Where to look for opportunities as markets rebound
They are the perennial questions for investors — when, where and what to buy. Here Pendal’s head of Multi-Asset Michael Blayney (pictured) runs through the outlook for major asset classes.
NOW that markets have rebounded somewhat, the questions of when, where and what to buy take on a greater significance.
It is not unusual to get a sharp rally in stock indices during a bear market. The key feature this time is how quickly equity markets fell and then rallied — and how quickly the economic situation has evolved.
This means investors need to look a bit harder to find fair value and they need to be comfortable taking a longer-term view.
The outlook for the world’s leading equities market — the United States — is mixed.
Large caps, defined as those in the S&P500, have generally rallied hard. The price-to-earnings trailing multiples are just under 20 times earnings and those earnings are forecast to fall.
Purely on a valuations basis, large caps are expensive, particularly when you throw a deteriorating economic backdrop with a massive increase in unemployment into the mix.
Not helping the outlook for large US companies has been a decade-long trend of increasing leverage, in part through corporations regularly undertaking buy-backs. Over the last decade, median US company leverage has almost doubled (measured by the ratio of debt-to-earnings before interest, tax, depreciation and amortisation for the constituents of the MSCI USA Index).
High valuations, increased leverage and deteriorating earnings make up a pretty unattractive combination. The US mid-caps — the next 400 companies by size — look much more reasonably valued.
Although they have increased leverage over the last decade, these are higher-quality companies than small caps in terms of leverage and reliability of earnings. For the US equity market, this is our preferred exposure.
At the small cap end in the US, companies are less profitable, more highly geared and more cyclical. They tend to be lower quality and as such we believe mid caps offer a better risk/return trade-off at this point of the economic cycle.
Aussie equities look reasonable value, but there is a caveat. The big four banks are a large part of the index — around 18 per cent — and there are obvious risks faced by that sector given the deterioration in economic activity and consequently significantly increased risk of bad debts.
Further, the banks are expensive compared to overseas banks. However, overall, the Australian market is reasonable value.
Asian markets still look reasonably valued, though there are red flags are among less-developed nations that lack the ability to manage coronavirus. India, for example, doesn’t have the infrastructure to cope with COVID-19.
As a result, we prefer the more developed economies in the region.
European markets are trading around fair value. The pick of them are Germany and the United Kingdom from a valuation perspective.
The overall picture on equities is they were quite cheap, and now they’re not as cheap, though pockets of opportunity remain.
Real Estate Investment Trusts
REITs have been hit hard by the coronavirus pandemic. Many have suffered from their high exposure to shopping centres and to a lesser degree office space. REITs with exposure to logistics haven’t suffered as much.
The Australian REITs index almost halved last month. For long-term, patient investors, A-REITs look cheap.
As the economy re-emerges and restrictions are relaxed, A-REITs should benefit. They could be very good value for the investor with a 3-5 year time frame.
In a low interest rate environment, yielding sectors are very important for people trying to generate income. Buying into A-REITS is sensible, though the ride may be a little bumpy.
Government bond yields are very low. While they still have a place in a portfolio — providing some ballast — their expiration date is getting closer.
As bond yields fall, their ability to help protect portfolios in equity market declines reduces because there is less scope for yields to fall further.
It doesn’t mean it is now time to offload all bonds — but investors need to be aware they won’t be providing the returns of the past.
The question becomes whether their defensive qualities make up for the lack of return — and this latter feature is not what it once was.
There are opportunities in investment grade credit.
When economies slow and defaults increase, the magnitude of lost repayments in respect of higher quality borrowers is not normally large.
Meanwhile, the spread in the US between government bonds and corporate bonds is 200 basis points. The long-term median is 110 points.
Given the premium available, and the likelihood that defaults will be relatively benign, investment grade credit provides opportunities for investors.
There are opportunities for investors.
A portfolio of Australian equities where the valuations are fair, some European and Asian equities, mid cap US equities, some foreign currency exposure and investment grade debt looks like a reasonable portfolio in the current climate.
Michael Blayney manages Pendal’s Multi Asset Target Return fund. Michael has more than 21 years of investment management and consulting experience. He is a qualified actuary and holds a Bachelor of Laws (Hons) and a Bachelor of Science from the University of Queensland.