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Reporting date 31 March 2016
There was no Reserve Bank of Australia (“RBA”) meeting scheduled in January, leaving February as the first month for the Board to meet and consider the level of domestic interest rates. The Board left interest rates on hold at 2.00% as expected, however, Governor Glenn Stevens did make reference to the recent volatility in global markets and the potential for it to drag on domestic economic growth.
Domestic economic data remains reasonable given the slowdown observed in other areas of the global economy. Unemployment data has recently been stronger than expected and the January inflation reading of 1.7% remains below the RBA’s upper tolerance level of 2%. The RBA did reassure investors that it is willing and able to cut interest rates should the recent financial market volatility leak into the domestic economy. This message was consistent with the March meeting where interest rates also remained on hold at 2.00%.
The RBA was under considerably more pressure for the remainder of March after global events caused a strong rally in the Australian dollar (“$A”). The currency bounced after changes to United States (“US”) interest rate expectations caused the US dollar (“$US”) to weaken against almost all the major currencies. A weaker currency has been an extremely important factor in domestic economic strength and increases the likelihood that the Board will try and “talk down” the currency at its April meeting.
Recent changes to bank funding profiles have provided some attractive term deposit rates.
The highest term deposit rates currently available are 3.00% across 3 months, 3.10% across 6 months and 3.12% for 12 months.
A sharp decline in risk appetite during January led to an increase in volatility and weakness across equity markets. Global fixed interest markets saw increasing inflows as investors sought a safe haven. The weight of money pushed yields lower and prices higher. By the end of January the global fixed income sector increased by 1.65%, whilst the Australian sector rose by 1.22%.
Risk appetite declined further in February, adding to investor caution and driving further support for the sector. Concerns over global growth and commodity prices resumed, convincing many investors to remain parked in fixed income investments. As a result, fixed income markets continued to climb, with global fixed income rising 1.09% and the domestic sector posting a 1.03% increase. The positive returns from the sector during the first two months of equity market volatility provided excellent portfolio diversification.
Sentiment became much more positive during March as global central banks moved to restore confidence. March saw some of the recent gains in the sector reverse as volatility in global equity markets declined. Investors cheered the likelihood of lower US interest rates for longer and the renewed confidence caused investors to relocate some of their fixed income holdings back into the equity market.
The Australian equity market experienced a volatile start to 2016, finishing the month of January down -5.48%. Global market weakness was the key driver, with the Australian market generally following offshore market moves. Commodity stocks once again led the market lower, with Materials and Energy falling -9.1% and -6.5% respectively for the month, as concerns around Chinese growth intensified.
The selling pressure grew stronger in February as investors weighed continued weakness in the global economy. Investors also focused on the domestic reporting season, which was generally better than expected. Aggregate profits rose 2.10% for the half year compared to the prior period. Dividend payments rose by 7.1%, with 62% of companies lifting payment levels.
The major themes for the resource sector remained cost cutting and lower dividend payouts as profits declined. Much of the bad news had already been factored into share prices, leading to a recovery in the Materials sector of 9.12% during the month.
The other main area of focus was the outlook for bank profits and dividend payouts. The reporting season saw banking bad debts start to tick up, adding to existing concerns about the need for capital levels to protect against a downturn in the property market. The negative sentiment surrounding the sector led to a decline of -5.32% for the month. The market as whole declined 1.76% during February.
Source: Ord Minnett
The theme of stronger Resources stocks and weaker Banking stocks continued during March. The remainder of the market was generally well supported as investors continued to embrace the prospect of US interest rates remaining on hold. The rebound in the $A did limit gains for those companies with offshore earnings which benefit from a weaker currency.
Global equity markets were dominated by threats of slower growth in China and a sharp drop in oil during January. Chinese economic data was generally weaker than forecast, with investors alert for further weakness in the currency. Volatility and caution remained the overarching themes, however, shares globally came off their lows towards the end of the month on hopes of further central bank action. The sector finished the month off 3.23%.
January’s themes remained in focus during February. The market volatility reflected uncertainty surrounding the US Federal Reserve’s March meeting to decide on interest rates. Global equity markets began to rally towards the end of the month as rumours of further easing from global central banks gained traction, with the sector down -1.7% for the month.
Co-ordinated action from central banks arrived in March, with the European Central Bank announcing a raft of new measures to spur European economic growth. A further boost was provided by the US Federal Reserve when it announced that had reduced its forecast of interest rate hikes from four to just two in 2016. Markets responded favourably to these developments, led by a strong bounce in US equities.
Hedge Funds and alternative strategies also provided significant diversification benefits during January and February. Positive contributions from fixed income, currencies and commodities generated strong returns 2.8% and 3.2% in January and February respectively. Returns have moderated somewhat during March as equity markets and risk appetite rebounded.
The Australian commercial property market has been one of the primary beneficiaries of record low global interest rates. Cheap debt and lower returns on other asset classes has fuelled increasing demand for income producing commercial property. This dynamic has contributed to strong returns in the sector since the bottom of the last cycle in 2009.In this update we will take a closer look at what has driven demand in the sector and how the current market compares to other historical points in the commercial property cycle. It is extremely difficult for anybody to call a turning point or top in a cycle. However, considering the current environment from a historical context can provide some guidance going forward.
Low global interest rates have caused many investors to consider alternative asset classes to satisfy their income needs. Commercial property has been a primary beneficiary of this theme due to its steady income profile. The sector also appears less volatile than other asset classes because it is unlisted and not subject to the same level of volatility as listed equities.
The Australian commercial property sector is particularly attractive to foreign investors as overseas interest rates are generally lower than Australia. This makes the yield on Australian commercial property quite attractive. Lower overseas interest rates generally allows an offshore buyer to borrow more at a lower cost and therefore pay more for the property.
Foreign investors have been the main driver of commercial property price appreciation in recent years. Fund Manager Folkestone concluded that foreign investors accounted for over 50% of Australian non-residential transactions during the 2015 calendar year.
Australia is also particularly attractive to foreign investors due to its stable political system and transparent capital markets. The fall in the Australian dollar has also made Australian commercial property comparatively cheaper for offshore investors.
A key measure to consider when valuing a commercial property is the capitalisation (“cap”) rate. In simple terms, the cap rate reflects the net income on the property divided by the value of the property. Therefore the cap rate reflects the net yield on property after the payment of all expenses. Below is a simple cap rate calculation on a property:
As demand for commercial property increases the price goes up, which in turn compresses the cap rate lower. The cap rate can fall even if rent or expenses remain the same. The compression in the cap rate is caused by a new buyer willing to pay above the previous property price to set a new valuation benchmark.
The following example shows the cap rate decreasing from 7.00% to 6.63% because a new buyer is willing to pay 10.00% more for the property.
A top in the cycle usually occurs when cap rates stop falling and then start to increase. This is caused by a new buyer who is unwilling to buy a property for sale because the yield is too low or the price is too high. Both these issues are essentially different sides of the same coin.
The chart below shows commercial real estate cap rates over the last 10 years compared to the Australian 10 year bond rate. The commercial property sector is generally broken up into three key sub-sectors: office, industrial and retail.
The chart above shows that the Australian commercial property market last peaked in 2008 immediately prior to the Global Financial Crisis. Around this time retail cap rates were ~6%, office ~6.25% and industrial ~7%. During and immediately after the GFC cap rates across the sector increased materially causing prices to fall. Any investor who purchased property at the top of the cycle experienced substantial capital losses, particularly if the property was highly geared.
Cap rates are currently resting at similar levels to the last market top in 2008. The major difference in the current environment is that interest rates are significantly lower, making the lower commercial property yields still appear attractive. However, if history is any guide, it does not appear to be an attractive time to buy when cap rates in the sector approach this level.
This current low interest rate environment could create the potential for further cap rate compression and price rises. Whilst the weight of offshore money could push yields even lower, the scope for further cap rate declines and associated prices increases appears limited.
In Part 2 of our look at the commercial property sector we will take a closer look at the risks of investing in the sector and examine the outlook for the sector in the coming years.
It looks increasingly like 2016 will see another year of uncertainty in the global economy. There will be two distinct forces working against each other, with the dominant force setting the tone and direction of equity markets for the remainder of the year.On one side we have a global economy which is slowing after many years of solid growth. China is in the middle of long term transition which creates immediate headwinds for economic growth. The United States (“US”) is growing at a reasonable rate, however recent economic data has been “patchy.” A slowing global economy means lower company profits, which has been reflected in lower equity markets since the turn of the year.
On the other side we have global central banks diligently fighting against any slowdown. Central banks remain committed to low interest rates and other forms of stimulus to make any slowdown manageable. These policies are also designed to kick-start future growth.
This battle means another year of equity market volatility. Markets will remain skittish around economic data released from China and the US. Similar reactions are expected around meetings and announcements from global central banks. Investors should try to avoid this short term news flow and volatility as it is largely “noise” in the context of a long term investment strategies.
As always, we will continue to monitor international events and provide you with an interim update should a material event occur which impacts your investment portfolio.