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By Chris Rylands, Principal, Wealth Advisory
Reporting date 28 February 2017
Reporting date 31 December 2016
The Reserve Bank of Australia (RBA) cut interest rates twice in 2016, in May and again in August, taking the cash rate to 1.5%. Continued low inflation was the main driver behind both rate cuts, with the economy’s moderate growth seemingly less important.
The initial rate cut in May saw the RBA specifically downplay the strong housing market which some commentators believed would prevent the Bank from cutting rates. Commentary accompanying the August decision focussed on the domestic economy’s “modest” expansion and continued subdued inflationary pressures, particularly wage growth.
It was a tale of two-halves for Fixed Income, with the majority of the year seeing yields push ever lower as many commentators proclaimed that “lower for longer” was here to stay. This view would be firmly challenged by the end of the year where bond yields ended sharply higher.
During 2016 investors saw the Bank of Japan adopt negative rates for the first time, while the United States (US) 10 year treasury reached a record low yield of 1.37% as investors sought safe haven investments in the face of the Brexit uncertainty.
US 10 Year Bond Yield
Bond yields increased in the second half of the year, especially post the unexpected victory of Donald Trump in the US presidential election. President Trump’s economic policy focused on government spending and tax cuts, both of which have the potential generate inflation.
Bond markets responded accordingly, with the United Sates (US) 10-year Treasury yield jumping from a low of 1.37% in early July to around 2.50% by the end of the year. Similarly, Australian 10-year Bond yield rose from 1.80% in early August, to 2.76% by the end of December.
Australian Fixed Interest (as measured by the Bloomberg Ausbond Composite Index) returned 2.92% for 2016, whilst international Fixed Income (as measured by the BarCap Global Aggregate TR Index) returned 5.24%.
Investor sentiment towards Australian equities shifted dramatically during the year. Early concerns around China and Australia’s economic prospects were brushed off, only for anxiety to return post the Brexit vote. After an initial setback, investors turned positive after the US election with ‘Trumponomics’ seen to be positive for cyclical stocks and economic growth. Materials and Financial stocks drove the market higher into the end of the year.
Australian Shares – 2016
The total return on Australian shares (SP/ASX 200 TR Index) was 11.8%, easily beating the 2.6% gain in 2015. The biggest capital gains were made from Materials stocks, returning 42% during the year. The big banks were the other biggest contributor to the SP/ASX 200’s yearly performance.
Resource companies were assisted by an unexpected leap in most commodity prices over 2016, despite a stronger US dollar in which most commodities are priced. Financials were the best performers in the last quarter of the year (+12.5%) on expectations that a steeper yield curve and financial de-regulation in the US would benefit domestic banks and insurers.
Energy (+7.4%) and Utilities (+9.3%) were the other two best sectors in the final quarter as oil prices rebounded after OPEC agreed to cut production. However, Healthcare suffered in line with its global peers given noise around the repeal of ‘Obamacare’ and rhetoric around drug pricing. Telecoms also suffered as challenges around the NBN rollout emerged in the last quarter.
Australian Market Sector Performance
After a shaky start to 2016, international equities performed well, rewarding investors who remained committed despite concerns over China, Brexit, the EU (especially Italy and its banks) as well as the US election.
The MSCI AC World benchmark returned 8.5% in 2016 (unhedged) and 8.0% (hedged). Calendar year returns can often conceal all sorts of intra-year volatility, with markets first selling off and then rebounding over events such as Brexit and the election of Donald Trump.
Donald Trump was not the only area where forecasters got it wrong in 2016. Concerns over China in January and February were overstated, as the Chinese Government responded with a powerful stimulus package that supported commodity prices and producers.
The UK’s exit from the European Union seemed implausible to everyone, yet it too became a reality. The initial Brexit vote was met with fear and widespread selling in financial markets. However, the initial response was seen as an overreaction given there remains much to negotiate and debate prior to the proposed exit in March 2019.
The announcement of Trump’s proposed economic policy prompted a major shift in sentiment towards the end of the 2016. Market participants began to expect more expansionary US fiscal policy which would be beneficial for the world’s largest economy.
Investors have enthusiastically embraced the potential for Trump’s economic policy to kick-start the US economy. However, we are still yet to see much of the policy detail and therefore risks remain around the actual implementation. Volatility is likely to arrive if a gap develops between market expectations and economic reality.
Movements in the $A neither helped nor hindered international investors, with the currency trading in a relatively tight range over the year and ending 2016 almost exactly where it started it, at 73 US cents.
Hedge Funds are traditionally held in an investor’s portfolio to increase diversification across sources of risk and return. The sector performed as expected during the various bouts of uncertainty during the year. This was most evident during the Brexit panic, where the sector increased in value sharply against steep falls in equity markets.
However, the sector was caught on the wrong foot going into the US Presidential election. Much of the positioning was set to benefit from uncertainty post the US election, including a fall in global equity markets. Global share markets did decline sharply on the day of the election, reflecting the uncertainty surrounding the election of Donald Trump. However, global markets reversed quickly, moving sharply higher into the end of the year, leaving many Hedge Funds misplaced. Returns suffered as a result. With the Credit Suisse Hedge Fund Index finishing 2016 up 1.25%.
With no meeting in January, the Reserve Bank of Australia (RBA) left the cash rate on hold at 1.50% in February. Global conditions continued to improve towards the end of the year as higher commodity prices boosted Australia’s national income. However, labour markets remain mixed and wage growth has been slower than expected, meaning domestic inflation remains below trend.
The RBA’s March announcement remained consistent with a Central Bank on hold. The RBA stepped up its commentary surrounding both the housing market and household balance sheets. Growth in household income remains low, whilst household debt continues to increase on the back of historically low interest rates.
The RBA also expressed some concern about lending standards in some parts of the residential property market, whilst acknowledging that supervisory measures have contributed to some recent strengthening in this area.
Government bond yields trended higher in January and have since stabilised after a rapid jump at the end of last year. Yields increased in response to the potential for higher inflation, a stance which has been supported by recent data releases in Europe and the United States (US).
In January, the US 10-year Treasury yield finished at 2.45%, after reaching a high of 2.51%. Global bonds, measured by the Barclays Global Aggregate TR Index, returned 0.81% in January. Returns on Australian Government Bonds were 0.57%, with the yield falling slightly from 2.77% to 2.71%, some 85 basis points higher than the historic lows in August 2016.
Government Bond yields stabilised during February. The US 10-year Treasury yield finished at 2.39% after reaching a high of 2.49%, while the yield on Australian 10-year Government Bond increased slightly from 2.73% to 2.75%. Global bonds returned 0.91% in February, while Australian Bonds returned 0.17%.
The Australian market had a sober start to 2017, following the strong rally into the end of last year. The S&P/ASX 200 Accumulation Index lost -0.79% in January, following December’s gain of 4.38%. Strong gains came from the Health Care sector (+ 4.76%), led by heavyweight CSL, which jumped 11.84% after upgrading its full year earnings. Materials had another positive month, with the sector gaining 4.74%.
Small stocks lost ground in January with the S&P/ASX Small Ordinaries Accumulation Index declining -2.44%. A strong theme during 2016 was the rotation away from large stocks into small stocks, as investors speculated that large companies would struggle to achieve strong earnings growth.
However, a string of profit warnings from small cap “market darlings” such as Bellamys, caused investors to reassess the risk in the sector. Investors responded by selling down the sector towards the end of the year and allocating funds back to larger “blue chips.”
The S&P/ASX 200 Accumulation Index gained 2.25% in February following January’s loss. Strong gains occurred again in the Health Care sector (+3.84%) led by CSL Limited (+4.95%), whilst Consumer Staples (+4.86%) was the best performing sector for the month. Materials declined by -3.66% largely due to a reduction in commodity prices, in particular copper, from mid – February onwards.
The Australian December half profit reporting season wrapped up in early March, leaving company profits on track for a 19% rise after two consecutive years of falls. The profit turnaround was driven by resources companies, which are on track for a rise in profit of 150%. The jump in profits reflected the benefits of higher commodity prices, with Iron Ore up more than 100% from its lows.
Profit growth across the rest of the market was around 5%. At the end of reporting season, 46% of companies exceeded earnings expectations, while 59% increased dividends. Returning capital to investors rather than increasing capital expenditure was also a theme, with Rio Tinto, Coca Cola and AMP all announcing buybacks.
Australian profit results relative to market expectations
Shares in the United States continued to push higher in January, although a weaker $US meant Australian investors experienced a decline of -2.81% from the US S&P 500. Earnings season was also off to a solid start, with estimates for fourth quarter 2016 earnings showing growth of just under 5% and growth for the full year in the 10–12% range.
While the ‘Trump trade’ was a winner in December, the New Year brought a greater degree of scepticism. Investors were hungry for more detail on President Trump’s policies, especially with regard to tax, regulation and government spending. Sectors such as Information Technology (+4.41%) and Health Care (+2.25%) performed well in January, although the impact of potential regulatory changes on these sectors remains difficult to evaluate. Materials (+4.64%) continued to surge ahead as commodity prices rose. The global MSCI World Net TR Index lost -2.29% in $A terms.
US markets rose again in February, with the S&P 500 gaining 2.66% in $A terms, partially erasing the loss experienced in January. Appreciating commodity prices translated into strong earnings results in the Materials sector. Financials stocks continued to benefit from higher yields.
The scepticism regarding Trump’s polices present throughout January extended into February, as markets awaited further detail. Health Care (+4.75%) continued to perform well throughout February, despite comments from President Trump on pharmaceutical pricing reform. Globally, the MSCI World Net TR Index gained 1.53% in $A terms.
The US reporting seasons concluded in early March with 65% of S&P 500 companies beating earnings estimates, with Info Tech, Health Care and Financials responsible for the largest upside earnings surprises.
The Credit Suisse Hedge Fund Index finished stronger in January and February, with returns of 0.70% and 1.23% respectively. Strategies exposed to rising equity markets were the main driver of performance, whilst strategies which benefit from falling share prices were the main detractors.
Quantitative trend following strategies recouped some of the losses from 2016 during the first two months of the year, with gains in commodities and select equity markets, in particular Japan, driving performance.
Investors are facing another eventful year in 2017, with a continued focus on global politics and interest rates. As discussed earlier, investors have enthusiastically embraced the potential for Trump’s policy to kick-start the United States (US) economy. Much of the policy detail is still to be released and risks remain around the potential response from investors should there be any problems.
A deeper analysis of Trump’s fiscal policies has caused investors to contemplate that a new environment of higher interest rates may be emerging. The prospect of Trump’s infrastructure spending and tax cuts pushing up inflation may prompt the US Federal Reserve to raise interest rates quicker than forecast. It is uncertain how investors would respond after being accustomed to lower interest rates for so long.
On balance, a steady and expected increase in interest rates can be digested by financial markets. However, a sharp, unexpected, increase in response to higher inflation is generally negative for equity markets and the global economy.
Global politics will also be major factor during 2017, with both Brexit and Trump surprising investors last year. The next phase of this European political regime shift is likely to play out during 2017, with major elections in France, the Netherlands and Germany. The risk of more countries leaving the European Union will be front of mind for many investors given the Brexit result last year.
There also remains a risk that President Trump’s erratic behaviour may cause tensions with other countries. Trump’s economic policy has generally been “pro US” at the expense of other countries and this may also impact global economic growth.
Expected returns on Australian and international equities have reduced for this year post the strong rally after the US election. Equity markets would benefit from a period of consolidation to digest Trump’s economic policy and remain susceptible to volatility surrounding global politics or interest rates. Appropriate diversification across asset classes and investment strategies will provide the best opportunity to navigate this environment.