The global economy performed well
As the year progressed, the global economy improved. A welcome feature ‒ and one absent for years ‒ was that all the major economies were growing at the same time.
Across the eurozone, economic conditions improved markedly as the year unfolded. In Japan, signs of more consistent and sustainable growth emerged after the numerous false starts of recent years. Economic growth in the US and China remained strong throughout 2017. As a result, the year concluded with considerable optimism about the outlook for 2018.
In emerging economies, stronger global growth and trade also helped lift many countries from their depressed levels of 2016. Foreign capital gradually returned due to better growth, significantly lower exchange rates and attractive yields on bonds compared with developed world peers. Positive sentiment about the outlook for emerging economies helped the MSCI Emerging Markets Index deliver a substantial return of 27.5% (unhedged) for the year.
Global shares provided strong returns
The global economy’s strength and consequent recovery in corporate earnings was very positive for share market returns, with global shares returning 21.4% on a hedged basis. The 15.4% unhedged return was lower (though still substantial) because the Australian dollar strengthened against the US dollar and Japanese yen but weakened slightly against the euro and sterling.
After modest returns in 2016, European share markets performed well in 2017 due to the eurozone’s economic upturn, employment growth and improved consumer and business confidence. The failure of anti-eurozone parties to achieve political success in elections in The Netherlands and France also helped reassure markets. Although Germany’s post-election political stalemate remained unresolved at year’s end, its share market was up 12.5% during 2017. In France and Italy, share markets gained 12.7% and 13.6% respectively.
In the UK, despite continuing uncertainty about Britain’s withdrawal from the European Union (‘Brexit’) and its impact on the economy, the FTSE 100 Index provided a return of 11.9%. The mechanics of the withdrawal process were complicated by the ruling Conservative Party losing its majority in the mid-year general election. With the complex negotiations due for resolution in March 2019, this political saga still has a long way to go.
In the US, the S&P 500 Index gained 21.1% in local currency terms and achieved record high levels towards the end of 2017. Optimism about President Trump’s significant corporate and personal tax cut reforms, which passed into law late in the year, was a significant driver of the market’s performance. US economic data was also very supportive, with solid jobs growth, lower unemployment and encouraging business survey results.
In Asia, Japan’s Nikkei index rose 21.3% in response to the economy’s marked improvement. Despite continued robust growth in China, the impact of fiscal and monetary policies designed to cool the economy meant the Shanghai Stock Exchange Composite Index provided a return of just 6.6% for the year.
Global listed property performed well, with a hedged return of 9.2%, as property market conditions in many countries were favourable. The sector continues to provide strong earnings growth and an attractive distribution yield. Financing costs have remained low, new supply has been limited since the global financial crisis and improving global growth has supported demand for space and property valuations.
Bonds generally delivered modest returns
Global and Australian government bonds delivered modest returns as yields increased, partly due to action by a number of central banks to raise rates (as in the US, UK and China) or take steps (like the ECB) to curtail monetary stimulus measures. However, there was some positive news for bond investors in that hedged global high yield bonds had a comparatively good year with a return of 4.5%, outperforming nominal bonds. Rising corporate profits and the promise of lower US corporate taxes saw credit spreads sharply narrow and corporate bond values rise.
Some central banks began to shift to a tightening phase
After years of substantial monetary stimulus, including large-scale asset purchase programs, a number of central banks decided in 2017 to change course to a tightening stance. However, these central banks are doing so very cautiously and gradually to avoid undermining markets and ensure they preserve the economic recovery that has been successfully engineered.
In the US strong economic growth, solid jobs creation and the lowest unemployment rate since early 2001 have had a benign impact on inflation so far. However, this didn’t stop the US Federal Reserve (the Fed) from raising interest rates by 0.25% three times during 2017, taking its benchmark cash rate range to 1.25%-1.5%. The Fed also plans to begin a gradual reduction of its swollen balance sheet by selling down its holdings of US government bonds and mortgage securities. Having upgraded its economic growth forecast for the US economy in 2018 to 2.5% (from 2.1%), the Fed has also signalled that it expects to raise rates three more times in 2018.
In Europe, the broad-based improvement in economic conditions enabled the European Central Bank (ECB) to cut its monthly bond purchases by half to 30 billion euros for a period of nine months, commencing in January 2018. However, the ECB has also permitted itself the discretion to change course and increase its money printing if economic conditions deteriorate.
Late in the year the Bank of England reversed its 2016 post-Brexit rate cut of 0.25% as it attempted to bring inflation (which reached 3.1% towards year-end) back to its preferred 2% target.
Another good year for the Chinese economy
China’s economy continued to perform well, with industrial production growth stable at an annual rate of 6% and retail sales growth of around 10%. Most important economic indicators were positive, with few surprises.
However, the extraordinary expansion of China’s economy compared with its global peers has been achieved with an excessive rate of credit growth. At 13% on an annual basis, China’s credit growth is nearly double the economy’s growth rate. As a result, China’s central bank implemented a number of measures during the year to curb credit growth. These included pushing interest rates higher, increasing the interest rate at which banks lend to each other by 1.6% to 4.7% over the year and restraining the asset management industry’s use of leverage.
An important political development in 2017 was the confirmation of President Xi Jinping’s second five-year term by the Chinese Communist Party Congress in November. At the Congress, a number of important policy priorities for the next five years were flagged, including strengthening financial regulation through the creation of a new super-regulator, the Financial Stability and Development Committee. There will also be greater emphasis on improving welfare, education, controlling pollution and improving quality of life in China’s cities. The Congress renewed its previous commitment to double the value of gross domestic product (GDP) and per-capita income in 2010 by 2020. To achieve these targets, China’s economy will need to grow at over 6% per year for the next three years.
Political risks moderated, but didn’t go away
After 2016’s unexpected Brexit referendum result and election of Donald Trump as US President, market focus moved to Europe, where a string of national elections were scheduled in 2017. However, concerns that electoral success by extreme anti-European Union and anti-immigration parties could threaten the cohesion of the European Union proved misplaced.
In The Netherlands, the incumbent VVD party won the most seats, soundly defeating the anti-immigration Party for Freedom. In the French Presidential election, moderate and pro-Europe candidate Emmanuel Macron decisively defeated National Front President Marine Le Pen, who had campaigned strongly for France to reassert its sovereignty by exiting the eurozone. A month later, Macron’s newly formed En Marche! Party won the majority of seats in the National Assembly election.
In Germany, Angela Merkel secured a fourth term as Chancellor, though the loss of seats by her Christian Democratic Union/Christian Social Union coalition has required extensive negotiations with minority parties to try to form a government. The year concluded with no resolution in sight.
Across the English Channel, Britain finally triggered the Brexit negotiation process. This process was further complicated by the surprise outcome of Britain’s general election in June 2017, which saw the Conservative Party lose its parliamentary majority and compelled Prime Minister Theresa May to seek the support of the Democrat Unionist Party in order to maintain power.
In Asia, tensions escalated as a result of North Korea’s nuclear missile testing program and claims it now has the capability to strike US cities. However, markets were largely unfazed by these threats and the potential for US military action.
Ups and downs for the Australian economy
Australia recorded mixed economic data over 2017, though the economy picked up speed as the year progressed. Real GDP grew by 2.8% over the year to 30 September, which was significantly better than the sluggish 1.9% growth for the year to the end of June. Business investment improved, with annual growth of 7.9% (to 30 September) as the downturn in mining investment neared an end and non-mining investment showed signs of life. Surveys of business confidence and business conditions also showed positive results.
Substantial public sector infrastructure spending provided added stimulus. However, one concern was that the housing construction boom is rapidly fading. Higher mortgage interest rates for housing investors and concerns of a potential oversupply of inner city apartments in Sydney, Melbourne and Brisbane caused residential construction to fall over the year.
The jobs market was very strong, with the creation of more than 380,000 jobs, mostly full time ones, in the year to 30 November. However, wages growth was subdued due to considerable spare capacity in the labour market. The unemployment rate remained at an elevated 5.4% and 8.3% of the Australian workforce was underemployed (working fewer hours than they would like).
Low wages growth, high debt levels and sharply higher utilities costs meant 2017 was a difficult year for many Australian households. This undermined consumer sentiment and slowed retail spending to just 2.2% annualised growth. The fall in the savings rate to 3.2% suggested that many consumers were being forced to fund their consumption by saving less.
With subdued wages growth and only mild inflationary pressures, the Reserve Bank of Australia (RBA) has left the cash rate at 1.5% for the last sixteen months.
In the housing market, action by regulatory authorities and the banks to tighten lending standards had an impact on prices by year’s end. Sydney and Melbourne prices came down marginally from their previous highs and in mining-related markets such as Perth and Darwin there were more substantial declines.
Australia’s share market was a solid performer
The S&P/ASX200 Total Return Index (which includes dividends) returned 11.8% in 2017. While it lagged the performance of global market peers like the US and Japan, its 2017 return was its best calendar year performance since 2013 and the sixth consecutive positive year for investors. Favoured sectors were Materials, with the resources-laden S&P/ASX 200 Materials Index rising 22.9% over the year, Healthcare (up 26.4%) and Energy, which increased 23.3% in response to higher oil prices.
Despite generally favourable office and industrial property market fundamentals, the return for the listed property sector was just 6.4%. Retail property trusts underperformed due to the challenging conditions in the discretionary retail sector and concerns that the entry into the Australian market by online global giant Amazon would harm shopping centre owners. A notable global transaction during the year which impacts the Australian listed property sector was the proposed acquisition of Westfield Corporation and its global portfolio of shopping centres by European retail giant Unibail-Rodamco.
The Financials sector returned just 5% due to headwinds for the major banks, including a new levy announced in the May Federal Budget, competitive pressures, low earnings growth and the Royal Commission into bank conduct.
In a risky environment, a defensive portfolio stance remains justified
The strong market returns in 2017 indicated widespread complacency among investors, despite potential risks being well known. This under appreciation of risk was also reflected in measures of market volatility such as the VIX Index, which remained at unusually low levels.
Significant risks and uncertainties remain. After such a long period of good returns, valuations in both share and bond markets are stretched. Very low interest rates and large asset purchases by central banks have been significant contributors to strong market returns. That stimulus is now being wound back and it’s highly uncertain how this policy reversal will affect financial markets and the real economy.
MLC has believed for some time that where possible, it’s appropriate to defensively position our MLC Horizon, Inflation Plus and Index Plus portfolios. At the start of 2018, given the potential risks that are being overlooked by the market, risk management remains uppermost in our mind.
Our defensive positioning has been achieved in a number of ways. We have maintained a low exposure to Australian shares. Our portfolios are holding more cash than usual, as are those of our investment managers who have the discretion to hold cash to manage risk. We’ve maintained allocations to alternative strategies which we believe will help preserve investors’ capital in volatile markets. After extensive research, we have implemented new currency and derivatives strategies to expand the number of investments generating returns and to carefully manage risks in our multi-asset portfolios. And we remain highly selective about the type of fixed income we invest in, limiting exposure to securities that will fall in value if interest rates rise quickly.
While these positions may not prevent negative returns in weak share market conditions, our caution should provide some insulation.