Since mid-year, the tone in investment markets has changed. Initially, some may have considered this just another cycle in the ‘flat but fat’ or range bound trading we have seen for more than a year. It is now increasingly evident that we will not return to the monetary-anchored, bond and equity friendly conditions of the past five years.
A higher rate of inflation in the US is the most predominant thesis that is currently influencing asset allocation. As we have noted for some time, the likelihood of increasing inflation is all but cemented in by the change in commodity prices, higher healthcare, utilities and ultimately wage rates. It also remains unlikely that inflation will get much above the 3% to 3.5% range.
Other factors that may influence financial assets are the looming elections in Europe and the decision by the ECB to extend its bond purchases. As we have learnt in recent months, the unexpected is probable. On the other hand, many commentators are pointing to respectable economic data out of Europe, particularly in employment trends and correlated consumption growth.
Locally, the direction is less clear. Inflation is very subdued and recent wage data suggests this will remain the case into 2017.The economy is far from weak, though any pullback in the housing sector may leave an activity vacuum.
We have therefore recast our fund recommendations based on:
· higher inflation, off the current low base;
· likelihood of fiscal spending and
· higher interest rates
In this update we focus on the securities and recommended fund managers within portfolios. Not only do different strategies suit different portfolios, but the positioning and style of a fund manager is likely to have a significant bearing on its performance against the relevant index.
A long held investment fundamental is that fund managers should not change their investment process to skew towards some of the patterns in the market. For example, a fixed income manager for a long duration mandate should not shift to short duration even when the rate environment moves against it. Similarly, a big cap manager should not add more than its stated limit in small caps when the latter rally. Global equity managers are segmented into growth and value and are expected to remain true to label.
In our third quarter 2016 asset allocation (dated October 2016) we reduced the weight to fixed income assets. In recent weeks, all fixed income assets have repriced as bond yields have spiked (bonds lower), credit spreads widened (mostly investment grade credit) high yield performance has softened while emerging market currencies have depreciated leading to outflows in this sector.
We now look at changes to the mix of fixed income strategies within our underweight FI allocation.
Movements Across Fixed Income Markets FY17
Does this represent a buying opportunity or are there more challenging times ahead for fixed income assets?
The answer is yes to both. There will be sectors of the fixed income universe that have been oversold and others that will be more volatile moving forward.
Below is a summary of the overall risks we see across Fixed Income sectors, and our revised recommendations for fixed income portfolios. The funds are listed according to their predominate bias under generic strategies, albeit recognising that they all have a degree of diversification away from this framework.
Long Dated Fixed Rate Global Government Bonds
· Franklin Templeton Global Aggregate Bond Fund
· Pimco Global Bond Fund
Long dated fixed rate bonds are the most vulnerable, reflected in some of the biggest repricing. Bond yields have lifted significantly, pushing the prices of bonds lower, particularly for the longer dated maturities, driven by the expectation of higher global growth and higher inflation.
As fiscal policy looks to take over from monetary policy, yields may rise higher. Global managers do have the ability to rotate into different countries, taking advantage of regions where growth and inflation may remain weak. However, the correlation in bond yields will make it difficult to escape the trend. Rising interest rates in the US and the impact of the extended duration of indices caused by a lengthening of maturities by governments over the years, and a potential slowdown in quantitative easing by the ECB, Bank of England and BOJ suggest that investment in these funds requires a rethink.
In context of the above, political global instability is perhaps more heightened than ever before, and if a ‘black swan event’ were to occur we would expect that investors would seek protection within this asset class.
While this is something we can’t predict, some ‘insurance’ within a portfolio of equities and credit is prudent. For this reason we recommend maintaining some exposure to this sector, albeit on a reduced basis.
Recommendation: Marginally reduce exposure
Unconstrained Global Credit Funds
· JPM Global Strategic Bond Fund
· Legg Mason Brandywine Global Opportunities Fund.
The fall in asset prices within fixed income has been indiscriminate over the last week, although, this will undoubtedly open up opportunities. Funds such as these are not linked to any benchmarks and can rotate into oversold sectors where they see value. During these volatile times we lean on the expertise of portfolio managers that have flexible mandates, and will act to preserve capital within the fund whist seeking out value and oversold sectors. The duration of these funds can and will be ramped up and down depending on market conditions.
Recommendation: Hold allocation
Long Dated Fixed Rate Domestic Government Bond Funds
· JCB Australian Government Bond Fund
· Henderson Australian Fixed Interest Fund
Given the nature of global markets, the direction of Australian government bonds are beholden to much of what happens offshore. These funds have had negative performances in the last couple of months as bond yields have risen. (JCB is all govt bonds and Henderson has about a 40% exposure to credit). Their vulnerability is more pronounced as they are domestic only and have either no or moderate credit to buffer portfolios. As running yields are lean given low coupon payments, capital repricing is the predominant influence on returns. Expectation of further easing by the RBA has been scaled back, adding to the complexity.
Performance has been good in 2015 and 2016, and reducing allocation in the short term is prudent given the volatility. Ease of access means that reallocation is practical when we have better visibility on the direction of markets.
Similar to global fixed rate government bonds, we cannot predict when there may be a flight to bonds and once again maintaining some ‘insurance’ within portfolios is recommended.
Recommendation: Reduce exposure on both of these funds.
Short Duration Credit Funds
· Kapstream Absolute Return Income Fund
· Macquarie Income Opportunities Fund
The lack of duration means that they are well poised to reap the benefits of higher interest rates as floating rate product within the portfolio reprices upward. While credit spreads may be more volatile, we believe that returns in these funds should still exceed that of cash and capital preservation will remain intact.
Further, these funds are very liquid (daily pricing), so investors may look to temporarily increase their allocation to these funds as a proxy for cash.
Recommendation: Hold asset allocation. Temporarily increase for liquidity purposes.
Bank Hybrid and Listed Debt Securities
This part of the fixed income universe has held up well in light of bond yield movements over the last couple of months. These securities have floating rate coupons that are determined by the benchmark interest rate (BBSW), so will benefit from a higher interest rate environment.
The majority of the listed market universe is made up of bank hybrids, which have performed well given the expectation that higher interest rates is of benefit to banks. While credit spreads have edged wider globally, this has mostly been in investment grade credit. Lower rated credits and subordinated bonds within the capital structure have benefitted from the rise of risk assets.
Escala Model Portfolio of Listed Debt Securities
Alternative Fixed Income Funds
· Aquasia Credit Fund
· Alexander Opportunities Fund
Both of these funds have a high weighting to RMBS and other opportunistic loan structures. While the funds run a low duration strategy, they may come under pressure if there is a correction in the property market led by rising interest rates. An increase in defaults will negatively impact this sector from a valuation perspective. However, we do not think this will lead to loss of capital given the structural robustness of these securities.
Cash and term deposits have underperformed the majority of the fixed income markets over the last few years. While we don’t see investment here
as a long term solution, we recommend an increased allocation at present as market volatility is expected to continue. Having cash available gives flexibility to deploy capital quickly into other investments when opportunities arise.
Recommendation: Increase allocation (or Kapstream as a liquid alternative).
The weightings of this mix of funds will be bespoke for different investors according to their risk appetite and personal circumstances. The objective is for portfolios to have:
· A modest exposure to government bonds as a buffer to risk assets;
· A consistent income stream and stable return profile through an allocation to investment grade credit and listed debt securities;
· A proportion of funds deployed in higher yielding assets such as high yield and emerging markets, through managed funds that have flexible mandates that will rotate sectors as they see value; and
A cash like/liquidity bucket.
The US S&P 500 has proven resilient, notwithstanding high valuations and patchy earnings growth and funds have been reluctant to go significantly underweight despite sparse opportunities. Conversely, many potentially attractive investments in Europe have been ignored given political uncertainty and risks with the financial sector, leaving Japan to fill some of the gap in developed market allocations.
With that backdrop, it is no surprise that many fund managers turned to emerging markets, supported by improving fundamentals, low valuations and a relatively stable dollar. This trend, however, has undermined by the sharply negative reaction to rising US bonds and possible restrictions on global trade. From a flow perspective, weaker local currencies have resulted in a sell-off by US based investors.
However, the biggest differential in performance has been between sectors. There have been spikes in the performance of energy and material stocks, while utilities and telcos have sold off in the last few months. But the strongest rotation has been in healthcare, which was the worst performing sector over the year to end September, only to recover some ground as the threat to drug pricing was ameliorated post the US election. On the other hand, the steady returns from information technology unwound rapidly in November. In short, the changes point to a sell-off in ‘safe’ stocks and those supported by low interest rates into banks, where a steeper yield curve will assist profitability. Further, industrial companies are judged to be the most likely beneficiaries from infrastructure spending.
The US sector performance highlights the significant influence of November to date.
These developments are more than likely to support the current positioning in developed markets, sustaining the weight in the US, while retaining the selective approach to other regions. The biggest swing factor may be in Europe. With French, German and Netherland elections in 2017, the reaction and implications are hard to judge.
Emerging markets represent a dilemma. From a positive bias through most of 2016 to date (though mostly through EFTs rather than active flows), the opinion is now mixed. Some are of the view the economic fundamentals and still-attractive valuations will override other issues.
The sector direction is clearer. While there will be episodic pullbacks, the trend seems set for financials, industrials and select cyclicals to take precedent over consumer staples and higher yield, low growth companies.
Fund Positioning and Recommendation
The overarching objective of global equities is for growth and access to sectors with inadequate representation in the Australian market. Our recommendations are framed with this in mind.
WCM Global Growth (Separately Managed Account) is mandated to maintain a high profit growth portfolio and consequently tends to be underweight sectors such as financials, materials and utilities, while overweight IT and consumer discretionary. The solid performance of recent years has inevitably been hurt by this skew in recent weeks. While we would not expect the portfolio to change substantially, it is likely that some names will be introduced that are expected to be beneficiaries of the change in pattern.
MFS is a long term holder of companies it believes have structurally advantageous features. Similarly to WCM, this leans towards a low weight in sectors with low growth (financials, utilities etc.). Nonetheless, the overlap in holdings between WCM and MFS is low.
Recommendation: The combined allocation to the WCM SMA and MFS funds should be considered. We would suggest this should not be more than 50% of a global equity portfolio.
While not strictly speaking adhering to value, Magellan is exhibiting a bias towards the value style. Given the rotation, it is therefore unsurprising that the performance has picked up after a relatively weak period. The fund maintains a significant skew to familiar large cap companies, especially in the US, and therefore can complement other funds.
Platinum Asset Management funds also have a value-based style, with the added mix of short or large cash positions and active currency management. In recent years, Platinum International has underperformed due to its low weight in the US and overweight in Asia/Pacific. With the recovery in emerging markets, the performance has been better, but the value style has also come into play.
Due to the soft performance from value funds, it has been difficult to assess their merits, as the evidence of their stock selection and portfolio construction has been muddied by the style bias. We are finalising the addition of another option which will complement the positioning of the growth funds.
We recommend adding to value. Platinum remains a viable option, though we prefer the European and Japanese funds, especially for US-centric portfolios. Magellan is a reasonable fund for conservative portfolios with the brand recognition and list of top holdings where many would be familiar with the names.
Unsurprisingly, the move in bond yields has been detrimental to the performance of funds in this category. To some extent, the funds can protect themselves through companies with CPI-linked price models or sectors which may gain benefits from fiscal spending. Nonetheless, it is likely that consistent relative performance may be hard to achieve.
We recommend reducing weights in infrastructure funds such as the RARE Value Fund. However, the merits remain in providing access to fixed assets (albeit in an equity framework rather than unlisted) and an intention to pay out regular distributions.
As noted, there is divergent opinion on the expected performance from this regional segmentation in the coming year. The two funds we recommend, Aberdeen Emerging Opportunities and Macquarie Asian New Stars, did, until recent weeks, perform very differently. Aberdeen benefitted from its weighting in Latin America, which has had some of the best upside this year. Macquarie Asia New Stars has underperformed due to its high weight to Korea and Taiwan as well as the absence of banks in its portfolio as it concentrates on consumer companies.
Given the recent volatility in performance we would not realise positions at this stage and will reassess the funds in early 2017.
For the broadly-based ETFs in portfolios, (IVV for the S&P 500, VEU for ex-US and IOO for large caps), we continue to recommend their inclusion to reduce specific manager risk or to lower the average fees in implementing global equity portfolios.
The AUD has been range bound against the USD over the past year, but taken a downward leg in line with the US bond market move. The recent strength in commodities and improved terms of trade may see a recovery to the higher end of the range. We recommend partial hedging of portfolios with ETFs an effective execution tool.
The dispersion of performance across the Australian equity market has been large over the last week. Below we list the factors that have been behind the returns of specific sectors:
– The most significant factor has been the sharp lift in bond yields, caused by increased inflationary expectations as a result of a change in US fiscal policy. While a US-centric issue, this has filtered around the world and translated into higher yields, including here in Australia. The valuation of all equities should be lower with the assumption of higher interest rates, but some sectors are more at risk than others.
The Australian equity market has more losers than winners from this scenario. We have noted before the positive tailwind that ‘bond proxies’ (such as REITs, infrastructure, Telstra and utilities) have received as interest rates have fallen; these stocks have hence lagged since the US election. The list of stocks that may specifically benefit from higher interest rates is more limited, but the two most obvious companies are QBE and Computershare, which have operational leverage to rising US rates. Other sectors have secondary potential outcomes.
Australian High Yield Equities: FY17 to Date
– The yield curve has steepened, which is a positive for the banking sector. While there is less leverage in Australian banks from a steeper yield curve compared with international peers, the change should ease the pressure on net interest margins.
– Miners have found renewed support on the hope of fiscal stimulus and increased infrastructure spend in the US. As there are few policy details, commodity prices have rallied on expectation of increased demand and the possibility that these policies may be replicated in other countries around the world.
– Among the miners, gold has been the exception. Higher yields and a strong US dollar are both poor outcomes for gold.
– Finally, a weaker $A (or stronger $US) has been beneficial to stocks with US earnings. Less clear, however, is what the net effect of Trump’s policies may be. For example, will the positive influence of fiscal stimulus more than offset a potential increase in more protectionist policies?
Escala Preferred SMAs
Should the trends of the last week extend in coming months, the Escala large-cap SMAs may experience a period of relative weakness. The conditions described above tend to favour the more cyclical or growth sectors of the market, which conflicts with the underlying style of the managers.
Investors Mutual (IML) has had a low allocation to the mining sector for some time as mining stocks fall short on the manager’s preference for predictable earnings and a long-term investment approach. IML typically performs well relative to the benchmark index when market returns are weak, however may underperform when the market is rallying (often driven by the mining sector). The manager has also had an underweight position in the major banks, citing the numerous headwinds for the sector, such as soft top line growth, cost pressures, regulatory capital requirements and the potential for bad debts to normalise. As a ‘value’ manager, however, we would expect that IML would take the opportunity to add to holdings in stocks that, in their view, have been oversold in the current environment.
The Martin Currie SMA (MC) similarly has a low allocation to the mining and banking sectors. MC targets companies that pay high and, more importantly, sustainable dividends, meaning that mining stocks would rarely pass this screen. The structure of the MC portfolio is also one that limits sector exposures, is more likely to differ from the ASX 200 (i.e. the portfolio is more index-agnostic) and incorporates portfolio weights that are closer to an equal-weighted portfolio. A further outcome of this is a natural underweight to the major banks (which account for over a quarter of the ASX 200).
An obvious risk from the MC SMA portfolio, given its focus on high-yielding stocks, is that further increases in interest rates will be a drag on the capital performance of the underlying stocks. Mindful of this risk, MC has kept its exposure to the interest rate sensitive sectors at low levels, somewhat insulating the portfolio from this recent trend.
Small cap Australian equities are exposed to a different set of drivers of performance as compared with large caps. Firstly, the index is not dominated by the largest companies in the index, leading to a more even spread of contribution to performance. Mining stocks do not have the broad diversification of the large miners in the top 200 and the gold sector has a much larger weight. Finally, the interest rate sensitivity of stocks is lower, with less large defensive companies and more of a growth orientation.
The performance of our two preferred small cap managed funds, Karara Australian Small Companies and Regal Small Companies, was disappointing in October in what was a difficult month for many active managers. Outside of the broad weakness in the gold sector, the poor performance of funds appears to have been more driven by stock-specific issues and a high concentration of common names across the fund’s universe. As opposed to the macro factors influencing the large cap universe, we would expect that the underlying fundamental outlook for individual companies will be a greater influence in determining returns from here.
In a relative sense, the performance of our preferred fund managers in Australian equities has been tested over the last several weeks, with a low exposure to the key factors driving the market. It is worth bearing in mind, however, that this same positioning has led to material outperformance over the last few years. We are comfortable that these managers are appropriate for clients based on their key investment objective, whether it be capital preservation, capital growth or maximising income.
For investors who are willing to incorporate a level of shorter term trading within their portfolios, we believe that the conditions will be supportive for banking and mining shares, notwithstanding the challenges both face in the longer term.
An investment in growth or the more cyclical sectors of the market could also be made on a more selective basis, however, given the premium attached to these stocks due to the scarcity of growth across the broader market, each has to be judged individually.