Investment Committee outlook
Investment Committee outlook for Q2 2019
Below is the Investment Committee’s outlook for various asset classes for Q2 2019.
Cash – Australian dollar
The first quarter of the calendar year saw equity markets rebound after the 2018 year-end-sell-off, and as a result, equity valuations remain elevated compared to historical averages. We have also observed increased levels of volatility as a result of ongoing geopolitical and macroeconomic risks, reinforcing our view that holding an appropriate level of cash is an essential element of all portfolios. Cash operates as a key risk management tool and its weighting in a portfolio should be largely independent of the returns being paid for at-call cash.
Australian interest rates have been on hold at historic lows since September 2016. Forward expectations have shifted with the Reserve Bank of Australia (RBA) reducing its economic growth outlook and commentators fretting about low inflation and the knock-on effects of falling Australian house prices on the consumer and construction sectors. Markets now appear to be pricing in rate cuts over the coming year.
Specifically, the unexpectedly low March inflation figures have increased the chance of an RBA rate cut over the year ahead. We have previously noted that the RBA will be hesitant to cut rates further given its belief that low rates encourage poor investor behaviour, for example excessive usage of debt. However, we expect that it will continue to closely watch economic data, particularly the jobless rate, for any information that may change this view. Based on the RBA’s most recent statement, it appears it believes a further improvement in the labour market is needed to hit its inflation target, so any stagnation or deterioration may be used as justification for a rate cut.
During the first quarter markets saw an inversion of part of the yield curve for the first time since the financial crisis as an increase of bond buying, driven by lower growth projections and the prospect of US Federal Reserve (Fed) easing, upended the gap between threemonth and ten-year yields. Historically an inverted yield curve has proven to be an accurate early predictor of US recessions – over the last 30 years, the lead time from inversion to recession has been on average about 15 months.
However, it is important to bear in mind that the yield curve only just inverted and did not invert on all measures. A number of commentators maintain the two-year/ten-year measure is a better indicator as it is less volatile and has given fewer false signals. We are loath to say “this time is different” but there are arguments that the unprecedented monetary policy looseness and experimental monetary policies the world has seen since the financial crisis may have disrupted this once accurate mechanism.
The Fed has moved to a more dovish tone in the wake of slowing global growth and subdued inflation pressures, and rate markets are now pricing in a potential reduction in US interest rates. However, we note that US economic data, particularly with respect to GDP and the labour market, remains strong, and the Fed seemingly does not believe there is currently a case for a rate cut. We believe the Fed will remain data driven and patient in its policy setting, and will remain on hold in the near term, notwithstanding political pressure to cut rates.
Against this backdrop, the fixed income environment remains challenging and we believe the risk-return balance for many fixed interest instruments is not particularly attractive, based on the very low level of yields generally available.
Given this, our preferred exposures for new investment in this asset class are government guaranteed term deposits, select actively managed exposures to global high yield markets, and fixed interest securities with significant downside protection that cannot be compulsorily converted into equity or otherwise impaired in a financial downturn based on certain financial metrics or at the election of a third-party.
We remain comfortable with conditions in global high yield markets at this time. While we note spreads remain relatively tight by historical standards, this in part reflects the changing composition of the high yield market and that default rates are low and are forecast to remain low, as well as the impact of sustained low interest rates. We continue to watch high yield issuance data and potential issues around lower-rated investment grade debt potentially being downgraded.
The Australian dollar has been on a downward trend, relative to the US dollar, since early 2018, despite a brief respite towards the end of the first quarter of 2019 and has recently revisited levels below US$0.70. Trade tensions between the United States and China have impacted the prospects for Chinese trade (and by default also affected Australia), while divergent monetary policy settings with the Fed has impacted currency movements. We have maintained a negative view on the Australian dollar since 2011 and while over the long term the dollar has been gradually trending lower, we note that short-term volatility and periods of strength for the Australian dollar may continue.
Over the medium term, however, we see a number of reasons the AUD may continue to weaken against the USD. As described above, we believe the outlook for domestic rates remains weak (with futures markets now pricing in a likely near-term RBA rate cut) and this combined with US rates remaining on hold may further invert the interest rate differential between the countries – which is a key driver of the exchange rate.
We also expect lower Chinese commodity demand over the medium term as its industrial economy slows and increased supply in key commodity markets is likely to result in weakness in commodity prices. Noting Australia’s heavy reliance on commodity exports, any decline in prices will likely negatively impact the country’s terms of trade – and consequentially impact the Australian dollar.
These factors have been evident with the Australian dollar falling from its January 2018 highs and on balance are likely to result in further Australian dollar weakness over time.
While our medium-term outlook remains negative for the AUD, we do note that the potential for short term Chinese stimulus as well as ongoing positive iron ore price dynamics following Brazilian mining company Vale’s tragic tailing dam collapse and subsequent mine closures may act as short-term ballasts for the currency.
The portfolio effect of gold as a portfolio diversification tool, inflation hedge and currency protection continues to be of value to us – particularly as equity market valuations and geopolitical uncertainty remain elevated, and equity market volatility has increased in recent months.
However, we note that in the sustained low interest rate environment, some incomefocused funds may find it less attractive to hold this asset for its insurance value, because a physical holding in gold does not generate income. For this reason, we only favour gold holdings in portfolios that hold a higher proportion of growth assets.
Commodity pricing is notoriously volatile and difficult to predict over the shorter term, which is naturally reflected in the volatile prices for commodity-exposed companies.
Years of significant capital investment during the commodity boom of the 2000s has led to supply catching up with demand across the commodity spectrum.
While demand for commodities should remain solid – underpinned by continued growth across many emerging and developed markets – factors such as continued supply growth, ongoing developments in competing technologies and price movements that have been driven by speculation (rather than fundamentals), lead us to believe that long-term equilibrium pricing for many commodities may be below current price levels.
Falls in the iron ore price occurred over the course of 2018, following reduced Chinese demand for the commodity, rising stockpiles in Chinese ports, and increased Chinese usage of scrap steel – highlighting the impact China’s demand for the commodity has on its value. We see a further fall in iron ore over the longer-term as supply growth continues to exceed weakening Chinese demand – and as a result of concerns about the US-China trade war. However, in the short-medium-term, prices are likely to remain elevated due to supply uncertainty following the Vale dam collapse in Brazil, and production downgrades from RIO and BHP due to Australian cyclone outages.
After Brent oil reached US$86 per barrel in early October 2018, there was a significant sell-off until December 2018 as markets focused on global demand being detrimentally affected by a US-China trade war, Iranian sanction waivers, record production from Saudi Arabia and slightly better than expected US shale oil production. This has reversed somewhat over the course of 2019 due to more favourable global growth outlooks and more recently the expiry of the Iranian sanction waivers. We will continue to monitor the pricing as an extended period of oil price strength may weigh on global economic growth prospects.
Property assets, particularly assets in globally significant cities, are an important diversification element in portfolios and provide valuable hard asset exposure. We remain cautious on Australian residential property values, noting the ongoing softening in the Sydney and Melbourne markets as credit has been restricted and that granularity between different regions and property types remains important. However, we continue to believe Australian commercial property represents an attractive investment to generate income and longer-term capital growth.
While capitalisation rates (valuation rates) for commercial property have firmed, particularly over the last 5 years, the spreads to long-term bond rates (and borrowing costs) remain healthy. In addition, certain areas of the commercial real estate sector, such as retail, can provide inflation-linked cash flows via CPI-linked leases, helping to preserve real income levels. Noting ongoing concerns around potential weakness in discretionary consumer spending and the impact of the rise of online retail, our preference remains to be exposed to properties focussed on non-discretionary retail spending, or commercial assets in non-CBD locations that benefit from proximity to key infrastructure.
In the US we believe the long-term outlook for residential property in the greater New York area remains favourable. With New York being one of the globally significant cities, we believe it has characteristics that make it an ongoing destination for international capital. Stronger US economic growth and consumer spending and sentiment data is likely to remain supportive of US housing. While we will continue to monitor the impact of rising mortgage rates on the housing market as the economy improves, we note the average 30-year fixed rate mortgage has fallen by around 80 basis points since the recent spike seen in November 2018.
Infrastructure remains an important portfolio diversification tool, particularly in the current uncertain economic environment. Investing in infrastructure typically involves ownership of real assets generating predictable, long-term income streams secured through contractual obligations, monopolistic status, or regulation. The defensive nature of these cash flows and real asset backing provides some support in the uncertain macroeconomic environment we find ourselves in.
We have identified significant opportunities in the solar energy space, particularly the ownership of large-scale utility-size power plants where we think excellent risk-adjusted returns are available.
We also continue to favour global listed infrastructure funds. We note that global listed infrastructure valuations remain somewhat stretched historically, although relative to the level of interest rates valuations they are less so. While values in recent years have been driven in part by the very low level of long-term interest rates, increased global infrastructure spend, and a global hunt for yield – we have seen recent periods of weakness in the sector driven by increases in real interest rates. As businesses in the sector react in very different ways to each other in the face of changes in interest rates and inflation, the current policy environment reinforces the need for active, rather than passive, management – given the importance of granularity.
We remain cautious on the Australian share market. Valuations improved during the 2018 year-end-sell-off, but they did not become compelling. The forward price to earnings ratio briefly dipped below historical averages – however the positive start to 2019 has pushed the market back above this metric.
Results from the most recent reporting season were broadly in line with market expectations that, for many companies, had been lowered in the confession season last year. Guidance was generally negative, with the largest number of downgrades since 2013. Aggregate market earnings per share growth for FY19 was cut and now stands at 3 per cent.
We believe the issues behind the current low interest rate environment – a slowing economy, low inflation, stubbornly low wages growth, poor capital investment (noting future capital expenditure surveys remain weak) and household indebtedness being amongst the highest in the world – remain prevalent and key causes for concern.
Noting our cautious outlook for the domestic economy and elevated valuations on broad share indices, our preference is to have exposure to a greater proportion of actively managed funds within the asset class and a lesser proportion of passive index funds – as we are looking for value, rather than broad exposure. As part of this strategy, we note the domestic market is highly concentrated towards ‘traditional’ market segments with arguably lower growth prospects, including banking and resources, and underweight in industries and thematics that we believe will help drive global innovation and growth going forward (i.e. robotics, artificial intelligence and cloud computing, among others). To help mitigate against this emerging risk of disruption in the domestic market, we encourage exposure to global corporates identified as disruptive innovators.
While ‘active’ fund managers have found outperformance difficult in recent years of a steadily rising market with limited volatility (by historical standards), we believe the value of these managers will be highlighted in times of market stress. Given our first priority is capital preservation, we believe this strategy continues to make sense in the current climate.
Volatility and valuation remain strongly influenced by sentiment in other markets, particularly China. Despite more positive rhetoric, we still note the Australian economy is in a less resilient state compared to that during the financial crisis – and as a result, is much more susceptible to external shocks.
International equities – US
We continue to believe the US remains fundamentally one of the stronger economies in the world – where unemployment remains low, inflation is positive and growth has improved. An increasingly competitive jobs market and historically low unemployment rate will likely lead to wage growth over the medium term, and as the US does not rely heavily on exports, it is therefore relatively insulated from the ongoing global malaise affecting other parts of the world. After a period where growth was globally synchronised, the US has emerged as the global growth centre, while other regions (e.g. Europe and China) have slowed. The Fed’s apparent intention to keep rates on hold over the near term should continue to support domestic economic conditions.
It remains difficult to predict the so called “Trump Factor” and a potential acceleration of a US withdrawal from global politics, policing and trade. The geopolitical implications of this (and other Trump policies) are very difficult to assess and, in our opinion, markets find it very hard to price in geopolitical risk. We do note that US equities are likely to be supported by some of Trump’s policies, including the tax reforms, although the positive effects from tax cuts are likely to prove transitory and fade over 2019. However, segments of the stock market may be impacted by Trump’s trade policies, namely the ongoing trade war with China.
A strong first quarter to 2019 has seen US equity valuations return to levels that are elevated relative to history on a number of metrics. This reinforces our view that we are looking for active, rather than passive, investment management. While US market valuations are broadly elevated by historical standards, certain select public equity exposures – particularly those companies identified as disruptive innovators – are an important diversification tool within an asset allocation context, noting the speed of which technological change and innovation is impacting existing markets, industries and companies. Importantly, while these companies are predominantly listed in the US, their revenue footprint is global. Ongoing volatility may provide opportunities to access these companies at more attractive valuations, although we believe active management is imperative in the space given ongoing challenges including increased regulatory scrutiny.
International equities – Europe
Conditions throughout European markets continue to be volatile, while geopolitics and long-term structural issues remain and provide uncertainty in the region. Economic conditions have softened into 2019, with overall eurozone growth faltering and Italy falling into recession. While European monetary easing has had a positive impact on equity markets in recent years, there remain significant risks which are both political (e.g. antieuro member sentiment, protracted Brexit negotiations) and structural (i.e. unemployment differentials, government debt positions, immigration issues and the variable impact of the common currency).
While longer term, these structural and political problems do exist and make it challenging to justify broad investment in the region, over the shorter-term, tactical opportunities generated by volatility may offer some value. For example, global companies listed in Europe that have been caught up in the region’s malaise and are consequently trading at discounted valuations compared to developed market peers.
International equities – Asia and emerging markets
We continue to believe there is a strong case for investment in select areas of Asian and emerging markets over the longer term, with stronger economic growth profiles than developed markets, demographic drivers such as growing middle classes and low valuations underpinning the long-term investment proposition. However, volatility and exposure to geopolitical risks cannot be ignored.
Markets have reacted positively as top Chinese policy makers have endorsed a focus on economic growth, in turn putting a pause on a crackdown in lending and injecting liquidity into the economy. Asian markets are expected to be supported by tailwinds from Chinese policy easing, reported progress on the US-China trade war and more dovish stance from the Fed on US rate rises.
However, we continue to note a number of medium-term headwinds for broader emerging markets. Specifically, we are keeping a close eye on the direction of US interest rates and the potential for ongoing US dollar strength and increasing geopolitical risks. Protracted tensions over the US-China trade war may also continue to impact Asia’s largest economy and the broader emerging markets.
It is important to note however that we expect the outlook for these markets to vary markedly according to country-specific characteristics – and investments should be targeted towards those countries and industries which have the strongest economic growth profile over the longer term. In this regard, we prefer active investment opportunities within these markets and look to target those countries with lower exposure to commodity price movements and US dollar denominated debt. We remain favourable on key Asian markets in particular.
We also note that large, globally significant companies increasingly offer exposure to both emerging and developed markets and are another way that investors may benefit from the longer-term emerging markets growth dynamics.
Private investments (investments in unlisted companies - also known as private equity) offer investors the potential for strong long-term capital growth and diversification benefits from traditional asset classes such as listed equities and fixed income. We believe exposure to private investments is appropriate as part of an investor’s growth asset allocation where they are comfortable with the higher-risk nature and often lower liquidity of these opportunities.
We continue to pursue private investment opportunities in the US market given our positive view on the economy and the much deeper pool of investee company opportunities than the Australian market. Within the US, our preferred area of focus is small and mid-market private investment managers that primarily operate in the expansionary capital space (i.e. providing capital to grow and expand established companies that are already at or near profitability) and use lower levels of leverage. Empirical evidence shows that smaller private investment funds have tended to outperform their larger peers, given they have a greater investment opportunity set, are able to purchase companies at more attractive prices due to lower competition and because they are typically more nimble.
Valuations in US small and mid-market private investments compare favourably to valuations in public equity markets and we therefore continue to favour these funds as a means of exposure to the US economy. As well as valuation benefits, unlisted investments in small US companies provide exposure to the well performing domestic economy in the US – rather than focusing on export markets like many large capitalisation listed stocks.
We also believe that a small exposure to select venture capital opportunities may be appropriate for growth-focused investors. Specifically, we believe accessing the disruption thematic via venture capital may provide investors with potential long-term growth opportunities and diversification that may not otherwise be available via traditional asset classes. However, due to the early stage nature and the long-term investment horizon, these opportunities should be viewed as a higher-risk and are therefore not suitable for all investors.
Against a backdrop of rising equity market volatility and the presence of a number of geopolitical risks, we believe that alternative equity strategies can also play an important role in providing portfolio returns while exhibiting low correlation to traditional equity markets. In particular, long-short equity strategies involve taking long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. These strategies can minimise broad-based market exposure and allow investors to profit from a manager’s call on individual stocks. This allows good managers to operate effectively in both bull and bear markets.
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