November Economic Update
Written and accurate as at: Nov 21, 2017 Current Stats & Facts
The outlook for the world economy continues to strengthen, particularly in the formerly moribund eurozone, and it provides greater support for growth-oriented assets. But valuations remain expensive across all asset classes, and are vulnerable to an eventual normalisation of interest rates, which is already under way in the United States and the United Kingdom, although it is still some time away in the eurozone and Japan. Investors also appear overly complacent about potential risks that could kick away the props for today’s expensive valuations. In Australia, official and private-sector data point every which way, and while there are some hints, it is still not clear that the economy has moved into the higher gear that would support improved growth asset prices.
Australian Cash & Fixed Interest - Review
Review Short-term rates are again unchanged, reflecting the latest monetary policy decision: On November 7 the Reserve Bank of Australia left the cash rate at 1.5%, and 90-day bank bill yields have stayed close to 1.7%. Longer-term yields have been more volatile: Although it initially followed U.S. yields upwards in September, the local 10-year Commonwealth bond yield has dropped back more recently, and at its current 2.6% is little changed from where it started three months ago. In headline terms, the Australian dollar has recently been weakening in headline terms against the U.S. dollar to its current USD 0.758. But this has mostly reflected a global strengthening in the U.S. dollar rather than any intrinsic weakness of the Australian dollar. Year to date, in overall trade-weighted value, the Australian dollar is effectively unchanged from where it started the year.
Australian Cash & Fixed Interest — Outlook
Like many developed-world central banks, the RBA has struggled to get inflation back up into its target range. At its recent policy decisions, however, it has said that leaving rates where they currently are will eventually see inflation get back into its target 2.0%-3.0% band. In the November Monetary Policy Statement, the bank put some numbers on this. It expects underlying inflation will still be a little on the low side (1.75%) throughout 2018 before finally reaching 2% in 2019. While the bank has not given any clear signal of what it might do next, or when, it evidently feels that leaving rates alone will get it to where it wants to be. Some forecasters agree: Westpac, for example, expects the cash rate will still be 1.5% in the middle of 2019 (which is as far as its forecasts go). Most forecasters, and the futures market, think that the RBA will have moved before then, with one or perhaps two 0.25% increases by the end of next year. But either way it will take some considerable time before the likes of bank deposit rates rise from their unusually low levels. Longer-term interest rates are likely to be more influenced by global developments. Forecasters generally expect local yields to follow overseas yields upwards. With overseas central banks expected to take a very careful approach to normalising monetary policy, expectations are for quite modest rises in both overseas and local bond yields. The Commonwealth Bank and Westpac, for example, both expect a 0.4% rise in the 10-year bond yield to 3.0% by the end of next year; National Australia Bank sees the potential for a somewhat larger rise, to 3.4%. On balance the outlook for the currency favours some depreciation. The RBA does not want to see a stronger Australian dollar; interest rate differentials look likely to move against it; and the recent weakness of commodity prices, if maintained, would also weigh on the currency. Most of the big banks tend to the view that the Australian dollar could be trading somewhat lower against the U.S. dollar by the end of next year (the ANZ has USD 0.68, Westpac USD 0.70 and NAB USD 0.73). But investors cannot place great reliance on any currency forecasts. Sentiment can change very rapidly in the foreign exchange markets: the tax-cut-based ‘Trump trade’ in the U.S. dollar could fall over, or (as is discussed in the Australian equities section) the Australian economy could out on a head of steam and attract portfolio investment into the Australian dollar. It’s not the mainstream view, but it is possible that something like the Commonwealth Bank’s pick of a steady rise in the Australian dollar to USD 0.83 could also come to hand.
Australian & International Property — Review
While the wider Australian sharemarket has shown some signs of picking up from a long period of underperformance, the A-REITs have continued to miss out. The S&P/ASX200 A-REITs index is marginally down (0.6%) in capital value year to date, and its total return of 2.8% lags well behind the overall market’s 9.1%. A determined optimist could look at a graph of REIT prices and argue that the sector bottomed out in July and has been on the mend since, but the net result remains that investors have had little to show from the sector. Global property has continued to lag the performance of the wider global equity market. Year to date the FTSE EPRA/NAREIT Global Index in U.S. dollars has registered a total net return (including taxed dividends) of 10.9%, well behind the 17.4% net U.S. dollar return from the MSCI World Index. The sector has relied heavily on outstanding performance from the eurozone, with a net return of 25.9%, with German property shares returning an extraordinary 37.5%. Other major markets contributed relatively little: the key U.S. market returned only 3.3%, while Japanese property recorded a 4.2% loss (all net returns in U.S. dollar).
Australian & International Property — Outlook
Like the wider economy, the operating outlook looks fair rather than strong. As the latest (December) quarterly ANZ/Property Council of Australia survey showed, property operators have become somewhat more optimistic about the growth outlook, and in Western Australia in particular the decimated property market finally looks like starting to turn for the better. In terms of expected property value growth, respondents rated the retirement village sector by far the strongest, followed by more modest expectations for hotels, offices (principally in Sydney and Melbourne), and industrial space, with retail bringing up the rear— unsurprisingly, given the twin challenges of cautious household spending and the online threat from the likes of Amazon. But as in many other countries the attractions of better returns from more growth-oriented sectors and the relative valuation threat from higher interest rates have kept investors on the sidelines. And investors are right to be wary of the interest rate cycle turning. Credit Suisse recently calculated that, looking at 11 of the largest REITs over the past three years, some two thirds of the increases in the value of the property they own came from the lower interest rates (‘cap’ rates) used to value them. “Reversion to Jun ‘14 cap rates would see an average NTA [net tangible asset] decline of 15% (all else equal) ... the impact on pricing would be material.” Unless something changes to upset investors preferences for growth over defensive sectors or to reduce their concern over higher interest rates, the A-REITs look likely to remain out of the limelight. Much the same calculations apply to global property. The economic outlook is supportive, particularly in Europe. As Colliers International said in a recent report, “A quick review of the vacancy rent and yield outlooks for the major city markets of Europe points to an almost universal improvement in landlord conditions in the shape of flat and declining vacancy, firm or upward rents and stable or declining yields.” In 24 of the 29 cities in the report, office vacancies are likely to be steady or lower over the next year (Brexit-affected London being one of the exceptions), while industrial vacancy rates are expected to be steady, or tighter, in every single city surveyed. The same picture comes through from the latest (September) Royal Institute of Chartered Surveys quarterly survey of global commercial property. The global upswing is supporting both tenant and investor demand pretty much everywhere. The RICS survey again found that European markets were in especially strong shape, but conditions were also good in the major Indian and Chinese cities, for example. London (Brexit) and New York (very expensive valuations) are the major exceptions, while there is only a sprinkling of markets (Jakarta, Singapore, Zurich, Dubai) where conditions are outright poor. But (apart from the understandably strong gains for European property shares) investors are underwhelmed. In particular the key U.S. market, which is the largest component of global property indexes, does not offer much attraction given that interest rates in the U.S. are likely to be rising earlier than in other markets, and that growth oriented sectors (notably IT and biotech) have been delivering very large returns. Another key market, the U.K., is struggling with the potential impact of Brexit, particularly as negotiations currently look headed for a ‘hard’ Brexit. Active fund managers avoiding the U.S. and U.K. have opportunities to deliver for investors, but the likelihood is further aggregate underperformance.
Australian Equities — Review
Australian shares, after a long period of underperformance, finally started to participate in the global bull equity market with a strong October performance. More recently, however, they have been caught up in the global equity sell-off, with the resources sector in particular affected by lower commodity and energy prices. October’s good run, however, has helped the market put improved year-to-date outcomes in the shop window, with the S&P/ASX200 Index up 4.7% in capital value and by 9.1% including dividends. By sector, the largest gains have been in IT (18.1%), industrials (15.2%), and (despite the recent declines) miners (13.8%). The laggards have been the A-REITs (-0.6%) and the financials (unchanged).
Australian Equities — Outlook
The October sharemarket rally suggested that investors were coming round to the view that the Australian economy was finally emerging from the unwind of the mining project boom. But it remains difficult to be sure that business activity is indeed beginning to pick up enough pace to make a real difference to corporate profitability. Official data have been no great guide: The latest jobs numbers, for October, could be read positively (a drop in the unemployment rate from 5.5% to 5.4%) or negatively (far fewer jobs—a marginal 3,200—created in the month than the 17,500 forecasters had thought was likely). Some indicators suggest that business activity is indeed improving rapidly. The October monthly business survey run by NAB in particular was remarkably strong: “business conditions hit a high of +21 index points in October, up +7 points from September and the highest level since the monthly series began in 1997.” Unpicked, the story wasn’t quite so good. While construction, mining and manufacturing have all been picking up strongly, the retail sector remains weak, and forward-looking indicators (such as the inflow of new orders) eased back a little. Even so, the bank came to a “cautiously optimistic view that Australia may temporarily see above trend rates of economic growth over the coming quarters.” But other business surveys don’t show the same acceleration; they show the economy more pottering along at the same sort of speed. The Commonwealth Bank’s relatively new Composite Purchasing Managers Index for October showed that “with the index reading unchanged from September’s 53.1, the rate of growth was maintained at the joint-slowest in the series’ 18-month history.” The longer-running PMIs run by the Australian Industry Group showed a weaker picture again, with all three of them (manufacturing, services, and construction) showing ongoing growth in October, but at a slower rate than before. And right down the other side of the ledger is the latest (September) reading from the Westpac/Melbourne Institute, which came to the opposite conclusion to NAB: “The growth rate remains negative pointing to below-trend momentum and a sharp turnaround from strong positive, above-trend reads at the start of the year.” Westpac explained the downbeat result: “Constraints on growth next year are likely to centre on a lacklustre consumer who struggles under the weight of weak wages growth, high energy prices, and excessive leverage. Conditions in housing markets, particularly in the eastern states, are likely to soften while the residential construction boom will turn down. We are also less euphoric about growth prospects for our major trading partners than seems to be the current consensus.” Westpac’s view got some support from the subsequent release of the Westpac/Melbourne Institute consumer confidence survey for November, which showed a relapse into slightly pessimistic territory. In sum, the jury is still out. October’s rally has not yet been validated by a clear-cut improvement in likely corporate performance. Renewed underperformance looks likely until investors can get a clearer read on a genuine acceleration in the business cycle.
International Fixed Interest — Review
After a strong rise in September on renewed prospects of tax cuts, U.S. bond yields have shown little net trend in recent weeks: The 10-year Treasury yield peaked at 2.47% on October 26, and has since been trading a little lower (currently 2.34%). Other major markets have generally shown similar patterns of an initial rise but more recent stability or modest retracement. The benchmark 10-year German government bond, for example, peaked at 0.48% (October 25) and is now 0.38%, while the U.K. equivalent peaked at 1.41% (also on October 25) and is now 1.29%. The Japanese market, however, has gone its own way due to the distinctive full-on monetary policy of the Bank of Japan. Although yields also rose in September, the rise was miniscule and the 10-year yield remains close to zero (0.04%). Despite the recent rises, which have inflicted capital losses, year-to-date returns from global fixed-interest have remained positive, partly because U.S. yields are still lower than where they started the year and partly because credit spreads have compressed, which generates capital gains. Year to date the Bloomberg Barclays global aggregate Index in unhedged U.S. dollar terms has returned 6.3%; global government bonds have returned 6.2%, while global corporate bonds returned 7.7%. There has been a setback in the higher-yield (low-credit quality) end of the market, partly due to Venezuela’s debt default and partly due to investors no longer being prepared to accept unusually low credit premiums on riskier corporate borrowers. Year to date emerging-markets debt has still returned 7.1%, and global ‘high-yield’ (low-credit quality) 8.7%, but the gains have narrowed over the past month. Month to date, for example, U.S. corporate high yield debt has had a loss of 1.3%, and emerging-markets debt is down by 0.75%.
International Fixed Interest — Outlook
Interest rates look set to rise further from their still historically very low levels: Remarkably, according to the latest estimates by Bloomberg Barclays, there are still some USD 11 trillion worth of debt securities trading at negative yields. The key market is the U.S. To date, moves towards higher yields have been erratic. Inflation has generally remained lower than the Fed would like, but the latest data, for October, showed that ‘core’ (ex food ex energy) inflation was running at 1.8%, and getting closer to the 2.0% the Fed would like to see. The outlook has also been affected by politics: uncertainty over the appointment of the next Fed chair (since resolved, with a responsible choice of a successor to Janet Yellen), and ongoing uncertainty over the passage of a U.S. tax cut and tax-reform package, with bond yields tending to rise when tax cuts have looked more likely. It now looks very likely that the Fed will raise interest rates again. There is a very high degree of forecaster and financial market consensus that the fed funds rate will be raised by 0.25% at the Fed’s December meeting. Ongoing growth in the U.S. economy and gradually higher inflation suggest that bond yields are also heading higher, with the attest (November) forecasts from the Wall Street Journal’s panel of forecasters picking a rise in the 10-year Treasury yield to 3.0% by the end of next year and to 3.3% by the end of 2019. Interest rates are also heading higher in the U.K. As expected, the Bank of England raised its policy rate (’bank rate’) by 0.25% to 0.5%. The bank will be taking a very careful approach to any further increases, which is understandable given very large Brexit uncertainties. Unlike the Fed it is not yet prepared to start running down its stock of bonds (purchased to keep yields low) and it emphasised that “All members [of its policy committee] agree that any future increases in Bank Rate would be expected to be at a gradual pace and to a limited extent.” But as in the U.S. the tide has turned on the era of ultra-easy monetary policy. The European Central Bank is also heading in the same direction, but even more cautiously. The most it is currently prepared to do (as it announced after its October 26 policy meeting) is to scale back how quickly its bond stockpile will grow (from net purchases of EUR 60 billion a month to EUR 30 billion, starting next January). But it too is gradually beginning to move away from peak monetary ease. Only in Japan is policy likely to remain on an ultra supportive setting for the indefinite future. The likelihood is that global bond yields in aggregate are on the rise, making the outlook challenging for the asset class. Fund managers continue to be wary. In the latest (November) Bank of America Merrill Lynch (BAML) survey of fund managers, 77% expect world interest rates to rise over the coming year (only 5% think they will fall). As a result, they remain very heavily underweight to the asset class: A net 56% are underweight, which is the level you get when 73% are underweight and only 27% are overweight. And “a crash in global bond markets” was rated the second-highest risk that worried the fund managers. While all sectors of the bond markets are likely to feel some pain, the higher risk end, which was disproportionately bid up in price during the era of the “hunt for yield”, looks especially vulnerable.
International Equities — Review
At time of writing world equity prices were amid a sell-off, variously attributed in the media to the impact of lower commodity and energy prices and to investors dialling back their appetite for risk; some reports also mentioned slightly slower-than-expected economic growth in China. The MSCI World Index of the developed economies has dropped by 1.7% from its November 8 peak. Despite this recent setback, however, year-to-date performance has been strong. The MSCI World Index has made a capital gain of 12.5% in the currencies of its component markets, and a gain of 15.4% in U.S. dollar terms (17.4% including the taxed value of dividends). Among the developed markets, Japan (Nikkei up 15.2%) and the U.S. (S&P 500 up 14.6%) have been the strongest performers, and while Germany has also done well (DAX up 13.0%), the wider European market has been less impressive (Eurofirst300 up only 5.3%). The U.K. has continued to struggle with the challenges of Brexit, and the FTSE100 is up only 3.2%. The real stars of the show, however, have been the emerging markets, where the MSCI Emerging Markets Index is up 25.3% in the emerging-markets’ currencies and by 28.9% in U.S. dollar. The key contributors have been India and Brazil, though there have been widespread increases across the emerging-markets universe, other than in Russia where equities are broadly unchanged (slightly up on some indexes, slightly down on others).
International Equities — Outlook
The economic outlook continues to be broadly supportive for global equities. Most focus, particularly given the high valuations of American equities, is on the outlook for the U.S. economy. While the data have been knocked about by the impact of hurricanes, the latest indicators have been good. The September quarter GDP came in at a stronger-than expected 3.0% annual rate. The jobs numbers have also been solid, with 261,000 more jobs in November, and a fall in the unemployment rate from 4.2% to 4.1%. More widely, the pace of business activity in the overall global economy appears to be accelerating. It has helped that two of the more mediocre economic performers of recent years, the eurozone and Japan, are both—at least cyclically—on the mend. On the latest (September quarter) data, for example, Japan has now managed to achieve seven straight quarters of GDP growth for the first time since the turn of the century. In the eurozone, the latest (September) GDP numbers show that the European Union grew by a respectable 2.6% over the past year, a clear pickup from its 2.0% growth rate a year ago. As the latest IHS Market Global Business Outlook says, in October “Worldwide confidence towards the 12-month outlook for business activity is running at its highest for just over three years.” For investors, the key issue is whether the pickup will flow though to corporate profits, and the Outlook suggests it will: “With demand conditions predicted to strengthen and higher cost burdens projected to be shared with clients, profitability is expected to improve especially solidly in the euro area, the U.S., Russia and Brazil.” The key challenge for the asset class remains expensive valuations, particularly in the U.S., and excessive complacency about potential risks and surprises. The latest BAML global fund manager survey found that the managers also expect a supportive world economy: over half of them expect growth at a faster than usual pace, and with lower than usual inflation. Some optimism is therefore clearly justified. But BAML pulled no punches about overly gung-ho investor sentiment. It said that “investors' risk-taking has hit an all-time high. A record-high percentage of investors say equities are overvalued, yet cash levels are simultaneously falling, an indicator of irrational exuberance.” To some extent fund managers are trying to deal with valuations and risk by aggressive regional and sectoral tactical allocations. In the BAML survey managers are heavily overweight to the eurozone and to emerging markets, and solidly overweight to Japan, while running a substantial underweight in the more expensive U.S. They are also heavily underweight to the U.K. as a way of managing the uncertainties of Brexit. But these regional bandwagon allocations—and some similar sectoral ones, notably high allocations to tech stocks, which survey respondents felt was now the “most crowded” trade— have their own risks if adverse surprises mean that everyone is trying to get through the same exit door at the same time. Risk also continues to be underappreciated. In the last few days one of the bellwether indicators of investor anxiety— the level of volatility expected from the S&P 500, as measured by the VIX Index—has picked up a little. It is currently 13.1, but it is still well short of its long-run average of about 20, suggesting the outlook is seen as substantially less risky than usual. This is rather surprising, given for example that geopolitical tension has been particularly intense over North Korea’s nuclear missile programme, and that there is a wide range of other geopolitical or economic risks that might materialise. On the economic front alone, the Trump administration’s tax plans may not make it through Congress, against investors’ current expectations that they will. Central banks could make a mistake with their gradual tightening of monetary policy (the top risk identified by the BAML respondents). China’s growth could falter (it has already been the factor behind recent falls in commodity prices). To date, investors have been generously rewarded for taking the view that all would turn out well, and it is helpful that the latest global economic data provide further support for holding risk assets. But it is likely that coming months will see investors’ insouciance around risks tested more vigorously.
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