December 2014 David Bassanese, Chief Economist
THE YEAR THAT WAS: COMMODITIES AND INTEREST RATES SURPRISE IN 2014 Despite a few false dawns during the year, the overall Australian equity market ended up only 1.1% in 2014, with weaker commodity prices dragging down resource stocks while lower bond yields boosted returns from high income producing sectors such as financials and property. Commodity prices fell harder than many imagined, not helped by weaker Chinese economic growth and a capacity war between producers in both the iron ore and oil markets. A related surprise was the continued decline in bond yields despite the strength in the US economy, and heightened expectations the Federal Reserve would start to raise official interest rates in 2015. Weakness in the European and Japanese economies and a related threat of deflation helped keep bond yields low. That said, even with a broadly flat market, local equity total returns were a better 5.6% once dividends were allowed for. Add in the benefit of franking credits, moreover, and the market s total return was north of 6.5%, highlighting once again the importance of the income element that can be derived from the market. WHERE TO FROM HERE? The coming year for investors promises to be just as challenging to negotiate as was 2014. Given likely continued low inflation and ample spare capacity in the global economy, the major positive for risk markets is that central bankers can afford to leave policy settings quite accommodative in 2015 indeed, further quantitative easing would seem likely should global growth falter, due to continuing fears of deflation. Rightly or wrongly, the consensus among central banks is to fear consumer price deflation more than reflation of asset price bubbles. Accordingly, central bank support should remain an important backstop for the equity markets, suggesting any sell-off should be temporary and corrective in nature. Within the Australian equity market, a major issue will be whether defensive/high yield sectors outperform cyclical/resource stocks again, which in turn will depend on the degree to which commodity prices are able to stage a comeback. With both iron ore and oil prices falling to levels consistent with significant production cut backs, a bottom for commodity prices seems likely this year, with some rebound potential. Together with a likely rebound from low bond yields especially if the US Fed starts to tighten chances are we ll see a better performance by resource stocks relative to interest-rate sensitive sectors by the second half of the year. The weaker Australian dollar should also start to have a major transformative effect on the local economy, boosting the earnings outlook for both mining and non-mining trade-exposed sectors. Due to the weaker $A, my base case remains that the Reserve Bank of Australia will leave interest rates on hold though if there is a move either way, I expect it will cut rather than raise them. At least in Australia, the yield chase in the equity market may continue, irrespective of how resource stocks perform. 2
SUMMARY OF DECEMBER 2014 The major development over the month of December was the further drop in commodity prices, especially for oil. This was associated with further weakness in the A$. On a hedged basis, however, the local equity market produced modest gains in line with the global benchmark, with interest-rate sensitive financials and property sectors outperforming resources. A major theme was that weaker oil prices added to expectations that global inflation and interest rates will stay low, supporting both fixed income and equity markets. ASSET PERFORMANCE DECEMBER 2014: SUMMARY Price returns for latest month, total returns for 3 and 12 months periods. Source: Thomson Reuters DataStream. Past performance is not an indication of future performance. 3
CASH Despite further weakness in the Australian dollar, financial markets continue to speculate over a possible further cut to the official interest rate this year due to persistent soft Australian economic growth. As at 31 December, the 1-year overnight indexed swap (OIS) rate was yielding 2.26%, implying a quarter-point interest rate cut (from 2.5% p.a.) was priced in by the market. The drop in oil prices and the strong gain in December employment and drop in the unemployment rate to 6.1% - however, suggest the RBA is likely to remain on hold at least for the first few months of this year. Housing demand also remains firm, though home building approvals appear to be peaking. Indeed, the overall economic outlook remains subdued, suggesting unemployment might well creep higher again in coming months. In the least, this suggests the RBA will leave interest rates on hold with a modest bias to ease. Bassanese s Outlook: My core view is that official interest rates will remain on hold for some time, and I now consider it a close to even-money bet the RBA could cut interest rates again by H2 2015. A weaker $A is a major reason the RBA could remain on hold even in the face of continued economic weakness. Key indicators to watch are business and consumer sentiment, along with the unemployment rate. Cash returns for the coming year look like being 2.5% p.a. or less. 4
FOREIGN CURRENCIES All major currencies rose against the Australian dollar in the month of December, in line with the steep declines in global commodity prices. RBA jawboning of the $A lower helped also, as did growing expectations that local interest rates would be cut in 2015. The US dollar rose 3.5% against the $A in December, to be up 6.7% in the past three months and 9.1% over the past year. Despite the weaker $A, however, it still remains a little overvalued relative to the equally steep declines in commodity prices in recent months. The RBA has indicated it would prefer to see the $A end this year closer to US75c, than US85c. Bassanese s Outlook: The A$ is following my script fairly well, having already reached my year-end target of US85c. While there may well be a short-run corrective rebound in the A$ and commodity prices in coming months, I retain a negative view on the A$ due to likely continued weak commodity prices and an anticipated eventual rise in US interest rates next year. Given today s level of commodity prices, the A$ remains overvalued even at US82c. I would expect the $A to break below US80c by mid-year, especially if local interest rates are cut again. 5
AUSTRALIAN BONDS Already low bond yields fell even lower in December, confounding wide-spread market expectations that yields would eventually rise as tightening by the US Federal Reserve loomed into view for the new year. Instead, weaker commodity prices, and new jitters concerning the sustainability of the Euro given fears of a Grexit (Greek exit from Eurozone), gave bonds a continued safe-haven bid. Australian 10-year government bond yields declined from 3.1% to 2.8% over the month of December. The UBS Australian Composite Bond Total Return Index gained a further 1.7% in December, to be 9.8% higher over the past year. Long-term Australian bond yields remain low by historic standards, but are still relatively attractive against even lower yields on offer in the United States, Europe and Japan. Bassanese s Outlook: Despite the continued rally in bond yields, I remain negative on the medium-term bond market outlook - given my confidence in America s economic recovery and prospective US monetary tightening. That said, with growing risk of a local interest rate cut, the spread between Australian and US bond yields might narrow further. However, given global bond yields should eventually move higher from today s quite low levels, only muted fixed income returns over the coming year should be expected. 6
LISTED PROPERTY The listed property sector rose a solid 2.9% in December, helped by the further decline in bond yields. The sector continues to outperform the overall Australian equity market in line with yield chase by investors, given the distribution yield is still holding above 4%. Relative earnings stability is also helping given the long-lived nature of most commercial rental agreements. In outright terms, price-to-book valuations are looking stretched, though yields are still attractive compared to the low level of bond yields. Bassanese s Outlook: With price to book valuations getting stretched, the listed property sector is vulnerable to a correction as and when bond yields rebound. In the meantime, the yield chase is likely to continue to favour outperformance by the sector. In line with my view on bonds yields, however, I would adopt a cautious medium-term outlook with property likely to underperform the broader market on a 5-year view. 7
AUSTRALIAN EQUITIES Australian equities rebounded by 1.8% in December after dropping 3.9% in November - continuing the choppy performance of the past few months. The market gain was driven by a modest lift in the price-to-earnings ratio, again likely helped by lower bond yields. Earnings expectations, meanwhile, remain under downward pressure, with the market s forward earnings measure edging lower again in December. In outright terms, the price to 12-month forward earnings ratio continues to hover above its 10-year average. Relative to bond yields, however, the market has moved into cheap territory. If bond yields stay low, this could result in further market support through PE expansion. Bassanese s Outlook: While outright market valuations are not especially cheap and earnings are under downward pressure, the market s dividend yield still remains attractive in a low interest-rate environment. That said, our market may grind up only gradually, or range-trade around current levels. It is expected to underperform global markets in both hedged and $A terms. 8
RESOURCES VS. FINANCIALS SECTOR The trend favouring financials over resources remained in place in December, with the former sector rising by 2.5% and the latter falling by 2.6%. As with listed property, declining bond yields are helping support high yielding sectors like financials, while weakness in commodity prices continues to plague the resources sector. Bassanese s Outlook: Given low interest rates and weak commodity prices, the market environment should continue to favour outperformance by financials over resources. Rising bond yields pose a risk to the financial sector outlook, however, over the coming year. 9
INTERNATIONAL EQUITIES The MSCI World Index (developed markets) slipped by 0.9% in hedged (local currency) terms during December, slightly reversing the trend of outperformance against Australia over the past year. Weakness was most evident in European equities, with the US and Japanese markets broadly flat. On an unhedged basis, however, the world MSCI index rose 1.7% due to weakness in the Australian dollar. As in Australia, outright global equity price-to-earnings valuations are above their 10-year average. The bond-to-earnings yield gap, however, remains close to its 10-year average, suggesting that relative to bond yields the market is still fairly valued. Earnings growth expectations, however, remain under downward pressure. Disappointing growth in Europe and Japan, and concerns for US energy companies in light of falling oil prices are new negatives for global equities to digest. Bassanese s Outlook: I remain positive on global equity markets despite some signs of economic weakness due to still reasonable valuations against bond yields. Low inflation means central banks should also keep policy expansionary, especially if equity markets correct. That said, global forward earnings have started to turn down in recent months, meaning more of the market s gains have come from a rising PE ratio and declining bond yields. As a result, the market seems increasingly vulnerable to another decent correction to restore more alluring value back for investors. Either way, continued outperformance against Australia is anticipated in both hedged and unhedged terms. 10
EMERGING MARKETS The MSCI Emerging Markets Index dropped back in December, falling 2.5% in local currency terms, and by 1.2% in unhedged (A$) terms. Performance across the major emerging economies was mixed, with China s market rising strongly, while those of Russia and Brazil fell hard due to the decline in commodity prices. On a hedged basis, emerging market relative performance against Australia has leveled out in recent months, though strength is more evident on an unhedged basis due to $A weakness. As an asset class, emerging market valuations do not appear stretched, though earnings expectations (as elsewhere) remain under downward pressure. Bassanese s Outlook: My core view is that emerging markets should continue to benefit from the broader global equity market upswing, but due to greater capital flow and commodityproducer exposure the asset class may underperform developed markets. I am neutral on the asset class compared to Australia. China s market, however, appears to be developing a major head of steam as speculative capital switches from the property market to equities. The fact China is a net-commodity importer also helps. 11
COMMODITIES Despite continued stabilisation in gold and agricultural prices in December, oil prices slumped by a further 18.9% - taking the declines over the past three months to a staggering 41.4% The failure of OPEC to cut production in the face of slowing demand and rising non-opec supply (chiefly from the United States) continued to weigh on the oil market. As a result, the broad S&P GSCI Light Energy index fell a further 7.9% in the month. Gold prices are trying to hold the important support level of $US1200/ounce. Bassanese s Outlook: As I ve long maintained, modest global economic growth, low inflation, rising supply and a gradually strengthening US dollar make it hard to be positive on the nearer-term commodity price outlook. That said, the slump in oil in recent months has been so severe that at least a short-run corrective rally now seems possible. That said, the long-term agricultural price outlook remains positive - due to rising Asian living standards. As has been evident in recent years, moreover, commodities such as oil and gold continue to offer useful hedges should a more severe outbreak of geo-political instability or global inflation arise. 12
ASSET PERFORMANCE DECEMBER 2014: DETAILED REVIEW Asset Performance: Detailed Review* Month 3-mth 12-mth Cash 0.2% 0.7% 2.7% US Dollar 3.5% 6.7% 9.1% Aust. Bonds 1.7% 4.0% 9.8% Aust. Property 2.9% 11.5% 27.0% Aust. Equities 1.8% 3.1% 5.6% Financials 2.5% 7.2% 9.8% Resources -2.6% -13.0% -16.4% Int. Equities -0.9% 3.4% 10.4% -unhedged 1.7% 7.9% 15.1% Em. Markets -2.5% -0.3% 5.7% -unhedged -1.2% 1.8% 7.5% Commodities -7.9% -14.7% -20.0% Agric. -0.6% 8.7% -10.8% Gold 0.4% -2.2% -1.8% Oil -18.9% -41.4% -45.8% Price returns for latest month, total returns for 3 and 12 months periods. Source: Thomson Reuters DataStream. Past performance is not an indication of future performance. *ASSET BENCHMARKS Cash: UBS Bank Bill Index US Dollar: spot US dollar exchange rate vs. A$ Australia bonds: UBS Composite Bond Index Australian property: S&P/ASX 200 A-REITs Australian equities: S&P/ASX 200 Index Financials: S&P/ASX 200 Financials (ex A-REITs) Resources: S&P/ASX 200 Resources International equities: MSCI World (developed market) Equity Index, local currency & unhedged $A terms Emerging markets: MSCI Emerging Markets Equity Index, local currency & unhedged $A terms Commodities: S&P GSCI Light Energy Index, $US terms Agriculture: S&P GSCI Agricultural (excess return) Index, $US Gold: spot gold bullion price/ounce, $US Oil: West Texas Intermediate, price per barrel, $US. 13
BETASHARES PRODUCT OFFERINGS ACROSS ASSET CLASSES BetaShares Product Offerings across Asset Class Types Asset Class Investment Exposure BetaShares Fund ASX Ticker MER(%) Australian Cash Australian Cash Australian High Interest Cash AAA ETF 0.18% Foreign Currencies U.S. Dollars U.S. Dollar ETF USD 0.45% Euro Euro ETF EEU 0.45% British Pounds British Pound ETF POU 0.45% Australian Equities Largest 200 Australian FTSE RAFI Australia 200 ETF QOZ companies by fundamental weight 0.40% Financials Sector excluding A- S&P/ASX 200 Financials Sector QFN REITS ETF 0.39% Resources Sector S&P/ASX 200 Resources QRE Sector ETF 0.39% S&P/ASX 20 + Equity Income Equity Yield Maximiser Fund YMAX strategy (managed fund) 0.79% S&P/ASX 50 + Dividend Australian Dividend Harvester HVST Income strategy Fund (managed fund) 0.90% Geared exposure to diversified Geared Australian Equity Fund GEAR portfolio of Australian Equities (hedge fund) 0.80% Short Australian Equities Australian Equities Bear Hedge BEAR Fund 1.38% International Equities US S&P 500 Index + Equity S&P 500 Yield Maximiser UMAX Income strategy 0.79% Largest 1000 US companies by FTSE RAFI US 1000 ETF QUS fundamental weight 0.40% Commodities Gold Bullion (US$) Gold Bullion ETF - Currency QAU Hedged 0.59% S&P GSCI Crude Oil Index Crude Oil Index ETF Currency OOO Hedged (synthetic) 0.69% S&P GSCI Index (Light Energy) Commodities Basket ETF QCB Currency Hedged (synthetic) 0.69% S&P Agriculture Enhanced Agriculture ETF Currency QAG Select Index Hedged (synthetic) 0.69% Other costs may apply. Please refer to the relevant PDS for more information. 14
ABOUT BETASHARES BetaShares Capital Ltd ("BetaShares") is a leading provider of exchange traded products ("ETPs") which are traded on the Australian Securities Exchange. BetaShares offers a range of ETPs which cover Australian and international equities, cash, currencies, commodities and alternative strategies. BetaShares currently has approximately $1.9 billion in assets under management. BetaShares is a member of the Mirae Asset Global Investments Group, one of Asia's largest asset management firms. Mirae currently manages in excess of US$60B, including over US$8B in ETFs. This information has been prepared by BetaShares Capital Ltd (ACN 139 566 868 AFS Licence 341181) ( BetaShares ). This is general information only and does not take into account the individual circumstances, financial objectives or needs of any investor. Before making an investment decision, investors should consider their circumstances, the PDS for the relevant financial product, and obtain professional financial advice. The PDSs for BetaShares Funds are available at www.betashares.com.au or by calling 1300 487 577. Only investors who are authorized participants may invest through the PDSs. Other investors may buy units in BetaShares Funds on the ASX. This information is not a recommendation or offer to invest in BetaShares Funds or any other financial product or to adopt any particular investment strategy. An investment in any BetaShares Fund is subject to investment risk and the value of units may go down as well as up. Any past performance shown is not an indication of future performance. Future results are impossible to predict. This document may include opinions, views, estimates and other forwardlooking statements which are, by their very nature, subject to various risks and uncertainties. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in such forward-looking statements. Opinions and other forward-looking statements are subject to change without notice. Any opinions expressed are not necessarily those of BetaShares. To the extent permitted by law BetaShares accepts no liability for any errors or omissions or loss from reliance on the information herein. 15