Monthly Financial Markets Update – May 2016

In most of the major economies the outlook remains fragile, as a result of political uncertainty and disappointing earnings results. However recovery in equity prices has continued into April, primarily to the bounce in commodity prices and supportive central banks.

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Welcome to our May monthly market update.

Positioning

Recovery in equity prices has continued into April, primarily to the bounce in commodity prices and supportive central banks. However in most of the major economies the outlook remains fragile with risks skewed to the downside.

In Australia the equity index is heavily tied to the fortunes of the banks, major miners and supermarkets, which are all struggling to generate growth. The long election campaign is also likely to create some political uncertainty over the coming months.

Political uncertainty in the United States and Europe along with the British vote to leave the EU on 23 June 2016, loom as major risks for international markets.  Recent earnings reporting seasons, both in Australia and the US, have been mostly disappointing.

In an environment where markets may struggle to move outside their recent trading ranges, we recommend investors take a cautious approach with portfolio positioning, favouring defensive sectors along with small and mid-sized companies which offer long term growth.

Summary of policy developments

RBA cuts interest rates on low inflation reading

At its May meeting, the Reserve Bank of Australia cut interest rates from 2.00% to a new record low of 1.75% to try to combat low inflation which had slipped below the RBA’s 2-3% target range to 1.6% in the first quarter of 2016.  The RBA also revised its 2016 inflation forecast from 2-3% to 1-2% suggesting further rate cuts may be needed.

What’s changed in April?

Equity and commodity markets continued to recover off their mid-February lows, helped by reasonable economic data and improved sentiment:

  • • Developed share markets returned 0.9% in April with solid gains in Italy and Spain. Australian shares returned 3.4% for the month.
  • • Emerging market shares fell 0.1% with gains in Brazil, which rose 7.7%, offset by a decline in China which was down 2.2%.
  • • 10-year government bond yields rose marginally in the major bond markets, up 2 to 11 basis points.
  • • US corporate bond index credit spreads narrowed further from 170 to 152 basis points and high yield bond index spreads narrowed from 705 to 624 basis points over US Treasury bond yields.
  • • The US Dollar weakened against most currencies with the Euro, Pound and Yen up against the US Dollar.  The Australian Dollar lost ground on weak inflation figures.
  • • Commodity prices were 10% higher with oil prices up by US$7.60 per barrel to US$45.98 per barrel, while gold rose by about US$49 per troy ounce.

Macro monitor

April saw a further rebound in commodity prices with both iron ore and crude oil up around 20% over the month. The rise in commodity prices was helped by stronger investor sentiment, speculative buying and a slightly weaker US Dollar.

In the United States, the initial estimate of GDP growth in the first quarter of 2016 was a little disappointing with annualised growth of just 0.5%, down from 1.4% in the prior quarter. Business investment and net exports continue to hold back growth, while personal consumption and residential investment were positive contributors to growth. At its April meeting, the US Fed kept interest rates unchanged, as expected, but the changes to the wording in the accompanying statement suggest that although the Fed is less worried about global economic and financial market risks, there is no evidence that they are contemplating another interest rate rise in the months ahead.

In Europe, recent economic data has been reasonably positive. First quarter GDP growth came in at 1.6% year-on-year, which was higher than expected, with the Spanish economy continuing to grow strongly. Unemployment in the Eurozone was also better than expected in March, falling to 10.2%, compared with 11.2% at the same time last year. However inflation in Europe remains very soft, with the annual core rate of inflation at 0.7%, well below the European Central Bank’s 2% target.

In China, GDP growth in the March quarter rose to 6.7% higher than the previous year. Stronger-than-expected rebounds were seen in industrial production, retail sales and fixed asset investment. Government stimulus measures, and the strong rise in house prices, appear to be supporting economic growth.

In Australia, March quarter CPI was much weaker than expected. The headline CPI recorded a 0.2% decline in prices over the quarter while underlying inflation rose just 1.6% over the past year, lower than expected, and the lowest ever recorded. As a result of softer than expected inflation and the more subdued increase in property prices, the RBA elected to reduce interest rates at its May board meeting from 2.00% to 1.75%.