Quarterly Market Review Q4 2014

–  The importance of monetary policy in asset values will be tested over the coming 12 months as a prospective divergence occurs in the US and UK versus the Eurozone and Japan. We would expect central banks to err on the side of caution to avoid adverse trends after so many years of effort. In our view the RBA will follow the US and UK in raising rates after a time lag. Significant moves in currencies are a potential complicating influence.

–  Investment markets and economic growth have a relatively low correlation over 1-2 year time horizons, but a closer relationship in the longer term. The current cycle of economic growth on a global basis is weak at a headline level, but also somewhat disjointed at an industry or sector level.

–  Selected corporations, particularly in global IT, discretionary brands and healthcare, have done well navigating the trends and markets have had the support of the interest rate cycle. Equity portfolios now require a higher level of oversight with higher expected volatility and differentiation in stock performance. Similarly, fixed income investment funds are increasingly making decisions on trends in segments of the market, rather than relying on falling rates and tighter spreads across the board.

–  Equities offer better relative value over fixed income assets, though it is fair to suggest absolute value is less compelling in either. Equity valuations are judged to be at or slightly above historical averages. This is not a cause for current concern in our view, though it is likely to mean a greater differentiation in stock performance than in past years. In our opinion equities are for the moment fundamentally supported by the low discount rate (i.e. the relative value compared to bonds) as well as corporate dividend and capital distributions.

–  After a period of unusually low volatility, September has been a reminder that periodic and unpredictable sell-offs and rallies can occur. Our assessment is that the combination of respectable US data and therefore interest rate expectations, met with weak China data and falling iron ore prices, resulting in outflows from Australian investments. Institutional investors had indicated that they viewed the market as relatively expensive and stood aside waiting for a better entry point. As much as we would like to predict these events, we believe portfolios should be constructed with expected volatility, unique to each investor.

On a 1 year and 3 year timeframe to the end of September, our recommended portfolios have achieved their goals.

       Current allocation is overweight equities relative to strategic portfolios.

We are comfortable that portfolios are overweight equities compared to fixed income, assuming investors accept the rise in volatility associated with the asset class. Given the recent retracement in equity indexes we recommending adding at this time if underweight.

However, we have moderated our view of asset class performance which has reduced the expected annualised return by approximately 0.5% in all portfolios.

Interest rates

       Interest rates are likely to be the key determinant of investment markets over coming 18 months.

In the coming months the primary financial influence on investment markets is likely to be the direction of interest rates. Until recently there has been a near unanimous view that the Fed would make its first official rate rise in 5 years by mid-2015.  With the renewed instability in recent weeks there are some suggestions it may be delayed until later in 2015. Nonetheless, this transition is likely to have a significant impact on all investment assets. The inflection comes without precedent given both the very low level of rates and extended period of this setting, which makes the consequences difficult to judge.

Three questions emerge:

1) the pace and extent of rate rises,

2) whether inflation or deflation is the greater problem, and

3) the potential impact on investment assets.

The balance of probabilities is that, while a mid to late 2015 rate rise will come through as envisaged, the Fed will be highly sensitive to the reaction of the real economy (rather than financial assets). The test is therefore whether the corporate sector will continue to grow its labour force and whether the household sector will continue to consume as the rate environment changes. Given the pronounced signalling from the Fed, keen to make sure all know what its intentions are, we take the view the economy is already attuned to a slow rise in rates and could interpret it as a sign of confidence.

The extent of rate rises is more troublesome. The forward curve implies a steady pace through 2016, with the Fed members themselves suggesting an even faster pace than the market. The absolute level of the official rate at 3.5% to 4% by 2018 does not sound exceptional compared to the monetary tightening in other cycles, but would imply the US and global economies are ‘back to normal’, which we have difficulty envisaging at this time. We side with the view that rates will remain lower for longer.

Deflation or inflation?

        Deflation now, inflation later?

While deflation is current concern, the case for higher inflation lies with the stimulatory monetary policy of recent years. Some also suggest governments will be comfortable with higher inflation as a way of dealing with debt. Both issues may well emerge in time, but the reality to date is that the two big determinants of inflation, namely wages and commodity prices, have been subdued.

In the US, wages growth is more than likely to pick up given increasing signs of tighter labour markets in selected sectors. Services inflation has been running at just over 2% for a few years and the combination of a push for higher wages for low income earners, demand for healthcare and residential rents (which are approximately 23% of the CPI) suggest the rate of cost rises here could move towards 3%. Goods inflation is mostly cyclical, but also substantially influenced by the exchange rate. Hard commodity demand is broadly speaking expected to lag supply growth, implying this component will remain subdued. Energy is also soft and with marginal demand from Asia and Europe now slowing, the consensus is that a sharp move in energy prices is unlikely. The Fed views its 2% inflation target excluding food and energy and its tolerance of a rising cost of living could have a significant impact on financial markets.

The interplay between rates and inflation expectations from the trendsetting US market implies a lift in volatility over the coming year. There is likely to be some timing imbalances and periodic over-reaction in both inflation and interest rates. Nonetheless we very much doubt the Fed would let any inflation last long enough to impact on longer term inflation expectations, which later prove hard to curtail. Given this trade-off, economic growth is expected to be below recent decades.

Fixed Income

        Fixed Income participants are positioned for a rising rate environment.

In the early part of this year, bond and credit markets largely tracked sideways in anticipation of the changing interest rate environment. The recent unexpected fall in yields has seen the asset segment provide positive returns in the past weeks, albeit with a wide dispersion.

Most investors have already shifted their portfolios in anticipation of rising rates and a somewhat uneasy calm reflects a reluctance to make substantial changes to security positioning now. There is also a lack of alternative investments which offer the same features as fixed income, specifically uncorrelated returns to equities and the low volatility in total returns. Institutional investors appear to be taking a cautious view on economic trends, compared to investment banks, always keen to see asset rotation. The notion investors would undertake a major move out of fixed interest has, for the moment, abated.

In our view there are two risks to fixed income assets outside of interest rate movements. The first is the re-gearing of balance sheets, especially where that has funded capital management rather than an investment to add to cash flow streams in the future. The second is the low liquidity in credit markets, a combination of the issuance in recent times and the much smaller balance sheets of banks which facilitate the trades.

We have elaborated on the outlook for US interest rates as the direction is predominantly determined by the US. The global financial world has become increasingly interconnected and Australia will not escape the overflow from Fed decisions.

As we have noted in our weekly reports, the RBA is uncomfortably wedged between what it believes is an overextended housing market and the lacklustre level of activity outside housing. Inflation here too, has been much more subdued as wage growth diminished. In our view the RBA is keen to raise rates, but is likely to hold back, awaiting the US moves, and may also be taking a view that the implementation of stronger capital adequacy ratios at lending banks may unintentionally tighten credit in any event. Lastly, the RBA is keen to see the A$ fall further against its trade weighted index and a rate rise would certainly not help.

Expected returns and recommended investments

         Asset class returns are likely to be modest but continue to offer capital stability.

The absolute returns from fixed income are expected to be low, with coupon yields in Australian investment grade credit markets of 4% to 4.5%, with global equivalents about 1% lower, pre hedging benefit. There is some risk of capital loss if spreads widen or rates rise. We therefore continue to recommend maintaining low interest rate sensitivity (through duration strategies) and active managers, who are able to trade some of the changing pattern in rates.

We do not, however, believe there should be excess anxiety on a potential sharp rise in interest rates as central banks are likely to remain accommodative for some time. Instead investors may have to accept relatively lower returns compared to recent years for some time in the interests of maintaining a position in this low volatility asset class. The key in our view is to ensure the capital stability of allocated funds is as secure as possible.

Where there are securities or funds which aim for enhanced returns by selecting securities lower in the capital structure or taking on more risk, we suggest that this is balanced with a lower allocation to equities than might otherwise be the case. For example, listed hybrids with equity like characteristics may be viewed as 50/50 equity and fixed income in terms of asset allocations.

Equity markets

        Equity has shown solid longer run returns, but is coupled with high sensitivity to events and global          growth.

In summarising equity market returns over the past 5 years, the chart below illustrates that this has been far from an easy path. The apparent correlation between the ASX200 Accumulation Index and the All Country World Index also belies the outcome, with the global index at 11.1% per annum for the past 5 years to end September 2014, outperforming Australia at 6.8% per annum.

A shorter time frame of three years produces relatively solid investment returns and therefore many feel cautious about further performance at this time.

The sell-off in September, while somewhat unusual in its extent is, in our view, a relatively typical phenomena. We had noted that some securities felt extended in terms of valuation and were therefore vulnerable to any stock specific issues or sentiment changes. The combination of rising US bond rates and the sell off of the A$ pulled global investors from our rate sensitive market segments, and then the weakening trends in Europe and China added to uncertainty.

Finally, we believe most investors have much of their investment allocations in place and therefore marginal buyers are missing. Others point to the continued high weighting of cash in self managed funds and suggest this will find its way into investment assets. While we believe cash holdings are generally too high, the reality is that households with higher wealth are also much more cautious in order to protect that wealth.

On the fundamental side, the earnings cycle has lagged and on the traditional measure of P/E, global markets are in line with history, while the US screens above its long term median.

The problem with assessing market valuation is that it is more open to interpretation than many would imagine. For example, the trailing P/E and therefore its median value includes the extraordinary peak of 2000 where a large number of companies with little or no earnings were highly valued. Similarly, the low valuation of the 1970’s were due to elevated inflation and variable interest rates.

MSCI All Country World trailing P/E

 

The above chart also shows that low or high P/E markets do not necessarily give a buy or sell signal.

Ultimately our judgment rests on a number of factors. Equity returns have averaged 8-9% p.a over an extended period of time.

– The fundamental support, in our opinion, is based on nominal GDP, the ability to gear up a company and therefore achieve a return over the cost of capital, and the likelihood the equity market represents higher growth sectors of the economy.  For example, Australian nominal GDP has been in the order of 6% (3% inflation plus 3% real growth), gearing has been about 50% and sectors such as social services are not in investment markets.

– There are periods where certain sectors of the market have influences which cause excess returns. Typically there is then a ‘payback’ where that high point lingers in the data and the equity segment screens as having poor returns. Examples are the internet bubble of 2000 on the S&P500 and the impact of the secular shift in commodity prices, as well as unusually high credit growth, on the ASX200 in the mid 2000’s.

Currently we assess potential returns on:

–  Economic growth is expected to be below the past couple of decades, both in real GDP and the likely level of inflation, assuming the issues we noted earlier in the report do not translate into high inflation. Other long term factors include demographics and high levels of sovereign debt which is likely to limit fiscal flexibility. This implies the nominal GDP is likely to be lower in coming years.

–  Recent sector influences converge on issues such as the impact of the internet, healthcare and brand value. These have been important as many companies have been able to create their own destiny rather than just depend on economic growth. Conversely, since 1990, the market cycles have tended to follow economically sensitive sectors such as financials and commodities. We believe these structural shifts will add to investor returns though we acknowledge risks such as the recent pullback in brand names due to changing demand in China, the potentially higher tax payments from IT companies and the inevitable limitations to healthcare spending over time.

Companies are increasingly ‘shareholder friendly’, distributing capital back to shareholders rather than undertaking higher risk acquisitions. Demerger and asset sales are also in general enhancing investor returns.

In the current circumstance we would therefore guide investors towards equity returns in the order of 7-8%p.a for the foreseeable future.

        We expect lower returns from equities than in the past.

        Australian dividends a major benefit.

Within Australia equities, investors are likely to achieve a relatively stable income stream, but the offset is a greater level of capital volatility than in recent times. We recommend ensuring that the dividends achieved are spread within sectors and, in particular, giving full consideration to the appropriate level of total exposure to the banking sector, where the risks are very similar across each organisation.

        Global equities achieve diversification.