Investment Update – June 2017

By David Collins, AFA

Managing Director

Stratus Financial Services, Ltd

In January I summarized that we were cautiously optimistic for 2017, as there were no known market issues that could critically dampen markets, other than geopolitical issues or a black swan event.

2017 so far

In the first 6 months of this year, this view has played out with International Share Markets performing well. We have seen funds performing around the 10% to 14% gross return margin for the first 5 months of this year. While the US market may be overvalued, with P/E ratios of approximately 28 times, the US market has held up well. This has been due to good fundamentals and Donald Trump rhetoric around the need for infrastructure development. However, a cautionary warning is needed for two reasons. As Rob Arnott (Research Affiliates) has highlighted, Donald Trump will find it increasingly difficult to get his initiatives through Congress and the Senate compared to what he is used to when running his own businesses. Further, sales data from companies including Walmart missed their forecasts last month, suggesting that Americans are not spending as much as expected. Further, geopolitical issues will continue to hinder the market (mainly around Donald Trump’s presidency), though the impact of these issues has not significantly affected markets to date.

Performance in China continues to improve as seen in several funds we use. With the Chinese Communist Congress sitting later this year, President Xi Jinping is continuing to hold a steady reign on the economy. This can be seen in the economic and political policies for internal consumption, though this objective has been harder to realize than hoped (Stephen Roach – Yale University). However, countering this is China’s foreign policy, which is helping improve their position going forward, and as Stephen Roach indicated, “In short, the Next China is shaping up to be more outwardly focused, more assertive, and more power-centric than I envisioned”.

The other two markets of interest are Europe and emerging markets. According to Rob Arnott of Research Affiliates, both these markets are undervalued compared to US markets and currently represent a good value. While emerging markets have seen a rise in value over the last six months, there needs to be a cautionary tale to this market. As Greg Fleming, Head of Research at AMP Capital has written in his blog, “… it is difficult to build exposure to the Ems [emerging markets] in a portfolio without buying significant stakes in economies governed by different norms to our own [New Zealand]. Russia, Brazil, China, and India all present forms of political risk. An example has been… the widening corruption and bribery scandal surrounding caretaker President Temer of Brazil, which has hit local assets hard last week.” (by 18%). Further, as Greg Fleming summarises, “When deployed moderately, emerging markets can boost portfolio returns, but it is vital to know when to reallocate between individual markets, how to mitigate the risks of passive exposure, and how to minimize currency risk. Above all, being prepared for sharp market moves and retaining an acute awareness of the power of sentiment can prevent disappointment”. As such, we remain underweight in emerging markets, and are more comfortable with Europe, even though this market has major banking and debt problems. We believe governance in Europe is sounder and of these two markets, we believe Europe may prove to be the long-term bargain.

New Zealand shares have performed modestly over the last five months, with capital growth being modest. The NZ market corrected in September 2016 and then rebounded, but surprisingly, only modestly compared to international markets. This is despite a strong economy.  Australia continues to be problematic. The positive start to the year there has gradually corrected over the last few weeks, mainly due to banking concerns.

The major issue facing investors is the continuing low rate of cash returns and the bond market. We do not see cash rates rising significantly over the next twelve months. However, with inflation potentially occurring in the next twelve to twenty-four months, and a need for banks to rebalance or reposition their need to fund debt and mortgages, we may see term deposits rise in the longer term.

It is important to note that, rising inflation and interest rates may not be good for bonds. This could be “horrible” for US Bonds (Rob Arnott), pushing long-dated bonds in to negative territory. Consequently, for conservative investors (and all investors), it is imperative to be underweight in long-dated bonds and to hold more cash for security and potentially a better rate of capital return. Also, cash can be used to reallocate to growth assets when appropriate.

Summary

Therefore, where appropriate, we have modestly increased our position in growth assets, but remain cautious in this approach, to offset the low return in bonds and cash. We are underweighting bonds and holding more cash, though this position does suppress returns, it is more a defensive position to protect portfolios in a correcting market. Consequently, the next few months will remain interesting whilst the environment remains politically volatile. Extending any position in growth assets must be taken into careful consideration, whilst being aware of the inherent risks attached to that position.