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Investment – Quarter ended 31 March 2020

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

Almost any data point or scenario covering the global economy and the health of global growth which was valid until mid-February, has, in the subsequent six weeks been thrown totally off course by the rapid escalation of the COVID-19 pandemic crisis. Therefore, it is of limited value to reprise in detailthe forces prevailing at the beginning of this year, except to the extent that they define a starting point from which economies and markets will be moving away from in the immediate future months.

For instance, full or near-full employment in the USA and New Zealand, as was the case when 2020 began, now defines the high-water mark from which the current and coming major strains on thelabour market will unfold. Thus, countries whose economies were performing comparatively well leading in to the current crisis enjoy somewhat more leeway, as their demand levels will take longer to decline in response to the lockdowns, health-protection measures, business closures and the like which seem probable to continue through much of the second quarter.

Upbeat fourth quarter 2019 US corporate earnings as they were reported in January, improving business sentiment and a phase one trade deal being agreed between the USA and China led equities higher for approximately the first half of the quarter ― until the global spread of coronavirus brought about a swift and sudden reversal. Concern over the human and economic impact has prompted emergency measures from international agencies, national governments and central banks.

Equity volatility is likely to persist as investors weigh the substantial impact on corporate earnings and global supply chains. Expect earnings to be hard hit in 2020, and in the next three to six months it is likely that even if public health measures are effective according to best-case scenarios, the impairment to expected US corporate earnings will probably exceed -20% on an annual basis. Investors are already testing balance sheet quality and sales vulnerability given the new reality, divesting securities deemedto be too greatly exposed from their portfolios.

This has led to market sentiment swinging between phases of intense concern/panic, and short,sharp rallies as news supports more positive potential resolutions. Much of these news flows are medical, rather than financial, in nature – it is far too early (as at 31 March) to fully measure the damage to employment, spending-power, profitability, investment and global sentiment that the COVID-19 shock will inflict before it has run its course.

On the stimulatory side of the equation, monetary and fiscal policies swung rapidly into action with unprecedented vigour in mid-March. Already-low developed market policy and short-term interest rates have been pushed downwards to zero or barely-positive levels.

Global equities dropped -13.7% in the March month and by 21.7% for the first quarter as a whole, while emerging markets were slightly weaker still, falling -15.6% in March and -23.9% for the quarter. Global listed real estate, having enjoyed very strong 2019 returns, reversed and logged a -27% decline in the first three months of 2019. With the failure of any oil supply agreement to emerge from February’sOPEC plus Russia forum, commodities tracked other growth assets sharply downwards, with the broad index declining -23.5% in the March quarter.

Meanwhile, income assets performed moderately well as portfolio diversifiers, although in some segments of the bond market they were a little less effective. This was because their correlations with growth assets proved higher than is typical in market shock situations and liquidity issues doggedsome parts of the market, making accurate price discovery difficult.

Global sovereign bonds returned 1.0% in the March month and 3.3% in the quarter, performing their diversifying function well. However, the global aggregate bond index was not as resilient, as it contains non-government securities in addition to the core ‘Treasury’ bonds. The Global Aggregate dipped -2.0% in the March month and logged a decline of -1.1% in the first quarter, which while not anything approximating the weakness in other asset types is still surprisingly soft. The prime cause of that has been that parts of the bond market wherein yields had been supressed for several years by a global hunt for yield and deliberate central bank policies, re-priced rapidly and logged historically-unusual negative returns. US high yield bonds, for instance, fell by -12.4% over the quarter while even high quality investment grade bonds experienced rising yields as investors preferred cash to any kind of risk and sold their most liquid holdings. Investment grade debt securities are in general much more liquid in the market than high yield or credit-rating compromised bonds.

After a tumultuous month of wide price swings, the US 10-year Treasury bond closed on 31 March with a yield of 0.67%. At the beginning of March, its yield had been 1.11% and in the course of the month it traded between a low of 0.32% and a high of 1.28%. The extremity of such swings in a major international benchmark security – US T-notes – reflects the extraordinary swings in both trading volumes and sentiment that has marked out the March quarter as an exceptional period in market history. Similarly wild price moves were recorded by the main equity benchmarks, with the US S&P 500 peaking on February 19 at 3,386 before plunging by over -30% to an intraday low of 2237 logged on March 23.

Central bankers are unwilling to allow extended bouts of weakness to develop and compound in asset markets. Nor do the monetary authorities wish to run the risk of crushing activity in their economies, already hit so hard by demand and supply shocks arising from the CoVd-19 crisis. More extremely easy monetary policy lies ahead for the foreseeable future.

Even prior to the crisis, the US Federal Reserve (the Fed) had clearly indicated it had no plans to commence an interest rate tightening cycle, until measured inflation had sustainably begun to rise. Now, the risk is that inflation will begin falling as the deflationary effects of COVID-19 mount. While it is unwilling to move to negative policy interest rates in the manner of the European Central Bank, the Fed has stated it is willing to buy quality bonds in unlimited fashion to suppress interest rate volatility, to extend emergency loans on a massive scale, and to arrange emergency FX swaps which allow global investors to access USD credit lines and thus prevent a counter-productive upward squeeze in the value of the US currency.

In summary, the top level macro environment was already uncertain due to the extent of the manufacturing weakness, but has now become perilous in the near-term (probably, the remainder of 2020). Awareness of this risk has led to the full range of fiscal stimulus announcements, most ofwhich will be deficit-financed. However, the authorities are judging that is a lesser price to pay than being too slow and thus allowing a long and intractable recession to unfold across the globe.

Global share markets are now expected to consolidate sideways, with bouts of volatility in both upward and downward directions, until much greater clarity on the trajectory of COVID-19 is better known, with the probable risk being some further downside. However, once any positive news flows about apotential exit date from the COVID-19 restrictions should assist in the formation of a durable market base.

Returns from cash and fixed interest are expected to remain low. Given the more moderate interestrate track, it seems likely that listed real assets such as property and infrastructure will eventually begin to rebuild to higher levels based on their much better valuation levels. Broader equity markets, however, may need longer to achieve the required degree of surety that the impacts of the crisis are moving into the past. Assets with more defensive qualities will continue to be sought after in highly uncertain times.

LOOKING AHEAD

Global growth indicators should improve once the health crisis of COVID-19 has resolved. The unprecedented size of stimulus packages provided globally should eventually be supportive forshare markets given the current low interest rate setting.

Global shares now appear to be significantly cheaper after the recent pullback related to the COVID-19 virus and relative to low bond yields, though given the lack of earnings visibility over the near-term, some caution is still warranted. While global economic activity is being sharply impacted due to the virus, we expect this to be transient in nature and likely to rebound at some point. Monetary and fiscal policy are also now heavily supportive, which is likely to continue to aid share markets.

Governments and central bankers around the world have announced unprecedented support and stimulus measures to ensure that the collateral damage to businesses and households is kept to a minimum through the shutdown period necessary to contain the spread of COVID-19. To date, these appear to be containing upward pressure on bond yields, with asset purchase programmes bycentral banks also likely to encourage yields to move lower.

Global listed real estate markets will likely be subject to near-term volatility, which is affecting all risk assets, due to deepened concerns about the spread of COVID-19 and the impact of the extensive containment measures on economic activity in the US and globally. When there is a fall in the risk-free rate because central banks around the world are loosening their monetary policy, investors often turn to listedrealestateas are liable alternative for yield and a defensive asset class. We expect this to happen once the extensive containment measures have been relaxed and economic activity begins to recover. Opportunities to acquire individual companies at attractive valuation levels may arise as geopolitical developments lead to heightened volatility and diverging stock performance. However, retail is expected to remain challenged and see further store closures. Growth in online shopping, connectivity and data usage are likely to provide opportunities in logistics and data centres through the business cycle.

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 and transportation sector shale gas revolution supports attractive volume growth in North America. In the short term, USoil production growth is expected to moderate given lower commodity prices, but in the long term, low-cost US production should continue to drive export growth as overall demand recovers.

The outlook for the transportation sector has changed rapidly for 2020 as COVID-19 is expected to have a substantial negative impact on short-term traffic trends. However, trends are expected to revert to normal in the coming one-to-two years. In the communications sector expect to see increased activity around 5G, as the race between countries, and between carriers, accelerates. Capital expenditure is likely to increase as new spectrum and antenna technologies are deployed in order to build functionality, as well as increase speeds and capacity on the network. In the transmission and distribution sector, drivers such as renewables, grid modernisation, safety and security, and electric vehicles, represent a secular tailwind for infrastructure investments

Australian shares will likely remain to be strongly influenced by global markets, as the impact of the COVID-19 virus plays out. Australia’s economic growth is likely to sharply fall, though similar to its international peers, this is likely to be temporary and bounce back at some stage. Valuations nowappear significantly cheaper after the recent virus-related falls and relative to low bond yields, though given the lack of earnings visibility over the shorter term, a degree of caution is appropriate. Highly supportive Australian monetary and fiscal policy should also aid markets over the medium term.

New Zealand equities will be challenged in retaining their still fairly high valuation levels as domestic growth and hence earnings will turn out to be substantially softer than investors had expected.Earnings downgrades will dominate for domestically-focused companies this year, as well as for many exporters as commodity prices remain depressed.

CASH AND FIXED INCOME

The Reserve Bank of New Zealand (RBNZ) cut its Official Cash Rate by 75 basis points (bps) to the effective lower bound of 0.25% on 16 March in response to COVID-19 related travel restrictions and ensuing lockdown. A week later the RBNZ announced a Large Scale Asset Purchases (LSAP) programme, targeting $30 billion of government bond purchases in an effort to keep bond yields at low levels to support the economy. The RBNZ also announced a Term Auction Facility (TAF) and Term Lending Facility (TLF) to assist market liquidity while bank capital changes were delayed a year and the core funding ratio cut to 50%.

The 90 day bank bill rate fell 80 bps to 0.49% in the March quarter following the RBNZ’s rate cut.

The 2 year swap rate was 74 bps lower to 0.53% over the quarter. Similarly, the 10yr swap rate fell 85 bps to 0.93% which saw the 2 year-10 year curve flatten back to 0.28%.

The New Zealand 10 year Government bond rate (April 2029) fell 57 bps to 1.08% over thequarter. COVID-19 threatens recession across much of the globe, with central banks responding in kind by embarking on quantitative easing programmes to help support lower yields ahead of a tsunami of expected issuance. Similarly, Australian and US 10 year bond yields fell by 60 bps and 25 bps respectively over the three months to March.

New Zealand government bonds underperformed swap rates with the 10 year swap spread falling 33 bps to -0.25%, the first time it has been negative since 2011. The key driver in this move was anticipation of increased government bond supplyto fund the significant fiscal stimulus requirement.

Breakeven inflation rates tightened 39 bps to 0.83% due to lower nominal rates and an expectedslowing in inflation.

GLOBAL BONDS

Global government bond yields drifted lower at the start of the year amid geopolitical tensions in the Middle East and the impeachment of US President Donald Trump. Yields subsequently accelerated lower as a rapid escalation in the human and economic impact of COVID-19 prompted global central bankers to significantly lower interest rates and governments to undertake unprecedented fiscal stimulus. Trading was characterised by heightened volatility, reflecting market concerns over the longer- term cost of the fiscal response, contrasting with optimism regarding its near-term social benefits.

The US 10-year bond yield ended the quarter 125 basis points lower at 0.67%. Similarly, theGerman 10-year bond yield declined by 28 basis points to -0.47%, while its Japanese counterpart ended the quarter unchanged at 0.01%.

Global credit spreads tightened modestly in early January, as market sentiment was buoyed by the signing of the Phase One trade deal between the US and China. Spreads tightened further in early February, as market sentiment was buoyed by generally favourable US corporate earnings reports. However, widening pressure took hold late in the month amid signs of tension in the primary issuance market.

The rapid escalation of the COVID-19 crisis in March pushed global credit spreads significantly wider and prompted an evaporation of market liquidity. Action by the US Federal Reserve to provide support via direct intervention in the US corporate bond market proved helpful, evidenced by a late-month surge in investment-grade issuance from a range of sectors.

GLOBAL SHARES

The March quarter was one of the worst periods ever for global share markets as the COVID-19 pandemic rapidly escalated fears around the globe. The MSCI World ex Australia index finished the period down by 20.0%, having briefly reached lows not seen since 2016 before finishing the periodwith a laterally.

Across regions and sectors, few stocks were spared from the falls, with some panic-selling evident, particularly later in the quarter as fundamentals undoubtedly took a backseat to momentum trading. In the final week of March, the market was able to recoup some of these losses as panic sellingsubsided. Price movements in many stocks were further exacerbated by the triggering of stop-losses, as well as some evidence of forced selling from funds in order to meet redemption requests.

A positive for shares later in the period was global stimulus levels promptly reaching unprecedented levels, as a swift, synchronised policy response was seen around the globe in the forms of monetary easing and enormous amounts of targeted fiscal stimulus. In many cases, packages included direct payments to residents and businesses.

Emerging markets couldn't escape the sell-off during the period and performed only marginally better than their developed market peers. The worst-performing emerging markets included those most exposed to commodities, with Brazil (and Latin America more broadly), South Africa, Russia and Mexico falling significantly. Asian markets fared relatively better, in particular China, as well as Taiwan and Korea. (All indices quoted in local currency terms and on a total-return basis, unless otherwise stated.)

NEW ZEALAND DOLLAR

The flight to safety caused by COVID-19 saw the New Zealand dollar (NZD) tumble, moving well below fair value. The immediate future does not present any obvious catalyst for a substantial or sustained rebound given the degree of negative trade and activity risk at quarter end.

The NZD, however, did show some signs of strength towards the end of the quarter, as it bounced off its March lows as global equities recovered slightly. The New Zealand dollar ended down 12.1% againstthe US dollar and 12.7% against the Japanese yen over the quarter.