Investment Market & Portfolio Update – 8 February 2017
Summary of key points
- The Trump rally in equities markets has faltered in recent weeks, but the longer term dynamic has stayed in pace and has strengthened.
- Do not expect President Trump to become conventional, clear or consistent in his public utterances. This is a deliberate part of the disruptor strategy being adopted. He is not changing the habits of decades just because of a job change. It will continue to be a source of market instability around a longer-term positive trend.
- The longer term trend will be driven by the Trump administration implementing:
- Major cuts in corporate taxes
- Increased federal spending and deficits
- Reduced regulation
- Leading to:
- Higher bond yields
- Moderately faster economic growth in the USA and somewhat higher inflation.
- Faster growth in earnings per share of US and other companies.
- Monetary policy may become less accommodative but is still broadly supportive of asset prices.
- Risk factors to be aware of include:
- Any deadlock that re-emerges between the US Congress and the President.
- The potential for Chinese credit and lending that is now being reined in selectively by provincial governments to stall or be interrupted.
- Growing market concerns about the strength of some “globally systemically important financial institutions” in Europe, including the biggest banks in Italy.
- Even allowing for such risk factors our updated valuation and momentum analysis lead us to recommend an increase in weighting to Australian and International equities to benchmark or neutral weight funded by a reduction in the overweight to cash and alternatives.
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 late December:
- Short-term interest rates in most countries have remained stable at levels that are at or near historical lows, indicating continued strong monetary support for asset prices. In Australia, the RBA official rate of 1.5% p.a. looks low relative to recent inflation of +1.5% p.a. for 2016, but is unlikely to be raised much given the patchy nature of the domestic economy;
- Long term bond yields which had risen significantly in recent months, paused or fell slightly, reflecting some reweighting back into bonds by major global institutional investors;
- Commodity prices firmed with gold up 7.6% in US dollar terms, oil up 3.7% reflecting the OPEC supply restraint agreement starting to take effect a copper up 2.4%, continuing its major move upwards since June of 2016. The latter is a reflection of stronger industrial production, particularly in China, where there has been major government stimulus in 2016;
- The stronger commodity prices and the continued relatively high level of Australian interest rates led to strength of the Australian dollar against all major currencies (+5.2% versus the USD and GBP, +1.2% versus the EUR and +0.4% versus the JPY);
- Equity markets in Australia, the USA, UK and Germany were all up between 1.5% and 2.5% over the month while the Chinese market was up by 5%. The Japanese market was weaker by 2.5%. Overall the equity markets are still finding support from the prospect of lower taxes, higher spending and less regulation in the USA, but the implementation of these now looks more uncertain to many market participants;
- In the financial year to date, equity markets have provided positive returns, with strength in local currency terms being offset by the rise in the Australian dollar, to produce more modest returns for Australian based investors. Apart from the German stock market, developed markets have provided single digit returns to international investment by Australians;
- Overall momentum in equity markets, which has been slightly positive but unstable, appears to have consolidated as a source of future returns. While long term valuation analysis tempered by shorter to medium term qualitative analysis is still needed when deciding how much to allocate to equities, the balance overall has tipped towards reducing any underweight position in developed market equities;
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 summarised in Table 3. These are discussed in more detail later on.
Table 3: Summary of equity markets assessments
Discussing these assessments in more detail:
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. It is important to note that while we regularly review the valuation factors, they are a guide to long term direction rather than shorter-term timing of equity markets. We do however put greater weight on the valuation assessments, the further that current market prices diverge from the long term Fair Price estimates.
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. We have recently updated our long-term earnings per share growth assumptions for the Australian and major international equity markets. We did so using updated long-term analysis from Farrelly’s as well as the recent World Economic Outlook published in late January by the International Monetary Fund, which is relatively independent source inflation and GDP forecasts. Our current assessments are summarised in table four below. The figures in red reflect changes in assessments. In general, the assumed rates of EPS growth factored into the valuation analysis have been increased as a result of the update. This has led to a reduction in the ratio of current market price to long-term fair value in a number of markets.
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 largely unchanged since our last Update but 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 2.83% p.a. to around 3.6% p.a., which 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 for equity prices and this 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. Notwithstanding the Brexit vote in the UK in June and the emerging fragility of major European banks, the more positive outlook for the US economy leads us to now rate this scenario of slower growth perhaps with mild deflation over the next for the next 3 to 5 years as a 20% likelihood.
Table 5: Fair Price assessments for the Australian and International equity markets
In summary, the valuation work indicates that:
- The recent increase in bond yields that made all international equity markets more expensive has been offset by higher growth prospects for earnings per share.
- Equity markets in the US, Canada, Britain, Australia and China are now fairly priced. Most other international equity markets are still expensive from the point of view of an Australian investor, although the German market is almost in the fair value range. Holdings in international equities should be tilted towards the less expensive markets either directly or via funds that invest in them.
- 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.
- The Australian equity market is still reasonably fairly priced overall but the property sector is bordering on expensive while the energy sector is still definitively expensive. The major sectors of financials and materials look more attractive than previously and industrials also still look attractive but there is still a need for careful stock selection in either direct investment or via SMAs funds.
Momentum in most major markets has continued to be positive in the last month and has now consolidated a pattern so that it is now a more reliably supportive factor for equity investment. Given the uncertainties that abound in Europe and the lack of policy certainty that is still the case in the USA, we expect market volatility to be higher in the months ahead, but overall momentum has become a positive factor.
The qualitative factors that impact equity markets include monetary and fiscal policy as well as overall economic conditions and geopolitical factors. Overall our current assessment is that the positive factors (supportive monetary and fiscal policy) now more forcefully 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) and a reduction in political and policy paralysis, albeit with some unconventional surprising aspects.
Our analysis of factors that will have impact over the next twelve to twenty four months takes place within a framework over ten years that provides the driver of long term asset allocation strategy. This longer-term framework is as follows:
- Inflation will be continue to be subdued worldwide, driven by aging demographics that lead to an excess of savings over investment, continued low inflation expectations among populations and overcapacity in manufacturing worldwide. Exceptions to this now include the USA, Canada and Australia, where population growth rates are more supportive and in the USA, there is the prospect of greater fiscal stimulus, at least in the USA and Canada.
- In many places, real GDP growth will be slow but still mainly positive and nominal GDP growth (i.e. growth in money terms) will also be slower than has been usual in the past. The USA, under Trump will prove to be an exception to this in the next four to eight years. To the extent that the US adopts more restrictive trade policies, GDP growth elsewhere, including China, may face even stronger headwinds.
- Governments are generally weak and not prepared to borrow and spend, even on much needed infrastructure. China has been an exception to this and now the US, with the Republicans controlling both an expansionary Presidency and both houses of Congress, may be about to become another important exception.
- Short-term interest rates will continue to be low worldwide as most central banks continue to fill the stimulus void left by governments but the US Federal Reserve will gradually lift its cash rate to around 3% p.a. over the next five years. In late 2016 the Federal Reserve lifted its target rate from 0.5% p.a. to 0.75% p.a. and indicated further rises to 1.50% p.a. over the course of 2017. This is still well short of the so-called neutral level of 3% p.a. and is still very supportive of asset prices. If US labour costs accelerate due to fiscal stimulus at a time of low unemployment, a Republican appointed leadership of the Fed may accelerate the rate increases within a five year time frame to well beyond 3% p.a. and closer to 6% p.a.
- Government bond yields will be low or negative as long as central banks buy bonds to add more stimulus, but this may well be coming to an end in the English speaking world. The European Central Bank has started a modest scaling back of its bond buying from EUR80 billion per month to EUR60 billion per month, but has extended it for a longer period which ends in October 2017.
Our baseline scenario for the next 12 to 24 months includes:
- 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 Germany, France and the Netherlands 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. There is less fiscal austerity and more government debt.
- Real economic growth is slower 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. The People’s Bank of China cuts rates to avoid a hard landing.
- 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.
- 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. Most of the increase in government debt since the GFC continues to be funded by central banks rather than private sector investors.
- Equity market prices continue to be driven by earnings per share growth, low bond yields and low cash rates but are prone to episodic falls whenever there is a significant shock, such as a European banking crisis.
- Increased instability in politics will have a negative feedback effect on the economy in Europe, China and elsewhere. The USA may look more stable, post Trump’s election, with the Republicans in full control of the apparatus of government, but there is much to be settled before this becomes a reality. Some caution is still warranted, but it appears as though the Trump administration will implement the program that it took to the election. We do not expect president Trump to become conventional, clear or consistent in his public utterances. In our view, this is a deliberate part of the disruptor strategy being adopted. It will continue to be a source of market instability around a longer-term positive trend.
- Even after recent bond yield increases, the level of bond yields and short term interest rates and the pursuit of yield are still important factors making US equities appear to be reasonably fairly priced against other asset classes in addition to the prospect of renewed fiscal stimulus.
- Given the volatility of markets we could not rule out a further significant pull back in equity prices in the US of the order of 10% or more within the next six months. This would offer an attractive accumulation opportunity for investors operating on a longer-term 5 to 10 year timeframe as we see continued low bond yields being fairly supportive of equity prices in the medium to longer term. In the meantime there now appears to be a stronger long-term argument in favour of a more fully invested equity market position in the US, Australia and elsewhere on a selective basis.
What to do next with Investment Portfolio Strategy:
- Reduce or eliminate the underweight to Australian equities and increase to neutral or benchmark weight. Some investors may prefer to do this to a six-month period.
- Reduce or eliminate the underweight to International equities and increase to neutral weight. Some investors may prefer to do this to a six-month period.
- Fixed interest should be slightly underweighted and more importantly kept short in duration. Returns on typical bond portfolios and bond funds will continue to be low with the prospect of increased losses on credit securities from some sectors of the economy. Holding short term fixed interest funds; cash or cash funds will be more attractive than bond funds and more flexible than term deposits.
- Where the portfolios are significantly underweight relative to benchmark levels the allocation should be increased carefully and progressively over the next six months. If the client fund allocation to any 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 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. The prospect of continued market volatility means that allocations to trend following funds such as AQR and Winton should be scaled back.
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
These indicators are sending the same message as the valuation indicators in table 5:
- Reduce investment in the Energy sector of the Australian equity market that has benefited from a run up in oil prices.
- Accumulate investment in the Materials sector of the Australian equity market.
- Hold other sectors of the Australian equity market.
- Hold a neutral or benchmark position in US, British and Chinese equities but are cautious and underweight international equities elsewhere, unless investing via funds managed by proven, superior international stock pickers.