Investing in reality over one version of the future

Markets were dominated by geopolitical events in May, driving volatility over the month. The biggest impact came from Italy where the reverberations from the March 4 election continue. A power struggle between the Eurosceptic populists — strong performers during the March election — and the President saw fears rise of another election and the potential of a populist win. This led markets to price in the risk of an Italian departure from the European Union.

The US administration was also at the epicentre of the political uncertainties. With the US-China trade dispute, the US withdrawal from the Iran nuclear deal, and negotiations around an historic meeting with North Korea's Kim Jong-Un adding to the uncertainty. 

These concerns were felt most significantly in bond markets. After rising sharply in early May, global bond yields ended the month lower as events in Italy led to a 'flight to quality'. US 10-year Treasury yields initially rose by 0.18% to 3.13% before ending at 2.86% — a fall of 0.09% over the month. Both German and Japanese 10-year government bond yields also fell, with German bonds more impacted by issues in Italy. Italian 10-year bonds fully reflected the market’s fears with yields rising by 1.0% over the month. Credit spreads in both investment grade and high yield widened slightly over the same period. Notwithstanding this volatility, equity markets had a reasonable month with US and Australian equities gaining ground. It was tougher going in Europe though, as the concerns around Italy weighed on confidence. 

The Real Return Strategy posted a small negative return in May. The biggest drag on returns during the month was security selection in the active equity strategies, which accounted for around two thirds of the negative return during the month. This in turn largely reflected the ongoing “growth” thematic that has been a key driver of recent equity performance, and a thematic we think has largely run its course. Modest gains in the Australian dollar, modestly wider credit spreads and a bounce in A-REITs on the back of developments in Westfield were also modest detractors.  

At a recent investment conference I was challenged regarding our preference for Australian equities over global equities on a one- to three-year horizon. The overwhelming consensus in what was a relatively large room was that global equities were likely to be the best performing asset class over that timeframe, and that Australian equities would struggle. I defended our position arguing we partly preferred Australian equities specifically because the consensus was the other way inclined (the consensus isn’t typically right). While somewhat tongue in cheek, there is an element of this in our thinking. More fundamentally though, the key reason for our preference for Australian equities is that they look reasonable value in both absolute terms and relative to the global equity market. This generally translates through to better return prospects over the medium to longer term. To be clear, our valuation concerns with respect to global equities are mainly related to the US market, with the other major markets offering more favourable valuation support. This is important though as the US still comprises around 50% of the key global equity benchmark indices as well as being the tone-setter in the shorter term.

The table below highlights this clearly. Across a range of metrics, the Australian market is trading on a much less demanding multiple than the key US market.

 Source: Datastream, MSCI and Schroders. Based on MSCI indices from 1970 to April 2018 (and 1975 for Price to Book Ratio).

The reasons for this are partly compositional. The stocks that have been driving US multiples up are technology-related stocks where investors have been prepared to pay up for future potential growth. This may or may not be the case, but certainly current pricing requires some pretty solid earnings outcomes to validate them. In contrast, Australian stocks have been somewhat unloved. While earnings growth has rebounded in Australia in recent years, much of this has come from resources, which are clearly much more cyclical than the US growth stocks that have been attracting all the attention and investor demand. That said, even conservative assumptions around commodity prices suggest decent and sustainable earnings from the major commodity producers. Another factor that has clearly held back the Australian stock market has been the banks. Australian banks represent 26% of the ASX200 and have been challenged by a potentially structural softening in credit growth, concern about the housing sector, and more recently, the focus and publicity of the Banking Royal Commission. Given the recent poor performance of banks, much of the potential downside appears priced.

To be clear, short-run correlations between equity markets are likely to remain high. If our concerns about the US are validated, then at some point we will see a significant retracement in US stock prices and other markets, including Australia, will be dragged along. However, looking through this, we would rather own the market that has underperformed and has a more negative view priced in, then one that is arguably still priced for something close to perfection. None of this takes into account the higher dividend yields and franking benefits for Australian investors.

The above is reflected in the portfolio. We have more Australian equity exposure than we do global equity and with some short US S&P futures positions and some S&P put options have only a low, single digit effective exposure to the US. We also recognise that the US will have a big impact on the broader direction of markets and this is why our aggregate equity exposure is on the modest side. While the broader cycle in risk assets may not be over yet, we are much closer to the end than the beginning.

We did make a couple of changes to the portfolio in May. In early May, before the European concerns erupted, we closed the short Bund (German bond) versus US Treasury position given growing uncertainty over European growth and policy and we added a long Nikkei (Japanese equity) futures position given reasonable return prospects for Japanese equities.