In this quarterly report we will present the ‘central case’, that is, the assessment of economic fundamentals which underpin our recommended asset allocation. In the current climate, however, the degree of confidence in this case is not as high as we would like. We highlight these ‘fat tails’ (the terminology referring to the shape of a probability distribution curve where there is a relatively high distribution outside the mean).
The discussion can be summarised as reconciling the momentum in economic growth, policy issues in three major economic regions – US, Europe and China, the removal of the monetary anchor to where rates reflect investor judgement and the valuation levels in asset classes.
Asset Allocation Recommendations
Our recommended asset allocation and expected annualised 2-3 year returns are shown set out in the following table. This quarter, we have made the following changes:
· Reduced the return from Australian equities as we believe that there is medium term downside risk in the key sectors of resources and financials.
· Reduced the tactical allocation to equities in all portfolios and raised the cash weight. We recommend investors rebalance their portfolios and selectively reduce holdings. While this is portfolio specific, we believe weights to local banks (through both equity and hybrid) should be managed. We have reduced our conviction in a couple of global strategies and would recommend realising a proportion.
· Listed hybrids are separately designated. There is no index for these assets and we use 30% equity/70% Australian fixed income as a proxy for volatility and correlation. Purchases of these securities are very dependent on pricing and any investment should only be made if the total return is within our range.
Asset Allocation and Expected Returns
Expected index return (excluding alpha and franking)
Expected return (including alpha and franking)
Economic Outlook – The Central Case
The improvement in global economic growth has gained credence over the past quarter supported by a wide range of data. This synchronised upturn was seeded in mid-2016 from the improvement in household wealth and employment conditions in the US, business investment in Europe (partly driven by the weak currency) and stimulus in China.
While the pace may prove uneven, there is reason to believe growth will be sustained. Expectations are that US spending will lift through a combination of higher investment, improving labour markets and the prospect of tax changes. Europe has confounded the sceptics with a growth rate that looks likely to match that of the US. The political landscape is as problematic as ever, yet households and businesses appear to be focused on their own sphere and fiscal policy is expansionary. China is retracing some of its easing to curtail credit growth. Nonetheless, with the National Party Congress later this year there are widespread expectations the government is intent on a stable outcome.
On aggregate, developed economies are expected to grow at 2% this year and emerging regions at 5%, resulting in a rise of just over 3% in global GDP.
US rates are expected to be increased by a further two to three times this year taking the base rate to 1.5%-1.75%. Recent commentary is that the Fed balance sheet will be brought into play later this year as a supplement to the funds rate. Currently, the Federal Reserve Bank holds US$4.5tr in assets of which US$1.8tr are in mortgage backed securities (MBS). To put this in perspective, all commercial banks in the US collectively hold US$1.7tr in assets. The table below shows the holdings of the Fed and weekly movements, indicating the degree of influence the bank can achieve through its transactions.
Fed Balance Sheet
With European growth ahead of expectations, the ECB may also decide to restrain its quantitative support. Currently the bank re-establishes its facilities every 6 months. The base case, however, is that it will be slow and likely hold the official rate at 0% into 2018. The ECB holds Euro 4tr in assets, with a heavy weight in corporate bonds.
The combined actions in official rates and balance sheet management from the US and European central banks will determine the path of interest rates in the coming few years. The degree of uncertainty of how this will unfold and the reaction of investment markets should not be underestimated.
Inflation has taken a notable step up, combining commodity prices with a slow, but steady, rise in the cost of services. Wage increases have yet to show up in a measurable impact on prices and without this influence the rate of inflation looks likely to remain lower than in the past.
A hurdle to rising inflation from higher demand is household debt and in some countries, housing costs limiting discretionary spending. The case for rising inflation has weakened without the multiplier effect of oil prices into other goods and services. Inflation is therefore expected to remain largely range bound, yet high enough for rates to rise.
The predominant (but uneasy) view is that China will swing within easing and tightening to avoid excess credit fuelled growth, while still showing that there is some credibility in its 6.5% targeted GDP increase for 2017. The use of the repo rate (repurchase rate) is the defacto official policy tool to price credit and this has been rising this year as the People’s Bank of China (PBoC) treads a fine line between curtailing property debt without raising the cost of funding for local authorities. In the meantime, export growth has stet time, raising GDP in Q1. A lower growth trend is probable into the remainder of the year as these two effects fade.
The Australian economy is benefitting from higher commodity prices and nominal GDP growth is expected to be as high as 6% this year as export values exceed the soft trend in imports. On the other hand, the domestic economy’s tailwind from housing activity is easing, while business investment has yet to kick in. Of concern, is sluggish household spending with rising costs of non-discretionary items (housing, utilities, education, health) crimping the capacity to spend elsewhere. The likelihood is that the RBA will remain set at 1.5% into 2018 and that inflation will track the lower end of the 2-3% range.
It should not surprise that there are many risks to the above scenario. The emphasis is on the downside skew, given investment markets are priced to reflect much of the upside potential.
Most prominently, after years of monetary support, it is unclear what the consequences will be of tightening financial conditions. Then there is the question of practical outcomes from the US administration that can translate into economic activity. Tax cuts should be positive for corporate earnings (though likely to be offset by eliminating some deductions), but need to be funded. Further, they may do little more than make business owners wealthier without necessarily resulting in business expansion.
The handicap to expanding growth in the US is the weakness in household cash flow and as noted, without higher wage inflation, the contribution from consumption spending is limited. There are signs that household income could be more supportive to spending into the coming year. In the 16-24 age demographic, the Atlanta Fed shows that wage growth is now around 7% and that wage inflation in industries such as hospitality has been above average. Once low paid workers gain higher wage rates, it is likely to trickle upwards. Further, this demographics has a high capacity to spend.
US Wage Growth by Age
Another positive trigger may come from housing, with a shift to single family homes from apartments. This aligns with better employment conditions, demographic trends and a low level of supply in the free-standing category. While long term mortgage rates will inevitably move, the Fed has some control through its ownership of mortgage securities.
There are, however, some signs that credit supply is tightening. Commercial and industrial loan growth has shown a sharp deterioration since late last year. The reasons behind this slump are not obvious. Some suggest it is just a hiatus, as businesses absorb rate rises and the uncertainty surrounds the new administration. It may be sector specific to energy and certain parts of the real estate sector (apartments and retail malls), both of which have fundamental reasons to slow. Even so, if it persists, economic growth will inevitably disappoint.
US Commercial and Industrial Lending
Yet there is still the potential for policy in the US to lift growth a notch as business surveys show they are focused on the upside.
Destabilising Europe’s progress, aside from political events, is the legacy of weak financial systems. Debt levels in Italy and Greece are clearly unsupportable, but there appears to be a stubborn effort to protect the Eurozone in the face of political discontent. However, the larger economies are generally in a reasonable position. Potential for changes to the German tax rate will support this trend even further. Spain is showing widespread growth with a much more competitive labour rate. France may build on its modest improvement if an incumbent government addresses some of the endemic structures that have held that economy back. Then there are early signs that the Italian banking system is exiting its large bad debt legacy.
The risks in Europe therefore are mostly centred on political aspects. Global trade recovery in the past year is critical to Europe and ironically, if the political landscape proves benign and economic growth is maintained, the Euro might strengthen, dampening momentum.
China remains an opaque country to judge with variant views on its prospects. Some argue that the high level of private sector debt is less problematic given a large chunk resides with state owned enterprises. Partial nationalisation of this debt would therefore make the data look less bad. But to execute an outcome of stable high GDP growth and contain debt has become contradictory. Blunt implementation of financial management has not helped the cause. Efforts to stem capital outflow has required intervention, the sharp devaluation in the currency last year has left a legacy of uncertainty on a repeat of such a step and selective targeting of property are examples of the struggle between letting the markets determine conditions versus a central determination.
The pressure on the housing sector in Australia has been in the headlines in the past quarter. Given the movement in debt levels, reports of questionable lending standards and interest only loans, the sensitivity of the household sector to interest rate movements and employment conditions is substantially higher than before. A perfect storm of falling commodity prices, rising funding costs for banks and weakening employment could spiral into a self-reinforcing downturn. History suggests that the housing sector will be resilient due to the recourse nature of lending in Australia. The pain will therefore be felt in lower discretionary spending.
There is little doubt investment assets have been supported by the anchoring of interest rates. The combination of the low yield and the certainty in that level has impacted on all valuations. Even with the change in pace from the US Fed, the story quickly adapted to the assumption of higher earnings growth. That has yet to emerge.
The summary conclusion now is that the implementation of the investment strategy must demonstrate different characteristics than before.
The Australian equity market has carried through with the momentum built in the second half of 2016 and has erased most of the losses experienced through 2015. The key drivers of the market’s returns in FY17 have come from a more supportive commodity price environment (a lift in bulk commodity prices of iron ore and coal have been important), a pause in the regulatory headwind to the banking sector, sentiment following the US election and some improvement in broader industrials earnings.
More so than other developed equity markets, the Australian sharemarket however, has many stocks and sectors that have been negatively impacted by a rebasing of interest rates. REITs, utilities, infrastructure and telcos have, in varying degrees, been influenced by the changing interest rate environment over the last 12 months. As the rate outlook has become more certain, stock prices in these sectors have mostly stabilised and are now responding to company specific issues.
The rotation from ‘growth’ into ‘value’ has had a more limited effect on the Australian equity market. The largest companies in the index are generally well established and relatively mature in nature; the dividend imputation system encourages companies to return capital rather than reinvesting in their business; and there is a cyclical benefit from our large resources sector that is associated with a rally in value. The preponderance of equity managers to focus on higher growth/quality companies in their investment process has led to a challenging period for relative performance over the last year.
There are several reasons to take a positive view on the outlook for the Australian equity market. The rally over the last 12 months has been underpinned by a change in earnings growth. Indeed, the typical pattern of downward revisions to financial year earnings estimates has not materialised this year (refer to following chart). Instead earnings growth is now expected to be higher than it was at the beginning of the financial year. This has been reflected in a positive trend in the earnings revision ratio (i.e. the ratio of upgrades to downgrades) for the market. Outside of the obvious turnarounds in the banks and resources, there has also been an improved outlook in several other large sectors, including the insurers and supermarket retailers. Finally, while the risk is on interest rates rising from here, the gap between the yield on Australian equities and bonds remains wide.
ASX 200: Evolution of Financial Year EPS Forecasts
Other factors lead to the conclusion that caution is warranted. The better earnings environment has been narrow in its range; that is, it has been driven by a small number of large stocks and sectors. The recovery in commodity prices may prove to be short-lived and few see much further price appreciation without a corresponding increase in demand. While the banks are now relatively well capitalised, regulatory risk remains a recurring issue, whether it involves higher capital requirements or macro prudential restrictions on lending growth.
Lastly, the market is not cheap by typical valuation measures. The market’s dividend yield is reasonable, but the payout ratio is high. The high P/E multiple of the market may look justified based on earnings growth for FY17, but this is likely to be transitory in nature, as it is being driven more by cyclical elements. A broader level of earnings growth will thus be required in the medium term, particularly in the face of what is likely to be a more challenging valuation period for equities as interest rates normalise around the world.
The key tail risks for the Australian equity market revolve around the health of the domestic economy and a sharp correction in commodity prices. The consensus view for the Australian economy is that growth is likely to be in the mid-2% range (consistent with the recent trend) and will continue in the medium term. However, there are sufficient warning flags to be more circumspect.
The risks primarily relate to several factors including:
· The level of aggregate domestic household debt. Australian household debt to disposable income is now approaching 200%. With debt at such high levels, the sensitivity of households to any change in interest rates is thus higher than usual, whether it be from the RBA or out- of- cycle mortgage hikes by the banks.
· The employment market remains fragile. While the headline unemployment rate has been relatively steady in recent times, it has been characterised by a poor composition, with the bulk of job creation in part-time, as opposed to full-time employment. Under-employment is thus high and job security is low.
· Wages inflation is low, which is partly an outcome of the employment market characteristics outlined above. This ties in with the level of household debt and households may struggle with debt repayments should interest rates rise.
· The unhealthy reliance of the domestic economy on rising house prices and housing construction. Building approvals have already peaked, which foreshadows a reduced contribution to economic growth.
The tail risk scenario would thus involve rising domestic unemployment, higher mortgage costs (most likely driven by rising long-term international interest rates), soft retail sales and a correction in the housing market.
The sectors that would be affected by such a scenario are retailers, the broader consumer discretionary sector, housing construction stocks (building materials and property developers) and, of course, the banking sector. Consumer discretionary stocks are under pressure from low wages growth, with rising house prices a counter support, while earnings related to housing construction have likely peaked.
It is the banking sector, however, that poses the greatest risk to market earnings in this scenario. This would be evident in a slowing top line (credit growth), but more notably in a spike in bad debts, which are still close to historic lows. A doubling in bad debts across the major banks to an average rate of 35bp (not an unreasonable assumption) would have the effect of reducing earnings across the banks by around 10% and imply a further rebasing of dividends.
All else being equal, the scenario described above would have some offsetting factors, predominantly a lower $A. If weakness in the Australian economy was isolated from the rest of the world then the group of companies with international earnings would receive a boost. So too would the resources sector, with a high proportion of domestic costs and $US earnings.
An additional tail risk for the Australian equity market is a much sharper commodity price correction, as opposed to a gentler reversion to long-run or marginal pricing. For Australian equities, this is most relevant for the iron ore market, with the recent rebound driven by supply-side steel market reform by China rather than a pick-up in demand. A more coordinated recovery in developed economies is certainly a positive for commodity demand, but in general, these countries are not high consumers of iron ore. As such, it is the growth in demand from emerging Asia which matters most. In contrast to several years ago, China’s steel demand is thought to be close to peaking, which leads to the conclusion that the recent rebound may be short-lived.
A significant commodity price correction matters less for the Australian equity market than it did several years ago – resources currently account for 16% of the ASX 200 by market cap, as opposed to 35% in April 2011. Nonetheless, because there are often large swings in profitability on a year-to-year basis, the direction of commodity prices will still have an influence on changes in overall market earnings. By way of example, off a low base, resources earnings are expected to double in FY17; if valuations across the market are unchanged, this alone would add approximately 16% to the benchmark index over the course of the year (coincidently, the ASX 200 Accumulation Index is up 17% financial year to date).
For portfolios, our recommended Australian equity weight is based on the objective of the investor. Investors that have made income maximisation a priority, we recommend a neutral to underweight position (from a high base). The income from the asset class (grossed up inclusive of franking credits) remains sufficiently attractive to compensate for some level of downside capital risk, provided investors recognise the additional volatility such high levels introduce. For other investors, we recommend a greater tactical underweight position relative to strategic allocations; our preference for achieving capital growth in the current environment lies with international equities given the better opportunities available and prospects for participating in an economic recovery in this subset.
In the final quarter of 2016, many investors were caught unawares by a big rotation out of long standing favoured sectors such as healthcare, consumer staples and income producing stocks into energy, materials and financials. In the first quarter of 2017, this partially reversed, with the energy and financial sectors retracing some of their gains.
In financial markets these trends are captured in a debate on value versus growth. Value stocks are often those with high leverage to economic conditions, as earnings are likely to move sharply to changes in momentum and are associated with rising inflation. For value to sustain its path it will require some of the growth factors referred to in our comment on economic conditions to materialise. In less buoyant circumstances, growth stocks have held up better, as they are skewed to companies with a high degree of earnings certainty, albeit without the above-expectations potential of a value oriented strategy.
The following chart shows the pattern of value performance out of weakness or uncertainty – the 2009 crisis, European instability in 2012 and more recently the economic pickup post the slump in oil prices and slowing China data from early 2016.
MSCI Global Value versus Global Growth
We believe most Australian based investors are nonetheless best served with a skew to growth in their international portfolios. The ASX has a tendency towards performing best when value is in favour, given that rising global economic growth benefits the resource sector and, in turn, drives GDP. The equity portfolio is therefore usually absent an appropriate weight in longer term fundamental growth sectors and stocks. Our recommended global fund universe has exposure to value, but predominantly outside the US where the style bias tends to be more rewarding.
The question then turns to regions and sectors that are attractive into 2018.
On a regional basis, the US is trading well above its historic average along with a few smaller country markets, usually those dominated by a few high weight stocks; for example, Nestle and Novartis in Switzerland and Unilever in the Netherlands. Better value can be found in other European markets, Japan and across the emerging region. As illustrated in the following chart, key is to what extent earnings can surprise and move the historic valuation (in the light blue dot) towards or below its average (the dark blue line). Again, the consensus is that Europe and Japan have the highest probability of upgrades.
Developed Markets: 7-Year P/E Valuation Ranges as of 31 March 2017
Emerging Markets: 7-Year P/E Valuation Ranges as of 31 March 2017
On the basis that P/E expansion cannot play the role it has in forthcoming years, there are other multiple paths from which a productive outcome could be achieved. These include:
· The financial sector as a beneficiary of higher long term rates as a steeper yield curve supports higher margins. Easing of the regulatory changes could be another positive factor.
· Potential for lower tax rates will impact on companies with low deductions. These companies can be readily identified and are commonly found in consumer staples and discretionary sectors.
· Information technology corporations generally can create their own destiny outside of interest rate changes; indeed, with cash balances they will benefit from higher rates. The key is selecting those where the revenue growth is sustainable and matches the hype in the share price.
· With private equity sitting on cash resources, companies that are able to issue equity at high valuations and rising leverage in hedge funds, M&A activity can pick away at corporations that have latent value. Further, many companies are self-selecting to restructure and realise assets that are not fundamental to their operations. Focused businesses tend to do better.
Global equities are judged to be the best asset segment in relatively fully valued financial markets. While the volatility and downside risk remains undiminished, the past few years have demonstrated the ability of companies to extract a benefit from economic factors such as lower interest rates and the focus on yield. These influences are changing but the opportunity remains in place.
As the AUD is balanced between interest rate differentials, commodity prices and the narrowing current account, we note that most forecasts imply a narrow range within 0.70-0.80/USD. In our view, some degree of hedging is appropriate, depending on the asset allocation (lower global weight, less hedging) and the time frame (short term frame, more hedging). Unhedged continues to provide a buffer to downside risk as the AUD tracks risk trends, however investors need to be prepared to forgo the potential to lag on the upside if economic growth picks up.
On a sector basis, financials, information technology and selected stocks in consumer discretionary and healthcare are favoured above other sectors. Increasingly, funds are moving away from the prescriptive GICS (global industry classification standard) based stock and sector allocations. Instead, the categories are descriptive, such as digital champions or disruptors, domestic demand beneficiaries or restructuring candidates.
Our preferred product solution is therefore for all country, active strategies with a distinctive approach for the longer run, while using low cost passive index trackers or regional active funds for tactical weights. A portfolio can rarely do well in all conditions and investors should acknowledge the bias. This should be by design. Each investor can choose between growth over value, downside protection above upside participation, valuation sensitive or valuation agnostic. If there is no aim but to participate in global markets or where deviation from the benchmark is not the aim, a broadly based passive approach should be considered. Otherwise, the active component should be left to play its role while we commit to understanding the drivers of performance.
Allocating within fixed income is a challenge at present given a backdrop of rising interest rates in the US, potentially less accommodative policies by the ECB and BoJ, rising global inflation, and tight credit spreads. We acknowledge the diversification benefits of holding this asset class, but are cautious of the tail risks. Being tactical with timing of entry is key and we suggest being patient in sectors where pricing has been eroded until such time that value is restored.
Tail Risks – Bond Yields to Rise
While nearly all asset classes are affected by US interest rates, Treasuries have the most direct relationship given yields are set using this ‘risk free’ rate. The bond yield curve is determined by market expectations for the path of interest rates, which is constantly changing as consensus views develop, and current bond prices readjust in line with this curve.
US corporate fixed rate bonds are also impacted by the yield curve. However, they also have a spread premium which can protect against some of the price moves. Given investment grade bonds have a shallow spread margin, the effect of changes to the rates curve is greater than that of a high yield security in which the spread premium is wider.
After a slow start to the rate cycle in the US in 2016, it is now in full swing with 2 rises in 3 months (December and March). The bond market remains focused on the future path of interest rates and has priced in another 2-3 rate rises this year and the same again for 2018. If this gradual path of interest rates plays out as the curve suggests, then there should be a benign outcome for bondholders who will see the capital value on their investments remain close to par ($100).
However, we are mindful of large exposures to long dated fixed rate bonds in the US, as we see risk to yields tracking higher than expected, either through a parallel shift upward in the yield curve, or a steepening to the long end.
Following the US election result, we witnessed significant moves in markets whereby equities rallied and bond yields rose. Since then sentiment has changed. Bond yields softened, and interest rate expectations are now lower than the March Fed ‘dot plots’ (expected rate from each voting member of the FOMC) would suggest. In our view, this recent pull back increases the risk of another push upwards in yields and we would be looking for the rate on the 10 year US Treasury to track back towards 3% before suggesting that value in this investment segment has emerged.
FOMC Dot Plots
Along with higher rates is the potential change in the US balance sheet.
For these reasons, the global funds that we favour tend to trade treasuries opportunistically, rather than maintain them as a core holding within the portfolio, and use US TIPS (inflation protected bonds) to maintain a defensive bias, whilst enjoying upside if inflation overshoots. Volatility is currently relatively low, but this is expected to rise as rates move up, which may also create trading opportunities for portfolio managers.
Elsewhere in global markets, the trend for higher rates may become widespread. Europe is suppressing bond yields on a short basis. However, the medium-term outlook for Europe is pointing to better economic growth and a desire (perhaps led by Germany) for the ECB to remove the negative interest rate policy in the region and taper the quantitative easing (QE) program further after reducing buying in December.
The QE program has been artificially lowering spreads in the region, and our expectation is that pricing of government bonds in peripheral and developed countries in Europe will come under pressure during the unwind, including those in Germany.
The risk of higher yields is a widely-held view and there is a chance the non-consensus plays out – weaker growth, a fall in oil prices or flight to bonds based on global conflicts. We rely on the expertise of the funds to manage positions accordingly.
The consensus outlook in Australia is for the cash rate to be on hold for the rest of 2017. There are outliers to this view on both sides of the equation. While weak retail sales figures, low inflation, below trend growth and elevated unemployment perhaps warrant further easing by the RBA, the housing market in Sydney and Melbourne coupled with high household debt levels are a concern. The recent announcement by APRA to further curb investment lending to 30% of a banks’ loan portfolio potentially opens the door to further rate cuts by the RBA and this view has therefore gained momentum. However, while we acknowledge that this could be a favourable outcome for holders of fixed rate Australian bonds, it is not our base case and instead there is scope for some further curve steepening should the domestic market follow global rates higher. We express this view through exposure to floating rate product (via short duration credit funds and selective hybrid securities) and domestic funds that are active and can take advantage of a steeper yield curve through the roll down.
A year ago the price of oil collapsed, equities tumbled, and credit spreads blew out. This (in hindsight) created a plethora of opportunities to buy securities at their lows. A year on, the value appears to have dried up as energy prices recovered and economic conditions pulled in credit spreads. In fixed income, high yield (HY) spreads, which in the US have a high weight to energy names, and their European equivalents are both trading near historic lows.
US vs Eurozone Investment Grade Credit Spreads, 2014-2017
Tail Risk for Emerging Markets
Concurrently, credit spreads on Investment Grade (IG) securities have contracted and are also lower than their long-term average (see chart above). This opens up the risk that if default rates rise (in high yield) and credit spreads widen (assuming contagion across both HY and IG) it will lead to some capital losses in spread products.
Sector rotation and security selection is perhaps more important than ever if fixed income funds are to protect capital and post positive performance in the near term. Riding on the tail coats of the market’s tightening trajectory no longer appears viable, and once again we seek funds that can be dynamic in their approach.
Debt in emerging markets still looks quite attractive relative to other sectors. Inflation appears under control in many of these countries and progress is being made on structural reforms. Inflows continue into this sector as investors search for yield, supporting bond prices.
The risk is if the USD strengthens again, as many expect. Any instability in commodity prices will also have negative implications, given the high weight in the category to exporters. In addition, the US trade policy could still impact many countries. While acknowledging these risks, diversification and yield uplift warrant some allocation to this sector, albeit on a diluted basis through funds.
In conclusion, we remain cautious of fixed income at this time as many sectors appear expensive (as shown in the following chart below). This view is reflected in our tactical underweight to fixed income in our overall asset allocation. It remains important to have defensive assets in the portfolio and one that offers diversified returns to equities, which correlations would suggest is still the case.
Current and Historical Fixed Income Index Yields