Quarterly Market Review January 2017

Our cautious stance in 2016 proved unwarranted as fixed income markets held onto early returns, while equities rallied into the year end. The momentum into 2017 is likely to be sustained, though pullbacks are likely given the fluidity in policy. The maturity of the investment cycle and valuation also suggests this is not a time to take on more risk.

What is more clear is that the long-awaited rise in interest rates will play its way out and we do not discount a change in approach from central banks outside the US. Low rates are no longer proving productive and data suggests economic activity is stable enough to reduce the level of monetary support.

The key economic influence on this year’s investment markets is expected to be inflation. Inflation is not at troublesome levels, rather it is that the rate of the increase that is relatively pronounced. In this report, we discuss this implication across asset classes.

Equity valuations are higher than the historic average and recognition must be given to the impact of higher rates through the risk premium. This makes better than forecast earnings and valuation critical for stock selection rather than longer term growth.

The fixed income sector will be challenged by rising rates, yet fund managers can point to selected opportunities within the asset class that support an adequate level of return. As bond yields rise, the case for their inclusion will improve, particularly to buffer against any deteriorating economic fundamentals or unexpected events.

Australian Equities: Neutral weighting. An improving earnings outlook in sectors such as resources is balanced with above-average valuations. We recommend a higher allocation for income investors, rotating from more expensive hybrid securities. Lower weight for growth portfolios due to high valuations for growth stocks.

Global Equities: Neutral to overweight. Balance between growth and value oriented strategies. Growth portfolios include specific Japan tilt and maintain emerging market exposure due to attractive valuation.  Modest tilt to unhedged due to lower volatility as exchange rates have proven to be a valuable buffer.

Fixed income: Underweight, maintain short duration. Bonds fulfil a role as a cover for unexpected events or economic deterioration. Adapting timing of investment to periodic rise in yields is likely to be productive. Riskier end of the asset class offers good nominal returns.

Alternatives: Macro strategies may come back into favour as correlations change. A case by case assessment of vulnerability to category dynamics.

Asset Allocation

Expected Index Return (Excluding Alpha and Franking)

Source: Bloomberg, Escala Partners

Expected Return Including Alpha and Franking

Source: Bloomberg, Escala Partners

There is a universal view that a new set of circumstances will influence investment markets into 2017 compared to the years post the financial crisis. From the substantial monetary intervention designed to, at first, support regional financial institutions and later, to induce demand-driven inflation, the agenda has turned to the long-awaited evidence that economic growth in the developed world is recovering. The major influence has been consumer spending, especially in residential property; itself clearly a beneficiary of low interest rates. Alongside investment markets, this has contributed to the ‘wealth effect’ where perceived household financial conditions encourage spending.

Amongst the key trends are employment levels which have been rising for some time, though wage rates remained static. Global manufacturing indexes have also picked up into the end of 2016. These have yet to prove sustainable, though corporate profitability does support investment spending.

The growing evidence that inflation rates will pick up through 2017 is arguably the most compelling theme in investment markets determining interest rates and leadership in equity sectors. Not only do we annualise against the low point in the oil price (US$26) in February 2016, but hard commodity prices are substantially higher than a year ago, and already evident in producer price indexes across the world. More importantly, wage growth has come through in the US. With political rhetoric high across the developed world, a case can be made that income support (wages and or indirect payments) is likely to be forthcoming.

Notwithstanding these positive developments, it remains unlikely global growth will be much more than moderate. The combination of high aggregate debt levels (government, corporate and household), demographics and weak productivity point to the persistence of lower growth than compared to past decades. Much attention is being paid to the US, ignoring the predominant contribution required from China and other emerging economies, where the trends are mixed.

Consensus is also factoring in a modest slowdown in Europe amongst political uncertainty, a lower contribution from Germany due to reduced migrant spending and the rise in energy prices. However, baring the election issues and meaningful disruption to global trade, we believe there is upside to the expected growth for Europe based on the indicators into the end of 2016.

The onus of growth dependence on the emerging world looks riskier than it is. Clearly, China is the predominant influence. The government has been priming activity to sustain its somewhat unreasonable growth expectations. While there are many moving parts, the central government appears to be aiming for stability this year, given a change in leadership across the Politburo, along with possible tension in its relationship with the US.

There has been much comment on the rise in corporate debt in China. While it is high, the bulk (estimated to be circa 70%) relates to State Owned Enterprises (SOE) and converting this in some form to central government debt may be the longer-term outcome given that the lending banks are mostly state controlled. China’s recent moves to restructure basic industries (steel, cement, etc.) should lift their profitability.

Australian economic growth presents as a mixed bag. The impact of higher commodity prices will support the terms of trade and is estimated to add about 1% or more to GDP by mid-year. On the other hand, residential building has been a big factor in the past two years and based on recent approvals, looks likely to fade through 2017. That leaves business investment to pick up the slack, which, so far has not provided a compelling leading indicator. Nonetheless the RBA may turn hawkish if the GDP numbers do improve as expected. A rise in the cash rate may only come through in 2018, yet markets are likely to price in that expectation well in advance.

In summary, we expect global GDP growth to be mildly supportive of investment markets. More critically, there is a low chance of recession.  While there is much discussion of possible events such as a disruptive European election(s), a meaningful trade war or a structural problem with Chinese private sector debt, we have no way to judge the probability or impact of such an outcome. As we experienced in 2016, unexpected events had unexpected repercussions, rather than those feared.

Inflation and Rates

There are two key, inter-related issues that we will focus on in this report. The first is inflation and the second is the impact of higher bond yields. We take the view that neither the rate inflation nor bond yields will move substantially, but that the change will be enough to recast the likely return profile of asset classes.

The inflation watch is clearly focused on the US. Core inflation is already above the 2% Fed target with wages, healthcare and housing all placing further pressure on the trend. Import constraints may add to inflation, while the relatively strong USD acts as a buffer. Consensus 2017 CPI is currently at 2.3% and we view the bias leaning towards a higher outcome. For Europe, the median forecasts are inflation of 1.3% after a likely low of 0.3% in 2016.

From a portfolio perspective, we do not believe that there should be specific inflation protection (for example gold). The behaviour of financial markets, however, such as currencies, bond yields and securities will respond to the return of pricing pressure and implied monetary policy.

Bond yields have a natural upper range barrier, where the rate constrains economic momentum due to the high levels of debt. Even allowing for a reduction in easing by the ECB, the divergence in monetary policy by the ECB and BoJ limits the Fed as otherwise financial conditions in the US tighten much more than intended. On balance, most economists believe that a US 10 year treasury yield of greater than 3% will have a negative impact on growth.

Currency

A strong USD is possibly the most consensus view in financial markets. The rationale seems clear: rising rates, repatriation of global cash and higher growth from lower tax and other programmes. Other major cross currencies (Euro/Yen, AUD/Euro etc.) are directionally less obvious. There is a counter argument. The USD is overvalued in terms of purchasing power and the case can be made it already reflects the positive features. Then the ECB may turn mildly hawkish and take an undervalued Euro up with it. The renminbi, an increasingly important currency, may also not weaken as expected if the steps to stem capital flows succeed. In our view, the USD strength is likely to persist, but capped by the overvaluation and impact of a strong USD on the economy.

For most global equity portfolios, we therefore recommend some hedging, with the degree bespoke to the investor depending on the weight allocated to global equities, the willingness to accommodate currency and equity volatility and the time frame.

With the starting base of higher than average equity valuations, the support for equities rests on the earnings cycle. We are therefore cautious on the likely upward potential for indexes, but there is a good case for additional returns based on regional and sector selections.

The source of vulnerability for equities is from the risk premia, that is, the additional return required over the risk free rate. Investors should acknowledge the significant tailwind from the long cycle in bond rates that is now reversing.  Equity values should therefore come under pressure unless there is a commensurate lift in earnings.

The Australian equity market has, like others around the world, been caught up in the US euphoria over the last two months, with positive sentiment underpinning returns over this time. The pressure from a spike in interest rates, which had a big influence in the second half of 2016, has also eased in the last few weeks, providing relief for bond proxies and long-duration stocks.

In contrast to more recent years, recent index performance has been assisted by an earnings upgrade cycle and not simply P/E expansion. This trend has been in place for almost 12 months now, coinciding with the bottom of the recent cycle in many commodity markets. While mining and energy stocks are now a smaller part of the overall index compared to the peak six years ago, the earnings leverage within these sectors is nonetheless very high and has a disproportionate impact on earnings forecasts for the index.

ASX 200 Rolling 12 Month Forward Earnings Per Share

Source: Bloomberg, Escala Partners

A secondary development which has helped contribute to the better performance has been a stabilisation across the major banks. They have been under pressure on several fronts, including requirements for additional regulatory capital, rising bad debts, slow credit growth, and margin pressure from higher funding costs. Therefore, earnings and dividend forecasts have been progressively lowered over the last two years. The worst of this cycle now appears to be behind the sector and the prospect of even higher capital requirements has been pushed out by the delayed Basel IV framework and a likely slow implementation of the standards by APRA.

Winners and Losers from Higher Inflation and Interest Rates

The risk of higher inflation and long interest rates is currently a key theme among investors. It is worth considering the winners and losers from such a scenario if indeed inflation and interest rates were to trend higher.

From a sector perspective, one of the beneficiaries should be mining stocks. Commodity prices typically have a positive correlation with inflation, given these periods are associated with an uptick in demand. In the short term, supply tends to be relatively inelastic given the long lead times and investment required in bringing new capacity to market.

An additional beneficiary would be the banking sector, where higher rates translate into improved margins (banks have short term borrowings against long term lending). Given the high rate of variable rate lending in Australia, however, this is unlikely to translate into the improvement that would be evident in banks in the US and Europe. While this may be the case, our domestic banks can be expected to receive support as the environment for global banks improves and in a rotation from other high yield sectors.

Finally, earnings in the insurance sector, particularly for conservative insurers which invest primarily in short-term fixed income securities, would also be better in a rising yield environment. QBE, with a large exposure to the US, is well placed given that short term rates are the most likely to rise, while flat cash rates anchor the short end in other regions.

Most of the rest of the equity market may struggle in a rising rate/inflationary environment. The principal reason for this is that higher discount rates negatively impact valuations, and may offset potential margin expansion. The two broad groups that would face the greatest headwind, however, would be ‘bond proxies’ and companies with a high rate of expected earnings growth already factored into the valuation.

We have noted before the high correlation that ‘bond proxies’ – infrastructure, utilities, REITs and Telstra – have had with falling interest rates. These companies generally have a combination of defensive, predictable earnings and/or high dividends (making them a substitution for low-yielding fixed income investments) and high levels of debt (which leads to a greater sensitivity of earnings to changes in interest rates). Within this group of stocks, infrastructure screens best in an inflationary environment, particularly, where the companies have embedded price mechanisms.

Companies with a higher rate of expected earnings growth face pressure as interest rates rise. The reason for this is that a higher proportion of their value lies further into the future, which has a disproportionately negative impact when these cashflows are discounted at a higher rate. Broadly speaking, this is more likely to affect smaller companies in the index as opposed to, for example, the ASX 50. On a sector basis, health care, IT and consumer discretionary are most at risk here. To a degree, the derating of several high growth companies has already occurred in 2016, with these stocks now trading on a narrower premium compared to 12 months ago.

Outlook

The key factors that will dictate the market’s performance this year include the sustainability of the recent recovery in commodity prices, the extent to which bond yields continue to climb and the direction of the AUD.  Other influences will be the strength (or otherwise) of the domestic housing market and the level of consumer spending. While the market has an (narrow range) improved earnings momentum, complicating the outlook is the fact that domestic equities remain expensive.

Our view is that the commodity rally may be sustained for longer than many expect, although ease into the second half of the year. The recovery across the mining sector has primarily been a result of policy in China. Domestic supply has been curtailed (particularly across coal and iron ore), while fiscal stimulus has boosted demand. Both factors are expected to reverse at some point in 2017; we note that China’s policy change reducing the number of working days at its coal mines from 330 a year to 276 has already been relaxed in recent months.

Latent supply is the other risk for commodity markets if higher pricing remains, although a question on the sustainability of the recovery may lead many miners to be cautious about this course of action. The energy sector has similarly been given a boost from supply restrictions from the recent deal by OPEC to cut production levels, however the pricing cycle has now shortened following the growth in the US shale energy industry.

For the listed diversified miners, broker forecasts for earnings have been slow to incorporate the higher pricing environment. Using spot prices, earnings would be expected to be at least double that of what is currently assumed. As such, even if we are approaching peak pricing across the commodity spectrum, the sector is more than likely to continue to be subject to earnings upgrades. A bonus for shareholders should be a lift in dividends following the payout ratio policy adopted by the majors. A general reluctance across the sector to reinvest capital into growing production levels would support this outcome.

Our view on the interest-rate sensitive sectors is that they will clearly be under additional pressure should bond yields continue to climb. Having said that, stocks exposed to this theme have been sold off since the beginning of August. This has created some short-term trading opportunities across these stocks, however we prefer to remain underweight.

While banks will have a positive tailwind from a steepening of the yield curve, we believe that a neutral stance is warranted. With the sector presently showing little support from underlying earnings, we would expect the majors to be range-bound and trade more on their dividend yield.

Finally, industrials remain on a similar trend to recent years (although better than FY16), with expected earnings growth in the mid-single-digit range. The challenge for many companies will be achieving satisfactory top line growth after a multi-year period of cost out and restructuring. Some pockets of strength are likely to exist, such as companies exposed to infrastructure spending or tourism, however a softening property construction cycle will likely weigh on other sectors.

Regionally the US S&P500 screens as fully valued, though the degree of any underweight is buffered by the global reach of many companies and the big cap bias. Investors are likely to remain attracted to the potential infrastructure build, tax cuts and business confidence.  The risks lie with the potential rise in operating costs, the translation effect of the higher USD and unintended consequences from trade or immigration barriers.  The sensitivity to the expected rise in interest rate adds one more flavour. US corporate debt has been rising and the household sector is likely to retain an active memory of the 2008/9 housing credit induced recession.

Referencing our themes of higher inflation and rates expected to emerge from the US, it may not be the case that the equity market is vulnerable to the same extent. Inflation has mixed consequences for equities with some sectors gaining advantage from higher revenues and with good operating leverage. Rising rates benefit the financial sector, but are likely to cap the higher leverage of some smaller companies

Europe, including the UK, is reasonable value, based on a range of metrics such as forward P/E, CAPE, Price to book and dividend yield. The handicap is the political landscape and uncertain earnings. The index has a high weight to financials (20%) and cyclical sectors such as industrials and materials which may be in its favour given the current bias to value stocks, but also adds to the earnings risk.

Stoxx 600 EPS Growth

Japan is a consistent pick amongst investment firms to outperform this year. Economic growth expectations of 1% for 2017 may appear suboptimal, but is taken in context to its potential, held back by demographics and low inflation. A key component for the equity market is the fall in the Yen and a combination of industrial sector leverage, corporate restructuring and a distinct position in industries such as robotics and speciality chemicals.

Emerging markets (EM) represent the biggest challenge. The first point is to acknowledge that this regional classification is a matter of convenience with significant divergence in their outlook. Where it does matter is in flows, with allocations to EM driving overall movements rather than a country approach. Selecting the country, however, can be the most important decision. Through 2016, Brazil (a 7.7% index weight) and Russia (4.5% index weight) were the standout performers, both arising out of an extreme bear view.

This year will require nimble judgement. Fears of trade barriers will hold back export-oriented sectors, those with USD denominated debt are under pressure due to the rise in the USD and idiosyncratic risk such as the demonetisation in India are always around. The flip side is the much higher growth potential from many stocks in the region. Financials are a case in point. In the developed world, they are largely a play on rates and cyclical demand for credit. In emerging countries, the take-up of financial services is low and the sector screens akin to a consumer staple option rather than one driven by rates. Another theme is the home-grown nature of internet services with many regions.

As at the end of 2016, the 2017 estimated P/E for the EM index was 11.8X, a major discount to the 15.5X for the MSCI All Country index. EPS growth is also judged to be in the low teens with a price to book ratio of 1.5X compared to 2.1X for the world index.

We recognise the vulnerability of emerging markets, but remain attracted to the high growth option and low representation in global indexes, almost certain to lift over time.

Sector Rotation

The most significant change in equity markets in 2016 however, was not regional but sector rotation. After several years of strong performance, the growth sectors of the market – consumer and healthcare –  have given way to the pickup in commodity, industrial and financial companies, which usually have a higher correlation to economic growth and therefore are cyclical by nature.

Source: Bloomberg, Escala Partners

Source: Bloomberg, Escala Partners

This rotation is out of kilter with the economic cycle. Typically, the ‘value’ sectors in cyclical stocks outperform as an economy recovers from a slump.  The profitability of these companies is leveraged to the economy and earnings improvement is usually underestimated. This time it has been the bounce in commodity prices from extreme lows and the rise in rates, which is positive for financials. Our judgement is that this pattern will remain in place for much of 2017.

In recent years fund managers have coalesced behind growth companies, without which they are likely to have lagged the index. Now these growth managers are falling behind the change in sector performance.

Inherently the aim of equities is to realise real growth in capital value. We therefore do not recommend a major shift in emphasis to a value style, rather a reweighting towards managers with a value bias. At this time, we also support investment in Japan while taking a neutral position towards Europe. As mentioned, we expect emerging markets to gain traction in the longer term, while recognising the shorter-term risks.

2016 was a tale of two stories for bond markets. The first three quarters was about the unusual rate environment, as circa 30% of the government bond market in the developed world fell into negative territory, resulting in a bull market for long duration bonds (fixed rate bonds that are sensitive to interest rate movements). High yield recovered off a slump induced by the sharp fall in the oil price with energy stocks well represented in the category.

In the last quarter of last year, the situation changed. The US election result put the accelerator on what was already a changing story of higher expected global rates as the market re-evaluated the outlook for inflation, leading to a significant steepening in bond yield curves across global markets. Pressure on emerging markets reduced their return in local currencies in the quarter, yet the full year returns remained at the high end of the asset class.  Conversely, credit spread tightening, particularly those lower in the capital structure or in below investment grade securities, dominated fixed income markets in the latter part of 2016. Annual performance for these sub-sectors of fixed income in 2016 is shown below.

Outlook

For fixed income, inflation and US rate rises will have a direct impact. In addition, company debt levels will be closely watched. Long dated yields and credits spreads will potentially determine much of the outcome for the asset class.

Defensive Sectors

Global sovereign bonds – Long dated fixed rate government bonds are extremely sensitive to interest rate moves and a continuation of an upward trajectory for bond yields will be a headwind for these securities. Given that expectations of higher inflation and higher growth have been priced into bond yields in the last few months, there may be a pullback or stabilisation in rates in the near term. However, the outlook for this sector still looks challenged given the low coupon buffer against capital loss and the likelihood of increased volatility given their sensitivity to interest rate moves off a low yield base.

We have revised down our allocation to this sector. We are mindful of maintaining some exposure as in ‘insurance’ for portfolios should a return to disinflation and or recessionary conditions occur, or in the event of a global macro-economic event.

Global investment grade corporate credit – Periods of stronger growth, a faster pace of rate rises by the Fed and a pull-back in QE out of Europe will be a negative for credit, as a rising yield environment bites debt-laden companies. While increased defaults are unlikely in high grade credit, we may see profitability crimped (as refinancing off higher interest rates occurs) leading to some company downgrades by the rating agencies and subsequent credit spread widening (price falls).

Increased balance sheet leverage is widespread across most sectors of fixed income, including investment grade.

Source: JP Morgan

High debt levels, together with the tight spread environment, detract from this sector. However, some pockets of value do exist and security selection and sub-sector allocation by managed funds that have flexible mandates will be key. While our overall asset allocation is underweight duration and fixed income, we do recognise the role for some fixed rate product if economic growth expectations are not realised. The historic correlation between interest rate yields and credit spread acts as a natural hedge to each other. With a steeper yield curve and some return to a term premium, these securities can benefit from the ‘roll down’ (i.e. the bond value will rise as they move towards maturity as investors can price in the rising likelihood of redemption).

Floating rate exposure is still well represented in portfolios through securitised product (residential, corporate and asset back securities) and subordinated bonds and bank hybrids. In summary, we recommend an underweight to global corporate credit, with the reduced allocation assigned being to longer duration and sector specific securities.

Australian Government bonds – The long end of our domestic yield curve is driven by global factors, which we expect will remain volatile in 2017 (as per global sovereign bonds above). Government bonds maturing within three years will remain anchored to the RBA’s rate settings. While our base case is that rates will remain on hold in 2017, a change may get priced in if the recent rise in the terms of trade persists (higher commodity prices) and inflation picks up. A potential downgrade of the sovereign credit rating may put this sector at a higher risk of underperforming.

In line with global bonds, we recently revised down our weighting to this sector. Some allocation, albeit underweight, is appropriate to mitigate the risk of portfolio under performance caused by unforeseen economic deterioration and as a diversifier to risk assets.

Higher Risk/Return Sectors

Domestic subordinated bonds and hybrid securities – These securities performed exceptionally well in 2016 driven by credit spread tightening as investors moved into floating rate product. We expect spreads will stabilise in 2017 with potential for some spread widening. Nonetheless, coupons paid on many of the recent issues remain secure, buffering this change. Our weightings to this sector remain unchanged, however, we note that new money should be allocated with caution as the entry price is important.

Global High Yield Sector – 2016 was a strong year for high yield, as credit spreads contracted after the expansion that was triggered by the collapse in the oil price. The continued search for nominal yield, low expected default rates in the near term and stable commodity prices may support valuations for the time being. The risks to this sector will be duration-driven volatility, high leverage in companies and current tight spreads that don’t allow for an unexpected rise in defaults. On balance, we are comfortable with a small exposure to this sector gained from one of our global managers.

Emerging markets – The fourth quarter pull back in local emerging market debt was largely due to currency moves. USD denominated debt remained one the better performing subsectors. High coupons will buffer some of the expected volatility, particularly as US federal policies become clearer, and once again, a small position through a global manager may add to the low return from the asset class.

After a period of generally disappointing results, increased volatility and lower correlation between asset classes provides a better backdrop for many alternative managers which use equity, debt and currency markets for their positons. This will apply to hedge funds, global macro strategies and managed futures (CTAs).

Long short and market neutral strategies were largely unable to match their historic returns as equity sector rotation, referred to previously, undermined many of their positions. For funds with long term track records of sound performance, we see no reason these will not continue notwithstanding periodic pullbacks.

Other alternative investments such as unlisted property and private equity are assessed on a case by case basis, while considering the cycle.

Specifically, we pay attention to the impact of a change in capitalisation rates in property as this is in most cases the determinant of total return. Private equity valuations are correlated to equities and therefore the same degree of caution should apply. Further, the appetite for leveraged loans on which private equity depends, changes with risk appetite and therefore the impact of investment markets again comes into play.