Madison Investment Market Update – 25 May 2017
Summary of key points
Equity market valuations have improved in the USA, Australia and Europe as bond yields declined and long term earnings per share growth improved.
China is taking steps to carefully rein in its credit growth without triggering too sharp a reduction in growth.
In Australia the RBA left its short-term official rate unchanged at the record low of 1.5% p.a. again while the Federal Government Budget tacitly envisages larger deficits for longer.
The new bank levy contained in the Budget will have little if any adverse effect on bank profits and shareholder returns as they pass on the costs to borrowers and depositors.
In our mainstream scenario we are assuming that the ten year Australian bond yield will rise from the current 2.5% p.a. to around 3.3% 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 September.
- 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.
Table 1: Recommended asset allocation positioning for portfolios managed with a three-year horizon
Recent events and their significance to investment strategy
Federal Reserve has indicated that it will reduce the size of its balance sheet which currently holds over 44 trillion of government and mortgage backed bonds. Significance: this will put upward pressure on long-term bond yields in 2018 if not before.
Treasury Secretary Mnuchin concedes that the introduction of legislation to cut corporate and personal taxes will now not be in August and could well be in 2018. In addition, both the form and the size of the tax reform are being contested between congressional leaders and the Trump administration. In any event, both the Presidency and the Congress are now heavily distracted by other matters, including discussion of impeachment. Significance: May cause short term market sell-off by as much as 15% but in the longer term a one or even two year deferral of tax cuts has little impact on equity market valuations. See any sell-off as an opportunity to accumulate equities.
Trump has proposed $3.6 trillion of spending cuts over the next ten years in his budget sent to Congress. Given that this will impact the constituencies of many senators and congressmen, it is unlikely to pass Congress. Yet another continuing Resolution will be needed by September to allow the Federal Government to continue paying salaries and other costs. Significance: expect last minute drama in the face of a Federal Government shut down and a short term sell off in equity markets
US Consumer Sentiment (University of Michigan Index) at a 12 year high and small Business Optimism at a 15 year high. Significance: will tend to underwrite growth in the economy and in corporate earnings per share.
Industrial capacity utilisation at just 75% and underemployment in the labour market is high. Significance: the prospect of an outbreak in inflation in the next few years is low in spite of monetary and fiscal stimulus.
Economic rebound is slowing down slightly as the central government acts to rein in the burgeoning secondary banking system, which has assets of 76 trillion Yuan (USD 15 trillion). An escalation of loan defaults is expected but the government is anxious to avoid systemic financial problems. Nonetheless a sharp increase in interbank interest rates has occurred and real GDP growth could slow towards 5% p.a. in 2018. Significance: a modest slow down of this order would be negative for Australian coal and iron ore exporters as well as both State and Federal Governments in Australia. A more pronounced slow down in China would lead to recession in Japan and Europe and possibly the USA. At that stage the outlook for equity markets over the subsequent three to five years would change fundamentally for the worse.
Other North Asia
The crisis on the Korean peninsula has moved to a more serious stage with an escalation of missile activity by the DPRK and deployment of cruise missile and nuclear-armed ships by the USA. Significance: potentially quite large but hard to predict. As yet there has been no discernible effect on financial markets including the South Korean stock market, which has also endured a presidential sacking and jailing and major corruption allegations against leading listed companies.
The French Presidential election resulted in a rejection of anti- European candidates and recent German state elections have reinforced the prospect of Chancellor Merkel being re-elected to a fourth term in September. Significance: reduces the prospect of a Eurozone break up and the consequent economic and financial market disruption that would follow.
Meanwhile President Draghi of the European Central bank forecasts that Eurozone GDP growth will plateau at 0.5% p.a. through till 2019, a lower rate than forecast by the IMF, while inflation will increase to only 1.7% p.a. from 1.3% p.a. Significance: If these rates come to pass, current equity valuations in Europe will turn out to be definitively expensive rather than borderline fair price.
The Commonwealth Government introduced a budget that clearly retreats from the debt and deficit rhetoric and envisages continued deficits (i.e. stimulus) for some years to come. While projecting a return to surplus in four years, this is based on optimistic assumptions about the growth of wages and taxes collected on them. A longer period of deficits is more likely. Significance: more stimulus for longer will be more supportive of corporate earnings growth but there will be higher bond issuance putting upward pressure on long-term bond yields in addition to pressure from US bond yield rises.
Commonwealth Government introduces new bank levy. Significance: little or none as the banks will pass on costs and protect margins and returns to shareholders.
Iron ore prices fell 25% in a month, following 13% decline in Chinese imports over the last six months. Significance: looks like BHP and RIO still overpriced and federal tax collections under pressure.
Where are we now?
Table 2: Financial market movements
Since the last Update in early April:
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 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. In our base case scenario we have allowed fro an increase in the Australian ten-year government bond yield from the current level of 2.5% p.a. to 3.3% p.a. This effectively gives us a margin of safety in the valuation analysis.
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. As indicated, these have been revised and are summarised in table four below. While there has been some increase in the assessed rates of growth, they are still assuming a moderate rate of increase over the next ten years.
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 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 2.5% 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 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 equity market is still on the cheaper side of fairly priced notwithstanding comments that it is testing historic highs. The combination of low bond yields and earnings per share growth that is picking up modestly provide strong support. The Australian equity market is also in the fairly priced range, but by a greater margin, reflecting the relatively lower price to earnings ratios compared with the USA.
Elsewhere, equity markets in Europe and China are also in the fairly priced range, while the Japanese market is bordering on expensive. The British market is now definitively expensive following its recent price rise.
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 may however be running out of steam and there may be periods of shorter-term instability 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). 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 current tension between the Congress and the Presidency.
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