Investment – Quarter ended 31 December 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.
The mid-year period of 2019 revealed starkly conflicting views about the health of global economic growth, with market sentiment swinging between bouts of concern and positive resolutions. However, the fourth quarter has decided the year as a whole in favour of the bulls. Low interest rates and some clarification of key international risks have been supportive.
Global equities rallied 8% in the final three months of the year, while developed market government bonds gave up some of their gains accrued during the mid-year growth slow-down. Several factors helped drive equities and bond yields higher in the last quarter of 2019. Firstly, the US and Eurozone manufacturing business surveys picked up slightly from their September level in October and November, although fell in the US in December. Secondly, the service sector business outlook surveys (which have a higher impact for GDP growth) also improved, through to year-end. Most importantly, despite headlines involving large job cuts at some companies in Europe, overall employment has held up well, and in the US more than 200,000 jobs were added in November, keeping the US unemployment rate at 3.5% the lowest since 1952.
The pick-up in the service sectors, and the resilience of overall employment to the weakness in manufacturing, has helped restore market confidence that a recession is not in fact imminent. This led to a loss of credibility in some of the more gloomy forecasts that commentators and media has been stressing during the darker moments of the year’s US-China trade tensions. Investors who had positioned for no trade conflict resolution, additional tariffs, or even diplomatic escalation by the US began to capitulate and as December continued, exited safe-haven positions in favour of equities, commodities, and trade-sensitive currencies such as the New Zealand dollar (NZD).
The overall improved market sentiment assisted the New Zealand equity market to a 5% gain in the fourth quarter, though much of that rise occurred in the month of December alone. For the 2019 full year New Zealand equities remained at the top of the global performance table, recording a 30% rally. This placed the domestic market return 2% ahead of the US S&P 500’s 2019 gain but 4% below the remarkable result from the technology-oriented US NASDAQ index, which surged by just under 35% over for the full year. Most European share markets enjoyed annual returns in the mid-20% region, with the EuroStoxx aggregate gaining 25% overall. Among the markets that recorded strong, but less stellar, 2019 returns were Japan’s Nikkei and the Australian ASX index, both close to 18%.
The fourth quarter saw two significant political risks avoided, at least for now. US tariffs on China were scheduled to increase on 15 December but a phase one trade deal avoided that potentially highly-disruptive outcome and provided a significant relief for equity markets. The fact that the US chose not to impose tariffs on European Union (EU) automobile exports also helped support global equities.
How long the trade peace will last is uncertain, but the market ended the quarter cheered by the fact the worst case scenario for trade had, been avoided. The fact that consumer activity around the world remains quite robust, despite a major slowdown in the manufacturing sectors, has soothed investor nerves. The single quarter-percent additional reduction in the key US Federal Funds interest rate at end-October, accompanied by the US Federal Reserve (the Fed) signalling that no further adjustments to the policy rate were foreseen for some time ahead, has helped nurture a resumed ‘Goldilocks’ economic mood where growth and inflation are mutually supportive of equity market gains and stable bonds.
The world’s 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 actual recessionary conditions emerge at a future time.
In terms of policy action, both the Fed and the European Central Bank (ECB) started to expand their balance sheets modestly. By no means all of the world’s monetary experts are convinced that negative policy interest rates work, and some (particularly in Europe) are noting their negative effects like the inflation of property bubbles and the undermining of banking sector lending incentives and profitability.
The end of 2019 also saw a transition at the helm of the ECB from long-time President Mario Draghi to Christine Lagarde, the respected former head of the International Monetary Fund (IMF). In the UK, it was announced that Bank of England’s Chair Mark Carney will be replaced by Andrew Bailey, currently head of the Financial Conduct Authority. Given the problems that have occurred in UK banks over the last decade, this is reassuring, particularly considering the complexities that will accompany the country’s departure from the EU.
The large parliamentary majority for the Conservative Party in the UK’s December election removed the threat of nationalisation for some utility companies, which assisted the infrastructure sector there. The utility sector in the UK rallied 6% following the election result. The election result meant that the UK could pass a European Union withdrawal bill, activating a transition period which will last until the end of 2020.
The combination of these election outcomes helped lift UK stocks and currency over the quarter. However, the pound’s initial rally after the election result soon faded when it was announced that there would be no extension to the transition period beyond the end of 2020. This gives the UK government a very short period of time to agree a free trade deal with the EU allowing the country to then open independent trade negotiations with non-EU nations such as the US, Canada, African and Gulf nations, and Australia/New Zealand.
Given the continuing uncertainties, it was unsurprising that the global manufacturing indicator flat-lined in December after having improved in November. While manufacturing indicators in emerging markets improved further, this was offset by a weaker result in developed markets, particularly for the US ISM survey, which dipped to its lowest since June 2009. A similar divergence was observed in the new orders index – the key forward-looking subcomponent of these surveys – as declining new orders in developed markets offset the improvement in new orders in emerging markets.
The continued but slow-moving recovery in the emerging economies, which are more exposed to trade, as well as the rebound in Korea’s exports in December, suggest a gradual re-acceleration for the manufacturing and trade sectors, which will help to support a recovery in global growth from early-2020 onwards.
In the near term, trade tensions have abated with the proposed signing of the preliminary US-China deal on January 15, but geopolitical tensions in the Middle East have increased as a risk to the global outlook, and the price of oil is likely to remain comparatively elevated. In anticipation of the improving outlook and assisted by a weakening in the US dollar, emerging market equities rallied sharply during the fourth quarter of 2019, gaining more than 11%. As emerging market equities had broadly lagged developed markets for much of 2019, their performance surge in the final quarter left the asset class up 15% for the year as a whole, lagging their developed market peers by between 10% and 15%.
The Asia-Pacific regional economic chill induced by the recent trade war dynamic led to interest rate cuts from both the Australian and New Zealand central banks in the mid part of 2019. However, recent months have seen a moderate rebound in housing market activity in both countries, helping shore up fragile consumer and business confidence. In New Zealand, the Reserve Bank of New Zealand (RBNZ) has held the Official Cash Rate at 1.0% in recent months, while the Reserve Bank of Australia (RBA) has similarly kept rates unchanged at 0.75% pending more data clarity on current economic risks.
In spite of the better sentiment that emerged in the fourth quarter of 2019, risks to the global outlook are still skewed slightly to the downside. Even if a cease-fire in the trade war holds, other parts of the world are still contributing to global geopolitical uncertainty. Tensions between Iran, the United States and Saudi Arabia are rising in the Gulf with attacks on Saudi oil production facilities following on from attacks on oil tankers and Iran also backing insurgents in Iraq who have attacked the US embassy in Baghdad – breaking a diplomatic taboo. US retaliation with drone strikes in early 2020 is likely to escalate the cycle of unnerving military incidents in the Middle East.
Central bankers still appear unwilling to allow extended bouts of weakness in asset markets, which is therefore still rewarding a ‘buy-the-dips’ approach for investors. Nor do the monetary authorities wish to run the risk of stalling their economies, preferring to either ease policy, buy bonds to suppress interest rate volatility, or make comments calculated to lower their domestic currencies and thus spur growth through the export channels.
The top level macro environment was uncertain due to the extent of the manufacturing weakness, but some issues keeping markets unsettled throughout 2019 have recently diminished.
- President Trump’s trade war with China eased. Recent positive news suggests the US will want to bring this to a conclusion sooner rather than later. Some détente is building on both sides, and a January partial deal is on track.
- Growth slowed in China, but no more than expected. However, amid concerns about a more precipitous decline, China’s government has responded by removing restrictions on lending introduced earlier in 2019 for prudential reasons. Chinese producers remain cautious even as the government has moved more clearly to credit stimulus.
- President Trump’s political woes remain as the campaigning towards the November 2020 election intensifies. The Republican’s loss of the House of Representatives means policy-making will remain confrontational, an impeachment process is underway, and growth-boosting measures like tax cuts are ruled out. Impeachment looks unlikely to succeed but will be a distraction until it is resolved by the Senate. Meantime, expect more distractions.
- Brexit has become clearer with the UK December election result, with 2020 likely to see full-on preparation mode in the UK during the transition period.
- A lower US dollar in the fourth quarter eased pressure on emerging markets, especially those with ongoing structural weaknesses and/or high levels of US dollar denominated debt. This has helped trigger a rally in emerging assets and currencies, which had become undervalued following two years of global trade policy uncertainty.
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. Nevertheless, a period of supressed investment growth is given political uncertainties will need to fade and be replaced by positioning for cyclical re-expansion. 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.
Heading into 2020, global share valuations continue to look broadly reasonable, particularly when compared against low bond yields. Global growth indicators are expected to improve over the medium term and monetary and fiscal policy have become more supportive, all of which should support share markets on a 6-12 month horizon. Global shares are expected to see total returns around 9.5% in 2020, helped by better growth and easy monetary policy.
Although the US and China have reached a preliminary trade deal, there remains a downside bias in global bond yields. The last few months have seen significant uncertainty injected into the global outlook amid a broader slowdown in activity. Sentiment has become more cautious, with bond markets pricing in an increased likelihood that further monetary stimulus will be required. Trade tensions have been the primary cause but an ongoing slowdown in global capital expenditure has contributed. Low starting point yields and a slight rise in yields through the year are likely to result in low returns from bonds.
The outlook for global listed infrastructure as an asset class 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 developing economies’ liquefied natural gas imports surge and supply investment is needed on a global basis to facilitate the increasing demand for cheap gas. In the utilities sector drivers such as renewables, grid modernisation, safety and security, and electric vehicles represent a secular tailwind for infrastructure investments. Additionally, expect to see increased activity around 5G, as the race between countries, and also between carriers, accelerates. Capital expenditure spending 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.
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 are likely to continue to be largely driven by global markets, despite constrained growth in Australia. The government is thus likely to introduce accommodative policy changes and the RBA will likely experience increasing pressure to further reduce the interest rate, particularly as inflation remains below target. The Governor of the RBA has indicated quantitative easing may be considered once the cash rate reaches 0.25%. The consensus is this threshold will likely be reached sometime in 2020 (despite the RBA's optimism) and is thereby supportive for Australian shares.
In New Zealand, the GDP growth outlook has greatly improved in recent months as both business and consumer confidence recovers in response to easier financial conditions. Rising house prices and increased infrastructure spending will further support the outlook.
Headline inflation is expected to lift above 2% in early 2020, up from 1.5% at present, before tracking at 1.7-2.1% in the year ahead. This should support a lift in inflation expectations from their lows – previously a key focus for the RBNZ.
The RBNZ is expected to leave its Official Cash Rate (OCR) on hold at 1.00% when it next meets in February. Indeed, the hurdle to further cuts has increased in recent months as the activity outlook improves, with the RBNZ’s lowering its estimate of potential growth (and therefore a lower economic speed limit required to generate inflation), and as core inflation gradually lifts towards the mid-point of the band. A higher New Zealand dollar, potential rate cuts in Australia and rising geopolitical concerns could still see the RBNZ return to the cutting table around mid-year. For now hikes are off the table.
CASH AND FIXED INCOME
The 90 day bank bill rate increased by 14 basis points (bps) to 1.29% in the three months to December as the RBNZ left the OCR on hold.
The NZ 10 year Government bond rate increased 56 bps to 1.65% a six month high in the December quarter. This compares to a trough of 1% in early October. Yields were higher in response to both the improved domestic outlook and improved global market sentiment as tail risks around Brexit and US/ China trade concerns subsided. Similarly, Australian and US 10 year bond yields increased 25-35 bps over the quarter.
New Zealand swap rates were 33-58 bps higher over the December quarter, with the 2 year-10 year curve steepening 25 bps to 0.52%.
Swap spreads were little changed, with the 10 year swap spread tightening 2 bps to 0.08% over the quarter.
Breakeven inflation rates increased 30 bps to 1.23% in the three months to December, benefiting from both a rise in nominal yields and signs of emerging domestic inflation pressures.
Global government bond yields trended higher for the majority of the December quarter, with markets buoyed by optimism stemming from improving trade relations between the US and China which could lead to a resolution of their long running trade dispute. At the same time, the risk of a hard Brexit in the UK was reduced in December following the resounding re-election of Prime Minister Johnson’s Conservative party.
In a period where markets experienced bouts of volatility, global central banks continued to provide stimulatory monetary conditions, with the US Federal Reserve cutting the Federal Funds Rate earlier in the quarter by a further 25 basis points to 1.50-1.75%. However, the central bank did signal a pause in their interest rate easing cycle, with any future accommodative moves to be considered in light of the influence of economic data.
The global economic backdrop was further supported later in the period by improving data in the major global economies such as China, which provided further tentative evidence of a global economic upturn. The US 10-year bond yield ended the quarter at 1.92%, while its German and Japanese counterparts ended at -0.19% and -0.01% respectively.
Global credit markets generally performed well in the December quarter, with credit spreads moving tighter overall over the course of the period. Geopolitical influences continued to be a significant influence on markets, which benefited from a turnaround in sentiment as optimism returned with concerns around global trade dissipating. This culminated later in the period with the US and China reaching a Phase 1 trade deal. Sentiment was further bolstered by the Conservative Party’s victory in the UK election during December, which greatly reduced the likelihood of an economically disruptive separation from the European Union.
Credit markets were also supported by further accommodative monetary policy on the part of central banks, as well as some improving data on the economic front, particularly in the latter part of the period, which showed positive signs of a global economic upturn in the major global economies such as China.
Global share markets were up significantly over the December quarter, with the MSCI World ex Australia Index finishing the period up 7.66%. Drivers included strong US corporate earnings, the announcement of a ‘phase one’ trade deal between China and the US in December, prevailing stimulatory central bank policies around the globe and an emphatic election result in the UK (leading to an apparent resolution to ongoing Brexit delays).
Against a backdrop of a solid US economy with generationally low unemployment, these factors combined to spur optimistic investor sentiment around the globe. Indices that were notably strong included the US S&P 500 (up by 9.07%), the Chinese S&P/CITIC 300 (up by 7.13%) the European DJ Euro STOXX 50 (up by 5.35%) and the German DAX (up by 6.61%).
Emerging markets, meanwhile, produced some of the strongest returns of all. The MSCI Emerging Markets index finished the quarter up by 9.54% on improving trade relations between China and the US, strong commodity prices and broader positive market-sentiment. Within emerging markets, Asia led the way with Chinese, Taiwanese and Korean equities posting strong gains. (All indices quoted in local currency terms and on a total-return basis, unless otherwise stated.)
NEW ZEALAND DOLLAR
Despite an overwhelming consensus for a 25 basis point cut, the RBNZ surprised the market at its November meeting by keeping its Official Cash Rate unchanged at 1.00%. This supported the New Zealand dollar which ended 7.6% higher against the US dollar, 3.2% against the Australian dollar and 8.2% against the Japanese yen over the quarter.