In general, equity markets have been strong over the past 12 months. This is reflected in the performance of the MSCI World Net Total Return Index in AUD Dollars, which has risen by 20.3%. The current investment environment is extraordinary. Many world equities indices ended June at or near all-time record highs, the 10-year bond yields of Spanish, Irish and Italian government debt closed below 2.85%, credit default swaps on major banks are now below 2007 levels and the European Central Bank has recently reduced the interest rate on deposits by banks to minus 0.1%.
We continue to see capital flows that are distorting markets and causing asset prices and currencies to diverge from underlying economic trends. The enormous US$600 billion per annum quantitative easing (QE) being undertaken by the Bank of Japan, as part of Prime Minister Abeâ€™s economic plan, is encouraging Japanese banks, insurers and pension funds to sell Japanese government bonds and invest in other assets, including foreign sovereign bonds. This may, in part, explain the rally in US and European government bonds over the past six months (as well as the strong Australian dollar), when economic data would have suggested that the opposite might have been expected. We also note recent reports that Chinaâ€™s State Administration of Foreign Exchange, which manages Chinaâ€™s vast foreign exchange reserves, has become the worldâ€™s largest public sector equity investor; elsewhere, numerous other central banks have also increased their exposure to equity markets.
It is a little surreal that equity market volatility and other risk measures appear benign as we edge closer to a cycle of increasing long-term interest rates, with the US Federal Reserve and the Bank of England ending their QE programmes and China appearing to be entering a period of lower growth. While we are not predicting a major downturn in equity markets (in the absence of a major global event), they have become more challenging and value has become harder to find as share prices have continued to rise. While nothing is certain in investing, we predict that the next three years will be challenging for equities as they battle the headwind of rising long-term interest rates.
At Magellan, we feel strongly that people cannot retire on â€œrelative investment returnsâ€; only by generating investment returns that exceed the rate of inflation (ideally by a satisfactory margin) will investors increase their wealth over time.
To help achieve this, we continue to be exposed to the following major investment tailwinds: