Financial Keys - A member firm of Genesys Wealth Advisers

 




Economic and Investment Update - June 2016

by Lonsec Research

Summary of Key Views         

External factors drive uncertainty

It is certainly an interesting time for markets. As we have flagged in previous editions of the IOR our expectation has been that markets will be characterised by increasing levels of volatility and subdued growth. This has been the case when we reflect on the first half of 2016 which started off with a bang with markets falling on the back of uncertainty surrounding the Chinese market followed by a rebound in the oil and copper price which was positive for markets. This has been coupled with external factors such as the direction the US election will take, increased tension in the South China Sea and offcourse the prospect of the UK leaving the EU or ‘Brexit’ all contributing to market volatility.

If we look at overall market fundamentals we still don’t see strong valuation support in equity markets with lacklustre company earnings prospects on a whole. We do think that we’re at a tipping point where Central Banks are possibly realising that they have used up much of their ammunition in a bid to stimulate growth with limited effect. It is unclear what will be the catalyst for the market to pull back however we remain defensively positioned in our medium term asset allocation positioning preferring cash and liquid alternative assets ahead of equities. We will be looking to close up our underweight to equites market when we see the market pull back to around the 4800 level for Australian equities and 10% to 20% for global equities.

Market developments during May 2016 included:

Equities

Australian shares continued their run higher in May, with the S&P/ASX 200 Index finishing at 5378.56 points—its highest level since August 2015. Returns on Australian equities, as measured by the S&P/ASX 200 Accumulation Index, reached 3.36%, driven by large gains in the Health Care (9.47%), Information Technology (6.47%) and Consumer Discretionary (5.78%) sectors, with falls in Materials (-3.20%) and Energy (-1.85%).

The market was taken by surprise by the RBA’s May rate cut, with Australian shares moving 2.30% higher on the day of the announcement. Lower rates were supportive of shares, as was a declining AUD.

Australian small cap shares outperformed in May, with the S&P/ASX Small Ordinaries Accumulation Index returning 4.09%, continuing its run of outperformance over one- and two-year periods. Health Care sector shares overtook Industrials as the best performer over a 12-month period, returning 17.84%. Primary care shares were boosted in May by the government’s announcement that it would delay pathology bulkbilling if re-elected. The sector has also attracted investors due to large offshore income streams, which have benefited from a falling AUD.

US equities rose late in the month on the back of April home sales data, which showed the largest monthly increase since 1992, lifting shares by 2.08% and reassuring investors that the economy can withstand higher interest rates. The S&P 500 Index closed the month 1.53% higher, amid speculation of a Fed rate hike as early as June.

European markets were mixed, with a disappointing first-quarter earnings season and economic data still presenting an unclear picture. The German Stock Index (DAX) gained 2.23% in May, while the FTSE 100 Index dropped -0.18%, with the Brexit issue still the cause of much uncertainty.

Earnings in Europe have been mostly in line or below expectations, with weak global demand and recent appreciations in the EUR taking a toll. The ECB is due to begin the purchasing of corporate bonds in June, reducing the cost of debt for Eurozone companies and possibly prompting share buybacks.

Crude oil prices neared US $50/b at the end of May, with implied volatility declining despite an increase in unplanned supply outages. The MSCI World ex Australia NR Index gained 6.02% in May, with mixed results from Asian markets. The Nikkei 225 Index gained 3.41%, the Shanghai Shenzhen CSI 300 Index gained a modest 0.41%, while Hong Kong’s Hang Seng Index lost -1.20%.

Fixed Interest

Australian bonds returned 1.26% in May, with the RBA rate cut early in the month pushing Australian yields to record low levels. The Australian 10-year Treasury yield hit 2.22%, before ending the month slightly higher at 2.30%, significantly reduced from its 2.55% level prior to the rate cut.

Global bonds, as measured by the Barclays Global Aggregate Bond Index, returned 0.57% in May (in AUD hedged terms), with a modest expansion in investment grade yields. Monthly returns on global corporate investment grade and high yield bonds were -0.94% and 0.03% respectively. The Bank of America Merrill Lynch US High Yield Option-Adjusted Spread fell from 6.21 to 5.97 during May, alleviating recession worries.

Government bond yields underwent further compression in May, with central banks keeping rates on hold but maintaining flexibility. The US 10-year Treasury yield fell from 1.83% to 1.84%, and the UK 10-year Gilt yield fell from 1.60% to 1.43%. The German 10-year Bund yield fell from 0.27% to 0.14%, and the 5-year Bund yield moved lower from -0.29% to -0.38%. Japanese yields moved further negative, with the 10-year yield dropping from -0.08% to -0.12% since crossing the financial Rubicon in March.

REITs (listed property securities)

The S&P/ASX 200 A-REIT Accumulation Index retuned 2.63%, underperforming the market but still an attractive source of yield for investors, helped by a dovish turn from the RBA. Concerns remain about excessive gearing and overpricing in some cases, driven by persistently low interest rates. With the Federal Reserve leaning towards a rate increase, and the resulting decline in the AUD, investors may be moving away from the yield trade, although the weaker US jobs data is likely to keep the funds rate on hold for longer.

 

June 21, 2016
 
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