Quarterly Market Review December 2017

For the moment, we remain positive on equity allocations, though there are signs that we are at the mature end of a bull market. The elevated level of global economic activity, as measured by the PMI (Purchasing Managers’ Index) across the globe indicates that the business cycle has some way to run.

Sector rotation is expected to be the theme of 2018, as equity holders seek exposure to this growth, as well as new or evolving stocks. The predominance of the large cap and high profile ‘disruption’ stocks may have run its course.

Australian equities are likely to follow global trends, though the opportunity set is more limited. Global equities have broader options, with unhedged holdings a potential path to ameliorate some of the downside risk given the likelihood of AUD depreciation in a risk-off event.

Fixed income assets are possibly at the low point of potential return. Floating rate spreads have contracted, and any duration is a hurdle in a general trend to higher rates. That said, the market does misprice both short and longer-term segments where relative value trades can be productive. The demand for credit from pension funds and other structural holders remains high. We maintain our underweight, with the holdings dependent on the investor’s required portfolio outcome, be it income or capital protection.

Alternative assets are biased to those that can provide returns in the event of a decline in equity and fixed income markets.

We have adjusted the tactical income portfolio. Risk to Australian equity dividends has largely passed and we raise the weight to its strategic level. Fixed income is reduced to 30%, equally spread in each subsegment. Offsetting these changes are a 5% (from 10%) allocation to cash, given expectations of low rates for some time, and a 15% (from 10%) allocation to other assets. The capital preservation and growth portfolios are unchanged.

Our expected returns from hybrids has reduced by 0.5% given the movement in spreads. The return for other asset classes are unchanged, based on rolling 3 years.

Asset Class

 

Expected index return (excluding alpha and franking)

 

Expected return (including alpha and franking)

 

For some time, we have guided investors to expect lower returns. 2017 will stand out as contradicting that outcome. Yet we are even more firmly of the view that the logic in lower nominal rates of return have foundation. Low interest rates are incongruous with returns above the historic average. Retracement towards the longer-term rate of return is likely and given economic growth is below the 1990/2000 decades, investment returns should reflect that reality.

As an illustration, the chart for the S&P 500 shows that the five-year return for this cycle is well above its average. There is no fundamental reason for this outcome, suggesting there will be some payback in coming years.

S&P500 Current versus Average Total Returns (as at 1 Dec 2017)

 

We believe investors should be patient with respect to their holdings. While some asset segments and investment funds have recently lagged the stellar returns relative to their benchmark, there are fundamental reasons for this divergence. This could prove of value when the current relatively narrow cohort of support shifts emphasis.

The structural and cyclical influences on investment markets can be quite distinctive and, at times, the same theme will be at odds within these two dimensions. In this year-end report we provide a selection of current views under these two influencing factors.

There is little disagreement that demographics, productivity and debt have been overriding influences during the past decade. Yet, the longer-term consequences are up for debate.

Demographic reality is a fact and countries with a large aging cohort face a host of inhibiting restraints on economic growth. There are some unexpected outcomes. Japan is the iconic example. The recent uplift in activity has seen a larger proportion of older Japanese stay in, and even join, the workforce. On one hand, this is helpful in providing income, yet it has also caused the wage rate to be capped by the lower wages on offer to these employees. Sweden is a different example, with one of the highest levels of participation in the workforce ascribed to its family friendly policies. Demographic impact on an economy is often cited as inevitable, but there are meaningful differences on how significant it will be.

The fall in productivity over the past decade is widespread. The causes are far from simple. Most likely is the rise in services versus manufacturing, where the former has a low multiplier effect. For example, healthcare is a challenging sector to improve productivity as it requires one on one interaction and is widely stated as resistant to change. Others note that the adoption of technology is biased to non-productive usage such as social media or downloading movies and is therefore overstated.

Labour productivity (y/y change in %)

 

The most optimistic outlook is that a new cycle of productivity will kick in as there is greater adoption of robotics, artificial intelligence and automation. In practice this will take time; capital can be unevenly distributed in industries and countries. ‘Cost out’ has become a major catchcry for many companies and this investment theme is likely to be important in the coming years.

The globalisation of trade and importance of emerging economies will remain in place (notwithstanding politicisation of the merits and some of the inevitable iniquisties). By now, supply chains are integrated and a return to protectionist policies will likely inhibit long term growth. It certainly would not be helpful in enhancing any country’s productivity.

One of the most underrated repercussions has been the flows in financial markets that have become global. If anything, we expect this trend to increase, particularly in debt markets. In a recent report, ANZ highlights the demand for Australian corporate credit in Asia given the relatively attractive yields from our issuers compared to other developed markets. High global debt is often stated as a limitation to growth. Yet, at the current cost of debt and demand for debt securities, it is not yet evident it will have such an impact. It is, however, important where there is any question of the cash flow required to pay off principal. High yield markets and high household debt are arguably more problematic than high government debt/GDP.

Low inflation is here to stay. Context is important in this case. Inflation struggles to move much as capacity can be readily added or supplemented in many industries. Wage rates are contained by weak bargaining power and the constant threat of being replaced by technology or lower cost workers elsewhere. But that does not mean inflation will not surprise on the upside; it is a question of degree. We do expect this business cycle to be accompanied by an uptick in inflation, but far from the levels of a few decades ago.

Of the cyclical factors, credit growth will arguably remain the most influential. There is a time lag that can disguise the impact. The European recovery through 2017 has a foundation in the monetary conditions that emerged from the ‘whatever it takes’ statement by ECB’s Mario Draghi. That was supplemented by the 2016 credit stimulus in China that has persisted, notwithstanding efforts to reign in excess debt expansion. The delayed impacts can be understood through the local mortgage market, where it has taken the better part of two years for APRA and the RBA to finally cap the rate of investor lending.

The problem with these lags is that they have a twin on the other side when financial conditions tighten. The largest risk in 2018 is expected to be this interplay between central bank tightening, yet still low rates and the persistence of the economic cycle. At some point, higher rates will result in softening conditions.

Locally, the focus is likely to be on housing. After many years of rising prices and demand, 2018 appears to herald a turning point. Globally, the housing cycle often causes disruption to economies and in recent experience had an unhappy ending. The structure of the domestic sector is very different to most global counterparts, yet the lesson should not be ignored.

Structural

Demand for income: 

In addition to the already low level of interest rates, deriving income from high grade fixed income products will become more challenging in 2018 as credit spread contraction in 2017 requires reinvestment at tight valuations. The choice is to either accept the lower income on offer or seek out yield and take on higher risk in ASX-listed hybrids, debt from emerging market countries and lower rated credit markets.

Locally, the royal commission into the banks should ultimately lead to lower risk, assuming a change in culture. In the short term it may bring some temporary volatility to the hybrid market, as the inquiry unfolds and impacts funding costs. Nonetheless, supply and demand factors should dominate market direction, with demand for these assets set to outstrip shrinking supply in 2018. We note spreads are tight, but selective hybrids still satisfy income requirements, assuming franking is accrued.

Normalisation of rates in the US and inflows into emerging markets (EM) arguably pose correction risk to this sector in 2018. EM hard currency (USD denominated) will feel the brunt if this occurs, but local currency bonds should be more resilient. The EM index is broad and diverse, and the best returns are likely to come from those countries with sound domestic growth and less reliant on global trade. EM sovereign debt with high real rates provides some cushioning against adverse moves.

The high yield market also has elevated income capabilities, with the key being to avoid companies with weak earnings and balance sheets. Rate rises may cause some capital volatility, but these will be somewhat offset by the higher coupon.

These sectors represent the lower-rated parts of the fixed income universe. The key to generating income in 2018 and reducing risk is diversification across bond maturities, credit quality, countries and spread sectors, ideally with offsetting correlations.

The Australian equity market has been an attractive source of income for investors, with the dividend imputation system incentivising companies to pay out a high proportion of their profits. As interest rates have fallen to historic lows, income seeking investors have migrated from other asset classes and stock prices have reflected increased payouts.

We have previously discussed the interest rate sensitivity of certain sectors such as REITs, utilities, infrastructure and telecoms, particularly given their weight in the Australian market. The primary risk is one of valuation –  the leverage within the businesses means they are disproportionately affected by a rise in interest rates. Domestically, at least, this issue has receded through this year, with the RBA on hold and the slow change in global rates. Within this basket of stocks, underperformance has mostly been company or sector-specific, such as the sell-off in retail REITs with the entry of Amazon and weak consumer fears, or telcos on competitive pressure.

For Australian equities, a concern is a lack of dividend growth. This is a function of benign earnings growth and prevailing high payout ratios. The following chart details consensus dividend growth of ASX 50 companies with a yield greater than 5%. Not only are the options for investors seeking income growth limited, but the stock specific risk is ever present, as is the case with Telstra and its reduced dividend into 2018.

One year forward dividend growth and yield

 

Global equities are usually dismissed as a source of income. Dividend yields are mostly lower, there is no franking and unit trust distributions can vary significantly. While this holds true, a blend of funds can provide a reasonable yield or a specific selection of fund, for example, an infrastructure manager, can generate greater stability in income. Where appropriate, investors can create their own income by realising some of the holdings. In any event, we encourage realisation of returns above their long-term expectations, such has been the case in 2017. In a simple calculation, we estimate that for a portfolio with a 25% allocation to global equities, given performance this year (portfolio total) this implies 2% of global holdings should be realised to return the allocation to 25%.

Outside of traditional asset classes, an alternative has been unlisted property funds offering tax-advantaged income, usually paid quarterly. The irregular revaluation cycle also contributes to lower volatility for a portfolio.  Specifically, we look to the sensitivity to changes in capitalisation rates, the tenancy profile and mix, the weighted average lease terms, focusing on any risk in tenant renewal that may impact on yield and designated maturity date or redemption windows.  Our preference has been for property assets that may have a lower correlation to equity, such as health and medical centres, as well as long lease asset funds that do not have frequent renewal risk at difficult stages in the cycle. For the same reasons we have avoided single asset trusts, or those with development risk even though the potential return might be attractive.

High debt

Cheap funding has resulted in high global debt levels, with both sovereign and corporate debt at their peak levels. Terms have also extended, pushing out the duration on global bond indices against which global bond funds are benchmarked. The repercussions are increased interest rate risk for investors; longer duration implies greater price sensitivity to rates. Floating rate exposure and active duration managers are therefore likely to outperform the traditional benchmarks. Perversely, high debt levels are a contributor to weighing down long dated yields, as reflected in the flattening of the yield curve throughout this year.

Issuance by companies in the high yield market has doubled over the last ten years. On the surface this appears worrying, as one would expect leverage to have grown. However, data shows that 65% of new issuance is being used to finance existing debt, as opposed to ten years ago when 50-60% of new proceeds were used for leveraged buy outs. The growth has come from new market entrants, increasing the number of diversified industries, which is a positive development.

 

High household debt levels, in conjunction with elevated house prices reflects on the vulnerability of Australian bank bonds and Residential Mortgage Backed Securities (RMBS). Capital adequacy ratios of the banks and resilient structures in the investment grade asset-backed market make defaults unlikely. A spike in unemployment or rapid rate rises by the RBA would be required prior to any sustained price falls on bank and RMBS debt, both of which are not currently evident.  

The same arguments do not apply to equities. High debt invariably has a payback in either a cut in dividend or a capital raising as we have seen in recent years; for example, Woolworths and large resource companies. At the very least, for a company to take on a high level of debt either means its growth options are limited or it is embarking on a long-term growth path with some uncertain outcome.

Screening out highly leveraged companies remains a prudent process. Conversely, participating in the recapitalisation of companies that have been sold off due to debt concerns can be a productive outcome.

Debt is an integral part of a company’s capital structure. Low rates should not change the appropriate level of debt.

Disruption and industry change

The beating heart of global equity performance in 2017 has been centred on a relatively small number of large companies under the umbrella title of ‘disrupters’, such as Amazon, Facebook or Tencent. They have aggressively taken market share, invested heavily into new ideas and acquired competitors or businesses where they perceive a similar outcome could evolve.

Yet they may not prove the winner-takes-all that can be implied by their valuation. The traditional tech companies, such as Microsoft, have come back into favour and low-profile semiconductor stocks have also found a productive position in portfolios. While one does not argue against the likely dominance of the aforementioned cohort of stocks, they alone cannot be a portfolio and may see periods where growth does not unfold as implied by the valuation. For example, this year hotel groups hit back at online accommodation providers by fine tuning their prices and loyalty programmes.

That does not disturb the main thrust of a large component of global equities, where change is underpinning profit or valuations. That may require some lateral views. An example is the banking sector in India. A messy ‘demonetisation’ has driven more assets into the formal financial sector supporting the likely growth in banking for many years to come. In another vein, the improved corporate governance in Japan (and recently in South Korea) is often cited as underpinning the robust equity returns from those regions through this year.

The primary sectors of the global developed equity market that have positive structural growth drivers are technology, health care and consumer discretionary. On this measure, at a broad level, the Australian market gives a relatively poor exposure to companies that have positive long-term demand growth; a large part of the index is made up of mature, domestic-focused businesses.

Health care is one of the few areas where Australia does have some companies that are among the global leaders, such as CSL, ResMed and Cochlear, although the overall weighting in this sector is also below global benchmarks. On balance, however, the typical Australian equity portfolio or fund will be underweight the themes that are driving global equities.

Two structural themes notable through this year have been the Chinese consumer (through Australian food brands) and lithium (for electric vehicle batteries). In both cases, access is limited to a relatively small number of companies, while momentum has played a key part in lifting valuations in these sectors as they gets wider recognition. Accessing these themes is via mid or small cap funds, which if well judged, have been the source of significant attribution in the last year. We note however that the persistence of performance can be problematic if valuations are excessive, as has been the case in past years.

In summary, the pressure on companies to adapt to a period of rapid change should see the winner versus loser circle bifurcate at a greater pace than before.

While a long-time frame, the charts of the US equity markets sector weights remind us that the past is not a guide to future industry structure.

US equity markets in 1900 (left) and 2015 (right)

 

Cyclical

Valuation

Valuation remains at the core of investing. Cyclical patterns in equity (P/E ratios) and fixed income (rates and spreads) play out time and time again. Within this there are nuances as we note in these short comments.

Favourable credit conditions and low default rates in most fixed income assets play the role of preserving capital, while generating a low level of income. The risk lies in the capital fluctuations as the cycle changes pace. Fixed rate government bonds will weaken as rates rise, while changes to US tax reforms may also create challenges for high yield markets and spread to investment grade.

The fixed income product of choice for 2018 is floating rate investment grade bonds for the risk averse, and private loans for those with a higher risk appetite. The fall in business lending by the banks has been absorbed by ‘market based’ or ‘peer to peer’ private lending groups. Funds are being raised through unit trust structures with investment into direct loans. While competition for new corporate loans by these groups has driven margins lower, the low default rate continues to attract investors. The key is in a manager’s effective due diligence in elected businesses and diversifying across many loans to reduce the risk. These loans pay higher rates than in the public market as they represent companies that usually don’t have a credit rating, nor access to the bond market and in some cases bank funding. Additional premium is paid to compensate investors for the credit work required and illiquidity of the loans. Lack of pricing transparency can play both ways; valuations are difficult to determine, but for an investor this takes away mark-to-market volatility.

The real risk to a fixed income investor is default risk. Default rates are at exceptionally low level,s which has driven credit spreads tighter. Industry disruption, interest rate movements, investor appetite and structural changes such as the US tax reform are the candidates to change the pattern in defaults. Recent recovery rates are yet to be fully tested, but some express concerns that these might be lower than historic averages.

An example is the retail sector, represented in the commercial mortgaged backed market (CMBS), predominately in the US. Refinancing has been difficult for this industry, with investor concern over closures and loss of mall tenants. In 2017, these securities weakened, albeit so far contagion to the broader CMBS market has been limited.

Percent of retail real estate loans that are delinquent by metro area

 

The domestic equity market is driven by more cyclical factors than most overseas markets, with the two largest sectors – financials and resources – falling under this category. Financials, which are dependent on credit growth in the economy, have benefited from a low point in the bad debts cycle and an extended period of unbroken domestic economic growth, while there is a somewhat unhealthy dependence for many companies on the property market. Resources and mining services are also highly cyclical, although reliant upon the health of the global (rather than the domestic) economy. Depressed commodity prices typically come with a weaker $A, buffering the downside, but also limiting the upside when conditions are robust. These act as restraining factors to the aggregate valuation of the ASX 200, a point that is often lost when comparing headline P/Es.

Global equity valuations have, for most of this year, pointed to the premium the S&P 500 has enjoyed compared to other regions. The expectation was that this gap would close, yet it has persisted. Funds have commented that they have found less overvalued stocks within the US market, while noting the weight towards less attractive sectors elsewhere as a rationale for retaining US stocks.

Nonetheless, paying attention to valuation has proven to be the key to investment success. We maintain the view that balancing away from the US is still appropriate. The US weight in the index is over 50%. This means the representation in that region is likely to remain high, it’s a question of degree.

A particular feature of the current bull equity market has been the historically low level of market volatility. As commonly cited in the media, the VIX, which measures short-term expected volatility in equity markets, has remained low for an extended period of time, while actual realised volatility has also been soft. We have highlighted before, however, that the absolute level of the VIX has little predictive power in forecasting future returns of the market.

Volatility has been low primarily because investors have been comfortable with the current investment environment and have glossed over any geopolitical concerns. Global earnings growth has been quite supportive, economic growth has been synchronised around the globe, inflation has been subdued, monetary policy remains quite accommodative and central banks have been signalling their intention to markets, leaving little guess work. Equities, while on the expensive side of valuations, have been a favoured destination for investors given the low yield on fixed income.

What should be of more interest to investors is not the level of volatility, but the fact that the risks are skewed to the downside in equity markets due to the combination of above-average valuations and that much of the recent cycle has been driven by falling interest rates. A market correction and/or spike in volatility could be driven by a long list of events, including, a spike in inflation and bond yields, which may trigger a faster pace of interest rate normalisation, central bank missteps (as the transition from the unwinding of quantitative easing/emerging policy settings is untested), any number of potential geopolitical events, a credit event in China or a rapid reversal of ETF flows as momentum investors change direction.

Asset allocators, including ourselves, design portfolios around the expected volatility. We have resisted using short term data to determine volatility due to the current low level. For example, the measured rolling three-year volatility for equities is barely 10%, whereas we use longer term data of 13%. For fixed income we have added 0.5% to the long term volatility data to represent some of the risks noted in this report; not least that the index is unrepresentative of most portfolios.

There are, however, asset allocators that follow a systematic process of using recent volatility to weight asset classes. This may see a big rotation out of equities when volatility does pick up, even if the expected return remains the same. Locally, we have noted the high weight to unlisted investment such as private equity and infrastructure by the large super in reducing measured volatility.