William Buck Australia
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Welcome to the August 2016 edition of Private Wealth View.
Reporting date 30 June 2016
The March quarter inflation figures, released late in April, showed an unexpected drop in prices of -0.2% for the quarter and 1.3% year on year. The latter reading was well below the Reserve Bank of Australia’s (RBA) target range of 2 – 3%.
The largest declines came from the retail, food and transport sectors. Intense rivalry between domestic and offshore retailers, combined with lower oil prices were the main contributors to lower prices. The RBA moved quickly to cut the cash rate by 25 bps in May, to a new historic low of 1.75%.
The divergent path of US and Australian interest rates will likely place renewed downward pressure on the Australian ($A). The $A has been strong recently as the US Federal Reserve delayed raising rates in the lead up to the Brexit vote. However, the domestic interest rate cut in August and the potential for a September increase in the US is likely to see the downward bias reinstated for the $A.
The highest term deposit rates on offer are currently 2.85%, 2.90% and 3.05% across 3, 6 and 12 months respectively. We are negotiating directly with term deposit providers on a case by case basis to ensure we secure highest possible interest rate on your behalf.
Australian and global bonds returned 0.26% and 0.31% respectively in April as yields drifted higher. The increase in Government Bond yields was driven by increasing confidence as equity markets bounced higher in March and April from the February lows.
Australian bonds outperformed global bonds in May as the RBA cut domestic interest rates to a record low of 1.75%. Australian bonds returned 1.26% for the month, largely driven by capital gains1 in Government bonds as the yield on the Australian 10 year bond hit a record low. Global government bonds returned 0.57% for the month as yields fell across the major markets, pushing prices higher.
Australian bonds returned 1.33% in June, with the Australian 10-year Treasury yield falling to a new record low of 1.98% during the peak of the Brexit uncertainty. Likewise, Global bonds returned 1.98% during the month as a result of the flight to safety from equities into bonds. The performance during June highlighted the sector’s diversification benefits during periods of increased uncertainty.
Australian shares started the quarter stronger, building on the recovery from the February lows. The main drivers of performance were the materials and energy sectors, whilst banking stocks lagged as investors digested mixed earnings results.
Investors cheered the RBA’s May interest rate cut, with Australian shares moving 2.30% higher on the day of the announcement. Lower rates were supportive of shares, as was the decline in the $A. Healthcare stocks were the main driver of returns for the month, with investors attracted to the sector’s defensive qualities and offshore earnings which benefit from a falling $A.
Global equities were higher during April as global central banks paused in anticipation of upcoming Brexit volatility in June. The US Federal Reserve (Fed) and European Central Bank (ECB) both kept rates on hold, preferring to keep powder dry for a response to any Brexit fallout.
US economic data was better than expected in May, lifting US shares by 1.53% for the month and reassuring investors that the US economy could withstand higher interest rates. German shares were also higher as the ECB confirmed it would begin buying Corporates Bonds in an effort to reduce the cost of corporate debt.
Market falls in the wake of the Brexit vote meant that global equities were significantly weaker in June, with the UK market hardest hit. The major global markets have also bounced in the weeks post the Brexit announcement, with US and European shares up over 7%. The rebound was helped by verbal support from global central banks, with the Bank of Japan, Bank of England and ECB all hinting at potential intervention to stem market volatility.
The focus has now turned to the US reporting season which is occurring in the midst of US equities posting a series of new highs. With the SP500 trading on a PE Ratio of 17x (long term average of 14.3x), earnings will need to meet expectations for these levels to hold in the coming months. Approximately 68% of reporting companies have so far released earnings above expectations.
Hedge Fund2 strategies generally struggled with the increase in volatility during April and May. Many commodity and currency markets were lower in April, only to reverse course in May, wrong-footing many strategies. The plunge in many markets during the height of the Brexit volatility was a timely reminder of the diversification benefits of these strategies, with returns of 3 – 8% delivered during the month of June alone. The strategies benefited from the sharp fall in the British pound post the Brexit result and an increase in some commodity prices, primarily gold and silver.
1. There is an inverse relationship between the yield on a fixed rate Government Bond and the price. As investors buy Government bonds the price increases resulting in a lower yield and vice versa.
2. Hedge Funds aim to generate a return by using a number of strategies to take advantage of rising and falling prices across stocks, bonds, currencies and commodities.
In the first part of our commercial property sector review (here) we discussed sector valuations in a historical context. We concluded that that the low interest rate environment would sustain a level of demand, however the scope for further material price appreciation appeared limited.
In Part 2 we will examine the common risks associated with investing in a commercial property fund. A commercial property fund allows an investor to achieve a level of diversification and scale which is difficult to achieve as a single, stand-alone investor.
The primary risk for any investment is the specific market risk. The price of a commercial property is affected by a number of factors; including the demand for a particular type of property compared to future supply. The rental income is subject to the demand by tenants for commercial space and tenants’ ongoing ability to make rental payments.
Property expenses vary over time and may include capital improvements and ongoing expenses for general maintenance and repairs.
The current commercial property cycle is now over eight years old, implying market related risks are growing higher.
Gearing magnifies both gains and losses on a property investment. A fund with higher gearing may experience larger fluctuations in value compared to funds with lower levels. A higher gearing level can create the illusion of superior returns.
The following example illustrates the impact of gearing on a fund’s equity when property prices change. Consider a scenario where a fund purchases a property for $1 million using a loan of $650,000, equivalent to a Loan to Valuation Ratio (LVR) of 65%.
The example illustrates the power of gearing. A +/- 10% return on the property translates into a +/- 29% change in the value of the investor’s equity. Gearing works well in a rising market, but can be equally damaging in a falling market.
Investors should look for investments with lower gearing or look to reduce gearing at this point in the cycle. This will reduce the impact of falling prices on equity values when the cycle begins to turn.
An investor should look closely at the composition of any income distributions received from a fund. It is often easy to assume the income received is only the rental income remaining after expenses. Unfortunately, this is not always the case.
A commercial property fund may distribute other forms of capital which creates the illusion of a higher yield. A higher yield is more attractive to investors in a low interest rate environment.
For example, a manger may draw down additional capital from the loan secured against the property to “top up” the distribution. This reduces the value of the investment as the investor is receiving a portion of their own capital back.
Changes in interest rates may affect the amount of income available for distribution. Rising interest rates may require rental income to be diverted from distributions to pay the higher interest expense.
Interest rate risk can be migrated on some level by fixing the interest rate for a period. However, the fund may be unable to refinance a debt facility on agreeable terms when the current loan agreement expires.
Commercial property transactions occur in an unlisted market and the asset class is considered illiquid. This means an investor does not have immediate access to their capital.
Selling commercial property generally takes three to six months and may take longer in a market downturn. The lack of liquidity in the property markets means an investor is unable to readily react to changing market conditions by selling an investment.
An investor in a fund delegates the day to day management of a property to an investment manager. As a result, the fund is reliant on the manager’s experience and skill. An investor should ensure that thorough due diligence is completed on a manager prior to investing.
Key areas include the key personnel’s background, the organisation’s investment track record and governance structure.
An investor is relying on the manager to mitigate the key risks discussed above. Poor investment management can lead to substandard investment outcomes, even when the overall market is rising in value.
In Part 3 of our commercial property focus we will conclude our analysis with a discussion on the outlook for the sector and how this is reflected in our current asset allocation and portfolio construction.
With the uncertainty surrounding the Brexit vote now seemingly behind us, attention now turns to the next action by the United States (US) Federal Reserve (Fed). Investors may well be questioning if the Fed has cried wolf one too many times regarding interest rates.
The usual pattern is for the Fed to slowly increase market anticipation of an interest rate rise, only to find a reason not to move due to a global risk. This pattern resumed recently as the Fed’s statement left the door open for a September rate hike. December remains a more likely scenario as the election scheduled for November 8th will have passed.
The Brexit vote and US interest rates are examples of “event risk” that can often tempt investors to time markets. This usually leads to poor investment outcomes. In the two days after the Brexit decision, the SP 500 Index fell 5.3% as many investors sold out. In the next three days financial markets gained back almost all of the losses.
Brexit is also a reminder that investors should always expect the unexpected. Investment markets can be unpredictable. The only way to prepare for unexpected events is to have a long term investment strategy, including a diversified portfolio of investments which reflect your tolerance to risk.
An investor who holds a diversified portfolio based on a pre-agreed investment strategy is more likely to avoid panicking during market volatility. During the Brexit volatility, equity markets declined, while government bonds and hedge fund strategies increased in value. Diversification across a number of asset classes and strategies reduced overall portfolio volatility.
We will continue to monitor events in the UK and Europe post Brexit for any further impact on financial markets. Market volatility may also increase leading up to and after interest rate announcements by the Fed. We will provide another market update in the event there is a material impact on financial markets.