeit gradually). We expect developed markets will probably range-trade in the near-term, until some new positive catalyst is found.

The risk of a minor correction has risen. Equity markets will likely continue to outperform bond markets as bond yields trend higher over time, reflecting central banks’ precautionary actions on the road to normalization more than actual inflation surprises.

CASH AND FIXED INCOME

Headline inflation will retest the bottom of the 1-3%target band in early 2018 as high previous quarter numbers fall out of the annual calculation. Core inflation pressures remain subdued as wage growth remains similarly subdued. Monetary policy is on hold with the RBNZ continuing to flag no tightening in conditions until late 2019. We expect the first move in late 2018.

Despite ‘on hold’ monetary conditions, retail interest rates are higher reflecting higher demand for retail deposit funding by banks. At the same time, the banks have become more cautious about new lending. Those factors alongside ongoing loan to value rate (LVR) restrictions has seen a slowing of house price inflation while sales of existing homes are down 24% from year ago levels. However, with demand still exceeding supply we expect to see renewed strength in the market into 2018.

With RBNZ Governor Graeme Wheeler stepping down and Grant Spencer acting in the role in a caretaker capacity until early 2018, we do not expect a change of direction from the RBNZ. This was confirmed by a continuing on hold message delivered by Spencer at the September OCR review.

Following the general election on 23 September 2017 ,there is unlikely to be a substantial change in monetary or fiscal policy direction once the new government is formed (parties are still in coalition negotiations at the time of writing). However, a change of government may see a slight upward track in the government bond programme from what is currently forecast.

We still expect shorter term rates to be well contained. However, with continuing improvement in global growth and inflation outlook we see longer term rates continuing to move higher. The higher rates outlook is also supported by continuing rate hikes by the US Fed, as well as the tapering programme announced by the Fed, as well as the tapering programme announced by the Fed and likely to be announced by the ECB before the end of 2017).

A complicating factor are the rising tensions between the US and North Korea. Any flare ups in the "war of words" will see bouts of risk aversion and falls in global yields.

Money market rates were flat over the quarter. The 90 day bank bill rate fell slightly to 1.96%, reflecting there has been no change to the OCR in the last three months.

Swap rates were lower across all maturities. The shape of the swap curve was largely unchanged.

Government bonds were lower across all maturities with larger moves in shorter maturities. The government bond curve steepened.

GLOBAL BONDS

Global government bond yields were buffeted by various news stories during July. However, none was sufficient to drive a major movement in yields. Subsequently in August, yields generally moved lower against a backdrop of relatively benign economic data releases.

The US set the tone for an upward movement in yields towards the end of September, as Federal Reserve Chair Janet Yellen said she was “wary of moving too gradually” on interest rates.

US 10-year Treasury bond yields ended the quarter at 2.33%,with comparable maturities in Germany and Japan ending a t0.46%, and 0.07% respectively.

Low ,though rising, sovereign bond yields point to low medium-term returns. The abatement of deflationary pressures as commodity prices trend up, a gradual utilisation of spare capacity, and a shift in policy focus from monetary to fiscal stimulus indicate that yields are likely to steadily trend higher.

GLOBAL SHARES

International equity markets had another positive quarter, exhibiting low volatility despite geopolitical tension around North Korea and the US Federal Reserve’s announcement o fits much-anticipated ‘quantitative tightening’ programme. Investor sentiment remained positive as synchronised growth continues across most developed economies.

Global shares ended the period up by around 4.0%, as measured by the MSCI World ex Australia Net Index in local currency. The USS & P500 Accumulation index steadily rose through more new all-time highs in September, closing the quarter up4.5%(in USD terms). This ongoing rise has caused some analysts, of late, to question if any complacency is slipping into the market’s rosy outlook, with earnings multiples now factoring insignificant profit growth over the coming years.

Other major markets were firmly in positive territory, with the Euro STOXX 50 Accumulation Index up by 4.5% and Japan’s TOPIX 100 Accumulation Index up 4.1% (all in local currency terms).

Emerging markets were even stronger, with the MSCI Emerging Markets Accumulation Index closing up 7.6% in local currency terms.

NEW ZEALAND DOLLAR

The New Zealand dollar (NZD) fell against all the major currencies in the September quarter. The softness in the NZD over the period was a reversal of a period of robust performance

in the June quarter, which was probably excessive given the lack of new domestic positives, and which did not reflect declining interest rate differentials between the US and New Zealand.

The relative strength of the New Zealand economy, rising budget surpluses and strong demand for our commodities is likely provide a supportive backdrop to prevent accelerated NZD declines, particularly if the post-Election coalition government does not sharply change the current economic course. Risks to the downside are mainly political, and may intensify if the US Fed is more aggressive in tightening than the markets currently expect.