Markets priced for optimism


Much has been said about the impressive returns most investors have enjoyed over the 2020/21 financial year. A year ago, few would have even countenanced the possibility that returns could be this strong. For context, Australian equities (ASX200) returned 27.8% for the financial year, which was a relatively modest outcome when compared to local currency returns from US equities (42.5%) and emerging markets (36.5%). Equity returns in Australia though were broadly in line with Europe and Japan. The strength in equities was reflected across the capital structure with credit markets also performing strongly.

On one level, the strength in asset prices still seems counterintuitive. As the financial year in Australia ends, half the Australian population is in lockdown, and the biggest proportion that isn’t in lockdown (Victoria) has just emerged. Our borders remain effectively closed and the news cycle can’t escape the COVID tally, the problematic vaccination roll-out and the struggling small business sector. Globally, the challenges in combatting the virus and re-opening to a “COVID-normal” status remain confronting – although countries are pushing ahead with more aggressive re-opening timetables.

The bigger story for markets has been liquidity – and more particularly, a world awash with it. This liquidity has been created by both governments, through wartime-like fiscal largesse, and central banks that have re-written the playbook when it comes to how far and how wide they can go to combat a crisis. Economic activity has rebounded off a very low base in Q2 2020 and company profits have also responded. Levels of activity and profits are now back (broadly) to where they were pre-COVID, but policy settings remain broadly where they were when the crisis was at its deepest. The liquidity taps remain on.

As always, extrapolation of recent performance (the ‘recency effect’) is dangerous. Amid the cheering on of the stellar market returns of the last financial year, it’s worth remembering that the returns from Australian equities for the 2019/20 financial year were -7.7%, putting the recovery into context. Also worth noting is that the 2020/21 return from Australian equities was the highest since the 1986/87 financial year, the financial year that immediately preceded the 1987 stock market crash. This is not to say that a crash is imminent, rather a reminder that markets have a habit of catching investors out – particularly complacent ones.

Taking stock

Against this, it is worth reviewing our current thinking and what it might mean going forward.

As alluded to above, there is a looming mismatch between policy settings and the business cycle. While central banks (including the Reserve Bank of Australia [RBA] and the US Federal Reserve) have laid out a timeline for rates and tapering, to the extent that this mismatch is flagging inflation risk, this timetable could well be brought forward. Central banks have been known to change course as events dictate. While central banks would welcome some inflation, it’s a fine line between the right amount and too much. This is why the inflation debate is such an important one at present. The market consensus is that current upside surprises are temporary, reflecting the re-opening effect and pressure on supply chains. If it turns out to be more permanent, then interest rates and stimulus – the fuel of the recovery so far – will need to be reset.

Another point to note is that compared with a year ago, markets are pricing an exceptionally optimistic outlook. Credit spreads are very narrow (with limited room for further compression) and while earnings have come through to support elevated equity multiples, most still suggest expensive valuations consistent with modest future returns. Starting point valuations matter.

As suggested above, none of this implies that a sharp adjustment is imminent, but it does imply future returns are most likely going to be moderate and the risks of adjustment should not be dismissed. While credit returns are mathematically constrained, equities still have the potential to move upwards. Valuations are clearly full and shouldn’t be ignored – but on the other hand, economic growth, corporate profits and liquidity conditions continue to be supportive.

Portfolio changes

Reflecting these cross currents, we moderately increased our risk asset exposure in June, taking equities to a target exposure of 27% and adding around 2% to credit (split between US high yield and US investment grade exposures). The latter move was more aimed at capturing credit carry than looking for material upside. The other change to the portfolio was to reduce foreign currency exposure after the AUD declined to around USD 0.75 from USD 0.77 over the month. Overall, we continue to tread a path that seeks to remain in markets as long as possible, but that recognises the good news is well reflected in pricing and the path forward could be quite choppy.

Equities

Global equities returned 2.4% in local currency terms during June, while the Australian market performed in line with a return of 2.3%. Falling longer end yields resulted in growth stocks outperforming value stocks by almost 6% in June, a reversal of the trend that we have seen year to date. This divergence in factor performance was also reflected at the sector level, with the technology sector producing the strongest returns, while more value-oriented sectors such as financials and materials underperformed, both in Australia and globally. Despite this sharp reversal, value stocks have still outperformed growth year-to-date. Emerging markets were broadly flat, delivering a return of 0.2% in USD terms, hampered by a stronger US dollar. Over the quarter, Australian equities returned 8.3%, global equities returned 7.6% and emerging market equities returned 5.0%. Globally, a group of 130 countries agreed to a global minimum corporate tax rate, which is expected to be at least 15%. Previous research suggests that this is likely to have a negative impact on corporate profits at the margin for the overall market, but could be more of a headwind for sectors such as technology.

At the start of June, we increased our target equities exposure by 2%, bringing the portfolio to a 27% allocation. We raised exposure emerging market equities as recent underperformance has improved relative value and we also increased our broad developed market exposure. Additionally, we continued to roll out our put protection strategies which provided protection to the portfolio from shallow drops of around 3% to 13% from current levels for zero premium.

Fixed income

As inflation numbers in the US surprised on the upside, a more hawkish comments from the US Federal Reserve (FED) saw yield curve flattening in the US as yields on short dated bonds increased but yields on longer dated maturities fell. This also brought forward expectations around when the FED may taper its quantitative easing (QE) program. The Australian bond market followed the US and saw a similar degree of yield curve flattening through the month. Locally, stronger jobs data and the continued rise in house prices around Australia, saw the RBA respond by reducing its bond buying from $5 billion per week, back to $4 billion per week. Credit spreads tightened in both Australian and global investment grade credit, but the largest spread tightening was in the high yielding market, where spreads are now below post GFC lows.

We maintain a low duration exposure in the fund of 0.75yrs at the portfolio level. In credit, we removed our investment grade and high yield derivative hedges – which in effect increased our credit exposure by 2%. This is aimed at providing the portfolio with some additional carry on a more tactical basis. While credit spreads are extremely tight, as earnings improve, net leverage is also improving and default rates continue to fall, which provides support for the carry environment to continue.

Currencies

The US dollar (USD) rallied sharply in June as higher than expected inflation saw expectations of FED policy tightening brought forward into 2023. This resulted in sharp falls of around 3% in the Australian dollar (AUD) and the Euro (EUR) against the USD, while the British Pound also fell by 2.7% against the USD. The Japanese yen (JPY) fared moderately better, but still weakened by 1.4% against the USD.

The weaker AUD provided us with an opportunity to reduce the portfolio’s foreign currency exposure. We trimmed the portfolio’s currency exposure by 5% in the month, primarily cutting our EUR and JPY exposure, which are markets where we think central bank hawkishness and tightening is unlikely to occur. We still maintain a moderate amount of currency (12.5%) in the portfolio, primarily through the USD and emerging market currencies.

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