Licensee Economic Update – July 2014
Financial year 2013/14 was another year of progress in repairing the world economy from the problems caused by the Global Financial Crisis (GFC). In terms of investment portfolio returns, the good news is that most diversified portfolios described as ‘balanced’ have once again generated double digit returns (anticipated at 12% on average). This follows strong returns generated during the 2012/13 year (average 14%) and notably, is above the long term forecasts anticipated by the investment management industry.
From a global outlook post GFC, some countries such as the USA and the UK have recorded faster than expected improvements, while others, notably those in the emerging markets bloc have confronted some significant challenges and remain erratic – but still delivering. With inflation generally under control, central banks have been able to maintain what might be termed an ‘accommodative’ stance in monetary policy and in summary this has helped the performance of both equities and corporate debt.
Currency markets appear to have surprised most forecasters particularly against the US dollar, where we have seen continued strength (in the 90c range) which is well above the long term trend. This can be partially explained by the US dollar remaining relatively soft given the improvement in the US economy while Australia has retained higher interest bearing rates which has attracted currency investors.
Geopolitical events, notably in the Ukraine and the Middle East, provided bouts of volatility but in accordance with history did not disturb the markets in a sustained fashion. Timing of investment decisions based on political posturing is fraught with risk of course but is projected via the media as opportune. The price of gold was a beneficiary of these events, given its ‘traditional’ safe haven status and Snapshot also noted oil prices rose.
Looking ahead, there are questions about how long the current low levels of realised volatility and bond spreads can persist and many commentators have observed record share market levels once again. However, although some managers are concerned about a market correction, many economists feel the coming year could well see a similar pattern of economic conditions to 2013/14, with continued but modest improvements in growth and low inflation in the wings. It also seems that central banks will not be in any hurry to see interest rates rise. Under these conditions it is possible that equities and corporate debt can rally further, though one would expect to a lesser extent than in the year just completed. In addition, the Australian dollar may remain firm for longer than envisaged.
In the following table, Snapshot has reviewed the performance of all asset classes for the fiscal year. Stellar returns have been achieved in International Equities (including Emerging Markets), High Yielding International Bonds, Australian Equities and Real Estate Investment Trusts. Remarkably, all of these asset classes returned synchronised double digit returns such that portfolios with a growth bias will have been rewarded for diversification and asset allocation in growth assets.
Figure 1: 2013/14 was a good year for most asset classes, especially equities
The all-important US economy had a much better year in 2013/14, despite the effects of some abnormally cold winter weather. Economic activity generally improved, with key indicators reaching the highest positive level seen since 2011. Employment growth picked up and the unemployment rate fell from 7.3% at the start of the year to 6.3% by the end of the year. Measures of housing market activity including sales, construction and prices all improved, as did consumer sentiment. The US budget deficit responded favourably to the better economic conditions and contracted significantly through the year. Inflation remained low throughout 2013/14 although it picked up towards 2% by the end of the year. However, inflation expectations remain well under control and there is still a reasonable amount of spare capacity in the US economy.
Against this backdrop, the Federal Reserve saw fit to start unwinding its Quantitative Easing programme with a phased reduction in the volume of bond purchases each month. This so-called “tapering” of the QE programme will see bond purchases cease by the end of 2014. However, the Federal Reserve has been at pains to tell the markets it is in no hurry to lift interest rates. The Reserve has been surprised by how quickly the unemployment rate has fallen to below the levels at which it had said it might start to lift interest rates. As the unemployment rate has fallen towards 6% so they have modified their language about intentions for interest rates. The key message is that it seems likely that US interest rates may not increase before this time next year. This will disappoint currency markets looking for a weaker Australian $ if the interest rate disparity between the USA and Australia continues.
The environment of improving growth, contained inflation and low interest rates has been very good for financial markets. Yields on US government bonds finished 2013/14 at almost exactly the same level as a year earlier, but in the meantime had risen to around 3% in response to the firmer economic statistics in the second half of 2013. These lower bond yields flowed through to the rest of the world, including Australia, and helped support the solid performance of the REIT’s market both here and overseas.
Figure 2: The US economy has had a better year in 2013/14
The US equity market rallied strongly with the S&P 500 total return index posting a gain of nearly 24% and reaching new highs along the way. Corporate bond spreads continued to decline as investors chased yield wherever they could find it. These developments pushed the risk premium on corporate liabilities to record low levels.
Global markets in general
Elsewhere in the world, the UK economy also saw a faster than expected improvement in conditions, to the extent that by the middle of 2014 the Bank of England was signalling that it might need to start lifting interest rates sooner than previously expected. The extent of the increase in house prices in the UK has emerged as a particular issue for the authorities. However, in Europe there is still a long way to go before we are likely to see increases in interest rates. The past year has seen progress in parts of Europe, including the peripheral nations which are now posting positive rates of economic growth. However, they are also still experiencing very high levels of unemployment and very low rates of inflation.
For the Eurozone as a whole, inflation has fallen to around 0.5% while Spain and Portugal have inflation rates of 0% and Greece is in outright deflation. These conditions led the European Central Bank to cut its headline interest rate again in June 2014 and to impose a negative interest rate on bank deposits at the European Central Bank.
The persistent strength of the Euro has been a significant factor behind these developments. Likewise in Australia, the local currency has been persistently stronger than expected a year ago. The $A/US$ rate had fallen sharply in the first half of 2013 as the Reserve Bank cut the cash rate towards the record low of 2.5% reached in August 2013 and was generally expected to fall further in 2013/14. Instead however, the dollar rose just over 3% to US$ 0.943. This has surprised many and even Governor Stevens of the Reserve Bank has attempted to talk it down in recent weeks. This has to be considered unusual.
Firmer economic conditions in the second half 2013, including signs of improved confidence in the business sector, robust activity
in the housing sector and some better-than-expected data from the labour market, all contributed to the Reserve Bank removing its easing bias. This prompted some speculation that the Reserve Bank might lift interest rates as soon as late 2014, which in turn put upward pressure on the currency. However, although the housing sector has continued to enjoy strong price activity in the major capital cities, business sentiment has slipped back in the first half of 2014 while consumer confidence has declined sharply. Events in Canberra have contributed to this. For example, relief associated with the change of government last year has dissipated in the face of the prospect of a dysfunctional Federal Parliament for the rest of this term. In addition, the Government’s persistent warnings about an austere budget have left households concerned about their job prospects and financial position. In this climate it seems highly unlikely that the Reserve Bank will be in any hurry to lift interest rates any time soon. Indeed, the cash rate finished 2013/14 at 2.5% where it has been for the best part of 12 months and yet the $A has stubbornly remained above US$ 0.90 cents. The more fundamental driver of the currency’s performance seems to be what has been happening with the US dollar. Until the Reserve eventually starts to lift the US cash rate the US dollar may continue to languish. Although we have seen significant moves in bond and equity markets over the past year or so, we are still yet to see the significant currency adjustments needed to unwind the distortions caused by the Fed’s policies. While this persists, the US will continue to export a low interest-rate environment to the rest of the world and foster the chase for yield.
Figure 4: After falling sharply in 2012/13, the $A is up slightly in 2013/14
China had an interesting year with a great deal of attention paid to the authorities’ new programme of reforms, the state of the housing market and the risks associated with the shadow banking system. Despite some dire predictions of imminent collapse, the Chinese economy continued to post growth in line with the authorities’ objectives around 7.5%. In fact, the Chinese economy seems to have settled into a pattern of many cycles around 7.5% rate of growth, especially since the authorities have proved willing to provide stimulatory nudges if growth looks like slowing too much.
Emerging Markets in general
Other economies came under pressure in the second half of 2013 due to concerns about the impact of the Taper. The United States Federal Reserve’s Quantitative Easing programme had provided a steady source of cheap funds with which to purchase high yield bonds from around the world, especially those denominated in currencies other than the US dollar. High yield bonds issued by emerging market governments proved attractive opportunities. However, unwinding QE started to undermine these trades, leading to weakness in some emerging market bonds and currencies. The impact of all this varied from one nation to another, with the countries most at risk being those with large current account deficits and relatively high inflation rates. This included Brazil, India and Indonesia and South Africa. Turkey also came under pressure associated with national elections, while Venezuela and Argentina also experienced difficulties. Prompt policy responses from a number of the vulnerable countries, combined with some relief as US bond yields and the US dollar slipped back in 2014; have taken the pressure off financial markets in these countries. Emerging market equities which underperformed developed market equities significantly in late 2013 have subsequently made up some lost ground.
Snapshot looking ahead…….as dangerous as that may be
Fund Managers feel the US economy is set to continue its improvement over the rest of 2014. The pace of growth should pick up enough to reduce unemployment further but without reigniting inflation. In that situation, the Federal Reserve is likely to sit on its hands with respect to interest rates, which in turn suggests the US dollar will remain relatively soft. That means the A$ may not fall as far as had been previously expected and the Reserve Bank will have an incentive to keep the cash rate low for some time yet. It’s unlikely the Reserve Bank will cut the cash rate again, unless the economy suddenly falls away very sharply, but at the same time one would not be surprised to see the cash rate around current levels well into next year. Sentiment in Australia could improve in the second half of the year if the current political impasse in Canberra moves to a new footing after 1 July. That would be positive for spending and employment decisions as well as for the equity market.
Some other factors to bear in mind include:
- notwithstanding low interest rates, government bond yields could well rise modestly as economic growth continues to improve;
- higher bond yields would probably limit the ability of Real Estate Investment Trust’s to continue to perform as well as they did last year;
- there is likely to be further rotation out of defensive equities into cyclical equities;
- the $A may well revisit the sub-US$0.90 but is unlikely to reach the US$ 0.80 level;
- within the outlook of the dollar, there may still be opportunities for unhedged international equities to outperform domestic equities;
- developed equity markets are no longer cheap but neither are they alarmingly expensive; these markets could well have another reasonable year in 2014/15,
the demand for yield is likely to continue as low cash rates persist – this dangerous for fair valuations in the market and investors will need to be wary of capital volatility in the short to medium term.
This has been prepared by Paragem Pty Ltd [AFSL 297276] and is intended to be a general overview of the subject matter. It is not intended to be comprehensive and should not be relied upon as such. We have not taken into account the individual objectives or circumstances of any person. Legal, financial and other professional advice should be sought prior to applying the information contained above. Advice is required before any content can be applied at personal level. No responsibility is accepted by Paragem or its officers.