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Perspective: Investment Background – May 2016

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Investment Background Briefing – 27th May 2016

 

What’s happened recently?

Australia moves into deflation and even lower interest rates.

At the end of April economists and financial markets were surprised to learn that Australia’s Consumer Price Index had actually fallen 0.3% in the most recent quarter. This kicked the annual rate of inflation down from an already low 1.7% p.a. to 1.3% p.a. This was one of the more significant movements in economic and financial indicators among the major economies in recent months. The other was the fall in Japanese real GDP growth from a low of 0.7% p.a. to an even lower rate of zero, leaving this major economy on the brink of renewed recession.

  • Not much else has changed with the world remaining in a low-inflation, low-growth mode, but still largely staying out of recession. The US and China are still the main motors of growth and are not weakening appreciably.
  • The economic environment is still supportive of earnings per share growth for most companies worldwide while the monetary policy settings are still very supportive of equity market prices. It is important to look at whether all of this is factored into equity market prices or whether they have more than allowed for the realistic growth prospects in the years ahead. The table below summarises this, based on our most recent fair value assessments.
Inflation

% p.a.

Real GDP Growth

% p.a.

Nominal or Money GDP growth

% p.a.

Unemployment

% of labour force

Ten year government

bond yield

 % p.a.

Stock market pricing relative to bonds

 

USA 1.1 2.0 3.1 5.0 1.83 Fair Price
Japan 0.0 0.0 0.0 3.2 -0.13 Expensive
China 2.3 6.7 9.0 4.0 2.69 Cheap but risky
Eurozone -0.2 1.5 1.3 10.2 0.14 Expensive
UK 0.3 2.1 2.4 5.1 1.41 Expensive
Australia 1.3 3.0 4.3 5.7 2.27 Fair price
  • In Australia, the Reserve Bank did not wait another quarter for confirmation of the weak to negative inflation reading. Perhaps seeking to avoid needing to cut rates during a protracted election campaign; it cut its Official Rate for overnight cash to a new record low of 1.75% p.a. on the day of the Federal Budget.
  • The RBA has since signalled that it stands ready to cut further later this year and some market participants are factoring in a cut all the way to 1.0% p.a. This will have continuing adverse impacts on investors in term deposits, whilst also contributing upward pressure on residential property prices.
  • With the fall in inflation, Australian bond yields have moved down a notch, but are still very attractive to international investors. Australia is one of only seven countries with a triple-A credit rating from all three major credit rating agencies and has the highest yields on offer out of this group.
  • As we have said before this should hold Australian bond yields down somewhat, providing support for valuations of long term asset such as property trusts and infrastructure.
  • Overall, since the rate cut at the start of May and the reduction in the ten-year bond yield, the Australian equity market has responded very positively. This is as expected and means that the beneficial effects have mostly been factored into equity market prices.
  • We have not made much mention of the Australian Federal election nor the fiscal policy outlook as there is little prospect of meaningful change in policies that will affect the equity market overall. Even if the election avoids a so-called hung parliament result in the lower house, neither of the major parties will control the Senate.

Political risks move up a notch, providing possible long-term investment opportunities later this year. 

  • Economic growth in Europe remains weak and is susceptible to politically induced disturbances such as those that we are seeing in France and Britain. The forthcoming UK referendum on exiting the EU is an important factor in adding to economic and market uncertainty. The high level of unemployment in continental Europe represents a large loss of potential economic activity and has become a serious social and political issue. Manifestations of this include labour unrest in France and the knife edge election result in Austria, which narrowly avoided electing the first far right head of state in Europe since the last Austrian who caused so much trouble in 1933-45.
  • The confirmation of Donald Trump as the Republican candidate in this year’s US presidential election combined with what he has said so far on key economic policy aspects and his strong polling versus the Democratic front runner, Hillary Clinton, brings political risk to the fore when considering US equity markets. There is a growing risk of a significant fall in US equity markets before the end of 2016 which would have knock on effects on all major world equity markets including Australia.

Key takeouts and implications for investment portfolios  

  • From a long-term point of view (ten years plus) stay fairly fully invested in equity assets to take advantage of economic growth, which will largely continue albeit at a slow pace, supported by continuing fiscal deficits and very stimulatory monetary policy.
  • If investing from a shorter to medium term point of view (one to three years) be prepared to take some profits out of equities and move more into cash with a view to reinvesting after any significant equity market falls over the next few years. A fall back to below 5000 on the ASX 200 or below 1900 on the US S&P 500 would be accumulation or buying signals.

 

 

 

 

 

 

 

 

 

 

 

 

 Madison

Planning Perspective Gold Coast Pty Ltd is a Corporate Authorised Representative of Madison Financial Group Pty Ltd | AFSL No. 246679 |

ABN 36 002 459 001 http://www.madisonfg.com.au

This information is of general nature only and neither represents nor is intended to be specific advice on any particular matter. We strongly suggest that you seek professional financial advice before acting.