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Investment – Quarter ended 30 June 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

The rapid escalation of the COVID-19 pandemic crisis and its impact on economies, communities and profits, continued to dominate markets and political discussion throughout the second quarter. The upheaval, coming after a very positive 2019 for global asset markets, has been dramatic, not only in the 35% drop in the US and other global stock indexes seen after their mid-February peaks to the trough in the last week of March, but equally in the extraordinarily vigorous rebound in the June quarter. This has delivered an unprecedented swift and large share market recovery from what had been widely described as a ‘bear market’ in early April. The puzzling element in this equity market rebound for investors is how it appears increasingly detached from the underlying global economic reality, which continues to be uncertain, seriously constrained and fragile.

Admittedly, some countries that were affected in the early COVID-19 outbreak, such as China and Continental European nations, have tentatively begun lifting restrictions and lock-down conditions, allowing domestic economic activity to slowly resume. However, many borders remain largely closed, and international travel is being widely shunned (in cases where it is even allowed by government health regulators).

The rapid change in the profitability of certain industries due to restrictions on movement (eg commercial property, airports) have held back the listed real asset sectors of the equity market. Nevertheless, the global real estate and global listed infrastructure indices have managed a rebound of almost 12% over the last three months. Infrastructure was also burdened by its energy pipeline and transportation components. A partial recovery in the oil price, and low interest rates, should allow more gains.

The most obvious impact of COVID-19 is arguably on labour markets and unemployment levels around the world. In the US, the unemployment rate surged from a 51-year low of 3.5% in February to a post-World War II high of 14.7% in April. In May, the re-opening of some facilities allowed for some re-hiring and the rate dipped slightly. All the same, the state of the US labour market will be a critical issue in the November election and could go against the President. The massive policy response, co-ordinated across fiscal and monetary stimulus in the US and around the world, will shape the global economy for years to come.

Unprecedented stimulus and the potential for a few years of non-inflationary growth suggest investors may earn a larger-than-normal equity risk premium going forward. However, the US still has relatively high coronavirus infection rates, so a second wave is an obvious downside risk as is the US November federal elections, which will become a major focus for markets if the Democratic nominee for president, Joe Biden, takes a decisive poll lead. So, share markets are supported by easy liquidity but challenged by weak profits.

Europe’s disadvantage heading into the COVID-19 crisis was its lack of scope to ease monetary policy, but the policy response has taken a side route by delivering more quantitative easing than had been expected. The European Central Bank increased its asset-purchase programme by over 12% of GDP (gross domestic product). Germany’s fiscal and monetary stimulus has been among the world’s strongest.

Europe’s exposure to financial stocks like banks and insurers, and the industrials, materials and energy sectors, gives it the potential to outperform in the second phase of the recovery, when global economic activity picks up and yield curves eventually steepen. However, it must be said that this eventuality could be several quarters into the future, absent a COVID-19 vaccine.

In the UK, severe economic uncertainty caused by a high infection and mortality rate has been compounded by stalled international trade and continuing Brexit negotiations. This is reflected in the FTSE 100 Index, which has been the softest performer of the major developed stock indices. Having said that, the UK FTSE index returned 9.6% in the June quarter – a fact which underscores how strong the rebound was in the other major equity markets. The EuroStoxx 50 Index gained almost 18% for the quarter, in line with the global markets gain of 18.5%.

Emerging markets were equally strong, despite a more intractable problem with virus containment due to comparatively weak infrastructure. The emerging markets Index rallied 18.1% in the three months to June, aided by a rebound in Chinese shares.

China’s recovery from the COVID-19 crisis has continued through the second quarter of 2020, with the services sector starting to catch up to the manufacturing sector. The Chinese government has also announced further stimulus measures, issuing coupons to households to encourage spending, while the People’s Bank of China is making monetary policy more accommodative. However, tensions over Hong Kong reaccelerated, once lockdowns eased.

In Japan, fiscal policy has also turned supportive, with the government recently approving a second stimulus package worth close to 117 trillion yen ($1.7 trillion NZ dollars). However, the country’s structural weaknesses in terms of monetary policy and persistent deflation mean it will likely remain an economic laggard relative to other developed economies. This longer-term factor did not depress Japan’s equity returns, which logged a robust 18% in the June quarter.

Remarkably, the US 10-year Treasury note closed on 30 June almost unchanged from its yield level on 31 March with a yield of 0.66%. However, this belies a good deal of pricing movement. At the beginning of March, its yield had been 1.11% and in the course of the second quarter the 10 year yield traded as high as 0.90% and as low as 0.57%. The extremity of such swings in a major international benchmark security reflects the extraordinary swings in both trading volumes and sentiment that has marked out the first half of 2020 as an exceptional period in market history.

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 COVID-19 crisis. More extremely easy monetary policy lies ahead for the foreseeable future.

Australia has been successful in containing the coronavirus through a combination of border controls and lockdowns. High household debt levels and a slow growth in wages, however, translate to a very cautious consumer – a headwind to the nation’s recovery. House prices have recently been falling in Australian cities, indicating nervousness. Australian shares rewarded the monetary and fiscal support with a 16.5% June quarter rally, which was only slightly behind the New Zealand equity market’s 16.9% quarterly gain.

LOOKING AHEAD

Pressure on global economies has started to ease as various lockdowns and restrictions have been lifted, and aggressive monetary and fiscal policies continue to provide support. Amid changing consumer dynamics, many companies will likely struggle for some time, while stronger businesses could emerge from the COVID-19 crisis with greater market share. However, fears of a ‘second wave’ of COVID-19 infections persist and are temperamentally traded on, thereby presenting potential pullbacks, although we believe the long-term market trend will remain upward.

After a strong rally from March lows, global shares remain vulnerable to short-term setbacks given uncertainties around coronavirus, economic recovery and US/China tensions. But on a six to 12 month horizon, shares are expected to see good total returns helped by a pick-up in economic activity and massive policy stimulus.

The outbreak of COVID-19 has likely triggered a global recession and policy makers around the world are having to respond with dramatic levels of monetary and fiscal stimulus. The emergence of COVID-19 within an ongoing weak state of fundamentals and consistently weak inflation, as well as the adoption of yield curve targeting and quantitative easing monetary programmes, continues to argue for a bias towards long duration positions, although as global cases peak and the first wave is brought under control we expect there may be some risk asset retracement.

Global listed real estate markets will likely be subject to near-term volatility, which is affecting all risk assets, due to the impact of extensive COVID-19 containment measures on economic activity globally. We have reduced risk in segments that are directly impacted, such as lodging, and we will continue to assess and actively manage these risks, as well as those in segments that are indirectly impacted as additional information becomes available.

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 listed real estate as a reliable alternative for yield and a defensive asset class. However, this has not occurred yet due to the challenges some segments of real estate face because they are usually places where people gather. 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, especially those in peripheral locations with commoditised market propositions. Growth in online shopping, connectivity and data usage are likely to provide opportunities in logistics and data centres through the business cycle.

The combination of the COVID-19 pandemic and the volatility in commodity prices presents a challenging environment for global listed infrastructure. However, our long-term outlook for the asset class remains positive, supported by a recovery in economic activity and industry-wide structural investment tailwinds.

In the North American oil, gas storage & transportation segment, we believe US oil production growth in the short-term will moderate given lower commodity prices, reflecting the impact of the COVID-19 pandemic on overall demand. We also believe the investment community will assess energy and production counterparty exposure with additional scrutiny, due to the potential pressure on spreads, volumes, and tariffs on incumbent pipelines. However, in the long term, low-cost US production will continue to drive export growth as overall demand recovers.

The transportation segment outlook has changed rapidly for 2020 as COVID-19 will have a substantial negative impact on short-term traffic trends. We ultimately expect trends to revert to normal in the coming three-five years, and now see clear valuation upside for the transportation sector.

We are positive on the theme of digitalisation, connectivity and data usage for the communications segment, but valuations remain elevated. Within the sector we favour European and developing economies’ assets over the US, due to more supportive valuations. Although we remain cautious on the utilities segment due to relatively unattractive valuations, we see some opportunities in the transmission & distribution segment, with drivers such as renewables, grid modernisation, safety and security, and electric vehicles representing a secular tailwind for infrastructure investments.

Australian shares will likely continue to be primarily driven by global markets. Like its international peers, Australia’s economic growth has slumped, though evidence of a bounce-back is emerging. Australia’s greater degree of government stimulus (relative to other countries) should help support Australian shares, though there are some near-term risks, such as souring trade relations with China and a lack of earnings visibility for many companies.

The New Zealand economy still faces challenging times and there is significant potential for a reality check once the corporate earnings season begins. At a corporate level, the outlook remains very mixed and market volatility is expected to continue to be elevated. In addition, the well published flood of retail investors into the equity markets appears to be pushing markets well beyond even the most optimistic outcome scenario.

CASH AND FIXED INCOME

The Reserve Bank of New Zealand (RBNZ) reaffirmed in June that the OCR would remain on hold at 0.25% until at least April 2021 – the date at which banks are expected to be operationally ready for negative interest rates if needed. The RBNZ also signalled it was open to increasing its $60 billion Large Scale Asset Purchase (LSAP) programme in its August Monetary Policy Statement (MPS) if further policy easing was required. We have doubts around the efficacy of negative rates but wouldn't fully discount a move in that direction in 2021. With the activity and inflation outlook somewhat clouded, we would expect the RBNZ to increase its bond purchase programme in the coming quarter if further easing was deemed necessary.

The 90 day bank bill rate was 19 basis points (bps) lower to 0.30% in the June quarter as markets continued to adjust to the RBNZ’s earlier rate cut, and as a significant boost to market liquidity led to a compression in bank funding spreads.

Similarly, the 2 year swap rate fell 32 bps to 0.21% in the June quarter as markets continued to price in some chance of further easing. The 2s10s swap curve steepened 12 bps to 0.52% as the 10 year swap rate fell by only 20 bps over the same period (to 0.74%).

The NZ 10 year Government bond yield (the May-2031 bond) fell 31 bps to 0.93% over the three months to June as demand from the RBNZ’s bond buying programme initially exceeded increased supply.

The 10 year swap spread increased 11 bps over the June quarter (from -0.25% to -0.14%) as RBNZ bond buying supported overall demand amid significant market volatility in earlier months.

The 10 year breakeven inflation rate tightened 8 bps to 0.75% over the three months to June due to the slump in activity and lower energy prices.

GLOBAL BONDS

Global government bond yields moved higher in early April despite the US Federal Reserve only slightly slowing its pace of US government bond purchases, which had capped upward pressure on yields over prior weeks. Yields subsequently traded sideways through most of May despite shifts in sentiment variously associated with the tentative easing of lockdown restrictions, economic stimulus measures and speculation regarding progress in the development of a COVID-19 treatment. Favourable US economic data provided renewed upward momentum in early June, however yields subsequently reversed course as economic sentiment deteriorated amid fears of a ‘second wave’ of the pandemic.

The US 10-year bond yield ended the quarter one basis point lower at 0.66%. In contrast, the German and Japanese 10-year bond yields rose by one basis point to -0.46% and 0.02% respectively.

Global credit spreads tightened over the June quarter. The tightening trend was initially prompted by the US Federal Reserve extending its bond buying programme to include high yield bonds and increasing the size of its Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility from US$200 billion to US$750 billion. Subsequent tightening momentum was reinforced by the market’s ongoing expectation of further policy support measures on the part of central bankers, which outweighed the impact of renewed trade tensions between the US and China, and a surge in COVID-19 infections in the US which prompted several states to partially reintroduce lockdown measures.

GLOBAL SHARES

Global shares surged back from their March lows over the June quarter, with the MSCI World ex Australia index finishing the period up by 18.5%. This came as virus-related market panic progressively dissipated and lockdowns began to be lifted. Death rates, while high, were also far below previous 'worst-case' scenario estimates.

As businesses reopened, most governments maintained (and in some case even increased) their stimulus programmes on offer, leading to continued support for share prices. Various economic indicators also appeared to confirm a global economic recovery was indeed underway, reflected in sharp rises in business confidence and falling rates of unemployment.

Contrary to the markets' bullish sentiment, the list of concerns on many investors' radars only appeared to grow, with issues such as civil unrest in the US, the upcoming US election, Chinese tensions (with Hong Kong, the US, India and even Australia) and an apparently rising risk of a 'second wave' of COVID-19 infections (particularly in the US) leading to a growing sense of unease. Perhaps most pressingly for shares, corporate earnings visibility remains low, resulting in many businesses being hard to value, particularly over the short-term.

Emerging markets meanwhile were also very strong, driven by the same trends as broader developed markets to return 16.7% over the quarter as measured by the MSCI Emerging Markets index. Commodity-sensitive markets such as South Africa and Brazil generally fared well, as did export heavy markets such as Taiwan and South Korea. (Indices quoted in local currency terms and on a total-return basis, unless otherwise stated.)

NEW ZEALAND DOLLAR

The risk-on environment had an impacted on the New Zealand dollar (NZD) which gained five cents against the US dollar over the quarter as global economies reopened their borders. Throughout the volatility of the first half of 2020, the NZ/US cross-rate finished June only a few cents below its 2019-year end level.

The NZD declined from its March peak against the Australian dollar, with the cross-rate closing at 0.935.