June 28, 2016

Monthly Financial Markets & Asset Allocation Update: June 2016

Brexit is a significant shift in the geopolitical landscape, with associated uncertainty. Investors will need compensation for this with lower share prices. We believe a 15% global equity sell-off over the next 6-8 weeks is a reasonable base case.

Welcome to our June monthly market update.


The Brexit result caught us, financial markets, pollsters and odds-makers by surprise, however we see the outcome as irreversible. The 1.3 million votes to “Leave” is comprehensive enough to ensure politicians (who overwhelmingly supported “Remain”) are compelled to implement Brexit.

Brexit will be a messy Break-up. The UK will want to maximise strong trade access to Europe while regaining control of regulation and the movement of people. Core Europe will want to make Brexit a painful process for the simple reason that it might serve as a deterrent to others. If the EU allows Exit to be a quick, clean, potentially prosperous route, then the European Union will be over.

The outcome of the referendum substantially changes the macroeconomic backdrop for the UK and Europe. We expect a significant reduction in UK growth and the Pound, along with weaker Eurozone growth. This should elicit easing from the Bank of England, and keep the European Central Bank on its toes for some time. We see the timing of the next US rate hike being pushed out.

Brexit is a significant shift in the geopolitical landscape, with an associated step-shift in uncertainty. Investors will need compensation for this with lower share prices. We believe a 15% global equity sell-off over the next 6-8 weeks is a reasonable possibility. That said, Brexit is not, in our view, the start of another Global Financial Crisis.

In Australia, our preference is for sectors such as utilities and consumer discretionary stocks – and we remain underweight in financial stocks. We also favour quality mid-sized companies that offer attractive growth, although in some cases the valuation on these companies is relatively expensive. We are also investing in selected companies with offshore earnings and companies exposed to the housing sector.

Internationally, we continue to favour sectors where Australian investors have little opportunity to invest locally, including healthcare, IT and consumer brands.

Although we remain underweight in domestic and global fixed income, we prefer shorter duration floating rate corporate bonds. We are also beginning to see value in international credit which has underperformed this year but should provide attractive returns if our assumption is correct that default rates will remain relatively low over the next few years (outside the materials and energy sector).

Summary of policy developments

Japan delays tax hike – Japan’s Prime Minister, Shinzo Abe, recently announced that he would delay increasing the sales tax from 8% to 10% from April 2017 to October 2019. It is the second time in two years that the tax rise has been delayed. This coupled with government debt at 200% of GDP means the delay in bringing the budget back to surplus could risk the country’s credit rating.

What’s changed in May?

Developed market equities rose further in May helped by marginally better economic data, stronger commodity prices and supportive monetary policies:

  • Developed share markets gained 1.9% with Japan and France the strongest markets. Australian shares gained 3.1% led by healthcare and IT stocks. Emerging market shares fell further in May with a 0.8% decline, led by Brazil which was 10.1% lower.
  • 10-year government bond yields were around 10-20 basis points lower in Germany, UK and Australia.
  • US corporate bond credit spreads widened two basis points to 154 points above US Treasury bond yields and high yield bond spreads narrowed 27 points to 597 basis points over Treasury bond yields.
  • On currency markets, the British Pound, Euro and Yen all weakened against a stronger US Dollar, with the Australian Dollar losing nearly four US cents to 72.5 US cents
  • Commodity prices were 2% higher with oil prices up by around US$3 per barrel while gold lost about US$74 per troy ounce.

Macro monitor

In the United States, the unemployment rate fell from 5.0% in April to 4.7% in May, and wages rose more than expected to be up 2.5% over the past year. Recent ISM surveys of activity in the manufacturing and non-manufacturing sectors have also picked up, and new home sales rose nearly 24% over the past year, to the highest level in eight years. However, despite the stronger economic conditions, the US Fed has talked down the prospects for interest rate rises in coming months, citing the weaker-than-expected jobs figures that were reported in early June

In Europe, economic data has been patchy. Core inflation ticked up a little – from 0.7% year-on-year in April, to 0.8% in May, and the unemployment rate remained steady. German first quarter GDP growth was better than expected, helped by the mild winter, which brought forward construction activity. Eurozone manufacturing activity fell slightly, with stronger readings in Germany and France offset by weakness in Spain and Italy. Meanwhile Germany’s IFO business climate survey rose one point to 107.7, its highest level so far this year.

In China, data in the past month has been underwhelming. Manufacturing surveys showed flat to slightly weaker activity levels. Likewise, growth in industrial production, retail sales and fixed asset investment eased slightly, but the figures were still relatively strong, and the slower annual growth rates in April may be linked to the timing of the Chinese New Year in 2015. The Chinese housing market continues to drive overall growth, with new home sales rising 56% over the past year, and strong price rises for new homes in the major cities.

In Australia, March quarter Gross Domestic Product growth was stronger than expected. The Australian economy grew 1.% over the quarter and 3.1% over the past year, which was the highest annual growth rate in three-and-a-half years. However, the stronger growth was primarily driven by a surge in net exports, which is not expected to be sustained over the medium term. Other indicators of economic activity have continued to hold up reasonably well, such as building approvals and house prices which have resumed their upward trend.

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