Economic and Investment Update - November 2016

Summary of Key Views

The big rotation

The US election has come and gone, and despite markets getting the wobbles in the lead up to the election it has certainly been ‘risk on’ since the result. Are we experiencing a ‘Santa Claus rally’, or is this the start of something more structural?

For some time, we have discussed the so called ‘bond proxy’ sectors which have dominated market returns for the past several years. Sectors such as REITs and ‘defensive’ equity sectors such as telcos, healthcare and infrastructure have all benefited from a low interest rate environment. However, this dynamic has been gradually unwinding as economic growth figures have been picking up for the last nine months or so, and the recent spike in bond yields post the US election has accelerated the rotation out of these sectors towards more cyclical sectors, most notably resources and materials as well as the banks. Over the past three months alone the resources sector has returned 10.38% (S&P/ASX 300 Resources Index) compared to healthcare, which returned -9.85% (S&P/ASX 300 Healthcare Index) as at 30 November 2016.

Indicative of this trend has been the price of copper, which has risen 26.7% (LME Copper 3 Months AUD). There is a growing belief that the US Federal Reserve will be more emboldened to raise rates following a Trump election win, with one rise already announced, and we have already witnessed some Australian banks raise their variable rates on investment property loans. This may put further pressure on some of the ‘bond proxy’ sectors, which even following a retracement of gains in recent months do not look particularly cheap.

As to the persistence of this rally from a bottom up perspective, we have noted that many equity analysts in the market have upgraded their EPS forecasts for next year. We have also noted an improvement in earnings momentum, however our overall asset allocation positioning remains cautious. With valuations across most asset classes still not presenting significant value, and despite cyclicals performing exceptionally well, we continue to remain cautious on the longer term earnings profile of the market. From a relative asset class perspective, we have communicated for some time that REITs and infrastructure have been fully priced but that the low rate environment has provided support for these prices. Despite the recent fall in prices, these sectors remain expensive, and with the increasing risk of rates moving upwards, we have reduced our exposure to these sectors and reallocated the exposure to equities.

The 2017 year will no doubt be as eventful as 2016. Geopolitics are likely to continue to dominate headlines, with Trump formally taking the reins in the White House and key elections coming up in Europe. Next year will likely be the year we see whether the ‘lower for longer’ thesis in relation to rates holds true, or whether we start to see a ‘normalisation’ of rates.

Inflation will also be something to watch, with inflation linked bonds beginning to price in some inflation. No doubt we will continue to see a number of leftfield events impacting markets — we’ve certainly had some of those during 2016.

Market developments during November 2016 included:

Equities

The Australian market gained strongly in November with the S&P/ASX 200 Accumulation Index gaining 2.99%, reversing October’s slide. US banks rose in the immediate aftermath of the presidential election, and they took Australian lenders with them. The Financials sector increased 6.80% during the month, with the strongest gains coming from globally exposed BT Investment Management and QBE Insurance. The Energy sector had a positive month as commodity prices rose, gaining 3.67% in November, although energy shares remain volatile.

The Materials sector added to its year-long run, gaining 2.50%, with large gains from Galaxy Resources and Western Areas. A2 Milk shares rocketed 36.00% in November as the company reported growing demand, but faced a crunch in early December on fears of heightened regulatory risk from China. Boral exited a trading halt after raising $2.05 billion to acquire US building products manufacturer Headwaters, with shares trading well below the theoretical ex-rights price and down -14.32% through the month. Small cap returns, measured by the S&P/ASX Small Ordinaries Accumulation Index, returned -1.19% in November, although small cap miners have returned 62.97% over 12 months.

Global markets approached the US presidential election with mounting trepidation, but reaction to early results showing a likely Trump win showed just how unexpected the outcome was. S&P 500 futures fell 5.75% from their election day high as the magnitude of the upset hit home, while global share markets underwent a brief panic. Of course, that was not the end of the story.

Markets were quick to recover, with futures gaining 6.45% the following day. From that point the S&P 500 and Dow Jones indices surged through the month to finish at record highs, as the market’s attention turned to company tax cuts and other forms of stimulus, with the promise of reflation outweighing the broader uncertainty around Trump’s policies. Oil and gas sectors, as well as banks, all gained strongly throughout the month, while the healthcare sector rallied.

Global shares, measured by the MSCI World TR Index, returned 4.53% in AUD terms, while the S&P 500 TG Index returned 6.81%. Meanwhile, Europe’s largest shares struggled, with the Euro Stoxx 50 Index falling -0.12% in EUR terms. Major banks and insurers were the big winners, but a broad-based sell-off came late in the month despite positive factory figures from euro zone manufacturers. The FTSE 100 TR Index gained 3.28% in AUD terms, while in Asian markets the Nikkei 225 Index rose 5.07% in local currency terms and the Shenzhen CSI 300 gained 6.05%.Time Warner shares climbing 11.78% during the month.

In Europe, the Euro Stoxx 50 Index was up 1.77% in EUR terms, led by a strong recovery in banks and insurers. Following a horrid September, Deutsche Bank shares gained 13.70% as talks with the US Department of Justice neared a settlement. The UK’s FTSE 100 held up well in local currency terms, but saw a drop of -4.51% in AUD terms. In Asian markets, the Shenzhen CSI 300 gained 2.55%, while Hong Kong’s Hang Seng dropped -1.56%.

Fixed Interest

Historically, presidential elections have had little direct impact on fixed income markets, but November’s poll may be the exception to the rule. Yields had begun the climb from record lows in October, only to be propelled higher in November on the back of anticipated inflation and a rotation into equities. The US 10-year Treasury yield underwent remarkable expansion, increasing from 1.86% to 2.38%.

The return on US corporate investment grade bonds was -2.72% in November, while US high yield debt returned -0.68%. Remarkably, credit spreads were further compressed, with the Bank of America Merrill Lynch US High Yield OAS falling slightly from 4.91% to 4.67% and ticking upwards only briefly mid-month. Global bonds, measured by the Barclays Global Aggregate TR Index, returned -1.63% in November (in AUD hedged terms). Australian bonds returned -1.44% in November after losing -1.28% the month before. Returns on Australian corporate bonds were -0.68% while government bonds returned -1.68% as the 10-year yield continued its upward march from 2.35% to 2.71%.

The UK 10-year Gilt yield recovered from its postreferendum lows, moving from 1.24% to 1.42% in November and now higher than its pre-Brexit level of 1.37%. The German 10-year Bund yield turned positive in early October and has continued to move higher, pushing from 0.16% to 0.27% in November, although the 5-year Bund remains in negative territory, moving from -0.40% to -0.42%. Japanese 10-year yields turned positive mid-month, rising from -0.05% to 0.02%, which may test the Bank of Japan’s policy to target a zero yield for long-term maturities.

REITs (listed property securities)

The S&P/ASX 300 A-REIT Accumulation Index posted a modest positive return of 0.75% in November, following October’s return of -7.70%. The index has suffered significant falls since the start of August, losing -13.40%. November looked to be a horror month as investors clamoured to move out of bonds and bond proxies, but the sector managed to stage a small comeback in the second half of the month. Falls came from names such as Charter Hall (-3.83%) and Stockland (-2.04%), while Abacus Property Group rose 6.43% on the back of raised payout guidance after hitting a 52-week low earlier in the month.

With investors anticipating that the interest rate cycle has reached the bottom, both in Australia and overseas, yield shares such as A-REITs have taken large hits. Nevertheless, stable and attractive yields from income producing trusts appear well supported by property fundamentals, and a fall in price may present opportunities for investors. Globally, REITs took another fall in November, with the S&P Global REIT NTR Index returning –1.46% (in AUD hedged terms), and the FTSE EPRA/NAREIT Developed NR Index losing -1.30%. In a rising rate environment, REITs will face additional pressure on cap rates and leasing spreads, and US REIT prices have suffered from the recent sharp rise in yields.