2018 investment commentary

Investment review for the year ended 30 June 2018

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 theme of geopolitical risk was prominent throughout the 2018 scheme year, with the Trump administration continuously seen in the middle of the action. Early in the year, the threat of a potential nuclear war hit headlines, with heated exchanges between Donald Trump and Kim Jong-un igniting fears that the conflict would be escalated. A truce called between North and South Korea appeared to alleviate the tension, but before investors could catch their breath, the US had announced major tariffs against China. This saw volatility spike in February, and the ever-rising global equity market finally lost ground. However, markets recovered strongly, and as a result, the MSCI World Index (hedged) returned 12.0% for the scheme year.

Many central banks kept their benchmark interest rates unchanged throughout the scheme year, although a few banks made major policy movements. The US Federal Reserve raised its target rate range to 1.75–2.0% through multiple hikes during the scheme year. The US Federal Reserve’s most recent review talked of a strengthening US labour market and rising economic activity, suggesting a likely rate hike in its September review. The Bank of England raised its official bank rate from 0.25% to 0.5% in November – the first increase in the interest rate for more than 10 years. Record low unemployment, rising inflation and stronger global economic growth were given as reasons to support the bank’s decision. After a prolonged easing cycle, South Korea’s central bank raised interest rates for the first time in six years, up to 1.50% from 1.25%.

The environment of rising interest rates made it a challenging year in fixed interest markets. In line with the US Federal Reserve rate hikes, the strongest rise in 10 year bond yields was in the US, reaching 2.86% at year end, up from 2.30% the previous year. The uncertain global backdrop meant that investors shied away from more risky corporate bonds in favour of government bonds. This led corporate bonds to underperform relative to sovereign bonds.

Commodities posted a positive return for the scheme year, up 7.7%. Rallying oil prices were a key factor, with the price of crude oil reaching almost $74 per barrel at year end, up from $46 per barrel the year before. The rally was backed by a political move from the US late in the scheme year to limit Iran’s ability to export oil, effectively limiting the world oil supply.

The New Zealand economy continued its strong run, with the NZX 50 outperforming all other developed share markets we track. The Reserve Bank of New Zealand (RBNZ) maintained its official target rate of 1.75% throughout the scheme year, indicating that there is the possibility of a rate movement in either direction in future reviews. In their June review, the RBNZ stated that economic growth within New Zealand remains robust, close to sustainable levels, but the consumer price index remains below target, requiring supportive monetary policy (i.e. low interest rates) to stay in place for some time. The New Zealand dollar depreciated against all major currencies over the scheme year, including moving down 7.5% against the US dollar.

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.

2018 Market returnsHedging 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.

Market outlook

Despite a moderate slowdown, which has been mostly confined to Europe, the global economy remains upbeat and supported by key economic data. At present, escalating trade tensions between the US, China and the rest of the world appear to be the largest threat to sustained growth.

Although there has been some concurrent market volatility, it is too early to evaluate the real impact of these potential policies, as economic data covering the recent period is yet to come in and final policy outcomes are yet to be known by the market. The US economy remains strong and appears to be outpacing most other developed markets, despite the sustained raising of short-term interest rates by the US Federal Reserve. Although emerging markets have suffered recent falls, this was largely due to weakening trade sentiment and the strengthening US dollar. We remain confident that emerging markets will see continued economic growth.

While economic growth generally benefits equity markets, this can be offset by high valuations in some cases. Rising trade tensions, combined with generally high valuations across developed equity markets, may cause investors to view share prices as overly optimistic. We maintain our slight positive view towards equities in general, although we view emerging markets as demonstrating better value than developed markets.

We remain in an environment of increasing inflation and rising interest rates, especially in the US. We view global government bonds as having somewhat stretched valuations in this environment, although we expect market uncertainty will prop up demand. Credit spreads could be expected to widen further as investors seek better compensation for the relative uncertainty of the ability of corporate borrowers to service their debt compared to government borrowers.

Sector commentary

GROWTH ASSETS

Trans-Tasman shares

New Zealand shares performed well over the scheme year, returning 18.9% and outpacing all other developed markets we track. A2 Milk was the top performing share in the New Zealand share market, up 186% over the scheme year and contributing strongly to the overall index return. Across the Tasman, Australian shares also outpaced most other developed markets, returning 13.0% for the year.

Global shares

Global shares had a positive year overall, returning 12.0% (hedged) for the period. The global equity bull market began the year strongly, storming ahead until hitting a wall in early 2018, where political uncertainty combined with fears of rising inflation and interest rates sparked a sudden sell-off. Investors regained some confidence in the final quarter of the scheme year, recovering lost ground and rounding off a strong performance for the scheme year.

Property

Despite weak performance throughout most of the scheme year, global listed property stocks rallied in the final quarter, finishing the scheme year up 6.7%. The sector benefited from the move to defensive equities in reaction to market uncertainty later in the year.

Listed infrastructure

The global listed infrastructure sector struggled to gain momentum throughout the scheme year, returning 4.3%. As with property, listed infrastructure benefited from the general move to defensive assets later in the year.

Commodities

The commodities sector delivered a positive return for the scheme year, rising 7.7%. Commodities largely benefited from the crude oil price rally throughout the period, reaching almost $74 per barrel at year end, up from $46 per barrel the year before. The gold price finished the scheme year practically where it began. However, we would expect this to recover if there are signs of more volatility and inflation.

INCOME ASSETS

New Zealand cash

The RBNZ held the official cash rate at an all-time low of 1.75% throughout the scheme year. In its May and June reviews, the RBNZ indicated the possibility of an increase or decrease in the official rate in future reviews. These record low interest rates have meant low cash returns.

Global fixed interest

Global government bonds delivered a low but positive return, up 2.7% for the scheme year. The increased prospect trade war later in the scheme year saw investors lose confidence that some companies would be able to repay their debts, hurting the performance of global corporate bonds, which were only up 1.1% for the scheme year. Rising global bond yields limited gains in the sector, with the US 10-year yield reaching 2.86% at year end, up from 2.30% the previous year.