A quick look back
Investment portfolios weighted to our recommended asset classes have met expectations over a three year rolling period to end December 2015. The data is based on the underlying index and does not include any return in excess of the index or franking benefits from Australian assets. As we have previously noted, it represents total returns, which assumes any distributions are promptly reinvested in the asset class.
This does, however, disguise the modest returns of the past 12 months and the skewed contribution from global equities, particularly unhedged holdings.
For some time we have guided investors towards anticipating a lower contribution from growth assets, while the yield in fixed income assets is also below historic levels. A new challenge is now likely to come from the rise in volatility as measured by the standard deviation of returns.
The chart shows the rolling annual return and volatility of the equity asset class (MSCI All Country index) in local currency terms. Periods of high returns are clearly associated with low volatility. Good, or improving, returns tend to draw in investor flows which dampen asset class volatility.
MSCI ACWI (Local Currency): 1 Year Rolling Volatility and Returns
The current pattern would suggest equity returns could deteriorate, though the level of volatility appears to be settling down for the moment. The point is more that investors directly experience these two measures – returns and volatility – whereas the other parameters, such as valuation or earnings expectations, are less readily observable.
Fixed income, based on the hedged Barclays Global Aggregate as the most representative index, shows similar characteristics. Once returns improve, the volatility typically drops sharply. In practice, it’s a vote on the direction of economic growth and views on corporate risk.
Barclays Global Aggregate: 1 Year Rolling Volatility and Returns
In the near term, we see the fixed income sector as the key to providing evidence on the next move for equities. If fixed income assets, specifically credit, regain investor confidence, equity returns are much more likely to stabilise.
Reassessing our Asset Allocation
In reassessing our asset allocation, we have focused on the defensive aspects that can be achieved from changing the tactical mix to act as potential countervailing weights. We recognise that many investment assets are highly correlated in times of stress. Historically, in the event of a major financial crisis, cash and selected longer dated government bonds have been the cushion. Today, the potential return from such assets is already low. Further, unless there is a severe downturn, government bonds may instead fall in value. Therefore, we believe that while holdings in cash and bonds are warranted, the allocation of such positions are there to dampen volatility rather than expectations of high returns.
In summary, the changes we recommend are:
• Reduce the Australian equity weight while allocating to unhedged global equities, as currency should dampen the volatility;
• Increased the cash weight; and
• Rebalance fixed income to domestic relative to global. This is due to the lower volatility strategies we recommend in the domestic market. Global fixed income remains an important differentiator as the options are far greater and the determinants of rates can be very different.
• Australian equities continue to offer relatively high income, but with low potential for dividend growth the weighting is moderated in preference for domestic fixed income assets; and
• We have adjusted our strategic mix within fixed income to rebalance between domestic and global assets. Given the fall in Australian interest rates compared to global, the bias to local fixed income is less pronounced.
• We recommend reducing the Australian equity weight further and increasing the unhedged global allocation. Earnings growth is highly concentrated in the Australian market and there are better options in other regions; and
• Previously, we had reduced our cash weight, but recommend in the current investment environment a slightly higher level of cash is available for opportunities as appropriate.
In summary, we are at or below our strategic weight in equities across the portfolios. Our fixed income allocations are specifically designed with respect to the purpose of the portfolio and, therefore, the tactical weight in capital preservation is lower than strategic in preference to cash and alternative assets. For income investors, we have reallocated from Australian equities to fixed income to capture distributions while reducing risk.
The Australian equity market has fallen almost 20% since April last year, leading some observers to the conclusion that the market now represents good value. Has the decline in equities been warranted? If we look at the two drivers of the market – earnings and how much investors are prepared to pay for these earnings – it could reasonably be concluded that the selloff has been fair.
As we highlighted in our 2015 year end summary, the market has experienced a decline in forward earnings over the last 12 months of around 8%. Whilst it is true that this has largely been driven by an almost halving in forecast earnings for the resources sector, other sectors have also had challenges (for instance, the banks with higher capital requirements) and it remains unlikely that we will see a rebound in commodity prices and subsequent recovery in earnings for resources companies. The collapse in the mining sector has also brought to the surface a number of other risks, most notably with the banks and the associated potential bad loan losses that may be realised in coming reporting periods.
The decline in the forward P/E of the market – or how much investors are prepared to pay for earnings – is thus responsible for slightly more than half of the overall fall in the equity market. The P/E though, has now moved from a position that was above its historical average to one that is now more in line. This may not yet represent value given an overall weak earnings outlook, although is balanced against low interest rates.
The Australian market has rotated through various themes over the last few years that have driven returns. The two most obvious of these has been the flight to high yield sectors (such as telecoms (particularly Telstra), utilities, infrastructure and the major banks) and the tailwind of a lower AUD for many companies. A third theme which has had less of an influence on overall market returns (given a relatively narrow sector) has been the strong housing cycle, with several companies benefiting from these conditions.
We believe that there are now less legs in the yield and lower AUD themes. The former, which was the primary driver of market returns from mid-2012 to early last year, resulted in stretched valuations for traditional yield sectors of the market and a convergence of yields across stocks. Similarly for the AUD, the dollar has now steadily depreciated against the USD for four years, boosting the profits of companies with overseas earnings, however we believe it is unlikely that this trend will continue much further.
Other themes to emerge typically have a low representation in ASX indices. These include the strength in the tourism industry following the fall in the AUD (beneficiaries include Sydney Airport, Star Entertainment/Crown, Mantra Group and Ardent Leisure) and stocks that are leveraged to the Chinese consumer (such as Blackmores, Bellamy’s and A2 Milk). This latter group has enjoyed a wonderful run in the last 12 months and would appear to be highly susceptible to a change in momentum.
As the various themes have matured and with the market in a relatively low-growth environment, this in turn has led to a greater level of P/E dispersion across ASX-listed stocks. Put another way, investors have placed a greater premium on companies that are expected to exhibit earnings growth, leaving little room for earnings disappointment in the upcoming reporting season. The chart below illustrates the bands of P/Es of ASX 200 stocks (several infrastructure and mining companies, whereby a P/E is not an appropriate valuation measure, have been removed from the analysis). Just under a quarter of ASX 200 stocks now have a P/E greater than 20X compared with 12% just two years ago.
P/E Dispersion in Australian Equities
At this stage in the cycle, the dividend yield of the market is one of the more compelling reasons to remain invested in Australian equities. Payout ratios are high and there is the prospect of dividend cuts, with companies given little room to move if earnings deteriorate. The apparent yield is currently artificially inflated by the recent dividend history of resources stocks, which will inevitably be reduced over the next 12 months. While other sectors look to be relatively safe in terms of maintaining dividend levels, the banks (which represent over a quarter of the large cap index) have recently been attracting more attention in terms of the sustainability of their dividend payments.
With this in mind, we have made a slight downward adjustment to our recommended weightings in Australian equities. With an element of dividend uncertainty in certain sectors of the market, for investors who have an income priority, we believe that the distributions from hybrid securities at this point in time are safer in terms of distribution security.
Investing to Achieve Desired Outcome
We encourage clients to assess their desired outcome when allocating capital to Australian equities. For a core, large-cap equity exposure, we utilise the expertise of two different SMA Australian equity managers, Investors Mutual and Martin Currie (formerly known as Legg Mason). Alternatively, we provide a model portfolio for investors who wish to exercise a greater degree of choice with their direct holdings. If investors have adequate capital, we also recommend complementing these large cap holdings with a small cap manager. We discuss our preferred funds below.
Investors Mutual (IM) are most appropriate for investors who have a capital preservation focus. IM is a value manager and their portfolios will focus on quality companies with a defensive bias. Portfolios managed by IM will tend to perform well in a relative sense when markets are falling, however may underperform when momentum is driving certain sectors or stocks and valuations become stretched.
Martin Currie (MC) run a portfolio with a dividend focus and thus are appropriate for investors who are targeting income generation. The MC portfolio is more benchmark-unaware than IM. Hence, they will have a lower allocation to ASX 20 stocks than is typical for an Australian equity manager. MC seeks to invest in stocks that have a sustainable dividend policy and thus investors in this portfolio should be beneficiaries of lower volatility in their dividends.
Investors who may wish to exercise a higher level of flexibility with their portfolios can instead choose to blend either of the SMA portfolios with a list of direct stocks, or, alternatively, be guided by the model Australian equity portfolios that we publish on a monthly basis. The intention of the model portfolios is to provide a relatively style-neutral balance of stocks with an adequate level of active share (that is, differentiation from the benchmark ASX 200). Given the particular style-biases of Investors Mutual and Martin Currie, this approach would be more suitable for an investor with a capital growth focus.
In a period whereby equity market returns have been rather challenged, each of the Investors Mutual SMA, Martin Currie SMA and Escala guided model portfolios have produced solid returns over the last 12 month period, outperforming the ASX 200 Index. The defensive characteristics of the Investors Mutual and Martin Currie portfolios have held them in good stead, with low exposure to resources, the key sector which has held back the market’s returns. Martin Currie has done particularly well with a more equal-weighted portfolio than most of its peers. This has led to a low weighting in ASX 20 stocks which have experienced a difficult 12 month period.
We recently published a piece on our preferred Australian equity small cap managers and believe that these can complement an existing large cap portfolio well. Small cap equities further diversify an Australian share portfolio, provide a broader exposure to different sectors compared with the ASX 200 and are typically under-researched compared with their large-cap counterparts, providing more opportunities for fund managers to discover undervalued companies through fundamental analysis.
For investors whose primary objective is capital growth, we would recommend a higher allocation to small cap equities. As we have noted recently, there are a limited number of large cap stocks in the market that are expected to deliver attractive earnings growth in the medium term. This provides further reason to invest in small caps, which typically have the capacity to realise a higher level of growth compared with blue chip stocks.
The two managers that we recommend are Karara Small Companies Fund and Regal Small Companies Fund. Karara is a well-established manager that has a solid long-term track performance track record. We believe that the fund is suitable as a core small cap holding and recommend the fund for clients with a preference toward capital preservation or income.
Regal, on the other hand, is a smaller fund that is hence less constrained by liquidity concerns with its individual investments, allowing the fund manager to be more nimble and to have a higher allocation to stocks at the smaller end of the universe. The manager also employs a degree of short selling, drawing on its experience with its absolute return funds. With these characteristics, we believe that the fund is appropriate for investors who are targeting capital growth and can tolerate a higher level of volatility in their returns.
As we will address later in this report, the causes of spread widening in credit emerged from the risks in energy high yield, resulting in a re-think of the use of credit in recent years. In the US, a significant amount of debt raised by the corporate sector has gone into buybacks and M&A activity, neither of which create cash flow to service the debt.
Momentum and earnings revision have been key determinants of short term equity performance in recent times. Both these signals are exhibiting far less support than before.
Equities do need earnings growth. It may be obvious, yet over the past few years equity prices have leveraged the earnings momentum and valuations are therefore at or above average. The data can be distorted by selected sectors (for example the energy stocks, where earnings are cyclically weak and therefore stocks can be at high P/Es). Putting these aside, there is some discomfort with the implied 2017 growth forecasts for some other sectors which are dependent on economic activity. Downgrading these estimates may weigh on the index through this year.
Given these bearish comments, investors might well question why we recommend maintaining global equity exposure. The sector correlations, as shown below, demonstrate that investors need not be beholden to the market overall.
Five Year MSCI AWCI Sector Correlation
The recent sell off has addressed some of the overvaluation that has troubled market participants. The influence of index funds, volatility traders and hedge fund managers frequently result in an indiscriminate fall in all stocks rather than a differentiation based on the fundamental outlook. The other notable feature is that companies increasingly experience extreme movements around profit releases or revisions. Both these circumstances can be used by a fund manager to extract returns above the index.
Quantitative easing has been viewed as a core support for investment assets in recent years. Though the US is now on a different path, the liquidity from the ECB, Japan and, potentially China, goes some way to compensate for the lower level of support out of the US.
On a regional basis, the consensus view is that the US is likely to lag other regions, mostly due to valuation. As the S&P 500 still represents approximately 50% of the global index, the sector P/Es noted above are heavily influenced by stocks in that region.
The favoured areas of investment in the US are concentrated in their now iconic global IT and consumer companies, selected stocks centered on domestic consumption and late-cycle companies, such as financials.
While European stocks are trading at around historic averages, their earnings trail the current improving economic momentum. The weighted average dividend yield of 3.3% (versus 2.1% in the US) is another positive factor, especially in light of the low yield on bonds. The combination of a supportive central bank and a significant recovery in household income and wealth is partially offset by the uncertain political climate and legacy of unreconstructed banking institutions.
The Japanese market has been the best performer over the past year amongst the major regional indexes. This has less to do with the local economy, but is being driven by structural changes in corporations under pressure from the government and shareholders. The extent of monetary accommodation and required change to asset allocation in the Japanese institutional investment sector has also added to the outcome. These issues have not yet run their course and with valuations below historic average the potential upside remains in place.
We therefore look to fund managers to extract returns above the MSCI World Index. Global dividend yields are approximately 3% and we seek a combination of index and outperformance to achieve mid-single digit returns.
One region that requires a top down view is Emerging Markets and specifically Asia. For some time, the investment in the region has been centred on the middle class consumer. This very large cohort is expanding its goods and services consumption and, as yet, the trend remains well in place. On the other hand, the primary and basic manufacturing sectors have come under pressure due to slowing demand for products such as steel and cement. Excess production, government interference and high debt have been symptomatic of these industries. In the middle of these two segments is the heartland of Asia, a light industry manufacturing sector traditionally focused on consumption goods for the developed world.
It is here that the impact of currency can play an important role. China surprised many with a devaluation late last year. Most believe it needs to devalue further, as the Yuan had risen against its trade weighted index. In addition, the cost of protecting its exchange rate has resulted in a large capital outflow.
The equity markets in Asia/Pac are, on average, trading below their historic value averaging at 11X forward P/E, though with a wide dispersion. It is self-evident that the risks are currently accentuated, however the upside is significant given both the valuation and earnings potential from consumer oriented companies. Our recommendation to hold emerging market allocations is based on a three to five year view.
Recommended Funds with Distinctive Styles
We recommend the MFS Global Funds as a core holding. There are two options: a concentrated portfolio with very low turnover, which we believe suits longer term capital growth oriented investors given the likely level of volatility (this is available as a hedged or unhedged investment); and the global equity fund, which has a broader spread of stocks, lower volatility and is available as a fully hedged option suitable for capital preservation. Given the relatively small allocation to global equities in income portfolios, we recommend the concentrated fund.
Magellan Global Fund also offers both hedged and unhedged options. The fund has recently shown its willingness to move to cash which has helped to limit its downside in the current market. This approach, along with the value focus in stock selection, positions the fund well for defensive portfolios.
Platinum International Fund has had a variable performance record in recent times. The manager has taken a substantial skew away from the US market and towards Asia. It also has limited its net exposure to the market through shorts. We have carefully considered our support for this strategy. Our conclusion is that the fund is so different to mainstream core managers it represents an interesting diversifier to the more traditional approaches. We have therefore reduced our weight to Platinum but continue to recommend the fund as part of a portfolio.
The WCM Quality Global Growth portfolio (offered as an SMA) is a high growth strategy with a very good track record in recent times. The growth cycle, however, is maturing and the expected returns are likely to level off. For longer term portfolios it remains the core. For investors who do not wish to use an SMA, the Zurich Global Growth Fund is an option, albeit without the same levels of outperformance due to a larger number of stocks.
The RARE Infrastructure Value Fund is a somewhat difficult fund to judge. The premise is that it invests in infrastructure and similar equities but with an unlisted view on the valuation and time frame. The fund can therefore show unusual patterns of under or out performance. The intent is to replicate the holdings of large industry super funds.
Aberdeen Emerging Opportunities has not escaped the nature of these markets. At this stage we would not add further to existing holdings in the fund, but we do believe that in the longer term a meaningful exposure to emerging markets is important.
Macquarie Asian New Stars had a stellar 2015, yet this year has been caught up in the confluence of the China equity and currency markets. The fund invests in mid-cap stocks which service the growth in middle income consumers in the region. For those with a longer term growth orientation, the fund should be an important holding.
The influences on fixed income in 2016 are dominated by the same themes that evolved at the end of 2015 – central bank rate actions, global growth concerns and the energy sector. Within fixed income, each sector will react differently and will be affected adversely or positively by these outcomes. Obtaining the right tactical mix of government bonds and corporate credit will remain paramount to smoothing out the volatility that is prevalent in the markets and ensuring a positive return from fixed income allocations.
Government Bond and Longer Duration Strategies
Despite interest rates being at historic lows and the FOMC having commenced its normalisation in monetary policy, the volatility and positive correlation between equities and credit products in 2015 strengthened the argument for a continued allocation to long duration strategies. While one might argue that rates can’t go any lower and the global rate cycle will need to turn now that the US is raising rates (which will result in a fall in the price of long government bonds), we believe recent conditions highlight the importance of having a component that will support a portfolio when risk assets turn down. Fixed rate government bonds can be considered a cheap insurance for these times.
That said, we favour domestic government bonds over global at this time. We do expect that ACGB (Australian Commonwealth Government bond) yields may eventually push higher as rates rise in the US, but this will not be significant enough to cause capital deterioration. Our yields will be anchored by the RBA, which still looks unlikely to raise rates anytime soon (the market is pricing in a further rate cut by mid-2016). However, the timing and positioning of an allocation is challenging with the recent compression in yields in the short-end and an easing bias priced back into our curve. Fund managers in this space need to be opportunistic in their timing and be prepared to seek out value in the curve when they present.
For access to these strategies we use the Henderson Australian Fixed Interest fund which is a long duration fund with a high allocation to government bonds. In addition, we have recently added Jamieson Coote Bond Fund which exclusively invests in government bonds, but is also very active in trading, looking to add alpha through curve positioning and momentum trades.
US treasuries and German bonds have become the safe haven asset class when equities sell off, but we remain cautious given the Fed are raising rates and European bonds don’t offer a meaningful return. However, we are comfortable in our recommendation of the Franklin Templeton Global Aggregate Bond Fund which has a bias towards sovereign debt and seeks out value across the globe, not just in the US and Germany. They have a proven track record of performance and are a traditional bond fund that should protect portfolios when equities sell off.
Credit Centric Funds
Allocating to credit products is not straight forward either, with the starting decision being to determine whether to buy long dated fixed rate credit (long duration), or strip out the interest rate risk and buy short duration credit products (for example, floating rate notes). We recommend doing both.
Credit spreads and interest rates (as represented by government bonds or swap rates) are often negatively correlated, so an adverse movement in the credit spread often means a positive move for interest rates. Depending on the issuer and the size of the moves, this often results in somewhat stable pricing of the underlying securities as these two factors can offset, or partially offset each other. The chart below is a good example of this relationship. It depicts the movement in credit spreads (using the AUD iTraxx index) and interest rate swaps over the month of January this year. Fixed rate corporate bonds are priced off both the movements in credit spreads and interest rate swaps.
Relationship Between Credit Spreads and Interest Rate Swaps
Australian Short Duration Credit
As we recommend an allocation to longer duration Australian government bonds and are therefore comfortable keeping the local allocation to credit biased to short duration. The benefits include being able to tactically dial up and down the duration/credit mix, as well as diversifying the fund manager risk. To access this strategy, we use the Kapstream Absolute Return Income Fund. This is a short duration credit fund that invests mostly in investment grade credit with a focus on preserving capital and providing liquidity.
Global Opportunistic Credit
For our offshore allocation, we recommend the use of longer duration credit funds as these fund managers are better placed to make decisions on the duration overlay that best protects their credit portfolios. This is the case for our global funds Legg Mason Brandywine Global Opportunities Fixed Interest Fund and the JPM Global Strategic Bond Fund.
In terms of sector allocation within credit, investment grade offers better value now than it did in 2015 given recent spread widening. Despite the fact that company earnings are weak, capital should be preserved as balance sheets remain strong and debt levels manageable.
Nonetheless, we have revised down our allocation. The current interest rate environment suggests that returns are expected to remain low for these funds throughout 2016, and will most likely be only marginally higher than term deposits. Clients therefore should be mindful of the fee structures when assessing investment options between these funds and term deposits
Higher Yield Assets and Satellite Funds
Assessing and recommending risk assets in fixed income has never been more challenging. The main sectors include emerging markets, non-investment grade credit (high yield), and bank hybrid and subordinated debt.
The emerging market sector suffered underperformance in 2015 and has already had a rocky start to 2016. There is no doubt that we need to remain cautious as some countries in this sector will increasingly find it harder to finance their debt as their currencies weaken in response to low oil prices, contagion from China, and Fed rate rises. While we believe that the worst may be over as valuations are at an all-time low, we think it prudent to reduce exposure for low capital volatility portfolios. Further, the positive correlation between emerging market debt and equities implies caution at a time of uncertainty. The Legg Mason Brandywine Fund has the highest exposure to emerging markets.
For investors prepared to tolerate some volatility in order to increase returns, the JPM Global Strategic Bond Fund (which invests ~35% of their portfolio into the US and European high yield sectors) is our recommended option.
The end of 2015 proved a difficult time for US high yield. Spreads widened considerably due to the weight in the energy sector. However, given this shift in pricing, the market now looks more attractive and, with prudent asset selection, we think decent returns can follow. JPM only invests in the higher rated part of this sector, avoiding CCC rated issuers and most energy-related securities, offering a diluted way to gain some exposure to this part of fixed income.
Domestic Listed Hybrid and Subordinated Debt
These securities represent the most reasonable path for private investors to gain direct access to fixed income. It became evident throughout 2015 that some securities were priced incorrectly due to the inherent risk of a non-call event, non-viability triggers, capital triggers and the growing supply.
Further, while large equity raisings by the banks should have been favourable towards bank hybrids, as they now have more subordination, the opposite held true. Investors switched out of hybrids to fund the new issues and prices fell throughout the year as the market increased the spread premium across all securities.
Given this adjustment, we believe the potential returns now are attractive and we have increased our allocations to this sector. We expect that the banks will call any securities as they need to satisfy future funding requirements and keep their reputation intact. In particular, we recommend a diversified portfolio of bank hybrid and subordinated debt securities, with maturities in short dated securities and out to the middle part of the curve. Longer dated securities offer little risk reward for the increased volatility.
As volatility in the riskier parts of fixed income has picked up and with returns quite lackluster in the safer sectors, we have increased our allocation to term deposits for 2016 (for income and capital preservation clients only). It offers capital preservation, certainty of income and no mark to market risk. However, we are balancing this against reduced liquidity capabilities (difficulties around breaking the deposit) and a slightly lower expected return.