Quarterly Market Review December 2018

In this asset allocation report we provide a brief summation to three issues:

1. Long term, big picture, impacts on asset classes, a response to the reasonable critique that investors are too reactive to short term news.

2. What would make each asset class the best pick now, with reality check and consistency in argument?

3. A gift for the year end? What would be a good proposition, why, for whom and for how long?

In the infamous parlance of ‘known knowns’ those in the economic world have barely shifted in the past decade. Debt, demographics and distribution of income remain intractable factors that are likely to be significant determinants of investment markets for years to come. The overarching conclusion is that interest rates will be lower than before through future economic cycles. In turn, this implies that investment returns are likely to be lower than past decades. This year has delivered a weak outcome, yet the rolling 3-5-year returns are within expectations.

Portfolio returns, based on our recommended allocations, (fully invested in the underlying index and assuming reinvestment of any income) are shown below.

Historic Returns and Standard Deviation (p.a. %)

 

The ‘known unknowns’ are the most fruitful debating points for a portfolio. Issues can be identified, yet the outcome is typically constructed around a range of scenarios and adapted as new knowledge comes to hand.

At a political level, the economic consequence of the current rise in ‘populist’ support is hard to predict. It has resulted in a heightened level of policy instability, which is invariably incorporated into business decision making. It is also likely to result in either a structural valuation discount and/or greater volatility. It is rational to assume there will be some form of costs imposed on business and certain segments of the household sector.  Locally, that is already evident in energy markets, probable changes to tax benefits and recent ACCC comments on digital platforms. Globally US tariffs, Brexit and changing targets on emissions are a few of the many examples.

Other issues can take a more optimistic tone, the extraordinary rapid development of now-not-so-new technologies has a long runway. In systems technology, voice recognition may parallel the ubiquitous smart phone, the auto sector is likely to be near unrecognizable within 10 years, healthcare could be transformed through immunotherapy and genomics and alternative energy is likely to dominate. There are certainly more sectors and industries where the almost unimaginable becomes normal.

A further change to investment market behaviour is expected to be the universal inclusion of ESG (environmental, social and governance) screening, sustainability and responsible investing. We have noted an avalanche of new funds proclaiming their adoption of such criteria. Not all are as good as the marketing would suggest. Pressure is likely to improve the products, both in terms of the process undertaken by the fund manager, and accountability in performance. Corporate behaviour will have to adapt accordingly. In keeping with the seasonal spirit, the current iconic example (albeit a private company) is the UK supermarket chain, Iceland, that has attracted widespread support for its marketing campaign (for those interested, view the “Rang-tan’ video clip).

To state the obvious ‘unknown unknows’ are, by definition, unpredictable. For example, geopolitical events or a large-scale cyber-attack can be discussed at length, yet the timing and outcome is almost always unpredictable.

Asset allocation, by defined indices such as the ASX200 Accumulation Index, MSCI All Country, Bloomberg Composite Bond Index or Barclays Global Aggregate Index, is imbedded in investment markets. Yet increasingly these are not reflected in the construction of a portfolio.

Many investors will skew their domestic portfolio towards income producing stocks, or alternatively to small cap for growth. To then measure the outcome based on the standard index may not be appropriate.

The sector that is likely to be most affected is fixed income where it is rare for an Australian allocation to resemble the index. This is exacerbated by the weighting towards government bonds in the index compared to the growth in private debt markets, RMBS, leveraged loans and a raft of other options, not least of which are listed hybrid securities that are not represented.

The general comments on asset classes are therefore not necessarily reflective of the ultimate investment but do give context on the factors that influence that decision. Similarly, we note that measuring relative performance is becoming increasingly challenging.  Again, application of ESG considerations will mean a deviation from the index while the inconsistency in methodologies by a variety of providers of ESG indices is also notable.

Global Equities

What do ‘lower returns’ really mean, will there be more losers versus winners, or lower for all? Our assessment is that it will be more of the former. The reality is that monetary policy created a large tailwind for investment assets; with that now turning to a headwind, any poorly structured company is likely to gap down significantly. The Bank of International Settlements (BIS) has released a report on ‘the rise of zombie firms’, defining zombie as those that cannot cover the debt servicing cost from current profit over an extended period (a broad measure) as well as inferring from a stock valuation that low profitability is likely to persist (a narrow measure).

Years of lower rates and tolerant lending standards have resulted in anything between 6-12% of firms being defined as unviable. In our view, these will fall by the wayside in coming years as liquidity dries up and the revenue accrue to others creating greater winners from the losers.

 

Secondly, as flows into equities become less prevalent, stock selection will matter more and create dispersion. The use of EFTs as a generic investment tool may result in periodic shorter-term correlations, but these will fade once the trade is over.

In a broad sense we support the view that the relative outperformance of the S&P500, will persist notwithstanding the higher valuations than elsewhere. The structure of the index, weighted towards higher growth sectors and profiled stocks that retain investor interest, is unlikely to be challenged.

We believe the best value is in emerging markets. The combination of politics, tariffs, currency and (until recently) higher oil prices weighed heavily against many sub-indices in this diverse index. Some of these issues are now fading, the earnings growth, while lower than before, is still attractive and the relative valuations represent an iconic entry point. The PE ratio is in line with that of past recessions or crisis, the price/book at 1.57X is below the 1.76X average, the dividend yield is 3% on average and the flows have been negative until the past month.

Australian Equities

Over the last decade, the Australian equity market has lagged the earnings recovery experienced by many other regions. There are several reasons for this outcome. The Australian economy fared better through the downturn, leaving less scope in the normalisation of profits, The ASX has a large weighting in resources companies (where the demand remained high for a few more years), and, despite the first point, ASX companies have raised a high level of equity to strengthen balance sheets and substitute for high payout ratios.

The character of the domestic market, however, is a further reason and just as important in terms of the longer-term outlook. Many of the ASX’s largest listed companies are mature and exposed to structurally low organic growth. ASX weightings in high growth sectors such as IT remain low. It has been the cyclical sectors (resources and those linked to the commodity markets) that have provided the brief periods of superior domestic earnings growth relative to the rest of the world.

Additionally, a cloud of regulation has captured a range of sectors, including the banks and financial services, telcos, miners and the energy retailers. Meanwhile, investor preference for the maximisation of income has led to higher payout ratios and lower expansionary capex plans, which has even seen participation from the resources sector.

The medium-term earnings outlook is not too dissimilar. Long term interest rates have edged up but a normalisation in the domestic cash rate is expected to be slow, maintaining reliance on high dividend payments. Dividends should continue to comprise a large part of the overall return from domestic equities, however the challenges in several large sectors (such as the banks) will mean that dividend growth may be more limited. Despite the valuation impact from a higher rate environment, growth stocks are likely to retain a healthy premium to the broader market based on their relative scarcity.

From the perspective of the Australian equities asset class, the most appealing trait is the high dividend yield on offer (the forward yield on the market is 5.1%, or approximately 6.6% on a grossed up basis including franking credits). Compared to other asset classes, the yield is comparatively high and is even more so on an after-tax basis.

An obvious question is how safe is the yield? Barring an unforeseen event such as a domestic recession, we believe that the yield on a diversified Australian equity portfolio is quite secure for the following reasons.

– Dividends have shown to be much more stable over time in comparison with the volatility of underlying earnings, as cutting dividends is generally a ‘last resort’ situation for companies.

– Capital allocation policies across the market remain tilted towards higher shareholder returns despite a pick up in capex.

– Earnings growth is low and payout ratios are quite high, leading to the conclusion that dividend growth will be low, however balance sheets are in good shape and there is little evidence that sectors of the market are paying excessively high dividends that are unsustainable.

Finally, as we noted in a recent publication, it is worth highlighting the prospect of additional capital returns over and above that of ordinary dividends over the next 12 months as companies distribute franking credits ahead of a possible change in franking credit policy should the Labor Party win next year’s federal election. This has already commenced in recent months (resulting in large share buybacks from Rio Tinto and BHP), although other companies may follow suit in the new year.

REITs

Expectations for REITs were subdued heading into 2018 in the face of interest rate movements at the Fed. In the short-term, REITs generally react negatively to rate rises. Yet REITs give positive returns during longer periods of rising rates reflecting the associated economic growth. Aside from this, REITs are now better positioned for any further rises due to lower levels of debt. An increase in merger and acquisition activity has also assisted the uptick in REITs’ performance in the latter part of the year as a result of the share price discount to the value of the properties.

Relative performance – FTSE EPRA/NAREIT Developed Index / MSCI World Index

 

Given the view that economic momentum will likely be slower in 2019, the benefit of cap rate compression may cease. From here, fundamental demand within sectors and regions will now be the primary driver of performance rather than rates and valuations. As a result, there will be de-synchronization in the performance between different sectors and regions. Industrial REITs have been one of the strongest performing sectors due to the increase in demand from the e-commerce market. The offset is a weak retail component, itself a high weight in the Australian REIT index.

We prefer a small allocation to global REITs to diversify from the likely exposure to Australian assets. However, if the franking credit change eventuates select local REITs may receive support given their relative yield will be more attractive.

Fixed Interest

Australian fixed income may finish 2018 as the best performing asset class based on the index. This result is akin to Steven Bradbury’s Winter Olympic win in which the other asset classes fell late in the year. Yields on the long end of the curve finished lower even though short rates (BBSW) set higher. Looking to 2019, the RBA is unlikely to move rates in either direction. This removes the opportunity to buy at higher yields and ensures floaters will continue to reset off the low levels. If growth and inflation slow, fixed rate bonds may get a kicker, but the benefit is limited given the current rates and flatness of the curve. Short dated yields will be determined by the cash rate assuming no cuts given the low base. Fiscal, rather than monetary policy, will be the likely tool used if stimulatory measures are required given the upcoming budget surplus. Our view is that long duration domestic government bonds look unattractive unless a recession is imminent.

Adding long duration strategies from offshore markets had appeal a month ago when US rates peaked for the year. The subsequent retreat suggests that markets are far less certain about the growth outlook. The Fed will probably pause next year, but the balance sheet unwind and increased treasury supply will continue to drive yields, with 10 year rates expected to move back above 3%. The narrative points towards a ceiling of mid 3% over the next year as any large upward move will be met with distaste by equities. These levels would be one tactical signal to add duration.

Credit spreads have widened improving the attractiveness of domestic investment grade bonds. Floating rate high quality corporates and financials seem an adequate safe place to invest, with returns expected to be in the 3.5-4% range. Hybrids offer decent income, subject to maintenance of franking credits and APRA’s plans for banks to raise more capital above hybrids on the capital structure. The premium pick up for longer hybrid maturities is tight, offering value in short dated maturities that mitigate some of these risks (out to 3 years, noting limited supply). Margins on highly rated domestic Residential mortgage-backed securities (RMBS) have widened, a result of supply, falling house prices and tighter lending standards, but the structures remain sound and pools with seasoned mortgages offer value. Disintermediation of the banks is expected to continue, opening opportunities to invest in private debt. On offer are higher yields, higher risk and considerable credit due diligence.

Offshore credit markets have pushed spreads wider as higher funding costs meet elevated debt levels. Nevertheless, a recent Fed study showed US debt servicing ratios are at the lower end of historical averages and coverage ratios are manageable even as rates go above 3%. Over 60% of corporate debt is from sub Investment Grade (IG) companies, which is where the risk lies. Offshore IG credit has weakened in 2018, and while heightened volatility is likely next year, valuations now look reasonable. High yield (below IG) spreads are at their highest in 18 months, reflective of weaker balance sheets. Opportunities may come through to cherry pick companies that have unnecessarily sold off in line with the market.

Global investment grade corporate bond issuance by rating bands

 

Emerging Markets are another example of bonds weakening without consideration of the economic metrics of individual countries, many of which have undergone fiscal reform reining in inflation and building reserves. The currency falls and bond spreads support valuations in the region, with improved returns a prospect assuming the Fed pauses and trade war tensions ease.  The corporate sector is in a relatively strong balance sheet position and does not appear at risk of rising stress.

Naturally we support all the funds on our recommended list, but they are not always suitable to all conditions and nor for all investors. Theoptions  below are those that we recommend adding to at present.

Global Equities

While we acknowledge that it is easier to use an ETF in Emerging Markets as a visible lower cost short term option, we believe the diversity of countries and stocks leans towards an active manager for longer term investing. We recommend the Somerset Dividend Growth EM fund for more conservative portfolios, and will add the RWC Emerging Markets fund in the new year for higher growth portfolios.

Regarding ETFs, we recommend the Vanguard FTSE Emerging Markets ETF (VGE), as it offers a broader exposure to emerging market equities with less of a bias towards large cap stocks and has a lower managed expense ratio (MER) compared to its peers. For those that prefer to focus on Asia we recommend iShares Asia 50 ETF (IAA). This ETF consists of the largest 50 companies from China, Hong Kong, South Korea, Singapore and Taiwan. The top 5 holdings make up over 40% of the fund and there is sector bias towards tech and financials, accounting for 60%.

The specific US thematic is best accessed through an ETF, the S&P500 gives the broadly based options and can be hedged as there is some risk the USD will weaken in 2019, while the Nasdaq is a narrower and higher risk/return approach.

The hedged version of the S&P500 can be accessed through iShares S&P 500 AUD Hedged ETF (IHVV) and the Nasdaq can be accessed through BetaShares NASDAQ 100 ETF (NDQ).

Overweight growth themes can be via the combination of active funds, WCM and MFS on a long-term basis. These distinctive funds will rarely overlap.

Australian Equities

Despite providing better capital protection through this recent selloff, the miners still have good prospects in the year ahead considering 1) outside of oil, commodity prices have generally held up well, while importantly for the sector’s profitability, bulk commodity prices remain quite high; 2) companies are committed to returning excess capital to shareholders; 3) some weakness in global growth could prompt stimulus from China, which would be supportive; and 4) earnings upside still resides if spot prices are assumed for the rest of the financial year and valuations are below average.

The resources sector can be accessed through the SPDR® S&P/ASX 200 Resources ETF (OZR), which replicates the performance of the ASX 200 Resources Index with BHP, Rio Tinto and Woodside Petroleum accounting for over 50% of the index. The VanEck Vectors Australian Resources ETF (MVR) follows an equal weighted, rules-based index. MVR is an alternative for those investors who may want to have less of an exposure to BHP and RIO and a higher weight to smaller companies.

Fixed Interest

For conservative mandates, short duration investment grade bonds offer a safe asset at reasonable returns, as do pools of secured private loans such as the Metrics Credit Diversified Loan Fund. Value can be found in Emerging Markets as they bottom off historic lows, where we recommend the Legg Mason Brandywine GOFI Fund. Private debt opportunities will continue to present and there will be winners and losers. In real estate, construction finance appears vulnerable given tighter lending standards and falling house prices, whereas warehouse mortgage facilities with strong originators and short loan terms may fair better.