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Economic Update - October 2016

Introduction

After a weak first half of 2016, global gross domestic product (GDP) growth should recover modestly in the second half of the year, as the large drag from inventories abates. However, the world continues to face headwinds, including the impact of Brexit, continued weakness in US investment ahead of their election, a moderation in Chinese growth and the impact of the stronger yen on Japan.

Around the world

In late September, the US left its official interest rates unchanged. Federal Reserve Chair Janet Yellen said the case for an increase in short-term interest rates had strengthened recently amid firm jobs growth, signalling a move is becoming more likely in the coming months and, potentially, soon after the US election. The Federal Reserve chair highlighted solid consumer spending and a string of payroll gains as she predicted moderate growth in the US economy as well as a return of inflation in the next few years.

In China, macro statistics for industrial production, fixed asset investment and retail sales growth all weakened. This data seemed to suggest that the overall growth momentum of the first half of the year is wobbling a little lower in China. The yuan has continued to weaken slowly, as capital outflows persist.

The Eurozone's slow economic recovery appears to have weathered the initial shock of Britain's vote to leave the EU with the July Purchasing Managers Index (PMI) surveys of business activity reaching their highest level in seven months. The European Central Bank has hinted at taking further action next month should economic conditions in the Eurozone fail to improve, with its top policymakers saying the impact of the latest wave of uncertainty to hit the global economy needed "very close monitoring". Europe's recovery has remained on track, but aftershocks from the UK vote to leave the EU and the poor health of the region's banks risked its derailment.

The Bank of England cut its benchmark interest rate to 0.25% in July, the lowest level in the Bank's 322 years, and introduced a series of bond-buying measures to support the economy after Brexit. The rate had been at 0.5% since March 2009.

In Australia, second quarter GDP growth rose +0.5%, and therefore +3.3% on an annualised basis: the latter represents the fastest growth rate in 4 years. Growth is being driven by strong domestic demand and increased government spending. This also represents the 100th consecutive quarter without a recession for the country.

New Zealand Bonds

As expected, in mid-August, the Reserve Bank of New Zealand (RBNZ) cut the official cash rate by 25 basis points to 2%. This was the 6th cut in the last 14 months. New Zealand bond yields were mixed over August despite this interest rate cut. The RBNZ clearly under-delivered with some market participants expecting a 50 basis points (bps) cut or a more aggressive interest rate track. The 90 Day Bank Bill yield ended August 5 bps lower, while the 10-year NZ Government bond yield ended up 3 bps, both finishing at 2.24%.

New Zealand Shares

The New Zealand share market has been one of the best performers, returning nearly 30% more than global share markets over the past two years. There are two main things that seem to have driven this:

1) New Zealand's economy continues to be strong compared to other economies across the world;

2) the companies on the New Zealand share market pay a higher dividend than other share markets. The second reason has arguably been the more important driver of the strong returns.

Globally, government stimulus is continuing to drive interest rates across the world lower and lower. With interest rates at these low levels, investors worldwide are no longer able to rely on traditional income-generating investments (such as term deposits) to generate the income they were once able to get. To illustrate, term deposits rates in the US are currently about 1%, while in Europe they are even lower at closer to 0%. This compares to the annual dividend return investors can get from the NZ share market of about 7%. Investors have been shifting money into the NZ share market to get this additional return, although taking on the additional risk that comes with share investments. Although relative share values have been pushed up, it is difficult to see this trend changing whilst low interest rates remain. The below graph illustrates the relative performance of the NZ vs the Global Share market.

Global Shares

Global equities delivered positive returns again, with developed markets gaining 0.4% while emerging markets rallied 2.8%. The month of August marked the sixth month this year that emerging markets have outperformed developed markets, and are now outstripping their developed market counterparts by 7% year to date. The Bank of England helped push markets higher at the start of the month by cutting rates aimed at stabilising the economy following the Brexit fallout. The UK's FTSE 100 returned 1.7% over the month. US shares were flat over the month as the expectation for a Fed rate hike ramped up. Japanese shares (as measured by the Nikkei 225) finished 2.0% higher, while the MSCI China Index rallied 8%. The latter was helped by further steps towards market liberalisation as the Chinese government approved a linkage between the Shenzhen and Hong Kong stock exchanges. This will allow foreign investors greater access to the domestic Chinese market. Authorities are also planning on removing the limits on how much foreigners can invest in the country's stocks.

Global Bonds

Global bonds were mixed, with movements in yields dominated by the region's central bank. As anticipated, the Bank of England cut rates in August, however it was the total package that surprised the market. The central bank's stimulus package included adding to its quantitative easing programme and introducing a corporate bond buying programme. Its forward guidance also flagged the possibility of additional easing if required. This saw the yields on the UK 10-year gilt fall to record lows. Yields in the US moved higher following Janet Yellen's 2016 Jackson Hole meeting of central bankers, which reinforced the message that the Fed is gaining more confidence about resuming rate hikes. Yields on the US 10- year Treasury closed the month at 1.58%, up 13 basis points over the month.

Property & Infrastructure

The New Zealand listed property index returned 1.3% over August to outperform the broader domestic equity market.

Both global listed property and global listed infrastructure ended the month lower, with the former declining 2.4% while the latter declined 2.2%. The lower beta, yield sensitive asset classes underperformed the broader market with rising bond yields (in the US) making the asset class less attractive.

Summary

Overall, we find that markets are still pricing in a world of low growth, low interest rates and low inflation without any visible road blocks to "more of the same" in markets. The end of quantitative easing is not apparent yet. Even after the strong rise in equity values over the last 8 years, we are cautious but not bearish on equities as there is no sign of recession and financial authorities appear prepared to ensure that the financial markets are well supported. Politics are becoming increasingly important to investment outlook. Sentiment seems to be moving away from policies that assist assets owned by the wealthy - real estate and shares - towards a greater focus on support for the average person in the electorate. At this stage, ensuring your investments are in line with your Risk Profile and well diversified remains appropriate.