March Market Commentary

March Market Commentary

As a result of an adoption of higher Price/Earnings (P/E) multiples across a range of asset classes: where ordinarily we would expect forecasts to be lower given the recent strength in Australian Equities, we continue to see this asset class in our Cheap valuation range and we therefore maintain our overweight stance (see explanation from last month’s commentary). As shown for International Equities, Asia remains preferable within Emerging Markets as well as Europe within the global market.

In the last of these notes we spoke of some extraordinary goings on in European bond markets, and particularly of the fact that many government bonds in Europe were trading at negative yields. In this topsy-turvy world a saver lends money to a government, and rather than receiving a regular income payment to compensate them, they actually pay for the privilege of lending their money. In the ensuing years of holding that bond to maturity, when interest rates change so too does the value of the bond. If you buy a 5 year bond paying an interest rate of 4%, but in two years’ time interest rates have risen to 5%, then you will need to discount the face value of your bond to attract a new buyer in the event that you no longer wish to hold to maturity. Absent the discount a new investor will opt for the new bond paying the higher income return. There is also a relationship between how long your bond has to mature and the amount of the discount that you will need to offer, with longer terms requiring a larger discount.

The inverse to the example above also applies, which is to say that when interest rates fall the value of your bond will increase. This is a phenomenon that has prevailed for much of the last thirty years, meaning that bond investors have received not only the income return on their investment but have also been regularly compensated by higher prices for their portfolio of bonds. We have seen a steady decline in interest rates in major developed economies, for example Australia which has seen a decline from peaks in the early 1980s of more than 16% to the current rate of just 2.3%. However it is to Europe again where we now turn our attention.

The severity of the financial problems in parts of Europe over the last few years has seen authorities seek to stimulate the economy by reducing interest rates, or cutting the price of money. Lower borrowing costs in normal economic cycles are enough to stimulate economic activity, however following such a severe crisis that policy prescription has been necessary but not yet sufficient to foster a recovery. As a result the Europeans are now pursuing additional policy measures to support economic activity in the form of quantitative easing. When a central bank starts buying a lot of bonds this will push interest rates down and alter the otherwise market driven forces of supply and demand from investors. With existing bonds that were issued at already very low interest rates, we have become accustomed to seeing the income return go lower than zero – that is, bonds that are trading at negative yields.

Indeed, in such an environment we are also becoming accustomed to seeing new debt issued at negative interest rates, most often with relatively short maturities but more recently in longer term debt. “Switzerland has become the first government in history to sell benchmark 10-year debt at a negative interest rate, as falling prices and unprecedented actions by the world’s major central banks send global markets further into unknown territory.”1

As always when we need to observe the current environment and determine how we think it will impact the future, in terms of both return and risk. Just as traditional fixed rate government bonds have received a tremendous boost to returns from falling interest rates, when rates do eventually normalise and rise this will represent a significant headwind and in all likelihood negative returns from what are the ‘defensive’ assets.


In an important speech delivered in late March, Federal Reserve Chair Janet Yellen laid out a very lucid and detailed policy framework when she spoke of “Normalising Monetary Policy: Prospects and Perspectives” in San Francisco. She spoke at length on the focus she and her colleagues have on their dual mandate, which is to pursue policies that promote full employment and price stability. While there have been impressive gains made in the labour market, notwithstanding the disappointing March data, she outlined that the target range for unemployment of 5.0% to 5.2% had not yet been reached. We also know from previous commentary that the Fed pays attention to other indicators of residual slack such as long term unemployment and the level of involuntary part-time employment.

With regard to the second part of their mandate, the concern is that inflation persists at a level lower than the objective of averaging 2%. Perhaps the most important area where the Fed would like to see signs of inflation is in wages, and that is an area that has underwhelmed for some time. Yellen noted that a range of factors including global competition, technological change and trends in unionisation are all likely reasons why wage increases haven’t kept pace with productivity gains for at least the last 15 years. Importantly she also pointed out that looking to past recoveries and subsequent interest rate tightening schedules “could well provide a highly misleading guide to the actual course of monetary policy over the next few years.” We will gain some further clarity with coming data releases about whether recent weakness is isolated or indicative of a slowing trend in the economic recovery. In the meantime, with valuations at current levels our forecasts for US equities are very modest given the associated risks.


In an unorthodox move we are going to reference a Japanese civil servant in our discussion on China, though it should be noted this is in an economic context rather than a geopolitical one. Takehiko Nakao is the President of the Asian Development Bank and he recently addressed the China Development Forum (CDF) in March. The CDF follows the National People’s Congress and is one of the primary platforms by which the Chinese signal their policy priorities to the international community. The theme of the most recent forum was that China has now entered a ‘new normal’ of more moderate but sustainable growth, anchored in the short term around the 2015 GDP expectations of around 7%.

Given his role Nakao’s speech2 understandably focused on public finance, and in particular the role of local governments and their borrowings, which has been an area that has attracted a lot of external criticism. He noted that the Chinese still have significant urbanisation activity to complete having set a goal of increasing this rate from the current 51% to 65% by 2020. He also highlighted the crucial role local government authorities will need to play in this process. Citing the importance of continuing the Third Plenum reforms announced in 2013, Nakao emphasised three areas; closing the gap between expenditure at a local level and revenue collection at a national level, establishing dedicated tax revenues for local governments and lastly continuing to establish a market for municipal bonds.

That there are imbalances within the Chinese economy is not in dispute. However, the existence of policies to address these imbalances, both with a short and long term view, also cannot be disputed. As we have observed in the past, the Chinese clearly have the intent and the capacity to deal with the imbalances; the question now is just about their efficacy in so doing. We remain of the view that growth slowing to something in the order of 6% in coming years is a healthy development, and with our forecasts remaining supportive we expect to maintain a preference for China within Asia, and Asia within Emerging Markets for some time to come.


It seems clear our own central bank doesn’t like to be predictable, and they have demonstrated that by wrong footing many observers so far in 2015. Their decision not to cut rates in early April was perhaps influenced by the weaker data from the United States, which may mean that the Federal Reserve delays ‘liftoff’ from their zero rate setting. We know from their public utterances that the RBA board has been particularly concerned about the headwinds from a strong currency in recent years, though it seems they are now more sanguine on that issue with the Australian dollar steady in the mid 70c range. Conversely, the United States is now facing that same headwind, with a stronger currency making imports more attractive and exports more expensive.

Certainly there would also have been some consideration given to the impact on housing markets if they were to make additional rate cuts. NSW residential property in particular has shown strong growth and attracts all sorts of gloomy predictions; though to be fair many of these same observations have been made consistently in past decades and are yet to come to fruition. In our deliberations we pay particular attention to the major banks. We do of course continue to monitor closely the banks’ current capital positions, and also the impact that regulatory change is likely to have. On the latter point, it remains clear that the banks will be required to become more conservative and increase their capital which improves the defensive nature of their respective income security.

There is a corollary to the increased capital requirements though, and that is a likely moderation to the levels of profitability that have been observed in recent years. At present our forecast for Financials is slightly below that of the broader market, and quite a bit lower than our mid and small cap estimates.

1. Moore, Giugliano “Switzerland becomes first to sell 10-year debt at negative yield” Financial Times. 8-Apr-15
2. T Nakao, ADB President, Speech at the China Development Forum 2015. 22-Mar-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.