Investment Manager Insights
Updated: Mar 29, 2020
Investment managers regularly provide us with their views on economic conditions and a wide range of other topics. Here are some views from their recent quarterly reports that may interest you.
Australian Shares Managers
“The Reserve Bank of Australia (RBA) has acknowledged that rate cuts may be required to stem the negative momentum in the domestic economy. A rate cut together with more expansionary fiscal policies, irrespective of who wins the upcoming federal election, would likely be helpful for house price stability, which would be at least one positive for the Banks, but is unlikely to do much to alter the current trajectory for construction activity.
One bright spot confounding both general cyclical concerns as well the general trend of lowered earnings expectations is the Resources sector. With China’s economy showing clear signs of improvement on the back of yet another stimulus program and the recent tailing dam disaster in Brazil further tightening the iron ore market, this situation looks likely to last for some time. While the sector on longer-term metrics is now closer to fair value, a strong short- to medium-term earnings outlook should be supportive.”
“Markets globally are confronting two strong but potentially conflicting forces. The first is the slowing in global activity which has been underway for several quarters. The second is the decidedly dovish response of central banks to this slowdown, especially over the last four months. Currently, the easier monetary policy, and possibility of lower rates have overridden any slowdown in earnings expectations.
The market is somewhat bifurcated, with extreme valuations in some areas and reasonable valuations in others. This differing performance has seen investment flow into the winners and out of the losers, somewhat exacerbating the valuation divergence. Historically such trends have tended to persist for long periods, but not been permanent. As such, we believe it is risky to base decisions around thematic and valuation factors that have previously been cyclical, and assume they are now permanent. In other words, is anyone really sure that ‘this time is different’?
The changes to franking will result in a permanent reduction in income for some investors, which may result in them undertaking different strategies in order to attempt to recover the reduction in income. Such action is likely to reduce demand for high yielding shares, however franking credits will remain valuable for the majority of domestic investors who receive franking credits. We view the other changes that could result under a Labor government as tending to be more business and market unfriendly, however, the current lack of consumer optimism may recover when electoral uncertainty lifts.”
“We believe that the market will provide average returns over the next 6-12 months. There are a number of reasons for this.
Investor sentiment still remains cautious despite the strong recovery over the past quarter. It usually takes some time for investors to come out of their shells after a large retracement like we had at the end of last year. Matching that, the consensus outlook remains weak, particularly in respect of domestically-focused stocks and the broader domestic economy.
We observe that investors are still very much attracted to what is perceived to be safe. This is seen in the continued recent outperformance of bonds, gold stocks, Real Estate Investment Trusts (REITs), infrastructure and comfort stocks like Woolworths that are now trading expensive. Investors are, however, incrementally paying more attention to fundamental drivers like earnings and growth.
Reflecting the cautious investor sentiment, valuations are relatively attractive. On consensus numbers, the market trades on 15.7 times next year’s earnings, and is paying a dividend yield of 4.7% (which grosses up with franking credits to around 6%). These metrics are around historical averages despite record low interest rates and other assets generally valued far beyond historical norms.
The issue is in the earnings. Based on consensus numbers, earnings are expected to grow just over 5% over the next 12 months. However, in our view, there is significant earnings risk right across the market. This is the risk that a stock disappoints the market by delivering earnings that fall short of expectations. Our view implies that earnings projections are optimistic, which in turn would mean the true price-to-earnings multiple for the market is actually somewhat higher.
We believe it is necessary to be particularly conscious right now of earnings risk taken within one’s portfolio. On the other hand, to the extent that companies can deliver to expectations, we believe investors can expect attractive returns.
Overall, the market is set up for reasonable, and about average, returns.”
“The RBA has now signalled that the future path of domestic interest rates is more broadly balanced (from a prior tightening bias).
Somewhat ironically, this more balanced prognosis was given in the context of an unemployment rate that continues to fall! House prices are still falling but the ultimate impact of this on the broader economy is still an ‘unknown”. It is fair to say that the final Royal Commission report into banking and financial services that was delivered in February was not as bad as some had feared: initially causing the major banks to rally. We have a federal election this year, where the major opposition party is proposing some quite far
reaching policy changes (for example abolishing some forms of negative gearing and cash refunds for surplus franking credits). But frankly, all that the last six months or so has shown is that the ‘animal spirits’ are alive and well: firstly on the downside and then
more recently on the upside.
With the Australian market around record highs, we view the market as fairly fully priced. One area of the market where we believe value can still be found is in the Resources sector. Admittedly after three years of strong share price gains there is less value than there once was, but valuations look attractive relative to most other sectors of the market. Whilst forecasting commodity prices always carries a larger than ‘normal’ forecast error, we continue to believe that the outlook for the key commodities that matter to Australian investors (namely iron ore, coking coal, oil and natural gas) is fairly healthy. In the case of iron ore, safety issues in Brazil have resulted in approximately 90 million tons temporarily coming out of the market (about 5% of global seaborne supply), resulting in higher prices for now. Overall, we expect the Resource sector to grow earnings modestly over the next few years.”
“The earnings outlook across key sectors remains widely divergent. The Bank sector faces a flat earnings outlook due to a number of headwinds including pressure on net interest margins, rising regulatory costs and weak credit growth. Valuations look cheap relative to long-run averages, but this discount may not close up until some of these headwinds begin to ease. Resource stocks are almost the reverse as share prices are starting to exceed long-term valuations, but short-term earnings momentum remains strong reflecting the strength in commodity prices. Low-cost iron ore supply has been lost following the tragic accident at one of Vale’s mines in Brazil. This low-cost output may not return for another 2-3 years. Strong capital discipline by the major miners means that none are investing to offset this short-term supply disruption. Earnings revisions for FY19 are positive and significant upgrades could be expected in FY20 if spot commodity prices prevail.”
Global Share Managers
“Since last quarter the positive development in the ongoing US-China trade talks and a more dovish US Federal Reserve (Fed) weigh on the positive side. However, the estimates remain very sensitive to the overall macro development; and a recession in the US would have a significant negative impact – which we do not see any strong signs of yet. That said, we did see an inversion of part of the US yield curve at the end of the month, which has historically been the single best predictor of a US recession. However, it is also worth taking into consideration that the yield curve inversion typically leads a recession with up to 12-18 months.”
“A bifurcation in stock markets has created opportunities, with the performance of US markets being driven by a small-subset of large, mainly technology-related, companies. While these are growing revenues at a fast pace, their attractions are well-recognised.
A number are now trading on similar valuation multiples to those seen in March 1999. This has led to opportunities in regions like Insights from MLC’s investment managers
Europe which have lagged the broader market by a considerable margin. In fact, over 60% of global stocks are currently in ‘bear
market’ territory, having fallen by 20% or more from their peak over the last two years.”
“The first quarter of 2019 could barely have been more different than the final quarter of 2018. All major asset classes (all of which, except cash, finished lower in absolute terms during 2018) are up in absolute terms year to date, with cash instead being the weakest performer of the group…Examining the investment performance of shares more broadly, one feature of the markets we have found interesting during quarter 1 is the significant divergence of the performance of shares carrying higher and lower amounts of indebtedness. Specifically, the Goldman Sachs index of ‘Strong Balance Sheet’ companies has outperformed its ‘Weak Balance Sheet’ peer by around 10 percentage points so far this year.”
Australian Real Estate Investment Trusts (A-REITs) Managers
“Overall, we continue to believe that the A-REITs remain in good shape. The key investment fundamentals remain sound – balance sheets are largely solid, distribution payout ratios haven’t been pushed and capital management strategies are sound. In addition, corporate governance practices are healthy and growth strategies look sensible. These factors were largely confirmed during the February 2019 profit reporting season.”
“This quarter marks the 10 year ‘anniversary’ of the A-REIT sector reaching its nadir post the disastrous Global Financial Crisis (GFC). The GFC resulted in a ruthless, Darwinian-like, cleanout of bad ideas and poor execution. Since that dreadful March 2009 quarter, the A-REIT sector has produced a cumulative total return of 315%, or over 15% per annum compounded, though it took many years to claw back the losses inflicted by the GFC.
The composition of the A-REIT sector has changed significantly since, but it has been very pleasing to see that some of the painful lessons learned during the GFC have not yet been lost. Most management teams have sensible investment strategies and run their balance sheets conservatively. The focus seems to be on long-term value creation and not short-term earnings accretion!
This quarter’s sale of the 50% interest in the MLC Centre in Sydney by GPT highlights that well-located real estate appreciates over the long-term and investors should pluck the fruits of this, if management manages the balance sheet prudently.
In our opinion, by and large the property sector remains in good shape. Building supply remains relatively modest and rents are moving upwards. Currently the sector facing the biggest headwinds is retail, where valuations for secondary assets are moving
The sector’s allocation to high quality retail should see it perform better than the retail industry average. Most A-REITs have strong operating platforms as well, which can change the tenant mix to keep the property relevant in a time when consumer preferences
are changing rapidly.
Post a very strong quarter for the A-REIT sector it’s prudent to be more circumspect in the near term. Nevertheless, we remain positive that the sector can provide reliable distributions to their investors in years to come.”
Global Real Estate Investment Trusts (REITs) Managers
“Following a strong rebound in the first quarter of the year, REITs now trade at a valuation closer to underlying asset values. Market fundamentals continue to be good, but not great. Also, declining expectations in terms of interest rates have attracted buyers for
assets which had been temporarily on the sidelines. As expectations for global growth seem to cool, REITs are positioned for an almost ideal environment: not enough growth to generate much new construction, but just enough to generate rental growth. The
one downside we are actively monitoring is on the expense side, especially for labour and real estate taxes. We are mindful of sectors with lower margins and lower pricing power. Two examples that do not rank very well according to these metrics are the senior housing and lodging segments.”
“It is notable that March 2019 marks the 10th anniversary of the GFC-induced share market trough. Put another way, we are 10 years into the recovery and, perhaps not surprisingly, concerns are rising given the 3 month/10 year US treasury yield curve inverting (a traditional signal of an impending recession) and the typical 7 to 10 year duration of economic cycles.
This time last year improving global economic growth and expectations of rising interest rates was encouraging rotation out of defensives and REITs were expected to struggle. Yet the global REIT index has delivered a total return of 16.2%1 in A$ Hedged terms over the past 12 months, surpassing global shares at 6.7%2.
Our own expectations of more moderate returns from the sector have been too early. As we have stated in the past, this does not mean we have a negative view. In fact REITs broadly remain in good shape with solid balance sheets, property development volumes not excessive and management teams disciplined late into this cycle.
Tenant credit remains our greatest concern at this point. Low interest rates are potentially keeping marginal tenants in business, and every cycle sees the rise and fall of corporations built on a mix of hubris, fraud, complacency or fundamentally flawed strategies (think Enron, Centro, Theranos, etc). Nevertheless, we believe REITs have broadly improved their resilience through this cycle, pruning weaker assets and greatly improving capital structures to weather future challenges.
While the value that emerged after last quarter’s sell-off has dissipated with the subsequent rebound this quarter, we maintain that REITs, with long-term contractual cash flows from a broad cross-section of the economy and backed by tangible assets, represent an effective means of diversification within a broad investment portfolio.”
Fixed Income Managers
Amundi, global multi-sector bonds
“The economic outlook is still positive but with a synchronised global economic slowdown. Central banks have recently used a more dovish tone and the probability of a rate hike in the US this year is low. March also saw further monetary policy softening as the European Central Bank announced a new targeted longer-term refinancing operations (TLTRO) program. Inflation may materialise in some areas, but it is expected to remain subdued at a global level, due to slower global demand. Geopolitical issues and the turmoil linked to the escalation of trade tensions remain, even if there have been some signs of appeasement between China and the US in trade talks.
The recent extension of the Brexit deadline has been positive for the British pound as well as Gilts and has reduced overall risk across the markets, especially now that a no-deal Brexit is off the table. Within emerging markets, there have been sizeable inflows. Within currencies, we expect the US dollar and Japanese yen to remain the safe haven currencies of choice while the euro is likely to see some weakness over the coming months as investors assess the scale of the European growth slowdown.”
Antares, Australian bonds
“Cyclical and structural issues continue to intersect posing challenges for policymakers, institutions and markets alike. Some resolution is the US-China trade tensions should be forthcoming even if tokenistic. This will help buoy risk markets further, amplifying the already stimulatory work the Chinese authorities have undertaken. It remains to be seen whether this stimulus will have as pronounced an effect on global trade and growth as did the 2016 round of reflationary policies.
To this end we are likely to see a greater emphasis on reflationary policies from central banks, including the US Fed, European Central Bank (ECB) and RBA. The Fed has already alluded to a more symmetrical inflation target which would imply targeting an inflation overshoot before policy rate tightening would be considered again. In a similar vein the RBA will be pressured to address its persistent inflation undershoot, given realised inflation has almost consistently been either at or below the lower bound of its inflation target for over 2 years.
As reflationary policies are pursued, central banks like the Fed will be looking to reassert their independence, which is being openly challenged recently. These pressures are unlikely to abate in the short- term given a politically charged and populist climate that has become anti-establishment and anti-economic orthodoxy.”
BNP Paribas Asset Management, global absolute return bonds
“In summary, the world is probably OK. Recession risk is there, but looks less today than it did in December. There are definitely clouds to surround the silver linings if you go looking for them, and it is absolutely a problem that market volatility is very low, and spreads tight: when these go, they could really go - as they did in quarter 4.
So where does that leave us? We think, well placed for the rest of the year. With rates as low as they are, unless you believe we are staring down the barrel of a recession, higher rates and somewhat higher volatility look like reasonable bets. It follows that the simple beta of fixed income – index exposure – may be rather less friendly later in the year than it has been in quarter 1.”
Insight, global absolute return bonds and government bonds
“Global central banks have moved from relatively hawkish to relatively dovish. This has been in response to disappointing economic data. In the US we are not convinced that this is more of a mid-cycle slowdown than an end-of-cycle slowdown. We are not convinced therefore that the next interest rate move will be a cut, but we could be in for a lengthy pause. In Europe, economic data in manufacturing sectors has been deteriorating, although services indicators have held up well. With the ECB’s deposit rate at -0.4%, the region will have limited monetary firepower to counter a downturn meaning the ECB will need to enact measures such as tiered deposit rates. Meanwhile risk assets could come under pressure as corporate earnings growth flat lines, or even reverses, given economic headwinds.”
Muzinich, global high yield bonds
“The key question for fixed income investors is generally two-fold – what is the outlook for rates and what is the outlook for credit? Global central banks have already answered the first question in the short- term. They will largely remain highly accommodative, meaning we see little headwinds from rates short-term. Longer-term, the direction of rates will depend on the strength of the economy. The other issue is credit. What is the chance companies will default? Defaults typically increase in weak economic environments, particularly when companies have taken on excessive debt and that debt is coming due and in need of refinancing. Default rates are currently at all-time lows and while we do believe they will likely move modestly higher from here, we also believe they will generally remain low as companies are able to meet their debt obligati