Investment Committee outlook
Investment Committee outlook for Q3 2019
Below is the Investment Committee’s outlook for various asset classes for Q3 2019.
Cash – Australian dollar
Global equity markets have continued to rally throughout calendar year 2019 and 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.
The Reserve Bank of Australia (RBA) cut the official cash rate to 1 per cent, a new all-time low, at its July meeting, following a quarter percentage reduction in June. Minutes from the RBA’s meeting highlight the bank’s concern about the state of the jobs market and the lack of wages growth experienced by Australian workers.
Financial markets have now priced in two further interest rate cuts by February next year. We expect that the jobs market will determine the direction of interest rates over the coming quarters and that the RBA will monitor any developments closely to determine if monetary policy needs to be adjusted to support growth.
We also believe that any decisions by international central banks to reduce interest rates may have a flow through impact on domestic policy as the RBA looks to negate any potential currency strengthening in a bid to support the economy.
During the first quarter of 2019 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 three-month and ten-year yields, and more recently the gap between two-year 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 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 moved to a more dovish tone earlier in the year in light of slowing global growth and subdued inflation pressures, and has since cut rates for the first time in a decade. Markets are pricing that more cuts may follow, although the Fed has not indicated that the first cut was the start of an extended easing cycle.
While there has been some weakness in the manufacturing sector, we note that US consumer data remains strong, and the consumer has historically been the country’s most significant economic force. If the Fed follows through with further interest rate cuts, it will do so in the face of a powerful consumer, a stock market at or near record highs and an increasingly difficult case to make for easier monetary policy, notwithstanding political pressure to cut rates.
Regardless, US 10-year yields have fallen significantly over the course of the year, and long-term government bond rates have fallen to low or negative yields in most other parts of the developed world, including Australia.
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 are also seeing select opportunities in private debt markets, although we note management expertise and access remains key in accessing private market investments.
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 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, 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 widening interest rate differentials with the US have 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. While markets are pricing in further rate cuts by both the RBA and Fed, we believe that the Australian economy is in a less resilient state compared to the US and may require additional stimulus (as evidenced by the two recent rate cuts). This 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 recent 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.
While gold has risen to all-time highs in AUD terms, this has been exaggerated by recent AUD weakness. In US dollar terms, gold remains around 25 per cent below its previous highs.
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.
Iron ore prices have continued to rise through much of 2019 due to supply uncertainty following the Vale dam collapse in Brazil and production downgrades from RIO and BHP due to Australian cyclone outages. However, there are reasons to believe that prices should begin to moderate from here. Chinese steel margins continue to drift lower which is why Chinese steel mills are becoming vocal about unsustainably high iron ore prices. Brazilian shipments have begun to recover, and while there may be further recovery to come, the worst may have passed. Chinese port stocks have also stabilised, with the first stockpile build since the Vale accident. Chinese imports of iron ore are also declining at the fastest rate on record, while China’s usage of scrap steel is hitting record highs.
After Brent oil reached US$86 per barrel in early October 2018, there was a significant sell-off until December 2018, where the price reached a low of US$50 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. The oil price rebounded strongly over the start of 2019, reaching as high as US$75 but has since fallen back below US$60 in light of the softer global growth outlook. There remain a number of factors that may influence pricing over the remainder of the year including Chinese oil imports, tanker pipeline sabotage in the Middle East, the US in a nuclear standoff with Iran, and OPEC production cut extensions. 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. Notwithstanding recent falls in house prices, which saw national prices drop by around 10 per cent since their peak, Australian residential property prices remain elevated both on an international basis and relative to their own history when looking at common measures such as price to income ratios. Pockets of value may present themselves as markets adjust to lower prices, however careful due diligence is vital given the broad opportunity set of assets.
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, especially noting recent significant falls in 10-year bond yields. 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 trade on less elevated valuations and 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 and that the asset class remains a store of value in portfolios. With New York being one of the globally significant cities, we believe it has characteristics that make it an ongoing destination for international capital. Continued strength in US consumer spending and sentiment data is likely to remain supportive of US housing. The average 30-year fixed rate mortgage has fallen by around 100 basis points since the recent spike seen in November 2018, and while this has not yet resulted in a significant improvement in the residential property market, we believe that the availability of cheap debt is likely to support real asset values.
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 global 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, which has continued to rally throughout 2019 despite the weakening macroeconomic outlook that has forced the RBA to cut interest rates. The forward price to earnings ratio (PE), a measure of market valuation, has risen back to close to 16x, which has served as somewhat of an upper limit on valuations over the past 15 years, while the earnings outlook has deteriorated over the course of the calendar year. It appears that investors are placing less emphasis on these fundamentals in light of low cash rates and lower prospective returns in defensive asset classes.
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. Despite some trade-related weakening in the manufacturing sector, the US consumer remains strong and historically the US has not typically entered a recession while the consumer has been robust. After a period where growth was globally synchronised, other regions outside of the US (e.g. Europe and China) have slowed.
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 continue to fade over the remainder of the year. However, segments of the stock market may be impacted by Trump’s trade policies, namely the ongoing trade war with China.
A strong first half to 2019 has seen US equity valuations return to levels that are somewhat 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 continued to soften over 2019, with overall eurozone growth faltering and the European Central Bank indicating further monetary policy is likely over the near term. 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. anti-euro 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.
Asian and emerging market equities had initially reacted positively early in the calendar year 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. However, since April markets have reacted negatively to further developments in the US-China trade war and have retraced towards their late 2018 levels.
We continue to note a number of medium-term headwinds for broader emerging markets. Specifically, we are keeping a close eye on 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 Asian and 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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