The rate of global economic growth failed to accelerate in 2015, leaving the pace of expansion at just over 3%. While far from a calamity, the reality of a protracted period of weak growth, vulnerable to imbalances, is fast becoming accepted as the most likely outcome. The long anticipated rebasing of China’s growth potential was the key feature of the year.
In Australia, the growth dilemma is particularly acute after coming off years of solid expansion. With the export sector unlikely to contribute as much as expected, revival of domestic lead growth is required. The service sector and housing activity have picked up, however, a sustained outcome will require investment spending and a return to local production of goods.
Deflationary trends originated out of the much larger than expected tumble in commodity prices. Excess capacity in many industries, competitive pressure from cost cutting, disintermediation and product substitution all appear to be persistent. The consequence has been lower than expected wages growth, reducing household income and consumption.
Inflation in OECD Economies (CPI)
The chart, however, does imply that any reversion in energy and food prices should see headline inflation move back to the 2% range. In particular, any hint that wages are rising faster than expected is likely to see a strong reaction in rates markets.
Locally, headline inflation touched its 20 year lows at 1.3%. Even after allowing for ‘volatile items’ such as auto fuel, fresh food and excise impacted tobacco, price rises have been muted. Tradeable (i.e. goods) inflation has been zero to negative for some time due to lower imports prices. To date, the fall in the currency has had little impact.
It has, however, been non-tradables (mostly services) which has held down the CPI. The impact of low inflation has moved to wages, limiting income growth and, therefore, consumption spending.
While the direction of major currency movements was as anticipated, the impact was greater than expected. The sharp rise in the USD acted as a restraint on the economy but, more importantly, resulted in dislocation in emerging economies dependent on external funding.
The decline in the AUD/USD exchange rate appears to be supporting the services sector with inbound tourism improving. Recent reports suggest further adjustment to the currency, especially against the Euro and Yen, will be required to limit import flows and create substitution to domestically produced consumption.
In the coming year divergent interest rate setting is likely to be the key feature, determined by economic momentum. US household spending appears relatively solid and while the Eurozone is improving, the risk from political factors and the overhang of a yet to be restructured financial system may weigh on the year. Emerging economies can be split into two; the first group facing the pressure of weak commodities reducing their income, with the second group acting as beneficiaries of lower costs but, in turn, are affected by low global growth due to their export orientation. The key factor, however, is domestic consumption where the potential growth is still very high.
In summary, for 2016 the US economy presents as a moderate growth year, with rising consumer spending offset by lower investment due to the energy sector. Europe appears likely to sustain its slow and sporadic recovery with accommodating monetary policy and a weak currency as the supporting factors. Most emerging countries require structural reforms to set the ground for further growth. There is a large divide between those progressing towards these goals and those that continue to lag.
The levels of indebtedness in the Australian household sector act as a restraint to consumption growth. Nonetheless, it would not be surprising to see a pickup in domestic demand. The key, however, will be any emergence in private investment or government lead infrastructure.
Asset Class Performance
For most portfolios, the largest contributor to investment returns over the past year is likely to have been the currency reflected in unhedged global equities.
Underlying these, the Japanese market looks like ending the year as the best performer in its own right. Europe gave up strong early gains, while the US lagged in the first part of the year. The ASX200 could not avoid the commodity cycle and the drag from the large weight in the banks, underperforming other regions. Emerging markets correlated to commodities and growth suffered from negative sentiment through much of the year.
Excluding the high yield part of fixed income, other sectors provided positive, but below par, returns in a volatile year. Government bond securities, particularly the long end of the curve, outperformed credit which experienced widening spreads.
Based on our recommended allocations, investors should have experienced a total return of 4-5% in their portfolios in 2015.
Over a three year investment cycle, annual investment returns are above their historic average. Equities, on aggregate, have sustained double digit figures. In fixed income, global indexes have delivered about 5.5%p.a., while the domestic index is near 4% p.a. Hybrids and listed bonds are not part of any index and we estimate that the return should have been in the order of 6%. All these have exceeded cash returns.
Investment Returns in 2015 (Accumulation includes income where relevant)
The outcome from hedged versus unhedged investment should not be confused. At the core are hedged returns without currency influences, which reflect each market participant’s views on valuation and risk.
In recent years, the MSCI All Country Index has risen on the back of four sectors, albeit with diverse options within them. Information Technology, Healthcare, Consumer Staples and Consumer Discretionary stocks, accounting for 49% of the market capitalisation of the index, have a number of features that resonate with investors.
– The thematic behind the case for investment is sound. Few would doubt the massive impact of IT, the capacity of healthcare to extract long term profit from successful patents, the resilience of household brands and the power of aspirational brands.
– These sectors have shown to have high cash flows, robust balance sheets and, in turn, an ability to add to EPS growth through buybacks and acquisitions.
– Merger and acquisition activity has supported stock valuations. With the potential of lower average tax rates, there have been some easy wins in earnings upside engineered through M&A, especially in healthcare.
These aspects have pushed valuations in these sectors, and most fund managers are now broadening their stock selections into other sectors such as financials and industrials. Consumer staples and healthcare are at particularly high valuations, when compared to their historical valuations.
From a regional perspective, Japan was an early winner, alongside Europe with monetary easing the common feature. Over the last six months of the year, however, much of these gains have dissipated and the second half of 2015 is likely to show a small negative return in local currency terms with little regional distinction.
Emerging markets have had a tougher time. Valuations have fallen away due to the combination of the period of mid-year instability in Chinese financial markets and the impact of a higher USD. Based on consensus data, emerging markets are trading at their historic average P/E, yet with an above average forecast of 10% EPS growth.
Australian investors have had the additional benefit of the fall in the AUD in unhedged exposures, resulting in a higher than historic rate of return for the year at 16% (MSCI World Index). It is important to bear in mind the currency is not part of the fundamental returns from equity assets.
In our view, the precondition to renewed near term positive returns for equities currently lies in credit markets. Until it is shown that the current unstable conditions in high yield can be contained, it is unlikely equity markets will perform well.
Historically, the USD weakens in the early stages of a rate cycle, while further gains are still supported by the divergence in monetary policy in the medium term. If this pattern is sustained, it will provide a breathing space for global equity markets in early 2016.
The predominant view is that the US equity market will still lag the performance of other regions into 2016. There is no doubt that the US has an abundance of innovative and interesting companies but the valuation of these stocks is less compelling that before.
In particular, buybacks, M&A activity and asset revaluations have been major factors and many view this as low quality support for the market. High yield credit poses another problem for US equities. A significant amount of the recent issuance in this sector (addressed elsewhere in this report), has been in US energy stocks. The events here are likely to impact on credit availability and cost for companies with high gearing or in cyclical industries.
European stocks are vulnerable to the political overtone within the region. However, they do offer the potential of earnings growth from recovery and restructuring. Many companies, in particular those within the financial sector, have yet to clean up their balance sheets while others are benefiting from improved consumer spending off a low base.
After the initial promise of a reform agenda, Japan has reverted to its low paced growth. Valuations are still attractive and investment funds willing to do enough work have been rewarded. Nonetheless, the conviction has waned and we do not believe an allocation to this market is required beyond the stocks held in global fund managers.
Emerging markets, specifically a handful of countries with improving economic trends, possibly present the most upside potential into 2016. The ETF industry, by nature of index participation, will trade regardless of individual merit when sellers believe the index is at risk. This has meant that companies with good prospects have been tainted with the overall problematic outlook for emerging economies. We continue to believe that investors with longer term time horizons should look to incrementally add to emerging market equities.
As always, the unpredictable will result in outsize returns. The energy sector tends to suffer large drawdowns followed by significant upside. The calendar year may not be the turning point, yet it may be closer than anticipated given the degree of distress in the industry. The chart shows the rolling annual performance of the energy index.
Energy Index (MSCI All Country Total Return): Rolling Year
Equity assets have performed well over the past three years while earnings growth is increasingly subdued. This does imply a note of caution and we recommend the weighting towards equities is contained to an investor’s strategic allocation. Returns may be sporadic and prone to sentiment based rallies and sell-offs. However, we do believe the fundamental outlook does not warrant a more cautionary stance at this time.
One could be forgiven for looking at the performance results across the fixed income universe in the last 12 months and thinking that it has been an uneventful year for this asset class. The indices of the different sub-sectors (cash, term deposits, Australian government bonds, Australian corporate bonds, global government bonds and global corporate credit) paint a picture of a benign return environment with consistent results across the strategies (with high yield being the exception).
In fact, despite the return profiles looking very similar across strategies, they each had a different path to get there. For long duration government bonds, the second quarter of this year was the worst performing in 25 years. This was initially sparked by unsustainably low yields in the global markets brought on by unprecedented low interest rate levels in Europe and the US and extensive quantitative easing by the ECB. A change in sentiment towards these negative yields in Europe filtered across all bond markets pushing prices down. Following this, the short lived Greek crisis, Chinese equity markets and the subsequent delay in the Fed raising rates all played in favour of the rates market as a flight to quality ensured. The global bond market put the 2nd quarter behind it and returned to positive performance for the next 4 months.
Splitting the fixed income markets into two very broad categories of duration vs credit, there were bets wagered on each side with the credit market winning in the first half of this year as credit spreads tightened or remained stable. However, those in the credit camp could only gloat for so long before the tide changed and spreads widened pushing corporate bond prices lower. The chart below illustrates the trend of credit spreads throughout this year.
Investment Grade Credit Spreads in 2015
Addressing the riskier part of fixed income, high yield (HY) and the emerging market (EM) sectors have both had their challenges;
– HY bonds have suffered through contagion of spread widening in the energy sector (~15% of HY is in energy companies), expectations of an increase in default rates (particularly in CCC rated bond) and liquidity concerns.
– The EM market (technically sovereign debt but trades more akin to credit) has underperformed due to a combination of a strengthening USD, falling commodity prices and weakening conditions in China. The result has been a vicious cycle of EM growth weakness and currency falls, bond spread widening and capital outflows.
Staying with these two broad categories of duration and credit, how does the market behaviour of 2015 impact on fixed income assets in 2016?
For duration products (rate sensitive) it’s all about the US Federal Reserve bank and its normalisation policy. While the RBA is widely expected to stay on hold in 2016, cementing divergence in central bank policies, we expect there to be a united front in the direction of bond yields. From a mark to market perspective, rising yields cause capital losses for fixed rate bonds. As the market is already pricing in rate rises it is more about the pace at which they will raise rates and whether this is correctly pricing this in.
For investors, therefore returns will come from fund manager’s successes in picking the best part of the yield curve to invest in. There is little doubt that the short end of the curve (particularly in the US) will see higher yields once the Fed start its rate hikes, but we expect that large sustained moves in the 10-30 year part of the curve is unlikely. This sector will be better supported by ongoing quantitative easing (QE) from the Bank of Japan and ECB, a still-large Fed balance sheet, modest moves in inflation expectations, and low global yields that will weigh on US yields as investors hunt for yield. These factors are likely to cause the long end to flatten next year.
The bigger story in 2016 is likely to come from the credit markets. Liquidity concerns in bonds market have been prevalent all year, but is really only now coming home to roost. The US high yield market has come under pressure in the last week, with a couple of US based mutual funds freezing their funds following some large redemptions. Illiquidity in the underlying assets (mostly risky unrated paper and distressed debt) have inhibited their ability to meet their outflows, resulting in a lock up of client money while they delay selling and do a more orderly disposal of assets. While this method certainly makes sense as it should help realise better results for those remaining in the fund, it does call into question the liquidity management of some credit funds and no doubt will have contagion affect into the broader credit markets including investment grade. Spread widening and wider bid/offer spreads are likely to continue into 2016, with the riskier end being most heavily affected. More pain may be yet to come.
However, the good news is mark to market price fluctuations are only temporary and upon maturity the price will reflect fundamentals. Have fundamentals changed? There is no doubt that the energy sector is under pressure and viability of these companies are in question. In the rest of the corporate bond market, ex-energy coverage ratios are still strong, default rates low, and as many companies have locked in the low yields for longer maturities they will not need to refinance their debt for years to come.
For investors, if there is no default in the bond it will get paid back at par (i.e. 100¢ on the dollar). With this in mind, we continue to recommend an investment timeframe that rides through these underperforming cycles. We prudently remain cautious but recognise that good buying opportunities will present themselves in 2016 and returns could be boosted significantly for those who seize the opportunity.
The year has been disappointing for domestic equity returns, with the Australian sharemarket underperforming most developed international markets. Year to date, the ASX 200 Accumulation Index is down approximately 5%, although the returns may feel worse given that the market had rallied in the early part of the calendar year.
The chart below highlights the key drivers of the market’s returns for the year. Unsurprisingly, it has been the resources sectors (energy and materials) which have been largely responsible for the underperformance of the ASX, with weak commodity prices across the board affecting these companies.
ASX 200 Year to Date Sector Returns
The chart below illustrates the change in 12 month forward earnings estimates by analysts across the key sectors throughout 2015. While earnings for financials and industrials have held up relatively well, it has been soft commodity prices that have seen ongoing revisions to the earnings of resources companies, with forward earnings now more than 40% lower compared with the start of the year.
Change in Forward Earnings of Key ASX Sectors
After generating solid returns for a number of years, large cap stocks failed to continue on with this momentum in 2015. There have been varying reasons for earnings pressure or weakness, however, large cap companies that have underperformed this year have included the banks (increased regulatory capital requirements), Woolworths (following downgrades to its earnings guidance), Telstra, the big insurers (IAG and Suncorp) and all resource-related companies.
Another feature of the Australian market which has held back returns has been the significant value of capital raised, thus diluting the returns for shareholders. The four major banks have raised a total of $17bn through the year to go alongside large raisings from Origin and Santos. Each of these deals were larger than the Transurban secondary offer last year, the largest such deal of 2014. This increased equity supply represents the highest growth since the 2009 and is in contrast to other equity markets around the world, where share buybacks reduced equity supply (although noting that the Australian market preference is for capital to be returned through dividends).
The ‘yield trade’ has been a key driver for Australian equity returns over the last few years and again proved so in 2015. With yields on fixed interest assets trending lower over this time, investors have looked to maximise their income via investing in equities. Traditional high yield sectors have outperformed the market to the point that dividend yields across the various sectors have the market have converged. Infrastructure and utilities have performed best among these stocks this year, while REITs have also outperformed despite a relatively benign operating environment.
The question is, can this continue into 2016? This theme is showing signs of maturity, particularly given valuations that look stretched. However, given that there remains downward pressure on the cash rate and a general lack of overall earnings growth across the market, it is quite possible that these stocks may hold their ground into 2016. Within this theme, given the compression in yields, we have preferred companies that have the ability to grow their dividends, whether it be generated from top line growth, cost cutting, the roll off of large scale capital expenditure or a low payout ratio starting base.
Another theme that has worked well for investors has been investing in companies with significant offshore operations, thus benefiting from the depreciating Australian dollar. The outperformance of these companies has not been universal, however. In several cases, the underlying earnings of a company have been disappointing and offset the favourable currency settings. This highlights that the currency, in itself, is not a reason to invest in a stock.
Looking ahead to 2016, we use our market predictor tool to give an indication of the current valuation of the market.
Financials now compose nearly half of the total weight of the market and at this stage are forecast to achieve mid-single digit earnings growth. Over the next year, the banks will be cycling the additional capital raised as highlighted above. Profit growth has begun to slow over the last year, with slow credit growth and no further assistance from improving bad and doubtful debts. Dividend payout ratios are high, although these will likely be maintained in the absence of a turn in the bad debts cycle and/or a correction in the housing market. The yield support for the sector should remain, particularly from the retail investor, with these stocks trading on a gross yield of approximately 9%.
Industrials should again produce a range of results, with pockets of strength (such as health care and consumer discretionary) offset by some weaker earnings growth forecast for other subsectors, such as the two major supermarket chains and Telstra. A wider range of opportunities across industrials leads to the conclusion that individual stock picking will be an important factor in achieving a good outcome as opposed to passive market participation. On a forward P/E of 18X, it is unlikely that the whole segment will rerate further, and so stock selection will be key.
Resources remain the high risk/reward option across the market. Forward earnings growth across mining and energy stocks is edging back towards zero, with a ‘reversion to mean’ forecast in many commodity prices. Based on current spot pricing levels, the sector would still screen as relatively expensive. However, the leverage in the sector is such that, were a turning point to occur in commodity markets (most likely by a significant supply-side response), the uplift in the equity market could be quite material. In our scenario, we have used a flat earnings result; an outcome which would imply a reasonable improvement from current levels.
The scenario below suggests limited upside from the current market levels on the assumption the earnings outlook improves through the year. The forward P/E of the market has moved down marginally over the course of 2014, with resources downgrades the primary driver of weaker earnings, and is now close to its longer term average.
ASX 200: Scenario Analysis