Investment Committee outlook
Investment Committee outlook for Q4 2018
Below is the Investment Committee’s outlook for various asset classes for Q4 2018.
Cash – Australian dollar
Equity market valuations remain elevated notwithstanding the recent US market correction and increased volatility levels we have observed – and this combined with ongoing geopolitical and macroeconomic risks continues 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 Australia (RBA) interest rate rise until at least the second half of 2019. While we too do not expect significant RBA rate rises over the short-to-medium term, we note that persistent offshore funding pressures are resulting in increases in interbank lending rates – independent of the RBA. This is now leading domestic borrowers to experience higher interest rates after Westpac, ANZ, Commonwealth Bank and a number of smaller institutions have all lifted variable mortgage rates, citing these rising funding costs as the key driver.
Australian interest rates look likely to be lower for longer. Tighter local credit conditions, slowing housing lending and recent out-of-cycle mortgage rate rises mean the 2-year Commonwealth bond yield is still under 2 per cent, indicating the market believes cash rates will remain under this level for a period of time.
The US Federal Reserve (Fed) has continued on its telegraphed path of rate increases and has signalled further rate rises throughout 2019 that would elevate the cash rate to over 3 per cent. The Fed’s actions and strong US economic data have pushed up longer-term bond yields. However, we note that the effect of an escalation in the US-China trade war has the potential to pull bond rates down and unsettle credit markets.
Outside the US, many other jurisdictions, including Australia, are yet to fully unwind stimulus measures some 10 years after the anniversary of the Lehman’s bank collapse. Duration (i.e. 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 as these stimulus measures continue to be unwound.
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 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.
The Australian dollar has continued its downward trend, relative to the US dollar, since the beginning of the calendar year. Trade tensions between the United States and China have impacted the prospect for Chinese exports (and by default also affected Australia), while divergent monetary policy settings with the 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 shortterm 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 inverted 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.
We also expect lower Chinese commodity demand as its industrial economy slows and increased supply in key commodity markets will 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 highs and on balance are likely to result in further Australian dollar weakness.
The portfolio effect of gold as financial insurance, an 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 begun to rise in recent weeks.
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 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 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 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 commodity prices as supply growth continues to exceed weakening Chinese demand – and as a result of concerns about a potential US-China trade war. While prices recovered somewhat over the September quarter, we expect to see prices continue to soften over the medium term.
Conversely, we are closely monitoring recent strength in oil prices and the potential for prices to continue to strengthen in light of potential supply disruptions, lower OPEC spare capacity and increasing Middle Eastern geopolitical risk. This is important because an extended period of oil price strength is likely to weigh on global economic growth prospects.
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 ongoing softening in the Sydney and Melbourne markets and that granularity remains important. However, we 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 spreads to both borrowing costs and global property capitalisation rates remain healthy. 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. 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, although we will continue to monitor the impact of rising mortgage rates.
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.
Growing consensus among fund managers is that the global economy is in the late cycle, which has traditionally led to higher levels of volatility in equity markets, as we have begun to see in October. The volatility to date appears to be largely driven by changing investor sentiment towards existing macroeconomic concerns – rather than a sudden deterioration in economic prospects, and has not affected all stocks equally. In particular, stocks that are more growth focussed have been more heavily sold off, as these stocks are perceived to be less defensive in a slowing economic environment and have risen more significantly in recent years.
We remain cautious on the short-to-medium-term outlook for Australian equities, however, also note that some recent data points do give some cause for optimism. While broad market valuations remain above long-term averages, recent earnings growth for domestic corporates has been positive, 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 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 a part of this strategy, we note that the domestic market is highly concentrated towards ‘traditional’ market segments 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 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 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 proposed by the Labor Party regarding the ability of franking credits to be refunded to low tax payers.
International equities – US
Despite recent equity market volatility and the US equity market correction, 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, while the US does not rely heavily on exports and is therefore relatively insulated from the ongoing global malaise affecting other parts of the world. After a period late last year where growth was globally synchronised, the US has emerged as the global growth centre, while other regions (e.g. Europe and China) have slowed.
As noted above, a persistently high oil price is one factor we are monitoring that has the potential to curtail US and therefore global growth.
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 recent tax reforms, although the positive effects from tax cuts are likely to prove transitory. However, segments of the stock market may be impacted by Trump’s trade policies, namely the ongoing trade war with China. Additionally, Trump’s actions in the lead up to the midterm election in November may become less predictable, as he may seek to press issues such as Chinese trade further, if these policies are popular among his supporter base.
Recent volatility has improved US public equity valuations, however they remain elevated relative to history on a number of metrics. This makes it difficult to justify broad-based US public equity exposure and reinforces 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. 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 improved in late 2017 however have weakened through 2018, while geopolitics and long-term structural issues remain and provide uncertainty in the region. While European monetary easing has had a positive impact on equity markets in recent years, there remain significant risks which are both political (i.e. strong anti-euro member sentiment, protracted Brexit negotiations, Italian conflicts with the EU over austerity measures) 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 are difficult to ignore, 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, as stronger economic growth profiles than developed markets, demographic drivers such as growing middle classes and low valuations underpin the long-term investment proposition. However, volatility and exposure to geopolitical risks cannot be ignored, as evidenced by recent market movements that have seen stocks in these regions underperform developed markets.
We continue to note a number of short-to-medium-term headwinds for broader emerging markets. Specifically, the withdrawal of global liquidity as the US raises interest rates, renewed US dollar strength, recent oil price 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 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 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 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 due to lower competition and because they are typically nimbler.
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 growth engine of 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. 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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