11 Dec November Market Commentary
It is worth noting again the divergence within International Equities. For Developed Markets we have the United States in the upper part of the Fully Priced range with relatively low commensurate returns, and most of Europe in the Cheap valuation band, though not without some attendant risks. Similarly, there are parts of the Emerging Markets which do not look compelling, however we do see good expected long term returns in China and Asia.
10 Year Forecast Returns
|Intl’ Dev Markets
|Intl’ Emerg Markets
|5 Year TD
|+ Currency Impact
|+ EPS Growth (’14 – ’24)
|+ Valuation Effect
|Index Return (Pre-tax)
There has been a different feel about many major investment markets over the past three months. For most of the year leading up to August there had been relatively calm conditions and low volatility, which some had characterised as complacency on the part of investors. A strong rise in February in the ASX200 index then gave way to more modest moves of around 2% to 3% until we got to a peak in early September. The increase from early February to early September was an aggregate gain of 11.6%; however most of this was given back in the 8.9% decline which unfolded over the next six weeks. The rollercoaster ride continued from that mid October low when we saw a 7.6% bounce, before again giving up most of that gain with a subsequent fall of 6.2%. The upshot of all those thrills and spills is an overall decline of 1.3% in the main Australian share market index for the calendar year to date.
Predicting these types of moves which occur over weeks and months is nigh on impossible, and not something we profess to be able to do regularly, if at all. You can see above that our forecasts are for the average annual return over a period of ten years, and in fact the expected returns are not dissimilar to the magnitude of the moves that we described above. The reality is that there is a margin for error around each of those forecasts, and we regularly reassess the expected returns in the context of the current market conditions. The fundamental components of the forecast don’t change much at all in the short term, as you should expect. What clearly does change a lot in the short term is the current price, and that has a significant impact on long term expected returns.
Many of the catalysts for the volatility which has become more apparent in recent months have come from the macroeconomic and geopolitical environment. One exception to this though is the United States where, as was well telegraphed, the central bank has deemed the economic recovery sufficient to end their extraordinary monetary policy. The next move from the Federal Reserve will now be to increase interest rates above 0% should the economic strength continue, and whilst there is a range of estimates most expect that this will occur in the middle of next year. One data point that will be critical to this decision is an increase in wages, considered to be a better signal of true strength in the labour market than the headline unemployment rate. A normalisation in interest rates, and by extension defensive assets such as bonds, could be disruptive to the equity markets which continue to set new highs.
In stark contrast to the United States the economic data for Europe is dismal. Economic growth is weak, unemployment remains stubbornly high and there is a very real chance that inflation becomes deflation in the near future, absent a significant policy response. That policy response is in question due to an ideological divide between Mario Draghi at the European Central Bank and the Germans. Draghi wants to embark on the sort of program that the Americans have just wound up, including the ECB buying sovereign bonds. The Germans are worried that this will amount to a bail out of the formerly profligate nations that have been crushed under imposed fiscal austerity requirements since the crisis. At the heart of the dilemma is the inherent structural flaw in the construct of the European Union. Essentially, there is no United States of Europe which allows for support to come from stronger states to weaker ones, for mobility of labour and normalisation of wages between member countries. In short, what has been good for the Germans has been terrible for the Spanish, the Italians and the Greeks. We will know more early in 2015 when Draghi intends to embark on this program in earnest.
Japan has entered recession as of the quarter ending September. The Abe government increased the rate of their consumption tax earlier this year and this contractionary policy led to a sharp fall in GDP in Q2 of -7.3%. Whilst this was widely expected, it was also thought that Q3 would see a rebound and this was not forthcoming. Rather, the Q3 GDP number came in at -1.6%, satisfying the technical definition of recession being two consecutive quarters of negative growth. The Prime Minister swiftly dissolved the Parliament and sought a renewed mandate for his economic reforms, which he appears likely to receive in the near future. A second intended tax rate increase has been delayed and meanwhile the Bank of Japan continues to pursue their own kind of asset purchase program to support the economy.
China has been able to adopt traditional policy support measures, but has nonetheless felt compelled to do so in recent times with cuts to key interest rates. Most expect that additional moves will be seen in the next several months, including a reduction in the amount of reserves that banks are required to maintain. We have spoken regularly that the sustainable rate and composition of growth will inevitably change for China from that which we have seen over the last several decades. Longer term policy reforms are still to take effect, and we continue to believe that a growth rate starting with a six is an enviable one for an economy that exceeds US$10 trillion in size. Recently there has been a very strong focus from Xi Jinping and his leadership on stamping out corruption, including at the recent Fourth Plenum which addressed justice and the rule of law. This has led to some paralysis at a municipal level, where local government authorities have stalled developments for fear of being caught up in the corruption investigations. Post the Fourth Plenum, it is expected that focus will return to implementing the economic policy reforms that will continue to transform China’s economy.
In Australia, our currency has fallen from the low to mid US0.90 range in August to the low US0.80 range in early December. This has been in no small part due to the pronouncements of the Reserve Bank who continue to see that the dollar is overvalued on fundamental measures. The nature of an exchange rate means that any move necessarily reflects both sides of the equation, and of late the US dollar has been particularly strong on the back of their economic recovery and the end of the Quantitative Easing program, pushing the A$ down as a result.
Our economy continues to transition from the mining led expansion, and indeed along with the currency there have been sharp moves lower recently in several key commodity prices. Notably iron ore has fallen by around half and this has dragged the resources sector of the share market down significantly, recording a little more than a 25% decline in the last few months. The largest miners are however still producing profitably at the lower iron ore price and are now shipping much greater volumes. This looks to be another example of where a long term view will be constructive, particularly as the dividend income becomes a more important part of the expected return at these lower prices.
In the early part of December the report from the Financial System Inquiry was handed to government, containing key recommendations for reforms to our banking, superannuation and financial system. The major banks will be required to hold more equity as security against the loans they make, though the recommended amounts are within the expected range and will be implemented over several years. This will impact the profitably of the banks by reducing their leverage. On balance however these seem to be prudent measures.
Finally, the most recent GDP number for Australia was weaker than expected coming in at an annual growth rate of 2.7% whereas expectations had been for 3.1% growth. This has prompted some observers to change their stance and predict that the Reserve Bank will be forced to cut interest rates as soon as their first meeting in early February. By contrast, we will continue to observe trends in the data rather than single releases and move decisively but incrementally with a long term perspective.
Our next long form commentary will be published in early January. Thank you for your continued support over the course of 2014, a year which certainly had many ups and downs. We look forward to writing to and seeing as many of you as possible in 2015, when we promise to keep true to the long term philosophy that guides the management of your portfolio.
Please accept our best wishes for a safe, relaxing and joyous holiday period.
DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (ABN 76 821 231 362 Corporate Authorised Representative of Paragem Pty Ltd AFSL 297276) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.
About Reuben Zelwer
Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.