Economic and Investment Update - October 2017

Summary of Key Views

A case for prudent optimism

We held our quarterly Asset Allocation Investment committee in September. As part of the committee process we assess the macro economic environment, the strength of the business cycle, asset valuations and sentiment. Over the past 12 months we have been defensively positioned in our asset allocation setting noting stretched asset valuations, improving but mixed economic data and uncertainty around process for the ‘normalisation’ of monetary policy around the globe.

The overall economic environment continues to show signs of improvement, economic indicators such as PMIs continued to rise in key economies such as the US, Europe and Japan. In Australia, non-mining business investment remains strong and employment is steady, although we remain concerned about the lack of wage growth, which unless shows signs of improving will be a drag on consumer confidence. We continue to watch how central banks approach their monetary policies settings as we see central banks gradually reduce their quantitative easing (QE) programs and subsequently reduce the size of their balance sheets. The rapid increase in liquidity into markets as a result of QE provided a significant boost to equity markets therefore central backs will need to manage the ‘normalisation’ of their monetary policy carefully as a rapid pull back in liquidity would be negative for markets. Our long term view on interest rates is that rates will increase from their current low levels however we do not expect rates to rise rapidly in the short term which will continue to be constructive for equity markets.

Our overall view on valuations has not changed materially. Asset prices continue to trade at fair to expensive ranges with the US market being one of the more expensive markets albeit not at extreme levels. We have noted that global infrastructure is beginning to look expensive and we are doing some more work into this area.

We have remained defensive in our asset allocation settings, however we have reduced our underweight exposure to equities moving from a Slightly Underweight from Underweight exposure to Australian equities and Neutral allocation to global equities from a slightly underweight exposure. The change reflects continued improvement in cyclical indicators and our view that rates will remain low in the short to medium term. As a result of the changes we have reduced our cash allocation. We continue to hold excess cash and have an Overweight exposure to alternative assets in recognition that asset prices are not cheap and that implied volatility in markets has been at historical low levels.

Market developments during September 2017 included:

Equities

The Australian market entered its fifth month of negative or flat growth in September, with the ASX 200 Accumulation Index returning -0.02% as commodity sectors pulled back. Healthcare (+2.32%) had the best month, led by listed aged care providers, including Japara Healthcare (+10.40%), which recovered from a late plummet in August but remains below the $2.00 mark, and gains from heavyweight CSL (+4.94%), which announced increased capex in August, with investors considering the company well positioned for growth.

Consumer Staples (-1.65%) shares could not match August’s performance, but did see another burst of growth from A2 Milk Co (+16.27%), which pushed to new highs after receiving approval from China’s regulatory body to continue selling its products in the country, while Blackmores (+6.25%) reported a 71% surge in direct sales to China. Telecommunications (-4.53%) was the worst performing sector, mostly due to TPG (-11.29%), which announced a cut to its dividend and warned of competitive pressure from the NBN. Financials (+1.21%) were higher, with gains from NAB (+4.30%) and Westpac (+2.08%), while CBA (-0.73%) completed the sale of its troubled CommInsure business.

In the US, the S&P 500 gained 3.06% in AUD terms as geopolitical tension gave way to natural disasters in the form of Hurricanes Harvey and Irma, which impacted jobs readings but failed to hold back shares. Energy stocks (+11.16%) were the highest performing, with large gains from Marathon Oil (+23.30%) as well as giants Chevron (+10.39%) and Exxon Mobil (+8.59%).

Financials (+6.31%) had a good month in September, which saw broad growth across the sector, with gains from global insurer MetLife (+12.16%), exchange operator CME Group (+9.62%) and banking icon Wells Fargo (+9.19%).

Globally, the MSCI World Index gained 0.68% in AUD terms, supported by US and European shares. The Euro Stoxx 600 Index rose 4.28%, with strong growth from energy producers, including BP (+12.62%) and Europe’s largest oil company Royal Dutch Shell (+10.97%). Retail shares (+5.56%) also performed well, with gains from big names Metro (+9.41%) and Tesco (+8.67%). In the UK, the FTSE 100 Index rose 4.54% as the Bank of England held the line on rates, but with a decidedly more hawkish tone as inflation pushed to 2.9%.

In Asian markets, the Nikkei 225 Index rose 2.47% while the Shenzhen CSI 300 Index was up 0.89%. The MSCI Emerging Markets Index rose 0.68%, predominately supported by Chinese markets, with the Indian index (-2.30%) down and Korean shares (+0.70%) marginally higher.

Fixed Interest

Global yields moved higher in most developed markets throughout September, but so far bond markets have been steady as the Fed begins its balance sheet ‘normalisation’. The US 10-year Treasury yield rose from 2.12% to 2.33%, with investors anticipating some ‘hunger pains’ as the Fed’s balance sheet slowly unwinds. The return on US corporate investment grade bonds was slightly negative in September at - 0.22% but the index was not far from all-time highs, while US high-yield debt returned 0.87%, with the index similarly near record high levels. The BofA Merrill Lynch US High Yield OAS contracted in September from 3.85% to 3.56%, following a high of 4.00% in August – still low by historical standards – and has generally undergone contraction since February 2016 as volatility has all but vanished.

Global bonds, measured by the Barclays Global Aggregate TR Index, returned -0.43% in September (in AUD hedged terms), with developed market indices still close to their all-time highs. The Ausbond Composite Index returned -0.31%, with government bonds returning -0.40% and corporate debt down -0.04%. The Australian 10-year Treasury yield rose from 2.71% to 2.84%, but is still down on its March peak of 3.05%. The UK 10-year Gilt yield rocketed higher in September after taking a beating in August, rising 36 bps to 1.36%. The German 10-year Bund yield rose from 0.36% to 0.46%, and the 5-year Bund edged higher from -0.35% to -0.27%.

REITs (listed property securities)

The S&P/ASX 300 A-REIT Accumulation Index returned 0.57% in September in what has been an average quarter for listed property globally. Some pain was felt by diversified managers such as Charter Hall (-5.29%), Stockland (-2.93%), Mirvac Group (-1.29%) and Dexus (-0.94%). Commercial specialist Propertylink Group (+7.51%) topped the leaderboard, rejecting a takeover bid from Centuria Capital Group late in the month, with Centuria building a 17% stake in the $1.8 billion property portfolio.

Global REITs were slightly lower in September, with the S&P Global REIT NTR Index down a modest 0.21% (in AUD hedged terms), while the FTSE EPRA/NAREIT Developed NR Index lost 0.10%. In the US, yield REIT sectors have generally outperformed through the middle of 2017, including the net lease and manufactured housing sectors. As a whole, REITs have been held back by growth sectors such as offices, malls and hotels. Low volatility remains an attraction, however, and a structural fall in volatility could boost valuations and risk-adjusted returns.