Investment – Quarter ended 31 December 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.
The generally good economic news of 2017 continued into the final quarter of the year.Activity indicators remained robust, particularly in Japan and Europe which hadbothbeen drags on growth for much of the post-Global Financial Crisis period. TheUnitedStates continued to post above-trend growth and the outlook there was buoyed bythepassage of tax reform by both houses of Congress just prior to Christmas.
Offsetting the good news, the UK hasn’t enjoyed the same pick-up in growth as Brexit uncertainties weigh on sentiment. India had a sub-par year as demonetisation and the introduction of a goods and services tax saw the economy underperform its potential.
While growth was picking up among the key developed economies, inflation still failed to fire. Core inflation went through a mid-year wobble that saw the annual rate in the United States dip back below 2%. Towards the end of the year inflation seemed to be heading higher again, though it is still below mandated levels in most countries.
Belief that the weak patch in inflation would ultimately prove transitory saw the US Federal Reserve (the Fed) continue the monetary policy normalisation process with a further interest rate increase in December. This followed the announcement in December that it would soon start to wind back the size of its balance sheet – in other words, quantitative tightening.
Against a backdrop of improving growth, the European Central Bank announced the much-anticipated tapering of its asset purchase programme during the quarter, reducing the quantum of monthly purchases by half for 2018 with an indicative end-date of December. And while inflation looked to be inching higher in Japan, it remains well below the Bank of Japan’s target of 2%. We see no change in monetary settings there in the foreseeable future.
Despite the continued tightening in monetary settings, the US dollar (USD) continued to be surprisingly soft. Weak inflation led markets to continue to question how much more tightening the Fed would be able to do, while at the same time a number of other central banks were beginning the long slow process of their own policy normalisation. Domestic politics, particularly the Mueller probe into the Trump election campaign’s links with Russia, also weighed on the USD.
China enjoyed a period of relative stability in 2017. The goal for this year was stability as the Communist Party held its 19th five-yearly Congress in October. That saw President Xi Jinping cement his hold on the Chinese leadership. A gradual tightening in financial conditions was starting to weigh on activity late in the year, which appears to signal a resumption of the gradual slowdown in growth in 2018. We expect the reform process to step up also in 2018.
Activity indicators in Australia remained mixed but the economy did manage to achieve the milestone of 26 years without a recession. However, as with most developed economies, inflation remained below target. While housing constructionstarted to slow and consumer spending was constrained, non-mining investment improved, infrastructure spending surged and export volumes were strong. Record low wages growth and low inflation continued to keep the Reserve Bank of Australia on hold.
A change of Government in New Zealand heralded a period of policy uncertainty. Business confidence and the (trade weighted) New Zealand dollar ended the year lower. We believe the drop in confidence will prove to be mostly transitory, though it remains a key risk to the outlook if businesses remain cautious about the outlook.
The economy had a solid enough year in 2017, though growth was constrained to some extent as a number of sectors hit capacity constraints, particularly residential construction. The outlook for economic growth remains positive with fiscal stimulus set to become a key growth driver from late 2018 and into 2019. Inflation remained subdued with the Reserve Bankof New Zealand (RBNZ) firmly in neutral. We continue to believe that monetary conditions will be on hold until late 2018.
Looking ahead to 2018, we retain a positive and constructive outlook for markets. The ‘sweet-spot’ of strong global growth and benign inflation will continue to be positive for profit growth and equity markets. That said, the meaningful correction we have been warning about for most of 2017 is yet to transpire. We continue to expect low returns from bonds as monetary policy continues to normalise and yields remain low.
The key question for 2018 is how long the upward growth momentum can last. Critical to that is the outlook for business investment and productivity. We remain optimistic on that front. Also, we are yet to observe any of the usual signals of excess that presage a significant down turn in economic activity and equity markets.
CASH AND FIXED INCOME
As expected, there was no change in the OCR as the RBNZ continues with its “on hold” message.
The 90 day bank bill rate declined in the last three months, falling 8 basis points, reflecting banks sitting on plenty of cash. A number of large retail bond maturities have not been refinanced meaning investors are looking at shorter maturity bank and money market investments as a place to park excess cash.
With the maturity of the 2017 government bond on 15 December there was good demand for government bonds by bank balance sheets, as well as fund managers and other investors looking at offsetting the 0.4 year extension in the government bond index following the maturity.
In addition, the December release of the Half Year Fiscal and Economic Update (HYFEU) by the new Government revealed no sizeable increase in the government borrowing programme. This was not expected by the market and sparked more buying of government bonds.
Government bond rates fell for most maturities. Shorter maturity bonds were targeted by bank balance sheets, while longer-term bonds were targeted by fund managers.
In contrast swap rates were only slightly lower over the quarter. Swap spreads widened for all maturities, with the largest moves concentrated in the middle of the yield curve (five years).
Breakeven inflation rates were higher following moves in offshore markets. Higher commodity prices and further reductions in excess capacity mean inflation pressures should become more obvious in the period ahead.
Global government bond yields were mostly mixed over the first two months of the December quarter. The US 10-year bond yield moved higher amid continued signs of strength in the US economy and generally favourable corporate profit results. In contrast, yields in Japan edged lower, while those in Germany remained relatively stable.
The mixed pattern of yield movements continued into December, amid the legislative passage of US tax reforms and a commitment by the European Central Bank to continue with monetary stimulus. The US 10-year Treasury bond yields ended the quarter at 2.41%, with comparable maturities in Germany and Japan ending at 0.43%, and 0.048% 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 equity markets saw yet another strong quarter and were again accompanied by low levels of volatility. Globally, conditions remain in somewhat of a sweet-spot, with strong economic growth and supportive financial conditions, even as the US (and others) raised interest rates.
Global shares ended the period up around 5.3%, as measured by the MSCI World ex Australia Net Index in local currency terms (the return was slightly stronger in New Zealand dollar terms due to currency movements). The US S&P 500 Total Return Index continued to climb through record-highs and closed the quarter up 6.6% (in US dollar terms) as corporate earnings remained strong and President Trump’s proposed tax cuts continued to drive optimism.
Most other major markets were also strong, with Japan’s TOPIX 100 Net Total Return Index up 8.7%, UK’s FTSE 100 Accumulation Index returning 5.0% and the Chinese S&P/CITIC300 Total Return Index returning 6.0%. However European shares lagged, ending the quarter close to flat.
Emerging markets also did well, the MSCI Emerging Markets Accumulation Index closing up another 5.7% (in local currency terms), and outperformed their developed counterparts as they continued to benefit from the global pickup in trade and generally strong resource prices. South Africa was the best performer, as the market reacted positively to the election of Cyril Ramaphosa to the head of the ruling ANC party. Conversely, underperformers included Mexico, which was impacted by ongoing concerns surrounding the NAFTA renegotiations, while Brazil also suffered as political tension weighed on returns early in the year.
Although the US administration has been broadly positive for stocks, there has been considerable uncertainty regarding future actions, particularly before the signing into law of the tax reforms in late December and some continuing political uncertainty. However, following any short-term weakness, we still expect shares to trend higher over the next 12 months, helped by the synchronised pickup in global economic activity data and the flow-through to growth and corporate earnings.
A major positive for emerging markets is the conjunction of re-invigorated governments, regulators and company management teams responding positively to the environment. Valuations are also supportive, remaining at a significant discount to developed markets.
NEW ZEALAND DOLLAR
For the second successive quarter the New Zealand dollar (NZD) fell against all the major currencies. The majority of the fourth quarter decline was experienced in October as the uncertainty over the General Election outcome weighed on investors’ confidence. Market participants continued to heap pressure on the NZD following the formation of the new centre-left coalition, which campaigned on less immigration and housing restrictions for non-residents.
The pressure on the NZD also reflected the declining interest rate differentials between the US and New Zealand, with the US Fed firmly locked into a gradual tightening cycle.