30 April 2016
Themes For April
Following a volatile March quarter, markets showed some resilience in April with most asset classes grinding out small positive returns for the month. Major equity markets have now made up all the ground lost in the first 6 weeks of the year and have moved into positive territory for the 2016. The US equity market edged 1.2% higher while European markets were up by roughly the same, led by France and the UK up by 1.4% while Germany was a little softer, up by just 0.7%. Across Asia, Japan was the laggard falling 0.5% reflecting concerns about the potency and direction of policy, while China was 1.5% lower as concerns linger about the extent of their slowdown. Australia was one of the better performed developed markets, up a healthy 3.4% supported by a rebound in energy and iron ore prices which saw the Resource sector up an impressive 15.4% for the month led by mining heavyweights BHP up 23% and RIO up 21%. Listed Property Trusts added a solid 2.8% for the month. Bond markets eked out small gains as yields on most major government bonds were more or less flat for the month as global liquidity conditions remained very easy around the world. Australian 10 year bonds edged up 3 basis points to 2.52% while US 10 year yields were 5 basis points higher to finish at 1.82%. The oil price once again posted strong gains up 17% to finish the month at $46 a barrel despite OPEC members failing to reach an output agreement at their Doha summit, which led to some intra-month weakness. Iron ore was 2.4% firmer at $62.9 tonne holding the strong gains made in recent months. In currency markets, the $A consolidated its gains from last month to finish more or less flat, although the strength of the Japanese Yen was the key story in foreign exchange markets much to the angst of Japanese policy makers, finishing the month 4.2% higher against the greenback.

Key Market Themes

US economy showing signs of slowdown

Amid signs of a global slowdown in economic activity centered on China, Europe and Japan, the pivotal US economy has so far remained resilient. During the month, the IMF lowered its forecast for global growth for 2016 from 3.4% to 3.2%. In the US, March quarter GDP came in at annualized rate of just 0.5%, the slowest pace recorded for the last 2 years. While negative contributions from the energy sector and inventories depressed the headline result, the market is closely watching for any sign that consumer activity is slowing which would be negative for the earnings prospects for US companies. Against this backdrop, it will be difficult for the US Federal Reserve to justify further increases to cash rates in the short term and the market has now pushed out its expectation for any rate rises to the second half of the year. The Fed is cognisant of external risks to the growth outlook and will be closely watching employment and wages data in coming months to determine its next move.

Better news was the March quarter GDP outcome for Europe which printed stronger than expected at 0.6% compared to a consensus forecast of 0.4%. Of some concern was the 0.2% decline in prices, highlighting the deflationary effects of lower energy prices and underscoring the problems faced by the ECB to reflate activity by expansionary monetary policy.

In Australia, headline inflation actually fell for the March quarter coming in at   -0.2% to be just 1.3% higher over the previous 12 months. Using the RBA’s preferred measure of inflation, prices rose by 1.8% for the 12 months putting it below the lower end of its 2-3% target band. This result shocked the market and laid the foundation for the unexpected 0.25% rate cut delivered on 3rd May.

In Japan, policy makers are at their wits end trying to conjure up an enduring recovery in an economy that has been in the doldrums for the best part of two decades. Frustrating their efforts has been the extraordinary appreciation of the Yen, which has taken on safe haven status in the region. Its sustained appreciation against the greenback is counteracting the efforts of the Bank of Japan to stimulate activity through negative interest rates and quantitative easing.

US profit reporting season

As mentioned last month, US Q1 earnings results will be a key factor in determining the future direction of the US equity market. While not all S&P 500 companies have reported yet, so far 76% have beaten profit forecasts and 54% have exceeded revenue expectations. While these aggregate results look reasonable, earnings overall are actually down 7.4% over the previous 12 months, negatively impacted by the lower oil price and a strong $US. Companies that failed to meet expectations were severely punished with no better example than former market darling Apple, which fell 18% in the 3 weeks since it posted disappointing sales in its earning result.


Are Bond Markets too complacent ?

While the risk focus of investors usually centers around equity markets, the extraordinary rally in bond markets, fuelled by very easy liquidity conditions and central bank bond purchase programs, has push bond yields to historically low levels such that the yield for $7.8 trillion of government bonds globally is now actually below zero. More broadly, the average yield on $48 trillion of government bonds is just 1.29% with a duration of 6.84 years. This means bond prices are now very sensitive to any increase in bond yields from here which will generate capital losses for bond holders. While the risk of this in the short term remains low, there is an extraordinary level of complacency about the longer term direction of bond rates in a scenario of tighter policy led by the US.


Investment Outlook 

Not much has changed concerning our outlook for financial markets since last month. We are still experiencing a slow, grinding recovery with the global financial system awash with liquidity directed towards stimulating credit growth and inflation.  While hope springs eternal that this will eventually lead to a sustained and durable economic recovery, there is increasing speculation that monetary policy is having an ever-diminishing impact and that authorities need to think more broadly about other policy levers going forward. This would include structural reforms aimed at improving productivity such as labor market reform and prudent use of fiscal policy.

What we do know is that low interest rates and quantitative easing has been very successful in inflating financial asset prices such as shares, bonds and property. For major equity markets, while valuations are not expensive, there must be earnings growth delivery to propel prices substantially higher from here. Based on relative valuations however, we still favor risk assets such as shares over defensive assets such as cash and bonds as shares will ultimately fair better once the impact of easy monetary policy feeds through to growth and inflation.

By Gary Burke
Chief Investment Officer