2017 investment review


Investment commentary for the year ended 30 June 2017 provided by Mercer.
 

It was another good year for investment returns, more so for growth oriented strategies than conservative ones, as equities outperformed bonds over the year.

The 2017 scheme year in investments was characterised by two factors; geopolitical surprises and strong global equity returns. Following the surprising Brexit result that occurred at the very end of the 2016 scheme year, Donald Trump’s Presidential election victory in November also caught the markets unaware. The Republicans claimed a clean sweep: winning control of the White House, the Senate and Congress. On the back of promises of tax cuts, increased expenditure and deregulation, the US market roared ahead. And while it started to look increasingly difficult for Trump and the Republicans to advance their agenda, the underlying economic fundamentals of the United States (and many of the advanced economies) continued to improve over the year.

The results of the recent European Elections were a key highlight of the final quarter of the scheme year. British Prime Minister, Theresa May, perhaps over-confidently, called for an early snap election in June, stating that securing stable and strong leadership was necessary in order to see the country through Brexit. However, the result, a 'hung parliament', weakened UK leadership and further complicates the Brexit negotiations. The French Presidential election resulted in a victory for the centrist (pro-European) candidate, Emmanuel Macron, winning against populist candidate, Marine Le Pen. Investors reacted positively to this news, and were further encouraged by the fact that parliamentary elections looked to be heading largely in Macron’s favour.

It was a more challenging year in fixed interest markets, with global bond yields rising over the year. The strongest rise in global bond yields was in the US, and most of that came post the Trump election. Investors feared that Trump’s policies would ultimately prove inflationary. Amidst the political uncertainty, central bank activity remained prominent throughout the year. The US Federal Reserve increased its Target Range for the Fed Funds Rate to 0.75% - 1.0% in March 2017, only the third rise since the Global Financial Crisis.

Continuing their recent trend, commodity prices fell over the year. Despite the OPEC announcement of an extended cut in oil production, which typically leads to a rise in price, the price of oil fell over the period. Shares in emerging markets defied any expectation of matching falling commodity prices, consistently delivering solid returns and outperforming most developed markets over the period.

The New Zealand economy continued to be one of the strongest performing economies in the OECD. The government posted budget surpluses and the prices we receive for some of our exports are at record levels. The Reserve Bank of New Zealand lowered the Official Cash Rate (OCR) to a record low during the year (1.75%), in an attempt to stimulate inflation to within its target range (1%-3%). The New Zealand share market had a relatively modest year by its standards, after three successive years of double digit returns.

 

Significant developments during the year
 

  • Moody’s (credit rating agency) downgraded the credit rating of Australia’s 'Big Four' banks (ANZ Banking Group, Commonwealth Bank, National Australia Bank and Westpac) from Aa2 to Aa3 – three grades below the highest rating of Aaa – citing “elevated risks” in the household sector. This could lead to higher funding costs for their NZ subsidiaries (ANZ, ASB, BNZ and Westpac).
  • The November US Presidential Election resulted in an unexpected Trump victory. Confidence in the Trump administration was shaken following the President’s failure to gain support for his healthcare reforms, triggering concern about the White House’s ability to push through tax cuts and other campaign promises.
  • The US has withdrawn from the Paris Climate Accord, which seeks to reduce carbon emissions and slow the effects of climate change. The unconventional move has brought criticism from major European nations and threatens to further weaken political and economic alliances with the US. This could have implications for companies that derive revenues from global trade.
  • The RBNZ Governor, Graeme Wheeler, announced in early February that he will step down from his role at the end of his term in September. Deputy Governor, Grant Spencer, will take over as caretaker until a permanent successor is appointed in 2018 (post the general election).
  • The UK finally lodged its notification to the European Union to formally start the negotiation of terms to leave the Union. The market was largely unaffected by this well anticipated action; the MSCI UK Index moved up +1.2% in local currency terms in March.

     

The chart below shows the returns for various market indices for the periods to 30 June. An index is a 'basket' of securities, the changes in value of which are designed to represent the movements of a particular market or market sector.
 


Hedging is a tool used to reduce the effects of changes in exchange rates on investment returns. The scheme’s international investments are largely hedged. In effect, it means our investments are made in local currency. The foreign currency effect is the difference between hedged and unhedged returns from international investments.
 

Market outlook

Economic growth in developed markets continues to be supported by fading deflationary fears, easier financial conditions, stronger credit demand and more expansionary fiscal policy stances. The outlook for emerging market economies is improving, driven by strengthening export growth, structural reforms, falling inflation and declining interest rates.

However, this growth scenario presents a risk to the global markets. The US Federal Reserve may eventually be forced into a faster than expected pace of rate hikes as the unemployment rate is near cyclical lows and inflationary pressures are building. If the Fed does accelerate rate hikes, it could have a damaging impact on asset prices.

The expected pick-up in global growth should continue to support equities over the near-term. However, equity valuations are elevated (particularly in the US) and have arguably already priced-in a lot of the upside potential from the favourable economic conditions. On balance, we expect that global equities will continue to drift upward on stronger earnings, but they are susceptible to economic disappointments and a rate surprise from the US Fed. We see more upside potential from developed equities outside the US due to better valuations and a more favourable earnings outlook, but economic and political risks are also higher.

We also expect emerging market stocks to perform well over the intermediate-term due to more attractive valuations and earnings growth prospects. Any faltering in global growth or a geopolitical shock could lead to renewed underperformance, although recent structural reforms should provide a cushion against higher US interest rates.

We expect corporate bonds to outperform government bonds over the short-term due to favourable economic prospects, but there is limited scope for further outperformance given current pricing levels. Furthermore, rising debt ratios suggest elevated risks of downgrades and defaults.

Locally, the NZ economy is still looking solid. Migration remains a key driver of the NZ economy and economic growth is expected to be robust through 2017. The wild card in the mix is the upcoming general election on the 23rd September. The next move in the NZ official cash rate is likely to be a hike, however, this not expected in the next 12 months.

 

Sector commentary


GROWTH ASSETS

Trans-Tasman shares
New Zealand shares performed well over the scheme year, returning 11.7%. The NZ economy continues to look in good shape relative to other markets. Across the Tasman, Australian shares delivered strong returns for most of the period, returning 14.1%. A decline of the ASX200 in the final quarter can be largely attributed to significant falls by the major banks and weaker iron ore prices in May.

Global shares
Global shares had a positive year overall, returning 18.8% (in local currency) for the period. Initially, global equity markets recovered strongly after the Brexit related sell off at the end of June. Post the Brexit recovery, political uncertainty kept returns in check for a few months, until sentiment in the global share market improved following the Trump victory, as investors anticipated a range of expansionary fiscal policies. Towards the end of the scheme year returns waned slightly, as momentum slowed down after indices, such as the Dow Jones, reached all-time highs.

Property
Global listed property delivered inconsistent returns throughout the period, but managed to add value, increasing by 2.6%. As expected, the sector benefitted when bond yields declined, and struggled in times when yields rose. Property lagged infrastructure throughout the period, as the outlook for future returns from real estate securities doesn’t look quite as bright in comparison.

Listed infrastructure
The global listed infrastructure sector performed well throughout most of the period, returning 11.5%. Trump’s infrastructure spending plans were a major driver of performance, with news that the spending could top US1 trillion dollars. Robust corporate earnings numbers consistently drew investor interest over the period. As with global listed property, movements in yields largely affect the performance of the global listed infrastructure sector.

Commodities
The commodities sector continued to perform poorly, falling -5.2% over the scheme year. Oil prices continued to fall, despite controlled production from OPEC, with the price of crude oil finishing the year at a relatively low $46.02 per barrel. While other commodities delivered positive returns at times, the general trend was downwards.

INCOME ASSETS

New Zealand fixed interest and cash
New Zealand Government and Corporate bonds rose 0.2% and 3.0% respectively over the period. The sector struggled with rising yields, with the NZ 10 year government bond yield ending the scheme year at 2.97%, up from 2.34%. The Reserve Bank dropped the Official Cash Rate to an all-time low of 1.75% early in the scheme year, and has left the rate unchanged since. The RBNZ indicated in its June meeting that monetary policy will remain accommodative for a considerable period.

Global fixed interest
Global government bonds struggled, while global corporate bonds performed well, returning -0.7% and 4.1% respectively over the period. Rising global bond yields hurt performance of the sector, with the strongest rise coming from US yields, predominantly post the Trump election.

Investors feared that Trump’s policies would ultimately prove inflationary. US yields were also pushed up by the decision of the US Federal Reserve to increase its Target Range for the Fed Funds Rate to 0.75%-1.0% in March. The majority of other central banks left their rates unchanged, holding them at relatively extreme lows.

 
 

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