Investment Committee outlook
Investment Committee Outlook for Q3 2018
Below is the Investment Committee’s outlook for various asset classes for Q3 2018.
Cash – Australian dollar
Elevated equity market valuations and ongoing geopolitical and macroeconomic risks continue to reinforce 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 from earlier in the year, with market economists beginning to push out the expected timing of the next Reserve Bank interest rate rise until mid-2019. We too do not expect significant RBA rate rises over the short to medium term however note that offshore funding pressures are resulting in increases in interbank lending rates independent of the RBA. The Bank of Queensland was the first of the major Australian banks to increase rates and we expect that others may follow suit, resulting in higher rates for domestic borrowers.
The outlook for Australian rates remains weak with the domestic economy burdened by high household debt levels and record low levels of wage growth. We believe the risk return balance for investing in many fixed interest instruments is not particularly attractive given the very low level of yields available in these markets and artificial risk-taking behaviour that has been fostered by central bank policies over recent years.
Against this backdrop, the combination of weaker macroeconomic conditions, unconventional monetary policy and heightened geopolitical risk has seen long term rates both domestically and abroad suppressed, highlighting the challenging fixed income environment we continue to find ourselves in.
President Trump’s corporate tax policy (and the potential fiscal stimulus that it brings), alongside the Fed beginning to unwind its stimulus policy and reduce its balance sheet, has acted as a catalyst to drive bond yields from historic lows, although the sharp yield increase in Q1 2018 has subsided somewhat given fears of a US trade war with China, and we remain concerned that the balance of risk and return is skewed to the downside.
Duration (a measure of price sensitivity to changes in interest rates) on broad bond indices remains heightened, which is likely to lead to higher levels of volatility going forward, particularly with the US continuing its path of interest rate ‘normalisation’, the European Central Bank tapering its stimulus program and the ongoing hawkish tone of other central banks.
Given this, our preferred exposures for new investment in this asset class are government guaranteed term deposits 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.
The Australian dollar closed the 2018 financial year at 18-month lows against the US dollar. Trade tensions between the United States and China have impacted the prospect for Chinese exports (and by default Australia), while divergent monetary policy settings with the US Fed will continue to impact 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 (higher short-term funding costs for Australian banks means the RBA is under less pressure to raise official rates), and combined with the gradual rise of US rates has narrowed the interest rate differential between the countries, which is a key driver of the exchange rate. The US is well placed for ongoing interest rate rises, given strengthening inflation and employment economic figures. The Fed has raised interest rates for a second time this year and upgraded their forecast to four total increases in 2018.
We also expect lower Chinese commodity demand and increased supply in key commodity markets will result in weakness in commodity prices. Noting the country’s heavy reliance on commodity exports, any decline in prices will likely negatively impact the country’s terms of trade and consequentially, the Australian dollar.
These factors have been evident with the Australian dollar falling from its January highs and are likely to result in further Australian dollar weakness.
The portfolio effect of gold as financial insurance, inflation hedge and currency protection continues to be of value to us, particularly as equity market valuations and geopolitical uncertainty remain elevated.
However, we note that in the sustained low interest rate environment some income focused 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 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 2000’s 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.
Specifically, we expect continued downward pressure on the value of iron ore. Falls in the iron ore price have occurred following reduced Chinese demand for the commodity and rising stockpiles in Chinese ports, highlighting the impact China’s demand for the commodity has on its value. We see a further fall in commodity prices as supply growth continues to exceed weakening Chinese demand and as a result of concerns about a potential US/China trade war. We expect to see this correction continue over the medium term.
Property assets, particularly assets in globally significant cities, are an important diversification element in portfolios. We remain cautious on Australian residential property values, noting the recent softening in the Sydney and Melbourne markets and that granularity remains important, but continue to believe Australian commercial property represents an attractive investment to generate income and longer-term capital growth.
Capitalisation rates (valuation rates) for commercial property are around or slightly below long-term averages, however the spread to borrowing costs and the spread to global property capitalisation rates remain above historical averages. Also, certain areas of the commercial space, such as retail, can provide inflation linked cash flows via CPI-linked leases, helping to preserve real income levels.
In the US we remain convinced of the long-term value of residential property in the greater New York area, New York being one of the globally significant cities we believe has characteristics that make it a destination for international capital. Stronger economic data related to US housing including an increase in private construction spending and building activity as well as positive mortgage credit conditions help highlight the returning confidence in the sector.
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 provide support in the confused policy 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 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 if 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 short to medium term outlook for Australian equities, however note that some recent data points give cause for optimism. While broad market valuations remain above long-term averages, recent earnings growth for domestic corporates has been positive (although noting the low base with which resource companies are comparing earnings results), corporate balance sheets appear healthy, economic growth has surprised on the upside and valuations are to an extent supported by accommodative monetary policy.
Despite this, we believe the issues behind the current low interest rate environment – low wage 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 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 – we are looking for value rather than broad exposure. As a part of this strategy, we note that the domestic market is highly concentrated towards ‘traditional’ market segments including banking and resources, and underweight industries and thematics we believe will help drive global innovation and growth going forward (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 a steadily rising market with limited volatility (by historical standards) we believe the value of these managers are 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 that 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.
We continue to closely monitor the impact of potential structural changes on the Australian share market, most prominently mooted changes to the ability of franking credits to be refunded to low tax payers.
International equities – US
Opinions on the US economic recovery continue to be the subject of much debate. In our view it remains fundamentally one of the stronger economies in the world – unemployment remains low, inflation is positive and growth, while unspectacular, is improving. An increasingly competitive jobs market will likely lead to wage growth over the medium term, while the US does not rely heavily on exports and is therefore relatively insulated from the ongoing global malaise affecting other parts of the globe. After a period late last year where growth was globally synchronised, the US appears to be reemerging as the global growth centre as other regions (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 hard 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 recent tax reforms. However, segments of the stock market may be impacted by Trump’s trade policies with the possibility of trade war with China and ongoing NAFTA negotiations with Canada and Mexico. A recent resurgence in the political polls for Trump makes his potential policy reactions arguably less predictable, as he may seek to press issues such as Chinese trade further if these policies are popular among his supporter base.
For us the high level of US public equity valuations makes it difficult to justify broad based US public equity exposure, and reinforce our view that we are looking for active rather than passive investment management. While broadly US market valuations are 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.
International equities – Europe
Conditions throughout European markets have been steadily improving, however geopolitics and long term structural issues remain and provide some uncertainty in the region. While European monetary easing has had a positive impact on equity markets, there remain significant risks both political (strong anti-euro member sentiment, Brexit negotiations) and structural (unemployment differentials, government debt positions, immigration issues, the variable impact of the common currency).
While longer term, these structural and political problems do exist and are difficult to ignore, over the shorter-term tactical opportunities generated by volatility are beginning to appear and may offer some value. Stronger economic indicators, discounted valuations compared to developed market peers, a revitalisation of the banking system and the potentially over-stated impacts of recent political events are aspects that we continue to monitor.
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, however volatility and exposure to geopolitical risks cannot be ignored. Stronger economic growth profiles than developed markets, demographic drivers such as growing middle classes and low valuations underpin the longterm investment proposition.
However, we do note a number of evolving short-to-medium-term headwinds for emerging markets. Specifically, the withdrawal of global liquidity as the US raises interest rates, renewed US dollar strength and increasing geopolitical risks. Increasing 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 will 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 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 can 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 class such as listed equities and fixed income.
We continue to pursue 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 given lower competition and are typically nimbler.
Valuations in US small and mid-market private investments compare favourably to valuations in public equity markets and thus we 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 growth engine of the US, rather than focusing on export markets like many large cap 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. Due to the early stage nature and the long-term investment horizon, however, these opportunities should be viewed as a higher-risk and are not suitable for all investors.
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