Quarterly Market Review October 2015

The past quarter has been unfriendly to investment returns, with long duration fixed income providing the best returns, making up for a weak second quarter. We note, however, that 3 year returns across all asset classes are close to our longer term expectations and that even 5 and 10 year returns are well within the boundaries of the guidelines we provide for investment portfolios. It is important to stress that the asset class returns are benchmarked on the broadly based indexes and are accumulation based; that is, all income is reinvested.

These are not easy conditions in which to make directional calls for portfolios. In line with our Asset Allocation report last quarter, interest rate markets are challenging. A low rate environment is irreconcilable with high returns. In itself, the subdued returns expected from fixed income should not skew a portfolio towards overweight equities. Both asset classes needs to stand up to scrutiny in their own right.

Fixed income strategy

         Interest rate markets are vulnerable to rate rises, yet retain defensive features and buffer against a possible economic downturn

The global appetite to raise rates has waned and most forecast that nominal interest rates will barely match nominal inflation in the medium term. That is, the ‘least worst outcome’, to coin the phrase. A slow move in interest rates may be difficult for bond and credit securities in the short term, but does not undermine their medium term returns. Fixed income securities reprice the likely interest rate outcome and therefore don’t necessarily persistently lose value as rates climb.

However, expected total returns at this stage are less than compelling, and while we strongly recommend maintaining a balance across interest strategies, we retain a tactical underweight view.

Equity strategy

         Equity returns are expected to be below recent historic averages in the next few years. Capital growth should be pursued to maintain the value of portfolios

Equity markets have also shown their colour in recent times.  Returns can be unpalatable when volatility rises given the expectation of lower economic support.  Yet equities are the only option of maintaining real capital value and there is the prospect for selected sectors to capture additional returns. The investment decision resides with the expected risk/return. Risk, measured by standard deviation, has not changed. Returns, however, are likely to be lower for some time, at least in nominal terms. Nonetheless, in our view, those with a 3-5 year time frame should be overweight equities in order to preserve the real value of capital.

In the short term, we recommend regional strategies with a Euro and Japan centric bias, while those with a value predisposition would add to holdings in Asian markets.

        Domestic equities offer income while awaiting for a change in conditions in the major sectors

The domestic equity market is at best fair value. The distinctiveness of the major segments requires a view on commodity prices, Australian financial conditions and individual company specific options for industrial companies. Dividends at this stage appear safe and supportive for income centric portfolios. However earnings growth is patchy and requires much due diligence to avoid potential loss of value.

Other asset classes

        Alternative assets need to fulfil designated role in portfolios

Alternative assets naturally attract attention when fixed income and equity securities are challenging. We have for some time considered the options within these strategies.

The product requires fund managers given the complexity in execution and risk management. However, there are many such strategies which fail an initial screen, similar to other asset classes. Our bias is skewed towards those which offer:

– An understandable, logical approach; no magic formulas or complex algorithms. We are respectful of those that undertake less common directional or unusual trades, but expect to be able to explain what they are to any audience.

– We are cognisant of chasing a momentum strategy that may not persist. It is a mistake to assume past success is necessarily predictive.

– The entity is vitally important. A combined judgement of the managers of the strategy, what financially supports them, their motivation and risks may mean one is reticent to support some investments.

– An appropriate fee schedule. Fees in this asset class are frequently high and unsupportable. A host of issues arise here; the benchmark used, the possible limitations in the size of the investment fund, the complexity of what is being undertaken, the number of options within comparable funds, concessions for certain outcomes and simple maths on what the manager takes versus the investor.

Our preferences in this asset segment will be addressed in a forthcoming report.

Our asset allocation framework is based on a 2-3 year investment horizon.

We input expected returns for the relevant index and add franking and hedging where appropriate. We also make an allowance for ‘alpha’, or returns above the index we believe is supported by our selection of securities and funds.

In past quarters, we lowered our overall return expectations to reflect current conditions. Within the asset classes we recommended an underweight position in Australian equities for capital preservation and capital growth portfolios, while maintaining the weight for income centric portfolios. Our commensurate weight in global equities was increased.

Global and domestic fixed income have proven to be highly correlated in the past year (R² of 0.86) compared to longer term (10 year R² of 0.56) and our efforts to differentiate these have not been particularly productive.

Nonetheless, we continue to hold our recent recommendation of managing the underweight in fixed income between global and domestic positions.

Expected Asset Class Returns – 3 year time frame

Recommended Portfolio Weights

Given the recent volatility in investment markets, it may be surprising to state that the underlying economic trends are unfolding much as expected.

The US is experiencing a modest, but relatively steady rate of growth, mostly supported by household spending as employment picks up. Europe (in particular southern Europe) has staged a robust recovery from the problems of a couple of years ago. Japan’s economic momentum remains sluggish; not unexpected given the slow pace of reform. China has struggled to turn its economy away from fixed investment spending, while consumption growth has been growing at a respectable pace.

Locally, the well heralded transition from a resource-investment economy towards one led by domestic demand has proven to be challenging. Housing has naturally responded to low interest rates, but business investment remains weak.

With the assumption that GDP growth is likely to track at a lower pace in nearly every region than was the case a decade ago, investment markets can be expected to react to inflation, employment conditions and specific indications from China.

The persistence of low inflation allows central banks to maintain low interest rates. With short term inflation data distorted by the fall in commodity prices, particularly energy, the Federal Reserve tends to focus on market expectations such as the ‘5y5y’ breakeven rate. This is determined by the yield on 5yr treasury bonds less the yield on 5yr inflation protected treasury bonds. In theory the difference should align with the expectation of the inflation rate in 5 years and override shorter term volatility.

The recent fall in longer term forward inflation bears watching given that the impact on interest rates is likely to be material.

Weak employment cost growth naturally feeds into inflation and the persistence of low wage growth not only contains inflation expectations, but also consumption spending. We have, for some time, been expecting the US employment cost index to rise due to an increase in minimum wages and shortages in selected skills. Beyond that, it is harder to envisage inflation arising from its usual source, excess demand over supply.

The potential for very low inflation will have an impact on the returns from investment assets. For example, fixed income with circa 3%+ returns becomes attractive, inflation driven assets (such as real estate) less so. Consumption patterns change to reflect the expectation that prices will remain stable and sectors with natural growth become incrementally more attractive.

The balance of probability is that China pulls enough levers to sustain respectable headline growth. Already there are a number of initiatives in property and monetary settings that are likely to gain some traction by next year.  However, it is possible fixed investment spending and export growth will be below par and continue to cause instability in currency and capital flows.

The sources of the selloff in investment markets in the third quarter is attributed to the indecision on US interest rates and the challenging conditions in China.  While these issues captured the headlines, there are specific financial market factors which may well have had additional impact.

China’s efforts to manage its currency have resulted in capital outflows as it sells other foreign exchange reserves to support the yuan. The impact has been exacerbated by the tendency towards locals to take their capital overseas when unsure of domestic conditions and where financial investment options (such as bonds) are limited. We believe this had an influence on the Fed, as they sought to understand whether the impact would be short term or cause longer term repercussions for US bond markets.

Widening credit spreads may also have influenced the Fed. For some time, many have noted that credit market liquidity has substantially changed character due to the restriction on banks’ ability to hold such lines. Widening spreads don’t change the final outcome for investors if held to maturity, but without the ability to price these in a timely manner, it adds to uncertainty. Bonds and credit are often noted as ‘the canary in the mine’, i.e. if there is dislocation, it tends to portend tougher times ahead.

The criteria we use to determine our recommended allocation to equity markets is based on a hybrid approach encompassing market sentiment and valuation.

Equity valuations are typically based on an assessment of earnings or cash flow. Earnings forecasts are naturally subject to revision, and markets rarely move up in the face of declining expectations.

         The outlook for earnings growth

The major shift in profit expectations this year has been in resource and energy stocks, with the bulk of these revisions coming through in the first few months. The US also has had to cope with the translation impact from the higher US$.  Energy earnings, accounting for some 10% of the S&P 500, are forecast to decline by in excess of 80% this year. Excluding energy, US earnings are estimated to rise by 8% this calendar year.

Emerging market profits are skewed to commodities and financials, with a tendency for over-exuberant forecasts, now trimmed back. The telling part of the following chart is that most of this revision occurred earlier this year and is therefore not the sole trigger for the recent equity performance.

           Valuing these earnings

In the majority of times it is the judgement on the price for these earnings that causes fluctuations in investment returns. The price is a combination of two factors. Market behaviour that cannot be explained by any metric is generally the cause of short term volatility. The other is based on historic valuations, which can be determined. However, even this is not that simple, as the time frame under assessment, changes in sector weights or industry dynamics (which can cause reassessment of a P/E) will impact on the appropriate multiple.

Taking each of these in turn, the time frame will almost certainly provide a valuation that will be different to that of another period. For example, ten year data on the US market (S&P 500) will cut off the major impact of the internet bubble when valuations were vastly extended; 20 year data will naturally include this rise and fall.

The most common long term valuation is the Cyclically Adjusted Price to Earnings Ratio (CAPE), which encompasses 10 year rolling earnings relative to the current market value. It assumes that earnings mean revert over cycles. There are plenty of investment professionals who adapt the concept to include various parameters, but the general thrust of a long term earnings cycle as a guide to indicate where valuations are remains valid.

The chart shows the major market segments, indicating that the S&P 500 is at the expensive, though not extreme end, while Europe and Asia Pacific are below their longer term average.

Any index P/E will reflect the weight of sectors at that time. Where the sector P/E is likely to reflect structural differences (for example, the valuation applied to resource companies, financials or healthcare) the weighted average will vary, even if the sectors themselves are within their normalised ranges. For example, financial companies currently make up 45% of the ASX 200 index compared to 36% four years ago, while resource companies are at 14% now compared to 26% in 2010. The valuation applied to these very different sectors will impact the current weighted average P/E of the Australian market.

Conditions which are likely to permanently impact on earnings are also likely to change the valuation. Due to regulatory requirements, banks across the globe now have higher capital requirements and in all probability will not achieve the same return on equity or book value as they were able to do a decade ago.

Nonetheless, historic valuation ranges remain an appropriate guide to over or undervaluation. Prior to the recent quarter, we had noted that the US market was relatively expensive and expected to mark time in the near term. European valuations were also somewhat above average, but given higher expected earnings, this was less problematic. Japan, on all counts, was the best value of the developed markets, based on historic averages as well as earnings potential. As such, this has impacted on performance in the quarter, with Japan exceeding the other markets.

Emerging markets were relatively cheap compared to developed markets, though less so within their own history. That has not prevented a further marked deterioration in the index, as other factors have come into play. In short, concerns on funding current account deficits, falling commodity prices and confusing policy settings eroded confidence in many of these economies.

The other major determinant of value is the corporation’s cash flows. Discounting the trajectory of future cash flow streams to today’s value should, if correctly assessed, underpin the valuation of any company. The key determinants are the longer term growth assumptions and the discount rate.

This is arguably a major reason for the past quarter’s sell down. The growth, or ‘g’ in the formula has taken a reality check. While the stocks in the S&P 500, which has led equity markets, have delivered solid earnings for some years, the tailwinds for those earnings are far less supportive now. Buybacks, cost reductions, energy prices and industry-specific factors are no longer offering a compelling combination.

Similarly, China’s economic growth, so supportive of the corporate sector in general for many years (our resource stocks being the poster child), is no longer to be taken for granted. Implicitly, as the risk applied to the expected earnings goes up, the valuation falls.

The discount rate has been a matter of debate for the quantitative easing years. In most circumstances, the 10 year bond yield forms the basis of the risk free rate. Today, this rate is abnormally low (which implies higher valuations, all other things being equal), but it also lacks the judgement of the market due to central bank intervention.

For example the S&P 500, 1980 at the end of Sept quarter, would be fair value at 2870 for a 2% bond yield, 2150 for a 3% bond yield and 1720 for a 4% bond yield, all other things being equal. Of course they never are. The earnings growth rate at a higher bond yield should be higher. For a 1% higher earnings growth assumption, a 3% bond yield arithmetically gets us to an index value of 2250. (We are using the valuation model from the Stern Business School, New York).

We don’t pretend that excel spreadsheets can precisely determine market valuation, or that we know exactly what data to impute. But it does give us a general guide on what kind of earnings and interest rate the market requires at any time. It also gives a good indication on the momentum driving the equity market.

To summarise, in the past quarter the lower expected earnings growth and a higher discount rate combined to drive down markets in the short term.

A final comment is from within the nature of markets. Equity fund styles are typically designated as growth or value, with growth at a reasonable price (GARP) attempting to straddle the two. In recent years, quantitative ‘factor-based’ investing has also become important. This includes momentum (stocks that are going up tend to continue for a period), size (big versus small caps), quality (screened for criteria such as ROE, balance sheet etc) or value (stocks that have low P/E’s, high yields etc). These investment strategies, along with the rise in ETFs, are likely to be impacting on the trends and volatility in markets, abstract from any fundamental judgement on the merits of companies. We may find that periods of market dislocation become more accentuated than before.

For investors, the question is what is the likely impact on the market from valuation and abovementioned factors? We hold to the view that most markets are around fair value, based on historic norms. That does not mean an even paced rate of return, but that within the next 2-3 years, earnings growth is likely to be the predominant feature rather than valuation changes.

Within that context, however, it is looking increasingly likely value stocks will emerge from some years of outperforming growth oriented companies. In practical terms, it means fewer healthcare, IT and disruptive stocks will outperform compared to those with lower valuations which can be excessively discounted for their apparently low growth characteristics. Further, momentum appears to be dissipating as a factor; itself correlated to growth. Buying winners of the recent past may not be the best outcome.

This leads us to conclude that portfolios should encompass a balance of styles and approaches. The weak part of this would be that returns converge towards an index-like performance. We can’t guarantee that won’t be the case, but offer the potential of at least smoothing the path. We remain mindful of specific opportunities. On balance, we seek to achieve those through ETFs given the cost of transaction in unit trusts, unless we believe the alpha generation compensates us for the fees of active investment.

Similar to other equity indexes, the Australian market has lost some ground over the last six months. There were several influences driving this outcome, including a resetting of growth expectations through reporting season, economic concerns over China and persistently low commodity prices. Compared with other markets, the Australian market has faced more challenges, given our high weighting to the resources sector and a round of capital raisings weighing on the banks.

August’s reporting season was one of the more disappointing of recent times. Outlook statements, were weak, leading to a number of notable downgrades. Revenue growth across most industries was soft, with earnings driven by various cost out programs, lower interest charges and a depreciating currency. As has been the case for a number of years now, maximising dividend payments was a priority of company boards, with this behaviour continuing to be rewarded by investors. A residual effect of this trend is lower re-investment by companies in their businesses and hence a lower capacity for earnings growth in the future.

        Financial sector

The major banks have now satisfied APRA’s new residential mortgage guidelines through conducting various equity raisings. Despite this, as a group, they have only marginally underperformed the market over this time. Like other high-yielding sectors, the banks have received solid support when share prices have corrected, with their dividends viewed as relatively safe. The prospect of dividend cuts can, however, be construed in a scenario that is not unrealistic; the high dividend payout ratios across the sector may leave little room to move should earnings contract.

While they may be able to limit the earnings per share drag from the higher share count via lifting their mortgage rates, the profit growth across the banks has been slowing for some time now. Credit growth has picked up somewhat, although the primary driver of this, housing lending growth, may be peaking. Other factors likewise point to a lower growth outcome, including net interest margins and flat cost to income ratios. The biggest risk over the next few years will be bad debt levels, which have recently been at historically low levels.

       Industrial sector

Industrials present a more mixed outcome, with several themes appearing to have largely run their course over the last two years. These include high dividend yielding stocks that have been bid up as interest rates have fallen, companies with international earnings that have benefited from the depreciation of the $A and sectors exposed to the residential housing cycle.

Yet looking across the market, industrials look to be best placed to offer a respectable level of earnings growth into the medium term. While companies taking costs out of their businesses is driving some part of this overall growth, the top-line outlook for a number of sectors is more favourable. Going forward, sectors that are still showing a respectable level of earnings growth include some retailers, gaming and health care.

      Resource sector

For the mining sector, commodity prices have stabilised somewhat in recent months, however most remain well down on a 12 month view. Currency movements have, generally speaking, moved in favour of the miners over this time. The miners themselves have made considerable progress on the cost front. However, given that this has almost been uniform across the industry, it has had the effect of lowering the overall cost curve, thus putting downward pressure on pricing. The benefit of this achievement is thus passed on to the miners’ customers.

Sentiment may have improved slightly in recent months, with discussion on whether commodities have found a floor and some production cuts filtering through the industry. While there may be some improvement in pricing in the short term, the oversupplied position and low demand growth of most markets should put a ceiling on any recovery.

As we have also noted before, the sharp deterioration in prices has raised the the progressive dividend policies of BHP Billiton and Rio Tinto (while noting that Rio is starting from a lower base). The policy is at odds with the cyclical nature of the mining industry, with their asset bases which provide exposure to a large suite of commodities providing only limited diversification benefits. The possibility remains that dividend cuts may result without any pick up in commodity prices.

The experience of the energy sector over the last 12 months has proven to be similar to mining stock trends of previous years, although the correction has occurred much more quickly. The two Australian companies – Origin and Santos – that have built new LNG facilities in Queensland have become exposed because of their relatively higher costs (slashing the expected profitability) and high debt burdens that they have carried in the construction phase of development.

Natural reserve depletion, ongoing demand growth and the high cost of new supply all point towards higher prices in the future, although perhaps not at levels that were previously generally accepted. The two keys are OPEC’s production levels and the time taken for the US shale industry to adjust to this new environment. The shorter lead time for capacity expansion in US shale should lead to shorter, sharper oil cycles than what has occurred historically. The current view of many analysts is that a recovery in oil markets may be slower and settle at a lower point compared with what was previously forecast. The benefits of a strong balance sheet and low-cost operations has been starkly highlighted over the last year and should again prove to be the safest way to participate in the sector.

S&P/ASX 200: 12 Month Forward EPS Growth and P/E of Sectors

Source: Bloomberg, Escala Partners

Notwithstanding some recent weakness in Australian equity returns in the last six months, the last four years has produced fairly solid equity returns. As we have previously noted, however, this has largely been driven by the willingness of investors to pay more for a given earnings stream from equities, as opposed to growth in the level of earnings.

Shorter term drivers of the market have typically worked in the market’s favour over this time. This has included a depreciating $A, particularly against the $US, boosting the returns for companies with overseas operations. While the $A may typically overshoot on the downside, it is safe to assume that the majority of gains have been extracted from this theme.

       Conclusion

The most significant short term driver has been falling short and long term interest rates. These have led to lower discount rates from which equities are valued, pushing share prices higher. More recently, interest rates have fallen to a point whereby investors with an income focus have diverted weightings from fixed income in favour of higher-yielding equities. Again, this theme has arguably largely played out, although a “lower for longer” interest rate setting will provide ongoing support for the equity market.

From a longer term perspective, we look to valuations and earnings growth. The forward P/E of the market is approximately in-line to slightly higher than its historic average. Forward earnings growth could be described as somewhat below par, although this is balanced against a low interest rate setting; we thus view the market presently as close to fair value. In our view, in order to rise significantly higher in the medium term, a higher and more sustained level of earnings growth (and spread more broadly) will likely be required by the market.

A ‘risk-off’ sentiment has been playing out in financial markets since the downturn in the Chinese stock market and the subsequent devaluation of the Chinese yuan. In addition to weak commodity prices and the threat of higher US rates, the slowing of Chinese growth has added to downward pressure on growth for emerging economies. This has resulted in capital outflows from these regions, and subsequent spread widening of emerging market bonds and further depreciation of their local currencies. The chart below illustrates the movement in spreads since mid-year. While the current return above the benchmark rate looks attractive, the volatility is having a significant impact on the capital value.

Credit Suisse Emerging Market Corporate Bonds Index – Total Spread over Benchmark

Source: Bloomberg, Escala Partners

The US high yield market has also underperformed, largely driven by the energy sector, which has hit its widest levels since 2009.  Expectations of higher default rates as corporates re-leverage and energy companies remain under stress, has driven spreads out. Demand from fixed income participants is patchy as supply increases after the US summer break, and markets remain cautious. The table below depicts the monthly total return this year from the US high yield sector.

Bank of America Merrill Lynch US High Yield Index – Monthly Returns

Source: Bloomberg, Escala Partners

High yield and emerging markets have felt the brunt of the downturn in credit markets, however, investment grade credit also moved out. This is particularly true for BBB corporates and even more so for long-dated maturity bonds. The Australian Itraxx (a proxy for 5 year investment grade credit spreads) is 15% wider than 3 months ago, though well below the distressed spreads of five years ago.

Markit iTraxx Australian Index

Source: Bloomberg, Escala Partners

This new playing field of higher credit spreads makes corporate bonds looks attractive, especially given the low interest rate environment. While credit markets are likely to display increased levels of volatility and the pathway of the Fed interest rate cycle weighs on markets, we are fundamentally comfortable with investment grade credit as company balance sheets remain relatively healthy. Further, the support of central bank policies is still in place.

Domestically, the capital position of our banks is becoming more robust. The increased requirement by APRA for higher capital requirements is a positive for bond holders. The aim of this measure is to position our banks within the top 25% of global banks. As capital preservation is the key metric by which bond investment decisions should be made, the sound credit quality of our banks remains attractive, with the added benefit of a favourable spread premium. We therefore are comfortable with our allocation to investment grade credit through many of the funds that we have selected.

The high yield market certainly looks attractive given the upward adjustment in credit spreads. The implied probability of default is now at a higher level than the sector’s long term average, inferring that the market is overdone. However, this sector is known to respond vigorously to a risk-off tone, making it vulnerable to price falls in this fragile environment.

Despite the refinancing for many US high yield issuers stretching beyond 2016, new issuance is expected in this sector, as corporates try to front run the Fed and finance buybacks and M&A activity. The current maturity profile for the US high yield sector is depicted below:

US high yield maturity (% of issuance)

While in theory we like the inclusion of a small allocation to high yield for diversification benefits and the boost to returns that it offers, we are cautious of this sector given the refinancing risk. We are cognisant of the sector’s positive correlation with equity markets, an issue given the recent spike in equity volatility. Despite the attractiveness of yields, we prefer to limit investor exposure to these securities at this time.

The currencies and credit spreads in emerging markets are likely to continue to be pressured. The threat of higher US interest rates (and hence strengthening of the US$) is a compounding factor in the capital outflow story for emerging economies. While there appears to be an indiscriminate nature of the emerging market sell-off, which fails to differentiate the strong fundamentals of certain economies, capital outflows are threatening to turn softening growth into a cycle of tighter monetary conditions and even softer growth.

Despite this sector looking ‘cheap’, we are wary of the recent market momentum and contagion across the sector.

       Duration

The inclusion of long-dated bonds in a portfolio (long duration) increases volatility as yields move. However, many bond investors have a buy and hold strategy. As long as there is no credit default then these price fluctuations are irrelevant over the longer term as the bond will revert to par ($100) and the investor would have received the coupon over its life. While there is an opportunity cost risk of locking in a lower interest rate when rates rise, longer-dated bonds do offer a spread premium over shorter bonds for taking on a longer maturity risk. Duration strategies, therefore, offer another way to boost returns and add diversification within a bond portfolio.

Last month we discussed our preference for some duration via the Australian market, as rates are anchored by the RBA. Yields domestically have softened and further rate cuts remain firmly on the table. Long duration strategies have performed well in this environment. While we still recommend the inclusion of some duration as part of the fixed income allocation, we look to the fund managers of these strategies to determine where on the curve offers the best value and apply accordingly.

Liquidity concerns within bond markets remain topical. Despite this, the markets have remained fluid throughout recent turbulent events. We are comfortable with our chosen fund managers’ approach to managing their liquidity, understanding that this will result in a slight drag on performance.

        Conclusion