Friday, 13 May 2016

Over April, markets were driven by improving risk sentiment and supportive central banks. Economic data was fairly mixed; it generally disappointed in developed markets but surprised positively in emerging markets.

Shares rallied modestly, driven by a reasonable earnings season in the US and expectations of ongoing monetary policy support. Oil also rallied, despite the Organization of the Petroleum Exporting Countries’ (OPEC) failure to reach a cap on production at their Doha meeting. Fixed interest sold off as investors moved into risky assets and inflation expectations built on higher oil prices. 

While central banks were generally on hold, the Reserve Bank of Australia (RBA) was the exception, cutting rates in May. As expected, the US the Federal Reserve (the Fed) and the Bank of England (BoE) left rates on hold with the BoE flagging risks to the outlook stemming from ‘Brexit’. Coming into June, few expect a hike from the Fed, which itself has done little to communicate otherwise. Back in Europe, The European Central Bank released details about a corporate bond purchasing program, which was more aggressive than some had originally expected. The Bank of Japan disappointed markets by not easing policy.

In Australia gross domestic product (GDP) growth in the first quarter of 2016 was the strongest since 2011, suggesting upside risks to most growth forecasts, including our own. Producer price inflation, which remains well below zero, is consistent with consumer price inflation being well below target for some time. And the weaker-than-expected March quarter inflation report – in which underlying inflation softened to a record-low 1.5 per cent – led many to revise their outlooks, including the RBA.

In the US, consumers increased savings rates, which, combined with continued moderate manufacturing sector activity, suggests sluggish growth in the second quarter of 2016. The US dollar continued to depreciate against major currencies through April.

Recent Chinese activity data remained upbeat in the month, further alleviating market concerns of a short-term downturn. It appears authorities have resorted back to their old playbook, aiming to rejuvenate sectors of the ‘old’ economy. The implication is they are kicking the proverbial ‘reform can’ down the road.  

In April, the International Monetary Fund released its latest World Economic Outlook report, containing forecasts for ongoing mediocre (positive, but below average) global growth and again highlighting concerns about risks to the global economy.

The question for us is ‘what does this really mean?’ In the past four years, we’ve seen global economic growth generally below trend, the European debt and geopolitical (Russian invasion of Ukraine) crises, a halving in China’s economic growth, extended monetary policy experiments (negative interest rates) and a collapse in global commodity prices. Yet the QSuper Balanced option delivered strong returns over this time.

We think this result reflects a mix of good portfolio construction and the fact that asset prices have continued to rise, despite the above, indicating that they’ve been driven more by the expectation that global monetary policy experiments will pay off. A good deal of the rise in asset prices over the past four years reflects valuation uplifts.

Our view is that this process has largely run its course, with further improvements in pricing needing to be driven by growth, rather than ostensibly better sentiment. To some extent, this process has begun. Global shares are currently priced at levels similar to that of late 2013. 

We think being in a risky, low growth world matters more now than it has at any time following the GFC. Prospects for global growth scares are high: Japan’s measures to boost growth could fail; the high level of debt in China and not enough economic reform; the impacts of ‘Brexit’ on the Eurozone and the Fed may not be able to raise rates or may raise them too quickly.

The consequence of this world is low returns and high volatility. With asset valuations having risen significantly, the opportunity cost of holding cash is low and investors are less driven to stay allocated through turbulent times. Systematic trading strategies related to volatility targeting and forecasting could heighten this effect. If any of the above risks are realised, and a growth scare turns into a crisis, we could see a rush to exit less liquid markets such as corporate credit. 

Currently our central view remains that global economic growth is likely to be modest in the year ahead, broadly in line with the past few years. Even so, risks to the outlook and for financial markets broadly remain elevated. We think returns to most listed asset classes will likely be low and volatile. 

The views of the author and those who provide the responses to comments posted on this blog are not necessarily the views of the QSuper Board. We’ve put this information together as general information only and you should get professional advice before relying on this information.

Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.