Themes For February

28 February 2016

Following a rocky start to the New Year, markets found a degree of stability in February. Despite a high level of intra-month volatility, most major equity markets finished the month either flat or slightly lower for the month, rallying strongly in the final 2 weeks of the month. It now appears that in January and the early part of February, markets sharply overacted to the fear of a global recession and had become over sold. It was a pleasing sign that markets demonstrated the resilience to rebound strongly from their intra-month lows.

The pivotal US equity market finished the month up just 0.4% while European markets were generally lower with Germany down 2.9%, France down 2.3% and the UK fairly slightly better up by 0.2%. Across Asia, Japan fell sharply by 7.6%, China was up 1.1% (after a shocking January) and here in Australia the market was down 2.5%.

Bond markets were generally firmer, flirting with the idea that the global economy was slowing. US 10 year bonds fell by 23bp to 1.76% while in Australia 10 year bonds fell 30bp to close the month yielding 2.38%.

The oil price finished the month up 4% to close at $32.80 per barrel. This provided support for equity markets in the second half of the month.

Key Market Themes

Central Banks maintain centre stage

It remains the case that Central Banks around the world are setting the direction for financial markets. Central Banks in Europe, Japan and China have all indicated they are willing to expand their monetary easing programs by a combination of measures such as Quantitative Easing, negative cash rates and reducing bank reserve ratios all designed to stimulate credit growth by encouraging banks to lend. In the US things are slightly different as the Federal Reserve contemplates their timetable of increasing interest rates which commenced with a small 0.25% rise late last year. Data released in the US continues to support the view that growth is holding firm with manufacturing, durable goods, autos and employment data all printing on the better side of expectations. In addition to this, the lower gasoline price is putting money in the pockets of US consumers that could potentially fuel additional growth in spending. In contrast to other investment cycles, signs of inflation especially from wages growth, will be considered a positive not a negative as it will demonstrate strength in the US economy. Although this will give the Fed justification to marginally lift interest rates, the US market is likely to react favorably to this on the expectation that profits will be set to grow.

In Australia, the RBA would have been comforted by data showing that the Australian economy grew by an impressive 3% in 2015 as the economy continues to rebalance to offset the sharp decline in mining investment associated with the decline in commodity prices. The lower $A is assisting industries such as tourism, education services and new dwelling investment in particular. More disappointing however is the apparent abandonment of any comprehensive tax reform by the Federal government in the lead up to the May election year Budget.

Oil continues to dominate

The market continues to be heavily influenced by the oil price. While oil was stronger in February, the global market remains awash with supply. OPEC and Russia announced they would freeze output at record levels while Iran has only just begun building output to the agreed level as part of the deal struck with the US. For economic reasons other major producers like Venezuela need to keep pumping at near maximum capacity. The problem with the oil market is that even if the price rises further from here, higher cost supply from US shale producers will come on stream as it becomes economic to do so. It’s clear that the major low cost producers are prepared to play the long game to squeeze US shale producers out of the market. While the price of energy producing companies has naturally fallen, the market has also become concerned about the possibility of corporate debt and bank loan defaults by oil companies.

Politics looming large in US and UK

On the political front, the US is captivated by the primary and caucus elections being run to elect the Republican and Democratic candidates for the November general election. The Republican side has been particularly colorful as the insurgent candidate businessman Donald Trump has won the majority of early States contested with Tea Party Conservative Senator Ted Cruz from Texas running second and Florida Senator Marco Rubio third. On the Democrat side despite an early win in New Hampshire by socialist Independent Senator Bernie Sanders, Hillary Clinton has since asserted her dominance amongst the Democrat faithful. She is almost certain to get her party’s nomination despite being under investigation by the FBI for allegedly holding classified emails on a private server while serving as Secretary of State. While markets generally favour a Republican in the White House due to the perception of more business friendly policies, none of this is impacting markets at present as the general election is still 8 months away. It should be noted however if Republicans were able to win the Presidency and hold both the House and Senate, then this would break the legislative gridlock in Washington that has plagued President Obama’s second term. This scenario would be likely see a boost to the US share market.

In Britain, the government has announced a June 23rd referendum to determine if the UK remains in the European Union (EU). Opinion polls indicate this will be a close run issue and is likely to result in considerable market uncertainty in the lead up to the vote. A vote to exit the EU or “Brexit’ will have negative implications for UK trade with the Continent and hamper economic growth. Expect a volatile UK equity market and Sterling over coming months.

Investment Outlook

2016 is likely to be a tough, grinding year for global equity markets. While it was pleasing to see the resilience of markets following early year declines, gains from here will be hard earned. While in aggregate global monetary policy will remain very easy despite the US commencing the process of normalization, share market gains will be largely driven by earnings growth without any strong tail winds from the global economy. While concerns remain about the strength of activity in China, Japan and Europe, the good news is that the bell weather US economy appears to be holding firm. It is worth remembering that the US economy is still the “tide that lifts all the boats” so as long as it remains sound, the global economy will record modest growth. Interest rates will remain very low for some time to come given the complete absence of global inflationary risks. A consequence of this is that yield will remain scarce so alternative sources of income from assets such as listed property trusts, listed infrastructure assets, corporate bonds, hybrids and higher yielding shares are likely to remain in firm demand. In such an environment, picking the winners in share portfolios will become very important, as the overall market return is likely to be modest. Profit results will be closely scrutinized by the market and to this end US Q4 earnings for 2015 came in slightly better than expectations albeit recording negative growth for the 3^rd straight quarter. With valuations still reasonable however, equities should still outperform other asset classes in a low return environment.

Despite a short term bounce in the $A in conjunction with a recent rally in commodity prices, the direction over the next 12 months is likely to be down. This will especially be the case in the event that the US continues to raise cash rates reducing the “carry trade” appeal of $A assets from foreign investors driven by a positive interest rate differential of 175 bp compared to the US at the moment. One thing appears certain however, the intra-month volatility we saw in markets during February is more likely to be the norm rather than the exception for the rest of the year.

By Gary Burke
Chief Investment Officer