Investment markets delivered another solid year in 2016. If we only looked at the year end returns of the various asset classes, we might reasonably conclude it was a relatively benign investment environment. However, having navigated all the twists and turns throughout the year, we know nothing could be further from the truth!

The major news headlines lurched from gloom (China worries in January) to doom (Brexit vote in June, Trump election win in November) but, through it all, investment markets showed real resilience. In fact, if there was ever a year when it paid to ‘stick to your plan’ and not be swayed by unexpected events,
then 2016 was surely it.

The major news headlines lurched from gloom to doom but, through it all, investment markets showed real resilience.

By the end of the year, major share markets had generally delivered high single digit returns, while property and
fixed interest delivered lower returns. In the case of fixed interest, these were naturally closely aligned with the low interest rate environment globally. Although overall these returns were not far away from our long term return expectations, it wasn’t all plain sailing along the way.

In fact, two of the biggest and most surprising stories of 2016 were the British vote to leave the European Union and Donald Trump’s victory over Hillary Clinton in the US presidential elections. In both cases markets instantly experienced sizable shock waves as investors struggled to come to grips with these previously unforeseen events, while attempting to divine their implications for the future.

Thankfully the initial shock waves subsided relatively quickly, although, in each case, some assets or asset classes were left rather more bruised than others.

The Brexit vote dented future prospects for the UK and the value of the Great British pound (GBP), in particular, took a beating. Global share markets were also hit hard initially, although recovered strongly over subsequent weeks. Unfortunately there was no such recovery in store for the GBP and, over the following six months, the pound weakened by almost 20% against the US dollar.

The US elections saw a similar antiestablishment victory, with Donald Trump defying the pundits to be voted the 45th president of the United States. While his pledge to build a wall along the Mexican border and to take a tougher stance on China enhanced Trump’s notoriety in the media, it was his promises to reduce taxes, and to provide fiscal stimulus to create jobs and boost growth, that suggested greater US indebtedness and higher US interest rates lay ahead.

It remains to be seen when (or if) many of these election promises can be implemented or how successful they willultimately be, but regardless, the market rapidly reassessed a much greater likelihood of rising US interest rates. While Trump’s growth focused policies helped support the share market, the realignment of interest rate expectations provided a sharp negative correction in the bond markets in the final quarter of the year as longer term US yields jumped.

However, with Brexit still facing a challenge in the UK courts and Trump only just inaugurated, it remains a matter of much conjecture about what lies ahead for these key developed markets and the global economy in general. Of course, it would be wrong to imply the resolution of these two issues alone will dictate the direction of markets in 2017. The next 12 months will no doubt also deliver events that we can’t even imagine today, and these will also have an impact – positive or negative – on market and investment returns in the future.

As for 2016, the table below summarises the key asset class returns in a little more detail by highlighting the performance of a major market index in each asset class. All returns are gross and from a New Zealand investor’s perspective (in New Zealand dollars):

Asset classIndexJan - MarApr - JunJul - SepOct - Dez12 months
New Zealand sharesS&P/NZX 50 Index (gross with imputation)0.0720.0230.073-0.0640.101
Australian sharesS&P/NZX 200 Index (total return)0.012-0.0210.0580.040.09
International shares (hedged NZD)MSCI World ex Australia Index (hedged to NZD)-0.0180.0180.0520.0530.108
International shares (inhedged)MSCI World ex Australia Index-0.015-0.0220.0270.0680.057
Emerging market shares MSCI Emerging Markets Index (gross)0.046-0.0240.070.0050.099
New Zealand propertyS&P/NZX All Real Estate Index (gross with imputation)0.0540.0270.023-0.0620.038
International propertyS&P Developed REIT Gross Total Return0.0590.016-0.02-0.0020.052
New Zealand fixed interestS&P/NZX A-Grade Corporate Bond Index0.0270.0150.016-0.0170.041
International fixed interestCitigroup World Government Bond Index 1-5 Years (hedged to NZD)0.0170.0120.005-0.0010.034
CashNZ 30 Day Bank Bills0.0060.0060.0050.0050.023

Note: The full 12 month return is not a simple sum of the four quarterly returns. The 12 month figures are compound returns which assume continuous investment throughout the year in each asset class.

This summary contains several noteworthy elements. Firstly, in spite of the uncertainties encountered throughout the year, growth asset classes generally performed the best. International shares (hedged to NZD) was the best performing asset class, closely followed by Australasian shares and emerging market shares. At the other end of the spectrum New Zealand property, which was one of the darlings in 2015, only returned a little more than fixed interest in 2016.

The October to December quarter also highlighted a considerable divergence between the performance of New Zealand growth assets and the performance of growth assets in other regions. For example, the New Zealand share market declined -6.4% over the quarter, while the Australian share market gained 4.0% and international shares (hedged to NZD) gained 5.3%.

Although we experienced a new round of earthquakes centred near Kaikoura during the quarter, and also witnessed the surprise resignation of John Key as New Zealand Prime Minister, it is unlikely that either of these events had any material market impact.

It appears the prospect of higher US interest rates (which had been signalled earlier in 2016 by the Federal Reserve and was reinforced by Trump’s victory) may be a larger part of the reason for this disparity.

For several years the New Zealand share market and listed property companies had been popular destinations for offshore investors chasing yield in a global interest rate environment largely devoid of appealing options. However, with the recent spike up in US interest rates, a renewed expectation of additional rate rises to come, and a strengthening US dollar, there seems to have been at least a partial repatriation of these funds out of New Zealand assets and back into the hands of offshore investors.

If there is some good news in all of this it is that local share market valuations, which had been getting stretched after an extended period of strong returns, are now more aligned with fundamentals.

In the mean time the New Zealand investment story in general is still quite positive, with rising dairy prices, a migration-driven construction boom and record visitor numbers providing a significant benefit to the many New Zealand firms with ties to the tourism industry.

The bond markets were the other sector of concern to investors in the last quarter, with the unexpected US election result seemingly fast-forwarding at least some of the rise in US yields that had been anticipated to occur in 2017 and beyond. The unexpected jump in yields that occurred in the quarter has two impacts for bond investors:

Immediate – negative

When interest rates rise, the price of existing bonds fall (as bond prices move inversely to changes in bond yields).

Longer term – positive

As bond yields rise, the expected future return on the bonds goes up.So, while the price fall is immediate and can be sharp (especially for holders of very long duration bonds), the higher future expected returns provides compensation for long term holders of these securities. There will be considerable speculation about where yields go from here but the reality, as always, is that nobody knows for sure. Certainly bond yields may go higher. Quantitative easing programmes in the US and Europe should eventually be wound back, and this could allow monetary policy settings to move towards neutral and away from the current very accommodative settings.

So, while the price fall is immediate and can be sharp (especially for holders of very long duration bonds), the higher future expected returns provides compensation for long term holders of these securities.There will be considerable speculation about where yields go from here but the reality, as always, is that nobody knows for sure. Certainly bond yields may go higher. Quantitative easing programmes in the US and Europe should eventually be wound back, and this could allow monetary policy settings to move towards neutral and away from the current very accommodative settings.

There will be considerable speculation about where yields go from here but the reality, as always, is that nobody knows for sure. Certainly bond yields may go higher. Quantitative easing programmes in the US and Europe should eventually be wound back, and this could allow monetary policy settings to move towards neutral and away from the current very accommodative settings.

However, the factors that took bond yields to such low levels last year can’t be easily ignored either. Despite risks that inflation may rise, strong structural influences still remain, in particular, technological innovation (generally disinflationary) and global demographics (ensuring an ever increasing demand for yield assets). In addition, political uncertainty – both in Europe and in the new Trump administration – continues to provide considerable scope for unsettling surprises, and surprises more often tend to be positive for bond markets.As the table of asset class returns in 2016 reminds us, different assets respond differently to the same market conditions and no single asset class can be expected to win all the time. This fact alone makes a compelling case for diversification; for ensuring you don’t have all your eggs in a single basket. But not only do different asset classes perform better (or worse) at different times, they do so in an entirely unpredictable fashion. This is what elevates diversification from a good idea to a great idea.

As the table of asset class returns in 2016 reminds us, different assets respond differently to the same market conditions and no single asset class can be expected to win all the time. This fact alone makes a compelling case for diversification; for ensuring you don’t have all your eggs in a single basket. But not only do different asset classes perform better (or worse) at different times, they do so in an entirely unpredictable fashion. This is what elevates diversification from a good idea to a great idea.

Risk seeking investors may like the idea of having all their eggs in one basket to try and achieve extremely high returns, but the dangers of getting it wrong can be severe. Post Brexit, the wrong basket was GBP denominated assets, and in the fourth quarter of 2016 it was New Zealand shares and property assets. Investors who had a concentrated exposure to these assets at the wrong time only ended up with a basket full of broken eggshells.Long term investors need to accept that risk is unavoidable and sometimes it will hurt returns. But by employing prudent strategies that include sound strategic asset allocation, and focusing on diversification across high quality and

Long term investors need to accept that risk is unavoidable and sometimes it will hurt returns. But by employing prudent strategies that include sound strategic asset allocation, and focusing on diversification across high quality and low cost assets, they put themselves in the best possible position to keep their nest eggs intact.

And as 2016 also showed us, this approach can still generate useful returns even when the investment environment is at its most challenging.

Bungee jump, Donald Trump and bird nest

 

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