Madison Investment Market Update – 31 August 2017
Summary of key points
Over the last few weeks, International equity market valuations have improved slightly even though the Australian ten-year bond yield increased slightly. Forward earnings per share growth estimates for major companies in the USA and Australia were, with some prominent exceptions, largely maintained or reduced only slightly.
Bond yields worldwide are still at low levels by historical standards. This provides support for asset prices and leads to Australian and US equities still being fairly priced.
The main recent events of significance have been:
- AUSTRAC initiated serious civil litigation against CBA, Australia’s largest bank and until recently its largest listed company. The litigation will take a protracted period to resolve. So far the market has marked down the CBA stock price by over 10%. This may not be sufficient to fully allow for the extent of the eventual penalties in Australia and in other jurisdictions.
- APRA, the Australian bank regulator, also announced a thorough enquiry into CBA and its operations. This will preoccupy the senior management and the board of CBA and may impact its future growth prospects.
- System wide growth in bank lending on residential property in Australia is still positive and underpins the growth in earnings per share and dividend per share for most banks. CBA may not be able to maintain its dividend for its own particular reasons referred to above.
- The US Federal Reserve held its annual symposium at Jackson Hole, which in previous years has been the occasion for major policy announcements. This was not the case this year, with the leaders of the Fed, the European Central Bank and the Bank of Japan, all giving away little by way of guidance on possible changes to monetary policy. The significance is that the current very stimulatory set of policies is as yet doing little to lift inflation of goods and services process but remains very supportive of financial asset prices and it appears that any change in this will be gradual and over a protracted period of the next three years.
Risk factors to be aware of
The Trump administration and leaders of the US Congress continue to be at odds over key policies, including tax reform or tax cuts that now seem less likely to be implemented. The US equity market has not yet given up on these and has not yet factored failure to cut taxes into its prices. If and when it does, there could be a 10% to 15% fall in US equity market prices. This would spread to other equity markets to some extent. When it does, it will probably represent a buying opportunity to go overweight equities on a longer-term basis. This will take courage and will be difficult for investors to implement for that reason.
In the relatively short run, the US Congress and President may trigger a financial crisis in September or October if agreement on two key issues cannot be reached. These are lifting the US Treasury debt ceiling and voting to continue Federal Government funding. The debt ceiling needs to be raised in order that the US Treasury does not default on payments on what is seen as the best quality debt assets in the world. In 2011, the US came close to this and it caused major if somewhat short-term instability in financial markets. The personnel involved this time, in both the White House and the Congress, are different and arguably less experienced and less predictable. The vote to continue Federal government spending has also been tested before, with the beginning of a government shut down some years ago. This could also be tested again at about the same time as the debt ceiling issue. The opportunity to exercise courage in investing with a longer term focus in a time of seeming market melt down may well come to us sooner than we think.
The most likely Factor X is the US- North Korea situation, which, if ignited, would impact Japan, South Korea and China, with flow on economic effects to Australia via the trade channel. There would be a parallel set of effects transmitted via the global financial markets, which would probably quickly overreact to an outbreak of war. The sell-off could easily be 20% plus within a week or two. Ignition is more likely to come from President Trump than from other more rational actors such as Kim Jong Un.
The challenge for investors is twofold:
- A resumption of war on the Korean Peninsula is a binary event – either it happens and is serious or it is avoided- there is no halfway house. Such events are inherently difficult to plan for in portfolios. To have any protective effect, selling equities to hold cash would have to be of the order of 30% or more of the portfolio. In the (more likely) event that war does not resume and equity markets continue to rise, the high cash weighting would be a dead weight drag on portfolio returns.
- If war resumes, how long would the economic and financial market effects persist? Something like the 2008-2009 period may occur where the markets bottomed out 6 months after the most critical event (the Lehman collapse) but only after globally coordinated activity by governments (Fiscal policy) and Central banks (Monetary policy).
The rational response would be to use any major equity market sell off as an opportunity to go overweight equities on a longer term basis, much as doing so in April 2009 when the S&P fell to 666, would have been a great move. This would take determination and courage, as well as a belief that eventually global growth will resume after such a major conflict. It is worth bearing in mind that the areas affected by a resumption, within the next year or so, of the Korean War (it has never been ended, we have had an armistice since 1953) would include South Korea, Japan (missile damage), maybe the west coast of the USA (missiles) and northern China (refugees). If war resumed in 2019 or later, the DPRK capability would be greater and affected areas would likely include most of the USA. Whether war resumed sooner or later, war damage to Europe is unlikely, however the globalised nature of the economy and trade as well as the globalised linkages of financial markets would ensure a global recession that may last some years. Financial markets would probably anticipate an economic recovery within 6 to 12 months of a major market sell-off.
Looking out longer term into 2018 an emerging risk to be aware of includes the potential for a sharp tightening of Chinese monetary policy as a newly re-elected President Xi attempts to contain and curtail the burgeoning level of debt in China. This would slow the real GDP growth of China; cut commodity prices and impact both the Australian economy as well as major ASX listed companies.
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 using a longer-term perspective. Any significant seel off in the months ahead would lead to a reassessment with the next likely move being to go overweight equities on weakness, although the prospects of prolonged weakness would need to be assessed.
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.
A modest overweight to alternative equities which target an absolute return higher than cash or fixed interest would be helpful in stabilising portfolio returns without giving up too much in return.
Table 1: Recommended asset allocation positioning for portfolios
Where are we now?
Table 2: Financial market movements last financial year and this financial year to date
So far, this financial year:
- Short term interest rates in both the USA and Australia have remained anchored at or near historical lows;
- The long term bond yield in the USA has fallen reflecting a flight to safer assets in recent weeks as geopolitical tensions have risen, particularly in Korea;
- The Australian long term bond yield has edged up, opening up a wider margin above its US counterpart, at +0.52% p.a., although this is still lower than the historical average, indicating plenty of scope for this gap to widen. That is, we expect Australian bond yields to rise more than US bond yields;
- Commodity prices have been stable or higher. Copper continues to rise, reflecting the strengthening of global GDP growth, especially in China. Gold has risen on the back of geopolitical tensions, but not much as yet. Oil has changed little, seemingly stuck below the $US50 mark, although disruption in the Gulf of Mexico due to Hurricane Harvey may push the price up a bit (although this has not yet happened due to a temporary downturn in demand for crude oil as the refineries have been closed by the storm).
- Global equity markets, with the exception of China, have been stable to weaker as uncertainty about the implementation of US tax cuts grows. Together with the increased prospect of war in East Asia, this has offset the effect of moderately stronger earnings per share growth for major companies.
- Monetary and fiscal policy in the major countries is unchanged and still broadly supportive of asset prices but having little effect on the prices of goods and services (i.e. inflation)
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.
Equity markets appear to be high, especially in the USA, when we simply look at the price indices.
When we look at forward Price Earnings ratios, they do not look so stretched. They are supported partly by earnings that have recovered since the GFC and partly by persistently low interest rates including bond yields.
Dividend yields relative to longer-term history tell a similar story. While they do not indicate that equity markets are particularly cheap, they are significantly higher than during the tech boom period around 2000.
A more complete valuation assessment takes into account the level of interest rates and projected earnings per share growth as well as the current level of prices.
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
Over the last few months the Valuation indicators have deteriorated slightly for Australia equities but they are still slightly cheaper than the long term Fair Price Assessment. Valuations for International Equities have improved relative to long term Fair Price and also relative to Australian equities, but are still, overall, slightly expensive. There is more detail on the Valuation Indicators in Table 5 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 shifted from positive back to neutral.
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
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 3.4% 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 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 market, major equity markets are within the fairly priced range, but none of them are cheap. Together with the shift in momentum back to neutral from positive, this indicates that caution is warranted and portfolios should not go overweight in equities yet, notwithstanding the positive contribution of qualitative factors.
More on the qualitative factors used in the overall assessment
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 and instability in politics and policy making in the USA).
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
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.
- 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 short term interest rates in the USA relative to interest rates in Australia. 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 premium returns above cash rates and lower volatility investment in growth assets should be maintained.
Table 7: Recommended asset allocation positioning for portfolios managed with a three-year horizon