Index Returns – as at 30 June 2017

Returns greater than 1 year are annualised.

Lonsec Market Update (issued 25 July 2017)

Many market commentators, including us, have commented on the low level of volatility in the market. The CBOE VIX index, which measures the implied volatility for S&P 500 options, is currently at very low levels, suggesting that the market is pricing in a low level of risk. At the same time, market momentum has been strong. This can be seen by looking at simple price momentum indicators such as the 50- and 200-day market moving averages as well as market trade volumes. Both measures indicate that market momentum is positive.

Valuations, while not at extreme levels, are certainly not cheap, and the equity-bond yield differential has also narrowed, making allocating capital increasingly challenging. As discussed previously, have seen an improvement in economic indicators, however, over the past month economic signals have been mixed, particularly in the US.

We believe that in the short term, markets may continue their upward trajectory, however, environments characterised by strong momentum and low expectations of risk can by symptomatic of risk being mis-priced and the risk of a tail event increasing. In such environments, we encourage investors to be cautious, mindful of the range of risks presently within the market (see below) and to be selective in their investment decisions.

Key Economic and Market Risks

• Global deflation pressures intensify (negative)

Excess global capacity and deficient demand growth have contributed to the weakness in wages growth, declining commodity prices, weak world trade and unusually weak service sector prices. China exports deflation as it seeks to lower its currency to deal with excess investment and capacity. Protectionism and currency wars further undermine growth and confidence. President Donald Trump winds back free-trade agreements, applies tariffs to China, leading to retaliatory actions.

• Chinese “hard landing” (negative)

A downturn in the property market exposes high levels of local government debt, the yuan is allowed to depreciate and capital flows intensify. This leads to GDP growth well below 5%. Negative for the global economy but particularly the Australian economy, equities, commodity prices, emerging markets and particularly resources and the AUD. Bonds outperform.

• Stronger global growth (mixed)

China stabilises growth around 6.5% while US domestic demand surprises to the upside on the back of sustained employment growth and fiscal expansion under President Trump, as well as an overdue lift in wages growth and investment. Europe and Japan continue to improve, supported by extremely easy policies. EM economies continue to recover. AUD rises, bond yields sell off sharply, undermining interest rate sensitive assets and sectors. Equities remain flat. Positive for cyclical exposures.

• European political risk (negative)

Significant political risks remain. In the aftermath of the “Brexit” vote there is concern over the rise of the populist parties across Europe broadly supporting reduced immigration and some “backtracking” on globalisation. France holds elections in May 2017. The threat of deflation remains given growth and incomes remain subdued and unemployment and debt levels are extremely high. Debt to GDP ratios are still extremely high and difficult to stabilise while growth and inflation are low. Equity markets suffer, defensive assets outperform.

• Trumpenomics fails (negative)

Following failure to repeal and replace Obamacare the Trump administration falls short on tax reform and infrastructure spending. Business and consumer confidence decline from elevated levels, taking growth expectations lower. Equities retreat while bond yields decline. Fed hike expectations are scaled back.

• US Fed tightening unsettles global capital flows and risk appetite (negative)

The Fed responds to the stronger US growth environment and fiscal expansion catching markets under-prepared for a series of tightenings. Markets adjust, particularly those that have previously benefited from low US rates and a low USD. Potential risks in emerging markets, high yield. The USD rise undermines US growth. AUD falls sharply.

• Low rates and stronger commodities (Positive)

With cash and mortgage rates at, or near, record lows and the currency at reasonable levels, Australian monetary conditions are accommodative. This, along with a sustained lift in commodity prices, eventually flows through to employment, incomes and domestic growth. Domestic equities markets lift.

• Australian house prices weaken considerably (Negative)

Although house prices have risen over the past 12 months, a global economic shock would place the Australian economy at risk, particularly given the already low RBA cash rate and high levels of household debt. Similarly, a looming oversupply in the “high-rise” market could severely impact rents, prices, construction activity and employment. Funding conditions tighten. Economy at risk of recession and bank sector impacted. AUD down, equities down, bond yields lower.

• Interest rate differentials (Negative)

Although interest rate differentials have halved, the level of rates in Australia is still attractive. A larger than expected Fed tightening would undermine the AUD.