Quarterly Market Review July 2018

In this edition of our Asset Allocation Quarterly we will focus on the impact of regulation and policy on asset classes that we believe are currently influencing investment markets.

We maintain our overweight stance on equity allocations. The asset class is supported by earnings growth and momentum, given the low return option of bonds and credit. With the onset of heightened tension in trade policy, rapidly diminishing support from central banks and the potential for a spike in inflation data, in the short term, we expect that investors prefer relative certainty over valuation support.

The US equity market has regained its leadership, though is relatively fully valued. Confidence in Europe and Japan has eased as economic growth has slowed while Emerging Markets (EM) are vulnerable to policy pressure. EM, however, has the best valuation metrics and for long term investors, current valuations represent an attractive entry point.

The Australian market has rallied this year and we do not recommend adding to allocations, though revisiting the product suite can ensure that the outcome is optimal to the investor’s requirements.

Our underweight to fixed income remains in place. Global bond yields are likely to move higher in the second half of the year while credit spreads are still judged as somewhat too tight. A modest allocation will be useful in a sell-off in risk assets. Our recent preference is to consider higher yield, non-index investment options on a case by case basis.

Asset Allocation

Expected index return (excluding alpha and franking)

Expected return (including alpha and franking)

It is clear that 2018 is proving more challenging for investment markets. The long-awaited move towards tightening monetary policy has been complicated by variable economic growth, the lack of inflationary trend that would be expected in this phase and external issues. None has been more influential than policies on trade which, if taken to the level implied by the rhetoric, could substantially change the outlook. Even without complete implementation, it is likely the attitude and approach to trade of major economic powers will change compared to the past decade.

We retain a bias to equity, noting that the risk of a pullback is higher than before. The allocation is supported by resilient earnings and valuations are slightly better than earlier this year as stock prices have not kept up with profit growth.

While the bulwark sectors of the recent years (technology and healthcare sectors) show little signs of retreat, we do recommend maintaining diversity in approach across portfolios. Energy and materials have been the best recent performers and even REITs and utilities have staged a recovery.

Our investment process recommends complementary managers and strategies in both Australian and global equity markets. At times some may underperform the headline index but prove their worth when markets change direction.

Fixed income is as challenging as we have noted in previous quarters. Bond yields are skewed to the upside, albeit the peak is likely to be far below previous cycles. Economic data suggests that the rise in bond yields will resume in the second half after tracking sideways in the second quarter. An allocation to government bonds is mostly to reduce volatility or protect against a severe event.

Credit spreads have widened from lows, but do not yet present as attractive on total return. Short maturity credit can provide a low but reasonable return.

Investors have turned to non-index credit strategies to access higher yields. We support some of these funds, though it is important to appreciate the risk that is required to get the expected return. Many have low liquidity and therefore don’t show changes to valuation based on mark to market pricing. The apparent low volatility is therefore a function of the investment structure rather than reflective of the risk.

There has been a push to alternative investment to fill the gap left by an underweight to fixed income. We prefer to consider options regardless of conditions for equity or fixed income and focus on the role they may fulfil within the portfolio. For example, alternative equity-based managers in Australia provide a useful offset to long only and we recommend both market neutral and long short to ameliorate portfolio risk. In global equities we prefer to lean on the hedged/unhedged mix, regional allocations and style bias to reduce volatility as the traditional long short or market neutral is difficult to access with confidence.

The past six months have been a stark reminder that political influence can play a large, potentially dominant role, in investment markets. For much of the decade the view has been that central banks prognostications have been key to asset markets, somewhat undermining the role that the Greek debt crisis, Brexit, and gulf state tensions have played. We judge these non-financial events or issues on their likely impact on financial markets and if there is any cause to change the risk in a portfolio. A current example is the South China Sea conflict. At face value this has little to do with asset pricing and the predictability of what might transpire is low. We do therefore not account for this impact. Conversely, the trade tensions are financial and already real.

In the coming months it is trade that is likely to remain the dominant influence, on the assumption the Fed rate moves are fully priced in and other central banks maintain their guidance to avoid upsetting markets as financial conditions tighten. Other known events are the US midterm elections (with the trade rhetoric part of that), while the perpetual instability in Italy and likely tricky Brexit are ongoing issues.

Economically the US has had the most short-term support from policy given the tax cuts, while the cost of debt is subdued by the low interest rates. Business confidence is strong and even though wage growth has lagged, the consumer appears to be managing without a debt binge. The threats are the perennial wallflower of higher inflation, energy prices or an adverse policy initiative (for example on social security or healthcare).

Europe has taken a step back from its unexpected strength of 2017. Even before the trade issues became prominent, Germany had slowed, in part likely due to political tension. Now with the auto sector under threat and other industrial heavy (transport and electrical equipment) also in the spotlight, the outlook is uncertain though its not the bearish story that is often associated with Europe. The region is in a much better position than five years ago and employment growth has been strong for some time.

Already trade looks set to detract from global growth albeit industry activity appears (so far) to be holding up reasonably well.

All-industry Purchasing Managers Index (PMI)

 

There is endless commentary on the possible trade impact. In our view the one issue that is most likely is a rise in prices, after all, the business and household sector will pay for the tariff. Given the possibility tariffs could be rolled back by a future administration, corporates may not invest to the same extent fearful that they may leave themselves vulnerable to policy shifts. An unintended result may be a stronger USD which could also limit domestic investment as the exchange rate offsets the tariff rate.

Emerging economies have been hit with a perfect storm. Political instability in Latin America and Turkey, USD strength, the trade tariffs and rising debt in China have punished the region from a sentiment point of view, yet so far the economic data has not rolled over. Supporters of the region (we often point out that there is no ‘emerging economy’, rather a set of countries with quite different structures that are lumped together for convenience) make note of the much better financial condition that EM is in compared to past periods of pressure.

Inflation is low and under control, reliance on external funding is, on aggregate low, and in many countries the government is shifting towards a more open market with fiscal responsibility. Unlike developed economies, most central banks in the emerging world have welcomed low inflation showing little interest in reflating through monetary policy. Real rates provide easing ammunition should that be warranted.

Emerging economies real short-term interest rates (excluding China)

 

Rather than paint a gloomy picture for these economies, we view the differentiation between them as more important. Those with current account surpluses, manageable debt, a robust monetary system and the long run theme of improving lifestyles will be able to stand out from the crowd.

China warrants a specific comment. So far, the economy is as expected, with a relatively constrained investment contribution offset by good consumption growth. The government has taken considerable steps to reduce unregulated lending and now appears likely to ease its monetary policy (via a range of instruments rather than official interest rates) while possibly picking up fiscal spending. The unknown is clearly the impact and reaction to tariffs. We can speculate that China will want to show a firm response, but not to evoke heightened tension. There is the possibility that post the US midterms some form of accommodation comes into play. Nonetheless, the Chinese government now has a major incentive to internalise its economy away from its reliance on exports and will certainly push harder to move its industrial base to higher value add.

Australian economic commentary can be brief; there has not been much new over the past six months. We have commented on the increase in state-based infrastructure spending, a policy initiative that is broadly welcomed (though funding is dependent on property tax, GST and debt). The services sector is also doing well through the combination of healthcare (particularly the NDIS), education, tourism and state government services.

On the other hand, the housing cycle is now firmly past the peak and the question is only how far it will retrace. Consumers are not well positioned to withstand any unexpected developments. Debt is very high and wage growth is low. The large investor base in the housing market and increasing consumption via buy now pay later schemes could unwind quickly in any adverse conditions.

Inevitably it is politics that may play a new role as we head into a Federal election cycle. Most will be only too familiar with the nature of proposals, from franking and negative gearing to price controls on utilities and possibly healthcare.

To summarise, the outcome of the trade battle and the potential for inflation and associated corporate cost pressure to come in higher than expected in the US are the key factors to consider for the coming six to twelve months.

Volatility has increased globally this year and risk premia has risen from unusually low levels, mostly in response to political issues leading to policy changes, which do have a direct impact on fixed income markets. We therefore examine the likely ongoing effect of Government policy and regulatory changes on the asset class.

US government bonds

Higher US bond yields appear inevitable as we move into the third quarter of 2018. Even with the increased levels of uncertainty, the Fed looks intent on normalising interest rates and unwinding its balance sheet. Opposing this, the bond market has dampened the enthusiasm for higher yields of late, as a ‘risk off’ sentiment encouraged flows into safe-haven bonds. Current rates have the Fed’s open market committee pricing a more aggressive interest-rate path beyond 2018 than market expectations. This suggests that rates may catch up to the FOMC projections, especially when coupled with the reduction of the balance sheet. A larger impact in coming months is probable as liquidity tightens at a greater rate (with the amount rolling off each month increasing from $10bn to $50bn), adding to supply.

Fed’s Asset Holdings ($bn)

 

Over a medium-time frame, fiscal spending policies could lead to overheating which, with rising oil prices and tariffs on imports, may trigger higher inflation. Markets may price in higher yields and a faster pace of monetary tightening policy by the Fed. At the same time the administration needs to fund the spending and the tax cuts by increasing issuance of US treasuries.

This has already had a notable effect on shorter dated pricing, with LIBOR rising significantly. If the Treasury were to lock in more term funding, this may push yields higher on the rest of the curve. In all, the repercussions will weigh against the bond market.

Selling of US treasuries has already materialised, as US corporates repatriate cash held in Treasuries offshore. There is much debate on demand. If the countries with a current account surplus shy away from the US bond market based on expected inflation, the yield curve could move more than expected, at least on a temporary basis. All the above suggests that US government bonds are likely to fall in price in the second half of 2018.

We have focused on the US bond market as it essentially determines the yield movement in most developed countries’ yields. This has been evident in the past six months with the Australian bond pricing following the US even though economic trends are different.

Notwithstanding our bearish view on treasuries, we acknowledge that yields have already moved a lot and demand from pension funds with long term liabilities will act as a natural cap to yields on the long end. An allocation to US treasury bonds (albeit underweight) is still appropriate as a hedge to risk assets and a mitigator to portfolio volatility. This trade proved effective during the recent Italian political upheaval. 

Credit 

Corporate fundamentals remain sound, but concern over rising input costs, trade wars, European political instability and rising rates have weighed on risk sentiment, pushing spreads wider. Nonetheless, given the spread tightening over the last 18 months, valuations still don’t look cheap, although some pockets offer better relative value.

Bank loans are appealing given they are floating rate and are less sensitive to rate hikes. High yield (HY) may offer an opportunity with spread widening and positive credit stories coming out of components of the sector. The number of ‘rising stars’ (HY companies being upgraded to Investment Grade) has increased in 2018 relative to previous years. Duration is shorter in high yield compared to IG credit and US treasuries.  On one hand this means that existing bonds won’t be revalued down as much as rates rise. However, the shorter maturities imply these companies will have to re-fund themselves sooner at the higher rate. The tax reforms will impact on the heavily indebted companies (usually within high yield) that will not be able to tax deduct all the interest on debt (this is easy for managers to assess), although it should be an overall positive for corporates.

The unwinding of the ECB’s balance sheet will affect demand for corporate paper in the Euro area, as the biggest buyer of these securities retreats. At this juncture we would favour credit in the US over that of Europe.

Private debt offerings have become more popular as the banks have retreated from certain types of lending given the regulatory changes and the amount of capital that they are required to hold for each of these investments. Opportunistically, many mutual funds have raised capital and are filling the void left by the banks with direct loans to ABS/MBS mortgage warehouses, loans to SME’s, and construction financing. Investment in these deals involves due diligence and a heavy reliance on the capability of the fund managers. Many require a lock up period, no secondary liquidity but hopefully higher returns. Volatility can be low given the difficulty in evaluating the pricing of the underlying loans. This should not be confused with the inherent risk in the loans within the portfolio, given they are often to higher risk segments of the market.

Credit markets are more influenced by regulation of financials services than policy, though of course underlying interest rates matter too. As noted, the shift to private credit appears to have gained ground and is largely unregulated. This puts the onus on the investor to judge the risk.

Emerging Markets

The start of 2018 has been challenging for (EM) debt as a stronger USD and tighter US monetary policy has put pressure on EM currencies. It has been exacerbated by negative fund flows for both local and USD denominated bonds.  We recognise the attractiveness of the lower currencies and cheaper bond prices in the region, especially given fundamentals are still largely positive for many of the countries.

However, in the short-term, tariff policies and further rate rises in the US will be a headwind. For those with a tolerance for volatility we recommend maintaining exposure. We suggest investors avoid an index tracking ETF, as the most indebted countries have the greatest weight and rely on a portfolio manager for selective country positioning. Our recommendation is through the Legg Mason Brandywine Global Opportunities Fund.

High Yield and Emerging Market Spreads

 

ABS Securities and Bank Hybrids

Regulatory changes to bank capital rules have had the most impact on these two sub-sectors within fixed income. The increased capital banks need to hold when investing in mortgage backed securities, has kept margins at elevated levels even as most spread product has tightened in the last 18 months. Add to this a healthy pipeline of new issuance and the run-off of the Fed balance sheet (which includes MBS). This trend will continue, with a risk to higher spreads as it gains momentum.

Domestically, a slowdown in housing prices has not notably impacted on the market, with many focusing on low employment levels and the robust structure of these securities to support valuations.

Inclusion of US and Australian mortgages are good diversifiers in many of the funds. AAA rated mortgages are included in the high-grade credit funds, with lower tranches included in the more opportunistic style funds, such as Aquasia Enhanced Credit Fund and Bentham Global Income Fund.

Australian bank hybrids are in a reasonably tight trading range. Regulatory capital requirements are at appropriate levels, therefore the new supply of hybrids is likely to be limited, supporting valuations. The proposal by the Labor party to abolish unused franking credits did push out spreads on the longer end, but in the absence of any clear path for the elections, are unlikely to weaken further. For conservative investors, maturities within 2.5 years is recommended, while the longer end opens ad hoc opportunities. We continue to support an allocation to this sector.

Summary

Aside from the financial sector, specifically the banks, and utilities, regulation has a relatively low profile for most global equity sectors. Conversely, policy via the risk-free rate stands out as a unique period of support for equities. Long duration growth stocks that discount earnings well into the future have outperformed by a considerable margin compared to those that are cyclical or where value metrics make the case for investment.

Financials

The balance is now shifting. Regulation for the banks, while still in place, is less intrusive given that many meet the required capital structure and have divested or closed the problematic parts of their operations. Conversely it is the movement in rates that should now predominate. In the typical scenario rising long term interest rates leads to margin expansion as global banks are commonly funded by shorter term deposits. However, in the US, the flat yield curve puts paid to this. Additionally, credit growth is mixed with the big five banks in the US each biased to a particular sector.

US bank sector exposure

 

European banks have not escaped the political overtones in addition to their legacy of poor lending practices. As the EU needs a viable banking sector given the bias towards bank debt rather than credit markets, the regulator has to be careful to ensure the industry is sustainable. Good banks benefit more from this attitude and can therefore be highly attractive investments even if their performance is correlated to the sector in the shorter term.

It is policy rather than regulation that determines the attractiveness of banks in the emerging world. An example is the demonetisation in India in 2017 as the government sought to reduce the informal system to encourage tax payments and formal banking. Unsurprisingly, there were a number of well run banks that were beneficiaries.

Financials have been a tough sector in the past six months, undermining the premise that good economic growth and rising rates lean in their favour. Stock selection here is the most obvious requirement.

Infrastructure

The infrastructure sector often has a regulatory framework. This requires specialist knowledge and therefore fund managers that construct a portfolio based on an understanding of the impact. As we have seen in Australia there is no shortage of twists to the outcome from a regulatory overview. The return on investment (ROI), risk free rate and consumer impact are in play and can be subject to political influence. UK utility sector prices have been affected by a reduction in the ROI and comments that a Labour government would look to renationalise some providers.

Clearly monetary policy has an additional influence. Not only do utilities often take on high debt to fund their infrastructure but as the return is weighted towards the distribution yield they are often termed ‘bond proxies’.

The recent level of volatility in the infrastructure/utility sector belies their stable income. We believe a small allocation to a dedicated manager in this segment of the equity market suits some portfolios that look for regular income.We recommend investors tolerate the changing unit price in the interest of long term investing.

Technology

Most technology companies operate with little or no regulatory framework. However, recently this has changed with the data privacy, tax and EU fines linked to distorting competition intruding the presumption of ‘laissez faire’. It is yet to be determined whether this will change their growth trajectory, though it is likely they will adopt to the conditions. In our view it is the behaviour of consumers that are more likely to determine a different outcome. If the users transition from social media, search engines or other data gatherers and advertisers may review their spending allocation to these companies.

The differential views on technology companies are based on a view that their growth is underestimated as they spread their reach from one source of revenue to another, versus an opinion that they are overvalued as they approach maturity or have negative cash flow.

The large Chinese companies (BAT, or Baidu, Alibaba and Tencent) have a separate set of issues. As these companies essentially operate as a bank to a consumer via payments, savings and exchange, the government recently has stepped in to regulate that part of their activities. Further, policy requirements see them brought into support some state based entities, the recent example being the recapitalisation of Unicom.

Global equity performance has been substantially reliant on the selection and weight allocated to these stocks (elsewhere we note that some stocks are about to be reallocated to ‘communication services’). Regulation is low key, but given valuations, can have a sizeable impact on the share price.  As they become dominant in their category, be it from advertising revenue, products or business services, they too will be prone to economic ructions rather than viewed as a disrupter that is all about market share.

Consumer goods

Consumer goods are inevitably subject to a range of regional regulations, such as safety, packaging and labelling. For many companies the major source of growth is demand from emerging world consumers. It is possible that the trade dispute may indirectly impact these products by restrictions largely driven by political considerations.  On a broader perspective, ethical sourcing of inputs and labour conditions may impose costs that are challenging to pass through to consumers conditioned to low inflation.

After lagging an equity market focused on growth, the consumer sector has recovered some ground. Most global managers remain cautious.  Margin pressure from costs without pricing power, private label, fragmenting brand loyalty and consumer that cycle through favourites more rapidly than ever mean that the traditional large participants are going through a major period of adaption. The focus is on thosecompanies that keep advancing their product suite while balancing the free cash flow between reliable distributions and investment.

Healthcare

Healthcare may yet prove vulnerable to policy measure, in part to stem the rise in costs. Already some companies have decided to limit price increases, the most recent example, Pfizer after direct intervention from Trump. Merger activity has also changed since the so called ‘inversion’ where a head office relocation to Ireland to take advantage of the 12.5% tax rate was challenged by the EU.  Pharmaceutical companies, in particular, werekeen on this structure.

The long-term healthcare thematic has been a useful balance between growth and defensive.  The challenge is to avoid companies that push the boundaries.

Summary

Regulation and policy will, in our view, become a larger part of global equity decisions. Populist politics, unease on the dominance of some companies and cost to consumer combine to push government towards advocating a greater degree of oversight.

The changes to such measures can be unexpected and lack clarity making it difficult for funds to judge their impact. In our view more fund managers will emphasise their understanding of any impact along with the traditional analysis of the prospects for any investment.

The adoption of MiFID (regulation of European interchange between equity research and fund managers, amongst other issues) and some of the issues raised in the Royal Commission in Australia highlight the increasingly complex way information is delivered and shared within financial markets.

It may require investors to exercise tolerance or judge performance against an index in the near term as fund managers can get unexpectedly caught out. Alternatively, investors can avoid investment if there is a risk, even though momentum is in its favour.

Summary

Further to an announcement earlier this year, the S&P Dow Jones Indices and MSCI have now released an initial list of the 2,146 companies that will be changing sectors due to the Global Industry Classification Standard (GICS) reclassification that will take place in late September. The GICS reshuffle will see the telecommunications sector be renamed to the communication services and expanded to include companies that are currently in the consumer discretionary and information technology sectors. These changes are being made to reflect the development and convergence of the companies within these three sectors.

MSCI ACWI Index Sector Weights Estimates (current versus expected)

 

With reference to the US S&P500, the restructure will reduce the influence of the IT sector, however, there will be an increase in stock concentration within sectors. The top five proposed weightings of each of the three sectors will all increase and as such will further skew the attribution of these stocks within the sector. For example, Amazon will remain in consumer discretionary and consequently will represent 30% of the sector.

Proposed top-five S&P500 sector stock weightings

 

ETFs and investors that track these GICS classifications will need to trade billions of dollars of stock to rearrange their holdings. In the US, there are 24 ETFs affected with a combined $72.3 billion in assets under management. The biggest ETF providers, Ishares, Vanguard and State Street, aim to minimise any price disruption caused by these rebalances. Vanguard announced that it will be using transition indexes and will gradually rebalance their sector ETFs over a three-month period.  State Street plans to rebalance its sector ETFs one week prior to the GICS reclassification taking effect.

The MSCI All Country communication services sector will undergo an overhaul to include companies such as Facebook, Alphabet (Google) and Activision Blizzard that will move from the IT sector, whilst entertainment powerhouses Netflix, Comcast, Disney and Twenty-First Century Fox will shift from consumer discretionary. This will result in blending some of the weaker performing stocks in the MSCI ACWI with the best.

MSCI ACWI Telecom/Communication Services top-five large companies and 1-year performance

 

In addition to a change in the performance attribution of these sectors, the investment metrics such as earnings growth, yield and valuations will change. The telecom sector has been viewed as a defensive allocation for investors, however, with the inclusion of high growth tech companies that traditionally pay low dividends, the sector will move from a yield of nearly 4% to approximately 1%. Analysing the past performance of each sector will also become more difficult as its history will now be somewhat irrelevant.

Investors who wish to maintain their exposure to high growth companies will need to reassess the new indexes and make the appropriate changes. This could lead to some initial interest in the communication services sector at the expense of both tech and consumer discretionary if investors wish to maintain their exposure to the popular names.

While global equity markets were more volatile in the second quarter amid rising concerns of a trade war, performance of  the ASX was assisted by a weaker currency, commodity prices and regional equity flows. .

The key trends have been the ongoing recovery in the resources sector and the performance of growth-orientated stocks. Overall, the market has shifted to the expensive side, with P/E ratios persistently above the average of the last decade, though earnings momentum remains reasonable. The chart shows the earnings revision ratio for the ASX 200, calculated as the net percentage of stocks that have earnings upgraded over the last month. Typically, the indicator is negative (as analysts are overly optimistic with their forecasts), yet after the upgrades to resources it has been closer to zero in the past 12 months. Nonetheless, the trend has weakened, perhaps a recognition of a soft outlook across some domestic-focused sectors.

ASX 200: Earnings Revision Ratio

 

High growth companies continue to demand an ever-increasing premium for their attributes, reflective in fund manager performance in FY18. Small caps also rebounded strongly over the year, consistent with this theme. While the momentum remains with these areas of the market, we believe that a value style is better placed in the medium term given the widening dispersion in valuations.

The past six months has been notable for the impact of regulatory and policy discussion that impact on many stocks. The Banking Royal Commission is but one, energy markets and healthcare costs have also been in the spotlight.  Below we discuss the current specific policy and regulatory risks applicable to the key sectors of the market.

Mining and Energy

Share prices are backed by robust commodity prices and forward earnings forecasts have been upgraded over recent months while free cash flow improved as operational costs were reduced. Only recently has cost inflation returned to the sector and there are fewer large capital projects of note. This capital discipline in the large caps is reflected in improved returns to shareholders.

The mining sector has much to lose if the trade war were to escalate further. The sector is highly dependent on China’s demand levels and the downside is thus quite material, particularly given that the ‘base case’ is for no trade war to materialise. Tariffs on European countries would also be unhelpful for the sector in reducing overall commodity demand.

The other key policy risk is China’s transition to a different growth cycle without relying on further credit growth. There are examples of other policies in China that have had a large impact on Australian producers, for example, a focus on pollution reduction favoured the miners of high-quality Australian iron ore at the expense of China’s domestic producers.

The energy sector has been the big surprise this year. The LNG expansion projects that weighed on cashflows are now complete, and the rise in the oil price has accelerated balance sheet repair and shareholder returns. Valuations now reflect this buoyant environment, recognising the high level of operating leverage to rising prices.

Oil has run ahead of forecasts due to supply disruptions in a number of OPEC countries (Venezuela and Iran), growing demand and compliance by OPEC to its agreed production cuts. Inventories are now below average levels and the price has remained elevated despite OPEC’s recent decision to increase production again, with the quantum judged to be insufficient to offset the production lost to disruption.

OPEC’s actions remain the key policy risk for the oil price, although the approach to date has been measured. Nonetheless, the risk is to the downside if the cartel looks to protect its market share from US shale, which is likely to be incentivised to increase production following the strong rebound in the oil price. This is a valid risk given recent history.

Secondary impacts from policy measures that affect global growth (trade and credit expansion in China the likely focus points at present) can have a substantial impact on the sentiment to resource stocks, while the oil state participants are known for their direct intervention. Within the ASX the resource sector is one of the more interesting, but investors should be aware that volatility is high, with price and policy as constant issues.

Banks

It is now broadly recognised that the banks are in a low-growth environment. Housing lending has slowed, declining bad debt is no longer providing a boost to profits and regulatory and compliance cost pressures remain. Price/book ratios and ROEs have declined with increased capital requirements. While there is little in the way of dividend growth in the medium term, current dividends appear safe, absent any deterioration in credit conditions.

While top line growth for the banking sector has slowed in recent years, it has been the increase in regulatory capital requirements that have been the most significant headwind for the sector. Banks largely meet these new standards, and credit growth is now most at risk. Caps on interest-only and housing investor lending have been compounded by a focus on lending standards, including loan servicing requirements. The desire of the sector to repair its image in the wake of the Royal Commission may also prevent out of cycle increases in mortgage rates, although we note some small lenders have already led the way in response to increased funding costs. A credit crunch scenario is not the base case assumption, although remains an outlier risk.

A recommendation to limit bank weight to below index has been entrenched for some time. We see no reason to shift on that position now, given a cap on profit growth and likely continued regulatory pressure.

Telcos

Without doubt, the changing landscape for the telcos sector in Australia has resulted from the Federal Government’s decision to build the nbn. The impact on the profitability of the domestic telcos sector has been grossly underestimated by analysts. Telstra’s loss of infrastructure network earnings over several years was recognised, but the fight for market share from this period of customer transition has led to reduced margins across the sector. The mobiles market has not fared much better and there has been a failure to capitalise on the exponential growth in data usage. The rollout of 5G presents a potential opportunity for Telstra to reassert its mobile network dominance, however there is also the downside risk of cannibalisation of broadband customers.

The sector currently presents as value, particularly from a forward P/E perspective (Telstra is now on a single-digit multiple). However, in a mature market with persistent high levels of competition, this is arguably warranted. Regulatory risk is low.

Infrastructure/Utilities/REITs

Monetary policy remains key to the performance of the ‘bond proxies’ – infrastructure, utilities and REITs. Domestic interest rates have eased since the beginning of the year, with forecasts for the RBA’s first hike pushed out further into 2019, providing some reprieve for this sector. Nonetheless, with global interest rate normalisation, the consensus view remains that there is likely to be upward pressure on domestic rates in the medium term, capping the returns of bond proxies.

Government intervention into the energy market is an additional risk for utilities such as AGL and Origin following a sharp increase in wholesale electricity prices. This has been partially realised with the release of the recent ACCC’s report into the retail electricity market and the regulator recommending regulation of consumer pricing.

A more difficult regulatory environment could pose downside risks for energy utilities, although valuations in the sector are undemanding. Elsewhere bond yields have the biggest impact, though we note that the politics of user price rises in some sectors (Transurban and Sydney Airport for example) and M&A (APA, with potential FIRB ruling) are arguably inherent and under-rated threats.

Healthcare

Among the large cap companies within the healthcare sector, the regulatory and policy risk is relatively low. The risk to the three largest companies (CSL, Resmed, Cochlear) is specific to each and would result from the failure to get approvals for new products or recalls of existing products. The regulatory risk among the next tier of stocks is greater, particularly those that are dependent upon government spending (aged care) or private health insurance (hospitals). Private health insurance affordability has been a key topic in federal politics, with Labor proposing to cap premium growth should it win the next election.

Healthcare was again among the best performing sectors in the Australian market in FY18, backed by another year of solid earnings growth. Valuation is the key risk, with P/E expansion across key high growth names expanding this year.  In the other stocks, restraint or restrictions on price increases are higher risk going into an election year.

Consumer Discretionary/IT/Other Growth

Regulatory and policy risk is assessed as low across most high growth areas of the Australian market. The key exception would be the group of consumer stocks that have a reliance on exporting into China; a changing policy framework has the potential for significant disruption in their outlook.

Similar to the healthcare sector, the key risk is one of valuation given the expanding premium that many of these stocks now trade on relative to the broader market. This is illustrated in the chart showing the average forward P/E of a basket of high growth Australian equities (a2 Milk, Aristocrat Leisure, Altium, Costa, Cochlear, CSL, Domino’s, James Hardie, REA Group, Resmed, Seek and Treasury Wine), which has expanded from 25x 18 months ago to greater than 30x today.

High Growth Equities and ASX 200 P/E

 

Regulatory and policy risk are stock specific and can have a large impact on a stock price. Examples are the wages at Domino stores and China’s management of milk imports. Views on these companies can change quickly and we defer to the fund managers to assess any impact.

Summary

The Australian market is arguably relatively vulnerable to the level of oversight and external influence due to its structural weight to sectors and dependence on global economic trends. Our recommended allocation to the asset class indirectly references this issue by expressing a purpose test for each product rather than focusing on the index.

Our preferred approach to the Australian equity market is to bias the large cap allocation to defensive or income-oriented stocks, depending on investors required outcome. Growth is achieved through small cap or ex ASX 100 managers. The balance between these holdings is specific to the time frame and risk appetite of the investor.

Alternative equity-based managers in Australia provide a useful offset to long only and we recommend both market neutral and long short investment styles to ameliorate portfolio risk.

Summary