Markets take a turn…so should we?
Equity markets, particularly in the US, have been in a well-established bull run accompanied with very low levels of volatility. In fact, the S&P 500 had not experienced a greater than 5% drawdown over the 18 months to January 2018. This bull market has been facilitated by concerted efforts from central banks to provide freely flowing liquidity. After such a long cycle it is not unusual to see a spike in market volatility as investors’ sensitivity is heightened in anticipation of a change. We saw this in early February, with the catalyst being a jump in inflation expectations in the US.
The following provides thoughts from each of our investment boutique heads on the implications for markets and how they are responding.
The Australian market’s fall in early February reflected an adjustment in relative valuations with the US, rather than concerns specific to our market. There are also signs that the selling was exacerbated by some investors scrambling to unwind their low-volatility positions. Despite this, the size of the decline was lower than for the US, given Australia’s more defensive character. These falls were followed by a reasonable rebound, resulting in a 0.3% return from Australian shares for the month of February.
The recent company reporting season revealed quite a different scenario. Earnings growth for industrial companies, in aggregate, was around 9% which exceeded market estimates and we have seen a net upgrade to consensus forward earnings expectations. It is earnings growth that has driven the market’s returns over the past year. A number of companies have reported resilient operating conditions and we expect earnings growth of mid-single digits this year. Add the return from dividends and we can expect to so total returns in the high single digits for the year.
We believe the market’s rating will be supported at current levels, which is underpinned by several factors:
• Valuations are not excessive. The 12-month forward P/E for the S&P/ASX200 is slightly higher than its historical average, but consistent with the low interest rate environment with the RBA showing no indication of a material policy shift in the near term.
• There is no sign of a recession. Australian growth remains muted, however tailwinds are emerging, such as the rise in corporate capital expenditure and the large pipeline of infrastructure. In combination with a small pick-up in mining investment and a housing slowdown which remains moderate and controlled, we think the Australian economic outlook remains reasonable.
• Inflation in Australia remains benign. The monetary conditions in the US do not reflect the situation in Australia, where inflation remains muted and the RBA has given no indication of aggressive hiking.
• Liquidity withdrawal remains modest. The withdrawal of liquidity from the equity market as a result of central bank actions does present a risk to valuations over the medium term. However, we expect this trend to be moderate globally. The US economy has displayed a historical sensitivity to bond yields and we would expect the Fed to temper their tightening efforts if there are signs of an inordinately adverse effect on growth.
“Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point.”
Crispin Murray, Head of Australian Equity Strategies
As active managers, market volatility creates mis-pricing – and more mis-pricing means more opportunities. Any change in volatility does not typically change our fundamental view of the market and where we see compelling investments. For example, at the moment we see the disruption of long-standing industry structures and business models as a key area of opportunity. Likewise, we also hold some previously unloved stocks where we think the market has not yet appreciated a turnaround in earnings. We also see some opportunity among those growth stocks which have not been pushed to challenging valuations. Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point and our large and experienced team looks to take advantage of these moments as they occur.
The US earnings season commenced in late January and indications to date show no material shift in the operating environment for industrial companies. According to data based on 90% of S&P500 companies that reported quarterly earnings, 79% of those exceeded the market’s consensus estimates. The group has on average delivered 14.9% earnings growth over the prior period and commentary from management has been generally favourable. Against this backdrop it is difficult to call the February correction in share prices as anything other than a realignment of valuations. The fundamentals of a bear market are just not there.
“Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates.”
Ashley Pittard, Head of Global Equities
We take the proposition of higher interest rates in the US this year as a given, and inflation will find its way in a lagging fashion. Returns from global equities are likely to remain positive this year, although we expect a greater degree of divergence in fortunes across markets and geographies. In broad terms we expect:
• A story of two halves – Global equity markets are likely to experience a strong first half, buoyed by strengthening economies and the broad-ranging boost of Trump’s corporate tax cuts and incentives. These conditions are likely to force the hand of the Fed and interest rates will rise ahead of market expectations for the year and weigh on equities. Hence, returns should be similar to their longer term average.
• US and European companies are well placed to continue to do well – Earnings reports are continuing to show that companies are operating well. Europe has entered their earnings season and given the synchronised growth globally for the first time in a decade, European corporates should deliver similar aggregate results to their US counterparts.
• Aussie dollar stability – The Australian dollar is likely to be range-bound in the US$0.75-80 band as we have seen over the past five years, which shouldn’t have a material impact on returns from global equities.
• Market valuations in select areas to remain attractive – Although the market has rallied, certain industries remain fundamentally attractive. Consider that US banks are trading below 1.3x book value, while pharmaceuticals are on an unchallenging PE ratio of 10x.
What is more of interest to us is balancing the assessment of companies that are achieving operational excellence and are using the buoyant economic conditions to generate strong cashflow. Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates to skilfully deploy capital and grow their businesses. We give merit to companies that have shown the ability to command a dominant position in their industry. They are much better placed to show resilience in varied market conditions.
Over the past year the market has been focusing on forward indicators of consumer sentiment and US economic growth such as manufacturing and services sector outputs to support expectations of economic growth. These have been in a generally positive trend over the past few years, however, consensus expectations of higher inflation have failed to materialise. We think that inflation will surprise on the upside this year but we are weary of expecting too much of a rise until we see sustained wages growth coming through. Pent-up expectations to seize upon the first signs of inflation was taken by the market as a precursor to inflation rising from stagnant levels.
“We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes.”
Vimal Gor, Head of Income & Fixed Interest
Whether a benign inflation outcome can continue is the subject of much debate. We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes. What is of significance to markets is if central banks expect inflation to pick up and continue to unwind their unprecedented monetary stimulus. This is a real possibility in the US given that there are two major fiscal forces now in play – company tax cuts and an extension of the debt ceiling. It is exactly the wrong time to be adding stimulus when the economy is running at near full capacity. We believe this will force the hand of the Federal Reserve to counter the inflationary impact, which will be negative for bond yields as the yield curve steepens. The risk then arises that this compensatory tightening will lead to recession in late 2018 or in 2019.
In the shorter term, we expect:
• Higher volatility for both equity and bond markets – Historically, heightened inflation expectations have been followed by a pattern of higher market volatility.
• Investment grade credit to outperform sovereign and high yield debt – Segments that benefitted strongly from the global wave of liquidity are now the most vulnerable areas of the credit world. This includes certain emerging market sovereigns and high yield corporates. An unwinding of favourable market conditions may be particularly unkind to these areas versus more structurally resilient investment grade credit.
• Australian inflation to lag the US – Inflation in Australia will surprise on the downside. Hence, the RBA will need to closely watch unemployment and wages growth before it can consider any pre-emptive strike against inflation. We find it difficult to build a scenario where the cash rate rises while wages languish and spare capacity remains.
Looking more broadly, the easy financial conditions and fiscal support from the past decade have left a legacy of debt, which raises concerns over financial stability and ultimately results in higher levels of market volatility going forward. We are positioned to capitalise on this environment with tactical exposures to investment grade credit.
It is important to put bouts of market volatility into context. Markets have experienced strong gains in the last few years so a correction like the episode in February was inevitable. However, what market volatility does illustrate is the importance of a well-diversified portfolio. While equities are a critical component in delivering long-term growth to a portfolio, this exposure needs to be balanced by assets that are diversifying – bonds, foreign exchange exposure and alternatives can all help to stabilise returns.
“One interesting feature of the recent sell-off is that bonds, in general, failed to provide a cushion against market volatility.”
Michael Blayney, Head of Multi Asset
Each episode of market volatility is different. For example, in the global financial crisis the correction was led by credit, with equities following and government bonds providing capital gains to help insulate portfolios. One interesting feature of the sell-off (although a very small correction compared to the GFC) is that bonds, in general, failed to provide a cushion against market volatility.
In a “normal” equity market sell-off, government bonds benefit from a ‘flight to quality’ effect, as investor demand for bonds increases. As the most recent volatility was initially triggered by fears of inflation and rising interest rates (poor conditions for bonds) this caused US bonds to sell off (with Australian bonds mixed depending on the term). The reaction in credit markets lagged equities, and while spreads widened, eventually there was no sign of panic, with investors exhibiting greater focus on strong underlying corporate fundamentals than shorter term equity market volatility.
While we believe that bonds are an important component of a portfolio, this instance of market volatility also illustrated the importance of holding both foreign currency and alternative assets – when one of your stabilisers fails to provide the desired protection it is important to have others. Currency exposure was particularly valuable in this instance, with the recent fall in the Australian dollar from US$0.81 to below US$0.78 providing a cushion to market volatility. When the Australian dollar falls in value, assets denominated in foreign currency become more valuable for Australian investors.
Recognising the inherent uncertainty of financial markets, we continue to hold a broad range of diversifying exposures to seek to smooth out inevitable bumps in the road.
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