Quarterly Market Review July 2017

Global economic momentum has improved at a steady pace through 2017 driven by better than expected growth in Europe and a recovery in trade. Employment growth is underpinning consumer spending, while corporate profitability has enjoyed a widespread rise given the recovery in commodity prices, restructuring and low cost of capital. Australia has lagged and while recent data shows an improvement, the imbalances are expected to hold back growth.

The absence of any inflation is a notable feature directly impacting on interest rates. There are structural developments that are likely to contain measured CPI, yet central banks and financial markets should not ignore asset prices and capital allocation decisions that are now uncomfortably dependent on rates.

A rise in interest rates, even if the extent and pace is moderated by low inflation, will impact on financial assets. In this report, we provide an analysis of the key impact on equities and fixed income from a rising rate environment.

Global equity markets are supported by a reasonable earnings outlook and dividend yields higher than that of bonds. We recommend full to overweight allocations to global equity markets, with a skew to those outside the US. We prefer active managers that can tilt to sectors, as the potential rotation towards value from growth could resurface if rates rise. Exchange traded funds are an option for those that wish to express a tactical view in regions without the longer-term time horizon associated with actively managed fund portfolios.

Australian equities are more sensitive to interest rates than most other countries given the weight in sectors such as financials, REITs, utilities and telcos. We recommend an underweight allocation at this time, particularly given the lower potential earnings growth. Small caps, having underperformed for the past eighteen months, should now be considered given valuations are relatively attractive.

The positioning in fixed income is to avoid high exposure to interest rate movements through global unconstrained strategies and low duration domestic holdings. A small holding in long duration is still a viable defensive allocation in the event of a significant sell down in risk assets, but the opportunity cost of such insurance is higher than normal.

Alternative investments in domestic market neutral, global macro and unlisted debt and property markets can act as an uncorrelated source of returns and income. Where appropriate we recommend higher weights to such holdings.

We recommend a higher allocation to cash in our capital preservation portfolio, notwithstanding low rates, as the historic correlation between asset classes may be different as central banks change their position. We recommend a modestly lower weight than the base case to Australian equities for income-orientated portfolios, given the risk in some dividend-paying large caps. For those seeking capital growth, global unhedged equities are a recommended overweight.

Asset Allocation

Expected index return (excluding alpha and franking)

Expected return (including alpha and franking)

Against expectations, it has been the strength in economic momentum in Europe and the emerging world that has driven the pace in the first half of 2017. By contrast, the much anticipated lift in US activity has been muted.

This outcome has been due to a confluence of factors. Europe was well behind in terms of its cycle and therefore had greater capacity to improve. Fundamentally, the tailwind of the fall in the Euro through 2016, uplift in manufacturing activity as evidenced by global PMI (purchasing manufacturing index) and the benefits of stimulus in China, all added to the momentum.

US growth below the expectations of last year, yet relatively stable

Over the coming twelve months the consensus is that US GDP growth will lift somewhat. It reflects a seasonal pattern that has become prevalent in recent years, but is also supported by corporate and consumer optimism. The unknown is consequences of policy, particularly tax reform. This is complicated by the restraints put on by the budget ceiling and political interests. Nonetheless, it is probable some elements will come to pass that are likely to be business friendly.

The US household sector has acted with restraint in spending and credit accumulation (outside a few areas such as student loans) and should be able to sustain consumption patterns. Due to the specific demographic profile in the US, many point to the potential for an increase in household formation and house purchases as another supportive factor.

Europe has been better than expected

Private consumption and gross fixed capital investment have been the source of European growth balanced across sectors. Domestic demand has been a key factor as labour markets brought about an uplift in confidence. In turn, credit growth has improved, assisted by (but not solely determined by) the low cost of funding.  Spain has recovered from its banking problems and more recently France is achieving better growth after lagging the eurozone. Another catalyst could come if the European Union undertakes reforms post the German election, assuming Merkel and the CDU coalition win. This is politically driven, given it will be her last term in the role, while in France, Macron must push through change or face quick disillusionment. Given Germany is operating at near full capacity, its policy into 2018 will be important.

The pickup in global trade has supported Asia and EM

In tune with the upturn on global trade this year, exports have had a large multiplier effect and the developments across Asia, and therefore require close scrutiny.

Contributions to world trade growth

 

Few disagree that the combination of investment programmes and the consumption pattern of the middle class should sustain growth in China for some years. The imbalance comes back to the usual global culprit of excess credit. Initially focused on the property cycle, it is now private sector debt at state owned or influenced corporations, that may prove the handicap.

Credit growth in China, and elsewhere, is a natural outcome given the low cost of debt versus equity. This is a topic we shall address in the investment outlook. Some suggest that China should officially nationalise some of its liabilities given the skew to state enterprises. While this may reshuffle the cards, the dependence on leverage remains an issue. The development of a deeper capital market is part of the solution. Credit issuance will then be more closely linked to the balance sheet and cash flow of companies rather than political expediency. A higher component of equity weight would be another positive outcome. Recent moves by the authorities to increase foreign participation in credit markets and the inclusion of China A shares in the MSCI are steps in that direction. However, structural changes in funding the local governments away from property asset sales, greater toleration of redundancies and a practical and realistic savings system for households are nominated as absent in the priorities at the central level.

Australian GDP growth below par with structural challenged ahead

Having skirted a technical recession, Australia’s growth path is no clearer. To summarise our regular updates from the weekend reports, the household sector is caught between soft labour markets, particularly wages, all time high debt and rising non-discretionary costs.  At the same time, business investment is muted and narrowly focused.  State government spending on infrastructure projects is arguably the bright spot.

The best case is that high dependence on household leverage ebbs away and that business investment picks up along with the growing contribution from tourism and education as export services. A major risk is contagion in the event China’s credit cycle turns unfavourable and capital restrictions are applied there. The second is the position of the investor housing segment and the potential that the transition to interest and principal loans results in an unwinding in housing values, so undermining household confidence.

Investment market outlook – a transition in the interest rate cycle

Underpinning investment markets in the past decade has been declining interest rates. Combined with central bank purchases of bonds and selected fixed income securities, this has pushed investors into other asset classes, resulting in a rise in valuations relative to earnings (in the case of equities) and a fall in yield (in the case of credit).

Now that the momentum is changing, following the US rate rises and indications other central banks will also reduce their monetary support. The question is whether the rug is pulled from these supportive valuation factors. We stress that interest rates will not return to historic levels, but that the sensitivity is higher than before.

Rates and equity valuations

The importance of a yield premium in risk assets

In equities, the risk premia (earnings yield – the inverse of a P/E multiple – above the bond rate) and the discount rate on future earnings via a DCF model (discounted cash flow) are primary determinants of medium to long term value. If interest rates are low, valuations can be sustainably higher. Below is a simple illustration. If the market is trading at a P/E of 15X, the earnings yield is 6.5%. At a bond yield of 3%, equity investors are pricing in a 3.7% premium for the equity risk that they take. If rates rise to 4%, to maintain the same risk premium for their equity exposure, the P/E would have to fall to 13X.

Low rates are used to justify current equity P/Es above their historic averages, and, in most cases, also above the so-called CAPE ratio (cyclically adjusted price earnings). The CAPE assumes that higher profit margins will be neutralised in a full economic cycle due to economic change and competition.

The US market will lead the way in assessing the impact of a change in the rate structure. The chart shows the implied risk premia on the assumption that investors expect a 7.5% annual nominal return (dividends, buybacks and earnings growth) over the coming five years.

Implied ERP and Risk-free Rates

 

Already, the rise in the 10 Treasury year rate in recent weeks has affected the equity market, as it compresses what is at face value a reasonable risk premia. If we combine the potential for a 3% 10-year rate, lower cash flow returns, particularly buybacks and lower profit growth, the likely return from the US market at this point is less than the implied 7.5%. It points to either low returns or a fall in valuation to reset the return target.

We know that this mechanistic application of valuations do not tell us where the market will trade in the short or even medium term. Nonetheless, there is fundamental logic that valuations should retrace when rates rise. Rate increases are intended to pre-emptively temper demand for credit, implicitly investment assets and household leverage. Economic growth should slow in pace and corporate profitability as well.

The CAPE ratio captures where we are in the pricing versus earnings cycle. There are plenty of caveats in this measure. The data are based on 10 year averages. At present, it is therefore still including the sharp fall in earnings of 2007-2009. Even if there is no earnings growth in the coming two years, the CAPE will fall given the shift in the starting base. The second is the change in weight in the indices (excluding Australia) from a heavy financial sector to consumer and IT. The former usually has a lower P/E to the average, while the opposite applies to growth sectors. The CAPE does not adjust for sector differentials.

Yet, it would be unwise to ignore that the current CAPE suggests some markets are expensive, in particular the US, though there is also enough below their average.

Cape Valuations

 

Rates and fixed income assets

Fixed income assets respond directly to changes in interest rates but that does not mean returns will be compromised

For some time, active fixed interest managers have been positioned in anticipation of higher interest rates. This past quarter has shown that rates will also respond to other factors, particularly data that suggests the cycle is far from a clear-cut outcome.

The impact of a rise in interest rates on rate markets will vary depending on the length of maturity of the bond and the time it takes for the rate rise to occur. The longer the maturity and the quicker the pace, the bigger the fall in the bond price.

If one assumes that rates in the US rise by 75bp across the curve over the next 12 months, single bonds in 3, 5 and 10-year maturities show a total return of -1.46%, -2.69% and -5.09% respectively over one year. The rationale is simple; the long maturities established at lower rates are now much less valuable than a new long maturity at the higher rate.

For investors who have exposure to interest rate sensitive global bonds, it is usually via a fund that tracks the Barclays Global Aggregate Bond Index. While it is difficult to determine what the actual performance will be on this index, it is possible that a large rate move in the US could still result in a positive or slightly negative return for the index. The index exposure to the US is only around 39%, with the remainder being in investments in other regions, including emerging markets. And even though the duration on the index is currently close to 7 years, it will have bonds maturing within the year that will be re-invested at the higher rate.

In addition, assuming credit spreads remain unchanged, the index is made up of approximately 50% corporate bonds and asset backed securities which offer an additional premium (~1% on average to the government bond rate).

For Australian investors, there is a carry hedge that is picked up as the currency is converted to AUD (reflecting interest rate differential in the foreign exchange forward markets). This may be eroded should rates in the US move above that of Australia, but the differential with other parts of the world should see this continue as a source of return. The actual performance of the global index will be dependent on the contagion higher US rates will have on other regions and the impact that this may also have on credit spreads.

To assess the potential impact of credit spread widening on fixed income funds, we account for the average credit spread duration of the portfolio (calculated in years). A slightly imperfect, but representative, estimate of the impact of spread movements is obtained by multiplying this average duration by the movement in spreads, less the coupons earned over that period to obtain expected returns.

For example, assume a portfolio with a credit duration of 3 years and a running yield of 3% (300bp). If credit spreads increased by (1%) 100bp over a 12-month period, then the performance on the fund would be 0%.

(Average credit duration (years) X Credit spread move (bp)) – Portfolio Running Yield (bp)= return

(3 X 100) – 300 = 0%

This example is typical of an investment grade portfolio in this environment. However, a spread movement of this magnitude is very rare and we would need to look back to the sovereign debt crisis and the global financial crisis to find a time when spreads on investment grade credit in Australia were 100bp higher than where they are today.

Australian iTraxx measuring investment grade credit spreads over the last 10 years

The portfolio positioning as we enter this period is intended to participate in where there is valuation support.

US

There is widespread consensus that the US market is overvalued. As noted in the section on equity valuation, the earnings yield to 10-year Treasuries is about at its long-term average, but the absolute yield is close to its historic low.

US equity market valuations, 1988-2017

 

The other risk in the US is the weight and activity in ETFs. These have a significant participation by momentum investors who would potentially move quickly were the direction to change.

As long as the Fed maintains its expected pace of moderate rate rises and the US economy is stable, higher valuations may be tolerated in the absence of other investment options. Nonetheless, the breadth of performance within the S&P 500 has narrowed to where the heralded FAANG (Facebook, Amazon, etc) stocks are disproportionately driving the index movement. As these companies continue to offer earnings growth well above the market, the support is unlikely to diminish. In other sectors, the task is to select companies with better prospects and lower valuations that can withstand a potential drawdown. For example, in the large healthcare sector, medical equipment and services are preferred over pharma stocks. The financial sector may also regain traction as it is the most leveraged beneficiary of rising rates, particularly if the yield curve steepens.

We recommend underweight US equities

– We are monitoring our recommended developed market funds’ weighting to the US. The key is the selection of stocks in the US that have merits outside the general index. Where it is viewed as higher than desired, we introduce a fund with a higher bias away from the US and/or a non-US ETF (for example VEU).

Europe

Europe is in the spotlight as the favoured overweight region. Earnings growth is picking up and supported by the dividend yield. Further, the P/E for Europe is at a relatively wide discount to that of the US.

The recent performance of the European index has come from a wide range of sectors and companies. Given the absence of the high-profile IT/consumer discretionary disrupters, it is a pointer that investors are embracing the potential for earnings surprise across cyclical stocks that have lagged for some years.

European (including UK) equities

 

A key issue is that the financial sector in Europe has recapitalised and mostly restructured. Unlike the US, Europe is still a high user of bank debt rather than the credit markets. Therefore, higher credit demand translates into asset growth for the banks.

Active European weight can be achieved through specific managers or ETFs

– We combine an active European manager (Platinum Europe) with developed market global funds that are skewed to Europe (RARE Infrastructure Value, Antipodes) and ETFs (IEU, VEQ) to combine longer term active stock selection with a shorter term tactical approach through the ETF.

Japan

After a burst in performance at the end of 2016, Japan has tracked the pack this year to date. We see this market as purely for active stock selection and discourage EFTs. The active managers have narrowed their focus to the companies that have challenged the traditional Japanese corporate approach and embraced the changes that the government encouraged, such as a focus on balance sheets, especially cash levels and non-performing assets.

There are sectors showing real growth – tourism has picked up as a safe haven affordable destination, IT stocks have as much growth potential as their global counterparts and Japanese companies are welcomed as long-term investors across Asia, particularly where they bring higher-end manufacturing expertise.

– Platinum Japan has an enviable performance record and Antipodes Global Fund is overweight Japan.

Other regions

Emerging markets have been the standout performer over the past six months as the concerns on global trade abated and the USD rally came to an end. The risks for emerging economies are centred on debt levels, commodity prices and their vulnerability to trade barriers.

The USD effect is a derivative of external debt and current account deficits where a country is dependent on global sources of capital. China, for example, has a low reliance on external capital flows, but a high internal debt. Its risk is therefore from within the economy, rather than refunding in global markets. The current account deficits in countries such as Brazil, Russia and Chile have improved with the recovery in commodity prices and domestic restraint. On the other hand, Turkey and Malaysia have a high external debt dependence and troublesome domestic growth.

The attraction of Emerging Markets is the potential growth from the household sector, a theme that still has time to evolve. Until recently, many investors were comfortable gaining exposure through developed world companies that had meaningful revenue from emerging economies. This has become suboptimal, as local champions have better growth and can even overtake the position of the global entities. The most obvious example is the tremendous acceleration in China-based IT companies, to where they are now encroaching on other regions.

Translating developed world consumption patterns to that of the emerging world is increasingly misleading. For example, China has a low reliance on credit cards due to its offline payment systems such as Alipay or Tenpay. In India, banks are growth stocks given the low penetration of banking in the community and the monetisation change in 2016. While patchy, the same story can be played out in many emerging economies, even those that don’t represent with the excitement attributed to the Asian region.

Timing investment in emerging markets is hard and the volatility of performance is notably higher than other equities. The key is the time horizon of the investor.

Emerging markets require long term time horizons but offer highly differentiated stock selection and participation in domestic demand growth

– Recommended funds include Aberdeen Emerging Markets as a conservative long-term fund, Somerset EM Dividend Growth (not strictly speaking focused on dividend growth, but rather cash flow) and Macquarie Asia New Stars, which invests in small cap consumer companies.

More so than most equity markets, the Australian share market faces a valuation headwind from a rising bond yields. The reason for this is twofold. The structure of the domestic market means that sectors that are negatively impacted are larger than that of international markets and the high dividend yield of Australian equities results in investors often purchasing shares for income, rather than capital growth. As the attractiveness of the yield will diminish when rates are rising, the yield differential equation can then only be balanced by dividend growth and/or a decline in capital value.

A rise in global interest rates is likely to cap the performance of a large component of the ASX 200

The winners in a rising bond yield environment in the Australian share market are limited. The financials sector is typically regarded as the biggest beneficiary of rising rates. Given the large weighting of financials in the domestic market (35%, including 25% in the four major banks), at face value it may be expected that a steeper interest rate yield curve would be a positive for these stocks. However, the benefit for the domestic banks is limited, given the high proportion of variable rate lending in Australia and probable slowdown in the credit cycle.

Insurance companies that invest primarily in short term fixed income and debt securities have material positive leverage to rising rates. It is probable, that Australia will be behind any global monetary policy tightening trend, given our higher starting base for interest rates, economic cycle and prevailing risks. Thus, the benefits to Suncorp and IAG is likely to lag that of global insurer QBE. Computershare, which invests its client balances in short-term fixed income markets, is the other obvious beneficiary, with the bonus of a high exposure to the US (where the cash rate is already rising).

As noted, the list of stocks and sectors that are negatively affected by rising rates is more extensive, including REITs, utilities, infrastructure and telcos. The common theme among these is they generally have relatively stable underlying earnings and thus can employ higher levels of leverage than other companies. Many of these stocks have had a positive tailwind from rising rates in recent years, as illustrated by the following correlation chart between bond yields and sector returns.

Five Year Correlation of Sectors and ASX 200 to Australian 10-Year Government Bond Yield

 

While rising yields are potentially the overarching driver of returns across this group in the medium term, there are still likely to be nuances within. If rates are in response to increasing inflation, then companies with in-built revenue inflation protection (such as Transurban) are less likely to be impacted. Likewise, companies that have long-dated fixed-rate debt will be partially protected from an earnings perspective.

High yielding equities are also at some risk from bond yields given the migration of income-seeking investors from other asset classes where income declined. There is some crossover here with the sectors described above and this also extends to other defensive sectors, such as consumer staples and telcos. For this group, one of the more important factors will be dividend growth and sustainability. The combination of a high payout ratio and downside risk to earnings pose the greatest threat to the capital of this segment. We have noted in recent quarterlies that the dividend payout ratio across the equity market has been rising over the last five years (indeed, companies have been rewarded by investors for giving back capital instead of investing), hence the list of stocks to which this is applicable is also high.

The extent that rising interest rates will be a drag on domestic equities will be dependent on the level of earnings growth achieved. On this front, the August 2017 reporting season is expected to deliver an impressive 20%+ increase in earnings year-on-year. The primary driver of this, however, will be the volatile resources sector, which has rebased earnings higher following the rebound in commodity prices from early in 2016. Excluding resources, earnings growth across the market is expected to be in the mid-single digit range – a similar rate to that achieved in recent years. Nonetheless, the returns of the Australian equity market since early last year have been underpinned by this recovery in resources profits and less so the P/E expansion that was a feature of the preceding few years.

From here, the outlook for FY18 needs to be considered. For resources, the earnings momentum that carried the sector through 2016 has since dissipated, with the difference between spot and forecast prices contracting. Iron ore remains the most important commodity and demand is inextricably linked to infrastructure and property spending in China with the price now seen as closer to what should be supported by marginal supply costs. Other commodities have been similarly weak in 2017 or consolidated at higher levels without appreciating further, including copper, while coal had a brief weather-related supply disruption spike in April.

The demand side for most commodities is judged as solid, particularly if the rebound in global economic growth is sustained. With more of the heavy lifting from developed economies, however, the incremental demand would be expected to be lower compared with the emerging markets-driven growth of the last decade.

On free cash flow yield measures, many resources stocks look good value and will support higher dividends in this reporting season. Forward yields may be at risk if costs have been cut too hard in the current cycle and investment spend is again required to maintain production levels. Resources look relatively attractive on a forward P/E basis, however the cyclicality of the sector has meant that this is often a poor measure of value.

We have discussed the outlook for the major banks on many occasions. The environment remains challenging. Credit growth is slow and is now being capped by regulatory restrictions; bad debts are low, with a risk of normalisation at some point; the new liability tax will drag on earnings this year; and cost pressure from ongoing rising compliance and technology sources. Dividends are expected to be flat in the medium term and while balance sheets have strengthened in recent years, the prospect of higher regulatory capital requirements remains. Price to book values have contracted over the last years largely reflective of a structurally lower return on equity given the higher capital base. Diversified financials have a better outlook on higher rates and on positive equity market movements in the last year.

The industrials sector has been the most consistent source of earnings growth for the market over the last five years and a steady increase is again expected in the next 12 months. The primary risks are generally associated with stocks exposed to a housing cycle and retailers, which may struggle in the face of soft household income growth and high debt levels. A few large sectors, such as telecommunications and consumer staples, are confronted by elevated levels of competition and margin pressure. Higher growth opportunities currently reside in the mid and small cap space, while companies with international earnings could possibly get an uplift if the AUD retraces.

Adding to small caps can capture the relatively attractive valuation gap to large caps

– We have highlighted the valuation gap that has emerged between small and large cap industrials stocks and believe that now is ideal time to consider an allocation to this subsector for portfolios that have no exposure.

Forward EPS of Key Sectors: Last Five Years

 

The expected earnings growth of the ASX200 for 2018 is a modest 7%, particularly given the inevitable downward earnings revisions that occur over the course of a financial year.

– With better growth likely to materialise in international equity markets and similar valuation levels, we retain our preference for an underweight domestic equity position relative to strategic asset allocation weights.

Given domestic equities are at the upper end of historic valuation measures, the role of alternatives managed funds is worth highlighting.

– Several of our recommended managed funds have a long/short mandate (e.g. Regal Smaller Companies, JCP Small Companies, Wavestone) and thus provide downside market protection by profiting from individual stock price declines. Funds that are market neutral (i.e. long positions are fully offset by shorts) take this a step further and should have little correlation with market movements. Dependent on the level of leverage employed by the fund (high in the example of Bennelong Long Short, low for Optimal Absolute Return), volatility will often be lower than that of the market. A blended approach is our preferred exposure given the varying stock selection process and performance outcomes in any given year.

Global Bonds

Until recently, higher interest rates only looked likely from the US Fed as it continued to ‘normalise’ monetary policy. However, recently there has been a shift in the tone from the European Central Bank (ECB), with a more balanced tone from Mario Draghi signalling the end (albeit gradually) of negative interest rates and its quantitative easing (QE) programme. With the bigger central banks embarking on a new era of tighter monetary conditions, there are implications for fixed income.  To compound the issue, there has also been a hawkish shift from other central banks including the UK, Canada, Norway and Korea.

In the second half of 2017, we expect a sell-off in the bond market as rates move higher. While there has been an upward shift in the overnight swaps rate in the last few weeks, the risk is that the market is insufficiently pricing in the upward movements given low inflation expectations.

The shape of the yield curve over the next six months will be the biggest driver of returns for investments in longer dated bonds. Demand for US Treasures is expected to stay strong as a wall of savings looks for a home, with relatively higher US yields attractive in a world of low interest rates. Recently, China increased its purchases of US Treasuries as it rebuilds foreign reserves after defending its currency last year and this pattern is likely to continue.

On the supply side, the Fed has indicated that it will begin to reduce its balance sheet, albeit at a conservative pace. In practice, this means it will stop reinvesting proceeds from maturing bonds, allowing the holdings of treasuries and mortgage backed securities to gradually run off over time.

As noted, further upward pressure on global bond yields could emerge from the ECB. It is likely to be cautious by first moving away from negative rates and QE pulled back over a lengthy time frame. The ECB has already tested this, with a reduction in purchases from $80 billion to $60 billion a month in 2017. This has been well absorbed by markets, although in reality it was done out of necessity, given the ECB had run out of bonds to buy. Nevertheless, with the right amount of transparency regarding the QE unwind and rise in deposit rates, we expect bond yields to rise further, but be broadly contained.

Global unconstrained funds can avoid the repercussions of rising rates

– The long duration global bond funds that we recommend share our views on an expectation of higher rates, and are therefore positioned short the benchmark. We favour unconstrained mandates over core global bond funds, until such time as rates have lifted to a level where value has been restored. In current conditions, this would be when the US 10-year Treasury reaches close to 3%.

Domestic Bonds

The shape of the Australian yield curve is often dictated by the RBA at the short end, while global factors and inflation forecasts impact the longer maturities. The market consensus is that the RBA is on hold for the rest of 2017. However, a recent pick-up in economic data and comments regarding a 3.5% neutral cash rate in the RBA minutes from the July meeting, has seen a reversal in sentiment to when a rate rise might be on the cards. The markets had been scaling back forecasts for rate cuts in favour of rate hikes over this year, the extent to which is constantly changing.

As our banks have been undertaking out-of-cycle interest rate hikes, and together with macro-prudential changes designed to curb the property market, this relieves pressure on the RBA to act.

Expectations of higher rates offshore have fuelled the bond market sell off, with yields across the Australian bond curve also lifting 25-40bp in June. While we are of the view that domestic rates may rise further in the second half of 2017, it is approaching levels on the long end which are a little more interesting, notwithstanding the outlook for the official rate.

As discussed in the economics section above, tail risks to the domestic economy are well recognised and the world is not immune to disruption.

–    We remain tactically underweight in fixed income and duration style funds overall, yet the diversification to risk assets within the portfolio makes the case to retain some exposure to the domestic market.

Credit and risk assets

Low duration domestic funds can offer modest but solid returns

Credit tightening has taken the spread to the bottom end of historic ranges. While technically many sectors appear overvalued, it is difficult to predict a catalyst for reversal. The necessity of reliable income yield, limits to risk exposure through equities and downward pressure on global bond prices, has credit as a beneficiary. The new issue market for corporate bonds remains buoyant, with oversubscription levels for new deals, even in riskier segments.  Default rates are historically low (e.g. US High Yield at 1.3% vs 30-year average of 3.9%) and corporate profit relatively stable.

Current credit spreads relative to their historic ranges

 

– We are neutral to credit exposure in our fixed income asset allocation, supporting fund managers to seek credit sectors that offer the best value at a given time. Despite the low default rates, we are mindful that credit selection is key to avoiding a poor performing security.

ASX Listed debt and Hybrid market

The listed debt and hybrid market has tightened to where value is hard to access

Our view on the outlook for this asset class over the next quarter is mixed. Spreads are above their lows of the end of 2014 (which marked a reversal), yet they do appear overvalued based off average margins of the last two years.

The case for spread widening includes:

– The credit rating downgrades for bank hybrids, which are now deemed to be non-investment grade by S&P and Moody’s

– The view that the changes to superannuation contributions as at the 1st of July resulted in a flow of cash to the hybrid market. This is expected to be redeployed into other asset classes at some point.

– Constant reminders on the bail-in risks in bank hybrids, as has been evident in global markets.

Outweighing these arguments has been the shrinking supply. In the June quarter, there was ~$2.4 billion in redemptions in the ASX listed debt and hybrid market and there are significant maturities to come over the next few months. Banks have elected to redeem maturing ASX-listed subordinated bonds and instead use the wholesale ‘over-the-counter market (OTC)’ for the issuance of tier 2 instruments, given tighter funding levels and ease of execution. What ANZ decides to do with the upcoming $1.34 billion hybrid ANZPC maturity will be key to supply levels over the next quarter. If supply remains restricted in a backdrop of investors searching for additional yield and favouring floating rate exposure as bond yields rise, then this market will continue to perform. For this reason, we remain neutral to underweight on this sector, awaiting further clarification on the new issuance pipeline.

In summary

– Central bank policies are expected to drive global bond yields higher over the next quarter, although demand dynamics for credit product and yield should contain the bond market sell off.

– Domestically we expect the RBA to stay on hold for the foreseeable future. Adding diversification and ‘insurance’ into investment portfolios via Australian long duration funds maybe a worthwhile bet as economic conditions remain fragile.

– In the bank hybrid market, restricted supply continues to keep spreads low, although a strong case for credit spread widening exists. We remain cautious of increasing exposure to the ASX listed market at present.

Headwinds are evident for fixed income performance over the next half year. However, we are reminded of the structural nature of this asset class (with the mean reversion of bonds back to par) and its ability to perform through market cycles with very few years of negative performance.

Global Bond and Credit Index Returns (hedged)