Investment Market & Portfolio Update – 11 April 2017
Summary of key points
There has been some sound and fury in the financial markets but it has signified nothing much.
The Trump administration was rolled by its own party, failing to get its healthcare change through Congress. Equity markets wobbled at the thought that this could also happen to the cherished prospect of tax cuts. We think that self interest can be relied upon to secure the tax cuts, which by some credible estimates may lift earnings per share by an average of 17% – a level not yet factored in to prices.
Meanwhile Chairman Janet Yellen at the Fed announced the long anticipated 0.25% p.a. lift in short-term rates. More importantly the Fed Open Market Committee is now signalling three more such rate rises. This sounds like a lot but would still leave the rate short of the Fed’s proclaimed neutral rate of 3% p.a. On this view, monetary policy continues to be stimulatory for the next three years
In Australia the RBA left its short-term official rate unchanged at the record low of 1.5% p.a. among much hand wringing about the speed of residential property prices and its potential impact on bank profits.
APRA will tighten controls on bank lending but not by enough to cause either a residential property bust or a dive in bank profits.
In recent weeks, the banks have lifted their mortgage interest rates in response to the rise in their wholesale funding costs arising from the Fed Reserve interest rate increase. They did this because they cannot fund all of their home loan assets from Australian sourced deposits. The rises, which have been extensively criticised by politicians and ASIC, demonstrate the banks’ willingness and capacity to defend their profitability, return on equity and dividend paying capacity. The rises ranged from +0.07% p.a. to +0.25% p.a. Given the level of gearing in the banks’ balance sheets, these increases would have led to an increase in their ROE by between +0.7% p.a. and + 2.4% p.a.
Given the importance of the banking sector not only to the economy but also within the ASX 200 stock market index, this demonstration of market power in defence of profits and dividends is noteworthy, especially in the face of growing sentiment towards convening a Royal Commission into the banks.
Meanwhile the Federal Government is doing little that amounts to real policy change apart from announcing a feasibility study into Snowy Mark 2. Given the numbers in the Senate and the political skills being deployed we expect little change in the next two years.
The main factor to watch is the long-term bond yield. The sound and fury referred to above has caused some shift back into bonds from equities. This has pushed down the bond yield making equities slightly more attractive from a longer-term perspective.
A possible offset to this view is the revelation this week by Board members of the Federal Reserve that they will be looking at running down the $4.5 trillion balance sheet of the Fed over the next few years as bonds that they hold mature (at a rate of $US 450 billion per annum) rather than replacing them. This will reduce the demand for US Treasury bonds and add to the upward pressure on bond yields. Based on historical evidence, the ten year US Treasury rate would need to move up from its current level of around 2.4% p.a. to over 3.9% p.a. before it has an adverse effect on equities in general, although bond yield rises will have more immediate impacts on interest rate sensitive stocks such as Real Estate Investment Trusts (REITs) and infrastructure stocks.
In our mainstream scenario we are assuming that the ten year Australian bond yield will rise from the current 2.6% p.a. to around 3.4% p.a.. This provides a buffer of safety in our forecasts.
Our valuation work combined with an assessment of the momentum and qualitative factors indicates that it is still appropriate to hold a neutral or benchmark allocation to Australian and International equities and an underweight to Property and Fixed Interest.
Risk factors to be aware of include:
- Any deadlock that emerges between the US Congress and the President in the implementation of the tax cuts that have been factored into US equity prices or any stalling of the continuing budget resolution that may cause a Federal government shutdown at the end of April.
- Any economic policy stumble by the Chinese leadership in the run to the 19th Party Congress later this year such as choking off credit and lending to loss making state enterprises too quickly.
- Any capital raising problems of “globally systemically important financial institutions” in Europe, including the biggest banks in Italy and Germany (although the risk of this seems to be receding).
- Continued attention seeking missile launches by North Korea at a time when South Korea is vulnerable due to the jailing of its President
Table 1: Recommended asset allocation positioning for portfolios managed with a three-year horizon
Where are we now?
Table 2: Financial market movements
Since the last Update in March:
Short-term interest rates in the US rose following the decision to increase the Fed Funds at the March meeting of the FOMC. In Australia, the RBA again kept the official rate at 1.5% p.a. at its meeting on 4 April in spite of rising tension about the state of the residential property market. Notwithstanding the US rate rise short term cost of money remains near historic lows in the USA, Europe and Japan as well as Australia;
The worldwide price of long-term money, as measured by the US Treasury ten year bond yield, fell by 0.16% p.a., a significant amount. This was in response to global investors shifting back from equities to bonds to some extent, as a result of growing anxiety about whether the tax cuts factored into equity prices may be delayed or not realised in full. The cost of long-term money remains low by historical standards. Notwithstanding short term jitters in the equity market, low bond yields still provide great support for financial asset prices everywhere;
Commodity prices were little changed over the last month except for oil, which declined by up to 10% at one point, then recovered somewhat to be down 4.3% over the month. This was the result of an apparent fracturing in the resolve of OPEC producers to constrain their production in line with their recent agreement;
The Australian dollar was weaker against all major currencies, providing an addition to returns on international equity assets;
Equity markets were mixed during the month. The US market was down 1% in US Dollar terms as a result of emerging concerns that the Trump administration may not achieve its announced (but as yet unspecified) tax cuts.
This followed its inability to have its Health Care legislation repealing and replacing the affordable Healthcare Act (Obamacare), passed by a Congress dominated by its own party. Investors have extrapolated that this may put in jeopardy the tax cuts already factored into equity prices. We believe that self interest, enlightened or otherwise, will prevail and tax cuts will be forthcoming. The program of lower taxes, higher spending and less regulation in the USA now looks more uncertain to many market participants but should largely prevail;
The Japanese equity market was also weaker over the month, by 2.5% while the UK was flat, influenced in part by the actual commencement of the process of British exit from the European Union. This still has the capacity to dive the UK back into recession and the UK equity market is wary of this;
Meanwhile the European and Australian equity markets were stronger. In the financial year to date, equity markets have provided positive returns to Australian based investors. This is in spite of the significant rise in long term bond yields which so far have done little to blunt equity market returns;
Current assessment of equity asset markets
Our current overall assessment taking into account valuation factors, momentum factors and qualitative factors such as monetary policy, fiscal policy and geopolitical factors is essentially unchanged since last month and is summarised in Table 3. The Valuation indicators have improved due to the fall in the ten year bond yield while our assessment of the projected ten year growth rates for equity earnings per share remain unchanged (as set out in Table 4 below). The medium to long-term assessment of the Momentum and Qualitative factors are unchanged, in spite of the short term wobble in equity markets, sparked by the setback that the Trump administration experienced in Congress.
Table 3: Summary of equity markets assessments
The valuation assessment is based on a comparison of the current pricing of equities in world equity markets with an estimate of the longer-term Fair Price of each market.
Long-term Fair Price is based on the long-term bond yields and estimates of long run earnings per share growth. A lower expected long-term bond yield implies a higher Fair Price for equities, as lower bond yields make cash flows from equity markets more valuable. A higher expected long-term bond yield has the opposite effect. We expect that the level of bond yields, which is still low by historical standards, will provide continued some support for equity prices, but this effect will weaken as bond yields continue to rise in the US and elsewhere.
The assessment of the long-term rate of growth in earnings per share depends on assumptions about the long-term rates of inflation and real economic growth, as well as the rate of issuance of new equity or buy backs of equity. Our current assessments, which are unchanged since last month, are summarised in table four below.
Table 4: Earnings per share growth rates for equity markets
We use these assessments of long term earnings per share growth, together with the bond yield, to derive the long run fair price estimates in the analysis set out below in Table 5. We do so for a number of scenarios, which imply different financial market regimes. While there are many possibilities, the three main ones in our assessment are as follows. These scenarios are unchanged since our last Update and we have not changed our assessment of the likelihood of each of them:
- Modest earnings growth where inflation and interest rates do not rise by much. This is good for equity prices. We rate this as the most likely scenario for the next 3 to 5 years with a likelihood of 50%. In this scenario we are assuming that the ten year Australian bond yield will rise from the current 2.6% p.a. to around 3.4% p.a.. This is a more demanding hurdle that provides a buffer of safety in our forecasts.
- Faster earnings growth where inflation and interest rates rise above 4% p.a. This higher rate of inflation is generally bad for fixed interest and to some extent is also bad for equity prices. This higher inflation prospect is reflected through the application of a higher assumed long-term bond yield. This effect is offset to a greater or lesser degree, in the case of equities, by the faster rate of earnings per share growth. We rate this scenario as 30% likelihood.
- Recession and possible deflation where inflation and interest rates turn negative and there is a risk of the economy being trapped in a zero or negative growth pattern. The more positive outlook for the US economy leads us to rate this scenario of slower growth perhaps with mild deflation over the next for the next 3 to 5 years as 20% likelihood.
Table 5: Fair Price assessments for the Australian and International equity markets
In summary, the valuation work indicates that the US and Australian equity markets are on the cheaper side of fairly priced. All major sectors of the Australian equity market are now in the fairly priced range, with Energy and Real Estate in the more expensive end of this range.
While the US equity market is near a record high, continued growth going into 2017 together with bond yields that are not yet high (or even average) by historical standards, makes the US equity market fairly priced from a long term perspective. Historical analysis suggests that rising US bond yields can rise above 3.9% p.a. (they are now at 2.5% p.a.) before threatening equity market prices.
Elsewhere, equity markets in Canada, Britain and China are also fairly priced. Other international equity markets are still expensive from the point of view of an Australian investor, with the German and French markets almost in the fairly priced range.
Momentum in major equity markets has continued to be positive when measured over the last three to six months. It continues to be a supportive factor for equity investment. This does not rule out the risk of bouts of shorter-term instability in equity markets as they react to events.
Overall our current assessment is that the positive qualitative factors (supportive monetary and fiscal policy) outweigh the negative factors (slower than usual economic growth in many places, political paralysis and discord as well as possible instability in the European banking system). In the USA, we expect an increase in GDP growth, fiscal stimulus (lower taxes and higher spending) together with a reduction in political and policy paralysis, notwithstanding the recent setback in the Congress.
Our baseline scenario for the next tree to five years is as follows:
- Inflation is low but rising modestly worldwide
- Real GDP growth is slowly picking up especially in the USA
- Overall fiscal policy worldwide is supportive of economic growth and equity earnings growth.
- As well, monetary policy is widely supportive. Short term interest rates are low worldwide with some capacity to rise as central banks slowly retreat from the stimulus given to fill the void left by governments
- Government bond yields are low but also rising especially in the USA. Eventually this may become a threat to equity prices.
- Equity earnings growth is slower than normal during this stage of a recovery (now 8 years old) but will be picking up in the US as tax cuts come into play
Over the next 12 to 24 months we expect the following to occur:
- The USA breaks its fiscal deadlock between the President and the Congress and directly stimulates the US domestic economy while borrowing more to cover the increased deficits.
- In Europe, established parties in face major challenges at elections from populists of both left and right, paralysing policy at least until 2018.
- Britain takes a long time to negotiate its trading arrangements in the wake of Brexit causing a slowdown in its economy and may lapse into recession.
- Real economic growth is slower than it has been in China, Europe and Japan and faster in the USA. Overall world real GDP growth is the same or slightly slower.
- Apart from in the USA, fiscal policies are unchanged due the perceived political constraints, but they still remain expansionary over the next two years.
- In China, Xi continues to exert dominance especially over economic policy, reducing credit growth and increasing the risk of a recession but not until 2018, i.e. after the 19th Party Congress later this year.
- Apart from in the USA, inflation is mostly unchanged and very low worldwide and does not break out above 4% p.a. in spite of the massive monetary stimulus and significant US fiscal stimulus. The main reason is that consumers remain on strike as their incomes continue to grow slowly (if at all)
- Monetary policies of central banks reach the limits of their efficacy with limited further reductions in short term interest rates (including further moves into negative rates) in Japan and Europe.
- US monetary policy tightens only slightly with modest increases in the Federal Funds rate but is effectively tightened more by the rising US Dollar.
- Major central banks do not shrink their balance sheets, keeping most of the government bonds that they bought under the quantitative easing programs that followed the GFC.
- Equity market prices continue to be driven by earnings per share growth, low bond yields and low cash rates but are prone to significant short term falls whenever there is a shock, such as a European banking crisis or a setback in US legislation.
What to do next with Investment Portfolio Strategy:
- Maintain a neutral or benchmark weight to Australian equities and International equities.
- Stay short in duration in fixed interest to avoid capital losses as bond yields increase.
- If the client portfolio allocation to either of Australian equities or International equities is less than 50% of the currently recommended target allocation, then the allocation should be increased to 50% as soon as practicable with the balance of the difference to be invested progressively over a subsequent six month period.
- The prospects for higher interest rates in the USA relative to interest rates in Australia means that the AUD is more likely to fall than rise against the USD, so international investment at this stage should be unhedged.
- A slight overweight to well managed alternative equities that offer lower volatility investment in growth assets should be maintained.
Table 6: Recommended asset allocation positioning for portfolios managed with a three-year horizon
Table Seven sets out guide points for buying and selling various share markets, for those who wish to manage portfolios on a long term basis with reference to accumulation or reduction guide points as an alternative to the approach of setting weightings relative to long term strategic benchmarks.
Table 7: Stock Market Investing Limits