Optimistic start for investment markets

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Investment Market Update, quarter ended 31 January, 2020

Inflation remains subdued, central banks remain committed to low interest rates, and trade tensions between the US and China have de-escalated (for now) with the signing of a Phase 1 trade agreement in mid-January.

The progress in trade negotiations between the world’s two largest economies appeared to have helped stimulate improved economic activity highlighted by improved commodity prices and better manufacturing data.

Consumers remain an economic strength in most developed markets. Jobs are plentiful, and real wages and salaries are rising. Low interest rates have reduced debt servicing costs, and strong asset prices, including for housing, have made consumers feel wealthier. Consumers will continue to spend (outside of coronavirus fears), and housing construction is buoyant.

But then came along coronavirus

Markets don’t like uncertainty, and coronavirus was an unanticipated risk.

Health-scares impact economic activity through factors such as people spending and travelling less. If it becomes significant enough – such as the coronavirus – quarantine measures are put into effect and places of work are closed.

China has quarantined an estimated 60 million people and extended the annual Lunar New Year holiday beyond the traditional one-to-two week celebration period. Because coronavirus is centred in China where so much of the world’s manufacturing is based, work closures can disrupt global supply chains meaning companies around the world are not able to obtain products and services essential to their businesses.

No one knows how far and wide the coronavirus may spread, and therefore what the impact on global markets may be. Other recent series viral epidemics include SARS (2003), MERS (2012), Zika (2015-2016), and Ebola (2018).

The most comparable to the Wuhan coronavirus is SARS, which infected thousands across the Asia Pacific region. At the start of that epidemic, the regional global equity index (MSCI Pacific ex Japan) dropped -13 percent. In the US, equities dropped as much as minus five percent. Markets did not fully recover until the virus was contained. China is now a far larger contributor to the global economy than it was in 2003, so the threat the virus represents is more significant today. However, if the coronavirus follows the pattern of previous epidemics, then the economic impact will be relatively short-lived.

Investors still need returns

The dominant influence on markets since the beginning of 2019 has been the world’s central banks’ commitment to low interest rates. Last year the markets climbed a wall of worry to deliver exceptional returns despite headline-grabbing risks such as trade wars, Brexit, Hong Kong protests, and US-Iran tensions.

In a world of ultra-low interest rates, we suspect equities will likely continue to be supported by the “TINA” effect. For many investors “there is no alternative” (TINA) to equities to generate an acceptable investment return. Meaning, as we have seen in early February, any pullback in equity prices will likely be met with good buyer demand.

Mergers and acquisitions remain a feature of the market

An additional consequence of low interest rates has been a sharp resurgence in corporate merger and acquisition (M&A) activity. 2019 saw a number of companies acquired and delisted from the NZX, including TradeMe, Methven, Orion Healthcare, and SLI Systems. Late last year the boards of both Abano Healthcare and Metlifecare recommended takeover offers, which are pending shareholder approval. And this year Augusta Capital has followed suit.

Conditions remain ripe for M&A activity to continue. High stock prices provide companies with a strong takeover “currency”, interest rates and funding costs are low, and private equity funds around the world have record levels of cash they are looking to deploy.

Diversification is the best risk management tool

Equity markets finished 2019 very strongly and that momentum carried on into 2020. The recent volatility due to coronavirus concerns should be taken in that context. Interest rates remain historically low and central banks are expected to provide further support to markets if needed this year. The outlook for global corporate earnings remains positive although we expect companies will now be more conservative around their outlooks.

The future is inherently uncertain, and markets can always face unexpected shocks. Diversification remains the key risk management tool. We recommend clients maintain a balanced approach with diversified exposure to both equities (across a range of geographies and industries) and high-quality fixed income. This helps cushion short-term volatility while also offering the potential to capture long-term capital growth.

This column is general in nature and is not personalised investment advice. This column has been prepared in good faith based on information obtained from sources believed to be reliable and accurate. Disclosure Statements for Forsyth Barr Authorised Financial Advisers are available on request and free of charge.

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Investment Advisor with Forsyth Barr Limited in Tauranga. Phone: (07) 577 5725 or email brett.bell-booth@forsythbarr.co.nz