As we enter a new financial year it is comforting to know that we find ourselves in a much more constructive investment environment than twelve months ago. This time last year, fear was the dominant force driving market prices - investors still had vivid memories of the Global Financial Crisis (GFC) and dreaded getting caught out again. However, as the year progressed, the news filtering through markets turned out to be not quite as bad as feared. Those investors who had the courage to stay invested through the period were rewarded as share markets made significant price gains.
Although the market has given back some of its gains over the past month or so, both domestic and global shares have still delivered more than 20% to investors over the past 12 months. Indeed, the period marks the strongest financial year for Australian shares since before the GFC.
The economy is on a more stable footing
Twelve months ago, the global economy was in a fragile state as advanced economies battled to reduce the debt burden created in the years leading up to the GFC. However, over the period, bold policy initiatives from monetary authorities in Europe and the US served to reduce the immediate threat to their economies. Over the past six months, policymakers have successfully defused two of the biggest short-term threats to the global recovery: the threat of a euro area break-up, and a sharp fiscal contraction in the US (which refers to a reduction in government spending and/or raising taxes). In response, financial markets have made strong gains on a broad front.
United States: The US economy has been a ‘good news story’ as private demand appears increasingly robust, and both housing and employment have risen from depressed levels. Quantitative easing, which is the US Federal Reserve’s program of buying bonds from its member banks, was introduced in an attempt to spur economic growth.
We believe that the Federal Reserve’s recent announcement to potentially reduce quantitative easing is a positive endorsement of the increasing strength of its economy. However, we do acknowledge that the transition towards a reduction in quantitative easing may lead to some market volatility.
Europe: In Europe, the economic and financial market crises we have witnessed since the GFC now appear to be well contained, although not fully resolved. Indeed, the upward adjustment in share markets over the past year reflects the reduction in fears of disorderly developments in Europe and there are indications that the downturn in economic growth has bottomed.
Japan: Japan has been another ‘good news’ story. After many years of deflation and little or no growth, the new government has announced a policy based on aggressive quantitative easing, a positive inflation target, fiscal stimulus and structural reforms. This policy is expected to boost growth in the short-term and is Japan’s best chance of breaking the deflationary cycle it has been in for the past 20 years.
Emerging economies: These economies face different challenges, one of which is how to handle capital flows. This is the movement of money for the purpose of investment, trade or business production. Attractive prospects in emerging market economies, together with low interest rates in advanced economies, have led to net capital inflows and exchange rate pressure in many emerging economies. The challenge for these countries is to accommodate the underlying trends while reducing the volatility of the flows when they threaten financial stability. The economic slowdown in China is likely to result in falling demand for commodities. In addition, there are ongoing concerns that China’s liquidity troubles will spill over into the broader financial sector. However, the central bank has recently allayed market concerns, outlining that it would provide liquidity as needed to banks.
Australia: With the resources boom coming to an end, and growth in China softening, Australia’s position has deteriorated from a year ago. While we expect slower economic growth over the next 12 months, the falling Australian dollar and further interest rate cuts should help stimulate areas of the economy such as retail and manufacturing. This, in turn, would fill some of the gap left by lower mining investment.
The outlook for markets
Over the past 12 months Australian and emerging market shares have underperformed developed markets. While we still favour developed markets, particularly US shares, the valuation gap has now narrowed between Australian and emerging markets and developed markets. As such, emerging market shares now look very cheap, and China shares are now at their cheapest levels since before the GFC. In Australia, the measure of valuations that signalled markets were cheap 12 months ago is now closer to ‘fair value’. However, we believe there is scope for further upside within Australian shares, and the asset class should continue to receive base support because of its yield advantage.
Government bond yields fell to historic lows in 2012 and appeared expensive, suggesting weaker returns going forward. This has indeed been the case in 2013 as bond yields have edged higher on the improved global growth outlook. In addition, talk of the Federal Reserve potentially reducing its bond buying has led to a sharp rise in yields on the back of concerns that interest rates might rise sooner than expected. Against this backdrop, our diversified portfolios have benefited from an underweight position in bonds.
The importance of active management
We believe that shares will continue to deliver good returns over the medium-term, particularly relative to other asset classes. However, as the global economy recovers from the events of recent years, the pathway to achieve these returns may, at times, be volatile.
In an environment of continued market volatility, staying invested in a well-diversified, actively managed portfolio is key. The ebb and flow of the business cycle creates pricing anomalies and mis-valuations on a medium-term basis. We believe that an active approach to asset allocation that anticipates and takes advantage of these anomalies is a critical portfolio management tool. Not only will active positions in the Australian dollar be important going forward, but so too will investment in alternative assets, such as such as infrastructure, absolute return strategies and private equity which have a low correlation with mainstream markets.
Important note: While every care has been taken in the preparation of this article AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties 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.