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Investment – Quarter ended 30 September 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

Continuing softness in the global economic situation, particularly in Europe and China, led the US Federal Reserve (the Fed) to lower its target interest rate twice during the quarter to 2.0%. The two quarter-percent rate cuts were widely expected by markets, which have been pricing a more aggressive easing path than the central bank has indicated throughout this year. The US rate reductions are their first easing since rates were reduced to 0.25% during the Global Financial Crisis (GFC) in December 2008. However, because the underlying economic and financial market conditions are so different to those prevailing eleven years ago, the Fed has been at pains to point out that the rate reductions are a ‘mid-cycle adjustment’ rather than the commencement of a new and deep easing trajectory.

Monetary conditions in the US and globally remain exceptionally stimulatory, and the weaker growth dynamics have political rather than monetary drivers. However, the major central banks have attempted to walk the line between keeping financial conditions accommodative enough to support growth, and using up all their potential ‘ammunition’ in terms of their scope for future emergency rate reductions when actually recessionary conditions emerge at a future time. Not all of the world’s monetary experts are convinced that negative policy interest rates work, and some (particularly in Europe) are noting the negative effects like the inflation of property bubbles and the undermining of banking sector lending incentives and profitability.

The European Central Bank (ECB) moved to a more dovish policy stance at President Draghi’s last meeting before he relinquishes the position to Christine Lagarde. The European target rate was reduced from -0.4% to -0.5% and the purchase of Euro-member state government bonds was resumed. However, the future scope for the ECB buying substantially more sovereign debt is limited, as there is currently a self-imposed holdings cap of 33% of the bonds of a single issuer and the ECB is fast approaching that limit. As a result, President Draghi used his departure speech to strenuously urge Eurozone governments to expand fiscal stimulus and to move forward with less reliance on monetary policy tools to support the economic cycle. The additional accommodation assisted European equities to a third quarter gain of 2.0%, led by a 4.0% equity market gain in President Draghi’s home country of Italy. This was in spite of political machinations still affecting the stability of the Italian government in the last few months.

The appeal for a fiscal boost is particularly apposite because the German economy, which is the manufacturing engine-room of the European Union (EU), has been hard-hit by the US-China trade war. Chinese demand for industrial and other manufactured capital and consumer goods from Europe has slowed as uncertainty about future sanctions by the US and a cautious domestic government has triggered a downward shift in local investment and output. A weaker China has dampened expectations for Asia-Pacific trade and the weakest equity markets during the third quarter were the trade-sensitive small open economies of North-East and South-East Asia (Hong Kong, South Korea, Singapore) which have a crucial function in global manufacturing supply chains. It is precisely these supply chains that are at risk from increasing trade nationalism.

This regional economic chill 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) again dropped the Official Cash Rate (OCR) in August, by 0.5% to 1.0%. The RBNZ cut was double the size that the market had expected, and it has led to a subsequent weakening in the New Zealand dollar (NZD) against both the Australian and US dollars.

Trade tensions persisted during the quarter but as September advanced, some form of compromise between the USA and China again seemed possible. President Trump deferred the imposition of a new round of tariffs until after China’s celebration of the 70th Anniversary of the founding of the Peoples’ Republic in October. Risks to the global outlook are still skewed to the downside, as even if a resolution or cease-fire in the trade war comes into view, other parts of the world are still contributing to global geopolitical uncertainty.

Tensions between Iran and Saudi Arabia are rising in the Gulf with attacks on Saudi oil production facilities in September following on from attacks on oil tankers in August. In the United Kingdom, Brexit uncertainty compounded as on the one hand, Parliament bound PM Boris Johnson’s hands with legislation restricting an EU exit with no negotiated deal in place. On the other hand, the Government appears resolved to push ahead and take the UK out of the Union on 31 October. UK equities therefore lagged the developed market pattern of flat-to-positive third quarter returns, with the FTSE UK Index marginally declining over the last three months.

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 August month, with a reversal in confidence as the US government again stepped back from a conclusive trade agreement with China, at the same time as the Congressional Democrats began their long-anticipated initiative to impeach the President and paralyse his administration. This disappointment hit equities and generated demand for the perceived safe haven of US and other developed market government bonds. However, improved sentiment in September largely reversed the negative August movements.

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 either ease policy or make comments calculated to lower their domestic currencies and thus spur growth through the export channels.

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

  1. President Trump’s trade war with China continued. However, more recent positive news suggests the US will want to bring this to a conclusion sooner rather than later. Some détente seems to be building on both sides.

  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 restrictions 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 are re-appearing 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. Impeachment looks unlikely to succeed but will be a distraction.

  4. The shambles of Brexit became even more shambolic. 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.

  5. Much lower US interest rates, which rallied particularly strongly in the August 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 mid-quarter weakness and several key markets (eg the US S&P 500) closed in on new all-time highs in September. However, the gains are quite fragile as they depend on major economies stabilising 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 or early next. 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 proven transitory, with the oil price declining 18% from its April high despite a mid-September spike after the attacks on the Saudi oil facilities. 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 during the remainder of 2019.

LOOKING AHEAD

Increasing predispositions by global central banks to become ever more accommodative during the September quarter have kept the bias on interest rates downwards, making equities relatively attractive and increasing the correlation between equities and bonds. However, the International Monetary Fund revised down its projection for global growth further during the period.

Global share markets remain at risk of further weakness in the months ahead on the back of the ongoing US-China trade dispute, Middle East tensions, and mixed economic data as we are in a seasonally weak part of the year for shares. However, valuations are reasonable, particularly when compared against low bond yields. Global growth indicators are expected to improve by next year and monetary and fiscal policy are becoming more supportive, all of which should support decent gains for share markets on a 6-12 month horizon.

Low sovereign bond yields point to a low medium-term return potential from global sovereign fixed interest. However, with a generally benign inflationary environment, an unresolved US-China trade dispute causing a flight to safety, and a general bias from central banks towards more accommodative stances; any upward pressure on bond yields is now likely to be subdued for the time being. Lower bond yields may persist, at least until the global economic environment shows signs of improved sentiment, momentum and visibility.

The outlook for global listed infrastructure remains positive, supported by robust economic activity and industry-wide structural investment tailwinds. In the North American oil, gas storage & transportation segment the shale gas revolution supports attractive volume growth in North America. Efforts to reduce carbon emissions have seen China’s liquefied natural gas imports surge and supply investment is still needed to avoid the forecasted shortfall by mid-2020. Additionally, we are seeing oil production outpacing takeaway capacity due to the years of delay in building new pipelines, and the value of storage assets, particularly in Canada, continuing to increase on the back of this bottleneck.

Global listed real estate markets are likely to be further impacted by short-term volatility that is affecting all risk assets, while investor focus remains on trade tensions, geopolitical uncertainty and concerns about slowing economic growth. However, listed real estate plays a defensive role in portfolios and is therefore likely to remain well supported while volatility is high. 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. Opportunities to acquire individual companies at attractive valuation levels may also arise as geopolitical developments lead to heightened volatility and diverging stock performance.

Australian shares remain exposed to global economic uncertainty and constrained growth in Australia. As a result, further short-term weakness is a high risk. Against this background, the Reserve Bank of Australia (RBA) has issued accommodative communications. However, valuations are reasonable, particularly when compared against low bond yields. Global growth indicators are expected to improve by next year and Australian monetary and fiscal policy are supportive, all of which should support decent gains for share markets on a 6-12 month horizon

In New Zealand, we expect growth to improve slightly on the back of fiscal stimulus, but for inflation to remain benign and the RBNZ to potentially implement another interest rate reduction later this year. That decision may depend on whether New Zealand business confidence extends its downward trajectory, having remained weak in the latest September survey despite the Government’s abandonment of a capital gains tax earlier and the RBNZ’s aggressive 0.5% rate cut.

New Zealand assets still look robust compared to their international counterparts, though New Zealand equities could be challenged in retaining their record-high valuation level if domestic growth and hence earnings prove softer than investors currently expect. Earnings downgrades appear more likely than upgrades for domestically-focused companies this year.

CASH AND FIXED INCOME

Both the OCR and 90 day bank bill rate were 50 bps lower in the September quarter.

The New Zealand 10 year Government bond rate was 47 bps lower on the quarter to 1.10%, spurred on by both the RBNZ easing and similar falls in global bonds markets. US and Australian 10 year government bond yields fell by 33 bps and 30 bps respectively over the same period.

New Zealand swap rates were 40-60 bps lower in the September quarter, outperforming moves in government bond yields. This saw the 10 year swap spread tighten 13 basis points to 0.09%. The 2 year-10 year swap curve flattened 18 bps to fresh lows of 26 bps in response to lower global yields.

Breakeven inflation rates fell 7 bps to 0.94% in the three months to September.

GLOBAL BONDS

After showing some signs of consolidating early in the September quarter, global government bond markets rallied into the widely anticipated move by the Fed to lower the federal funds rate range by 0.25% following its policy meeting on 31 July. Markets picked up momentum during August as an escalation of the US-China trade dispute eroded investor confidence in global economic growth prospects. The significant fall in bond yields prompted yield curves globally to flatten.

In September, bond yields initially moved higher amid indications that the US economy continues to create new jobs. However, yields subsequently retraced part of their rise after disruptive drone attacks on Saudi Arabian oil facilities saw the return of ‘risk off’ sentiment and the Fed lowered the target range for the federal funds rate by a further 0.25%.

Monetary easing also featured in Europe later in the period, where the European Central Bank announced a reduction in its deposit rate to -0.50% and a planned restart in November of its asset purchase plan at a rate of €20 billion per month. The US 10 year bond yield ended the quarter at 1.66%, while its German and Japanese counterparts ended at -0.57% and -0.21% respectively.

Global credit markets rallied strongly early in the September quarter, as central banks provided (and markets priced in further) accommodative monetary policy support, while reasonable US corporates’ earnings results overall also boosted markets. Positive sentiment was replaced by increasing market uncertainty during August, with an escalation in the ongoing US-China trade conflict, softer economic data and falling bond yields having some impact on credit markets.

Geopolitical influences continued to dominate credit markets in September, with the US-China trade dispute remaining as a key theme. Credit spreads initially tightened, as risk appetite returned to markets following the release of generally stronger economic data in the US. However, sentiment soured late in the quarter on the back of several major central banks easing monetary policy conditions. Credit markets saw significantly higher levels of new issuance during September, with the impact of political headlines on credit spreads being mostly limited to associated markets.

GLOBAL SHARES

International shares climbed higher in the September quarter, with the MSCI World ex Australia index rising by 1.50% over the period. Markets started the quarter positively amid generally good US corporate earnings and hopes of a favourable US-China outcome. A pull-back then occurred in August and some volatility emerged as speculation rose in regard to the sustainability of global (and particularly US) growth. Mixed messages on monetary policy from the Fed also didn't help.

Global markets then recovered to higher levels in September amid continued volatility. Drivers included central bank interest rate reductions and commentary (as the US Federal Reserve reduced the Federal Funds Rate range by a further 25 basis points to 1.75-2.0%), the drone strike in Saudi Arabia by Iranian-backed Houthi rebels, as well as some small but positive US-China trade developments. Against this background, the US S&P 500 index finished the quarter up by 1.70%, the Japanese TOPIX 100 index finished up by 3.39% amid suggestions of further monetary stimulus, and the European STOXX 50 index rose in the wake of new stimulus measures being announced by the European Central Bank.

Emerging markets, however, struggled during the quarter and underperformed their developed-market counterparts, with the MSCI Emerging Markets accumulation index finishing down by 2.07%. Geopolitical volatility, trade war fears and sovereign debt issues were all contributing factors.

NEW ZEALAND DOLLAR

The New Zealand dollar (NZD) weakened against most major currencies over the third quarter, with the US dollar (USD) and Japanese yen (JPY) gaining over 6%.

The NZD came under pressure following the RBNZ’s surprisingly aggressive 50 basis points cut, while the USD and JPY benefited from a rise in risk aversion and their perceived safe haven status.