Quarterly Market Review October 2017

The current strength in global economic growth is expected to hold its pace into 2018. Encouraging signs of investment spending are fundamental to the outcome.

Australia has lagged the cycle. Large infrastructure projects are proving to be the key to 2018, though tempered by the household sector which is labouring under debt, low wage growth and cost of living pressures.

The long-awaited end to Quantitative Easing (QE) will roll out in earnest through 2018. Bond markets are yet to reflect the potential rise in rates and act as a brake to returns from all asset classes.

In this report we focus on the impact of investment style and sector change on fund manager returns. Our recommended blend of managers aims to capture both long term, lower risk returns which can lag their benchmark at times, while also offering funds that are aligned to a shift in sentiment.

The change in monetary policy will present challenges for fixed income assets. While central banks have embraced the concept of providing clear guidance to market participants, this is not always expressed in forward yields. Central banks will also not be able to determine the attitude and appetite of other buyers, which may become more selective given the lower impact of excess savings.

We retain our underweight but active stance in fixed income. Domestic floating rate and global unconstrained funds form the key weight. Depending on investor risk and yield requirements, non-benchmark asset such as RMBS can be considered.

Sector rotation in equity markets has become apparent, with defensive, highly valued companies giving way to those exposed to cyclical growth. The key will be earnings growth rather than multiple expansion. This should be accompanied by higher output prices and a small rise in inflation.

We recommend adjusting the balance in a global equity allocation from the high growth and quality bias of recent years by adding funds with a value bias. The companies in these portfolios typically have leverage to the economic cycle or have been out of favour for some time. We retain a regional preference outside of the US. Exchange traded funds (ETFs) can play a role to achieve the required outcome.

Two themes have promise within the Australian equity market. Infrastructure spending has a handful of companies with exposure to this sector. Small cap companies have recovered after a weak 2016. We continue to believe better growth prospects are associated with this segment of the market. These investments are balanced by our core recommended SMAs which have performed according to expectations.

We maintain higher cash weights to compensate for the expected modest return from fixed income, while also reluctant to increase equity allocation at this stage of the cycle.

Asset Allocation

Expected index return (excluding alpha and franking)

Expected return (including alpha and franking)

There has been much discussion amongst financial commentators on the length of the current global economic cycle, as measured since the contraction in 2009. At face value, it is one of the longest in recent history but, in our view, disguises the character as well as differentiation in regional and sector performance. We therefore believe that judging the conditions over the coming three years requires an appreciation of the underlying factors.

The predominant influence has been central banks and the role played of financial assets; in short, a monetary phenomenon. This compares to previous cycles that have been based on economic activity. For example, the opening of Eastern Europe to capitalistic influence, China’s contribution when it joined the World Trade Organisation in 2000 and fixed asset or fiscal spending contained the main thrust of an economic cycle.

The price movement in the commodity index relative to the performance of European stocks is illustrative of the nature of cycles since 1991. We have used the Bloomberg Commodity Index which comprises a wide range of raw materials including energy, base metals, precious metals and soft commodities. We have elected to compare this to the performance of the European equity index, as it typically follows economic momentum.

Cumulative Return of Commodity and Euro Equity Indexes

 

This time frame shows three cycles. From 1990 to 1997 the commodity and equity market were correlated, supported by European integration and investment spending. The 1997-2001 period captures the Asian banking crisis and the US tech stock meltdown, which was therefore mostly financially driven. This is followed by ‘peak’ commodities, with strong economic growth driven by global trade through to 2008. After the early recovery and stimulus in China in 2009/10, the movement in commodities has been at odds with equity markets, implicit of a monetary market driving asset values, rather than strong demand-driven economic activity.

Regional growth has also been quite distinctive as the US rushed out of the gates soon after it initiated quantitative easing, while, until recently, the economies of Europe and Japan lagged. Emerging countries have also had a much more variable performance.

Australia may hold the record for the longest period of unbroken growth, yet that has not stopped the RBA from cutting interest rates to all-time lows indicative of the moderate level of growth.  As such, Australia has also coasted on a monetary push largely through housing investment.

The length of the cycle is therefore of less interest to us than its shape. It remains in a weak phase with structural limitations of demographic maturity, high debt levels and low productivity. It has relied heavily on central banks and the imminent change in pattern will inevitably also impact financial markets.

A key restraint has been the lack of wage growth that would otherwise have initiated higher levels of consumption spending. That has been offset by higher corporate profits, which in other circumstances typically contributes to an investment phase. Yet, the business sector has had to cope with excess supply in capital intensive industries, while the level of capital required to build intangible businesses has been low.

In recent months there are emerging signs that capital programmes will come through in both the corporate sector and from public spending. The latter rarely reach the promised levels, but even a modest rise would prolong and accentuate the economic cycle given the multiplier effect of such spending. The basis is simple: business confidence is at highs and inventory adjustment has left supply chains behind demand.

Indicators of Investment Spending

 

Australian economic growth is expected to rise into 2018 on the back of infrastructure spending supported by state governments, which have benefitted from property tax and stamp duty receipts. The trade sector is also shaping up well, with volume growth now matching pricing in importance for commodities. The services sector (education and tourism) is going from strength to strength.

The predominant cause of weakness is the household sector, facing low wages growth, rising non-discretionary costs combined with high debt. Unless there is a lift in wages, it is hard to see how this nexus can break. The RBA will only add to the problem if it raises rates as many expect.

In the coming years, the likely determinant of the global economic cycle, given our view that it is monetary, will be a tightening of money supply. The total money stock has been elevated since 2008, but the velocity (turnover, or number of times money is being used in transactions) of money has been low. Even if central banks reduce the level of bond purchases, if credit growth and transactional volume increases, it may compensate for this phase. It is only when credit becomes expensive or unavailable that the economy will react negatively. Most economists view this risk as occurring in the latter part of 2018 or into 2019.

The markets in Quantitative Tightening (QT) won’t be the reverse or opposite of QE (Quantitative Easing). QE resulted in a highly productive return from high quality equities that were not overly dependent on economic growth. Fixed income assets generated unusual returns from the combination of initial relatively high yields, capital gains and narrowing spreads as interest rates fell.

In broad terms, a rise in rates at a time of solid economic growth, modest, but rising wage inflation and investment spending should see companies with pricing power do well and those leveraged to the investment spending pattern. The nature of the ‘disruption’ theme is also changing pace. Overall earnings become more important than multiple expansion; indeed a fall in the price-earnings ratio (P/E) is quite probable due to higher rates (we addressed this in our July Asset Allocation report).

Fixed income becomes increasingly opportunistic and, at long last, short duration should pay off, returning the role of fixed income to its predominant purpose of income and insurance. The increasing requirement of global pension funds should also see support for fixed income remain. We can foresee a time in the next few years when this asset class re-establishes its position as its traditional role of providing reasonable real income alongside its low/negative correlation to equities.

Bond prices proved volatile in the past quarter following uncertain global trends. Yields are now trading at similar levels to the start of the year, despite two rate hikes by the US Fed.  We base our performance expectations for fixed income in the context of a continuation of a broad-based recovery as growth stabilises and inflation picks up. Central banks will continue to play a pivotal role in the direction of interest rates, with the Fed expected to raise rates in December and begin tapering its balance sheet at US$10bn a month. As Europe is contributing more to growth and the threat of populism becomes subdued, the ECB is likely to prepare the market for a gradual QE unwind in 2018.

Given the outlook above, our expectation is for rates to track higher in the US. Market pricing still lags the Fed’s forecast for four more interest rate rises between now and the end of 2018.  The benign inflation outlook, ageing demographics and large debt levels are common arguments for why the market is pricing in a very shallow path of interest rate hikes. However, we look to recent signs of inflation and wage growth and the demand side implication for US treasuries that should result in rising yields. The Fed has already raised rates, which has been well tolerated with no obvious drag on growth.

The unwind of the Fed’s balance sheet is unprecedented, but given the well telegraphed pace, it is unlikely to immediately move markets. Looking to 2018, the impact may become more pronounced as the balance sheet reduction becomes significant. The question then presents as to who will be the buyer of these assets, and in the absence of significant demand for US treasuries, how much pressure will this put on the yield curve and demand for bonds.

Two important dynamics support our view of higher rates.

– China and Japan own more than 40% of the US treasury market. China has reduced holdings over the last six years, with currency diversification and a fall in foreign reserves altering its appetite. Japan’s demand for Treasuries fluctuates, ranging from being the largest net seller in 2016 to one of the largest buyers of these securities in the first half of this year. More recently, the cost of hedging the currency risk has risen, reducing the benefit for many investors buying bonds offshore. Japan, Germany and the UK have scaled back purchases as the benefit of buying higher yielding Treasury debt has declined once the cost of hedging is applied. The price of the basis swap will be instrumental to demand from offshore.

Declining Benefits for Foreign Investors Buying Treasuries

 

– US tax reform is yet to be finalised but has the potential to reignite optimism about fiscal stimulus (of which government funding will change the supply side) and triggering the resurgence of the reflation trade, be a key catalyst for rates to rise. Further, data suggests that many US companies hold US treasuries in offshore subsidiaries, with the new reforms likely to result in the sale of these assets (pushing down bond prices and lifting yields) as money flows back to the US.

Inevitably, higher rates will lure investors back into treasuries; appetite from pension funds (that have long term liabilities to match) will likely return at better levels and corporates maintaining asset allocation to sovereigns. It may be that a 10-year rate in the 2.5-3.0% range will be the key level to induce buying.

The benchmark for global bond funds is the Barclays Global Aggregate Bond Index. Over 50% of this index is made up of government debt, with the most significant holding being US Treasuries. Given our views on the direction of US rates, and the contagion that their movements have in global markets, we are of the view that this benchmark will most likely experience a period of low to possibly small negative returns.

We therefore favour using investments that are not tied to the benchmark, either because they are truly unconstrained in their investment approach, or benchmark aware, but have a flexible mandate. The bias is towards short duration funds (Kapstream and Macquarie Income Opportunities) in addition to some exposure to duration bond funds that are actively managed, with the Pimco Global Bond fund well represented here.

Curve positioning (for example selecting 2, 3 or 10-year bonds) and rolldown (where the price of a bond rises closer to maturity) can be a source of alpha, as well as appropriate selections in credit. We expect our recommended funds to be defensive during risk-off markets. On the other hand, we expect these funds to provide returns over and above the benchmark when rates fall through investment in high yield product and positioning. The key criteria for the asset class is the long term low correlation to equities.

Asset Class Correlations (15 years)

 

While global investment grade (IG) credit spreads are notably tight, we are unchanged in our underweight recommendation as we expect levels to remain broadly range bound given:

– The low profile global growth and inflation environment;

– The market bid for paper and absorption of record new issuance this year due to mandates;

– The net positive flow of funds into corporate bond funds potentially as a function of investors hedging growing equity weightings as valuations rise; and

– Interest rates, albeit rising, are still historically low and credit benefits from the search for yield.

High yield credit spreads are more exposed to weakness because buyers in this asset class are opportunistic. Defensive trades in response to a deterioration in economic conditions or geo-political risks may be expressed through this sector. Our exposure to offshore high yield is low (through a component of the JPMorgan Strategic Bond Fund), with our preference for risk being in the Australian listed hybrid market. Limited supply is likely to support valuations of hybrids and consistent fair priced franked income in a low yield environment makes sense for portfolios.

Investment in emerging market (EM) debt has been popular as valuations became attractive post the energy sell-off in 2016 when currencies tumbled and spreads widened. Economic fundamentals and current accounts have improved in many of these countries and the spread differential between relative nominal yields in emerging versus developed markets is at its highest in three years, making the asset class attractive.

We remain mindful of the volatility of this asset segment, and recognise the risk of ‘herd mentality’ in EM at present, especially for exposures where the currency remains unhedged. We recommend a diluted exposure to EM debt through unconstrained funds, which have strong expertise in country selection and currency trading, with our recommendation of the Legg Mason Brandywine GOFI Fund.

Emerging Market Yields

 

The Australian market is pricing in rate hikes next year, with fixed income markets forecasting the likelihood of a 0.25% rise sometime in the second quarter. In our view, this appears optimistic. Economic conditions are still fragile, retail is struggling, inflation weak and the housing market is cooling as macroprudential changes start to take effect, offering no compelling argument for a rate rise.

If the RBA keeps interest rates on hold, we would expect domestic bond benchmarks to post positive returns. Active long duration bond funds are placed to outperform the index as they take advantage of a steepening of the curve and carve out returns over and above that of cash. The differential between 3, 5 and 10 year bonds and the cash rate is at its highest margin since before the 2008/9, offering opportunities for managers active in this space, such as Jamieson Coote Bond Fund.

In summary, expectations and recommendations for fixed income in the next quarter include:

– Global yields to rise, putting pressure on global benchmarks that have high weightings to sovereign debt.

– A preference for short duration funds and global bond funds that deviate from the benchmark by active positioning on the curve and investing in spread (credit) product.

– Emerging market debt should offer a pick-up in yield, but we are mindful of sizing in this sector.

– Opportunities in the Australian rates market due to varying views on the likelihood of RBA rate hikes in 2018.

– IG Credit and domestic hybrids are most likely to remain supported.

– Diversification benefits for fixed income remain in place as negative or low correlations are sustained.

In keeping with our rolling three-year views on investment markets, the following table shows sector performance over that period, as well as the past twelve months ending 30 September 2017. The data reinforces our view of the current rotation that is occurring.

Information technology has been the winner. The combination of the disruptor theme and the momentum in markets has supported this sector through most of the cycle. The laggard has been telcos, which have not offered more than 5% annual returns in any time frame of this period. No other sector has delivered consistent returns over this period.

‘Safe’ defensives, such as consumer staples and healthcare, have seen deteriorating and increasingly patchy returns, while cyclical sectors such as industrials, financials and materials owe much of their three-year performance to the past twelve months as the data for the past year illustrates.

Sector Returns (p.a.) as at 30 September 2017

 

We expect these trends to continue into 2018 as they are correlated with our comments on the economic outlook.

Regional returns have been less distinctive. Indeed, after the recent catch-up from Japan and emerging markets, the performance over three years is remarkably similar. This does, in part, reflect the global nature of many companies, but is likely more to do with overall asset allocation to equities. Even though the US market has had a relatively high valuation for the better part of the past year, its dominance in high profile tech names has kept the region in touch with the rest of the world.

Regional Returns (p.a.) as at 30 September 2017

 

The ongoing strength in cyclical indicators, with PMIs (Purchasing Manufacturing Index) as a appropriate collective measure of activity, point to a further rotation into cyclical sectors. Typically, the investment community underestimates the leverage that such companies achieve from increased demand and some pricing power.

Global portfolios are likely to follow this momentum, while net new allocations to equities are relatively contained. This is likely to mean that there will be trimming of some of the defensive and more expensive growth stocks, particularly in healthcare, IT and consumer staples. Sector weighting changes may not be as substantial, as there are better value stocks within sectors where fund managers have long held analytical strength and conviction. For example, we have noted that within IT, managers are electing to move towards some of the traditional long-standing companies (such as Apple and Microsoft) and out of the more recent internet names (such as Facebook and Google).

Investors may however experience some underperformance from high growth, quality-oriented funds that avoid the cyclical names. As mentioned, this can be ameliorated by a shift within a sector.

Specific to our funds we make the following comments:

– The WCM SMA and MFS are both quality growth managers, albeit via a distinctively different process and time frame. We note the agility of WCM, while with MFS the five year investment horizon is the key criteria. Nonetheless, we recommend reviewing the weight to these two funds to make room for alternative styles. We stress that this is not an outright bearish recommendation, it is rather to rebalance the investment style factors within the global equity allocation.

– Funds with a value bias and willing to select stocks that have been out of favour are expected to offer excess returns. Value companies are categorised as those with low price/book ratios, higher dividend yield, lower P/E and lower sales to price. Screening out companies with imbedded fundamental problems (rather than cyclical or out of favour) requires more than a superficial quantitative methodology.

However, even the purely quantitatively screened indices show the extent of performance drag from value relative to the category’s earnings growth potential.

EPS Growth and Price Performance of MSCI World Growth and World Value

 

In our manager universe, funds such as State Street Global Equities, Antipodes and Platinum exhibit a value bias. Pure or deep value funds typically have an elevated risk/return, which we believe is inappropriate as a core holding.

– While real assets, infrastructure and property, are vulnerable to a change in rates, there are selected securities which will revalue due to increased utilisation, or where inflation pricing links will be helpful to the income stream. We view RARE Infrastructure as capable of managing the selections within a rising rate environment, though we caution there may be periods of weaker performance if a collective movement in weighting drags the whole cohort of infrastructure stocks in an indiscriminate move.

– Emerging markets have been particularly strong this year. Many funds have lagged as a significant attribution of performance has been from a handful of China internet companies (for example Alibaba, Tencent and Baidu) and China in general. The chart illustrates the big divide in returns from China and the emerging index.

Emerging Markets and China Equity Indices

 

We would expect recommended managers to diversify from China and therefore the performance may be below the index. Our favoured funds include Aberdeen, Somerset and Macquarie Asia New Stars, as well as an exchange traded fund (ETF), VGE, which represents the FTSE index, a more broadly-based index compared to the MSCI.

As with many international equity markets, the ASX 200 has produced impressive returns since early 2016, with the accumulation index (including dividends) up more than 25% over this time. Despite this, the period has been characterised by poor relative performance by domestic fund managers, many of which have lagged the index.

It can be easy to dismiss the performance as solely attributable to poor stock picking by a fund manager, although there are multiple other reasons why a fund may underperform in any given year. In assessing the performance of individual funds, our process involves identifying what the key drivers have been and more importantly, judging whether the outcome was expected given the investment style of the manager and the primary objective of the fund. A manager that remains true to label in the face of a difficult market environment is preferred.

There have been two key drivers of domestic equity performance over the last year that would explain the performance of many Australian equity funds. The first of these has been the rotation from ‘growth’ to ‘value’. This has been evident in international equity markets and is associated with the coordinated uptick in economic activity, rising interest rates and a broader spread of earnings growth. With most active fund managers biased to growth companies due to their quality attributes (competitive advantage, higher margins and returns on equity), many have lagged with this backdrop. These cycles can remain for an extended period, however it would appear in Australia at least, that the outperformance of value has run its course for the time being, with a turning point evident in the last six months:

ASX 200 Growth – Value: Rolling Year Relative Performance

 

Secondly, the rebound in commodity markets has been underestimated by many managers, although many are also structurally underweight due to their low earnings predictability and undifferentiated product. It should be noted that this was previously a multi-year tailwind for most funds that were underweight the sector as the commodity oversupply was worked through. This was particularly evident in the small cap sector where it is common to screen out unprofitable or speculative mining exploration companies. The current cycle was initially supported by Chinese stimulus and now rising demand from the rest of the world as economic growth improves. While conditions are currently more supportive for the sector and cashflows are much better, the probability that the next 18 months will be a repeat appear to be low.

The expected earnings growth in the Australian market for FY18 is in the mid-single digit range, a sharp retracement from the healthy growth recorded in FY17. While this would be close to the average growth rate of industrial stocks over the last decade, the typical path of earnings revisions over the course of the year would suggest that is optimistic compared to the actual realised rate. The lack of broad earnings growth would help to explain why the ASX 200 has essentially tracked sideways since the resources rally began to taper in the first quarter of 2017.

As is often the case, the key swing factor for the Australian equity market will lie with profitability in the resources sector. Notably, a doubling in earnings in FY17 from a low base was the primary driver for the market as a whole in the last financial year. As it stands, resources earnings are expected to be flat in FY18, consolidating at this higher level. Commodity prices experienced an additional leg up in the September quarter to the extent that much of the listed sector is likely to be the subject of earnings upgrades in the short term.

The more pessimistic view highlights that iron ore and coking coal, have recently bucked this uptrend and remain susceptible to the changing pattern of Chinese steel demand. Nonetheless, the continuation of broad global economic growth and a tick up in asset investment provides a supportive environment for base metals, in particular. The major diversified miners have quickly turned from cashflow conservation and balance sheet repair to higher dividends, incremental capex and share buybacks. These changing capital allocation priorities are likely to mean that any excess cashflow generated in the medium term will be returned to investors.

The majority of the industrials sector is more dependent on the domestic economic outlook. We have noted the expected improvement in Australia’s economic growth into 2018. However, the composition of this growth does not translate into an optimal outcome for domestic equities. For instance, higher export contribution to GDP will be a function of higher volumes at Australia’s majority foreign-owned LNG projects. Increased domestic infrastructure spending is well understood, although as we have noted in a recent research piece, the expected flow through to listed equities is limited due to the diverse earnings exposure of many of these companies.

A key issue is that revenue growth is soft due to constrained household budgets. While employment growth has been robust through this year, wages growth has remained benign, costs (such as energy) and debt levels are high (with interest rates potentially rising in the next year), leaving little in the discretionary spending basket. A return to higher wages inflation would be welcome improve the outlook for these companies.

Finally, the financials sector (of which the four major banks comprise 70% of the index) is weighed down by soft credit growth and political and regulatory headwinds. Credit demand is held back by household debt levels and the lack of business spending. Financial asset managers that rely on higher markets for revenue growth may struggle in the current environment and the insurance sector was one of the weaker in the reporting season just completed.

In our June quarterly asset allocation, we highlighted our preference for mid and small caps, which have since subsequently performed well. These stocks and funds remain appealing given the better prospects for growth and valuations that are similar to large caps. We recommend investing in two or more of these funds to account for the differentiated approach and counterbalance those with high volatility for example combining Ophir, Regal and JCB for capital growth investors.

The forward P/E of the market has been largely unchanged through 2017 at around 16X forward earnings, which is at a premium to its historical rate. The high weight in the ASX200 to interest rate sensitive stocks reinforces our recommendation to be underweight Australian equities in favour of global stocks.

The performance of our Australian equity based alternative funds has been variable over the last year, with the quality bias affecting Bennelong Long Short and Optimal, and lower levels of volatility limiting the returns on Ellerston Market Neutral. Nonetheless, we believe that these relative value strategies remain an important diversifier from long-only investments in equity markets that are somewhat expensive.

Unlisted property assets have performed relatively well in the past year. We do however caution that capitalisation rate compression may not last and could reverse. We therefore pay more attention to the reliability of the income stream achieved from a diversity of property asset and lease terms.

The performance of global alternative funds has been somewhat below par. The predominant style is through judgements on macro conditions across asset classes. We do retain the view that these funds will be helpful to portfolios when investment asset markets transition and volatility increases as they are willing to respond rapidly to changing conditions.