Quarterly Market Review July 2016

In the near term we believe investment risks are elevated due to forthcoming macro events and higher than average valuations across most market segments. For investors seeking capital preservation or growth, we have held our cash weights above the strategic level and have balanced out the investment risks across and within the investment subsectors.  Income investors can reduce the equity volatility though the domestic listed debt and hybrid markets.

– The diversification of growth assets into global equities plays a key role in capital preservation and long term growth portfolios. The lower reliability in distributions reduces the allocated weight for investors where income is the predominant requirement. For investors with a longer time frame, emerging markets are currently judged to be the most attractive. The buffer from unhedged global equities assists in capital preservation.

– We believe that Australian equities remain relatively fully valued and note that dividend payout ratios across the market are high. For investors who are targeting capital growth, a higher allocation to small and mid-cap companies is recommended. Income-focused investors should have a bias towards companies that have sustainable dividends, while value-style fund managers are best for those with a capital preservation objective.

– Government bonds pay a low coupon and rely on capital growth to enhance returns. With this in mind, we have maintained our current weightings of this sector for clients seeking capital preservation and growth, but have reduced our allocation for those requiring income. Our view on the investment grade credit universe is neutral. We expect it will provide modest income, with capital preservation. For clients with a growth or income mandate we recommend the moderate inclusion of higher yielding sectors.

– Alternative investments are recommended where they have a low correlation with equities and fixed income, as well as to enhance potential returns.

Asset Allocation: Third Quarter 2016

Source: Bloomberg, Escala Partners

Within this report we will briefly summarise the expected conditions that underpin our asset allocation, given we discuss current influences and changes to the economic outlook in our weekly reports.

– Global GDP growth remains subdued, with no particular region able to demonstrate much momentum. Consensus expects the US to grow at 2.2% in 2017, Europe at 1.5% and Japan 0.8%. Most estimates have China at around 6.5% based on the official data. In all cases the skew is to the downside, with the impact of the Brexit vote on Europe still up for judgement. From a macro perspective, the greatest risks are political and the consequential impact on corporate and household behaviour.

– GDP growth in Australia is forecast to be within a tight band of 2.9% – 3.1% this year and 2.9% – 3.2% next year. The predominant sources of growth are the housing and services sectors, balancing the weak contribution from mining investment. The swing factor is generally judged to be housing; the potential for activity to remain at high levels versus a view that tightening of bank lending and oversupply in some regions will have a sharper than expected impact into 2017.

– The critical issue for financial markets will be the trend in inflation and the impact on inflation expectations. Exacerbated by the fall in commodity prices in the past year, the overwhelming problem is that global wage growth has tracked well below the improvement in employment.

Global Wage and Unemployment Trends

Source: Bloomberg, ANZ

There have been some indications that wage growth in the US is picking up. Hours worked are above previous highs, job switchers are achieving a lift of 4% in wages compared to job stayers at below 3%, and new job openings are exceeding the number of hires, implying skilled staff are becoming harder to find. Given there is persistent scepticism that inflation will be sufficient to trigger a rise in interest rates, any indication of a different trend is likely to cause a change in pattern.

– Other important determinants of global growth will be changes in trade flows. Trade tends to be leveraged to economic growth. China is clearly the vulnerable country that may cause ripple effects across Asia. Europe is also reliant on trade and can ill-afford any dip in demand.

– Domestically, the consumer is most likely to influence a variation in the expected growth path. Household spending has been relatively subdued and the saving rate remains high. Given changes in demographics, high household debt and the impost of expenses from utilities, education, health and other essential services, the household sector appears to be taking a cautious stance on discretionary spending.

For the remainder of 2016 the known major influences in investment markets are likely to be political.  Specifically, these include a constitutional referendum in Italy and the presidential election in the US. Within monetary policy, a rate rise in the US and a support mechanism for European banks are on the radar. Financial markets are beholden to the demand for investment income, in an environment which forecasts weak earnings and concern in the growth of corporate debt.

Longer term, the political risks will remain elevated, particularly in Europe. China is more than likely to return into the spotlight with a tricky combination of an overvalued currency, high corporate debt and growth ambitions to negotiate.

There are two possible scenarios we may need to take into account. Firstly, a potential improvement in consumption spending. Households have benefited from the wealth impact of investment markets and housing assets, employment has improved substantially and if wage growth comes into the equation, confidence could induce higher spending. The second is a round of fiscal stimulus from governments under pressure to do something.

It is a reflection of the current unique financial conditions that fixed income indexes have outperformed equities over the past ten years. The sustainability of low rates and the possibility that they could go even lower confounds those that look for a resumption of the business cycle, with long standing views on what should be expected from growth and inflation.

Universal investment commentary from asset allocators, fund managers and investment banks are presently focused on the uncertain direction of markets. Another consideration is the heightened impact of macro events. The case for portfolio construction therefore has to acknowledge this, while also avoiding indecision.

A critical element is to rebase the likely level of investment returns achieved in forthcoming years.

The two charts below give a guide on the direction of returns in the Australian financial market.

For fixed income, we have used the 90 day bank bill swap rate (BBSW) as the market proxy for short term interest rates. As shown, the margin above the CPI has narrowed from around 3% to 1%. (Note that in 2001, the introduction of GST temporarily elevated measured CPI).

Source: Bloomberg, Iress, Escala Partners

We will discuss our views on fixed income asset allocation in greater detail further in this report, however, in the meantime we note that in order to achieve higher returns than shown in the chart above, portfolios  have to take on credit risk and/or interest rate (duration) risk. We stress that this does not suggest an unattractive outcome, but rather that it is important to appreciate the particular influences on each asset class.

Corporate balance sheets have raised their leverage (a natural outcome from low rates) and therefore credit quality is critical. Long dated government bonds could lose capital given the nominally low yield.  We have considered these aspects in our asset allocation concluding that, more than ever, the construction of the fixed income component is of great importance.

Equity returns have a parallel pattern. We show the five year rolling All Ordinaries Index against the BBSW and the CPI. The excess return from equities over short term rates and inflation has fallen from 5-10% to between 0-5%.

Source: Bloomberg, Iress, Escala Partners

The challenge in asset allocation is that safe assets (bonds), or appealing components of financial markets (US equities), are trading at higher than historic valuations. In the case of bonds it is no surprise that they are at the extreme end of valuations. At face value, high yield, corporate credit and emerging market debt present as more attractive options.

US equities have been the best performers in recent years to the extent that valuations have been pushed up above their historic levels. Conversely, Japan, China and other emerging market equities are trading below their average, but have fundamental and sentiment headwinds.

Momentum investing  favours bonds, US equities and defensive sectors whilst tolerating the expensive valuation dilemma. On the other hand, value investing takes a contrarian view, emphasising credit, high yield, selected undervalued equity markets and sectors trading at the lower end of their range.

The following chart gives a sense of the valuation ranges, showing the asset class levels at the end of June 2016 compared to the prior year.

No name – click here to change

Valuations are a poor guide to short or medium term returns, but can be predictive of long term returns. This does not imply the patient are always rewarded. The example of Japan springs to mind, where many companies are reluctant to reform and domestic conditions remain unattractive. These valuations are based on current interest rates and forward earnings. Value segments are invariably more prone to resetting of expectations than those with defensive characteristics.

In summary, we have cast our recommended portfolio allocations based on the complementary role asset classes play and the current valuation of the components in those asset classes. The relative weighting of components is expected to have a distinct impact on the level and volatility of returns and can be adapted to suit each investor.

Investors in global equities have enjoyed above average real returns over the past five years. The MSCI All Country index in local currencies has delivered nominal 8% p.a. With the benefit of the fall in the AUD, unhedged investors have received 13.5% p.a. in this time. Given that the local CPI has averaged 2%, real returns have been attractive.

The US market has been a key contributor in this time, though on a five year basis one may be surprised to observe that the Japanese index has performed the best, with this market experiencing one of its positive cyclical phases. Among sectors, the notable exceptions to this strong performance have been energy, materials and financials.

Source: Bloomberg, Escala Partners

An important support theme for equity investors is the level and persistence of yield. In turn, corporate boards have raised payout ratios and in some sectors debt is funding the rise in capital management. Unlike investment capital, this clearly cannot ever improve the cash flow to fund future interest and debt repayments.

This phenomena is most pronounced in the US S&P 500, where the total of dividends and share buybacks now exceed earnings. The chart below shows a cash flow interpretation, adding back non-cash write downs, as well as adjusting inventory and depreciation to current cost. This lowers the payout to a still-high 70% of available cash.

S&P 500 Implied Cash Flow Payout

Most analysts are winding back on their forecast payouts which has historically signalled a period of lower returns.

The conclusion is that stock selection is becoming even more important in the US market. An example is the healthcare sector. Large pharmaceutical companies have experienced a substantial rise in valuation multiples over the past five years, while earnings momentum has been middling. The risk of government pressure to reduce drug costs is growing and merger activity is abating. Many funds are now focusing on the equipment and devices part of the sector which is more attractively positioned at this time.

Healthcare P/E Expansion and EPS Growth, Last 5 Years

Source: SSGA

At the riskier (but potentially high return) part of the market are energy companies, where the end of impairments and cost reduction should combine to see higher earnings. US financials may also get support if they commence regular dividends and reinforce their differentiation to other regions.

European investment potential has taken a knock with the Brexit vote. The repercussions are yet to be fully evident, mostly likely through a loss of business and consumer confidence due to the uncertain outcome and political developments within Europe. Separate to that, the financial sector has come under pressure as bad debts linger in the system, low bond yields reduce earnings on capital and some banks pay for past transgressions. We see funds taking highly selective positions in European stocks, recognising that most of the large companies listed in the region generate only a modest proportion of their profit from within Europe. The index, at 20% financials, is likely to lag an active approach.

As noted, many of the markets in the emerging world and Asia represent long term value. Investor views on emerging equities tends to rotate from despair to euphoria with regular frequency. This is exacerbated by the increasing use of index funds where emerging markets are a way to express ‘risk on’ or USD views with little regard for the stock fundamentals. Adding to the challenge is the wide dispersion of conditions in each  and local issues which can intervene with an investment thesis.

The sector weight can have a major influence on the emerging market index. Financials are over a quarter of the market, with Brazil and China particularly heavy in the sector.

Emerging Market Index

Source: iShares

In our view, the key is to have a long term investment horizon and rely on funds which are dedicated to these markets

Investment in the region is supported by historically low price/book ratios, reasonable dividend yields (circa 3%) and the long-standing theme of consumers looking to improve their lifestyles.

Volatility in fixed income markets typically occurs at times when there is a sharp change in risk sentiment following significant global events, such as the recent Brexit referendum, where we saw strong demand for fixed interest and defensive assets. Concerns around the Italian banking sector and speculation on the Fed’s interest rate policy have been other examples of issues that have created uncertainty in markets, leading to ‘risk off’ trades in the last quarter.

The types of sectors that are favoured when sentiment improves include lower-rated corporate bonds (such as non-investment grade or high yield credit), bonds ranked lower on the capital structure (hybrids, subordinated debt) and debt issued from emerging markets (e.g. Mexico, Brazil, Malaysia etc.). By contrast, when the market is risk averse, demand increases for government bonds from developed countries and highly-rated corporate bonds.

Notwithstanding volatility in markets, the quarter still resulted in strong performance in both credit and duration products. Globally, yields on long duration government bonds continued to test new lows, with investors pricing in further central bank stimulus. Credit spreads widened during this period, but quickly reverted as the low interest rate environment kept demand in place for higher yielding assets. Overall, fixed income had a strong second quarter across the board, with performance results highlighted below.

Fixed Interest: Second Quarter Returns

Source: Escala Partners, Iress, Bloomberg

This pattern will inevitably change and there are a number of factors to consider when assessing allocations to fixed interest. Duration exposure is perhaps the most important decision. How low can yields go, and how can we protect ourselves when the rate cycle turns?

From an outright yield-to-maturity perspective, there is no disputing that government bond income returns are low. Despite this, government bonds have been among the best performing assets over the last few years, benefitting from capital appreciation. Determining when this run is going to end rests on the ability to predict a credible turnaround in global economic growth, a lift in inflation and low unemployment.  Whilst we see glimmers of this in some data releases, the global economy remains fragile and reactive to the downside.

For this reason we continue to recommend the inclusion of long duration government debt. The two long duration domestic funds that we use (Jamieson Coote bond fund and Henderson Australian Fixed Interest Fund) are mindful of the duration within the benchmark. In contrast to passive funds, the managers actively manage interest rate exposure by positioning their fund shorter or longer than the index (usually up to 2 years either side).

Since the financial crisis, the duration of the benchmark (which is made up of 89% government debt and 11% corporate debt) has extended as issuers have taken advantage of low interest rates and locked in longer dated maturities. This has seen the index move from an average duration of 3.5 years in 2008 to 4.9 years. The result is that investors are unwittingly taking on more interest rate risk. This has been beneficial as yields have tumbled, however, it will exaggerate losses should yields rise; an actively managed fund can address this particular risk. The chart below shows the extension in duration alongside the fall in yields.

Australian Bond Market: Duration and Yield

Source: Henderson Global Investors

Given the prevailing conditions, we do not anticipate a turnaround in global growth and stability and therefore do not expect that yields will rise significantly in the medium term. While the risk to interest rates is to the downside, there is also the potential that market conditions will hold up enough for the RBA to refrain from lowering rates further, though conversely any rate hike is some way off. Further, with a large proportion of the developed world’s sovereign debt market offering negative yields, Australian bonds offer a positive yield and a (current) AAA rating, hence are expected to remain well supported.

It is feasible that the interest rate curve may steepen somewhat when the RBA does stop easing, however, yields will remain low as we go into a period of interest rate stability. Funds that have the flexibility to opportunistically trade the interest rate curve should still be able to add to returns, although perhaps not to the same extent as recent history. Further, they may have months of outperformance when periods of ‘risk off’ occur, which will aid in smoothing portfolio returns when paired against risk assets.

Holding long duration assets in global funds remains beneficial as fund managers take advantage of varied interest rate cycles. Quantitative easing by the ECB, and potential easing by the Bank of England, combined with the US Federal Reserve holding rates, are all likely to aid performance of long duration global funds.

Despite our constructive view on including duration in portfolios, we are mindful of the low coupon and reliance on capital growth to enhance returns. With this in mind, we have maintained our current weightings of this sector for clients seeking capital preservation and growth, but have reduced our allocation for those requiring income.

The banking sector is expected to remain under pressure. However, the recent increase in credit spreads now makes stronger issuers more attractive. Australia’s major banks have had a ratings revision to ‘outlook negative’ by S&P. No change is expected for about two years, so there is time for restoration, likely to be worn by equity holders via capital raisings. We are not concerned with their viability as they are more capitalised than ever, and even with a one notch downgrade they are still highly rated credits. Concentration risk and similar risk profiles in the majors do play a role in the degree of allocation.

Our view on the remainder of the investment grade universe is neutral; we expect it will continue to provide low income, with capital preservation.

The high yield sector remains interesting, and we are comfortable with a small allocation to this sector for investors looking for diversification within a growth and income mandate. The US is the largest market, and this can be accessed as part of funds as the JP Morgan Strategic Bond Fund. With exposure away from the fragile energy sector, this fund offers decent returns in a world of low yielding assets. Security selection is key to avoid defaults and a fund manager that has a strong track record in credit analysis is key. The table below depicts the current spreads on offer which are above the long term average, notwithstanding the fact that default rates are at historic lows.

Source: Bloomberg, Escala Partners

Emerging market debt remains one of the more volatile asset classes, mainly as the investment decision often involves taking on local currency exposure. These bonds are particularly vulnerable to risk sentiment with currencies such as the Mexican peso being widely used as a proxy and therefore maybe exposed to exaggerated moves. With volatility does come opportunity, and the global funds that we recommend that participate in this sector include the Franklin Templeton Global Aggregate Bond Fund and Legg Mason Brandywine Global Opportunities Fund. These funds will be more volatile than some other fixed income products, yet relative to equities this range is modest. Spreads are wider than the five year average in many emerging countries, and currencies have suffered significant devaluations in the last year, making this sector a worthy inclusion on a selective basis for growth and income seeking investors. We are cognizant of increased volatility in this sector when the Fed resumes raising interest rates, assuming the USD rallies.

Source: JP Morgan

We increased our allocation to the listed debt market at the beginning of this year, as we felt that investors were finally being sufficiently rewarded for the risk of this sector. We continue to hold this view, as spreads remain fair value and many investors require income.

Listed debt securities are not explicitly rated by the rating agencies, but the equivalent in the over the counter (OTC) market are, and they react to any ratings downgrade with respect to their position in the capital structure. Our major banks are at risk of a downgrade if the government loses its AAA rating. However, in this case it is not expected that lower ranked securities will be substantially affected, as they are not reliant on the government guarantee and are rated in their own right. With this in mind, we don’t foresee any risk to these bonds being called and recommend their inclusion in a diversified portfolio that complements the mix of managed funds.  .

In summary, we see the value in including long duration exposure into portfolios as a defensive play and for diversification benefits. However, we will monitor weightings and may look to revise this if yields fall too low. We have reduced long duration funds for clients seeking income, preferring to increase their allocation to credit. We like credit, and recommend diversifying across credit quality to mitigate risk and enhance returns.

Over the last 12 months, the Australian equity market has been range-bound and, following the recent rally since early February, is back at the upper end of this range. International macro events have arguably been the determining factor in short term returns, whether it be concerns about China, the deliberations of the Federal Reserve or, more recently, the Brexit vote. Falling interest rates have been the one constant factor, helping the equity market look through any other issues.

In terms of absolute valuation measures, Australian equities remain reasonably expensive. The forward P/E ratio of the market is close to the peak level where it has traded over the last decade. Earnings growth across the market is anything but consistent, and the expected growth of the next few years would not justify current valuations.

Relative valuations for Australian equities provide a more supportive argument for the current index level. Interest rates are low and when viewed in isolation, this factor provides an uplift to profits (as the cost of debt has fallen). Asking why, however, is equally important. Forecast economic growth and inflation have declined, and corporate profitability would be expected to be lower in the future.

The other unusual situation to arise from historic low interest rates is that Australian equities now offer a higher yield compared with fixed income, which has typically been the core asset class for investors seeking to maximise their income. Of course, the capital of equities is much less secure compared with most fixed income assets. Notwithstanding this, ‘bond-like’ equities have been among the strongest performers across markets in the last few years, leading to a group of ‘expensive defensives’, which include REITs, utilities and infrastructure.

With dividend levels providing a key plank of support for the Australian equity market, how secure are dividends going forward? The chart below illustrates the 12 month forward earnings and dividend levels of the ASX 200 over the last decade.

ASX 200: EPS, DPS and Payout Ratio Trends

Source: Bloomberg, Escala Partners

Underlying earnings have typically been much more volatile than dividend payments from companies; cutting dividends is generally the last resort for a company after it has exhausted all options to match its dividend from the prior financial year. Achieving that is often by compromising the dividend payout ratio (i.e. the proportion of profits paid back to shareholders). This was the experience of the global financial crisis years of 2008-09; earnings dropped by close to 40%, while dividends were cut by approximately 25%. Earnings have largely tracked sideways to slightly down over the last five years, primarily driven by weaker commodity prices and hence earnings for resources stocks. Dividends have actually grown over this time, with the boards of listed companies responding to investor demand for higher capital returns.

It has only been in the last six to 12 months that dividends across the market have fallen, driven by a rebasing of dividends by mining companies (some of which had progressive dividend policies) and energy (following a collapse in the oil price). Nonetheless, the dividend payout ratio of the market is approximately 75% and, until recently, had been steadily rising since 2011. The payout ratio is one of the better indicators of the ability of companies to sustain dividend payments, particularly when broader earnings growth is low. The takeaway from the current situation is that dividend growth is likely to be restricted in coming periods and that in some cases, companies may have to cut their dividends. Investing in high yielding stocks is not a fool-proof strategy and will not necessarily lead to a portfolio that will outperform; an understanding of both the sustainability and future dividend trajectory should be emphasised even more.

With a low earnings growth outlook, changes in the earnings multiple will often have a far greater influence on total equity returns. This has been especially true of recent equity market returns, although the impact is greater when we assess the change in P/E’s across different sectors, as well as individual equities. The chart below illustrates the change in key sector P/E’s in the last two years. The price appreciation of REITs and utilities in this time has largely been driven by a re-rating of these sectors as interest rates have fallen. Growth sectors (such as health care) have also attracted a premium given the scarcity of this characteristic, enhancing the overall returns of the sector. Conversely, the banking sector has struggled through a tough earnings backdrop along with a de-rating by investors.

ASX 200: P/E Change Across Sectors From June 2014

Source: Bloomberg, Escala Partners

Predicting the change in P/Es of companies, sectors and the broader market is a difficult task in the short term; stocks that can appear overvalued may continue to outperform, while those that appear cheap can become cheaper. Nonetheless, there is typically an element of mean-reversion in the longer term for P/Es, which would imply that returns may be lower as P/Es return closer to historic averages over time, though tested by other valuation criteria.

So, how should investors position their portfolios in the current environment? It depends on their primary objective.

For investors who are targeting capital growth, the best prospects to achieve this is from mid and small cap companies, and a higher allocation is recommended. As we have highlighted recently, larger cap stocks in the ASX 200 generally face a tougher environment in which to grow earnings. This includes the major banks (low credit growth, higher capital requirements and rising bad debts), resources (well supplied commodity markets), Telstra (competition from smaller players) and supermarkets (new entrants and high price competition across the industry). On current consensus estimates, the ASX 20 is expected to show EPS growth of less than 5% in the next 12 months, while stocks within the rest of the ASX 200 Index are estimated to grow earnings by approximately 8%.

Small and mid-cap companies have a greater capacity for earnings growth in the medium term, yet the trade-off is that they come with a greater level of risk – investors should be prepared to tolerate a higher level of volatility.

We believe that the best way to gain exposure to small and mid-cap equities is through a managed fund. Our two preferred funds, Karara Small Companies and Regal Small Caps, complement each other well. Karara has a strong value discipline, protecting returns on the downside, while Regal typically seeks companies at an earlier stage that have a steeper growth trajectory.

For investors with an income focus, Australian equities should typically form a core part of portfolios given the high relative yield from equities (even more so from a gross basis when franking credits are added). As we noted above, however, dividends from some companies are less secure than others and dividend payout ratios are high. The Martin Currie SMA addresses this issue via investing in high yielding equities, screening for stocks in which they have greater confidence that dividends can be sustained and increased from current levels.

Whilst valuations are relatively stretched across the market, however a manager focused on protecting capital can provide a higher level of protection. The IML SMA is our preferred Australian equity portfolio to meet this objective, having demonstrated a strong record over time when market returns are weak or negative. The manager’s focus on value provides a greater margin for error and stocks are generally selected that have predictable earnings.

We re-iterate that the primary purpose of alternative investments is to seek returns that have a low correlation to equities and bonds. It is the combined outcome from a small selection of fund strategies that is likely to achieve the goal rather than rely on one or two funds. We avoid fund of funds (combined investments in funds selected by an external party) as the transparency is generally low, costs tend to be high and most importantly, the individual funds and their representation in the strategy may not suit the investor.

Each strategy will have particular characteristics that will determine their inclusion in a portfolio. In summary, a number are high risk/return while others manage their positions to limit the degree of downside and forego the potential of high monthly outcomes.

Some alternatives have more limited liquidity windows than most funds in order to be able to buy into securities or assets that are inherently difficult to trade on a daily basis. We believe these may be appropriate subject to the nature of the investment and expected return.

There are specific conditions which may have an influence on each fund’s ability to perform. For example, when stock dispersion (the range of performance amongst stocks) is low, hedge funds tend to generate lower returns. Interest rates will have a big impact on alternative debt strategies and those with currency exposures.

In summary, alternatives are likely to play an important role given the lower expected returns from equities and bonds and we encourage all investors to have an allocation to these assets.