Investment – Quarter ended 30 June 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.
June quarter data was broadly consistent with our expectation for higher global GDP growth in 2017. In the United States growth in activity is expected to rebound from the weak first quarter, though only back to a level that leaves growth for the first half of the year at around the recent trend of 2%.
Economic conditions continue to improve in Europe with the possibility that annual growth may exceed 2% in the near term, the first time it has done so since 2007. However, the biggest recent data improvement has been in confidence surveys (the so-called ‘soft data’), and we question the extent to which the actual activity indicators (the ‘hard data’) will be able to match those lofty expectations.
Consumer activity remains soft in Japan, though the recent build-up in inventories may see growth move above trend through the middle part of 2017.
In the United Kingdom the major development over the quarter was the general election which saw Prime Minister Theresa May lose her parliamentary majority. This has served to make the already complicated and uncertain process of Brexit even more complex and uncertain. While the UK economy came through the immediate post-Brexit period better than expected, heightened uncertainty risks undermining business confidence and general economic activity in the period ahead.
Much of the move higher in headline inflation since late last year has been due to rising commodity prices, exchange rate depreciation and the ‘base effects ’ of low numbers from the prior year dropping out of the calculation. It therefore seems likely that headline inflation would begin to move lower again as those impacts begin to wane and raise questions about the sustainability of higher headline inflation. Indeed, annual headline inflation ended the quarter on a downward trajectory in both the United States and Europe.
However, central banks are mostly concerned about trends in underlying or ‘core’ inflation. Towards the end of the quarter central banks were becoming increasingly hawkish, or inclined to wind back their easing or move to tighten monetary conditions.That reflects the recent pick-up in 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 bond yields in the last few days of the quarter.
The Chinese economy surprised with its strength in the first three months of the year, indicating that efforts to stabilise the economy have been to a large extent effective.Activity then slowed in the early part of the second quarter as the authorities moved to tighten credit conditions, though activity appeared to be stabilising towards the end of the quarter. So while GDP growth will slow over the June quarter, we don’t anticipate a sharp slowdown. Indeed, the priority for this year is for both economic and financial stability as the 19th Communist Party Congress at the end of the year approaches.
The Australian economy posted another quarter of weak growth in the three months to March. The risk is that negative disruptions to trade from cyclone Debbie will mean another weak (or negative) June quarter GDP result. The forward-looking capex data indicates that the outlook for business investment is still challenging in Australia and, along with weak consumer spending and slowing housing construction, will keep GDP growth subdued and below trend.
The recent slowdown in house price growth will be welcomed by the Reserve Bank of Australia but we think another rate cut is unlikely right now because the headline unemployment rate is low, employment growth is good and business surveys still look strong.
The New Zealand economy remains in good shape, though March quarter GDP growth failed to deliver the anticipated bounce back in growth following the weak December 2016 quarter. However, we anticipate a return to around trend in the next quarter or so. From the Reserve Bank of New Zealand’s perspective, lower than anticipated growth means less pressure on resources and therefore no change in interest rates for the foreseeable future.
Equity market valuations are fully priced, even allowing for an improved earnings outlook. This makes further sustainable gains dependent on the other catalysts. Although in the US the Republican agenda is progressing in fits and starts, meaningful tax reform appears to be receding into the future.
Our economic view supports an expansionary phase ahead for corporate activity such as mergers and acquisitions and share buybacks, which should buoy markets. However, there is a greater awareness that ultra-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 spiked higher over the last two quarters to 2.2%, back in the top half of the 1-3% target band. But underlying or ‘core’ inflation is holding at around 1.5%, still short of the 2% mid-band of the target range. The next move in the OCR is up, but the RBNZ is expected to remain on hold until well into 2018.
The RBNZ held the official cash rate (OCR) unchanged at1.75% at its June Policy Review. This was expected by the market. However, the RBNZ maintained its neutral policy stance and said risk remained balanced around the next move in the OCR.
Low volatility and expectations around a strong New Zealand dollar helped the demand for bonds as offshore investors continued to favour the carry trade in New Zealand. The New Zealand government returning to a surplus in the May Budget likely also contributed to demand.
Short maturity yields continue to offer compelling carry but this trade is closer to the end game.
Money market rates were flat over the quarter. The 90 day bank bill rate fell slightly to 1.98%, reflecting there has been no change to the OCR in the last three months.
The NZ Government bond index declined over the June quarter reflecting global movements. The index fell 1.35% in the quarter driven by the decline in government bond yields.
Swap spreads widened for all maturities. The shape of the yield curve flattened with larger rate decreases for longer maturities. The government bond curve also flattened.
Overall credit growth dipped a little over the quarter in response to low interest rates, with housing the main driver of credit growth. Credit investment is still favoured in a low interest rate environment with a benign economic outlook. However, New Zealand credit issuance will likely remain strong into 2017 driven by bank maturities, credit growth and repayment of bank branch funding by major bank subsidiaries.
Inflation linked bonds slightly outperformed nominal bonds for the last three months. Inflation linked bonds now offer a yield advantage over nominal bonds with the recent pick-up in actual inflation and seeing it move above break even inflation rates.
Global government bond yields moved lower in April before trending higher over the remainder of the June quarter.
Yields were largely unaffected by the 0.25% increase in the US Federal Funds Rate announced in mid-June, as this had been largely factored into market prices. However, European Central Bank President Mario Draghi sparked a quarter-end flurry of activity when he said that the “threat of deflation is gone and reflationary forces are at play”. Although he subsequently attempted to downplay the comment, yields rose strongly over the remaining days of June.
US 10-year Treasury bond yields ended the quarter at 2.30%, with comparable maturities in Germany and Japan ending at 0.47%, and 0.09% respectively.
International equities had a solid June quarter, with sentiment still dominated by optimism, despite lingering geopolitical concerns around the globe.
Global shares were up by 2.7% as measured by the MSCI World Index in local currency terms.
The US share market reached yet another record high during June. However, it pulled back toward the end of the month as central banks made some further comments around reducing fiscal and monetary stimulus that were perceived as more hawkish than expected.
With some stronger than expected economic data being released, Asian markets did better than most; Japan’s TOPIX 100 Accumulation Index returned 6.8% and the Chinese CITIC300 returned 7.6%. The UK’s FTSE 100 Accumulation Index also climbed during the period, as the lower pound continues to assist many British companies’ earnings.
Although the new US administration has been broadly positive for stocks, there remains considerable uncertainty regarding future actions, particularly in the implementation of political intentions. 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, the growing inflationary impulse, and the ultimate feed through to nominal growth and nominal corporate earnings. Japanese and European equities continue to be our pick to see the better performance in this macro environment.
NEW ZEALAND DOLLAR
The New Zealand dollar (NZD) strengthened against all the major currencies in the June quarter except against the Euro where it weakened 1.8%. The lift in the NZD over the period was just as much about weakness in other currencies as much as the strength of the domestic economy.
The US rate hike was overshadowed by disappointing USCPI data causing the US dollar to weaken. In saying this, the relative strength of the New Zealand economy, rising budget surpluses and strong demand for our commodities did provide a supportive backdrop to help push the NZD higher.