Quarterly Market Review April 2019

Weakening global growth and downward revision to corporate earnings have not stood in the way of a first quarter equity market rally as central banks turned dovish.

Consensus is that economic momentum will remain sluggish, potentially flirting with recession by 2020. We believe it is possible that the combination of stimulus in China, an easing of trade tension and small cyclical uplift in Europe will combine to surprise on the upside, while acknowledging that such a trend it likely to be short lived.

The overwhelming opinion is that equity weighting should be maintained, reflecting the difficult return expectations for fixed income. We concur with these views but recommend portfolio have defensive investment within selection of funds and have a bias towards limiting downside rather than expecting excess participation on the upside.

We have further reduced our allocation to Australian equities in our preservation model and reallocated to global equities. In capital growth we recommend an increased weight to unhedged to offset potential risk to equities where the AUD is likely to fall.

Our expected return has edged down as we have reduced the likely outcome from fixed income given the recent movement in bond yields and tightening spreads. This will impact on level of income generation across the portfolios.

The alternative allocation includes fund strategies that are either a substitute for traditional equity or fixed income. We do however note that investments offering higher yields than the indices, are associated with higher risk. Further we recommend limiting the level of illiquid investments to retain flexibility across the portfolio and take advantage of any sell off where it to occur.

Asset Allocation

Source: Escala Partners

Expected index return (excluding alpha and franking)

Source: Escala Partners

Expected return (including alpha and franking)

Source: Escala Partners

The assessment of the investment outlook is framed by opinions on economic growth and financial conditions. In the past year, the emphasis on risks facing investment markets has shifted from monetary policy and trade to overall economic growth.

Where is the biggest risk to markets over the next 12 months?

Source: Barclays

These are, however, a moving feast and tend towards revisions biased to what is happening today, rather than taking a view on what will be the discussion points in a year’s time. Markets are forward looking, with equity managers commonly referring to expected earnings and fixed income participants on the likely change in rates. Investment returns will reflect whether those expectations are met and what the view is on the forthcoming cycle.

In this quarterly Asset Allocation, we provide a summary of current expectations based on consensus views, as well as the counter case against this consensus.

Consensus

Global growth will reappear through this year but remain sluggish. Organisations such as the OECD and IMF have downgraded GDP growth by 0.2% in the past month to an average of 3.4% (note that these are based on purchasing power parity exchange rates, whereas some forecasts are based on current exchange rates). Few regions have escaped the slowdown, pointing to global rather than domestic conditions as the culprit. The manufacturing and trade sectors have been the weakest, reflecting the impact of policy decisions and longer-term growth uncertainty has held back investment intentions. In all regions, the pace is expected to lift through this year. The first quarter was subject to one-off factors and the retracement on tightening monetary policy has given hope that financial conditions will stabilise.

The average forecast from 43 economists for US growth in 2019 is 2.3%. US business sector confidence has waned, confronted by soft revenue and rising costs, while the household sector has proven reticent to spend the modest income gains it has accrued in this cycle. Real personal consumption expenditure is rising close to disposable income growth.

Source: Bureau of Economic Analysis, Haver Analytics

Housing construction is likely to make a renewed contribution in coming months given mortgage rates are at two-year lows. Bank lending has also recovered; another indication that lower interest rates have proven to lift activity.

China is taking a light touch on stimulus, directed predominantly at mid to lower income groups and smaller businesses. Nonetheless, most are of the view that circa 6% growth will be reported, with a lift in the second half of the year.

Europe appears unable to break free of the effects of populism and self-imposed restraints. Trade talks linger and Brexit is unresolved. After a very weak Q1, there are some signs of a mild improvement, but it is clear the pace will be below 2018. Populist repercussions from Brexit and the potential for US protectionism to turn its attention to the European auto sector are repetitively mentioned as the key risks for this year.

Into 2020, risks are considered to be more elevated. Yet, there is no overwhelming thesis on why, apart from that there is little to support growth, debt is high and confidence is lacking. The absence of the trigger or theme to push opinion either way is notable.

Contrarian

The balance of probabilities is skewed to a stronger than expected run into the remainder of the year. A resolution to the trade dispute with China along with the home-grown stimulus may see global trade rebound more than anticipated. We note that the household sector has been stable and is accruing real income gains, which should translate into goods and services demand if perceived risks are ameliorated.

In both the US and China, the current political incumbents have a strong vested interest to bolster their economies. The US is entering an election year where the administration can be assumed to do what it can to paint a rosy picture. Undeniably, this is a risky thesis, as policy initiatives such as trade have backfired in terms of growth, but we assume that rationality will prevent unsettling changes as they try to attract swing voters.

The Chinese government can be expected to pull out all stops to lift growth through the year. It would not want its constituents to see the economy as vulnerable to US policy as it focuses on moving towards higher value-added growth and ambitions to have influence in its region.

The cynical view is that Europe will go to the brink before capitulating to inevitable pressure. In this decade, that has been the case, with the package to support Greece and the ‘whatever it takes’ statement from the ECB. Along with a resolution on Brexit and a satisfactory outcome from the EU parliamentary elections, the appeasement of trade tensions should have a meaningful impact on Europe’s large export sector.

By contrast, a mild moderation in growth into 2020 may be more severe than anticipated. Inflation could be either higher than expected if wage growth finally finds its way into the system, or lower than helpful, which implies price and margin pressure. The latter theme is gaining ground and would dent corporate confidence, possibly resulting in layoffs and therefore rising unemployment.

A raft of unresolved issues face major economies. Brexit has merely raised the spectre of the failure of the European Union to fully integrate and yet keep its constituents happy. China’s economic model is under increasing strain. The easy gains from initial reforms and trade have not been superseded by a structure that suits its middle-income GDP status, such as reform of state enterprises, the growing burden of an aging population and curtailing corruption. While the dynamic spirit in the US has been a major factor in the past decade, the budget deficit and income inequality now stand in the way of growth.

Consensus

Consensus is subdued (local economists) to outright bearish (global economists). The focus is on the excesses in the housing market and the consequences to the household sector. Banks are viewed as relatively safe from a bad debts perspective given comfortable spreads between value and loans (LVRs), but will experience slow credit growth absent the mortgage sector. Small and medium business, the engine room of employment and growth in many regions, is hampered by a lack of or price of debt capital, though the recent budget provides tax relief on capital purchases.

Conversely, the growing programme of infrastructure spending may emerge as the saviour, along with resilient commodity prices and volumes. The budget, or possible policy from Labor, is seen as unconvincing.

Finally, policy certainty would help, but also needs to provide a convincing benefit. The consensus can therefore be described as a ‘muddle through’ with frustratingly low growth.

Contrarian

The contrarian case is for a leg down. Assessing household risks are complex as simplistic metrics such as loan servicing skirt around the behavioural aspects of consumption where spending depends on confidence. The national accounts suggest a run down in savings as households seek to maintain lifestyles. The budget does give a boost to lower income groups, though it merely partially recovers the impact of bracket creep and the tightening of welfare benefits. The key risk is a rise in unemployment, which would set off a raft of counterparty outcomes across debt markets, the housing sector and state budgets, through a combination of GST revenue and stamp duty.  

Source: Escala Partners

While the first quarter rally may already have expressed a relatively optimistic opinion, a renaissance in economic growth is likely to hearten spirits and eventually lead to a stabilisation in earnings forecasts.

Most fund managers believe that there is still some further downside to forecasts, but that most of this should occur in the next quarter. BlackRock has created a forward earnings tracker that regresses MSCI EBITDA growth with global economic indicators including trade data, inflation, unit labour costs and input prices. The implication is that earnings growth may move close to zero before current conditions have been fully reflected. A rebound in trade is critical given already low inflation and likely continued pressure on costs.

MSCI World earnings and BlackRock tracker, 2007-2019

Source: Blackrock

The opinion is to maintain a modest underweight to developed markets with a reluctant overweight to US due to a lack of conviction on Europe and Japan. This is reinforced by the US investor surveys where respondents are set on a neutral to mildly bullish stance compared to their historic average. Nonetheless, a combination of indicators suggest the S&P 500 index may be hamstrung to retain its decade-long top spot. Profit margins are at all-time highs, valuation measures such as price to sales are heady and debt has increased off low rates and capital management, such as buybacks.

Corporate profits after tax as a percentage of GDP  United States: Price-to-sales 1974 – 2019

Source: Federal Reserve Bank of St Louis, Sanford Bernstein

It is hard to step away from a large weight to the US given the persistence in performance. We do observe that funds are increasingly careful on valuations, governance concerns and cost pressure in stock selections.

European wealth managers are particularly bearish on their region. The redeeming feature is a 3.7% dividend yield. Most funds are bunkered down into luxury goods stocks and healthcare, both now trading at elevated valuations. Conversely, materials, energy and particularly, financials, have a relatively high index weight in Europe and have held back the index. We see little scope for change until the macro issues noted are resolved.

There is a steady bias to emerging markets, though most concede it has run hard year to date and may move sideways in the near term. The foundation is the valuation gap to developed markets, a relatively stable exchange rate and accommodative monetary policy. Much does depend on China’s stimulus, with its beneficial overflow into other countries in the region.

Typically, cyclical sectors such as financials, materials and industrials benefit from rallies. However, the financials sector has been caught in the pincer grip of bond yields, where a flat curve undermines their ‘borrow short, lend long’ foundation. Earlier observations of deteriorating credit fundamentals have not helped either. Few are of the view this sector should be favoured.

Industrials have proven a mixed bag, with those exposed to trade unsurprisingly hit by earnings downgrades. Similarly, resource stocks are pro-cyclical, though vastly improved balance sheets appear to have been largely ignored.

The consensus is to hold onto defensive and high-quality stocks, with communication services, utilities, healthcare and information technology the preferred sectors.

The epitome of contrarian equity investing has been funds that have held to a value style bias. To summarise, these investments are skewed towards companies with lower than market P/E, Price/Book, higher dividend yields and typically lower return on equity. The concept is that the upside leverage is high if the company can achieve better than expected profit based on an underestimation of revenue flowing through to the bottom line.

The current MSCI Value versus Quality screen provides a very different lens to the industry weights.

MSCI Value versus MSCI Quality indexes – sector weights (LHS) and sector 1-year performance (RHS)

Source: Blackrock, Escala Partners

Long term, value has performed well, and a contrarian investor would persist in the expectation that mean reversion is inevitable. Currently, that would include a skew to Europe, and Germany in particular (where auto companies are trading on single digit multiples) and across the region, financials and select industrials. Japan has also not lived up to expectations that corporate governance would kickstart a capital management cycle and result in higher return on equity. Yet, there are a select set of companies that have unique assets and mid cap companies that do not carry the historic legacy of problematic governance.

In emerging markets, countries such as South Korea have lagged as large international-oriented corporations and the semiconductor cycle have been hurt by the trade battle. To date, low multiples have not attracted much appetite, but if these dynamics change the valuation appeal (11X P/E) is evident.

The consensus view is that the change in rates has been the catalyst in the recent strong performance of real assets. While this makes the income of real assets attractive in comparison to bonds, it could have an adverse impact on future performance.

Through 2018, supportive economics improved the fundamentals for REITS through demand for space. Occupancy rates and rents had moved higher and dividends rose on stable payout ratios. At a global average of 93.8%, occupancy rates remain near record highs and net absorption continues across major property types.

Rising interest rates have become less consequential. REIT operators have been much more prudent with leverage (measured to book value) at 20-year lows. Additionally, REITs have also taken advantage of the lower rates and have locked in low-cost, fixed-rates for extended lengths of time. The NAV (Net Asset Value) discount to private assets has made it all but impossible to grow through traditional acquisitions, further limiting the risk of excess debt.

A positive valuation sign for REITs is when the dividend yield is attractive relative to the yields on other income-oriented assets, such as corporate bonds. The spread between REIT dividend yields and corporate bond yields has narrowed, but suggests further positive returns, though lower than before.

Easing interest rates due to an economic slowdown could have a negative impact on REITs if tenancy demand softens or occupancy costs flatline.

Real estate categories will be exposed to these risks in different ways and cause dispersion between sector performance. For example, the retail sector is vulnerable to structural and macro-economic factors. Retail REITs have had to navigate a spate of store closures as a result of e-commerce over the past few years. While some have managed the impact, as retailers see the need for a physical presence in higher-quality properties as well as internet offerings, a dip in demand could cause a change in approach.

With valuations looking at the higher end, we would expect most the returns to come from distributions. Sector selection will matter more.

In our last Asset Allocation (January 2019), we noted that the Australian equity market had increased appeal on valuation grounds after the relatively sharp de-rating that occurred in the final few months of 2018. Our view was that the broader earnings cycle was holding up relatively well, dividend yields were attractive (with upside surprises to come from individual companies ahead of any change to the franking credit policy) and balance sheets were healthy. Interest rates were still relatively low, supporting equity valuations.

In the three-month ensuing period, the landscape has evolved with several significant changes:

– The most noteworthy development has been a dovish tone adopted by central banks. The prospect of a rising rates and shrinking balance sheets had posed one of the biggest headwinds to equity valuations in the medium term.

– February’s reporting season was soft. The banks were impacted by weak credit growth and elevated costs (a mixture of one-offs and structural) and a broad spectrum of industrial companies experienced moderating growth over the last 12 months. At an aggregate level, industrials profitability was flat in the December half. This was partially offset by the buoyant conditions in the resources sector; an outcome of relatively tight supply/demand conditions.

– Negative earnings revisions picked up into 2019. Some of the challenges include an uncertain domestic consumer, a downturn in the important housing market, a decline in business confidence, restricted access to credit, shifting goalposts on a regular basis with regards to government policy, high levels of competition in certain sectors of the market, and higher cost growth (e.g. energy prices, raw materials, transport and labour).

– An improving fiscal position, as outlined in last week’s federal budget. On the provision that commodity prices remain elevated, there is optionality for the government to support domestic consumption via stimulatory measures.

Market Valuations

After briefly falling in late 2018 to a multiple that reflected good value for Australian equities, the ASX 200 has quickly returned to a valuation that is within the band of the last few years. This has occurred despite a deterioration in the broader earnings environment, with the level of downgrades now slightly worse than is typically observed.

As we have highlighted in recent times, it is the resources and related sectors that have been the key in underpinning the domestic earnings cycle. However, given its cyclical nature and therefore lower level of sustainability, the value uplift for the market should be lower.

What is the consensus sell side view?

Aggregate sell side broker recommendations give an indication of which companies and sectors have consensus high conviction buy or sell calls (although the time frames are somewhat short-term). The clear takeaways are that resources (energy and materials) and growth (health care and info tech) are preferred, while defensive and interest rate sensitive companies (utilities, consumer staples, real estate) are avoided. (In the chart below, ‘1’ is a strong sell, ‘3’ is a hold and ‘5’ is a strong buy)

Source: Escala Partners, Thomson Reuters

Resources

Commodity prices have been stronger than anticipated in the first quarter, particularly among several that are important for the profitability of the sector. Iron ore and oil are the two obvious standouts, although base metals have also risen. There remains a large gap between spot prices and forecasts by sell side analysts over the next year; therefore the most likely path is further earnings upgrades in the short term (FY20 earnings may be 50% or more higher under a spot scenario).

Consensus is anticipating prices will taper over the next two years, driven by such factors as more variable global economic growth, China moving towards a less commodity-intensive phase of expansion, and the normalisation in some markets that have recently spiked, such as iron ore (disrupted by a mining disaster in Brazil) and oil (given OPEC’s balance in maximising profitability without re-incentivising US shale again).

The contrarian view is that prices continue to surprise on the upside, helped by a trade truce between the US and China, government stimulus in China and ongoing supply disruptions.

Our view would be closer to consensus, however we believe the risk is to the upside with resources earnings. Resources are in an upgrade cycle, a collapse in demand is an unlikely outcome and there is a high level of discipline among the major producers in limiting new production growth and returning excess capital to shareholders.

Banks

Despite the recommendations from the Royal Commission being not as bad as initially feared, the financials sector has lagged. Earnings continue to be recast lower, however some of the catalysts should be transient, such as restructuring (as certain businesses are divested) and client remediation costs. Below-par credit growth remains a key impediment to earnings growth, although we note that the sector will soon be cycling tighter responsible lending criteria. Consensus earnings growth is relatively flat, with stable dividends a best-case outcome. However, there is still concern that an accelerated decline in house prices could lead to a credit crunch.

The contrarian view is a return to respectable earnings growth as credit growth again picks up, the cost out opportunity is realised and funding cost pressures ease.

Our view is that we are closer to an improving environment for the banks rather than further deterioration, although in the short term there is some risk of negative dividend revision. We view the banks as an attractive high-yield option for investors that are underweight other high dividend paying interest rate sensitive stocks.

Industrials

We have grouped the industrials sector into four broad categories: cyclicals, value, high growth and interest rate sensitives.

For cyclicals that are linked to the resources industry, the consensus outlook is robust, with capex slowly lifting from a low point, while there is also some participation in government infrastructure spend.

A contrarian view would be that this rolls over quickly, although we believe that there is some certainty in the near term given the relatively healthy position of balance sheets of the customer base.

Housing and consumption-based cyclicals face a bleaker outlook, including many retailers. While this is the consensus view, a counter argument can be mounted given the resilience of the domestic economy and the possible support provided by fiscal and monetary policy. In the absence of the latter, we would view undifferentiated companies to face a challenging period.

Value companies are also hurt by a softer domestic outlook, as reflected in the fall in long bond yields over the last several months. The consensus view is that these stocks are relatively cheap compared to higher growth companies, but lack the catalysts for the valuation gap to close. We would concur with this view and surmise that this style is only suited to the patient investor.

High growth companies (typically health care, information technology and select companies within consumer staples) are almost universally viewed as expensive. The opposing view is that their scarcity and structural growth companies should be highly values given low bond yields. As a group, we would agree with the former consensus view, although believe that those that can avoid disappointing on earnings delivery will continue to perform well given the macro conditions. Perhaps more so than other categories, the ability to identify and pick these stocks is thus a higher priority.

Finally, interest rate sensitive companies (real estate, infrastructure, utilities) have been the biggest beneficiaries of the changing rates environment. To the extent that the yield curve is not going to take another significant step down, the consensus view is that the capital appreciation potential is now limited.

A contrarian view would highlight the large gap between yields on these securities and fixed income yields. Our view would be to prioritise companies within this group that can grow their distributions (infrastructure companies are therefore better placed).

Summary Recommendation

Following the recent rebound in the market and lack of broad earnings support, our recommendations are:

– A reduced exposure to Australian equities for capital growth and capital preservation portfolios and;

– Maintaining the weightings for income-oriented investors given the strong yield on offer in the market, backed by modest earnings growth and healthy balance sheets.

Australian rates market

Central bank forecasts have become the contrarian view, while consensus views come from market participants. The RBA continues to hold interest rates steady at 1.5% and accompanying monetary statements have made it clear it views the likelihood of rates moving up or down as evenly balanced. However, the futures market and a growing number of investment banks propose otherwise, with easing priced into the yield curve and some suggesting one to two rate cuts this year.

While consensus is that a rate cut is warranted, we have our concerns:

– Will the banks fully pass on the rate cut to make it effective? Banks are not obliged to pass on lower rates and have previously only offered a partial rate decrease to mortgagees.

– Further accommodative monetary policy could fuel a reversion to house price rises and once again increase household debt.

– A rate cut may spark concern on the outlook for growth and employment, in turn curbing household spending.

– Lower rates and a flat yield curve squeezes the banks’ NIM (net interest margin) and therefore profitability.

While a rate hike by the RBA seems a long way off, we suggest that the central bank will keep rates on hold and will be reluctant to use its remaining policy scope unless economic conditions deteriorate sharply; a rise in unemployment would be the likely trigger. We look to current low interest rates and fiscal policy (post the election) to support growth within the economy.

Our view is contrarian to the market, with consensus at ~80% probability of a rate cut this year. This has pushed yields to all-time lows, making bond prices unattractive. If the bears are right, then we expect that short-dated yields will fall, but there will be little capital appreciation for long duration bonds. Instead, we expect a steepening in the yield curve, with 5 to 10-year bond yields falling by a much lower margin than shorter dates (cash to 3 years).

If the RBA does not deliver lower rates, then this could trigger a greater impact on pricing, in this case negatively, as yields back up. The pay-off for holding duration is therefore limited, with more downside risk at play. We therefore suggest maintaining an underweight position to duration, with reduced holdings positioned as a hedge to risk assets within a diversified portfolio.

US Rates

The US Fed has adopted a more dovish stance in recent weeks, with the last quarterly update showing a downward revision of the Fed members’ interest rate predictions (median dot plots). Similarly to Australia, the central bank forecasts are for higher interest rates than market consensus, which predict rate cuts (a 60% probability of a rate cut by December 2019 is priced into the futures market).

US dot plots from latest FOMC meeting

Source: Bloomberg, Escala Partners

The outlook for GDP is slowing and in the absence of a rebound, interest rates are likely to stay low and range bound. Further, a recent inversion in the US yield curve (10-year rates were below the 3-month rate) raised concerns on the likelihood of a near-term recession. Lower rates on longer term debt is not good for bank profitability (given they lend long and borrow short) and rising recessionary fears can be self-serving as consumers and companies reduce their spending.

We are of the view the Fed will hold rates in the short term, though we have less conviction on the medium-term outlook. The question is whether the pause in rate hikes and the end of the balance sheet run-off in September this year will be enough. There is also support for more active fiscal policy to stimulate growth, which could contribute to rising inflation and, in turn, a steeper yield curve. Given current pricing, we would hesitate to add long duration funds, although may revise this if yields trade up to the top of their range. We recognise the diversification that duration offers to portfolios, supporting our recommendation for some exposure.

Credit

As identified by the Fed in its financial stability report, there are growing risks within credit markets. High yield companies that inherently have high leverage, low interest coverage ratios and unstable earnings have been increasing their debt levels the most. Credit standards for new leveraged loans have been deteriorating with the increase in covenant-lite loans (loose covenants) in a sector now facing headwinds from falling rates, given the coupons are floating. Even investment grade (IG) credit markets have pressures, with the rise of BBB rated bonds in the IG index (BBB is the lowest IG rating and now makes up 50% of the index).

While risks have risen, the consensus view is that the environment remains positive as default rates are low and serviceability of debt is manageable. Higher interest rates are unlikely to be the trigger for a reversal in these positive metrics, but a slower growth environment and therefore profitability could be. Credit spreads tightened in the first quarter of this year after widening in late 2018, taking margins below historic averages. Regardless, we recognise that IG credit will be supported, given the low rates on offer in the treasury market.

Global investment grade bonds

Source: JPMorgan AM