Week Ending 29.03.2018
- In summarising the developments in financial conditions for the first quarter of the year, we are of the view that judging asset performance based on the parameters of the past five years could result in misguided conclusions.
- After many years of relatively correlated macro factors, differentiation is likely to require specific assessment of each region.
- This quarter has the hallmarks of another challenge for financial markets if the US CPI does indeed surprise on the upside. Communication cost, health and housing are the possible culprits.
The tone into the start of 2018 was uniformly positive, with expectations economic momentum that had built up in the prior year would be supplemented by the US tax cuts and global business confidence, leading to investment growth. Through 2017 investors had brushed aside concerns such as Brexit, an unpredictable US administration, Middle East and Korean tension and, not least, the change in direction at the US Fed after many years of supportive stability.
The current conditions are not too different to 2017, it is rather that the reaction to issues has changed. With hindsight, the complacency would inevitably be disturbed; it was only a question of what data would trigger such a reaction. The answer was a benign rise in US wage growth at the end of January. Even so, that was quickly brushed aside as a speed wobble rather than a meaningful change in pace.
In our view however, equity markets had largely ignored the movement in bond yields, together with the relatively high valuations. Both these aspects don’t imply that a pullback was necessary but pointed to the elevated potential for a retracement of some of the stellar gains of January.
The remainder of the quarter has continued in the same tone. A combination of questions on the rate of economic growth in Europe (indicators suggest it is levelling off), the eventual repercussions of tariffs and trade barriers (which changes the path of growth and possibly inflation), the impact of the US tax changes (stimulation to an economy already heating up) and a new phase for China (a lift in its industrial sophistication and confidence) all imply that 2018 has the wherewithal to have a larger impact on financial assets.
Added to this have been specific issues such as the regulatory concerns on social media companies, higher short-term interest rates in the US, and locally, the bank royal commission and mooted changes to accessing dividend franking credits that all have direct repercussions for markets.
With this backdrop the fall in equity indices over the quarter is less of a surprise compared to the ongoing economic momentum. We have noted that financial asset performance and GDP trends are not directly correlated. Financial markets work on forecasts and sentiment plays a dominant role.
Where do we stand on the outlook?
The patchy economic trend is worth watching. We see no sign that there is any emerging factor that will cause a major reversal of the trend.
A full-scale trade war is unlikely. The issue is as much political as economic. Some form of concession from China may be enough to claim political victory. The European surplus is an intractable reality, in part brought about by the establishment of the Euro and the long-term benefits this has delivered to Germany along with the suppression of labour costs post reunification. If trade uncertainty inhibits business investment or does translate into an unexpected bout of inflation, the situation will require reassessment.
A moderation in the rate of European economic momentum is on the cards with gains harder to achieve post the stabilisation of financial conditions across the Mediterranean region. Japan, too, may see growth level off. By contrast the US fiscal stimulus has yet to hit its straps and, broadly speaking, the emerging economies are expected to hold up as domestic demand improves.
The coming quarters will be telling for US data. Either the indicators will roll over (unlikely) or GDP will start to accelerate. The overheating theme and rate settings then come into play.
ISM composite index and US GDP
A notable feature of the past decade has been the correlation in global growth. While it may seem as though each country determines its own destiny via its domestic policy and situation, the impact of trade, globalisation of themes, interest rate correlation and broad suppression of inflation has resulted in a greater similarity in economic direction.
The combination of a reduction in tariff free trade, diverging fiscal regimes, China’s determination to work to its own rules and the limitations demographic and structural issues impose on Europe and Japan, may imply a tipping point to this pattern. This will match the likely direction of central banks, with the US, UK and Canada raising rates while Europe, Japan and most of the emerging economies stay put.
- Unwinding the impacts that correlated economies has on financial assets is likely to set in train diverging performance of equity markets. The momentum factor, predominant in recent years, may wane in influence resulting in a greater disparity in portfolio structure across fund managers. Similarly, the dominant global themes may disperse into a narrower assessment of individual companies rather than a broad-brush approach.
This quarter could prove the pivoting point for the emergence of long awaited inflation in the US. We have noted that the data will cycle the effects of unlimited data plans in communication that pulled the CPI down some 25bp in March last year. Healthcare costs are expected to pick up as insurance rates respond to the lower coverage from the Affordable Care Act.
Housing has an outsize impact on the CPI and, in a paper by the Federal Reserve Bank of Kansas City the authors conclude that tight supply is putting pressure on rents and a shortage of qualified workers and limited land in desired location are constraining the capacity to meet demand. The impact is mostly on single family homes as multi-unit developments supply has been stronger. The low level of available existing homes has seen prices move up, but rents are not yet reflecting the trend. The data for the CPI uses rent as a broad assessment of the cost of occupying a home regardless of the ownership. A rise in rent therefore should have a big impact on measured inflation.
Sale listing of existing family homes
Rent and sale prices
- The relentless focus on employment conditions and inflation can be expected to continue, which may exacerbate the differentiation in the assessed financial conditions in regions.
While the past quarter has seen global equity markets retrace some of last year’s gains, the 12 month returns are still positive bar that for the US FTSE index. Over the quarter export-oriented economies bore the brunt of the sell off with Japan and Germany reflective of that trend. The past month however has been somewhat indiscriminate with most regions showing loses of 3-4%.
On a sector basis we await the global data available next week. The S&P500 however is indicative of the pattern. For the year interest rate sensitive and defensive sectors have lagged, but that has been the reverse in the past month given the movement in long term rates and sector specific issues for IT (Facebook etc) and Consumer Discretionary (home of Amazon).
S&P 500 Sectors Performance as at 28 March 2018
Investors may reflect on lagging performance from some global funds in the past year. Without index weight in IT, they were destined to struggle. Many had become cautious on this segment pointing to likely regulatory issues and valuations. It is likely some of this will be reversed in coming months, yet we continue to advocate for differentiation in fund strategies to avoid over-concentration on a narrow set of themes.
Investment Market Comment
- Commodity prices have always shown volatility reacting to data on demand or supply. In the March we have seen commodity markets (ex oil) experience a similar selloff to that of equities based on both fundamental factors and sentiment.
The worst performing commodities have been bulks. China, as the world’s largest producer and consumer of steel, inevitably determines the close relationship between the price of Chinese steel and the two key components namely, iron ore and coking coal. Hence reports of a slowdown in Chinese construction from the timing of the lunar new year, an extended winter-mandated production shut down and weak downstream demand steel has put pressure on the price of both these commodities. In addition, the suggested tariffs of 25% on the exports to the US added to the negative tone.
Commodities Price Performance as at 28 March 2018
Thermal coal, used in power generation, has declined in March mainly from the news that Indonesia, the world’s biggest exporter of the commodity, would cap the price of domestic coal for power stations at $US 70 per ton for two years.
Base metals have fared only slightly better than that of bulks. Nickel has had the best performance over the past 12 months thanks to the demand for lithium-ion batteries, which require more nickel than lithium, often cited as the key input. Copper has is also experiencing a negative sentiment with inventories on the rise amid questions on the near-term prospects for Chinese demand.
Oil prices have held up as OPEC and other suppliers appear set to continue restricting output for the rest of the year in an attempt to reduce oversupply.
The increase in volatility and correction in equity markets leads to risk-off sentiment that usually provides price support to gold. However, the impact has been modest, which suggests that gold might not be the appropriate alternative asset for downside protection in uncertain markets.
- Timing the exposure to resources via the equity market inevitably introduces volatility to the portfolio. Investors can elect to ride through the cycles or limit participation as timing can be difficult.
Fixed Income Update
- Market discussion focuses on the widening spread between Libor and the Overnight Index Swap (OIS) rate in the US. Historically this has been an indication of deteriorating credit conditions.
- BBB rated securities now make up nearly half of the investment grade corporate bond market. Increased leverage in this sector highlights the importance of portfolio managers security selection.
Concerns on the rising margin between Libor and the Overnight index swap spread (OIS) in the US have dominated comments on rates this week. The OIS rate is a swap that is derived from the overnight cash rate set by the central bank (Fed Funds rate). It is used by market participants to change the interest rate composition on bond holdings. Counterparties swap floating rate interest for fixed rate, without any meaningful credit risk. Conversely, Libor is the rate in which banks lend to each other, and therefore it does take into account counterparty risk (the risk that the borrowing bank won’t be able to repay the funds).
Historically, a widening in the spread of Libor to the OIS rate has been an indication that banks are less willing to lend to each other on the basis they are concerned with credit worthiness. This week the spread on the 3month Libor rate versus the OIS has risen to 58bp, taking it to its highest level since May 2009.
Rather than reflect deteriorating credit conditions most suggest the move has been driven by an increase in the rate on short term Treasury bills, which have jumped following increased issuance by the US Treasury as it seeks funding for the fiscal spending. With more supply competing for short term funding the rates have moved higher. The repatriation of corporate cash following the tax reforms is likely to also be a contributor. Many US corporates held US denominated corporate paper and T-bills in offshore markets which they have realised to repatriate the funds, dropping demand for these securities.
Spread movement between Libor and the OIS rate in the US
While this therefore may not be a sign of a funding crisis it does have ramifications for broader markets and investment portfolios. The most obvious is the increase in funding costs for banks and corporates where their funding costs are against Libor. Australian banks have approximately 8% of their funding book in offshore short dated debt. They may therefore issue more domestically which may already be taking effect given the lift in the Australian BBSW rate with the 3mth BBSSW rising from 1.78% a month ago to 2.03% today.
The beneficiaries of the rise in BBSW and Libor rates will be the funds and investors that that buy floating rate bonds. The coupons on floating rate securities will set higher, given they are generally a spread above the Libor rate in offshore markets and BBSW in Australia. Our recommend funds that will benefit include Aquasia Credit fund, Macquarie Income Opportunities fund and Kapstream Absolute Return fund. Bank hybrids are also floating rate and coupons will set higher.
- Another potential repercussion discussed is that the Fed won't feel the need to raise rates as aggressively given higher US borrowing costs will already be tightening financial conditions. This will have broad ramifications across financial assets.
While the pricing of an individual bond is determined by a number of factors, the most significant contributor is the individual credit rating of the underlying issuer. The rating agencies, Moody’s and S&P undertake credit analysis and assign a rating based off the assessed risk of default. Companies that obtain a rating between ‘AAA and BBB-’ are considered investment grade (IG). Ratings that fall below this are in the non-investment grade sector, known as high yield.
Bond funds are often mandated to maintain a certain proportion of the fund in IG rated companies. The higher credit quality funds are sometimes entirely limited to these securities. For the issuer, having an IG rated credit score allows them to access the bond markets more readily and raise capital at more favourable rates than those that don’t meet this standard.
Deterioration in credit quality within the IG market is illustrated by the number of companies that just make the IG cut, with the BBB rating up to 48% of the total. Further, given the ability of those companies to access more funding in a low interest rate environment, the net leverage (defined as total debt less liquid cash and investments/ EBITDA) of these issuers progressively risen to 3 times from 2 times prior to 2015. This makes BBB rate companies vulnerable to a credit downgrade.
Net leverage has climbed for non-financial companies
- It highlights the importance of security selection by funds that invest predominately in the investment grade space. When an issuer’s rating falls below IG, prices on their bonds will typically fall by a meaningful amount given the perception of risk and selling by funds limited to IG. Chasing higher yields into riskier bonds changes the role of Fixed Interest from capital preservation.
- There has been considerable sector dispersion in the Australian market through the first quarter of 2018.
- Positive earnings trends have continued to be driven by the resources sector.
With the first quarter of 2018 drawing to a close we have reflected on the performance of the Australian share market in this time. Predominantly driven by factors in the US, such as inflation, interest rates and trade policies, there has been a marked rise in volatility across equity markets in the quarter, which has been a significant change compared to the prior benign conditions.
While the volatility of the domestic market has been less pronounced, particularly compared to the US, we have not escaped these external influences which has led to two mini-corrections and a recovery in between. With the ASX 200 marginally down for the quarter to date, domestic equities have held up respectably against other indices compared to the lagging performance of 2017. Part of this can likely be explained by an above-average February reporting season, although other factors such as the $A (which has recently weakened), commodity prices and domestic interest rates have also been important.
The chart illustrates that there has been a fairly wide dispersion in sector performance through the first quarter. A few observations can be made:
- Continuing the momentum/growth theme that drove the ASX in 2017, it has been health care and information technology leading the way again into 2018. While these sectors have undoubtedly some of the better earnings trends, they have additionally been boosted by an expansion of P/E multiples as investors chase higher quality companies. In the first quarter, CSL and Resmed were two of the three top contributors to the index’s return. Some caution is warranted to being overexposed to growth as a style given elevated valuations.
- Consumer staples have also been among the market leaders. This partly reflects change in the view that the supermarket price tension will subside in the medium term (particularly as Wesfarmers divests Coles). Yet the rise in the sector index has as much to do with the robust returns of mid to small cap food and beverage companies, such as Treasury Wines, A2 Milk, Bellamy’s and Costa Group. Shareholders have been rewarded for this focus on higher growth, niche markets and hence our staples index has been another growth style rather than the defensive characteristics for which it is commonly known.
- Resources have had mixed results, although have largely kept pace with the broader market’s returns, particularly the larger diversified stocks. As noted in our commentary, there has also been a spread in the performance of commodity prices through the quarter, although a softening $A has aided the performance of the stocks.
At an individual commodity level, gold has been among the better over the quarter (though not on an annual basis), yet the largest listed gold stock (Newcrest) has been impacted by an incident at one of its mines. Some heat has come out of the mineral sands group of stocks (which were among the big winners of 2017) and volatility has remained high. The balance of the resources sector is reporting solid earnings momentum. The risk is slowing growth in China and a cycling of environment policies which resulted in a rise in demand for Australian ores. Mining stocks would also likely be among the hardest hit if the trade war were to escalate.
- The large financials sector has lagged, which provides a considerable headwind for the ASX 200. At face value, the banks have screened as relatively good value since late last year. A more positive outlook could be put forward given that they had broadly met their new capital ratio hurdles as set by APRA and there appeared to be little dividend risk in the short term. The prospect of a slowing lending environment has, however, is a risk given a tightening in lending standards that will inevitably follow the royal commission. Asset management groups have also similarly struggled through this year given the negative operating leverage that these groups have in softer investment markets.
- Without doubt, the impact of higher interest rates, which came into focus in early February, has held back the performance of rate sensitive sectors. The most obvious of these are property trusts, utilities and infrastructure. Notably, however, much of the underperformance of these three sectors occurred through January, ahead of when the recent concern on interest rates reminding us that the pattern of higher long-term rates had already been in place for some time. Nonetheless, the returns have been particularly weak over the course of the quarter for stocks that typically have quite strong capital preservation characteristics.
A final point worth noting is that Australia’s flat cash rate outlook for 2018 has led to less pressure on higher long-term bond yields domestically (the benchmark 10-year yield is now below where it began the year). Consequently, the sell off in this interest rate sensitive group of stocks may be somewhat overdone in the short term if one is pricing these off domestic rates.
ASX 200: March Quarter Sector Returns (Accumulation)
From an earnings perspective, it has again been the resources sector which has led the market’s aggregate earnings growth. Part of this is due to a catch up in analyst forecasts (spot pricing has been ahead of forecasts for some time now) leading to upgrades as commodity prices hold their level. In the last month it has been the energy sector which has provided support following strength in the oil price.
Earnings for industrials and financials stocks have been upgraded marginally through the first quarter, although not sufficiently to have a meaningful impact on the index. The earnings trend chart also reflects what remains a relatively soft growth outlook for many of the large key sectors of the market – the banks, supermarkets, REITs and telecommunications.
ASX 200: Change in Forward Earnings Growth of Key Sectors
- These conditions have held back the performance of some of our recommended strategies, particularly the SMAs. Their investment process is biased away from resource stocks and generally with a conservative valuation framework. Our preference has been to access higher growth companies via small cap managers.