Managing chronic anaemia

We have been defensively positioned for some time as we have consistently argued that generally extended valuations left little upside for investors and that capital preservation was paramount. Adding “risk” in the form of more volatile assets (like equities) was unlikely to be rewarded and would only increase volatility and expose the portfolio to unwarranted downside risks.

While there have been exceptions across the year as a whole, most assets produced fairly anaemic results for investors in 2015.

Australian equities for example returned a meagre 2.6%, the same return as Australian bonds and not far away from Australian cash at 2.3%. In the case of Australian equities this outcome masked significant sectorial divergence with materials down -15.7% and oil & gas producers –27.3%.  In contrast, the more financially leveraged parts of the market such as A-REIT’s performed strongly, defying our more bearish predictions to return 14.3%.

In aggregate terms global assets produced equally disappointing outcomes. Global equities returned 2.1% in local currency terms. Significantly though the equity markets that bucked the trend in 2015 (core Europe and Japan) were those where direct central bank support in terms of ongoing QE programs remain in place. It is also worth noting that for these markets it was a year of 2 parts – gains occurring in the first half of the year before giving way in the second half. For the US, where the QE tap has been turned off, returns were a meagre 1.4%. Emerging market equities generally had a tough time declining -14.9% in USD terms over the year. From a thematic perspective it was primarily growth and momentum (and increasingly the latter) that dominated with value being largely ignored.

For global debt assets it was also a tough year. US Treasury yields ground higher (more so at the front end of the curve) while credit spreads (in both the investment grade and high yield space) moved higher reflecting a combination of factors including developments in the energy sector and deteriorating corporate fundamentals.

The other notable feature of 2015 has been the increase in asset volatility across the risk curve. While the influences on individual asset classes vary, there were some common themes:

  • Moderating growth in China – the structural driver of the global economy for many years wreaked havoc on commodity prices and the share prices of commodity producers (eg. BHP) as well as  contributing to growing uncertainty around monetary policy;
  • Oil prices collapsing - adding to this has been the collapse in the oil price as OPEC remained on the sidelines with regards to supply controls which suppressed headline inflation metrics and in the markets, raised the risk of broad based price deflation;
  • Flagging global growth - anaemic global industrial production data added to uncertainty about the underlying health of the global economy;
  • The Fed ‘lift off’ - the growing consensus that the US Federal Reserve would lift rates for the first time in almost a decade on the back of consistently positive US labour market data (delivered in December); and
  • Stretched valuations - significantly these broadly mixed macro-economic factors were impacting against a backdrop of relatively extended structural valuations (particularly in the US sovereign bond and US equity markets).

Outlook and strategy

We enter 2016 faced with familiar challenges. While returns have been anaemic, increased volatility has not been sufficient to reset prospective returns to levels that would make us interested in deploying cash and taking more risk. In short, our return expectations for the major asset classes are not materially different to where they were a year ago and as a consequence, Strategy positioning is also not materially different to how it was a year ago.

To be more specific:

  • We believe the momentum trade that has been driving markets has its limits. Value will ultimately reassert, and the markets that have been most ignored as momentum has dominated will swing back in favour. To this end Australian equities remain our preferred “major” equity market as it has been a victim primarily of its close correlation to China and the slide in commodity prices. While it’s difficult to know how much further this has to play out, with BHP shares down 61% since their peak in 2011, we would argue that the downturn in commodities is significantly in the price.
  • Conversely, our least preferred “major” equity market remains the US, mainly because we view structural valuations as extended and see this as a market holding on to the crutch of central bank support. After adjusting for the S&P put option position we have in place, our delta adjusted exposure to US equities is close to zero.
  • While our medium term (3 year) return projections suggest decent returns in prospect from Australian equities, the anaemic outlook for the broader global share market means our overall equity exposure remains low. This is because in the short run we expect these broader global influences to dominate. Furthermore, as equity markets rarely move in straight lines, the repricing of an adequate risk premium across the mainstream global markets will likely occur through a relatively rapid price adjustment.
  • We have been relatively active in adjusting our credit exposure over the last 12-18 months, mainly within the high yield segment. After effectively cutting our global high yield exposure to 0% in mid-2014 as spreads narrowed significantly, we added back some of this exposure as spreads widened post the oil price collapse and have further increased this position as Fed/China induced market volatility pushed spreads wider. While at 4%, our current exposure is not large despite relatively wide spreads by recent standards, and we would prefer to see wider spreads before adding to this position. This is consistent with the arguments outlined above regarding equities in that higher yielding credit would be caught up in any broad based risk asset re-pricing. Caution is still warranted.
  • In terms of sovereign bonds, it has been a choppy year with yields in key markets ending the year flat/slightly higher than where they began. We remain of the view that sovereign bond risk is structurally mispriced (2% Treasury yields against an economy growing at 4.5[(-5) was not found] nominal) is out of line, and we believe that is what the Fed is effectively saying by nudging official rates higher. While we are maintaining some duration as a deflation / downside risk hedge, we are cautious overall on sovereign bond risk.
  • Despite our view above that the commodity rout is significantly priced into equity markets, we do not believe this is the case with currencies – especially the Australian dollar. We still believe “fair-value” for the Australian dollar is in the 60’s and with currencies typically overshooting we expect further downside in 2016. We remain long the FX (predominately the USD) as a result.

So what are the risks?

The following is not an exhaustive list but broadly encapsulates where we are focussing:

  • There are a whole host of geo-political factors at play at present (oil, Saudi-Arabia/Iran, Russia, ISIL… the list goes on). While we could speculate on how these may play out the relevant point is that markets generally are not well positioned from a valuation perspective to withstand a significant geo-political shock. This is in part why we still like cash in the current environment.
  • One of the key things we are watching is US inflation. This is relevant as we believe it will be the key determinant of the course of US Fed policy. Our analysis of US inflation suggests a broadly benign, but rising trend in core US inflation in 2016 on the back of labour market tightness and a stabilisation in more temporary and volatile factors like oil. While this view is consistent with that outlined by the Fed, it is not the consensus. We believe any pick-up in US inflation could rattle markets as it shifts market expectations away from limited and slow Fed policy adjustments to something more significant. This scenario would be bad for both bonds and equities and potentially be the catalyst for the broader risk asset repricing we are anticipating.
  • China remains deeply uncertain as the economy adjusts. While we expect a hard landing to be avoided given the deep pockets of Chinese policy makers, a more material slowdown than the one currently underway can’t be ruled out. Of course this works both ways. It is entirely possible that China could surprise the pessimists and produce better outcomes than the consensus currently envisages.

The bottom-line is that the world is, as always, uncertain. At the core of our process is a belief that value is created and risk best managed by paying attention to valuations. To this end we continue to believe that until risk premia rebuild, caution needs to prevail. This is likely to mean another tough year for investors. Our current positioning reflects this.

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