Market Watch

Turbulent financial market dynamics in recent weeks have demonstrated the importance of turning down the noise, diversifying widely and adopting an active approach to asset allocation. In this article, we address the situation in Europe and China and what this means for investment markets.

Over the past month China’s sharemarket has suffered sharp price falls approaching -30% for the Shanghai Composite Index. However, those investors who have been invested in the market for the past year have still generated positive returns of approximately +70%. For those investors who have only recently invested, this price correction has clearly had a dramatic negative impact.

In response, the People’s Bank of China said it would directly assist the China Securities Finance Corporation (CSFC), a provider of margin financing, in guaranteeing adequate liquidity for brokerages. Meanwhile, the country’s insurance regulator said that qualified insurers may increase their ratio of equity assets to 40%, from 30% previously, by buying blue-chip stocks. All short-selling — the practice of betting that stocks will fall — has been banned, and Chinese media has rushed to reassure citizens. All of this activity indicates that the Chinese Government will do what it takes to stabilise the situation.

What does this mean for the Chinese economy and Chinese shares?

Our view is that this is a significant price correction for the Chinese sharemarket rather any ominous sign for China’s economic growth. It’s also important to remember that the Chinese sharemarket is characterised by more volatility than we’re used to in developed markets. Although the falls are large, the recent gains have been much larger and sentiment could turn very quickly.

Apart from its impact on short-term market sentiment, at this stage the volatility it is unlikely to have a more in-depth effect on markets. The reasons for this are as follows:

1. Most Chinese consumers have limited exposure to China’s sharemarket: It’s worth highlighting that the average Chinese retail investor has only around 10% of their assets in shares. Compare this to US investors who have around 50% of their assets in shares.

2. The share market sell-off is not showing any signs of liquidity or banking stress: Corporate bond markets have remained well behaved, and interbank liquidity has, in fact, improved.

3. China’s central bank cut its key interest rates again in June: This should help support economic growth over the next year. Policy reflation in China is far from over.

4. China’s residential property market is stabilising: The property market recorded a second month of modest price gains in June.

5. The Chinese economy is not in a recession: China‘s business surveys such as the Purchasing Manager Indices suggest that China’s real economic growth is still running around the 6.5% pace. Fundamentals are still sound, and the recent correction has not had any impact on company earnings.

What does this mean for Australian shares?

The turmoil in China has had an impact on other financial markets, and in recent days we’ve seen falls in the Australian sharemarket as well as in US shares. It’s important to note that if the correction in China had been triggered by real signs of economic stress, then the impact on Australian shares could be long-lasting.

We believe that Australia is still on track to record modest 2.5% real economic growth in 2015. A lower Australian dollar will be beneficial to Australian exporters, and lower Australian interest rates, which has helped the housing sector record robust gains in construction activity.

What does this mean for global listed real estate, global listed infrastructure and Asian equities?

The sharemarket volatility has also impacted global listed real estate, global listed infrastructure and Asian equity markets. As reflected in the minutes by the FOMC yesterday, central banks will be watching the situation in Greece and China carefully. Should turmoil continue into September, then the chances of the US hiking rates in September will be low. This would likely have a supportive effect on asset classes such as global listed real estate and global listed infrastructure which perform relatively well in a low interest rate environment.

Is the situation in Greece worsening?

We expect that more uncertainty regarding Greece, and the threat of a flow on to other Eurozone countries, is likely to keep markets on edge in the short-term. However, the risk of contagion is likely to be limited as the rest of Europe is now in far stronger shape than was the case in the 2010-12 Eurozone crisis. In addition, defence mechanisms against contagion are now stronger. As a result, we don’t see the Greek debacle derailing the European or global economic recoveries. So while the correction in shares looks like it might go further in the short-term, the broad rising trend in markets is likely to continue.

Could the situation in China and Greece combined have a more substantial impact?

Central banks will be watching the situation in China and Greece carefully, and will be ready to act together to ensure that any negative flow-on effect to economic fundamentals is stemmed. It’s important to note that the situation now is different to 2012 when European authorities were in disagreement about how to respond to markets.

A buying opportunity for Chinese stocks

In terms of our views on asset allocation, we currently see the sharemarket correction in China as a buying opportunity for Chinese stocks. While there has been a significant readjustment in valuations, the earnings backdrop for Chinese companies remains good. We remain confident that there will also be aggressive support from central banks to stem any negative impact to economic fundamentals.

How have the markets reacted to the no vote

How is AMP Capital managing the situation in Europe and China?

About the Author Nader Naeimi, Head of Dynamic Asset Allocation. With over 16 years’ experience in Australia’s financial markets, including 12 years as part of AMP Capital’s Investment Strategy and Economics team, Nader’s responsibilities include analysis of key economic and market factors influencing global markets.

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. © Copyright 2014 AMP Capital Investors Limited. All rights reserved.

Statement by Glenn Stevens, Governor: Monetary Policy Decision

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

The global economy is expanding at a moderate pace, but some key commodity prices are much lower than a year ago. This trend appears largely to reflect increased supply, including from Australia. Australia’s terms of trade are falling nonetheless.

The Federal Reserve is expected to start increasing its policy rate later this year, but some other major central banks are continuing to ease policy. Hence, global financial conditions remain very accommodative. Despite fluctuations in markets associated with the respective developments in China and Greece, long-term borrowing rates for most sovereigns and creditworthy private borrowers remain remarkably low.

In Australia, the available information suggests that the economy has continued to grow over the past year, but at a rate somewhat below its longer-term average. The rate of unemployment, though elevated, has been little changed recently. Overall, the economy is likely to be operating with a degree of spare capacity for some time yet. With very slow growth in labour costs, inflation is forecast to remain consistent with the target over the next one to two years, even with a lower exchange rate.

In such circumstances, monetary policy needs to be accommodative. Low interest rates are acting to support borrowing and spending. Credit is recording moderate growth overall, with stronger borrowing by businesses and growth in lending to the housing market broadly steady over recent months. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities. The Bank is working with other regulators to assess and contain risks that may arise from the housing market. In other asset markets, prices for equities and commercial property have been supported by lower long-term interest rates.

The Australian dollar has declined noticeably against a rising US dollar over the past year, though less so against a basket of currencies. Further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices.

The Board today judged that leaving the cash rate unchanged was appropriate at this meeting. Information on economic and financial conditions to be received over the period ahead will inform the Board’s assessment of the outlook and hence whether the current stance of policy will most effectively foster sustainable growth and inflation consistent with the target.

Enquiries:

Media Office
Information Department
Reserve Bank of Australia
SYDNEY
Phone: +61 2 9551 9720
Fax: +61 2 9551 8033
E-mail: rbainfo@rba.gov.au

This year, what happens in the US is critically important to what happens in the global economy because of the intense focus on the Federal Reserve (Fed). We’ve had near-zero interest rates since the onset of the global financial crisis, and the Fed has indicated that at some point, probably this year, it will start to raise rates.

In this video, Shane Oliver, Chief Economist and Head of Investment Strategy at AMP Capital, provides an update on the US economy.

A couple of critically important points for investors to remember

• When the Fed does start to raise rates, it will only be because the US economy is coming out of the danger zone that it’s been in since the global financial crisis. As the US economy gets back on track, the Fed can start to take more of the medicine away;

• Any tightening in monetary policy will be a very gradual process. There is no need to be aggressive in an environment where inflationary pressures are very low;

• Historically, there has typically been a bit of volatility and corrective activity in share markets around the time of tightening. Once the market starts to get used to the fact that the Fed is only tightening because of stronger growth, the bull market in shares should resume.

Final thoughts

Our base case is that the US Federal Reserve will raise interest rates later this year, probably around September. When they do start to raise interest rates, the key is that it will be a very gradual process.

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

A question many investors face is where to invest for sources of income in a low yield environment. With the Reserve Bank of Australia (RBA) cutting the official cash rate by 0.25% to 2.0% in May, many investors are looking for income opportunities outside of term deposits. In this article, we discuss corporate bond investing as a way to access the benefits of diversification as well as a higher income return than what is currently on offer from term deposits and government bonds.

4 reasons to consider investing in corporate bonds

For investors looking to source income with stability, corporate bonds present a compelling investment opportunity. And for those who have ongoing liquidity requirements, this can be provided effectively through an actively managed corporate bond fund. Below are some key reasons for considering corporate bonds as part of a diversified portfolio.

• A strong buffer against share market volatility. Corporate bonds offer relatively stable cash flows and may be considered a lower risk way of gaining exposure to corporates than investing in equities. Since corporate bonds and Australian equities often move in opposite directions to one another, an allocation to corporate bonds can add to the defensive properties of a diversified portfolio.

• Offer higher income than term deposits and government bonds. The excess yield offered by corporate bonds over term deposits and government debt is expected to remain relatively high over the medium-term, providing an ongoing source of enhanced income for investors. Moreover, given sound company fundamentals, corporate bonds are well positioned in the current economic backdrop and can benefit from further economic recovery.

• Risk of capital loss is minimised. Active bond managers will commonly adjust a bond portfolio’s duration which measures the sensitivity of a bond portfolio’s capital value to a change in interest rates. Put simply, the duration will determine how long, in years, it takes for the price of the corporate bond to be repaid by its internal cash flows. This is important because generally speaking, corporate bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. By managing the fund’s duration, an investment manager can aim to limit the risk of capital loss in a rising interest rate environment.

• Gain access to the benefits of diversification. In an actively managed, corporate bond fund, investors are able to spread their portfolio risk by being exposed to a range of issuers, industries and geographies. Typically, when investors have exposure to a large number (upwards of 100) of securities the likelihood that a default or systemic event will have a major impact on the portfolio is minimised. Diversification across varying levels of investment grade corporate bonds continues to pay rewards, with the BBB-rated sector in particular performing well recently. We continue to prefer Australian and US corporate bonds due to their economic fundamentals, with a bias toward defensive or non-cyclical industries.

Overall, corporate bond investing offers investors a way to access the benefits of diversification as well as a higher income return than what is currently on offer from term deposits and government bonds.

Our position on corporate bonds

We have received several queries over recent months in relation to sell-off of Government bonds, particularly in this US and Germany, and what this means for corporate bonds as well as any associated headwinds in market liquidity. The key to the market backdrop has been an ebbing of the forces that pushed prices higher towards the end of 2014. That is, commodities and the US dollar have stabilised and this has helped stabilise short-term inflation expectations. From here we feel any sustained fall in bond prices will require stronger global real activity data.

A lack of liquidity in a rising rate environment is certainly a consideration. In order to prudently reduce the exposure to interest rate sensitivity, we reduce the duration (thereby minimising the risk of capital loss) in our actively managed portfolio of corporate bonds.

How we plan to manage ongoing uncertainty

The use of credit derivatives allows us to hold onto quality bonds, amidst volatile markets. For example, we recently bought credit protection against a part of our corporate bond portfolio to temporarily reduce our market exposure amidst the Greece uncertainty.

Due to the number of safeguards in place from the European Central Bank and national regulators we don’t see Greek contagion risk as being as severe as in previous periods. Accordingly, we will actively manage ongoing uncertainty and look to add corporate bonds during times of heightened volatility as we still like the underlying global policy support and corporate fundamentals.

On the whole, we are still constructive on corporate bonds and believe the low yields globally will continue to support the ‘search for yield’. This is not the end of the credit cycle because rates will ultimately respond to real activity improvements and views on inflation expectations, but the transition from quantitative easing in the US may see higher volatility, which supports active management strategies.

In the short term, however, we expect technical forces to dominate, that is, the strong ongoing bid for corporate bonds. The next leg of the cycle will be more about stock selection and sector rotation as opposed to just being invested in credit. Given the depth and breadth of our credit research team we believe we are very well placed to continue to deliver on our monthly income promise and preserve capital.

Final thoughts

Corporate bonds are traditionally considered lower down the risk spectrum than shares. Nevertheless, when exploring income investing from corporate bond issuance it is prudent to have a focus on investment-grade credit.

While the search for yield leaves many investors with choices surrounding how much risk to carry, it is important to invest in companies with strong or improving corporate fundamentals, a solid management team with a bondholder focus, whereby a normalisation of global growth could translate into revenue and earnings growth.

About the Author

David Carruthers is the Head of Credit and Core and the Portfolio Manager, AMP Capital Corporate Bond Fund

What’s driving the demand for Australian housing?

While it’s generally agreed Australian property prices are high in a global context, the reasons for it are subject to many factors. In our view, the shift to low interest rates since the early 1990s, deregulation of the banking system and the rise in two income households has clearly played a role. Consistent with this, the rise in price levels from below to above trend has gone hand-in-hand with increased household debt. More recent increases in demand may be due to:

• Higher population growth;

• Construction activity lagging the rise in demand for housing;

• State governments supporting densification, which is increasing land values in established areas close to infrastructure;

• Re-investment in the housing stock (the number of home renovation shows testament to this); and

• Record-low interest rates and risk aversion to other asset classes such as shares since the financial crisis.

Population growth has been a big factor, increasing since the mid-1990s in response to an ageing population, skills shortages, and more recently the resources boom.

Australian population growth (1983-2015)

Source: Australian Bureau of Statistics, as at June 2015

While interest rates get all the headlines, prices have risen because construction has not matched the rise in demand. Vacancy rates remain low and there has been a cumulative supply shortfall since 2001 of more than 200,000 dwellings. The main reason behind the slow supply response appears to be tough land use regulations in Australia.

It is a fact that house prices are high compared to rents and incomes which, combined with relatively high household debt to income ratios, suggests Australia is vulnerable on this front should something threaten the ability of households to service their mortgages. The trigger for this in our view could be higher unemployment.

How has the Reserve Bank of Australia responded?

The Reserve Bank of Australia (RBA) left rates on hold at 2.0% in its June meeting and has indicated that monetary policy needs to be accommodative for some time to come to stimulate the economy. Low interest rates are acting to support borrowing and spending.

Credit is recording moderate growth overall, with stronger lending to businesses and growth in lending to the housing market broadly steady over recent months. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities.

Will the housing market soften?

APRA is adamant that it wants to see growth in property investment lending slow into the second half of the year and if lenders don’t toe the line then tougher action is likely. As such, we should expect to see a slowing in the availability of credit for property investors and, as a result, some slowing in price growth in Sydney and to a lesser degree Melbourne over the next year.

Over the next 12 months weakness is most likely in the cities/towns exposed to a slowing mining boom. However, given the undersupply of dwellings, a downturn in property prices will likely have to await the peak of the next interest rate cycle or if the economy fails to respond to record low interest rates and unemployment rates rise.

Commercial property currently represents better value than residential housing

Historically residential property has been a great performer because of the consistency of capital growth over the long term rather than the income yield from rental income. The gross rental yield on housing is around 2.9% (after costs this is around 1%), compared to yields of 6% on commercial property and 5.7% for Australian shares (with franking credits).

With the prospect of weaker capital growth in residential, the commercial markets are likely to outperform in the next couple of years supported by higher income yields and increasing demand for higher yielding investments.

Final thoughts

Housing price vulnerability has been around since the house price boom that ran into 2003. As such, APRA and the RBA are right to be concerned about further inflating the property market. The renewed strength in auction clearance rates this year to record levels, particularly in Sydney and Melbourne, is a concern.

We expect commercial property to benefit from this environment. Our research suggests that the greatest opportunities lie in population growth areas/cities, dominant assets and core locations with ‘destination’ and experiential assets to attract customers and staff.

About the Author

Michael Kingcott is the Head of Property Investment Strategy and Research at AMP Capital leading commercial property research and investment strategy.

Financial planners are adopting new frameworks as they deepen their understanding of client goals in retirement and implement more targeted investment strategies both pre-and post-retirement. While this trend has been in place for some time, largely driven by changing customer attitudes, interest in new approaches has accelerated in the aftermath of the global financial crisis.

Exploring the two major advice frameworks

• The traditional approach – characterised by an investment portfolio, specified by its strategic asset allocation, judged to have a high probability of delivering returns to meet a client’s overall needs.

• An asset-liability management (ALM) approach – starts by focusing on the various goals of a client, segments the goals according to importance or priority and then identifies portfolio strategies whose cash flows and risk characteristics are appropriate for each goal and its priority.

How it works: Traditional versus the ALM approach

Maximising wealth is the central objective in the traditional approach. Fund managers build a series of high quality portfolios along the ’efficient frontier‘, with strategic asset allocations that reflect long-term risk and return forecasts implemented through sector portfolios designed to deliver returns above sector benchmarks.

An adviser will then work with their client to select the product with the optimal risk profile given the client’s risk tolerance, arguably a concept few people find particularly intuitive. The portfolio strategy employed to build up adequate wealth pre-retirement is often the same one used to draw down cash flow in retirement.

In practice, advisers wrap additional behavioural-based strategies around the portfolio to help clients deal with market volatility and resist the temptation to make poor choices at bad times.

A popular strategy, which seeks to insulate clients from short-term volatility, is based on allocating capital into three sub-portfolios:

• A cash portfolio of a size that covers spending needs for the subsequent three years;

• A capital stable portfolio to cover the next two years; and

• A balanced portfolio for the remaining capital.

Clients draw capital from the cash portfolio, which is replenished from the capital stable and balanced portfolios through a re-balancing program.

In the ALM framework, things are done in a different order. It starts with a conversation between adviser and client around needs and goals in retirement. These goals can loosely be considered as liabilities on the client’s household balance sheet. Critically, the various goals can be prioritised. This helps establish the capacity to take risk in pursuing each goal.

The goals with the highest priority centre on the capacity for clients to deal with emergencies and to meet essential living expenses on an ongoing basis, for example food, shelter and transport. The goals with moderate priority can be termed ’discretionary expenses’ such as overseas holidays and new cars. The lowest priority goals might be characterised as ’aspirational’ such as leaving a legacy for subsequent generations. While there is considerable scope to take on short-term investment risk in pursuing low priority goals, there is little capacity to do so for the high priority goals.

The ALM approach can address high, moderate and low priority goals

A key benefit of the ALM approach is that separate strategies can be employed to match different goals. For the goals identified as:

• High priority: clients want to be confident they will receive a regular income, ideally one that rises with the costs of living over time. Multi-asset income-focused funds come within a strategy that has been developed to meet this goal. While they carry no guarantees, the strategies, properly communicated, can promote confidence among clients that their income expectations will be met. For those looking for guarantees, insurance products such as annuities, especially if they are inflation protected, and variable annuities with a guaranteed income stream for life are also relevant products to meet essential needs in retirement.

• Moderate priority: resilient growth strategies that seek to increase wealth progressively while limiting the extent of temporary setbacks appear appropriate. The new multi-asset strategies described earlier are well-positioned to support the attainment of these goals.

• Low priority: it is appropriate to focus on long horizon strategies, which can include illiquid assets, aimed at generating real long-term compound growth. Provided the client is confident in the strategy, they do not need to worry about its short-term risk profile.

As advisers look to improve the confidence of their clients that they are on track to meet their goals, the ALM approach facilitates more effective discussion around risk by framing it in terms of failure to achieve a high priority goal. Under this framework, clients work with their advisers to determine how much to allocate to accounts supporting each goal and then select strategies for each account.

Final thoughts

While the traditional approach remains dominant in practice, there is growing interest in the ALM approach as it is more client-centred and arguably leads to a better experience for both financial planning businesses and their clients.

For more information visit the AMP Capital Goals-based investing microsite.

About the Author

Jeff Rogers, Chief Investment Officer, ipac Investment Management
Jeff Rogers joined AMP Capital in 2011 from ipac Securities and he has over 27 years’ of investment management experience. Jeff holds a Bachelor of Science (Honours) from the University of Melbourne.