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Market Watch

Global economic outlook

Challenges in a new year Heightening and easing market volatility has been a characteristic of the past few years with the start of 2016 no exception. Though the market movements have sparked concerns for investors, there are some indications for a reasonable year for investments overall.

Australia In its December meeting, the Reserve Bank of Australia indicated the domestic economy had experienced stronger employment growth with signs that business conditions were above average. This was reflected in the December employment report (published mid-January) with a loss of just 1,000 jobs compared with the market forecasted decline of 12,500 on the back of 130,000 jobs created between October and November (the strongest back to back gain in almost 30 years).

Australia Unemployment Rate % December

United States Data releases published in the middle of January indicated weakness in inventory, industrial production and retail sales activity. Further to this, December’s import prices release recorded a decline for the sixth consecutive month, while last month’s Producer Price Index report fell for the fourth time in five months. This suggests price pressures are not an issue, with potential implications for the outlook of further rate hikes this year by the US Federal Reserve (Fed).

Latest month ly commentary f rom the Investment Marke ts Research team at BT.

January Review 2016

INSIDE THIS ISSUE

1 Global economic outlook—challenges

− Australia − United States − Japan − Eurozone − UK − China

2 Questions

− Share market volatility − Chinese share market &

possible recession − Oil prices − Japanese GDP growth − Federal Funds Rate changes

4

− Australian Shares − International Shares − Property Securities − Australian Fixed Interest − International Fixed Interest − Commodities

Asset class outlook

2

Japan The Japanese government still anticipates an acceleration of Gross Domestic Product (GDP) growth to 1.75% this fiscal year despite substantial declines reported in January for November’s machine orders of 14.4% compared to estimates of 6%. This growth may largely depend on the spring wage negotiations creating wages growth given weak global demand, continued shrinkage of the domestic population base and sluggish corporate investment plans.

Eurozone There are some indications of improvements in the Eurozone with the European Central Bank’s (ECB) latest monetary data (published in late December) showing banking lending to households and non-financial corporate growing at 1% – its fastest annual rate since 2012. The monetary environment is supportive of potentially further growth as the year progresses.

UK The Bank of England (BOE) plans to refocus the British economy towards a balanced growth model, including manufacturing which continues to struggle. The mid-January release of the November Industrial Production Report recorded a 0.7% monthly contraction in activity – the sharpest monthly decline since early 2013 – compared with forecasts for no change. Total manufacturing output shrank by 0.4% for the second consecutive month, with a decline in pharmaceutical production having the largest impact on total factory output. Manufacturing output is also 6% below the peak reached just prior to the Global Financial Crisis.

China The latest monetary data from November indicated policy easing may be gaining traction. Annual M1, money in circulation, growth surged to 15.7%, the strongest since late 2010, while consumption metrics were supported by a 17.7% annual increase in motor vehicle output for November – the fastest pace of production since late 2013.

In late 2015, the People’s Bank of China (PBoC) also reinforced it would support its 6.5% GDP growth target with accommodative fiscal and monetary policies over the year.

Questions

What has caused volatility in share markets at the start of 2016?

While China is viewed as the primary driver for the volatility in markets for the start of 2016, it has also combined with concerns over the severing of ties between Saudi Arabia with Iran, along with claims by North Korea of the successful testing of a hydrogen bomb.

Changes in rules around government support, floats, insider selling and circuit breakers in China triggered losses of approximately 10% in the local Chinese share market. Alongside this, China depreciated its currency by 1.5%. This spurred fears in global markets about the state of the Chinese economy, although aggressive policy action in China and the currency depreciation is likely to support its economy longer term.

Are the recent large sell offs in the Chinese share market a signal that the Chinese economy will fall into a recession?

The Chinese share market behaves very differently to European and American counterparts because it is dominated by retail investors, rather than institutional investors. This means it tends to be more reactive and volatile. Many large capitalisation shares in China are state-owned enterprises so there is a tendency for retail investors to look to smaller companies for quick gains. Given both the size of the retail market and the fast activity in smaller companies, market movements can be exaggerated and create market volatility based on investor sentiment rather than underlying economic fundamentals.

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Questions continued..

The economic fundamentals in China suggest a more solid story than the share market. The late January publication of the fourth quarter GDP report saw economic growth for 2015 decline to 6.9%. While this is the lowest rate of expansion since 1990, it is still close to the PBoC’s targets. The latest national accounts also show China’s service sector is expanding by approximately 8.2% in real terms compared to the 6.1% recorded for industry. This supports China’s push to move to a consumption-led economy. Chinese President Xi also announced a focus on “supply-side reforms” for government policy this year to trim overinvested areas such as steel and shipbuilding. Based on these, it seems unlikely the Chinese economy will fall into recession.

What is happening to oil prices?

Commodity prices as a whole have fallen in value over the past year, with continued declines in oil in the start of 2016. This has been the result of an oversupply, combined with weakness in China. In the past, many economists have viewed the oversupply caused by the rapid increase in production as linked to market share competition between Saudi Arabia and the US. More recently though, there is some thought that it might be a tactic to hold market share from Iran, given sanctions have lifted and it can now trade again. Historically, when oil prices are determined by market forces rather than the Organisation of Petroleum Exporting Countries (OPEC), it has declined to approximately $20 in inflation-adjusted terms.

What measures has the Japanese government introduced to seek to accelerate GDP growth?

Japan’s ongoing efforts to stimulate its GDP growth are part of a three-stage initiative established by Prime Minister Abe in late 2012 dubbed “Abenomics”. The initiative sought to use monetary easing, fiscal spending and deregulation to end Japan’s chronic deflation and boost wages and overall sentiment. To date, these initiatives have failed to gain lasting traction and large Japanese corporations have been hesitant to invest due

to weak global demand and diminishing Japanese population growth. The traditional northern spring round of wage bargaining is being heavily relied on to generate growth. Labour unions are seeking a smaller wage gain this time compared with last year though, due to weak inflation and the recent strengthening of the yen which may undercut wage demands further. On the basis of this, it seems unlikely for GDP growth to meet government targets.

The Fed increased the Federal Funds Rate in December for the first time in almost 10 years. Has this affected markets and is it likely to increase the rate further in its next meeting?

While there was some volatility in the lead-up to the Fed decision to increase rates in December, as a whole it has not caused any undue volatility. The Fed has indicated the prospect of four rate hikes in 2016 but it seems unlikely the next increase will occur at the next meeting. In fact, financial markets are not anticipating the next increase until the second half of 2016 given the risks of the current market environment. In its decisions, the Fed monitors factors like inflation, along with consumer sentiment. December measures of market-based inflation expectations have fallen within the 10 year break-even rate (as derived from comparing the yields of conventional and inflation-linked US government debt) to 1.39%, with the September measure of 1.38% a six year low. Survey based inflation expectations, such as the University of Michigan’s monthly consumer sentiment survey, are also at record lows.

What does this mean for investment strategies?

The start of 2016 will have impacted the value of investments, particularly shares. There are likely to be continuing periods of market volatility, although there are some indications for a reasonable outlook across the globe. Chinese markets should start to stabilize as aggressive policy actions and the depreciation of the currency take effect, and this in turn would alleviate global concerns over the Chinese economy and help to stabilize global share markets.

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Questions continued…

The falling oil and commodity prices create challenges for resource producers like Australia, but are more globally beneficial in the longer term by reducing costs for personal and freight transport, and also have a flow-on impact to reducing product prices (a positive for consumer sentiment). The fall in the Australian dollar is also likely to support Australia in light of low commodity prices.

Trends as a whole suggest central banks will continue to use monetary policies to support economies, which also are likely benefit investment markets, so we retain a positive outlook for Australian and international shares this year, particularly unhedged shares given the continuing strength of the US dollar against weakness in the Australian dollar.

Asset class outlook Australian Shares Since the start of the New Year the Australian share market has not been immune from the pronounced sell off that has afflicted the world’s major stock exchanges. And although market participants are unsure as to whether or not a slowing Chinese economy, the precipitous decline in the price of oil or the likelihood of potentially several rate hikes by the American Federal Reserve this year – or a combination of all three factors has been the catalyst for the dire start to the New Year nonetheless by mid-January the ASX 200 had tested a low of 4841 after having started the New Year at 5270.

International Shares Global share prices had one of their worst ever starts to the New Year. Not only did collapsing oil prices cause alarm to the American bourses but matters were further aggravated by the

Chinese authorities’ mismanagement of their own share market with Beijing ultimately abandoning its 7% circuit breaker rule which had caused much unnecessary financial market volatility.

Property Securities Despite a sluggish November – Australian Real Estate Investment Trusts (A-REITs) significantly outperformed equities over the past 12 months. Furthermore, A-REITs traded on a 5.2% dividend yield in November, representing a 2.6% premium to the return offered by ten year bonds.

Australian Fixed Interest Although the ten year Australian government bond was sold heavily at the start of December - breaching the 3.0% Yield to maturity level after the European Central Bank’s scheduled policy meeting failed to provide enough monetary stimulus – nonetheless Australian bonds had rallied by late January on flight to safety concerns due to the immense volatility which plagued markets at the start of the year.

International Fixed Interest The ongoing sell off in global commodity markets saw both commodity-linked emerging market debt and global high yield markets sold off appreciably with investors seeking the perceived safety of core government bond markets.

Commodities Since Saudi Arabia decided to flood the world market with oil a little over 18-months ago in an attempt to gain market share the question that now haunts the global commodity complex is whether or not the current weak oil price is simply a symptom of excess supply or something altogether more malignant causing a dearth of demand.

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