Private Wealth View February 2016

Global Economy

• The 2015 calendar year marked the beginning of a transitional period for financial markets which is likely to continue well into 2016. Many countries are undergoing fundamental changes as old economic growth models are reformed. This has led to a slowdown in global economic growth and a divergence in economic policy around the world.
• China underwent the most publicised shift during 2015. China remains in the process of transitioning its economy away from manufacturing and investment to services and consumption. This will cause economic growth to slow in the short to medium term as the economy adjusts and will likely require a further depreciation in the currency to support the economy. Whilst it was an eventful year, the Chinese economy still managed to grow at 5.9%.
• In contrast, the US economy continued to pick up pace, allowing the Federal Reserve to embark on  its first interest rate rise in over nine years during December. The increase was in response to continued strength in the US labour market and a generally robust economy which grew at around 2.5% during the calendar year.
• The Australian economy remains in the middle of its own transition. The dominance of the mining sector is declining and slowly being replaced by areas such as construction, tourism and other services.  The chart below shows the significance of mining to the economy over the last decade. Mining capital expenditure is now starting to decline, with non-mining capital expenditure beginning to trend up.

• The slow down in the mining sector continued to weigh on the economy during 2015, prompting two interest rate cuts by the Reserve Bank of Australia (“RBA”) to support the economy. As a result, economic growth remained robust at 2.3%. Lower interest rates also pushed the Australian dollar lower by 10.89% from $0.81 to $0.72 during the year, assisting exporters and companies with foreign earnings.

Cash and Fixed Income

• Australian interest rates decreased by 0.50% to 2.00% during 2015 as the RBA continued its measured approach to stimulating the economy. The cuts were confined to the first half of the year with the RBA taking a more “wait and see approach” in the second half as uncertainly in China unfolded.
• The RBA remains willing and able to act with additional interest rate cuts should any global or domestic issues begin to impact the local economy. Australia still has comparatively high interest rates by global standards and scope remains to stimulate the economy via further interest rate cuts if required. The chart below shows that most global interest rates are anchored at or near zero.

• The Australian fixed income sector provided a total return of 2.59% during the year. Whilst the return on the sector appears modest in absolute terms, the sector outperformed domestic equites. The sector continues to provide valuable portfolio diversification during times of equity market volatility. The sector generally delivered positive returns in months when the domestic equity market was negative.
• The global fixed income sector also highlighted its defensive qualities during 2015, with a total return of 3.35%. Investors continued to use US fixed income, in particular government bonds, as a “safe haven” during periods of increased volatility. This was particularly evident during the second half of the year as uncertainly increased post China’s decision to devalue its currency in August.

Australian equities

• The Australian equity market started 2015 well with the SP/ ASX 200 attempting to close above 6000 during March and April, with sentiment buoyed by consecutive interest rate cuts by the RBA.  The market was eventually overcome by volatility in the Chinese equity market and currency. The prospect of slowing growth in China caused a severe correction in commodity markets, pushing the Australian market lower in the second half of the year.
• Most of the damage to the Australian market was done in August as commodity prices declined post the Chinese currency devaluation. The market tracked sideways for the rest of the year to finish up 2.56%. The Energy and Resources sectors were the worst performing sectors, declining 27% and 25% respectively. The best performing sectors were well supported for their defensive qualities, with Utilities increasing by 22.80% and Industrials and Health Care increasing by around 16%.

Global equities

• Global equities rose by 3.83% during 2015 on a currency hedged basis. Unhedged global equities were able to enjoy the full benefit of the falling Australian dollar, posting a return of 11.80% for the year. Global equities began 2015 on a positive note, only to be eventually overcome by developments on the global stage.
• Uncertainty began in July with a return of the Greek debt drama. This issue was eventually resolved after bailout agreement was made between Greece, the European Central Bank (“ECB”) and International Monetary Fund. The ECB provided additional monetary stimulus during the remainder of 2015, supporting a rise in Europe’s main market, Germany, of 8.56%.
• The US ended the year relatively flat, with the SP500 returning -0.93%. The market was constrained for much of the year as investors speculated on when and by how much the US Federal Reserve would life interest rates. The US market also suffered from events in China during August, however, comments from the US Federal Reserve provided sufficient stability to allow for the interest rate increase in December.
• The Chinese equity market finished the year 5.58% higher. The positive performance masked a volatile period, with the market first rising 150% before suffering a correction. Unfortunately, much of the volatility was caused by Chinese authorities attempting to stabilise the market.
• It is important to remember that the Chinese equity market is still immature by most global standards and its underlying movements are not particularly reflective of the underlying economy. The market still requires significant reform to reach a level which reflects international standards. The market is still largely driven by speculators and there remains significant scope to improve research, governance and other operational aspects.

Alternatives

• Hedge Funds and other alternative investments strategies also provided important portfolio diversification during 2015. The Barclays CTA Index finished the year in positive territory, increasing by 1.62%. Hedge funds were one of the few areas of the market which were able to implement strategies which benefited from the falling oil price. Hedge funds generally exhibit as negative correlation to equity markets over the medium to long term and this was evident during 2015.

Global Economy

• The global economy is likely to remain influenced by many of the same factors during the coming year. Based on current information it is difficult to see what could cause either a sharp increase or decrease in global economic growth. Consistent with this outlook are leading economic indicators from the International Monetary Fund (“IMF”) which point to economic growth of around 3.4%.
• The Chinese economy will remain a key focus during 2016. The IMF forecasts economic growth to slow to 6.5% from 6.9% as structural economic reforms continue. It appears likely that China will allow its currency to fall further. The impact of a steady devaluation is manageable; however, an unexpectedly large devaluation would be more destabilising as we observed in August last year. A sharper than expected slowdown in China remains the key risk for the global economy.
• In the US, the IMF has forecast economic growth to be  similar to 2015  at 2.6%. The focus remains on assessing the impact of December’s interest rate rise on the economy.  Although a further rate rise is “on the table” in 2016, it seems difficult to justify a further increase in the near term given the current global backdrop and some “patchy” economic data.
• Australian economic growth also looks set to remain stable during 2016 with an IMF forecast of 2.9%.  A key area of focus will be developments in the Australian residential property market. Personal consumption accounts for nearly 60% of Australia’s economic growth. The willingness for consumers to spend in recent years has no doubt been assisted by the increase in wealth received from rising house prices.
• Residential property price growth is expected to decline during 2016 as lending restrictions placed on investors continue to impact demand. Residential mortgage interest rates also appear to have bottomed with the banks no longer passing on any RBA interest rate cuts. The chart below shows the declining participation by investors in new home loan creation.

Source: JP Morgan

Cash and Fixed Income

• The RBA is forecast to cut interest rates by 0.25% to 1.75% during 2016. The RBA made reference to the volatility in global markets at its February meeting and remains alert to any potential impact on the domestic economy. There is now more scope to lower interest rates to support the economy given the risk of further overheating the residential property market is receding.
• The structural headwinds for the Australian dollar will remain in place during 2016. China’s slowing economy continues to place pressure on commodity prices and the prospect of lower domestic interest rates looks likely to push the currency towards $0.65 under most forecasts.
• Lower domestic interest rates means yields on domestic fixed income will remain around 3 – 3.50% over 2016. The sector remains attractive for its defensive qualities which were again on display during January’s equity market decline. The sector provided positive returns during January against falls in the domestic equity market.
• Global fixed income also displayed its defensive qualities during January, posting positive returns against falls in global equity markets. Although global interest rates remain low, there remains scope to achieve a 4% income return from the sector by investing across a diverse range of countries and sectors.
• Our 2016 fixed income strategy remains unchanged in the current environment. We remain focused on areas of the market which provide both a reasonable yield and diversification benefits. We continue to avoid higher yielding sectors which carry a higher risk of capital loss. Sectors such as global high yield and emerging market debt still do not provide a sufficient a return for the potential risk to capital.

Australian Equities

• Australian equities appear reasonably valued trading on Price / Earnings (“PE”) ratio of around 15x in January against a long term average of 14.3x. The forward dividend yield is approximately 5% and in excess of 7% when franking is included. Dividend yields remain attractive when compared to domestic interest rates and the fixed income sector. The chart below shows the PE Ratio at December 2015 against the long term average.

Source: JP Morgan

• The main challenge for Australian equities is finding earnings growth in market dominated by banks and resource companies. Stocks which are exhibiting earnings growth are being aggressively re-rated by investors and any company showing declining earnings is getting aggressively sold off regardless of the quality of the business. This is causing some valuation extremes in both directions.
• Given the above dynamic, it remains better to hold a portfolio of quality stocks rather than follow short term momentum, which can turn quickly in a volatile market. Investors have “thrown out” blue chips stocks in favor of small and mid-sized growth stocks were there is higher perceived earnings growth. As a result, the S&P/ASX 20 is now the cheapest area of the market on a valuation basis.
• The market is likely to churn sideways for much of 2016 in what is likely to be a volatile year. Opportunities are likely to present themselves when good businesses, with stable cash flows are oversold during market volatility. An income return of 5% and modest capital gains would be a good outcome in what looks to be another transitional year.

International Equities 

• International equities will continue to play an important role in portfolios during 2016. The sector provides important diversification away from sectors which are prominent in the Australian market. International investing provides the opportunity to reduce exposures to the financial and resources sectors and increase exposure to the IT and health care sectors.  The table below compares the sector exposures between International and Australian equities.

Source: JP Morgan

• From a valuation perspective, Europe, UK and parts of Asia are undervalued relative to the US. Europe and Japan remain focused on easing monetary policy, whilst the US is moving in the opposite direction by raising interest rates. The Chinese market remains unlikely to attract significant professional interest under its current structure. However, many larger Chinese companies can be accessed via more developed Asian markets such as Hong Kong and Singapore.
• Investing in international equities during 2016 will also provide an opportunity to benefit from any further falls in the Australian dollar. The Australian dollar also tends to decline during periods of market volatility and this provides an added source of diversification for a portfolio.
• International equities generally favour growth over income and as a result income from the sector ranges from 2 – 2.5%. Capital growth is more likely to come from regions where economic policy remains accommodative. A positive total return from a combination of income, capital growth and the currency would be a satisfactory outcome during 2016 as the world’s major economies continue their transition.

Alternatives

• The primary role of alternative investments or hedge funds is to provide diversification from equity market risk. These strategies have been “true to label” during January posting strong positive returns during what has been a very weak start to the year for equity markets.
• The strategies are designed to benefit from rising and falling markets across stocks, commodities, bonds and currencies. These strategies are likely to play another important part in portfolios during 2016 given the volatility in these markets, looks set to continue.

Volatile investment markets increase the probability that an investor will make the wrong investment decision at the wrong time. Strong share markets make investors over-confident whilst volatile markets can often make investors want to sell out as panic sets in.

It’s generally not a good idea to make investments decision when equity markets are volatile. The prospect of losing money can cause an investor to lose objectivity. The focus turns to the very short term and away from the long term where the best investment decisions are made.

The situation becomes more difficult when a potential loss is involved. Studies show that investors feel the pain of a loss more than the pleasure received from making gains. Situations do exist where an existing investment should be sold, however, the decision should be based on objective research rather than reacting to swings in the market.

Investors are exposed to the risk of making a poor short term decision more than ever before in the “information age.” There is an abundance of information on offer through the internet and smart phones. Investors can now receive minute by minute portfolio information and “breaking” financial news whenever they want. Investors are now thinking about their portfolios more than ever, increasing the likelihood of making a poor short term decision.

A good strategy for 2016 will be to limit your exposure to financial news and apps. Also try to avoid  regularly looking at your portfolio outside your scheduled review with your Adviser. We are always monitoring portfolios and will contact you directly should a change be required outside of your normal review schedule.