Madison Investment Market Update – 20 July 2017
Summary of key points
Over the last few weeks, equity market valuations deteriorated slightly in the USA, Australia and Europe as bond yields increased while long-term earnings per share growth estimates were maintained or reduced only slightly.
In spite of the recent increases bond yields are still at low levels by historical standards. This means that Australian and US equities are still fairly priced based on a long-term horizon.
The main recent events of significance have been:
- The Reserve Bank of Australia maintaining its official rate unchanged at 1.5% p.a. but indicating that it now considered the neutral rate to be 3.5% p.a., hence foreshadowing a series of increases to this level over some unspecified period. This added to the upward pressure on bond yields and consequent downward pressure on equity market prices, particularly in interest sensitive sectors such as listed property trusts.
- APRA, the Australian bank regulator, announced its long awaited policy change in the minimum capital requirements for banks. It was less onerous than widely expected and it is unlikely that the banks will have to have new issues of capital beyond dividend reinvestment. On the day of announcement, the equity market liked it, with bank stocks rising between 2.5% and 3.0%, more than recovering the losses seen in the run up to the policy change.
- System wide growth in bank lending on residential property picked up in June, increasing at an annualised rate of over 7% p.a. This growth, in what is the single largest asset base of the banks, helps underpin growth in their earnings per share and dividend per share. These are critical to any assessment of whether the banks are fairly priced or otherwise. The banks appear to be fairly priced, assuming EPS growth of between 3.25% and 3.75% p.a. over the next ten years.
- The Chairman of the Federal Reserve, in testimony to the US Congress, indicated that it would be more cautious in tightening monetary policy due to inflation and wages growth continuing to fall short of its expectations. This helped reduce US bond yields slightly and spur the US equity markets to new record highs.
- Chinese GDP growth exceeded expectations coming in at 6.9% p.a. versus the planned 6.5% p.a., but this was accompanied by a very explicit warning from President Xi that action will be taken to rein in the rate of credit growth. While no real action on this is expected until after the election in November, the threat was enough to cause a 4% sell off in Chinese equities.
- Continued weakness in the oil price which reflects the structural weakness of OPEC, complicated by a serious political dispute among the Gulf nations. The depressed oil price is a factor contributing to low inflation in the more developed economies. The capacity for US shale oil producers to operate profitably at $US 60 per barrel puts an effective cap on the oil price.
Our valuation work combined with an updated 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.
Given the prospects for further bond yield increases over the next two years there should be a major underweight to listed property and an underweight to fixed Interest combined with a shorter duration position in fixed interest.
Risk factors to be aware of include:
- A significant loss of confidence in US equities due to the legislative program of the Trump administration stalling in Congress due to the unique blend of skills and talents employed by the new President’s team. In particular the delays seen in regard to healthcare may spread to its tax reform agenda.
- A stalling in economic growth in China if credit and lending is cut back too soon or too sharply.
- The biggest threat to equity market returns is the effect of rising interest rates, which will eventually come, adding to the debt servicing costs on what is now a large volume of debt worldwide. Global debt now stands at $US217 trillion or 327% of world GDP.
Table 1: Recommended asset allocation positioning for portfolios
Where are we now?
Table 2: Financial market movements
The 2016/2017 financial year, just completed, saw equity markets up strongly in Australian dollar terms. The US market has delivered a total return in Australian dollar terms of +11.8% with Japan producing +13.1%. Since the end of the financial year, the rise in the Australian dollar has taken the edge off returns in international equities.
The strength in the AUD is being caused by the current perception that Australian interest rates will rise more than US interest rates in the next year or so, together with the beneficial effects of strong volumes and prices for commodity exports to China.
In the next year or so, the possible combination of higher commodity prices (as Chinese growth continues above 6% p.a.) and more rapid interest rate increases by the RBA compared with its US counterpart, may well push the AUD higher versus the USD. Beyond 2018, the AUD is more likely to lose the momentum of higher commodity prices, as China reins in credit growth. In addition, by then, the US Fed Reserve may be increasing interest rates faster than the RBA. These factors are likely to combine to weaken the AUD versus the USD. This indicates that using a medium to longer term horizon, international equity investment ought to be unhedged rather than hedged.
Current assessment of equity asset markets
Overall, financial market conditions are very supportive of equity market prices. The assessment of equity markets is of central importance to portfolio strategy, given that equity assets are significant drivers of overall returns.
Our current assessment of equity markets, taking into account valuation factors, momentum factors and qualitative factors such as monetary policy, fiscal policy and geopolitical factors, is summarised in Table 3.
Table 3: Summary of equity markets assessments
Equity Markets Assessment – 19 July 2017
The Valuation indicators have deteriorated slightly over the last month (a higher ratio means that current market prices are more expensive relative to long term valuations) due to the rise in the ten-year bond yield while our assessment of the projected ten-year growth rates for equity earnings per share has been maintained unchanged apart from a 0.25% p.a. reduction for the US and Britain. (See Table 4 below).
The medium to long-term assessment of the effect of Momentum in equity markets, which usually persists between six months and eighteen months, has been unchanged over the course of the latest month and is still supportive overall.
Qualitative factors are mostly unchanged in their effect, with both fiscal and monetary policy still very supportive of equity prices in most countries and equity markets.
Table 4: Earnings per share growth rates for equity markets
Scenario 1 – base EPS growth assumptions over ten years
These assessments of long-term earnings per share growth, together with the bond yield, are used 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 essentially 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 2.7% p.a. to around 3.3% 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 in the higher assumed long-term bond yield. This effect is offset to some extent by the faster rate of earnings per share growth. We rate this scenario as a 30% likelihood.
Recession and possible deflation where inflation and real interest rates fall significantly and may even turn negative and there is a risk of the economy being trapped in a zero or negative growth pattern. We rate this scenario as a 20% likelihood.
Table 5: Fair Price assessments for the Australian and International equity markets
Equity Market Valuation indicators from Australian Investor Perspective – 19 July 2017
The valuation analysis work indicates that with the exception of the British and the Japanese stock markets, most major equity markets are within the fairly priced range (80% to 120%), but none of them are cheap, so caution is warranted i.e. do not go overweight at this stage.
Momentum in major equity markets has continued to be positive when measured over the last six months. It continues to be a supportive factor for equity investment. It has become prone to periods of shorter-term instability and it may cease to become supportive in the months ahead.
It would not be surprising to see a short term sell off in equity markets, triggered by geopolitical events, with equity prices falling by as much as 10% over the course of a month or so.
Such a fall would likely be self-limiting with a large volume of institutional cash worldwide coming into the equity markets, looking for bargains and yield, reversing any fall within a matter of months.
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 some places, instability in politics and policy making and possible continued instability in the European banking system).
Our summary of the qualitative factors and their effects on equity market returns for each major region is as follows:
Table 6: Qualitative factors affecting equity markets over the next three years
Key: Current overall effect: + (positive) – (negative) # neutral
What to do next with Investment Portfolio Strategy:
Maintain a neutral or benchmark weight to Australian equities and International equities.
- Stay short in duration or use floating rate investments in fixed interest to avoid capital losses as bond yields are expected to increase over the course of the next two years.
- Hold a major underweight to AREITs (Listed Property Trusts) and be selective about unlisted property assets.
- 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.
- In the longer run beyond the next year or so, the prospects are for greater increases in interest rates in the USA relative to interest rates in Australia. As well, there is the prospect of weakening commodity price growth. This means that eventually the AUD is more likely to fall than rise against the USD, so international investment on a three to five year horizon should be unhedged.
- A slight overweight to well managed alternative equities that offer lower volatility investment in growth assets that are less correlated with equity markets should be maintained in order to add stability to portfolio returns.
Table 7: Recommended asset allocation positioning for portfolios managed with a three-year horizon