Morningstar Economic Update November/December 2012
Written and accurate as at: Nov 23, 2012 Current Stats & Facts
Outlook for Investment Markets
Sharemarkets have been weak – more so overseas than at home – as investors have fretted over the 'fiscal cliff' in the United States and the Eurozone's ongoing debt issues. Bonds have been a beneficiary, yields dropping as investors looked for defensive safety. Looking ahead, political risks predominate: investors need to see a political agreement on US fiscal policy and political progress with the Eurozone's debt and reform issues. If these hurdles are cleared, the economic prospects for the global and local economies are reasonable, and growth assets could perform well. But it remains a big 'if'.
Australian Cash & Fixed Interest – Review
Short-term interest rates were steady over the past month, the 90-day bank bill yield close to 3.25 percent. Longer-term interest rates were once again influenced strongly by global bond market developments. The more optimistic investor sentiment of September, which had seen global bond yields rise and the 10-year Commonwealth bond yield follow suit with a temporary high of 3.35 percent on 17 September, was followed by increased nervousness in October and November. Global bond yields consequently dropped back again as investors returned to the perceived relative safety of bonds, and the 10-year Commonwealth bond yield has dropped back to three percent. Other longer-term yields also fell. The $A was strong in September, hitting $US1.055 at one point, weaker in October, and then firmed again in November ($US1.04 at the time of writing). The end result is that in overall trade-weighted value the $A was modestly higher (+0.80 percent) for the past month.
Australian Cash & Fixed Interest – Outlook
The September quarter Consumer Price Index came out higher than forecasters had expected, with a 1.40 percent 'headline' increase in inflation. But on closer inspection it was not as bad as it looked: some of it was seasonal (adjusted for seasonal factors, the increase was 1.20 percent), and some reflected the impact of the carbon tax, particularly on electricity prices. 'Underlying' inflation was 0.70 percent, a result the Reserve Bank of Australia could live with: after its 6 November meeting, the Bank said that it "judged that the stance of monetary policy was appropriate for the time being". The markets were more of the view that a near-term interest rate cut was on the cards, given the relatively slow growth of the economy, and indeed when the full minutes of the Reserve Bank's November meeting appeared, they included a statement that "further easing may be appropriate in the period ahead". The futures market's current assessment of one 0.25 percent interest rate cut in the next few months, and rates then stable throughout 2013, looks a reasonable guess.
The outlook for Australian bond yields remains heavily-dependent on the outlook for global bond yields, which in turn depends on investor confidence about the economic and financial outlook. On the assumption that the US addresses its 'fiscal cliff' issue, that the Eurozone authorities continue to make progress (however laboriously) on the region's debtor governments, and that no further financial crisis-style surprises come out of the woodwork, then global bond yields look set to rise from their historically extremely low levels, taking local yields up with them. Forecasters are leaning that way, too, Westpac picking 10-year Commonwealth bonds at 3.50 percent at the end of 2013, while Commonwealth Bank and National Australia Bank economists also think a rise will occur, but in 2014 rather than next year.
The outlook for the $A also depends on investor confidence. Part of the reason for its current high levels has been overseas investors' willingness to buy the higher interest rates on offer here, compared to what is available in the US, United Kingdom, Germany, or Japan, and that willingness rises and falls with their general levels of confidence. These purchases have pushed the $A to levels well above what is comfortable for local exporters, and many forecasters expect the Aussie dollar to fall to more justifiable levels in 2013/14. The major banks' latest forecasts are for the $A to fall gradually to around parity against the $US over the next 18 months.
Australian & International Property – Review
Australian listed property has performed defensively, the S&P/ASX200 A-REIT Index having risen throughout October, held steady in early November, and then took a modest hit in line with weaker global sharemarkets before picking up in recent days. The index had a modest -0.90 percent decline in capital value and an
-0.80 percent decline in total return (including income) over the past month.
Global listed property was also relatively resilient compared to wider sharemarkets, the EPRA/NAREIT Global Index down only -1.80 percent in $US terms for the month, and the Global ex-Australia Index hedged into $A down only -1.25 percent. The surprise was Japan, where prices rose by 4.75 percent, contributing to a 1.40 percent rise in Asian property share prices. The other major markets were weaker, the US (by far the largest component of the index) down -3.60 percent, the UK down -2.30 percent, and Europe
down -3.30 percent.
Australian & International Property – Outlook
The Australian economy has been slowing down, and is likely to slow a bit more over the coming year (the Australian Equities section discusses this in more detail). This has already had an impact on the returns from the sector, which have gradually been easing back. As the September quarter readings from the Property Council of Australia/IPD Australia Quarterly Property Index showed, the total annual return (income plus capital gain) from physical ownership of property eased back to 9.70 percent, from 10.60 percent a year ago. The dividend yield from the sector (5.0 - 5.50 percent) remains attractive, especially with bond yields having headed down again, and the domestically-oriented defensiveness has appeal when shares more widely face real uncertainties (notably the US 'fiscal cliff' and Eurozone risks). But in an economy likely to grow at a modestly sub-par rate over the next year, the prospect of the Australian listed property sector continuing to deliver outsize returns (29.60 percent including income over the past year) is unlikely.
Internationally, in the key US market the fundamentals of owning property have been improving gradually as the economy has strengthened. The National Council of Real Estate Investment Fiduciaries compiles an index of US property performance from a database of $US315.0 billion of physical property, largely-owned
by pension funds. This indicator showed a total return over the year to 30 September 2012 of a respectable 11.0 percent, made up of 5.90 percent income and 4.90 percent capital gain. An income yield of close to six percent looks attractive in a world of very low cash and bond yields. Investors in US REITs, however, unlike the directly property-owning pension funds of the NCREIF Index, are looking at a more modest dividend yield of around 3.50 percent, as income-chasing investors have bid up REIT valuations to expensive levels. Elsewhere, the picture is very mixed. Rental growth and capital appreciation expectations are strongest in Canada, Japan, and the US among the developed economies, and Russia, Brazil, Hong Kong, China, and Thailand (among the middle-tier and developing economies). But these expectations are very pessimistic in the more indebted Eurozone countries and the Eurozone more generally. The sector may therefore provide good tactical opportunities for active fund managers, but it remains an open question whether global listed property will provide added value relative to equities more generally.
Australian Equities – Review
Australian shares were relatively resistant to global weakness, at least until 19 October – at that point the S&P/ASX200 Accumulation Index was showing a 3.50 percent gain on a month earlier, at a time when global shares were weakening – but more recently have succumbed to the generally difficult climate for shares worldwide. Although prices have picked up a bit in the past few days, the S&P/ASX200 barometer showed a 4.60 percent loss for the past month. All the main sub-sectors shared in this, ranging from -2.75 percent for consumer staples and -3.10 percent for consumer discretionary through to -4.40 percent for financials,
-5.50 percent for industrials, and -7.30 percent for
the metals and mining sector.
Australian Equities – Outlook
The Australian economy has been growing at a reasonably good rate – analysts estimate around 3.50 percent growth this year – but looks like slowing down in 2013, mainly because of a less heated mining sector. In its November Monetary Policy Statement, the Reserve Bank predicted that the economy would grow by just under 2.75 percent next year, a bit slower than it had been expecting earlier, and said that "[m]ost of this revision to the outlook is accounted for by a change in the profile for mining investment, which is now forecast to peak a little earlier and at a lower level than had earlier been expected (around eight percent of GDP rather than around nine percent)", with iron, coal, and liquefied natural gas projects not expected to be quite as buoyant as previously.
There is some debate about the extent of the likely slowdown. The Economist's latest (November) poll of international forecasters has a consensus forecast of 2.80 percent, essentially the same as the Reserve Bank's, and also a bit lower than before (its previous poll had suggested three percent). But the range of views was quite wide, from a low of 2.10 percent, which would be distinctly sub-par, to a high of 3.50 percent, which would be quite a good year.
Looking at the arguments for a more bearish outcome, National Australia Bank economists argued in their latest monthly business survey that businesses were doing it tough at the moment, with "broad[ly]-based declines in employment, profitability, and trading conditions. Conditions deteriorated heavily to very low levels in wholesale, manufacturing, and construction, while retail remained weak". Their immediate outlook was not much better: "indicators of future demand (forward orders, capital expenditure, and capacity utilisation) were poor and point to continued soft near-term demand".
Westpac's take was more optimistic. The Westpac/Melbourne Institute Coincident Index – a measure of where the economy is right now – does show slowish growth. But the Leading Index, which aims to pick up what's likely to happen three to nine months down the track, actually picked up in September, leading Westpac to believe that 2013 will see little or no slowdown, any mining-related easing up not likely before 2014. Relative optimists about 2013 can also point to recently firming consumer confidence, and to the fact that the labour market has turned out better than expected. There were 10,700 new jobs in October, on top of the 15,600 created in September.
It's not surprising that these views are disparate. Forecasters are trying to balance the positives (still high commodity prices by historical standards, China's economy looking more solid, the large backlog of mining projects still in the pipeline, increased production from completed projects, and the gradually accumulating impact of easier monetary policy) against the negatives (an uncompetitive exchange rate, cautious household spending, and tighter government spending at both state and federal levels). Either way, Australia's growth over the next year, whether 2.50 or 3.50 percent, looks good by developed economy standards. Although businesses may experience softer trading conditions, profit performance should be enough to continue to attract equity investor interest.
International Fixed Interest – Review
With investors feeling a bit more confident about the outlook for the global economy, global bond yields
had been rising as 'safe haven' demand declined.
The 10-year US Treasury yield hit a recent high of 1.86 percent on 14 September. Yields stayed around those higher levels up to early November – the 10-year Treasury was still 1.75 percent on 6 November –
but thereafter investor nervousness increased again, principally over the prospect of the 'fiscal cliff' in the US, and the yield dropped back to 1.61 percent.
Yields in the more creditworthy bond markets showed similar modest declines, but it was a different story for the more indebted Eurozone economies, where yields generally increased. Ten-year Spanish yields increased 0.60 percent to 5.90 percent, and Portuguese yields rose 0.70 percent to 8.40 percent. Greek yields were 0.30 percent higher at 17.20 percent.
Corporate bonds have performed significantly better as running yields have been higher (boosting income) and credit spreads have shrunk (boosting capital gains), global corporates returning 10.0 percent. 'High yield' (lower-quality) bonds have done best of all, returning 15.40 percent over the past month.
International Fixed Interest – Outlook
The latest decline in government bond yields mainly reflects investor unease about the political difficulties of averting the 'fiscal cliff' in the US. The contractionary impact, estimated as anything up to five percent of GNP, is likely to tip the modestly-growing US economy into a new recession. This would normally be enough to concentrate politicians' minds, but brinksmanship, ideology, incompetence, and grandstanding have scuppered previous attempts at an agreed outcome.
At the time of writing investors were taking comfort from more conciliatory language coming out of the US political process. Economists polled in November by the Wall Street Journal also think there will be a workable outcome: about 60.0 percent expected "an agreement that kicks the can down the road, but doesn't seriously address the underlying deficit", 20.0 percent "a compromise that deals with the cliff and makes a dent in long-term deficits", and 20.0 percent a standoff that would trigger the fiscal cliff mechanism. The odds favour some sort of resolution, in which case 'safe haven' bond-buying would abate and US bond yields would slowly start heading towards some more sensible level, taking other government bond yields up with them.
The Eurozone debt issue is far from settled. The latest tranche of monies to Greece has been delayed, and even if eventually provided, the reality is that Greece is headed towards further defaults. Electoral resistance to reform and austerity is high in both Spain and Portugal, and only Ireland, where the 10-year yield is now down to 4.80 percent and the economy is forecast to grow in 2013 after earlier severe austerity, gives much cause for cheer. If spooked by Eurozone debt, bond market investors could yet choose to hunker down for even longer in very low-yielding government bonds, but if slow progress continues to be made in the Eurozone, on top of a 'fiscal cliff' resolution, then the way could be clear to noticeably higher global bond yields in 2013.
International Equities – Review
World equities had been performing well up to the middle of September. Share prices hit a high point on 14 September, at which point shares had just managed to climb back above the levels they had achieved in March, before the Eurozone debt crisis hit the markets. Thereafter, however, prices started to slide – at first gently, with a 1.70 percent decline between the 14 September high point and 6 November, and then more dramatically, with an abrupt fall of 4.20 percent between 6 and 15 November. In the past few days there has been some modest recovery, but for the past month the overall outcome has been a decline of 3.70 percent in foreign currency terms, and slightly more in $A terms given the Aussie dollar's modest appreciation over the month.
Virtually every developed market produced losses, the US down -3.20 percent, Germany -3.50 percent, France -1.90 percent, and the UK -2.70 percent. Europe as a whole was down -2.30 percent. The only exception was Japan, which produced a headline 1.90 percent gain. (This was somewhat misrepresentative, as the Japanese sharemarket has generated cycles of ups and downs in recent months with no real trend.)
The emerging markets were also off, by -2.20 percent, Eastern Europe weaker than most (-4.10 percent), due mainly to lower Russian prices, while China was also in relatively poor shape, the Shanghai Composite Index down -5.20 percent.
International Equities – Outlook
The principal concern for sharemarkets in recent weeks has been the threat of the 'fiscal cliff' mechanism being triggered in the US. A fiscal policy tightening of 'fiscal cliff' magnitude is likely to tip the US economy, currently growing at only a two percent annual rate, back into recession. As the Wall Street Journal put it (20 November): "Almost all American households would take a financial hit next year — and low-income families would be hit among the hardest — if the White House and Congress fail to solve the 'fiscal cliff' of big tax increases [US$400.0 billion] and spending cuts [US$100.0 billion] set to start January 2".
At the time of writing, sharemarkets had taken some comfort from what was looking like a reasonably constructive approach to an alternative fiscal agreement, and some of the sharp share price falls of earlier November had been retraced. Forecasters also believe that a deal will be struck. If so, US and global sharemarkets could well rally further on the news, but the outcome remains a wholly political imponderable, and both sides have shown poor form in the past. (President Obama ignored the recommendations of a
bipartisan deficit reduction commission he himself had established, while Republicans in the House of Representatives rejected an agreement their own leader had negotiated.)
Markets have also continued to be worried about the Eurozone, from a number of perspectives. Economic activity is turning out worse than expected, GDP declining in the September quarter (by -0.10 percent) after an -0.20 percent decline in the June quarter. Marginal growth in Germany (+0.20 percent) and France (+0.20 percent) was not enough to counteract weakness elsewhere (Italy -0.20 percent, Spain -0.30 percent). And forecasters are revising down their expectations: the European Central Bank's latest poll anticipates contraction by 0.50 percent this year, and lower expected growth of 0.30 percent in 2013.
The Greek rescue talks are also concerning investors. A marathon meeting of European finance ministers had adjourned without agreement at the time of writing, as creditors continued to mull over the timeframe for Greece to get its house in order, the cost of the larger fiscal deficits that will pile up if the reform timetable is lengthened, and who will bear the cost of the inevitable Greek debt write-downs. As with the fiscal cliff, progress would cheer sharemarkets, but the outcome is once again in the high-risk realm of
political negotiations.
Outside the unpredictabilities of politics, the economic data has been better in two important areas – the outlook for the US economy, and the possibility of a Chinese slowdown. In the US, October jobs figures were quite good, the number of new jobs (171,000) right up near the top end of market expectations, which had ranged from 120 - 180,000. The number of new jobs in September was also revised up from the original estimate of 114,000 to 148,000. Forecasters now expect the US economy to grow at a 2.40 percent rate in 2013, up from the likely 1.80 percent this year.
In China, a feared deceleration has not eventuated. Quite the reverse: latest data on exports, industrial production, and retail sales have all shown the Chinese economy to be picking up again in response to government stimulus. In October, retail sales were a remarkable 14.50 percent up on a year ago.
There are soggy parts of the world economy, notably the Eurozone and Japan, which has an uncompetitive currency and is embroiled in a trade spat with China.
But with the US improving, China picking up again, and the bulk of the other emerging companies also likely to post respectable growth outcomes, there's enough potential economic impetus to support good corporate profit outcomes and improved world sharemarket performance in 2013. The big question remains whether the politics of the fiscal cliff and the Eurozone will allow the markets to get there.
Performance periods refer to the month and three months to 19 November 2012.
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