11 October 2024
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As noted in our last quarterly update, at the start of 2013 we were positive on equities globally believing that they would again deliver outperformance in the year ahead. Despite this optimism, the extent of the rally since the start of the year in most equity markets outside of Europe was somewhat surprising given the previous negative reactions to macro issues like the renewed euro zone instability following inconclusive Italian elections and the bailout deal in Cyprus. Perhaps investors are finally getting more comfortable with the notion that central bank policy has indeed reduced the possibility of an extreme outcome in Europe leading to contagion, and that economic conditions in other parts of the world are slowly improving.
The MSCI World index (USD) was up 7.2% and the S&P 500 gained 10% to end the quarter at a new all-time high. Japan was again the standout market with the Nikkei 225 gaining 19.3% on anticipation of further monetary policy easing. Locally the ASX300 was up a more modest 6.7%, weighed down by the heavyweight Materials sector which lost 9.5% on concerns around moderating Chinese growth and weaker commodity prices.
Against the backdrop of a broader risk rally and the decreasing likelihood of further rate cuts by the RBA, the Australian fixed income market was broadly flat over the quarter with the UBS Composite Bond Index returning 0.13%. Despite weaker commodity prices and deteriorating terms of trade, the AUD remained frustratingly resilient given our unhedged international exposures, gaining +0.2% against the USD and +2.6% on a trade-weighted basis.
So have our views changed at all since last quarter following recent market movements? No. From a tactical asset allocation standpoint, across the more conservative diversified portfolios we remain broadly overweight Australian equities and fixed income while being underweight cash. Across the more balanced diversified portfolios we remain overweight both Australian and International equities while being underweight cash and fixed income.
While equities are now probably fair value on an absolute basis following the P/E rerating over the past nine months, the relative valuation appeal of equities versus government / corporate bonds and cash remain attractive. Admittedly a recovery in earnings – especially domestically where the recovery has lagged – is necessary if the rally is to continue. Following the most recent reporting season it does seem that earnings have bottomed, and that the required earnings growth is coming. Outlook comments by company managements appear to be improving, with a rising trend in the number of positive relative to negative outlook statements. Importantly, this improvement in the outlook is being backed up by rising dividends suggesting companies are confident that there will be an upturn in the profit cycle. Another key development to emerge from the recent reporting season was the increasing focus on cost saving programs across the market. As has proven to the case in the US, this focus will likely be supportive of future earnings growth, perhaps more than some analysts expect.
Despite our generally positive view on equities, some of the largest sectors in the Australian market (e.g. Banks, Food & Retail and Real Estate) have enjoyed fantastic returns as investors focused on stocks offering high dividend yields and earnings stability. Given the subdued growth outlook for companies in these sectors, on traditional valuation measures many of these stocks are now trading very close to or in some instances even above what we deem fair value. As such a repeat of the performances enjoyed is very unlikely. The Materials sector on the other hand has underperformed dismally as noted earlier, and at current valuation levels appears to be offering more compelling upside.
This positive view on the Materials sector is based on an acknowledgement that commodity prices have peaked, but also the expectation that costs and capital expenditure have too, and that volumes are rising (a driver of the declining future prices). If our expectations prove correct, this should result in an increase in free cash flow, allowing increased cash returns to investors going forward. Our preferred exposures are to companies with existing production, low cost positions relative to industry norms and strong balance sheets, which will enable them to withstand lower commodity prices.
Unfortunately, if we are right with respect to where value lies in the local market, based on research by Nomura, many investors may miss out on the next leg of the rally as market leadership changes due to household’s existing exposure to Australian bank shares as shown below:
Finally, a caution to those yield hungry investors looking to hybrids as an alternative to cash – be aware of the risks being taken. With the new bank hybrid issues which have been popular with retail investors, certainty of income is lower than with previous issues as coupon payments are required to be discretionary and non-cumulative. At the same time, the most recent Basel III regulations allow the regulator to mandatorily instruct hybrids to be written off or converted to equity under specific conditions, thus reducing the certainty of full capital repayment. Please note that we are certainly not suggesting that coupon payments will not be made or capital not returned, but are simply highlighting that these instruments must not be viewed as cash alternatives that offer guaranteed income and capital stability. The higher yield is compensation for the greater risk assumed.
As regards our fixed income allocations, with yields still at very low levels versus historic norms, and our view that rates are more likely to rise than fall from current levels, our exposure remains via floating rate Corporate credit rather than fixed rate Government and semi-Government debt. This is because fixed rate bonds provide direct exposure to interest rates – when interest rates rise, fixed rate bond prices fall and vice-versa. The prices of floating rate notes are not similarly impacted by changes in interest rates.
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