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By Christine Brown, Director, Wealth Advisory
February started with a bang, with the US market experiencing its biggest pull back since early 2016. The pullback occurred on the back of fears of rising inflation and interest rates as wage growth data in the US ticked up.
One of the measures used to ascertain implied volatility in the market is the VIX, which has been at historically low levels for some time. Leading up to the spike in volatility, the VIX was hovering around 10 before shooting above 50. Our expectation is that we will see volatility return to more normal levels, rather than the depressed levels we have seen in recent years.
On the economic front, fundamentals remain solid, with GDP growth strong across many regions. Lack of wage growth has been an issue for many economies, including Australia, but as mentioned we have seen this pick up in the US. The key question will be to what extent this drives inflation and to what extent rates will rise. The US Federal Reserve has clearly stated that they will be looking to raise rates three times this year and the market has factored this in. The key thing to watch will be whether inflation rises faster than expected, prompting a more hawkish response from the Fed, which would have a negative impact on equities and government bonds alike.
The S&P/ASX 200 Accumulation Index rose 0.4% in February, with losses during the start of the month fully regained on a total return basis. In price terms, the index hit a high of 6121 points early in February, bottoming at 5821 points (a fall of 4.9%), and then recovering to end the month at 6016 points (90% recovered from the start of the month). February’s gains were driven by the health care sector (+7.0%), with CSL (+11.4%) the top performer on the back of record HY profit and a lift in its full-year guidance.
Consumer staples (+2.2%) shares were also higher, with strong gains from market darling A2 Milk Co (+47.5%) following a big-earnings beat, while Woolworths (+2.5%) enjoyed a solid earnings performance, including a 3.8% rise in sales. The telecommunications sector (-6.0%) was the worst performing for the month, with Telstra (-4.4%) still out of favour since reducing its dividend, and Vocus Group (-18.1%) hit hard following a downgrade to its FY18 guidance and the departure of CEO Geoff Horth. The energy sector (-3.7%) also came under pressure, with Whitehaven Coal (-8.9%) battling higher-than-expected operating costs, albeit with the offset of a buoyant coal price.
S&P/ASX 200 share price performance for the month to February
S&P/ASX 200 share price performance for the year to February
The latest (February) monthly NAB business survey was particularly encouraging. The important reading is business “conditions,” which reflect the reality of firms’ own trading, profit, and hiring and the reading for February was excellent: The business conditions index increased a further +3pts to +21 index points. This is a record high since the monthly survey commenced in March 1997.
The Reserve Bank agrees that the business cycle is picking up. After its March policy meeting, the bank said that “The Bank’s central forecast is for the Australian economy to grow faster in 2018 than it did in 2017. Business conditions are positive and non-mining business investment is increasing. Higher levels of public infrastructure investment are also supporting the economy. Further growth in exports is expected after temporary weakness at the end of 2017.”
There is a reasonable prospect of 2018 turning out to be a stronger year for business, but the question is how strong an impact will modestly faster growth have on corporate profitability. Credit Suisse’s latest forecast is that earnings per share will grow by 7% this year. CommSec also thinks that faster growth is on the cards and expects to see the S&P / ASX200 trading somewhere in the 6,150 to 6,550 region by the end of the year. That would present a pleasant turnaround from an extended period of subpar performance: Over the past 10 years, the index has averaged an annual price gain of only 0.8%.
The MSCI World ex-Australia Index returned -0.4% in Australian dollar terms and -3.7% in local currency terms as global equity markets were rocked by volatility and a sharp correction early in the month. The US S&P 500 Index was down 3.7% over the month, hitting a low of 2581 points to end at 2714. The VIX spiked to a high of 37.3 to end the month at 19.9—still elevated compared to recent historic lows. IT was the only sector to gain (+0.1%), boosted by Apple (+6.8%) and Hewlett Packard (+13.4%). Energy (-10.8%) was the biggest losing sector, with oil giant Marathon falling 19.9%, while consumer staples (-7.8%) was not far behind, with popular defensive stocks like Walmart (-15.6%) and Kraft Heinz (-14.5%) failing to recover from the broader market correction. The US Dow Jones Index fell 4.0% but was still higher than at the end of 2017.
In Europe, the STOXX Euro 600 Index fell 4.0%, with falls in telecommunications (-5.1%) and utilities (-4.8%) shares. The German federal court paved the way for cities to ban or tax diesel cars, with the price of major auto shares reacting negatively, including Volkswagen (-9.0%) and Daimler (-4.4), whose Mercedes diesel SUVs may be impacted. In Asia, the Chinese CSI 300 Index was down 5.9%, Japan’s Nikkei 225 Index fell 4.5%, and Hong Kong’s Hang Seng dropped 6.2%. Global developed market shares fell 3.5% and emerging market shares fell 3.9% in local currency terms.
The economic and financial news continues to show that the world economy is picking up pace. The OECD, in its just-released update to its Economic Outlook, is of the same view. “Global GDP growth is estimated to have been 3.7% in 2017, the strongest outcome since 2011,” the OECD said, “with positive growth surprises in the euro area, China, Turkey and Brazil.” The OECD’s latest forecasts have also been revised upwards. It said that “The world economy will continue to strengthen over the next two years, with global GDP growth projected to reach almost 4% in both 2018 and 2019.”
Although the economic fundamentals have continued to improve, the outlook still faces some challenges. Despite the February sell-off, share valuations are still high, especially in the U.S.: While they are not as pricey as they were going into the “tech wreck” of the early 2000s, U.S. equities are priced at 17.2 times expected earnings, a reasonably high level by historical standards. Shares are consequently vulnerable to any earnings disappointments.
There is also the potential for unpleasant geopolitical surprises, particularly given the unpredictable outlook for U.S. economic and foreign policy.
The most likely scenario is that the progressively strengthening state of the world economy will underpin ambitious profit expectations, and equities will benefit. But it also seems likely that 2018 will spring more February style volatility along the way as investors periodically reassess the state of the global business cycle and, in all likelihood, confront geopolitical surprises they are not fully prepared for.
Australian bonds returned 0.29% over February, with Australian government bonds returning 0.28% and longer-term government bonds (ten years plus) returning 0.17%. The Australian 10-year yield was flat over February at 2.81%, but jumped to a high of 2.94% early in the month. Globally, the Bloomberg Barclays Global Aggregate Bond Index (AUD hedged) returned -0.23% as global yields pushed higher. The five-year breakeven inflation rate—a market-derived gauge of expected inflation—reached its highest point in over five years, reflecting the market’s focus on wages and consumer prices. The US 10-year treasury yield underwent significant expansion, rising from 2.72% to 2.86%. The Japanese 10-year yield fell from 0.09% to 0.05%, still hovering above the Bank of Japan’s zero yield target. The German 10-year yield fell from 0.70% to 0.65%, while the 5-year yield fell from 0.10% to 0.02%, but still managing to hold above zero.
The latest policy decision from the RBA on March 6 said nothing specific about the bank’s future plans, but analysts paid quite a bit of attention to the end of the sentence that read, “Further progress in reducing unemployment and having inflation return to target is expected, although this progress is likely to be gradual.” The “gradual” reference was taken to mean that the bank would need to leave interest rates where they are for even longer.
Although U.S. bond yields have drifted back down again in recent weeks, the likelihood is that the longer-term track for U.S. bond yields is upwards: The U.S. Federal Reserve is in the process of adjusting monetary policy back towards more normal levels, and other overseas central banks are likely to follow later on in the piece. Higher overseas bond yields are likely to feed through to higher local rates, probably much in line with the consensus forecast for U.S yields – up by around 0.3% this year and by a further 0.4% next year, which would take the 10-year Commonwealth bond yield to around 3.4% by late 2019.
The S&P/ASX 300 A-REIT Accumulation Index fell 3.2% in February, with higher yields bringing the sector under pressure. Shopping centre giant Vicinity Centres (-7.8%) was hardest hit after reporting a fall in H1 profit amid challenging retail conditions. News from major tenant RFG (whose brands include Donut King, Gloria Jeans and Crust Gourmet Pizzas) that it would be forced to close between 160 and 200 stores did not help. After a frustrating few months, National Storage REIT (+2.0%) gained in February, announcing a 22% rise in storage revenue and a 152% rise in profit driven by fair value adjustments to its portfolio. Globally, the EPRA/NAREIT Developed Market Index (AUD hedged) fell 6.3% in February, highlighting the relative tenacity of domestic REITs. US REITs, measured by the MSCI US REIT Index, tumbled 7.9% as yields spiked.
The latest (December quarter) survey of commercial property specialists run by National Australia Bank found that operators in the sector were reasonably upbeat about the business outlook, although they did not expect the outlook to translate into strong gains in capital value and rentals or sharp falls in vacancy rates. The overall picture concealed some sharp sectoral variations: Of the major subsectors, industrial is in best shape, with NAB finding “reports of high demand for warehousing arising from strong online retail (including Amazon).” Retail, on the other hand, is in outright poor shape: Respondents expected falling rentals, slightly lower capital values, and rising vacancy rates, and they expected the sector to be oversupplied with space for at least the next five years.
A faster rate of economic growth could improve the sector’s prospects, but as matters stand the economic outlook is only fair rather than robust, and even if operating performance picks up to some degree, the big challenge for the sector has not gone away. The prospect of higher bond yields is likely to lead to further underperformance.
The AUD was flat in trade-weighted terms over the three months to the end of February, with cooling commodity prices and reduced export volumes offsetting rises in the start of the year. The AUD rose 2.6% against the USD, hitting high of 0.8110 in late January to end February at 0.7792. The AUD was down against the JPY (-2.8%) and the NZD (-2.3%) and up against the EUR (+0.1%) and GBP (+0.8%).
AUD weakness in February in part reflected a vanishing yield premium, with the US Fed expected to hike rates, in March. The US Dollar Index rose 1.7% in February but still appears to be in a downward trend. Concerns over the rising US budget and current account deficits may have contributed to US dollar falls over recent months.
The outlook for the Australian dollar remains hard to call, partly because there continues to be a high degree of uncertainty around U.S. economic policy, not helped by the latest change in key personnel, with a new director of the White House National Economic Council. While there are potential upside factors – a “commodity-backed” currency, as the Australian dollar is sometimes classified, would be expected to do well in the current conditions of strong global trade growth – the downside pull of relative interest rate differentials may be more decisive, with U.S. short-term rates likely to rise in coming months but local ones likely to remain unchanged. NAB, for example, with its new forecasts of little change in local monetary policy, has the Australian dollar dropping from its current USD 78.7 cents to USD 75 cents by the end of this year.