Quarterly Market Review July 2015

Rather than Greece, the predominant global influence on Australian investment portfolios in the coming twelve months is expected to be the US, China and, as always, local economic conditions.

US

US economic data has been somewhat mixed in the first half of the calendar year, but to date there has been no indication that the Federal Open Market Committee (FOMC) will change from the widely held proposition that it will raise the Fed funds rate some time before year end. It should, however, be noted that there are a number of vocal economists advocating for a 2016 lift-off. The key data points are, unsurprisingly, the labour market and, to cite the Fed, ‘confidence inflation will move back to its 2% objective in the medium term’.

The labour market is making considerable progress, with consistent job growth and unemployment at 5.3%. What might trouble the Fed is the very low participation rate, implying that many potential workers have left the labour force. The Fed may be looking for other supporting trends, such as wages growth, to confirm the strength of the labour market before it moves. In turn, this would make the inflation target easier to achieve, which is unlikely without some uplift in wages.

The average hourly rate has not moved from a 2% p.a. increase since the downturn. However, other indicators point to the potential of an imminent upturn. The employment cost index consistently adjusts for compositional changes to the labour force and includes bonuses as well as non-monetary benefits. The employee compensation does not change the composition and therefore indicates that some sectors are experiencing considerably more wage pressure than average.

US: Wages Growth

While these and other measures may serve to confuse rather than inform, it paints a picture of a structural change in employment towards IT, professional services and maintenance rather than construction, extractive industries and sales. The lack of wage growth and low participation rate appears increasingly unlikely to benefit from low interest rates.

Assuming therefore that September or December is the base case, the debate is then expected to focus on the extent and timing of the rate hike cycle.  Expectations are centred on the Fed ‘dot points’ (a graphic view of rate expectations by the individual members of the Fed), which imply that once the first rate rise occurs there will be one 25bp increase every three months thereafter. This will have a significant impact on financial assets, with fixed income clearly directly affected as well as those equities leaning on interest rates to underpin their valuations.

China

China represents another complex influence on global economic growth. Having set ambitions for 7% GDP growth this year, the much of the data has been unsupportive of such an outcome with manufacturing soft and investment spending patchy at best, while consumption spending appears to be stable rather than improving.

On the other hand, the authorities have actively sought to open up the financial system. A raft of measures, including centralising and restructuring of local government debts, internationalising the renminbi (RMB), easing interest rates and lowering the reserve requirement for banks to encourage credit growth will have longer term repercussions for China’s integration into the global economy.

Other initiatives have been the New Silk Road (One Road One Belt) – essentially an infrastructure programme – the free trade agreements around the Pacific, easing the limitations on property investment and the opening up of the stock market to wider participation. The last mentioned has grabbed the headlines with an extraordinary run up, reports of a huge spike in margin lending and an inevitable sharp and messy retracement.

As Australia’s major trading partner and a key component in global growth, any hint that China is struggling to hold up activity without some success could weigh heavily on expectations for the year.

Few doubt the longer term capacity of China to maintain a solid growth rate given the potential of its middle class and the unquestionable success of what it has achieved in the past fifteen years. But the long anticipated change in the nature of its economy from the focus on investment is proving a less predictable outcome than some would have assumed. Examples of issues which could have larger ramifications than widely appreciated, include risks on the debt levels within state and regional governments (which have for a long time supported much of the infrastructure investment) and the impact on households of a rapid change in the property market and the recent equity market.

China: Middle Class and GDP Composition

Source:IMF

Source: CEIS

Significantly different or lower growth in China compared to current expectations has direct implications for Australia and also for many global companies which have come to rely on this region to achieve sales momentum.

Australia

In turn, the Australian economy has leant heavily on everything China in the past decade. As we have noted for some time, the next leg of domestic growth is hard to identify and it therefore makes sense to assume domestic economic growth will be lower in the coming years. The positives of decent demographics, flexible interest rates and relatively low government debt are balanced by the over-dependence on commodities and high household debt. The most probable path to lifting growth is from external investment into Australia and further inroads by the services sector to broaden its global reach.

In our April Asset Allocation we recommended a tilt to global equities for capital growth and capital preservation portfolios, while holding to our strategic allocation for income portfolios. This was offset by lower weightings to domestic equities and fixed income.

For FY16 we recommend selectively extending this tactical shift. A feature has been the maintenance of and, in some cases addition to, global equities. We acknowledge that this is in part a relative judgement, but this should not cloud the proposition equities can still provide acceptable returns even if interest rates rise within expectations.

Risks

The predominant risk in portfolios is therefore an equity sell-off.

Why do 10%+ sell offs occur?

– Extreme valuation – for example, internet bubble 1999, China 2015.

– Currently unlikely as valuations are not extreme across broader indexes.

– Interest rate shock – specifically 1994 to ward off rising inflation.

– It is very unlikely that central banks would follow a similar path, however the sensitivity to a relative change in market rates (bonds and credit spreads) given the low base rate may prove higher than expected.

– Systematic/technical factors/programme trading/margin calls – 1987.

– Possible given Exchange Traded Funds (ETF) and low liquidity in fixed income markets.

– Economic recession – early 1990s – high inflation, Savings and Loans collapse.

– Possible, for different reasons today.

Two of the three we note above as ‘possible’ are interlinked. The fixed interest market has changed due to regulation of bank balance sheets and, consequently, a lower level of inventory. This means clearing of fixed interest products can be challenging. We take some comfort that this is not an unknown issue and that the large participants in this market have been in discussions with the regulators.

Further, recent volatility in these markets, such as in April with the sharp movement in bond markets followed by the unsettled events around Greece, did not result in any apparent liquidity-based dislocation.

While the domestic participation in ETFs (and particularly fixed income ETFs) is low, globally there is sizeable investment into these products. In recent discussion with the providers, they indicate that many of the large institutional holdings in ETFs would be realised by an in-specie distribution of the underlying securities to the institution rather than sold on market. Nonetheless, we are mindful that we have not had ETFs represented to this extent before and it therefore is not entirely clear what might unfold in the event of a significant financial shock.

Before investors take an overly cautious view on fixed income, the possible situation noted above will almost certainly cause even greater volatility in equities. Once again, in April and June, both due to bond pricing and risk issues, equities experienced sharper falls than fixed income. As we will note in our assessment of this asset class, the diversity of holders, sectors and regions can be expected to alleviate specific risks in segments of the market.

The other issue we noted above is a recession. As often cynically expressed, the track record of economists predicting a recession is abysmal. We are not going to jump to their defence, though geological instability also does also not predict earthquakes with any precision; so too, economists cannot do much more than point out the conditions under which a recession is likely to arise.

The most common are excessively tight financial settings (rising interest rates, limited credit, effective exchange rates, stock markets etc.), and the other a systemic failure in a financial sector (the saving and loan crisis, subprime lending pools, asset bubbles). A loss of confidence is the inevitable consequence.

As noted, we doubt that financial conditions will be the culprit given that central banks are likely to step into any unexpected tightening. Overvaluation of assets does lurk around – housing and some fixed income –  though this does depend on one’s view of long term global growth. While many may have suggested that Japan’s bond market has been ‘overvalued’ for a long time given their low interest rates, this has instead reflected the low growth and inflation in the past couple of decades. In our view, the regulatory environment has tightened enough to suggest the risks within the financial sector itself are well understood.

We do not want to convey an overly bearish set of possibilities. In our opinion the risk is currently skewed to underperforming anticipated returns rather than a sharp and substantial loss of capital.

Asset Allocation and Expected Returns

Source: Bloomberg, Iress, Escala Partners

Source: Bloomberg, Iress, Escala Partners

The current atypical conditions limit the capacity to point to traditional patterns in economic cycles to guide likely investment outcomes. The most obvious component is the extent and length of the interest rate cycle. The absence of any signs of inflation brought about by capacity utilisation is also uncommon.

Instead, we have to consider the consequences of asset price and financial market inflation brought about by monetary easing, despite the underlying economies having remained relatively weak.

The one issue that persistently rears its head is the possibility of inflation, which is often countered by others that view deflation as the biggest risk. ‘Helicopter money’, as quantitative easing is often called should, under basic economic rules, translate into inflation. The difference in this cycle has been that the velocity of money, that is, the amount of times it is recirculated through credit growth has dropped considerably.

Inflation risk therefore is more probable from wage rises, not due to tight labour markets, but rather a readjustment of lower-end wages after an extended period of limited growth and specific skill shortages. In the US some states and corporations have elected to increase the pay rate of the lowest. In time this may trickle through other parts of the economy.

Nothing suggests that inflation of much more than 3% is possible, but even at that level interest rates in a leveraged world may be more problematic.

To reinforce the unusual conditions, the global interest rate cycle is rarely as de-synchronised as it is at present. The table below shows a number of rate events and whether they follow the US or not.

Early and measured bond cycle rate rises are usually good for equity markets in the medium term (though mixed around three months after the first hike) and other growth assets, as it has signalled better economic momentum. The question is whether this is the case now. The US is arguably already mid-cycle and the rate increases are coming off such a low ebb.

Equity markets tend to follow US rates, or rather, as rates have (see above) been largely in sync, all equity markets exhibited the same behaviour. At present, we have Europe and Japan holding rates down and indirectly supporting growth assets. The US domestic sector is therefore expected to reflect its economic conditions and other markets are likely to remain relatively highly correlated.

While it appears that volatility in equity markets has spiked in recent months, in reality, the market has only returned to more ‘normal’ levels of volatility after experiencing a period of unusually stable returns. We would expect this to continue through FY16, with several unresolved and challenging macro issues we noted above; the path of interest hikes by the Federal Reserve in the US, China’s ability to maintain a respectable level of economic growth and the lurking concern that monetary easing is ineffective.

Rather than imply a bias away from equities, these issues are a reminder that equity investing has to be longer term to achieve its desired outcome.

Consensus is strongly tilted to holding to an equity overweight, but expect returns to be more muted and an increase in volatility is likely. The overweight is based on:

– A high risk premium, while other assets do not offer such a buffer.

– Dividend payout and growth to continue.

– Changes from digital adoption, biosimilars, tourism services and other industry changes.

– Corporate restructuring, which is releasing capital.

This is offset by:

– Equity valuations when compared to their historic average, are towards the high end, particularly in favoured sectors such as healthcare.

– The earnings outlook is less certain post a period of cost reduction.

For Australian investors, an important outcome is to access a stock selection that is difficult to replicate in the ASX 200 given its structural mix. The table below illustrates the intended outcome.

Annualised total returns for the past five years are shown by sectors in the MSCI World Index and then the ASX 200, in local currencies. In this time frame, the Australian sectors which have outperformed global sectors are Financials, Telco and Utilities; all essentially based on the yield theme.

Source: Bloomberg, Iress, Escala Partners

Whilst Australian investors have worn a negative return in energy and materials, global indexes are positive. Important sectors such as consumer discretionary, largely representing global brands, media companies and some internet retailers have overwhelmed our stocks which are under-represented in these areas. Instead, the ASX 200 has a bias towards older-style media and store-based retail. Information technology is another, with the Australian sector consisting essentially of Computershare, Carsales.com and Iress; not the IT companies most would want to invest in.

In the past year, investors have been rewarded by following monetary easing, with Europe and Japan performing better than the US. Their economic cycle is not advanced and therefore the earnings recovery is only now emerging. Asia Pacific has also been a better performer as interest rates have been cut and valuations were particularly attractive 12 month ago.

Currently, the majority of fund managers and investment banks share the view that Europe, Japan and Asia Pacific continue to offer better valuations than the US. That consensus may appear somewhat dangerous, but we note the bias in weightings is relatively modest. Notably, dividend yields in Europe and Asia are the highest.

The key is the sectors chosen and the stock selection within the sectors, as is evident from the table above. The protracted outperformance of key sectors is a matter of some debate, yet the fundamental outlook supports this achievement. Healthcare and IT have shown the ability forcapacity to achieve higher profits to somea degree abstract from economic conditions, with strong free cash flow, global reach and a dose of M&A. The risk lies with the higher valuations which makes them vulnerable in a sell- off and could undermine the otherwise defensive characteristics. Consumer discretionary globally has a range of industries, and a combination of solid global auto sales, higher value media content, hardware-related retail and high margin and cash flow brands have supported this sector.

Most fund managers are still finding the best opportunities in these sectors, while financial companies (especially insurance), have been added to the mix.

From a regional perspective, we do believe Asia Pacific will be the best long term performer, notwithstanding the current dislocation in the Chinese market.

Australian equities are off close to 10% since the recent high reached in April, although are relatively flat on both a six 6 and 12 twelve12 month basis.  The volatility in bonds, the Greek crisis and recent events in the China stockmarket affected all equities. Nonetheless, however, the persistent weakness in commodity prices and our market’s higher vulnerability to interest rates have also weighed on returns. This correction is hardly without precedent; our domestic market has had four larger falls since it began its recovery from the financial crisis in early 2009.

In the upcoming August reporting season, we expect to see companies focus on cost-out or efficiency programs. The trend of prioritising dividend payments over potential capital expenditure options should also remain; partly out of a reluctance to invest in an environment of low-demand, but more likely because this behaviour has recently been rewarded by income-seeking investors. We note, however, that dividend payout ratios across the market have trended higher over recent periods and with a reasonably weak earnings backdrop, there is less scope for any substantial uplift in dividend payments into FY16.

Consensus expectations for the market’s earnings growth for FY16 has been impacted by the outlook for the two largest sectors, – financials and mining. Financials (ex-REITs) now accounts for close to 40% of the total capitalisation of the market, dominated by the four major banks. As we have previously highlighted, we expect that the banks will face a more challenged earnings environment over the next few years, with slow credit growth, no assistance from further falls in bad debts and an increasing regulatory capital burden.

The weight of the materials sector (predominantly the large miners) has halved over the last few years and thus the market is less dictated by the performance of commodity markets. Nonetheless, the volatility of earnings from this sector is particularly high and FY16 is expected to be no different. With all major commodities currently lower (in some cases, materially so) compared to 12 twelve months ago, the sector is set to face another year of negative earnings growth. Current forecasts have the earnings for the big diversified miners at least 20% lower in FY16, despite the benefits of favourable currency movements and their cost- cutting efforts.

The outlook for industrial stocks is generally better than that of the banks and miners, although it is the composition of growth that is of more concern. More companies than not will be achieving a large proportion of their profit growth through lower costs, as opposed to revenue increases. The ability of companies to restructure, divest or acquire value-adding businesses may become a more important driver of individual equity returns over the next 12 twelve months.

Source: Bloomberg, Escala Partners

Valuations of Australian equities have obviously improved somewhat over the last few months, with the market falling at a faster rate than the revisions of earnings. The forward P/E of the market is now close to its historic average over the last decade, although the forward earnings outlook is somewhat weaker than average. Up until recently, the key driver of the market’s returns has been a large positive P/E rerating of the market, particularly yield-focused stocks and sectors. While it cannot be ruled out, our base case does not assume a further positive re-rating of domestic equities.

An upside case for the Australian market would include several events which, logically, should not occur simultaneously and are likely to create offsetting factors:

– The most significant would be a further depreciation of the A$ustralian dollar, offset by further weakness in commodity prices as the cause.

– Better than expected consumption spending and housing, offset by a likely rise in the A$ as higher interest rates are factored in.

– Stronger credit growth, which also would imply rising interest rates.

As we have noted, yields have converged across the market over the last few years and thus the attraction of traditional high yield sectors, such as telecoms, utilities and REITs has been reduced. The appeal of these sectors over the next six months will more likely reside in their relatively defensive earnings qualities.

With this in mind, interest rate movements will remain an important driver of domestic equity returns in the short term. The Australian cash rate may show little movement in FY16, but longer term bond yields may be influenced by interest rate rises in the US; historical correlations would suggest at least some impact.

We recommend investors assess their total portfolio sensitivity to interest rates to establish the weighting for Australian yield stocks.  (banks, reits, utilities and infrastructure). On balance we recommend a neutral weight to such equities. The most attractive parts of the market are the selected stocks where dividend growth is emerging and a notable handful of companies with higher potential earnings coming from their capacity to grow share, restructure or disintermediate others in their industry.

The long term trend of falling interest rates globally has resulted in a 34 year bull market for bonds. Investors have enjoyed strong returns in a safe, highly liquid asset class characterised by low volatility. Now, despite many central banks maintaining an easing bias, the bond market may be entering a structural bear market, with liquidity pressures and higher levels of volatility.

The path of bond markets has been quite varied this year, with yields reaching all-time lows by mid-April before reversing in the last couple of months. The unfolding Greek crisis has added another dimension, with US Treasuries and German Bunds offering a safe haven amidst the turmoil while peripheral European bonds (Italy, Spain and Portugal) pushed lower. The actual rates domestically may be broadly unchanged when we take a 6 six month view, yet the domestic and global bond markets have experienced a dramatic spike in volatility. A number of factors are to blame, including:

– The unprecedented low interest rate levels in Europe. Quantitative easing by the ECB pushed yields to record lows and at one stage investors in German Bunds (bonds) were receiving a negative yield out to 9 nine years. Following this, we saw a change in sentiment reversing this trend and putting upward pressure on Euro yields.

– The Greek crisis causing divergence across bond markets.

– Continued speculation on the timing for of the first Fed rate hike.

– Concerns regarding liquidity within the bond market. Increased levels of debt issuance and reduced balance sheet capabilities by the banks has widened the gap for available warehousing should there be a reduction in buyers of this market.

The bond market landscape has certainly changed. However, we still believe that it should remain a core part of any investment portfolio. The key attributes of this asset class have always been capital preservation and income stability. The structural feature of bonds, repaying principal upon maturity and making regular coupon payments, has not changed. While we believe that they still offer good diversification to equities, correlations between these asset classes will vary. The tables below depict correlations over a five5 year and one1 year period. The shorter time frame demonstrates some of the recent convergence in correlation.

Source: Bloomberg, Escala Partners

Source: Bloomberg, Escala Partners

We acknowledge that volatility levels have increased and despite now being relatively high for this asset class, they remain well below that of equities. The low levels of volatility that the bond market has experienced in recent years has most likely ended and short term capital losses, albeit small, are a possibility for investors. These market conditions give us reason for caution, and we have therefore reduced our overall asset allocation to the fixed income markets.

Source: Bloomberg, Escala Partners

In our last asset allocation piece we recommended a high weighting towards short duration credit products. This proved to be a good strategy, as long dated interest rates rose sharply (causing long duration bonds to fall in price) whilst credit spreads remained stable. We now recommend a more neutral weighting towards credit. Some recent withdrawals in the US high yield market and local spread widening in hybrid securities and investment grade credit may be the start of further adverse movements for these products. Funds and bonds that maintain an overall credit spread duration of 2-3 years should hold their value if credit spreads widen further, but we are reluctant to extend beyond this.

Higher levels of volatility in all fixed income products opens up the prospect forgreater opportunistic buying. We therefore favor funds that are active and take these up, as well as selling down when the market is overstretched.

Long duration strategies are considered most at risk as interest rates start to rise. However, they offer diversification benefits both to equity and credit if a high risk event unfolds.

Whilst we do not think that local rates are likely to be increased in Australia anytime soon, yields will be pushed around in line with global markets. With this in mind, we would be more comfortable adding duration via Australian fixed income funds and benefiting from the roll down as rates in the short term are anchored by the RBA cash rate. Further, we consider downside risk in the domestic market to be lower than global peers, given the Australian duration benchmark is shorter and our rates are higher, limiting the percentage price fall should yields rise further. Capital appreciation in bonds from falling interest rates is unlikely, however our higher base rate and risk of poor economic performance means it cannot be taken off the table.

Global fixed income funds open up the opportunity set for adding attribution through sector and duration rotation and are currently still enjoying a ‘risk free’ pick up through the currency hedge. (Australian hedged investors gain the interest rate differential between our bank bill swap rate of 2.15% at present and global rates which are near zero). However, we remain wary of the rate cycle that is playing out, particularly in the US. A re-pricing by the market may be further exacerbated if liquidity dries up. We would therefore recommend reducing allocations to long duration global credit funds, preferring to access the global markets via Australian domiciled funds that take on global credit exposure, but maintain a short interest rate duration bias.

Unlike equities, the capital loss on a bond bought at par is only temporary unless it is sold prior to maturity, or there is a default scenario. Funds that get overly active in currency positioning, credit risk and long/short positioning on the curve, however, run the risk of losing permanent capital. We acknowledge the need to take on some extra risks to add value, but will monitor that in our fund recommendations. A low-to-zero return from fixed income for a short period may be acceptable as long as this sector outperforms when equities come under pressure. While correlations hold true, a blended mix of fund strategies and direct holdings should give an even-tempered outcome with results relatively smooth over the medium term.

In conclusion, the increased risks of short term poor performance by fixed income products has led us to be underweight this sector. Our recommendation remains that investors should be realistic about their investment time frame, with 3-5 years being an appropriate period in which to navigate through these changing economic cycles and produce the desired outcome.

Alternative investing represents a different approach to the same assets above; that is, equity and debt, as well as others which are essentially derivatives of those assets such as currenciescy and commodities.

We recommend investors with high equity exposure replace a component with a long short fund (130 long, 30 short). In addition, a market neutral fund should be considered as it has even lower correlation to equity than long short, and, in some cases, may have little correlation.

Global hedge funds are best accessed through a fund of funds. While that can add to costs, it sigificantly reduces the risk of single expossoures given the variability in performance and limited disclosure.

Private equity is a case by case basis and suit few due to large minimum investment requirements. We note that many domestic institutional and global managers are reigning in their weight to these funds given the investment cycle points to lower returns.

In fixed income, investors with a higher risk tolerance can look to domestic funds which can seek out components of the debt market that institutional investors generally avoid. They may represent smaller pockets of debt markets where the size precludes institutional participation or where the credit asset assessment is beyond the scope of the institution.

A final and appropriate alternative are funds which invest across asset sectors. Individuals can rarely do this due to cost and the trade which is potentially complex or requires unique insight. In this pool we include active domestic asset allocators which make distinctive and large moves within asset classes which individuals are unlikely to do.

If investors have an aversion to these funds, low return cash is the fall back option. As we note, however, the medium to longer term returns in other asset classes and alternative funds have outperformed cash for some decades.