Investment & Economic Review January 2018
For much of the past decade these quarterly reviews have contained references to the scourge of market and economic volatility, as we’ve been passing through an unusually disruptive investment and economic era. Thankfully, in 2017 volatility dissipated, (at least temporarily!) This quieter period can be illustrated by Australian share prices, which eked out positive capital (excluding dividends) returns of 7% in both 2016 and 2017, following almost zero returns in 2013 and 2014. Similarly, Australian cash interest rates are very stable, having not risen for seven years.
The most commonly referenced gauge of volatility is the US based CBOE VIX Index, which represents expectations of implied volatility on the US S&P 500 broad-based stock index. The VIX averaged 20.9 points for the ten-year period to end-2016, but only 11 points in 2017. This halving of implied volatility supported risk-based asset prices such as shares and real estate, and engendered more speculative activity in some commodities and cryptocurrencies.
Lower volatility has been assisted by a synchronised global improvement in some economic settings. For example, at the end of 2017 every OECD country had a Purchasing Managers’ Index (PMI) of over 50 (a PMI of below 50 indicates a manufacturing contraction). This has not added noticeably to global GDP, nor has it caused inflation or interest rates to rise – but this comfortable position of satisfactory economic and profit growth, coupled with extraordinarily low interest rates, have combined to support and elevate some asset prices.
As we contemplate investing in 2018 and beyond, we can take some comfort from low volatility and better stability. But regrettably such purple patches tend not to last, as lurking in the economic background are the next instability catalysts – be they the unwinding of strained central bank balance sheets, a reemergence of inflation and corresponding interest rate hikes, bout of nerves related to geopolitical tensions, unexpected currency gyrations, or the big one – a belated recognition that unprecedented mountains of debt worldwide are too excessive.
In 2017 the Australian stock market, as measured by the S&P ASX200 Index, rose by 7.05%, or 11.8% when dividends were included. Nearly all the annual capital gain occurred in the December quarter. The return in 2017 was broadly in line with the long-term average for Australian shares. As always, there was varying sectoral performance, ranging from strong 15%+ returns from the energy, materials (including mining), healthcare and information technology sectors, to the nasty 27% negative in telecommunications, and insipid 0% to 4% returns in financials, property, and utilities. Clearly, the economic sensitive and growth oriented sectors outperformed the staple interest rate sensitive sectors.
Within our managed portfolios we typically held elevated levels of cash during 2017, the purpose being to mitigate some of the risks that may have arisen from geopolitical, economic, elevated debt or valuation factors. Thankfully, whilst such risks are clearly apparent, they didn’t adversely affect market performance in 2017.
Some of the better stocks in our portfolio last year include CSL, which rose 40%; Santos, which was up 35%, a pleasing recovery from their 2014/15 woes; BHP Billiton which was up 18% having benefitted from higher spot iron ore prices; and Macquarie Group, which rose 14% on stronger earnings. Woolworths, despite being in the much-maligned retailing sector, also had a good year, rising by 13%. Other stocks held such as CBA, Westpac, Ramsay Healthcare, Wesfarmers and Woodside generated lesser capital returns but good dividends.
Our investment portfolios were affected by disappointingly negative returns from both Telstra and Brambles last year. Telstra shares suffered enormously, falling 29% following a deteriorating profit outlook, a lower projected dividend and delayed revenue due to changes in NBN Co’s corporate plan. Brambles is a strong business, being the largest global provider of pallets and reusable plastic crates, but copped a negative 18% share price in 2017 as investors fretted over the potential impact that ecommerce may have on pallet goods movements.
At its current level, the Australian stock market offers only satisfactory potential in 2018. The average dividend yield of 3.8%, plus some franking benefit, is reasonably assured, but achieving our required minimum return of 5.8%, that being twice the risk-free rate, is less certain. Our analytical fair value twelve-month projection for the market index is about 6300 points, being 2.7% higher than the current level. It will be a surprise if volatility, which was largely absent last year, doesn’t return in 2018, perhaps with a vengeance.
The major world stock markets enjoyed a positive 2017. America’s Dow Jones index rose by 25%; Britain’s FTSE index rose by 8%; Germany’s DAX rose by 12.5%; Japan’s Nikkei index rose by 19.1%; and China’s Shanghai Composite rose by 7%.
Global share prices have benefited from stable, very low interest rates, and small improvements in economic activity in most major blocs. Corporate profitability has also been generally favourable, driven by higher revenue, cost control and a significant increase in share buy-backs, funded by easier credit and the very low interest rates. Policy changes in the United States, most particularly the recent reduction in corporate tax rates, fueled a global rally in the December quarter.
In 2018 the generous accommodating policies of central banks will tighten, which will cause interest rate rises in the United States and probably Europe, and consequently less favourable valuation metrics for stock markets. There is much debate about the timing and extent of rate rises, and our view is that a persistent lack of inflation will cause such rises to be gradual. Stock prices therefore will retain some degree of support due to the low rates applicable to the fixed income and cash asset classes. However, this support does not diminish the risks of prices overheating and subsequently correcting, which we expect to occur this year.
The listed property A-REIT sector had a strong December quarter, reversing what was looking to be a relatively weak year. Prices were boosted by the proposed takeover of Westfield Corporation (the entity that owns Westfields’s US and European assets) by the European company Unibail-Rodamco. This proposed merger of two large mall operators, and the Lowy family’s support of the sale, reflects increasingly difficult operating conditions for large format shopping centres, in the wake of expanding ecommerce and low retail goods price inflation.
The REIT sector continues to provide a distribution yield of about 5%. This yield attracts some investors, the fundamental rationale being the appeal of quality real estate with a high dividend, relative to extremely low global interest rates. The A-REIT sector has maintained prudent balance sheet structures since their post-GFC recapitalisations, so a repeat of the excess gearing and valuations that caused this sector to collapse in 2008 are not currently likely.
Looking forward, the REIT sector appears to offer limited capital growth potential, as rental growth will be slim and vacancy rates could increase in a low trend economic environment.
The rapid upswing in house prices continued in 2017, most notably in Sydney and Melbourne, but showed some signs of easing in recent months, following an increase in supply and tighter lending criteria. Prices rose following a period of considerable undersupply and the stimulus of very low interest rates and easier credit. The undersupply situation has now alleviated, as construction activity has increased considerably. Real estate will no longer have the significant dual impetus of falling interest rates and undersupply, so we expect house price appreciation to ease and caution investors against over capitalising or borrowing too heavily.
Interest rates, in many parts of the world, have been set by respective central banks at artificially low levels, so the timing and extent of the inevitable reversion to more normal levels are the primary market issues for the next few years. How emphatically the central banks reverse policy is of great importance to financial markets in 2018.
A sharp rise in interest rates could trigger considerable dislocation in share, property and currency markets, but thankfully a rapid rise is unlikely, due to the absence of any significant wage and price inflationary pressures. The United States’ Federal Reserve has already commenced their rate-raising phase, lifting the Federal Funds target rate three times in 2017 to the current 1.25%-1.5% range, and indicating that a normalisation policy of 2.5% to 3% is likely in the coming few years.
In Australia, the Reserve Bank (RBA) has chosen to maintain the cash rate at 1.5% since the last reduction in August 2016, and have not raised rates since 2010. The RBA has indicated a preference to retain this easy policy, such that short term rates are unlikely to rise in the first half of 2018. Beyond that, higher rates overseas and a bit more inflation might prompt the RBA to ratchet rates a bit higher in the latter months of 2018 or early 2019.
The Australian long-term bond yield was remarkably stable in 2017, trading between 2.4% and 2.8% all year. Consequently, the domestic yield curve (the difference between long and short rates) which steepened in late 2016 following the US election, has remained steady ever since.
The specific investments contained in the fixed interest component of our managed portfolios are typically a combination of bank-backed income securities, term deposits and cash. The income securities are commonly referred to as ‘hybrids’ and have been a popular and successful asset class as banks have offered attractive margins to satisfy changing regulatory demands and their desire for longer funding duration. Term deposit rates remain low, and cash returns are poor, however the risk-free nature of this asset sector should not be overlooked.
It would be good if 2018 were to repeat the relative calm and solid investment gains of 2017, but this will be a challenging objective. As markets head into late-cycle mode the unpredictability risks become more acute, and it would be very surprising if there was not at least one sharp bout of financial market volatility in 2018. Credit spreads, which represent the difference between interest rates of different credit quality, have rarely been narrower, meaning that money is cheap and readily available, even for riskier borrowers. This scenario is often a harbinger of weaker markets.
Australian share investors should not be too concerned about the longer-term market direction, but ought to be more tactical with stock and sector selection, and be prepared to hold and deploy cash selectively during the year. Investors in real estate should expect a less robust year as more supply hits the residential market, and softer lease renewals affect commercial property. Bond investors need to be particularly careful, as any unexpected spike up in yield could diminish capital and quickly erode the already low returns.
Disclaimer General Advice Warning
This publication has been prepared by Joseph Palmer Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer Sons as at the date of publication and may change without notice. Joseph Palmer Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.
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