20 Jan December Market Commentary
Notwithstanding the year end move, the valuation on Australian Equities continues to look attractive, and within that asset class the highest forecast returns are for Resources and Small Ordinaries. However we should note that both of these sectors are quite volatile. We continue to favour Asia within Emerging Markets, and have been encouraged by the strong performance for 2014 in Listed Property. We have recently updated our cash forecast expecting rates to stay lower for longer. The 5 Year Term Deposit rate is the threshold between Fully Priced and Overpriced, and this now sits at 3.75% reflecting the steady fall in rates being offered by our major banks.
It took a late rally to lift the main Australian Equities index into positive territory for the calendar year. In the middle of December the ASX200 return to that point was -3.7%, however as trading wrapped up on New Years’ Eve the final figure was a gain of 1.1% for 2014, not including dividends. It was a different story when it came to our currency and several key commodities though, with the former starting last year at US$0.89 and strengthening to US$0.95 in early July ahead of relatively sharp declines in both September and December. The end result was a drop of nearly 15% from high to low, though that was minor compared to the falls in oil prices and iron ore. Both commodities fell by close to 50% over 2014, though iron ore looks to have stabilised for the time being while the fall in oil prices continues in early 2015 and fresh lows are being set regularly.
The US share market managed a solid gain for the year, but nothing like the 2013 results. In the last twelve months the S&P500 index added 11.4% compared with just shy of 30% in the previous year, and there was a new high set in the final days of 2014. Following this strong multi-year rally we continue to see the valuation as being fully priced and remain comfortable with this position at this point in time. Equity returns were modest in Europe and similar to those we saw in Australia, with the United Kingdom, France and Germany all recording 1% to 2% returns in their local currency. Our falling dollar aided the performance of the international exposures that were held, with the Asia index adding 10.5% and the Emerging Markets index a little more than 6% for the year.
Before moving on to the macro discussion on China and Australia, we need to note what has been happening in the bond markets. In Europe where there is now deflation, many shorter and medium term government bonds are trading at negative yields, meaning investors are once again focusing on the return of their money, rather than the return on their money. France, Germany, Sweden, the Netherlands and Switzerland all have negative 2 year bond yields, meaning investors that hold to maturity will receive less than their initial investment. That investors are paying for the privilege of owning government bonds does not speak well of their view on expected returns from other investments, at least in the short term.
For longer maturities there has also been a steady decline, with yields on 10 year bonds in the United States at just 1.89% (up slightly from a low of 1.62% in December) and in Australia the same figure is 2.61%. Both of these key reference rates are at or close to historical lows, which in turn has an effect on the pricing of a wide range of fixed interest and other investments. One particularly relevant example would be Australian term deposits which have also followed this pattern with a 1 year TD now paying around 3.3% and a 5 year TD at around 3.8%. This is an important figure in our valuation models, which are discussed in the Asset Class Valuations at the beginning of this commentary.
For the past few years when we heard comment passed on the Australian economy one of the oft repeated descriptions was of a ‘two speed’ economy, that is one that was led by the mining sector and where other sectors languished. More recently there were headlines about the end of the mining boom accompanied by no shortage of predictions that given Australia’s economy relied on only this sector, it would be inevitable that we would be beset by impending doom. In a lot of international minds Australia was also seen as an easy way of betting that the Chinese growth story of the last several decades was unsustainable and would come crashing down. Turning elsewhere, our house prices are seen to be very expensive by global comparisons, which someday would have to go through the sort of crash we saw in the United States and parts of Europe. That would in turn mean that our banks faced a huge risk of having to deal with large losses on their lending to residential housing.
Not surprisingly, we seem to have taken much of this negativity to heart, as reflected in weak confidence surveys being par for the course in recent times. This chart1 shows consumer confidence going back 20 years, and the December reading was almost as low as this measure has been in that period, save for the depths of the financial crisis.
That this reading comes at a time when mortgage rates are low, petrol prices are falling and recent jobs growth has been quite strong is a little perplexing. Certainly our politicians aren’t helping the matter with their short term views and incessant partisan sniping exacerbating the matter, or as it was recently said: “One of the few areas of bipartisanship we’ve had over the past dozen years is both parties have agreed to be short term and second rate!”2 To borrow a phrase from my colleague Jonathan Pain, we should beware the prism through which we view the world.
A recent speech3 from the RBA acknowledged that economic growth had been below trend in recent times, and this was punctuated by a weak number for Q3 2014 which was released in early December. It went on to note of our major trading partners that their growth had been close to average levels and that if anything it was likely to be slightly higher over the next two years. On the state of the Australian economy the speech noted “Growth over this financial year is likely to remain below trend, but our forecast is for growth to pick up gradually to an above-trend pace by 2016. There are already signs of better growth in some parts of the non-mining economy, supported by the very low level of interest rates.” Looking further forward, the bank expects that continued low interest rates along with the lower exchange rate and energy prices will help to boost household demand, which will be recognised by businesses as they increase their investment in both labour and capital.
Laying out a credible path forward the speech concludes: “The very low level of interest rates is supporting, and will continue to support, growth of household expenditure. In time, this is expected to support a recovery in non-mining business investment, and the economy more broadly, including an improvement in the labour market. If history is any guide, the recovery is likely to proceed in that order, from household expenditure to business investment to labour market conditions. History also suggests that a pick-up in business investment (outside the resources sector) will come, in time. The fundamental forces are in place to support that recovery.”
The only thing that we would add to that conclusion is that valuations remain favourable in Australian Equities with undemanding assumptions about earnings growth. Over the long term, the prism through which we choose to view the world, we continue to see that an investment in Australian Equities will remain appropriate in portfolios for some time to come.
Returning to the prism theme, we have commented regularly in the past on those who have consistently predicted the demise of the Chinese economy. Far from the outcomes that those people foresaw, the reality is the Chinese economy has been steadily moderating its rate of growth as should be entirely expected of the second largest economy in the world. President Xi Jinping made the obvious but seemingly not widely accepted observation that “[e]ven a growth rate of around 7% will put China among the top performers in the world in terms of both speed and size,” going on to note that “[s]ome worry whether China’s growth rate will slow down further, or whether China can overcome the obstacles – risks are indeed there but they’re not scary.”4
2014 was a year in which economic policy reforms took somewhat of a back seat to the high profile anti-corruption campaign, which culminated in the party’s fourth plenum focusing on justice and the rule of law. There has clearly been an impact at a local government level, which is apparent not just in official data but also anecdotally, whereby officials were paralysed by a fear of being caught up in the campaign. This has certainly curtailed a lot of economic activity, though some fundamental reforms in this part of the economy will be beneficial to managing the imbalances that accrued during the rapid growth phase. Not least of these will be refinancing debts in the form of municipal bonds, lowering the cost of debt and making repayment schedules more manageable.
Towards the end of 2014 we saw the economy benefit from some short term supportive policy moves such as rate cuts and accelerated infrastructure projects. In the longer term we know there are announced reforms that will have a positive impact, not least the changes to the registration scheme for urban migrants known as hukou. “The government set a target of granting 100 million new local urban hukou in the next six years. This means extending coverage of urban social benefits, such as education and health services, to a group almost as large as the population of Mexico. That was a breakthrough.”5
Assuming the economic recovery continues in the United States, then some time in 2015 we will very likely see the first move on interest rates from the Federal Reserve. By the time we write to you next month with the January commentary we should also have confirmation that the European Central Bank has started buying government bonds to stave off deflation in Europe. This promises to be another interesting year for the global economy and investment markets.
1. Westpac-Melbourne Institute Consumer Confidence, Consumer Sentiment (SA). Dec-2014.
2. Gerard Minack, quoted in “The bear is back: A cautionary tale of global boom” Cummins, P. SMH. 12-Jan-15.
3. C Kent, “The Business Cycle in Australia” – Address to the Australian Business Economists. RBA. 13-Nov-14.
4. Xi Jinping, quoted in “Xi Says Risks to China Economic Slowdown Aren’t Scary” Bloomberg. 9-Nov-14.
5. Kam Wing Chan. “People Not Buildings – China’s New Approach to Urbanisation” Bloomberg. Oct-14.
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.