Outlook for Investment Markets
Investors had second thoughts about the strength of economic activity over the past month, and equities and commodities were sold off. Bonds were the winner, additional 'safe haven' demand emerging as Eurozone debt problems intensified. Although global economic recovery is still intact, and growth-linked assets should perform well in time, investor focus in coming months is likely to remain more on downside risks than on upside potential
Australian Cash & Fixed Interest – Review
There was no change at the short end of the interest rate curve, 90-day bank bills continuing to yield just under five percent. Longer-term yields fell over the past month, in line with the global trend, 10-year Commonwealth bonds yields down from 5.50 to 5.30 percent and longer-dated swap rates down by similar amounts. The $A had another eventful month, at one point almost getting over the $US1.10 mark before being sideswiped by a sharp fall in global commodity prices in May. The $A ended the month down against the $US (from $US1.075 to $US1.055), and also modestly weaker (-0.60 percent) in overall trade-weighted value.
Australian Cash & Fixed Interest – Outlook
At its policy meeting on 3 May, the Reserve Bank of Australia stated that on present policy settings, underlying inflation was heading for over three percent in late 2012 and 2013. The Bank saw "the current mildly restrictive stance of monetary policy as remaining appropriate" for a while yet, but given the inflation outlook, "higher interest rates were likely to be required at some point if inflation was to remain consistent with the medium-term target". Financial markets are not expecting much of a further tightening, however, bank bills expected to be only 0.25 percent higher by this time next year.
Overseas trends are likely to remain the main influence on local bond yields. Eurozone debt worries are likely to keep yields in the more creditworthy markets at their current low levels, or even take them lower again on 'safe haven' grounds in coming months. On the other side of the Eurozone issues, however, there is likely to be a move to gradually higher global bond yields in 2012. The extent of the rise locally may be modest, however, as Australia's fiscal accounts and the associated limited supply of new Commonwealth bonds in good shape compared to many other government bond markets.
Most forecasters regard the current high level of the $A as unsustainable, and overvalued from the perspective of non-mining exporters. The Reserve Bank noted that "recent rises in the exchange rate [are] likely to have further tightened conditions, particularly in some sectors of the economy". While the consensus is that a weaker $A would be welcome, any depreciation could still be a long way off in a world economy still growing at above-trend rates and hence benefiting commodity currencies like the $A. The Bank also noted a further supporting influence, purchases by other central banks to invest their official reserve assets.
Australian & International Property – Review
The Australian listed property sector reverted to something like its pre-financial crisis behaviour over the past month, providing a relatively defensive result when the wider sharemarket was weakening. The S&P/ASX 200 A-REITs Index was down -2.10 percent in capital value, compared to the wider market's five percent decline. On an all-up basis, including income, the decline was -1.30 percent.
Global listed property also provided some defensive value, the EPRA/NAREIT index of global property ex-Australia hedged into $A ending up down only very slightly (-0.30 percent) for the past month. The best markets were in Europe, which gained 3.30 percent overall in euro terms, French prices up 4.90 percent. The laggards were in Asia, which experienced a 2.60 percent decline in $US terms as a whole.
Australian & International Property – Outlook
Investors are currently paying more attention to the potential risks to growth, and in this more wary environment have been buying bonds and selling the equities most exposed to world growth. While this more nervous state of mind prevails, the defensive characteristics of listed property, both domestically and overseas, are likely to persist in coming months. In particular, yield differentials have widened in property's favour as government bond yields have fallen. Although the pick-up is not large – a six percent dividend yield in Australia from listed property compared with a 10-year bond yield of 5.30 percent – the sector has become more attractive to investors. The risk profile, with rentals and occupancy linked more to domestic demand than to world trade, is also a more attractive proposition in the current market mood.
Although ongoing recovery is generally positive for global property, some pockets of weakness are likely to remain, particularly in the Eurozone. Data from research firm IPD shows that the total return from holding physical property in Europe in 2010 was eight percent in local currency terms, but that within this average, there was a very large country-by-country disparity. This ranged from a return of 15.0 percent in the UK through to Ireland's 2.50 percent fall. These disparities will be at least as large in the coming year as the more peripheral Eurozone markets struggle with financing and austerity. Another potentially risky area is China, where official efforts to rein in inflation and overheated property markets will be aiming to pull off a soft landing, but could potentially misjudge the tightening.
Australian Equities – Review
A period when overseas sharemarkets were having a rethink about various issues – the global economic outlook, commodity price bubbles, the Eurozone debt crisis – was unlikely to be auspicious for local equities, given Australia's leverage to the global economic cycle. And so it proved. All the local indices sagged, the S&P/ASX200 Accumulation Index down five percent over the past month. The miners were down 6.70 percent and financials down six percent. Industrials stocks had a smaller 2.10 percent decline.
Australian Equities – Outlook
The 10 May Budget was a set-piece opportunity for both government and private sector forecasters to update their views on the economic outlook, and on this latest reassessment the outlook is promising. Government numbers suggest four percent growth is likely in the current 2011/12 year (private sector estimates are similar), and nearly as much (3.75 percent) the following year. External demand for export commodities remains the key factor: our export markets are expected to grow by 4.50 percent this year and five percent next.
Consequently, Australia's terms of trade are forecast by Treasury to reach "their highest sustained levels in 140 years, based on strong price rises for Australia's key non-rural commodity exports" (although expected to ease off a bit in coming years from these unprecedented levels). This is underpinning a massive bout of mining and associated infrastructure spending. The volume of business investment is expected to rise by 16.0 percent in 2011/12 and a further 14.50 percent in 2012/13. By mid-2013, on these forecasts, the unemployment rate will be down to 4.50 percent.
There are some headwinds: households are being cautious with their wallets as they pay down debt, and fiscal policy has turned contractionary, while the high exchange rate is affecting export profitability. Indeed, the combination of a very strong $A and relatively high interest rates means that overall monetary policy conditions are tighter than in most OECD economies. But these are glosses on what should be another two good years for the economy and, ultimately, for Australian shares, although in the immediate future the mining stocks in particular will have to cope with investor concerns that shares have become overexuberant about the prospects for global growth and demand.
International Fixed Interest – Review
There were no significant changes to short-term interest rates over the past month, the only news of note being the US Federal Reserve's decision to hold press conferences after each policy meeting. The first, on 27 April, saw Fed Chairman Ben Bernanke announce that the bond buying program ('quantitative easing') would come to an end in June, but that otherwise monetary policy would remain at very supportive levels "for an extended period".
The bond markets were quite a different story, however, where there were two significant developments. Yields in the higher-rated markets, which had been rising, headed back down again. The 10-year US Treasury yield, for example, peaked at just under 3.60 percent on 11 April, but has dropped steadily since, and over the past month has fallen from 3.37 to a little over 3.10 percent. Other major markets followed suit (Germany from 3.30 to 3.10 percent, and the UK from 3.55 to 3.35 percent, for example). This also fed into lower corporate yields, generating capital gains. These lower yields reflected both investors' more sober reassessment of the prospects for global growth, and a measure of 'flight to safety' from the other significant development, the worsening troubles of the more indebted Eurozone governments. The yield on 10-year Greek government bonds, for example, is now over 17.0 percent, and on Irish bonds is 11.30 percent, while Portugal's is just under 10.0 percent.
International Fixed Interest – Outlook
Short-term interest rates will remain low in the major markets. In the US, for example, the financial markets are taking the Fed's "extended period" of low rates to mean that the Fed funds rate will not change this year, and will have risen to only 0.90 percent by the end of 2012. Rates are likely to increase earlier than that in the Eurozone, where the European Central Bank has already raised them once, and may do so again in the next few months given that inflation in the Eurozone was 2.80 percent in April, above the Bank's two percent limit.
Considerable turmoil is likely in bond markets. Default to some degree now looks increasingly odds-on for Greece. Irish default is also possible. Although the Irish government's policy intentions and effectiveness are recognised as being better than Greece's, the sheer scale of the banking meltdown may overwhelm Ireland's best efforts to meet its payments. Default is also not out of the question for Portugal, and recent protests in Spain against fiscal austerity do not bode well for investor confidence in Spanish bonds.
The next few months could well therefore see a continuation of recent trends – money flowing into the higher-rated, safer end of the market and fleeing the problematic issuers. At some point bond yields in the major markets will have to return to more normal levels. But that will remain on hold while Eurozone debt issues are front and centre of investors' minds.
International Equities – Review
As in many other markets over the past month, the period for world shares splits into two. The first period is late April and early May, when world shares were doing well, and the second more recent weeks, when they have sagged. The net effect is that world shares were down marginally for the past month as a whole, the MSCI World Index off 0.50 percent in overseas currency terms. Investors ended up pretty much all square in local currency terms, the $A up 0.60 percent for the period. The developed markets were broadly similar: most were effectively unchanged or down slightly, Japan a bit weaker than the rest as it struggled with various post-disaster issues. The major emerging markets were weaker, however, China and India in particular both down by six percent for the month as they attempt to get to grips with rising inflation.
International Equities – Outlook
Recent weakness reflects greater concerns about the economic and financial outlook. While investors are not outright spooked, they appear to be more wary on a number of fronts. On the economic outlook, the news has mostly been on the weak side of expectations. Most attention was focused on the key US indicators of GDP growth and jobs. Latest news of the former was disappointing – US GDP growth in the March quarter was 1.80 percent at an annual rate, below the consensus forecast of two percent. While some of this – notably the big drop in non-residential construction – can be explained by bad weather, some looked more permanent. The news in the labour market was better. There were 244,000 new jobs in April, more than the expected 185,000, all in the private sector. But even this was tempered by a small rise in the unemployment rate, from 8.80 to nine percent. Investors are having to come to terms with a US economy that hile not relapsing into recession, is not looking quite as strong as before. The Wall Street Journal’s panel of forecasters has cut it estimates of US GDP growth this year from 3.50 to 2.90 percent. This more sober reassessment was also one of the reasons commodity prices dropped suddenly and sharply in May. Significantly, commodities used in industrial production were down most, while the oil price (also linked to economic activity) dropped from nearly $US114/barrel at the end of April to $US99.50, a 12.70 percent decline.<</p>
Investor expectations were also challenged in recent weeks by the worsening of the Eurozone debt crisis. Some form of restructuring of Greek, Irish, or Portuguese debt now seems more likely than not, and this is now as much of a concern to sharemarkets as it has been to the bond markets.
There have, in sum, been some good reasons why world share markets have been more minded to look at the potential risks to economic activity than before. That said, a genuine global recovery is ongoing. In the Reserve Bank's view, "While there were many uncertainties about the world economic outlook, the central scenario was for a continuation of above-trend growth", while the Treasury has commented that "[t]he global economic recovery is gaining momentum, but remains uneven and subject to significant downside risks", although also noted that people ought to remember that "While the balance of risks is to the downside, there are also upside risks to the global recovery. There is potential for a rapid improvement in sentiment and a subsequent surge in investment and activity more broadly, financed from the substantial levels of liquidity sitting idle with banks and corporates, particularly in the United States but also in Japan". Ongoing recovery will in time re-emerge as the key investment driver for world sharemarkets, but for the next few months, looks to be overshadowed by a focus on the risks.
Performance periods refer to the month and three months to 24 May 2011.
