Madison Investment Market Update – 22 June 2017
Summary of key points
The main drivers of returns are equity market returns. In turn the main drivers of returns on equities are low bond yields (even though these will have a tendency to rise) and reasonably solid earnings growth.
Over the latest month, equity market valuations have improved slightly in the USA, Australia and Europe as bond yields declined and long-term earnings per share growth estimates were maintained.
The main events of the last month were:
- The Federal Reserve increasing its Fed Funds Rate as expected by markets- so no adverse impact.
- US deleveraging since the GFC appears to have stopped and may be turning around, leading to more support for corporate earnings growth.
- The Japanese economy has moved out of deflation improving the outlook for corporate earnings growth. Higher dividend payout ratios following government pressure are adding further to the stock price outlook.
- European Central Bank reaffirming a policy of very slow scaling back of its major monetary stimulus.
- The French election confirming the power of newly elected President Macron and consolidating the forces in favour of preventing a break up of the Eurozone, which would be very disruptive to global financial markets.
- Periods of equity market weakness resulting from political factors, but proving to be transient.
- Chinese growth continuing but with more emphasis on services versus manufacturing, indicating some increase in resilience in GDP growth.
- A major fall in the oil price showing the structural weakness of the OPEC attempts to boost prices by limiting production. This will reduce the level of inflation worldwide and reduce the risk of an inflationary overshoot caused by continued monetary policy stimulus. Overall positive for most equity market sectors but not for the energy sector.
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:
- Delays in the implementation of the tax cuts in the USA due to distraction of the Congress by issues relating to the possible impeachment of the President. There is also the risk of stalling the continuing budget resolution that may cause a Federal government shutdown at the end of September.
- Any economic policy mistake in China such as reducing credit and lending to loss making state enterprises too much or too soon.
Table 1: Recommended asset allocation positioning for portfolios managed with a three-year horizon
Recent events and their significance to investment strategy
The Federal Reserve increased its key interest rate to a range of 1.00% – 1.25% p.a. This was widely anticipated by markets and so its announcement had no effect. The markets view of future increases diverges from the announced view of the Federal Open Markets Committee, which sets the Fed Funds rate. The FOMC is indicating one more increase of 0.25% p.a. in 2017 and three more of 0.25% p.a. in 2018. Even if this happens it will bring the Fed Funds rate up to just 2.25% p.a. by the end of 2018, which is still a very low level that is supportive of equity asset prices. Financial markets are pricing in just two increases by late 2018. It needs to be borne in mind that the Fed mandate is to target inflation and unemployment and not asset prices. The Fed is concerned about weak inflation and underemployment, so it is tightening monetary policy very gradually. This includes its plans to reduce the size of its balance sheet. It currently holds $4.3 trillion of government and mortgage backed bonds, which is likely to be reduced over an extended period of five years or more. Significance: While this will put upward pressure on long-term bond yields in 2018, the effect may be limited in size or extended in time. Expect any negative effects on equity prices to emerge only after the ten-year Treasury bond yield has risen by almost 1% p.a. to over 3% p.a.
Equity market volatility as measured by the VIX index that is traded on the Chicago market has generally been low, in contrast to the increased volatility of US politics. Significance: Equity markets are largely discounting US political or legislative uncertainty and focussing more on earnings reports, which are running at healthy levels.
There is increased commentary about the need for authorities to remedy the interrelated problems of loss making state owned enterprises, the funding of these losses by increased debt via borrowing from the second tier or shadow banking system and the growth of doubtful debts in the shadow banking system. Eventually all of these will need to be fixed but the solution appears to be deferred until 2018 or later. Significance: There may be a delayed but sharper slow down in Chinese economic growth with consequent effects on global growth, commodity prices, profitability of Australia’s major mining companies and Australian Federal and State tax revenues.
The Chinese A share markets, which are the second largest stock markets in the world, were admitted to the MSCI Emerging markets Index with a weight of 0.7%. Significance: This will cause some rebalancing of global investors portfolios towards these markets, but the effect will be limited. Inclusion of the Chinese a share markets in the much broader MSCI World index would be much more significant but is not expected for some time.
There has been an 8.9% year on tear increase in exports and real growth in GDP is now running at 2.2% p.a. There have been five quarters of expansion, the longest expansion since 2006. Abenomics appears to be working with manufacturing profits up strongly and the Nikkei equity market index at a 17 month high. Significance: Japanese equities have become reasonably fairly priced
The crisis on the Korean peninsula has dropped off the media front pages lately. It is still serious and potentially more so for Japan than any other major market. Significance: Potentially quite large but hard to predict.
The French Assembly elections consolidated the power of President Macron who, together with Chancellor Merkel of Germany, can now act as a positive counterweight to an erratic US administration. Significance: the prospect of a Eurozone break up has receded markedly together with the consequent economic and financial market disruption that would follow such an event.
The European Central Bank at its most recent meeting did not indicate any reduction in its EUR 60 billion per month of bond purchases. This was counter to expectations and indicates that the tightening of monetary policy will be far more gradual. Significance: European equities will remain fairly priced for longer.
Moody’s, a rating agency, joined its competitor, S&P, in downgrading the credit rating of major Australian banks by one notch, citing concerns about their exposure to losses on mortgages on residential property which has experienced strong price growth in recent years. Residential property market price growth has fallen back slightly in the last month or so but is not yet showing any real signs of a sharp fall. A prolonged plateau is more likely at this stage. The effect of the credit rating downgrade will be a modest increase in wholesale borrowing costs of the major banks. The equity market reaction has been volatile and generally more extreme than warranted to this factor alone. Of greater significance is the potential slow down in the growth of bank lending as a result of constraints imposed by APRA. This may lead to longer-term slower growth in bank earnings per share and dividends. Ultimately, banks could experience a decline in Return on Equity from c 14% p.a. to c 10% p.a., the level that many international banks operate on. This would cause a re-rating and decline in bank stock PEs by as much as 30%.
The Governor of the Reserve Bank, Phillip Lowe has made some statements about the RBA’s optimism that “animal spirits” will re-emerge and encourage greater investment spending by companies, while at the same time employees should press for higher wage increases. The latter statement reduces the credibility or the former. It may be that the RBA is more concerned than it is letting on about the impact of the very low wage growth and its effect of consumer spending which is still the largest component of demand. Wage growth appears to be constrained by the increase in the proportion of the work force the is part time (rising fro 10% of the total work force in 1966 to 32% in 2016) and the shift into casualised or less unionised sectors such as hospitality or contracted arrangements via labour hire companies. Significance: The RBA wants inflation and growth to pick up, in line with the optimistic assumptions of the Commonwealth Treasury in its budget tax revenue forecasts, but both are likely to be disappointed. The Treasury will have yet another case of underestimating the Federal budget deficit (after seven in a row). The outlook for earnings in retailing and other sectors depending on discretionary spending will be adversely impacted.
Where are we now?
Table 2: Financial market movements
Since the last Update in late May:
- All major international equity markets have advanced, between 2% and 5% in local currency terms.
- The Australian Dollar has declined against the USD (by 1.5%), the Euro (by 5.9%) and the Pound (by 5.1%), adding a tailwind to returns on international assets.
- The Australian equity market has declined 1.9%, partly as a result of the fall in May of the major bank stocks after they had experienced a near term peak in April.
- Short-term interest rates in the US and Australia were stable and near historic lows.
- Ten-year government bond yields in the USA and Australia declined by 0.09% adding support to equity market prices.
- Exchange traded commodities were relatively unchanged except for a 3% fall in the copper price. Bulk commodities such as coal and iron ore were weaker.
Looking at equity markets from a longer term perspective in Australian dollar terms as shown in the chart below, we can see that the Australian equity market, in which most portfolios have their largest equity position, has outpaced international equity markets. In recent times the US market has had higher returns, with the European and British markets lagging.
Current assessment of equity asset markets
The assessment of equity markets is of central importance to portfolio strategy, given that growth 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, has been upgraded 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 has been increased in line with updated forecasts from the IMF. (See Table 4 below). The medium to long-term assessment of the Momentum and Qualitative factors are unchanged, except that the fiscal policy outlook in Australia now looks more supportive of equity prices.
Table 3: Summary of equity markets assessments
The Valuation indicators have improved further over the last month 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 has been maintained unchanged. (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 weakened a little over the course of the latest month but 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 markets.
Table 4: Earnings per share growth rates for equity markets
The 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 2.4% p.a. to around 3.2% 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
The valuation analysis work indicates that with the exception of the British stock market, most major equity markets are within the fairly priced range. None of them are cheap, so caution is warranted.
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.
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 instability in the European banking system).
The instability in European politics has subsided with recent election results in the Netherlands, German state elections and in the French presidential and assembly elections. In addition, potential crises in major banks have been averted or solved in Italy and Spain.
Britain is proving to be an exception, with the recent election result reducing the power of the government and markedly increasing both the uncertainty about its Brexit negotiations and the prospect of a recession in 2018 or 2019
In the USA we still expect an increase in GDP growth, with fiscal stimulus increasing due to lower taxes and higher spending although this may be delayed due to tensions between the Congress and the Presidency.
In China, the government is consolidating ahead of the 19th party Congress in the northern autumn and is not likely to tighten monetary or fiscal policy too much until at least 2018.
Japan is showing the benefits of the unusually long –lived administration of Prime Minister Abe and the success of at least some of his Abenomics policies such as fiscal and monetary stimulus.
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 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 7: Recommended asset allocation positioning for portfolios managed with a three-year horizon