15 Feb January Market Commentary
Performance in the A-REIT sector has been very strong over the last year, though this only brings our valuation assessment to the upper Fair Value range. In part this is due to the falling yields that we mentioned earlier, which are in turn reflected in lower risk free returns represented by term deposits from our major banks. In International Equities we see good forecasts in Europe though with attendant risks, along with weak expected returns from the US which overall sees the indicator in the middle Fully Priced range. Australian Equities have moved closer to the threshold between Cheap and Fair Value with index gains of 8.5% in the year to mid February, though remain attractive, particularly compared to many other major Developed Markets.
A strong start for 2015 in the Australian Equity market was bolstered in early February when the Reserve Bank concluded their first meeting for the year by cutting interest rates to 2.25%. We will discuss below the outlook for the Australian economy and our forecasts for Australian Equities. However, before embarking on that analysis, we will quickly address several of the key items that are expected to have an impact on the global economy in the year ahead, as well as others that are specific to individual regions.
One phenomenon that is happening all over the world is the continuing drop in interest rates and by extension the yields currently being earned on bonds. Not all that long ago it was a remarkable and very short term event that a bond would trade with a negative yield, now it is a common occurrence. Investors putting money into two year government bonds issued by the French, Germans, Swedish, Dutch and Swiss are paying for the privilege of lending them their money, in other words they are earning negative returns on their investment assuming they are held to maturity. The most likely reason for this otherwise nonsensical activity is that these investors expect rates to fall further and that they will be able to make a capital profit to offset the income loss.
Another potential reason for such activity is the growing expectation that deflationary forces will be unleashed, in particular in the European economy. There has been plenty of coverage of the fall in oil prices which represents a significant component of the spending of most households. Whilst central banks typically look at inflation measures that exclude changes in oil prices, as they can be volatile in the short term, there appears to be a considerable consensus that what we have seen recently is at least to some extent a structural shift. The traditional needs of an investor to earn an income and grow their capital to maintain purchasing power look somewhat different in an environment where prices are falling. As we have also said many times before, with rising uncertainty many investors are focusing again on merely the return of their capital, rather than the return on their capital, even to the extent of accepting a slightly lower capital amount when eventually it is returned.
It was reported in December that inflation in the Eurozone dipped to -0.2% which was one of the catalysts for the European Central Bank to embark on their Quantitative Easing program. By way of a quick refresher, QE is a policy tool that central banks employ when cutting interest rates to zero is insufficient to stimulate an economy. The ECB is in the somewhat fortunate position of having the last few years of US policy as a guide, but of course they have their own unique set of challenges. Principally these are the structural deficiencies in the EU and the inclination for member countries to protect their own interests. Not only are these being highlighted in negotiations about the Ukraine, but in ongoing debt negotiations with the newly elected government in Greece.
Notwithstanding the political instability, there is some evidence that the most indebted nations that had no option but to accept the austerity policies imposed upon them in order to restructure their debt are showing some signs of life. There remain some very significant uncertainties in the outlook for Europe, though that said there is also a plausible scenario in which Mario Draghi effectively implements the QE program, the ensuing decline in the euro supports competitiveness, and problem economies confirm that they have turned the corner.
The US economy grew at 2.6% over 2014 and of note in the most recent data was the strength of the US consumer. That this has occurred before the real effects of the fall in oil prices is encouraging, as it most likely will take several months for consumers to be convinced that lower oil prices are here to stay, and for them to spend the savings when they fill their cars. As investors we are of course concerned with the prospects for the US share market, and here our forecast continues to be for below average returns. Sometime this year the US market will very likely need to deal with the fact that interest rates are going up, which will provide confirmation that the economic recovery is continuing, but will nonetheless still be quite a disruptive influence, at least in the short term.
Our forecast of very modest returns for the US equity market is based on our outlook for earnings and the valuations reflected by current prices. The chart1 at the right shows the consensus estimates for Earnings Per Share and Sales for the S&P500 index, and the trend is clear. Analysts now expect that sales will be flat over 2015, with earnings growing at less than half the expected rate of just a few months ago.
The Chinese economy grew at 7.4% over 2014, in our view continuing to defy the sceptics though of course that didn’t stop the negative headlines. This steady moderation in growth is a welcome development in an economy that has grown 23x in a generation, though the reporting of this data in the Wall Street Journal was “China Economic Growth Is Slowest in Decades.” As Jonathan Pain noted “Students of arithmetic will know that 7.4% growth in an economy of $10 trillion in size is equivalent to 14.8% in a $5 trillion economy. It is perhaps worth noting that Japan’s economy is about $5 trillion in size. Try and imagine, if you can, that Japan grew 14.8% last year.”2 One suspects that may very well have attracted quite a different headline.
China has taken policy action to support the growth that we speak of above, and these moves including cuts to interest rates and accelerated investment approvals are expected to continue in 2015. Of note, we see the first signs that the Chinese leadership will move away from announcing specific growth targets with Shanghai becoming the first major region not to set a target for this year. This is a sign of maturity in the Chinese economy, and will help to curb past behaviour that exacerbated imbalances.
The statement from the RBA announcing their decision to cut rates included the following comment on the outlook for the Australian economy: “Overall, the bank’s assessment is that output growth will probably remain a little below trend for somewhat longer, and the rate of unemployment peak a little higher, than earlier expected. The economy is likely to be operating with a degree of spare capacity for some time yet.”3 The last part of that statement speaks to the deflationary influences that we have discussed earlier, for an economy operating at less than full capacity is not one in which central bankers need to be unduly concerned about rate cuts leading to inflation. The statement also noted that while the currency has fallen against the US dollar, it has not fallen to such an extent against the currencies of our trading partners and remains above the bank’s estimate of fundamental value.
In relation to households and their contribution to the economy the RBA noted several competing influences, including the positive effects on consumption of lower petrol prices and interest rates along with increased house prices. Offsetting that however is ongoing weak wage growth as depicted in this chart, which overall leads to “moderate, though not strong, consumption growth.”4
The outlook for our economy is essentially very similar to what we have seen over the last few years, though the expectation is that a return to long term trend and indeed above trend growth is not that far away.
We have unfortunately had our own version of political turmoil again in early 2015, and it would seem likely that despite the protestations of our Prime Minister that this won’t be the last such episode. Whilst there is still time to address the longer term issues in our economy, we don’t have forever and market conditions will not always be this benign. We will monitor developments in this area closely as there are important ramifications regarding our public debt and deficits for the investment markets.
1. Myles Udland, Sales growth for America’s big companies is now expected to be zero. Business Insider. 10-Feb-15.
2. Jonathan Pain, All Things Considered – The Pain Report. 29-Jan-15.
3. RBA. Statement by Glenn Stevens, Governor: Monetary Policy Decision. RBA. 3-Feb-15.
4. RBA. Statement on Monetary Policy. Feb-15
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.