Quarterly Market Review January 2019

Economic growth is slowing in all key regions, with the first quarter of 2019 likely to be particularly soft (US shutdown, Brexit, China pre-stimulus, post tariffs). A positive aspect is that household income is stable to growing, as employment conditions are supportive, in part determined by the structural shift towards services rather than goods industries. The key determinants that could change the outlook are a loss of confidence by businesses given political uncertainty or a policy misstep. Fiscal settings will play a meaningful role in economic developments this year.

Central banks are sensitive to the change in tone, with rate rises likely to be muted and delayed. However, the withdrawal of liquidity (as quantitative measures are reversed) is resulting in an adjustment in global asset allocation and valuation of long-term growth equities.

Notwithstanding the cautious overtone, we believe risk asset prices have more than adequately responded and valuations are relatively attractive. We doubt fixed income can be the best asset class for two years in a row given the current starting base.

We have increased our tactical equity weight at the expense of allocation to cash, although remain overweight cash in capital preservation and income portfolios.

In the capital preservation model, we have increased both domestic and global equities. In our view, the domestic equity weight in income models is already at an optimal level and we prefer to add to global equities where select strategies do lean towards dividend paying companies, albeit at lower yields than in Australia. In addition, we aim to mute the potential for some dislocation in the local market if there is a change to franking credits. Unhedged global equities have been up-weighted in the growth model. The currency exposure should buffer some of the potential volatility and access a broader range of growth strategies.

Fixed income tactical weights remain below their strategic level across all recommended allocations. In the income portfolio, we have reduced the proportion even further given current yields.

Asset Allocation

Expected index return (excluding alpha and franking)

Expected return (including alpha and franking)

Our return profile remains based on indices that assume reinvestment. Additionally, we propose returns which include excess to index outcomes (alpha) and franking (assuming full utilisation is possible).

The framework is on a rolling three-year basis, accounting for current conditions and the starting base of valuations.

The portfolio returns expected over the coming three years are modestly below those achieved in the last three years, which allow for the equity drawdown in 2018.

The economic overlay is muted but not without its bright spots. In many regions the household sector has benefited from increasing jobs and low inflation. The services sector has been a beneficiary of consumer trends and is often poorly measured and underrated. We view structural demand for education, travel, health and aged care as resilient to financial market machinations, though subject to the maintenance of employment. The growth in services will mute economic trends as they are typically less volatile than the goods market.

Another feature is that no large-scale counterparty risk (as was the case in 2008) is evident within the financial sector. Corporate debt may be high in some regions, yet is generally held directly by investors rather than via leveraged product. Losses, if they were to occur, should therefore be isolated to the holders. Generic selling via ETFs is sometimes nominated as a risk. While this may cause undue volatility, other investors are likely to pick up oversold positions. After years of increased capital ratios, banks can be considered broadly safe and the corporate sector can replenish capital through the equity market, mergers or takeovers.

Nonetheless, it would be wrong to dismiss the litany of problem areas that are commonly nominated. Carrying over from 2018 has been the risk the US Fed is overly strident on its rates policy. To some extent, that already has abated, with now frequent comments that the Fed will judge conditions rather than maintain a rigid plan.  Globally, benign central banks are a plausible outcome.

China’s debt, at a time it needs to provide support to its waning export sector, is also in the headlines. We, along with most observers of China, view it likely the government will pull out all stops to prevent a large pullback in growth, notwithstanding that these policies might cause problems in the future. One can argue that China is unfairly called out in its loosening of financial settings when growth is perceived to be below par, as the legacy of the US’s debt funded fiscal bump has yet to be measured. China can nationalise some debt and may resort to ‘required’ structural shareholdings to rescue some companies, a path it has been down in the past.

Somewhat obviously, Europe is in a challenging position. Dependence on exports and unstable politics clouds the outlook. An improbable positive would be for the new head of the ECB and the soon to be elected European Commission to overhaul the system.

The schematic below is a useful way to consider the current and longer-term distinction between the major monetary zones.

Source: Gavekal

We have commented on Australian conditions in many of our weekly reports. In short, the balance lies between investment spending and fiscal spending, offset by the clear negative drag from housing.

In summary, we believe forecasts of lower global GDP growth in 2019 are realistic, but along with others, do not see a recession as a predictable outcome.

On the watching brief are:

– Fiscal policy and its effectiveness.

– The labour market with skill shortages and generally supportive conditions, versus the lack of wage growth.

– Corporate capital formation and spending to improve competitive position, with productivity growth the imperative.

– Business and consumer confidence in the wake of unsettled politics and policy.

Since the financial crisis a decade ago, economic growth has been below historical recoveries, while investment returns have been above average. A degree of payback is now likely.

US Nominal GDP from trough 10 years onward    S&P recovery since trough

Source: Haver Analytics, Datastream and Goldman Sachs Global Investment Research

The shift from monetary support to fiscal drivers, particularly outside the US, is likely to see the gap between investment markets and nominal economic growth close. The typical inconsistency and uneven application of fiscal support is expected to contribute to greater volatility in equity prices compared to the confidence gained from the consistent message out of central banks. A meaningful skew in fiscal delivery will lean towards policies that appeal to lower income and disadvantaged cohorts, compared to the tax cuts enacted in the US. These will then result in a different equity bias than in 2018.

The liquidity cycle has turned. Investors cannot support the supply from all asset classes and are therefore becoming selective, as well as rotating in and out of segments depending on valuation and sentiment. It has been notable that investors (as opposed to central and lending banks) have increased their holdings in US Treasuries and, in turn, are showing a more cautious approach to equities.

Marketable US Treasury Demand

Source: Wells Fargo

Outlook

Given the retracement in valuations and notwithstanding lower earnings projections, we are of the view that a tactical uplift in equity weighting is warranted. The current reporting season may prove to be the catalyst to reset expectations to reasonable levels.

The corporate sector will need to work harder to achieve gains rather than rely on its newcomer status (tech stocks for example), cost cutting or stock buybacks. Instead, companies will now need to invest into efficiency and offer differentiated services to consumers to beat competitors which can be expected to result in a greater dispersion in performance. Profit margins are likely to be the focal point of 2019 as a function of a corporation’s capacity to deal with costs while gaining market share.

Theme – technology adapts

The overarching tech sector, as represented by acronyms such as FANG (Facebook, Amazon, Netflx and Google), is no more and will likely evolve into a divergent grouping of companies.  Not only has the official GICS (global classification) designation changed, with many stocks now represented in Consumer Discretionary and Communication Services sectors, but the outlook as well. This combines privacy concerns, regulation, politisation, higher costs and, in some, debatable persistence of revenue growth versus the cost of delivering the services. Further, there is substitution within the sector as participants grapple for share as well as a fight back from traditional providers.

There is also a debate on backfilling operations towards traditional and generally more costly strategic initiatives; for example Amazon’s acquisition of Whole Foods and Netflix growing its production of content. Finally, most of these platforms have not been tested in any downturn and it is not clear how consumers will approach these services if incomes are constrained.

Nonetheless, it is clear that there is still a long way to go in the development of services based on rebuilding dated platforms with a technological solution. The case is rather that valuations can become stretched (as evident in 2018) and with the dispersal of stocks into other sectors, the market may intuitively become selective on the names it wants to support.

– WCM Quality Global Growth Fund (as an SMA) has demonstrated its stock picking ability and allocation to information technology stocks. As a complement, the Nasdaq ETF can provide an index exposure to a high weight in these companies.

Theme – Healthcare remains core

A theme that coalesces a range of current trends is healthcare. Equity investors lean on the low correlation to economic growth, the demographic appeal, the generally strong cash flow and the ability to innovate. Big pharma has become relatively concentrated in a handful of major names leading to likely pricing power and a balance in earnings that will be less affected by individual product. By contrast, biotech provides outsized gains if there is a successful R&D pipeline while a host of other services can diversify the holdings.

It makes sense for any global equity manager to maintain some exposure to the sector. Longer term, the potential to add technological solutions to reduce health outcomes is expected to be realised. But a full-scale onslaught of technology that can overcome the entrenched structure of the health industry is unlikely. We are of the view that the best judgement of healthcare stocks will be in well resourced research funds, as there is a high level of specialist knowledge required.

– MFS Concentrated Equity Fund has maintained a high weight to healthcare as it aligns with their long-term investment time horizon.

Theme – Earnings do matter

If there was evidence that attention to earnings matters, the last quarter of 2018 proved a wholesome example. In our view, the bulk of the rationale for the fall in share prices was the downgrade in profit expectations. Fundamentally declining economic activity and concern with respect to China also played a clear role in forming the view that earnings forecasts were overly ambitious.

In the perfect world, an investor would manage a portfolio based on a formulaic fair value for each stock. This requires perfect vision on two factors –earnings; and then the price attributed to those earnings. Longer term, earnings require the detailed sector knowledge as noted above, yet are also clearly subject to constant revision. Valuations are, at best, an estimate given there is no one methodology that can be proven reliable. Growth stocks are often determined by a residual value, where a large proportion of the valuation is an assumption of long term potential. Where there is any doubt on these parameters, the bias shifts to near term certainty in profit.

After the tailwind of quantitative easing, growth in global trade and US tax cuts, the fundamentals of earnings are under closer scrutiny. Analysts often are reluctant to accept a different trajectory for a stock they favour. We therefore support a quantitative approach as a complement to the ‘deep dive’ fundamental process.

– State Street Global Equity Fund comprises a process that scores companies on a large range of criteria, including one year forward earnings. It can pick up shifts in opinion prior to the consensus and has proven defensive in times of market rotation as recently evidenced.

Theme – Emerging markets combine macro and micro more than other markets

For some time, the overarching theme for emerging markets (EM) was to cite the demographics and therefore growth potential versus the developed world. Yet, the volatility of index returns is evidence that other factors predominate. Monetary settings and politics often combine to create outsized movements in country indices. Recent examples are the dual current and fiscal deficits of Turkey that came to a head in a political conflict with the US. By contrast, the weak fiscal position of Brazil is being viewed through the lens of the new government on the basis there may be an improvement.

Selected EM performance return 2018

Source: Bloomberg, Escala Partners

While this differential country return is high, it is in fact no greater than the difference in the sector returns for the S&P500 in 2018 (healthcare + 6% versus -18% in energy stocks).

It is the determinants that warrant further examination. A rise in the US$ undermines dollar denominated government and corporate debt; this year appears a little easier on that count given the predominant view the US$ strength will taper off. Trade clearly causes investor concern, yet the evidence in corporate profits is sector-specific rather than across the board. Other issues such as global growth and debt levels are not unique to emerging markets. Local policy and politics have an outsized impact on country performance and we have a preference for fund manager strategies that include such criteria as well as stock selection.

– While 2018 was a tough year for selected EM fund managers, their process should, in our view, result in a recovery in performance. Somerset Emerging Market Dividend Growth focuses on capital management while the RWC Emerging Market Fund is based on themes. Active management in EM will invariably result in under and outperformance against the index and therefore we are of the view an index fund is a useful complement as well as allowing an easy cost effective way to manage the weight within a portfolio.

Theme – Global REITs provide stability and income

Twelve months ago, REITs were being shunned by investors in favour of growth assets and the fear of higher rates. However, since the last quarter of 2018 global real estate has been a meaningful outperformer.

The mainstay of any real estate investment is the value that comes from the cash flows generated by leases. As last year’s rate rises were accompanied with solid macroeconomic factors, it allowed for increases in discount rates and debt costs to be offset by an improvement in the net operating income of REITs. Assuming stable rates, the ability to deliver earnings and dividend growth determine REIT performance in 2019.  Dividend yields are near 4%, which we assume will be the base case return. The global REIT index is trading at a small discount to NAV, though this is heavily skewed to the UK and emerging markets.

Currently REITs are in good shape, cash flows have been steady, property values are stable, and leverage is the lowest in 20 years. In our view, the fundamental demand within sectors and regions will now be the primary driver of performance rather than rates and valuations.  Ongoing caution on retail REITs is warranted, while commercial properties are a function of local conditions.  In specialised sectors, the stock differentiation can be large depending on supply.

Reflecting on 2018

Based on total returns, 2018 was the first year since 2011 in which investors had a negative outcome the ASX200. The marginal decline in the Accumulation Index was masked by a marked rise in volatility, driven by international as opposed to domestic factors.

Throughout the year, several trends could be observed to explain the performance of the market:

– The high valuation/high growth rally continued through to September, followed by a sharp de-rating to lead the market lower.

– Mining and energy were again among the leaders, although faded as the year progressed, while energy fell as the oil price plunged late in the year. Few fund managers could anticipate such a rotation.

– Financials were the key laggard, primarily on the revelations from the Royal Commission, which were more negative than anticipated. Strategies with an income bias, typically heavily weighted towards this sector suffered as a result.

Positives

The primary appeal of the Australian equity market is presently based on valuation. The P/E of the ASX 200 has contracted from around 16x in September 2018 to 14x, close to the historic average. Given that forward earnings forecasts have been recast only slightly lower, current market levels represent an attractive entry point.

Additionally, the yield on the market has risen to 5%. While payout ratios are elevated compared with history, this yield is still relatively defensible and the inclination for most companies is to preference shareholder returns over capital investment. Combined with a softening in domestic interest rates and the expectation that the cash rate will remain unchanged this year, the income appeal of the market has again risen. As we have highlighted in a recent note, the prospect of returns over and above ordinary dividends via special distributions or buybacks is high, given the possibility that the value of franking credits may be changed after the upcoming election.

The chart below illustrates the current P/E and forward EPS growth forecasts by sector. Resources growth has moderated (energy is high although likely to pull back in line with the oil price correction), while financials are anchored in the low single-digit range. Communications continue to be impacted by Telstra’s declining earnings, while the P/Es of the growth sectors of health care and info tech are on the high side. The weighted average earnings growth sits at just under 5% – within the range of the last few years on an ex-resources basis.

Sectors: Forward P/E and EPS Growth

Source: Thomson Reuters, Escala Partner

The positive momentum from earnings upgrades has dissipated, mainly a function of the levelling off in commodity prices and the market has now returned to a slightly negative earnings revision cycle. Nonetheless, the level of downgrades that have filtered through in recent months is fairly typical of most environments.

While there are pockets of pressure in the economy (the housing market is commented on frequently), domestic growth should still be respectable in 2019. A federal election year adds an additional layer of uncertainty given possible policy changes, offset by likely fiscal spending.

The balance sheets of Australian companies are in good shape. This is notably the case in some of the cyclical areas of the market, such as resources, having learnt the lessons of early this decade.

Risks

Counting against domestic equities is better earnings growth available in international equity markets, although this gap has closed somewhat as the US tax cuts roll over and Europe softens. Further, many international markets also trade on similar or lower P/E ratios and thus the case is weaker relative to global equities.

Rising cost pressures have been a recent issue, whether it be in the form of escalating raw material prices, energy, some wage inflation and higher cost of debt. Different companies have varying ability to pass these onto to their customers, but it is hard to argue against the case that margins have peaked in the current cycle.

Lastly, sentiment is now weaker reflecting a pick-up in tail risks, be it the impact of tariffs, political events such as Brexit, or asset prices as central banks withdraw liquidity.

The ‘growth’ selloff that occurred in the last quarter of 2018 was driven by rising interest rate fears. This view has moderated and the risk to valuations from a sharp rise in rates has reduced. Despite the correction, growth as a style remains relatively expensive, although individual stock movements are a function of earnings disappointment and thus a careful assessment of the outlook and risks is required.

Sectors to Overweight

Resources are again a key pick for 2019. The sector is no longer in an upgrade cycle due to a levelling in commodity prices, however we note that commodity prices are supported by a lack of recent investment in new supply. Given limited capital spend and disciplined investment decisions, free cash flow yields are high and shareholders should continue to benefit from stable dividends and share buybacks.

Despite the recent correction, most high growth sectors trade on relatively elevated valuations. Within these, healthcare would be our pick given its defensive characteristics making it less susceptible to downgrades should the domestic or global economy weaken, while the longer-term drivers for the industry are structural.

Certain cyclical sectors have been among the biggest casualties in the recent correction. To the extent that it has been price correction and not a deterioration in the earnings outlook, these companies represent better value should the market recover some of its losses. Examples include diversified financials/insurance, building materials (particularly US-exposed) and mining services.

– Fund managers rarely hold longer term overweight positions in resources and we recommend that within a portfolio a selection is held external to managers. These can be lower risk options, such as BHP and RIO, or thematic, but higher risk, such as lithium stocks. Other mentioned sectors are well represented in growth managers. 

– Growth-focused small cap managers have generally lagged the market by some margin over the final quarter of 2018. An opportunity exists to add to managers such as Regal Small Companies Fund and QVG Opportunities Fund for investors with a core capital growth objective.

Sectors to Underweight

The major banks screen as relatively cheap, although arguably this is justified. Return on assets are lower in the new regulatory environment, compliance and technology cost inflation is high and credit growth is subdued as the banks adjust to new responsible lending guidelines. While 2018 was characterised by a much more severe reaction than expected to the Royal Commission, this risk remains given the imminent release of the final report.

We recommend also retaining an underweight position in telecommunications. Returns in broadband have been impacted by competition, the high wholesale access costs charged by the nbn and considerable capital investment ahead in mobiles for the upgrade to 5G, the benefits of which will not accrue this year. The proposed merger between TPG and Vodafone is also yet to gain approval from the ACCC.

Sectors that are exposed to the Australian housing market and/or consumer enter 2019 in a precarious position. There is a risk to consumer spending given its link with house prices. Household debt levels are high, funding costs are pushing mortgage rates higher and savings rates are low.

– We see little appetite in our recommended funds to be overweight the banks. Telstra may be suitable for income investors, but we observe a low allocation to economically sensitive stocks.

US Bonds – long duration

We expect yields on US bonds to be range bound over the next few months. Reacting to a slowdown in growth projections, the Fed has turned cautious on further monetary tightening (perhaps delivering one more rate hike) which will keep rates contained, particularly on the short end. Initial market reactions to the new Fed outlook took the 10-year US bond yield down to 2.55% at the beginning of 2019. In our view, this is overdone, but will provide a technical marker as the bottom end of the likely trading range. On the top end, a US 10-year rate above 3% is expected to be met with strong demand, with a level at 3.20% to be a ceiling at this stage.

In the absence of Fed rate rises, other factors will drive pricing. The notable increase in the US deficit of nearly $400bn needs to be funded through treasury issuance. This comes as the Fed is tapering its balance sheet, with $360bn expected in annual run-off. Foreign government reserves have fallen and yields after hedging are unappetising, reducing the demand from offshore investors.

Reliance is therefore on US domestic pension funds, insurance companies and households to absorb the new supply. Pension funds have reduced demand (as funding levels for private defined benefit pensions decline) following front-ended buying of treasuries last year prior to tax changes. Further, given the likely Fed pause, we would expect pension funds to rotate out of long bonds into risk assets as asset allocations are adjusted.

– We remain underweight duration at current pricing and would like to add to offshore duration bond funds such as the Pimco Global Bond Fund should rates lift higher. Reduce holdings in long duration bond funds as rates on the US 10-year hold at 2.75%.  Buy when above 3%.

Australian Bonds – long duration

Like the US, we believe that the rates rally is overdone in the domestic market. While commentary and futures pricing may imply rate cuts by the RBA, this is not our base case view. It is our view it will keep rates steady, as it is reluctant to take real yields lower and rather retain some ammunition should there be a capitulation in economic conditions. The RBA will be relieved with the housing price decline subject to employment remaining solid. Fiscal spending is a likely replacement for monetary policy to stimulate growth.

Valuations of domestic bonds look expensive given we don’t expect the RBA to cut rates this year. We suggest yields will drift higher led by offshore movements, but as with the US, remain in a 50bp range. For those that are overweight domestic long-duration style funds, taking profits now and moving to an underweight position is advised.

– Maintaining an allocation would be on the premise of insurance against a recession. For this we use the Jamison Coote Bond Fund and the Henderson Australian Fixed Interest Fund. Reduce holdings on long duration Australian bond funds as rates on the ACGB 10year trade down at 2.30%. Buy when above 2.80%.

Investment grade (IG) credit

Credit spreads have moved wider as investors price in slowing earnings growth. Assuming the Fed pauses, it will give some reprieve to higher leveraged corporates and spread movements. We note US corporate debt levels are high, particularly on lower rated BBB credits within the IG index, where US shareholders and rating agencies are becoming less tolerant. Tax cuts in the US have increased company cash balances and facilitated repatriation of funds that were previously held offshore, enhancing their ability to repay some of this debt. Further, profit levels can support current debt levels and interest coverage ratios are acceptable.

Investment grade spreads are at 18-month highs, offering a reasonable risk/reward even with some further weakness. We recommend an underweight to long bonds, preferring short duration US and Australian IG credit as a good home for de-risking portfolios, with returns expected to be in the 3.5-4% range (European credit will remain challenged as the ECB ends its QE program). As always security selection is key, as those companies that can’t reduce leverage may be downgraded and we look to the fund managers to avoid these risks.

– Hold US and Australian short duration Investment grade bonds such as represented in Kapstream Absolute Return Income Fund.

High Yield

The US high yield spread started 2019 at its highest level since June 2016, with the average reaching +537bps (up from +300bps a year ago), taking outright yields close to 8% reflecting many concerns noted in this report. While spreads have recently retreated, the index still offers a yield above 7%. Further weakness is a risk, especially given the possibility of BBB bonds being downgraded into high yield ($95 billion BBB- bonds are on outlook negative) and the looming maturity wall (2020 onwards) for high yield debt that needs to be refinanced. On the positive, credit quality has improved in the last ten years as more BB and fewer CCC bonds make up the index, which now has a shorter market duration (down by 0.4 years) and still boasts below-average default levels and record high interest coverage ratios.                

High Yield Index Effective Rates

Source: Escala Partners, Federal Reserve Economic data

Stress testing by fund manager Pimco shows that, over the last ten years, whenever high yield rates have risen above 7%, there is a very low probability of a negative return in the following 12 months. While we recognise the risks of this asset class weakening further, we think the current spreads price in a decent buffer and we suggest growth and income mandates add exposure to this sector.

– The JP Morgan Strategic Bond Fund has a ~30% allocation to high yield (mostly BBs) which has posted negative performance in 2018 in line with the high yield price falls. We expect better returns and see this as a conservative way to gain exposure to high yield. For mandates with a higher risk tolerance, buy US High Yield when effective yields are above 7%.  

Australian Hybrids

Hybrids still offer solid income, but valuations are likely to come under pressure if unused franking credits are abolished and APRA continues with its plan for banks to add capital above hybrids on the capital structure. Until these issues become clearer (post-election and after further direction from APRA) we suggest investing in short-dated maturities that mitigate some of these risks (out to three years, albeit noting limited supply).

– Consider realising longer dated hybrids. Buy short maturity banks (within three years).

Structured Products – ABS and RMBS

Margins on highly rated domestic RMBS (residential mortgage backed securities) have widened, a result of strong supply, falling house prices and tighter lending standards, but the structures remain sound and pools with seasoned mortgages offer value. In the US, the tight labour market and falling long end rates have cheapened mortgage refinancing, supporting household income and, in turn, US mortgage products.

– Hold RMBS. Domestically, we recommend Aquasia Credit Fund and, offshore, the Pimco Global Bond Fund, which currently allocates over 30% into secured mortgages.

Emerging markets

The outlook for emerging market (EM) bonds is positive as the Fed slows down its rate hikes, relieving upward pressure on the USD and supporting the appreciation of local currencies. Some currencies have been hit and many have had to raise rates causing bond price falls. Large outflows as a ‘risk off’ trade has also contributed, improving the attractiveness of valuations.

While one needs to be selective, many EM central banks and governments have succeeded in reigning in inflation, building reserves and strengthening their economies in a backdrop of favourable demographics. Further, credit quality and liquidity has improved; 70% of EM countries now have an IG rating compared with 2% 20 years ago.

– We recommend the Legg Mason Brandywine GOFI fund for this exposure, which has close to 50% of the fund currently invested in EM index countries, Mexico (which falls outside of the EM index) and Eastern European countries. 

Assessment of alternative investments has not been overly favourable in 2018. We prefer strategies that have a limited relationship with equity and fixed income indices, yet this will not determine their performance in any part of the cycle.

Typically, the market neutral equity strategies should benefit from higher volatility. In the 2018 sell off this did not prove to be the case but as company performance diverges we would expect greater opportunities to arise.

Alternative debt and unlisted property both have provided appropriate return for the risk in the strategy.

We are reviewing other alternative strategies that differentiate substantially from traditional investment markets and recommend consideration of these when made available in addition to our current list.