Market Overview - GFM Wealth · Market Outlook Page 5 of 13 June 2019 Quarter Market Overview & Market Outlook Australian Financial Services License No. 229401 As a result of the

Market Overview

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June 2019 Quarter Market Overview & Market Outlook

Australian Financial Services License No. 229401

Australian Shares • The S&P/ASX 200 Accumulation Index recorded another extraordinary gain of 7.97% for the June quarter,

outperforming global sharemarkets: o For the 2018/19 Financial Year, the Australian sharemarket posted a strong gain of 11.55%, buoyed by

exceptionally strong returns in the second half of the period as the market strengthened by a remarkable 19.73% in the six months ended 30 June 2019.

• While sector performance continued to vary widely, all sectors except for energy recorded positive returns.

The top three performing sectors were telecommunications, healthcare and financials, which all recorded double digit gains:

o Notably, the strong performance from financials came after the return of the incumbent government, in a relief rally that applauded no changes to taxation policies such as franking credits and negative gearing.

International Shares • The index for global equities rose by 5.28% in the June quarter, continuing its gains from the March quarter, to

end the 2018/19 Financial Year 11.95% higher: o The weakness in the Australian dollar, particularly versus the U.S dollar, helped to boost returns for

unhedged international share investors o Through the quarter, the U.S sharemarket (S&P500) pushed to new highs and ended 10% higher than

a year ago while developed markets continued to outperform emerging markets for the quarter and year.

• On a sector basis, technology was one of the best performers over the quarter and six-month period, however,

the best performing sectors over the 12-month period were utilities and communication services: o Significant country dispersion continued over the 12-month period, with some countries recording

double digit gains while others recorded negative returns. Global Infrastructure • Global infrastructure continued to push higher in the June quarter (S&P Global Infrastructure, Net Returns, $A

hedged index), to return 4.54%: o Over the 2018/19 Financial Year, the asset class delivered a significant gain of 12.40%

• There was a wide disparity in regional performance, with Pacific ex-Japan posting a solid gain while Japan

recorded a loss for the quarter: o Sector performance was also mixed with Toll Roads, Airports, and Water assets performing the best,

while the Rail and Utilities sectors lagged.

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Australian Property • Australian real estate investment trusts (A-REITs) recorded another gain for the quarter with the S&P/ASX 200

A-REIT Accumulation Index delivering a return of 4.07%, buoyed by further declines in Australian and global bond yields:

o For the 2018/19 Financial Year, the asset class returned 19.32%. • While A-REITs underperformed their global peers, sectoral performance trends were similar across the globe,

with the Industrials sector performing strongly while the Retail sector was amongst the lowest returning sectors.

Australian Cash and Fixed Interest • Reflecting concerns over slowing global growth, ongoing trade tension risk and the muted economic

environment, the RBA lowered the official interest rate in June 2019, the first cut in three years, to 1.25%: o Australian bond yields tumbled, and the 10-year bond yield ended the quarter at 1.32%, a notable

decline from 2.77% in November 201: o In the days following the end of the quarter, the RBA followed up with another 0.25% rate cut in July,

taking the official cash rate to 1%, its lowest on record. International Cash and Fixed Interest

• Concerns over slowing global growth mounted and comments from central banks around the world pointed to a softer outlook for monetary policy

• Global credit markets outperformed government bond markets as investment grade and high yield

spreads contracted further, while emerging market debt (in local currency terms) also strengthened over the quarter

Australian Dollar • The Australian dollar weakened against the U.S dollar over the quarter as bond yields fell in anticipation of the

official interest rate cuts, with the differential between Australian and U.S 10-year bond yields declining further:

o Over the past 12 months, the Australian dollar has weakened significantly against the U.S dollar and has also declined against a broader basket of currencies, including the euro and Japanese yen

• This has boosted the returns of unhedged international assets for Australian investors.

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The past Financial Year proved to be a roller-coaster ride for investors. Share markets plunged into Christmas over fears of interest rate rises in the US, higher oil prices, and the negative sentiment of a possible US/China trade war, before quickly reversing the trend over the last six months. This saw global share markets rebound sharply, with Australian shares having their best June half since the early 1990s, helped along by the return of the Coalition Government, which ensured that there were no immediate changes to the franking/imputation credit system.

Source: Thomson Reuters, AMP Capital For the Financial Year as a whole, global shares returned 6.6% in local currency terms, and thanks to a fall in the Australian dollar, they returned 12% in $A terms. Australian shares returned 11.6% (including dividends), touching an 11-year high. The plunge in bond yields bolstered the search for yield, and so helped yield sensitive listed property, and infrastructure assets generate strong returns, despite a rougher ride for retail property. Australian residential property fared poorly, with average capital city prices down 8%, but signs of stabilisation have emerged recently, helped by the election result, and rate cuts. While we remain cautiously optimistic for the year ahead, we are late in the economic cycle, and valuations look full. With slowing global growth, a weaker domestic economy continued geopolitical risks, and stretched valuations, markets are likely to be more volatile in the coming 12 months. After several strong investment years in a row, some caution now needs to be exercised.

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Australian Shares The Australian economy has achieved approximately 30 years of uninterrupted economic growth, a record that no other country has been able to match. However, while growth continues, it remains low, with the positive benefits of population growth, the only thing saving Australia for the moment. Two per cent growth now seems to be the norm, which is likely to continue while domestic consumer demand remains low as a result of stretched household balance sheets, low wages growth, and falling house prices.

Source: Bloomberg With only modest economic growth for a prolonged period now forecast, both inflation, and interest rates are also expected to remain low over the years ahead. With 10-year Australian bonds yielding just 1.32%, and the RBA dropping the cash rate to 1% in early July, the gap between the dividend yields of good quality Australian shares, and bond yields has rarely been wider.

Source: RBA, AMP Capital

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As a result of the large yield gap, the hunt for income appears to have pushed the valuation of the Australian equity market to a historically high level.

Source: RBA & Bloomberg monthly end of May 2019 Despite the full valuation, the Australian equity market continues to represent better value than fixed interest and many other asset classes and will continue to do so if interest rates remain at current levels or possibly fall over the 2019/20 year. A fully franked dividend yield of 4% becomes very attractive in the current low-interest-rate environment. In addition, despite the economic challenges of a low growth domestic economy, both interest rate cuts, and tax cuts appear to be helping to stabilise the downtrend in house prices, and the risk of an economic recession. While headwinds remain evident, the Australian share market’s high dividend yield, and general defensive nature is appealing to both foreign, and local investors, especially if the Australian dollar continues to depreciate. With lower interest rates as well as exchange rates expected to help corporate earnings, we should see a good level of support for the Australian equity market over the year ahead.

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Global Shares Global equity markets have performed positively over what has been a volatile 12-month period. Early on, healthy corporate earnings provided support while rising US interest rates, trade tensions, political uncertainty in Europe, and concerns about emerging markets led to volatility. Markets came under pressure in late 2018, as concerns over global economic growth intensified. However, investor sentiment rebounded in 2019 as a result of positive signs on US-China trade talks, and the supportive interest rate policies in major world economies. The global economic outlook is delicately poised at present. Growth has slowed, and the unresolved trade war, and geopolitical frictions remain the key risks for the outlook of the global economy, and financial markets. United States The cyclical bull market in US shares is now over ten years old. This makes it the longest since WW2, and the second strongest in terms of percentage gain. In addition, the current US economic expansion that started in June 2009 is also the longest on record, but like the Australian economy, it’s only been a relatively modest growth period resulting in low employment growth figures This record-long U.S. economic expansion, however, looks unlikely to run out of steam any time soon. The near-term risks of the traditional causes that bring economic expansions to an end, such as spending, debt, and inflation that then prompts central banks to overtighten interest rate policy are not evident. It has taken longer than normal for excesses that precede recessions to build up in the US economy on this occasion. The US economy has only recently hit full capacity, entering the “late” stage of the cycle that can often run for an extended period. Output gap, and stages of the U.S. business cycle, 1965-2019

Source: BlackRock Investment Institute In addition, there still plenty of spare capacity in the US labour market, with the participation rate still relatively low, and wages growth of around 3% remaining quite modest. The last three recessions were preceded by wages growth above 4%.

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Although US growth may slow further as a result of the escalating trade conflicts, the economic expansion should continue running on for longer, with the US Fed ready to act against any downside risks to growth by easing monetary policy with lower interest rates. The approaching 2020 US Presidential election could also provide more stimulus to the world’s largest economy, and help cushion it against any potential risks. As a result of the positive economic backdrop, US stocks have rebounded over the last six months, and helped push up valuations, with the price-to-forward earnings ratio also moving up in tandem.

Source: BetaShares However, falling interest rates remains supportive of higher valuations given that the US equity to bond yield gap also pushed higher, to be in the upper half of its range of recent years.

Source: BetaShares One concern for the US equity market is if there is a significant move back up in bond yields, especially if an easing in trade tensions causes the US Fed to consider raising the cash rate over the short term.

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However, it is more likely that the US Fed will ease monetary policy in coming months even if trade tensions ease, due to a renewed desire to push inflation up given still relatively subdued price, and wage pressures. This could lead to an improvement in the earnings outlook (or at least a levelling out in downgrades), and a possible further increase in equity valuations due to the low-interest-rate environment. As such, a supportive policy mix by the US Fed and the prospect of an extended economic cycle are positives factors for financial markets. US Fed Interest Rate Outlook

Source: FactSet, U.S. Federal Reserve, J.P. Morgan Asset Management. China Economic activity in China has faltered on the back of an escalation in trade tensions - industrial production is at a 17-year low, and fixed asset investment is very close to a 19-year low. Even credit growth has been lacklustre despite large policy stimulus. China’s Gross Domestic Product (GDP)

Source: FactSet, NBS China, J.P. Morgan Asset Management

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The resulting fallout from the U.S.-China rivalry threatens a renewed downturn. Confidence in both the corporate, and household sectors is currently running low, one of the reasons why the current recovery appears anaemic, even after the significant stimulus in late 2018. While China has found it difficult to boost growth under the current economic backdrop, they can revert to past trusted tools, such as infrastructure spending, and a further easing in lending restrictions, to pump-prime their economy. This would partially offset downside risks to growth, but should growth continue to weaken despite that support, the People’s Bank of China may decide to cut interest rates, and increase liquidity in the banking sector to produce a positive credit impulse.

Source: BlackRock Investment Institute Although China and the U.S. agreed to resume trade talks, the continuous conflicts between the two nations will most probably be the “new normal” going forward as they battle for global supremacy on economic, geopolitical, and technological fronts. As such, stock picking will be an essential factor for Chinese/Asian equities under the current market environment. The geopolitical events could trigger share price overreaction, and hence create value opportunities for companies with solid fundamentals.

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Australian Listed Property (AREITs) The A-REIT sector generated a total return of +19.3% in 2018/2019. However the returns were heavily skewed to the second half of the Financial Year, and primarily driven by falling bond yields, and the rotation of capital into the yield sectors such as A-REITs, and infrastructure. The A-REIT index was boosted by the industrial, and office sectors that delivered +57.7%, and +33.4% respectively over the year, whilst the retail sector delivered -7.6%. Over the year, there was a significant flow of capital from domestic, and global equities into A-REITs, with higher multiples being paid by investors seeking the relatively secure earnings growth in the sector. Many A-REITs took advantage of the strong appetite for yield, and raised more than $3.7 billion in the past six months, $1.7 billion of which was raised in June 2019 alone. This was the highest level of equity raised since 2009 when the sector was forced to recapitalise at the height of the Global Financial Crisis.

Source: FactSet, Colonial First State Global Asset Management The following is an update on each sector of the A-REIT market: Office Australia’s main office markets are well-positioned with historically low vacancy rates, and modest supply levels. This has led to strong rental growth along the east coast. The Sydney CBD vacancy rate is the lowest it has been in 18 years, while Melbourne’s vacancy rate is at a 10-year low. Given the strong positive office market fundamentals, capital values are expected to be supported by continued investment demand from A-REITs. Industrial The structural trends of urbanisation, rising e-commerce, and the need for geographical convenience has led to strong demand for well-located urban industrial premises, and higher investment into state-of-the-art distribution centres, driving longer leases. A significant pipeline of infrastructure projects and a lower AUD has also benefitted demand, leading to rental growth in most regions. The sector is expected to remain strong, given the solid rental, and capital growth expectations over the year ahead.

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Retail The retail sector has been impacted by a combination of cyclical and structural issues. Cyclically, retail sales have been under pressure due to higher living expenses that have not been offset by wage growth. In particular, discretionary retail is suffering from the rise of e-commerce, although FY 19/20 retail sales are expected to be boosted by the flow-through of the Coalition’s tax refund plan. This will see $7.6 billion tax refunds flow to consumers, with a large proportion of the refunds expected to be spent on retail consumption, possibly giving the sector a short-term boost. Residential Optimism seems to have returned to the housing market, following the Federal Election, RBA cuts, and APRA easing of lending buffers. While the sentiment is up this positive shift will take time to filter through the market, and positive earnings of those A-REITs exposed to the residential sector.

Source: APM, CoreLogic, Macquarie Macro Team The outlook for A-REITs With interest rates at record lows, and continuing low inflation, there are not many options for investors seeking a healthy yield. The sector is offering a 4.5% dividend yield, with forecast growth in dividends of approximately 3% per annum for the next four years. Profit growth is reasonably predictable, underwritten by contractual rental arrangements, and annuity-type management fees. Unlike some of the industrial companies listed on the ASX, there are very few concerns about the ability of the A-REIT sector to continue paying dividends. The sector will continue benefiting from solid operating fundamentals, low gearing, and strong interest cover, good dividend coverage, and demand for institutional-grade real estate. A continuation of low interest rates, reasonable consumer confidence, and corporate activity will support the sector, and the weaker Australian dollar will add to the appeal for offshore investors. The most considerable risk to the sector is a rise in bond yields, which would have a significant negative impact. However, under the current economic backdrop, this seems highly unlikely.

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Australian, and International Cash, and Fixed Interest Interest rates across much of the developed world have fallen to even lower levels, and Australia has been no exception. As widely expected, the RBA cut interest rates by a further 0.25% in July following its earlier 0.25% cut in June, taking the official cash rate to 1.0%, its lowest on record. However, it is unlikely that the RBA has finished cutting rates yet. The ANZ Bank, National Australia Bank, and Westpac Bank all expect the cash rate to be cut by a further 0.25% to 0.75% in coming months. Returns from cash in the bank look set to go even lower, which is not good news for Term Deposit holders. Term Deposits growth, and Interest rates movements

Source: FactSet, ICAP Plc, Reserve Bank of Australia, J.P. Morgan Asset Management As a result of falling interest rates, Australian bond yields have tumbled, with the 10-year bond yield ending the Financial Year at 1.32%, a significant decline from 2.77% in November 2018. Australian 10 Year Bond Yield

Source: Morningstar Direct

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Australian bonds have fallen considerably over the past six months in anticipation of rate cuts. With the RBA now having delivered two recent rate cuts, with the possibility of more to come, Australian bonds look increasingly unattractive. This applies particularly to longer-dated bonds, which are most sensitive to changes in interest rates, and inflation expectations. Moving overseas, world bond markets have continued to confound expectations, with already meagre bond yields falling even further. In the U.S. market, the benchmark 10-year Treasury bond now yields only 2.05%, down 0.6% since the start of the year, and at one point in early July, it was trading below 2.0%. Other bond markets have followed, with the benchmark German government 10-year bond offering a small positive yield of 0.24% at the start of this year but is now on a yield of negative 0.32%. The developed economy trophy for lowest 10-year yield continues to be held by Switzerland, now at negative 0.61 %! The recent falls in bond yields reflect three factors. The first is persistently low inflation, with many of the world’s central banks unable to get it up to the target rate of about 2%. The U.S. is nearly there, but the Eurozone and Japan are well short. As such, central banks have responded by cutting interest rates to try to move inflation higher, but they may cut them further again. A second factor is central banks’ anxiety about a potential economic slowdown. While the world economy is currently still growing at a modest rate, the outlook is relatively fragile, and as such central banks have also been cutting rates as a preventative measure against the economy coming to a halt. Finally, the third factor has been investor anxiety, which has resulted in precautionary buying of safe-haven assets like bonds as insurance against trade wars, and other risks derailing the world economy. The outlook is for a modest rise in bond rates from current abnormally low levels unless some of the more significant downside risks to the global outlook materialise.

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Market Overview - GFM Wealth · Market Outlook Page 5 of 13 June 2019 Quarter Market Overview & Market Outlook Australian Financial Services License No. 229401 As a result of the