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«OVERVIEW FOR THE MONTH  The New Zealand S&P/NZX 50 returned +6.5% over July while the Australian S&P/ASX 200 returned +6.3% (+7.2% in NZ Dollar ...»

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HARBOUR INVESTMENT CHRONOMETER

AUSTRALASIAN EQUITY FUND REPORT – JULY 2016

5 August 2016 | andrew@harbourasset.co.nz | craig@harbourasset.co.nz| shane@harbourasset.co.nz

OVERVIEW FOR THE MONTH

 The New Zealand S&P/NZX 50 returned +6.5% over July while the Australian S&P/ASX 200 returned

+6.3% (+7.2% in NZ Dollar terms) - their fourth best monthly performance since the 2009 post GFC

bounce back period. The MSCI World developed markets index rose 4.1% (in local currency terms).

 With more evidence that economic growth remains sluggish, the US Federal Reserve and the Bank of Japan extended already easy monetary policy settings. Global government bond yields fell, hitting new record lows, as markets reassessed the likelihood and timing of future rate hikes from the Fed. This triggered investors globally to continue to move cash from low/negative yield fixed interest securities into stocks that have relatively high earnings certainty.

 The New Zealand market rallied as global 'bond refugees' continued to move up the risk curve, into New Zealand equities with relative earnings and yield certainty. ETF related buying, and Australian investor buying of the lower volatility NZ market, drove large capitalisation stocks higher. Fletcher Building performed strongly in anticipation of a solid result. Sky City outperformed on the latest rumour that Sky City could be a takeover target. Kathmandu was the best performer over the month after upgrading profit guidance. While the Reserve Bank of New Zealand (RBNZ) remained on hold, the market continues to expect further rate cuts (more likely post-Reserve Bank of Australia (RBA) cuts) after the implementation of policy changes aimed at reducing house price speculation.

 In Australia, the consumer discretionary, consumer staples, and materials sectors led the market higher.

Energy, telco and real estate stocks lagged. Mining stocks rose, aided by rising iron ore and gold prices.

The energy sector fell, weighed down by a falling oil price. AGL, Asaleo and Austal gave profit warnings, while Bluescope and Sirtex Medical positively upgraded. Woolworths announced a major restructure, which the market took positively. The RBA cut official interest rates by 0.25%, to a record low of 1.5% in early August. The accompanying statement from the RBA was relatively upbeat about Australian economic activity, and the decision was about 60% priced by markets prior to the announcement.

This contributed to a modest reaction by markets, with Aussie bonds falling slightly, and the Australian dollar and equity market flat. The cut provided some relief to Australian banks, with not all of the cut passed through in lower mortgage rates and some banks increasing deposit rates.

1

OUTLOOK – TWILIGHT ZONE

Markets have entered an uncharted twilight zone. We expect a period of consolidation in local equity markets, with some profit taking likely during the reporting season with New Zealand equities on stretched valuations. Australian investors in particular may take profits after a period of high relative returns from investing in NZ equities, as better value options emerge in the Australian market. Globally, economic growth may continue to disappoint, political economic policy risk may remain elevated and a lack of additional monetary policy support may take some 'heat' out of the capital market 'fire'.

Medium to longer term, local market return dynamics are supported by relatively strong economic activity in New Zealand, a basing in Australian economic activity, and low interest rates. Local equities will continue to benefit from global demand for better than bond yield income streams. But near term returns may be lower than they have been in recent months.

Turning points in capital markets?

The long (one of the longest by historic standards), begrudged grind up in asset markets continues as investors struggle with the implications of ultra-low interest rates. Slow economic growth, political and economic uncertainty, and continued stimulatory monetary policy mean low interest rates are likely to support long duration asset valuations (including equities) in the near term. But there may be some changes occurring that test what has become a consensus view.

While U.S. economic data continues to be on the low end of expectations (pushing out potential interest rate increases by the US Federal Reserve until the next calendar year), US economic data is not getting worse. Global lead indicators continue to suggest economic activity will continue to muddle through. While global economies are still considered to be underperforming, 12 of the 17 surveys that Harbour's research partner Strategas follows are growing, with all 17 surveys having an average of 51.6 readings consistent with low but positive global economic growth.

Central bank monetary policy effectiveness may be running into the “law of diminishing marginal returns”.

Both the Bank of Japan and RBA's easing announcements over the last month were met with muted responses from markets as investors considered that the policy stimulus was 'all in' and expected.

Much like the RBNZ, the RBA’s decision to cut is first and foremost about inflation and labour costs being stubbornly low, despite solid economic activity. Key to the RBA’s decision was its comment that "prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy at this meeting". In their statement the RBA noted that the effects of supervisory measures had strengthened lending standards in the housing market, with house prices rising only modestly and housing lending slowing a little this year, suggesting the that likelihood of lower interest rates exacerbating risks in the housing market has diminished. The RBNZ may cut official rates on a similar basis to the RBA. In our view, given many NZ interest rate sectors are already firmly priced, their reaction to a cut may be muted. Currency-sensitive NZ stocks may get a bigger boost if the NZD shows weakness post-RBNZ easing.





The global swing towards protectionism and deglobalization may contribute to slower world trade and increased inflation. US general elections in October mean that politics will continue to have an elevated impact on markets in the near term. A win by Mr Trump would result in an increase in US trade protectionism. A Trump win may also contribute to higher fiscal spending within the US domestic economy, providing an offset to protectionism. The UK’s steady approach to Brexit, not triggering article 50, has 2 reduced near term economic concerns (the Bank of England cutting rates also helps). But the EU separation process will be long and will throw up unintended consequences.

For global economic activity to increase monetary policy must remain easy, but Governments need to open their wallets and increase fiscal stimulus, including increased spending on education, health and infrastructure. After eight years of post GFC austerity it’s time for governments to use all the tools in their tool kit and not leave it up to the central bank 'boffins'.

Bond refugees buying low volatility ETFs As growth, inflation and interest rates stay lower for longer we expect a continued move by bond 'refugees' from low yield or negative yield investments to higher yield but higher risk investments. Low yield is forcing traditionally conservative investors to move up the risk curve into equities, to sustain overall income yields.

Such investors are focusing on low volatility, high earnings certainty stocks. While a reasonable portion of this move may have occurred, there may be more to come.

In many cases such investors will use passive and exchange traded funds to implement asset allocation changes. As ETF's increase as a percentage of market capitalisation this means that market moves can trend for longer than historically has been the case. As active growth focused managers this means that many stocks that don’t rank well using our growth investment process may become more extended in valuation terms as investors crowd in.

As an active manager this 'crowding in' is creating opportunities to invest in attractive growth companies that the market is underestimating - but we need to be patient in making these investments.

Pause before re-engaging - selection key In our view equity markets are not priced for risk. We believe equity markets may pause here as investors consider global monetary policy as having little left in the tank and as US politics creates mixed signals, before continuing to grind higher as investors move up the risk curve to enhance returns. Local equity markets remain fully priced, but will remain well supported as interest rates remain low.

New research by Robert Shiller and William Goetzmann, both of Yale University, and Dasol Kim of Case Western Reserve University helps explain why this is a begrudged, reluctant bull market. Basically investors are overly pessimistic and overly influenced by negative media (it sells more content apparently!) according to their research. In their paper, Crash beliefs from investors’ surveys, they find that investors on average overestimate the chance of an imminent share market collapse by a factor of six. The papers author’s note that the statistical probability of a meltdown on par with Black Monday of 1987 (or the similarly hued Tuesday of 1929) occurring is one in 60, based on historical data between 1929 and 1988. But over the 26 years of surveying, they find investors on average put the likelihood at one in 10. The researcher’s wordsearched financial media over the period and found asymmetric reporting of negative news, which may increase investor risk aversion. The researchers find that poor recent returns, and the negative news it generates, leads to investors upping their estimates of a crash happening in the coming six months. It's a mental quirk that behavioural economists call "availability bias": a tendency to give more weight to information that is top of mind.

There are plenty of "top of mind" worries filling financial news pages: Brexit, China's debt problem, secular stagnation, Donald Trump, and terrorism. If the researchers are right, bad news is over-reported and has an outsized effect on investors' expectations of a coming crash. Paradoxically, if you subscribe to the school of thought that bull markets only die amid a frenzy of over-exuberance, then it's only on the day we all believe everything is OK that this bull market is likely to expire.

3 We continue to focus on stock selection, sustainable growth and quality. The portfolio remains tilted to companies with secular businesses that can grow through the cycle due to structural change. We continue to favour healthcare and technology stocks which continue to offer superior earnings and dividend growth.

We also favour high quality companies with strong competitive positons, which either benefit from technology change or have a low negative impact from technology.

Our research suggests equity markets continue to undervalue the medium term growth path for key overweight portfolio holdings such as Mainfreight, F&P Healthcare, CSL, a2 Milk, and Summerset.

Andrew Bascand, Shane Solly, Craig Stent5 August 2016

IMPORTANT NOTICE AND DISCLAIMER

The Australasian Equities Commentary is provided for general information purposes only. The information is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of publication and are subject to change without notice. To the extent that any such information, analysis, opinions or views constitute advice, they do not take into account any person’s particular financial situation or goals and, accordingly, do not constitute personalised advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting or other nature to any persons. Investment in funds managed by Harbour Asset Management Limited can only be made using the Investment Statement, which should be read carefully before an investment decision is made. The price, value and income derived from investments may fluctuate in that values can go down as well as up and investors may get back less than originally invested. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can change. The value of any tax reliefs will depend on your circumstances. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. No person guarantees repayment of any capital or payment of any returns on capital invested in the funds. Actual performance will be affected by fund charges. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this presentation or its contents.

S&P Dow Jones Indices Disclaimer



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