Quarterly Market Review October 2016

The combination of relatively elevated valuations and an unsettled political world is causing skittish investment markets. In this quarterly update we have focused on the ability to time investment versus the long held view that time in is what matters most.

There are conditions under which we believe the timing of building an investment portfolio will matter. However, there is clearly no certainty that events will unfold as anticipated, nor that one can judge the point of entry. Our tactical versus strategic guidelines are intended to provide a guideline on where we prefer to tilt a portfolio.

Being as fully invested as possible has been important in the longer run. This is very different to a ‘set and forget’ approach. In order to achieve these returns in a portfolio, weights should be regularly adjusted and attention paid to key factors such as security selection, currency exposure, fixed income duration and credit spreads.

While markets are focused on the US Fed, where most expect a rate rise this December, recent comments by the European Central Bank (ECB) and Bank of Japan (BoJ) have added to the debate on how monetary policy may evolve within a low interest rate environment. The reaction has been a rise in bond yields which also has had an impact on the valuation of equity sectors through the discount rate on cash flows.

Our asset allocation recommendations are unchanged from the September quarter. Tactically, we hold higher levels of cash in preservation and growth portfolios, while income generation requires taking higher risk, though we have skewed the mix towards listed debt rather than equities.

Our hedging sits evenly balanced given the predominant view the AUD is within its fair value range. Capital preservation portfolios, however, have a higher unhedged component as the AUD reacts sharply to growth shocks.

Alternative assets play an important role in diversifying risk with low correlation to equity and bond indexes.

Asset Allocation; Fourth Quarter 2016

A portfolio that has had a high weight to investment assets (rather than cash) has experienced good returns in the long run. In short, this implies that a ‘set and forget’ approach has been productive.  However, the variability of the returns and significant loss of capital during periods such as in 2008/9, would make for an uncomfortable path. A decision to move to a high weight in unhedged global equities when the AUD reached over $1.10/USD also had a major impact.  Our dialogue with investors consistently demonstrates concern on both near term events and long term structural economic challenges.  This is particularly pertinent today due to the unique circumstances such as low interest rates, high debt and weak inflation.

In this quarterly asset allocation we address if and how it is possible to time investment decisions.

Every portfolio has a time line and that presents a number of questions such as in the scenarios below.

– Those holding cash look for guidance on how to deploy their funds – all at once or over a specific period of time? If so, why, and should asset classes or particular securities be treated differently?

– Investors may be holding higher than normal cash in anticipation of a better return if the assets or securities can be bought at lower levels. How will that judgement be made?

– Fully invested portfolios may be expecting that fund managers assess how much to risk at any point in time. How does one judge their success in achieving that aim?

Timing and risk

Over the past few years a number of macro issues have had an impact on markets; Brexit, a collapse in oil prices and the sovereign debt problems of Greece, amongst others. Predicting the outcome may be obvious in hindsight, but the risks of unforeseen consequences are always present. In most cases we deal with such circumstances in recommending holding steady to the investor’s asset allocation. History shows that disruption can be short-lived and portfolios should be managed to cope with a level of uncertainty. If the movement in the portfolio’s value troubles the investor, it is likely there has been too much risk in the allocation in the first place (usually equity weight, but also factor concentration such as interest rate sensitivity).

– For events judged to be shorter term in nature, we do take them into account when a portfolio is being established from cash by delaying the implementation. This does not imply we are of the view that there will be a negative reaction, but rather that in the formation of a portfolio, it seems reasonable to err on the side of caution.

– In the case of excess cash in an existing portfolio, the important factor is that the nature of the potential investment should be identified and a disciplined approach employed. It may be opportunistic as there are rarely predictable occasions. It is also near impossible to be precise on the price or level at which one invests.

– Fully invested portfolios require oversight of the risks within the allocations. Rather than only judging risk specific to asset classes, it is the total behaviour of the portfolio under a range of scenarios that will matter. What will happen if interest rates change, inflation expectations are different, or a systematic issue arises in financial markets, most likely the counterparty effect of a particular entity or system? This raises a complex assessment of the correlation of investment components under a range of conditions. The practical application in a private portfolio is mostly based on the relative weight and structure in fixed income, the level of currency hedging in equities and the use of alternative investments.

At present, political event risk is high. Elections in many parts of the world at a time of unstable opinion are unhelpful. The potential for various barriers to be imposed on global trade could be negative for the corporate sector. China is also re-entering a challenging period where growth has been boosted by credit expansion and a regime change is forthcoming in late 2017.

Timing and valuation

For all the mantra on ‘time in’ markets rather than picking points ‘in time’, there is also a large amount of opinion on whether asset classes are cheap or overvalued. This suggests there should be some consideration on the timing of investment to limit adding to assets at the extreme of market cycles.

Many may think this a relatively easy assignment as there are well known valuation metrics. Yet there are so many interpretations of the valuation applied that it is far from a purely quantitative approach.

Valuation can be near term such as next year’s P/E, or longer term, such as the cyclically adjusted P/E that tracks 10 year trends, otherwise known as the CAPE. Discounted cash flows are another appropriate tool. However, the major challenge is in assessing the discount rate given today’s interest rates and the terminal growth, equal to long term potential GDP. Small variations make a substantial difference to the end result. In credit markets, the spread or yield differential to bonds, is a key assessment of value.

There is broad consensus that current valuation in equity and bond markets are at the higher end of historic norms. Bond yields are regularly mentioned, though the likelihood of a sharp change is low given the buying anchor of central banks. Other parts of the fixed income sector are open to interpretation.  They are usually judged relative to bonds and therefore may be expensive on an absolute basis.  Nonetheless there are inevitably sectors that are mispriced.  Relative value, rather than absolute, may matter more.

The equity picture is mixed. Not all sectors or regions are at the upper end of their range and the case is made that equity valuations can be high for some time due to the lack of alternatives, low interest rates and respectable cash flow which underpin distributions.

In elaborating on the key asset classes in this report, the starting base will therefore be that we should err on the side of caution. The assumption is that investment markets are entering the mature phase of a bull cycle, though there is not sufficient support for an extreme pull back.

Global equities

In the past year leadership has rotated from defensive and growth sectors to a value-orientated mix that has recently experienced difficult conditions, such as energy and industrial companies and those with a high correlation to bonds. On the other side, healthcare and consumer discretionary lost favour, while financials either benefited from low rates (REITs in particular) or in the case of banks, suffered from the low yields on their capital assets.

Global Equity Sector Performance, 1 year rolling

 

 

Regionally, emerging markets have been a standout due to a confluence of factors. China’s growth stabilised as the government cut rates and undertook direct stimulus. Countries such as India and Indonesia are undertaking structural reforms that could lay the path for greater optimism and even Brazil is slowing regaining the confidence of investors. We have seen this outcome from Aberdeen Emerging Opportunities Fund as well as a welcome improvement from Platinum International Fund.

The US market has maintained its momentum, but with a narrow number of stock concentrated in the IT sector. Europe and Japan have remained the laggards.

The key question for a sustained next leg in equity markets is earnings momentum. Global earnings growth has softened considerably in the past year. A lift in resource and energy profits off their lows is likely but this is not at the core of the issue where weak demand, excess capacity and changing industry structures is leaving many companies without much in the way of revenue growth.

There are strategies which may be able to outperform their index. For example, a fund manager that can move holdings through short term cycles akin to the above mentioned ‘bond proxy’ securities in REITs and utilities, or within healthcare, where medical devices have outperformed the traditional pharma companies.  Global managers that reweighted towards emerging markets and selected stocks in Europe where valuations are attractive have also outperformed.

We note in our meetings with global managers that they are reluctant to point out sectors or stocks with compelling upside. Some acknowledge that they are hitting the upper end of valuations when assessing opportunities for new investments. Non consensus potential investments that are therefore mispriced will be an important feature in global portfolios over the coming year, rather than following the favoured momentum driven stocks.

Australian equities

Aside from the abovementioned changes in the interest rate sensitive sectors of REITs, infrastructure and utilities, across the rest of the market a number of cyclical tailwinds that have supported various sectors are showing signs of maturity. These include the weakness in the Australian dollar, which is relevant given the proportion of international revenues derived by many large cap leaders. On a rolling 12 month basis, the AUD has now actually appreciated against most major currencies (with the main exception being the Japanese yen). Secondly, the housing market, where activity has remained high for an extended period, looks to have reduced prospects for housing-related stocks. These include those in the construction industry, but also big ticket retailers that have experienced a positive trading environment.

After a number of years of poor performance, it is the resources sector that has the potential to provide the most upside in the short to medium term. Several commodities have made a significant recovery since early this year, including a number that could translate into a large lift in profitability for the sector over the next 12 months. Oil, iron ore and coal are the most important to the Australian resources sector, with spot prices implying earnings upgrades. While some pricing recoveries are unlikely to be sustained without a lift in demand, the profit leverage in the sector from cost cuts is quite material.

Overall, market earnings growth is still fairly benign, with many large companies facing pressure from weak top line growth and competitive pressures. Among this would include the major supermarkets, the banks, insurers and telecommunications (particularly Telstra).

     Return over time versus valuation at a point in time

Equity market timing

While equity returns can be quite volatile on an annual basis, this is reduced considerably with a longer time frame, indicating that investors are typically rewarded for remaining invested.

On a rolling 10 year basis, the Australian All Ordinaries Accumulation Index has returned a minimum of 4.5% p.a. since 1980 even though it has experienced a similar level of decline to other equity markets at times of stress.

All Ordinaries Accumulation Rolling Returns

 

Nonetheless, investors should naturally expect lower returns if investing when valuations are stretched. A number of global markets are trading towards the top end of their ranges as demonstrated in the chart below. Given the size of the US weight in the MSCI Index, it attracts the most attention.

However, there are also regional markets trading below past valuations. This clearly is not the sole criteria. Much depends on the judgement of each company within its sector and region. It reinforces that there are opportunities, however robust analysis is required to avoid potholes.

Developed market equity valuations

 

The risk is investors miss the best returns when markets rise sharply. A good example to illustrate this shows the growth of $100,000 invested in 1980 (using the All Ordinaries Accumulation Index as representative). The value of this investment would have grown to nearly $5m in this time, despite a number of significant stock market corrections. If an investor were to miss just the 12 best months during this 36 year period, the $100,000 investment would have grown to approximately $1.3m.

Consistently Invested versus Missing the Best Months

 

An indicator of a fund manager’s belief in their ability to time investments is the turnover of the portfolio. A low turnover approach (for example, globally MFS Global Equity Fund and locally Investors Mutual) would imply that the manger takes a long-term view of investing, given it takes years and not months for a company to execute on its strategy.

A higher turnover approach may reflect a manager that has a greater belief in trading in and out of stocks and usually shows a momentum factor bias.

We tend to witness a greater level of turnover among small capitalisation stocks where the realisation of a stock’s intrinsic value can develop at a more rapid pace compared with that of large capitalisation stocks through faster earnings growth and simultaneously, multiple expansion.

The level of cash holdings in a fund’s portfolio is another way that managers can attempt to time the market such as Magellan Global Equity Fund, which has moved to a high level of cash. For most long-only equity funds, however, this is limited by a cap on their cash weighting, commonly 10%. There are reasons why many managers will often not hold large cash balances. These include the poor signal that it sends to investors, a risk of relative underperformance (and hence potential FUM outflows) should the market rise further and a preference for many investors to make the cash allocation decision themselves.

Like all financial markets, over the last quarter the fixed income markets have been impacted by:

– the fall out of Brexit,

– the upcoming US election,

– a rate cut by the RBA,

– expectations of a rate rise in the US, and

– concerns over the health of the European banking sector

With a number of varied themes playing out, it is perhaps surprising to see that the September quarter delivered positive returns, with Australian government bonds +0.08%, Australian investment grade +1.4% and the listed debt market returning +2.85%. Bond yields were volatile, but it was the tightening of credit spreads that aided most portfolios, as shown below.

Australian 5 year iTraxx (measuring credit spreads of investment grade bonds), September quarter 201

 

In global markets, it was high yield (below investment grade, or unrated securities) and emerging market sovereign debt that were the strongest performers. Both were recipients of the search for yield; the former benefitted most from the contraction in spreads, while emerging markets have had currency moves that has been the main driver of performance.

Overall returns for Australian investors in these sectors has been somewhat eroded by a narrowing of the basis spread for those that hedge their exposure. This is due to the easing bias at the RBA, a shift upwards in Libor due to expectations of further rate rises by the Fed and regulatory changes for money market funds which has resulted in a lift in Libor rates over the quarter.

     Timing the market

While we watch and regularly report performance of these different sectors, it is contrary to how we approach investment into this asset class. Using the table of performance for different fixed income sectors, it is clear to see that ‘winners’ rotate. Pre-determining the outcomes is a challenge for any investor. However, by diversifying capital across fixed income sectors, this will deliver sector returns of a varied nature (which may include positive and negative performance results over a period), but it will help to avoid major losses, as demonstrated by the ‘portfolio’ below.

Fixed Income sector returns

 

Investment across a diversified sub-set of fixed income remains our core thesis, however, this is overlaid with a tactical approach to sectors that look over-valued. While we generally recommend that new money is averaged in over a period of time, we call out where there may be time-sensitive opportunities.

The purpose of portfolio managers is to access outperformance within their asset class sector compared to the benchmark or peers, as opposed to being able to produce positive returns regardless of the environment. This comes in a number of forms, including positioning on the curve, credit analysis, timely employment of capital into the market, opportunistic trading and hedging capabilities.

An example of where funds (and direct investors) can add value, is when markets overreact to a situation. Early this year markets were negatively impacted as energy prices fell sharply and contagion from an unwinding ‘distressed fund’ in the US played havoc on credit spreads, which hit a four year high. Portfolio managers that chose to buy at this point, as opposed to get caught up in panic selling, would have reaped the rewards, as the index has tightened some 70 basis points from its peak, translating to an annualized total return of 6.6%.

A recent example of an opportunistic trade at a local level is the CBA Perls VII which was trading at BBSW + 5.75% in February vs BBSW + 4.4% at the end of the September quarter.

Movement in the trading margin of Perls VII

 

     Current positioning