By Chris Rylands, Principal, Wealth Advisory

Market Returns

Reporting date: 30 Sept 2017

Index 1mth 3mth 6mth 1yr 3yr 5yr
AUSTRALIAN EQUITIES
Australian Shares -Large -0.1 0.68 -0.91 9.25 7.08 10.08
Australian Shares – Small 1.31 4.41 4.04 2.98 8.15 5.09
GLOBAL EQUITIES
International Shares 3.44 2.53 6.25 15.38 11.82 17.67
Asian Shares 0.96 4.23 12.28 19.65 11.88 13.67
US Shares 1.93 3.96 6.63 16.19 8.5 11.83
FIXED INTEREST
Australian Fixed Income -0.3 -0.07 0.94 -0.75 3.9 3.9
International Fixed Income -0.4 0.89 2.07 0.53 4.77 5.1
EXCHANGE RATES
AUD/USD Spot Rate -1.4 1.89 2.69 2.22 -3.61 -5.47

Source: Bloomberg

Special Topic: Geopolitical Tensions Continue

In late April this year we sent out an update regarding the heightened geopolitical tensions between the United States of America (the US) and Syria, and the rise in tensions between the US and North Korea (NK). The update discussed the possible impact the conflicts could have on your portfolio.

Tensions have continued to rise in recent months with a new war of words breaking out between the US and NK. Despite UN sanctions supposedly enforced as an attempt to turn NK away from advancing its nuclear capabilities, the East Asian nation has continued to carry out tests, including hydrogen bomb tests.

In response, President Trump threatened to “totally destroy” North Korea, and that NK leader Kim Jong- un and Foreign Minister Ri Yong- ho “won’t be around much longer” – words that the NK constituents took as a declaration of war. Yong- ho retaliated, speaking about US aircraft flying close to the Korean Peninsula, suggesting that their rights included shooting down the aircraft even if it is outside North Korean airspace.

Although the two sides have been at opposing ends of this conflict for decades, this intensity of threats and provocations between the two sides has escalated dramatically in recent times. Markets have not really reacted to the news and any preliminary concerns have been short-lived, with investors quick to move on.

History as a guide

There is no single guide that explains to us how markets would react in the event of break out of war. Historically, in worst case scenarios (wars), falls in the markets have been anywhere from small to substantial, accompanied with volatility. In some cases markets have rebounded quickly and in other situations the bounce back has taken substantially longer. In general, investors would expect to see a decline in equity markets and a rotation into safe havens such as government bonds or gold.

Data from AMP indicates that US shares fell between -7% and -34% during six major conflicts, with the largest fall attributed to World War 2. In all of these cases, the market had recouped its losses 6 – 12 months after the low. Markets tended to fall once war broke out and tended to bottom prior to a resolution. The extent of the decline was also dependent on the market environment at the time.

With no clear historical precedent it is worth assessing the current market environment for some insight on the potential way forward. The current geopolitical unrest is occurring during a period when central banks are removing stimulatory policies and favouring rate hikes, which leaves markets more vulnerable to a pullback if a large negative event happens to unfold. However, in general central bankers have reaffirmed a commitment to step back in to support the market in the event of a large disruption to markets or the global economy.

After a very strong year for markets, it would not be out of the question for a pullback sometime soon – however predicting when and why remains beyond the control of all investors. The factors which investors can control are their risk profile and asset allocation. An appropriately diversified portfolio can partially insulate investors from a market decline or at least minimise volatility to the extent that the investor remains committed to their long term investment strategy. William Buck has ensured that your portfolio is appropriately diversified, given your risk profile

Moving Forward

Nobody can ever be certain of the outcome in financial markets, particularly when military conflict in involved. At present there are no signs that the US is preparing for a conflict given there have been no specific military deployments. This means there is still a possibility that the tension could de-escalate once again. However given North Koreas growing nuclear capability and the unpredictability of both leaders, a miscalculation from either side that has the potential to lead to conflict should not be ruled out.

We will continue to monitor the situation and update you appropriately. We anticipate that, given it is not in the interest of either side to engage in full- blown conflict, diplomacy will prevail and that a peaceful solution can be reached.

The Market Update

Cash

The Reserve Bank of Australia (RBA) left the cash rate on hold at 1.5% for the three months of July, August, and September.  At its August meeting, the RBA noted that inflation continues to run below the 2% target, however given higher electricity and tobacco prices, the RBA is expecting CPI to boost in the coming months.

As the same decision was handed down in September, it was noted lower petrol prices have contributed to lower inflation, with prices at the pump down 15 cents per litre (nationally) since early June. For the October meeting, the bank acknowledged an improvement in non- mining business investment, as well as positive business sentiment that has led to higher levels of capacity utilisation. However wages growth and core inflation remain low, and housing debt continues to outpace growth in household income – one of the main concerns of the RBA. Amongst this concern, it was good to know that a gradual pick- up in GDP is occurring.

Increase in non- mining investment                                                                                             Increasing household debt 

In the US, the US Federal Reserve left their funds rate on hold at 1.25% for their July and September meetings, also noting below- target core inflation.

Fixed Income

Global yields were mixed in July with long- term yields in Europe rising and spreads narrowing, versus US and UK yields finishing down slightly. In Australia, the 10- year Treasury yield rose from 2.66% to 2.68%. In August we saw some compressing of global yields as geopolitical tensions chased investors into safe haven assets such as bonds and gold. The Australian 10- year Treasury yield was up again, rising to 2.71%. Global yields moved higher in most developed markets throughout Sept; the UK Gilt, German Bund, and US yields all rose. The Australian yield also rose (yet again) to 2.84%.

 

Australian Equities

The Australian stock market had a flat month in July, posting a 0.01% fall. Gains in the Materials and the Financials sectors supported performance, with ANZ gaining 3.17%. Healthcare was down despite adding 23.48% in the first half of 2017.

Australian Equities were flat again in August, however this time returning a positive 0.71% and largely dependent on a price surge in commodities. Energy and Consumer Staples sectors posted gains of 6.07% and 5.94%, respectively.

In September, domestic equities entered its fifth month of flat or negative growth, returning -0.02% as commodity sectors pulled back. Healthcare was the leading performer for the month as it benefitted from a gain from CSL; the heavyweight announced increased capital expenditure in August, investors considering the company well positioned for growth. Telecommunications on the other hand was the worst- performing sector, falling -4.53%. Commonwealth fell 0.73% as it completed the sale of its troubled CommInsure business.

Australian equities have been strong month to date in October, with the key driver being renewed offshore interest rather than a change in the fundamental near term earnings outlook.

International Equities

For the month of July, global equities fell in Australian dollar (AUD) terms with Japanese and German markets being the main drag. US equities gained in US dollar (USD) terms but lost in AUD terms as the USD weakened. The Telecommunications and the IT sectors were the only US sectors to gain in AUD terms. The Eurozone fell 0.77% as gains in the Resources and the Insurance sectors helped stem the tide.

In August global equities made a turnaround and gained 0.85% in AUD terms, supported by Asia. US equities also gained in AUD terms, and so too did European equities, gaining 0.19%. In Europe the Resources sector continued its strong run from the month prior with our own stock holding, Rio Tinto, gaining 7.23%. Conversely Japanese equities fell whilst China was up 4.93%. Emerging markets were supported by Brazil and China.

International equities gained 0.68% in AUD terms for the month of September, supported by US and European markets. European stocks rose 4.28% with strong growth from energy producers, whilst US stocks gained 3.06% in AUD terms. Emerging markets rose 0.68%, predominantly supported by Chinese markets given Indian equities were down -2.3%. Japanese and Chinese equities rose 2.47% and 0.89%, respectively.

Global equites have largely tracked sideways during October, with reporting season in the US gathering steam and European equities supported by continual policy support from the ECB.

Alternative Strategies – Hedge Funds

The HFRX Global Hedge Fund Index $A returned -0.98% during the quarter, driven by gains in Equity Hedge and Event-Driven strategies. Trend following strategies remained in a holding pattern during the quarter, however performance during October has been noticeably stronger.

Outlook

Outlook

The month of September saw investors turn to safer asset classes as geopolitical tensions heightened and uncertainty turned up a notch. With unpredictability so prevalent, the question remains: what will the investment landscape look like come the next quarter?

The Reserve Bank of Australia (RBA) seems to want to deliver the people good news given it delivered a relatively upbeat statement in its latest meeting. The RBA noted that it expects a gradual lift in GDP to occur, given the recent quarterly increase of 0.8% points to signs that the previous quarter’s weakness in GDP growth was a temporary factor. However, the strong employment numbers are not flowing into wage inflation.

Price inflation doesn’t seem to be improving either, not helped by subdued consumer confidence as households continue to service mortgage debt.  These weaker factors may cause a headwind in the Australian economy in the next 6 – 12 months.  However, there are no indications that the RBA is ready to raise rates, despite countries like the US and Canada taking action. The RBA maintains that it did not cut interest rates as low as other countries and therefore should not be in a hurry to increase rates when these countries do.

In terms of domestic equities, this September month saw the small cap stocks (1.31%) outperform the large cap stocks (-0.15%), bucking a recent trend where large caps had shown greater strength. Australia, in particular Australian retail, was not immune from the Amazon effect. From the announcement that the giant is bringing business down under, we are still seeing negative sentiment in retailers. The main challenge for the Australian market remains finding earnings growth to support the next market upswing.

The US economy, too, is facing low inflation figures, which is not aiding the Federal Open Market Committee (FOMC) in carrying out its intended rate hikes. Nevertheless, markets expect one more rate rise for this year, with a December rate hike given an approximate 70% likelihood. So far markets have taken the prospect of rising interest rates relatively well, although the FOMC is flagging more rate rises next year than is currently anticipated by the market.

In the Eurozone, the European Central Bank (ECB) is also talking of ending its economic stimulus program. However, inflation is still below trend. Furthermore, the Euro (EUR) has risen by about 13% against the US dollar (USD), on the back of USD weakness and growth in the Eurozone. This is somewhat equivalent to tighter monetary policy and has left the ECB in a bind regarding ending its economic stimulus program.  There is a risk that reducing economic stimulus could bring the economy to a halt and further strengthen the EUR, which would be negative for the region’s exports.

The outlook on China remains one of moderating yet solid growth. Following higher- than- expected economic growth, indicators appear to show that momentum seems to have eased. It is clear that China’s modest tightening in financial conditions is having some impact, as money supply growth has slowed in line with GDP growth; this is a good thing from a financial stability point to view, suggesting the debt- to- GDP ratio is no longer climbing.

As we approach the end of 2017 we remain watchful on tax reform in the US. Markets have advanced in anticipation of successful tax reform, yet actual implementation remains. The latest information indicates that reform will be phased in over time, which is the minimum that market participants will be expect after such a long wait.