James Syme (pictured) is a London-based senior fund manager with Pendal subsidiary J O Hambro.

There are two broad drivers of the emerging market equity asset class: global growth and US dollar liquidity. This update serves to point out that neither of these drivers is showing any sign of being supportive, but also that a robust investment process and differentiated portfolio can still find opportunities in the asset class.

Global growth is sick and failing to respond to treatment because no treatment has been applied. In the developed world, the US has seen the weakest ISM manufacturing survey in 10 years as well as weakness in the crucial services data, while eurozone 2019 real GDP growth forecasts have been steadily revised down to the current level of just 1.1%.

In the emerging world, recent Chinese data has been particularly soft, with fixed asset investment (+5.5% year-on-year), retail sales (+7.5% year-on-year), industrial production (+4.4% year-on-year) and exports (-1.0% year-on- year) all coming in both low and below expectations.

Exports and the dollar

The exports of the most cyclically-exposed emerging economies tell a similar story, with Korean exports -11.7% and Taiwanese exports -4.6% in the year to September. Meanwhile, the inherent strengths of the US economy relative to the rest of the world, combined with the asymmetric impact of the trade war, have kept investors more optimistic about US assets and/or more pessimistic about the need to have sufficient US dollar-denominated assets. This has happened despite the enormous increase in the US fiscal deficit (federal government gross issuance will be around US$11.3 trillion in FY2019, up from around US$10 trillion in FY2018, with the majority of that issuance at maturities of six months or less), which represents a huge drain on global dollar liquidity.

The net effect of this has been a resumption of the uptrend in the US dollar relative to other global currencies that began in 2011. The slide in growth and tight liquidity have been transmitted into emerging economies, with negative GDP growth revisions in almost all of the 26 emerging market economies during 2019. Even previous areas of strength, such as India, Pakistan and Thailand, have been caught up in the slowdown, with the 2019 GDP growth estimate revised down 0.8% in India, 1.2% in Pakistan and 0.8% in Thailand. Global conditions remain tough.

Country focus yields opportunity

Our investment process is designed to seek opportunity, principally at the country level, and we have found various areas of opportunity through our process this year. One would be areas where GDP growth estimates have held firm, including Eastern Europe, where aggregate GDP revisions are about flat year-to-date. We have held some exposure in the Czech Republic, which has been a slight laggard, and considerably more in Russia, which has substantially outperformed.

Another source of opportunity is in the pricing (both equity and currency) of these macro conditions. Even where growth is weakening, panicking investors can drive valuations to levels that overstate the challenging fundamentals, and we aim, through a disciplined monthly review, to identify these opportunities.

One such opportunity has been Turkey. With 2019 GDP growth revisions of -1.5%, Turkey has been the second-weakest of all emerging economies year-to-date (Brazil, at -1.6%, is in last place). However, in May the pricing of that slowdown became wildly excessive and the Turkish stocks we bought at the end of that month have very substantially outperformed (and, importantly, have actually made money for investors). Interestingly, Turkey’s 2019 GDP growth estimate has in fact been revised up since the end of May, suggesting that the worst of the selling pressure (and the greatest opportunity for us) was right before the turn. Most, perhaps all, investing is a trade-off between fundamentals and valuation, and we look to use both to identify top-down, country-level opportunities in EM equity, no matter how good or bad the global environment is at that moment.

Fund Manager commentary for the month and quarter ended 30 June 2019 covering market reviews, Pendal fund performance and our outlook for the period ahead.

 

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Equity markets, particularly in the US, have been in a well-established bull run accompanied with very low levels of volatility. In fact, the S&P 500 had not experienced a greater than 5% drawdown over the 18 months to January 2018. This bull market has been facilitated by concerted efforts from central banks to provide freely flowing liquidity. After such a long cycle it is not unusual to see a spike in market volatility as investors’ sensitivity is heightened in anticipation of a change.  We saw this in early February, with the catalyst being a jump in inflation expectations in the US.

The following provides thoughts from each of our investment boutique heads on the implications for markets and how they are responding.

 

Australian equities

The Australian market’s fall in early February reflected an adjustment in relative valuations with the US, rather than concerns specific to our market. There are also signs that the selling was exacerbated by some investors scrambling to unwind their low-volatility positions. Despite this, the size of the decline was lower than for the US, given Australia’s more defensive character. These falls were followed by a reasonable rebound, resulting in a 0.3% return from Australian shares for the month of February.

The recent company reporting season revealed quite a different scenario. Earnings growth for industrial companies, in aggregate, was around 9% which exceeded market estimates and we have seen a net upgrade to consensus forward earnings expectations. It is earnings growth that has driven the market’s returns over the past year. A number of companies have reported resilient operating conditions and we expect earnings growth of mid-single digits this year. Add the return from dividends and we can expect to so total returns in the high single digits for the year.

We believe the market’s rating will be supported at current levels, which is underpinned by several factors:

•   Valuations are not excessive. The 12-month forward P/E for the S&P/ASX200 is slightly higher than its historical average, but consistent with the low interest rate environment with the RBA showing no indication of a material policy shift in the near term.

•  There is no sign of a recession. Australian growth remains muted, however tailwinds are emerging, such as the rise in corporate capital expenditure and the large pipeline of infrastructure. In combination with a small pick-up in mining investment and a housing slowdown which remains moderate and controlled, we think the Australian economic outlook remains reasonable.

•  Inflation in Australia remains benign. The monetary conditions in the US do not reflect the situation in Australia, where inflation remains muted and the RBA has given no indication of aggressive hiking.

•  Liquidity withdrawal remains modest. The withdrawal of liquidity from the equity market as a result of central bank actions does present a risk to valuations over the medium term. However, we expect this trend to be moderate globally. The US economy has displayed a historical sensitivity to bond yields and we would expect the Fed to temper their tightening efforts if there are signs of an inordinately adverse effect on growth.

 

“Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point.”
Crispin Murray, Head of Australian Equity Strategies

As active managers, market volatility creates mis-pricing – and more mis-pricing means more opportunities. Any change in volatility does not typically change our fundamental view of the market and where we see compelling investments. For example, at the moment we see the disruption of long-standing industry structures and business models as a key area of opportunity. Likewise, we also hold some previously unloved stocks where we think the market has not yet appreciated a turnaround in earnings. We also see some opportunity among those growth stocks which have not been pushed to challenging valuations. Bouts of volatility can provide the opportunity to pick up stocks we like at an attractive buying point and our large and experienced team looks to take advantage of these moments as they occur.

 

Global equities

The US earnings season commenced in late January and indications to date show no material shift in the operating environment for industrial companies. According to data based on 90% of S&P500 companies that reported quarterly earnings, 79% of those exceeded the market’s consensus estimates. The group has on average delivered 14.9% earnings growth over the prior period and commentary from management has been generally favourable.  Against this backdrop it is difficult to call the February correction in share prices as anything other than a realignment of valuations. The fundamentals of a bear market are just not there.

“Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates.”
Ashley Pittard, Head of Global Equities

We take the proposition of higher interest rates in the US this year as a given, and inflation will find its way in a lagging fashion. Returns from global equities are likely to remain positive this year, although we expect a greater degree of divergence in fortunes across markets and geographies. In broad terms we expect:

•  A story of two halves – Global equity markets are likely to experience a strong first half, buoyed by strengthening economies and the broad-ranging boost of Trump’s corporate tax cuts and incentives. These conditions are likely to force the hand of the Fed and interest rates will rise ahead of market expectations for the year and weigh on equities. Hence, returns should be similar to their longer term average.

•  US and European companies are well placed to continue to do well – Earnings reports are continuing to show that companies are operating well. Europe has entered their earnings season and given the synchronised growth globally for the first time in a decade, European corporates should deliver similar aggregate results to their US counterparts.

•  Aussie dollar stability – The Australian dollar is likely to be range-bound in the US$0.75-80 band as we have seen over the past five years, which shouldn’t have a material impact on returns from global equities.

•  Market valuations in select areas to remain attractive – Although the market has rallied, certain industries remain fundamentally attractive. Consider that US banks are trading below 1.3x book value, while pharmaceuticals are on an unchallenging PE ratio of 10x.

What is more of interest to us is balancing the assessment of companies that are achieving operational excellence and are using the buoyant economic conditions to generate strong cashflow. Rather than be concerned over higher future interest rates, we would seriously question the quality of companies that have not taken advantage of ultra-low interest rates to skilfully deploy capital and grow their businesses. We give merit to companies that have shown the ability to command a dominant position in their industry. They are much better placed to show resilience in varied market conditions.

 

Bond markets

Over the past year the market has been focusing on forward indicators of consumer sentiment and US economic growth such as manufacturing and services sector outputs to support expectations of economic growth. These have been in a generally positive trend over the past few years, however, consensus expectations of higher inflation have failed to materialise. We think that inflation will surprise on the upside this year but we are weary of expecting too much of a rise until we see sustained wages growth coming through. Pent-up expectations to seize upon the first signs of inflation was taken by the market as a precursor to inflation rising from stagnant levels.

 “We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes.”
Vimal Gor, Head of Income & Fixed Interest

Whether a benign inflation outcome can continue is the subject of much debate. We are cautious of expecting any meaningful pick-up in inflation until we see the whites of its eyes. What is of significance to markets is if central banks expect inflation to pick up and continue to unwind their unprecedented monetary stimulus. This is a real possibility in the US given that there are two major fiscal forces now in play – company tax cuts and an extension of the debt ceiling. It is exactly the wrong time to be adding stimulus when the economy is running at near full capacity. We believe this will force the hand of the Federal Reserve to counter the inflationary impact, which will be negative for bond yields as the yield curve steepens. The risk then arises that this compensatory tightening will lead to recession in late 2018 or in 2019.

In the shorter term, we expect:
•  Higher volatility for both equity and bond markets – Historically, heightened inflation expectations have been followed by a pattern of higher market volatility. 

•  Investment grade credit to outperform sovereign and high yield debt – Segments that benefitted strongly from the global wave of liquidity are now the most vulnerable areas of the credit world. This includes certain emerging market sovereigns and high yield corporates. An unwinding of favourable market conditions may be particularly unkind to these areas versus more structurally resilient investment grade credit.

•  Australian inflation to lag the US – Inflation in Australia will surprise on the downside. Hence, the RBA will need to closely watch unemployment and wages growth before it can consider any pre-emptive strike against inflation. We find it difficult to build a scenario where the cash rate rises while wages languish and spare capacity remains.

Looking more broadly, the easy financial conditions and fiscal support from the past decade have left a legacy of debt, which raises concerns over financial stability and ultimately results in higher levels of market volatility going forward. We are positioned to capitalise on this environment with tactical exposures to investment grade credit.

 

Asset allocation

It is important to put bouts of market volatility into context. Markets have experienced strong gains in the last few years so a correction like the episode in February was inevitable. However, what market volatility does illustrate is the importance of a well-diversified portfolio. While equities are a critical component in delivering long-term growth to a portfolio, this exposure needs to be balanced by assets that are diversifying – bonds, foreign exchange exposure and alternatives can all help to stabilise returns.

“One interesting feature of the recent sell-off is that bonds, in general, failed to provide a cushion against market volatility.”
Michael Blayney, Head of Multi Asset

Each episode of market volatility is different. For example, in the global financial crisis the correction was led by credit, with equities following and government bonds providing capital gains to help insulate portfolios. One interesting feature of the sell-off (although a very small correction compared to the GFC) is that bonds, in general, failed to provide a cushion against market volatility.

In a “normal” equity market sell-off, government bonds benefit from a ‘flight to quality’ effect, as investor demand for bonds increases. As the most recent volatility was initially triggered by fears of inflation and rising interest rates (poor conditions for bonds) this caused US bonds to sell off (with Australian bonds mixed depending on the term). The reaction in credit markets lagged equities, and while spreads widened, eventually there was no sign of panic, with investors exhibiting greater focus on strong underlying corporate fundamentals than shorter term equity market volatility.

While we believe that bonds are an important component of a portfolio, this instance of market volatility also illustrated the importance of holding both foreign currency and alternative assets – when one of your stabilisers fails to provide the desired protection it is important to have others. Currency exposure was particularly valuable in this instance, with the recent fall in the Australian dollar from US$0.81 to below US$0.78 providing a cushion to market volatility. When the Australian dollar falls in value, assets denominated in foreign currency become more valuable for Australian investors.

Recognising the inherent uncertainty of financial markets, we continue to hold a broad range of diversifying exposures to seek to smooth out inevitable bumps in the road.

 

BT Investment Management’s Crispin Murray, Vimal Gor, Peter Davidson and Ashley Pittard provide a summary of the key drivers of investment markets in 2017 and share their thoughts on the prospects for each asset class in 2018.

 

Look beyond the headlines

It is customary to sit back and take stock at this time of year to contemplate what has been, could have been and what is likely to be. Participants in investment markets are accustomed to navigating developments on many fronts and 2017 has offered its fair share of these. Fear factors ranged from North Korea’s nuclear aspirations, Trump’s ambitions to thwart those of Kim Jong Un, Amazon’s desire to scare domestic retailers, Holden marking the end of car manufacturing in Australia and Tesla revealing it fell short of its production targets due to a shortage of batteries to power electric cars. Add to these the constant reminders of escalating household debt, housing affordability, persistently low wages growth and pundits even warning of the next global financial crisis, the average investor has had enough reasons to be fearful.

However, capital markets didn’t quite see it that way. Australian and offshore share markets have delivered healthy gains to investors and other asset classes have achieved positive returns. It shows that market noise can be disparate to reality. Investors who looked beyond the headlines with a degree of perspective and remained invested have done well this year.

Australian shares

Investors in Australian shares oscillated between fear and favour for Resources and bond-sensitive stocks, although Resources may have won the battle this year, with a sector return of 17.5%, compared to 8.4% for Industrials. But look a little deeper within the sectors and there are a plethora of winners and strugglers. Consider the retailing segment, Breville Group (+56.9%) has continued to be a solid performer, although sellers of Breville products like Myer Holdings (-40.0%) and Harvey Norman (-16.9%) languished. Within the travel and leisure segment, Qantas (+78.5%) materially outpaced Virgin Australia (+21.7%). In Media, Ten Network (-82.7%) ran into financial trouble while Nine Entertainment (+61.5%) saw a strong recovery in ratings and earnings.

These varied results provide another timely reminder of the importance of deep and rigorous company research to identify risks and opportunities within the market. Most importantly, the quality of a company’s management team and its strategy in navigating a challenging environment to ultimately drive stock performance should not be underestimated.

“The uncertainty created by disruption is unlikely to abate. This leads to mispricing and therefore great opportunities for active fund managers like us to add value, which is what we saw this year.”
Crispin Murray
Head of Equities

The Australian market does not have the same proportion of high growth stocks as the US so we won’t face the same issue with market valuations in that market. At recent levels the market is considered fair value. In the year ahead, valuations will largely be driven by earnings which are expected to be around mid-single digits. Add a sustainable dividend yield of 3-4% and we should see another healthy total return from Australian shares in 2018.

Australian Listed Property

The listed property sector produced healthy double digit returns over the 12 months to November on the back of solid earnings growth and rising asset values, although some of the gains were surrendered in January. Retail property was an expected focal point for investors, given the economic influences of dwindling retail sales and wages growth together with household indebtedness and the anticipation of Amazon’s arrival in Australia. Hence, retail property was not the place to be for investors, with weak returns from Westfield, Scentre Group, Vicinity Centres and Stockland – which together represent over 40% of the A-REIT index. The Office and Diversified REITs sectors delivered double-digit returns, while Industrial REITs – which are limited in offerings – was the best performing sector.

“US bond yields are an unavoidable headwind for the listed property sector, but the market can really be differentiated by qualitative factors”
Peter Davidson
Head of Listed Property

Filtering the sector for quality provides a fundamentally attractive picture. Despite the interest rate headwinds, key support factors such as the net withdrawal of Sydney office supply, low debt profiles, long term leases with inflation provisions and low vacancy rates make listed property an attractive asset class in 2018. The sector offers fair value and is priced at a discount to the direct property market, based on prices paid in major property transactions this year. We are expecting total returns of 6-8% in 2018.

Global shares

Global equities did a reasonably good job of delivering the growth our super funds aspire to achieve, with more than half of the companies within the MSCI World Index rising by at least 10% (in Australian dollar terms). Most regions registered double-digit gains, led by the US (+19.9%) with two thirds of US stocks achieving a positive return. Investing in the mega-techs – Facebook (+46.9%), Netflix (+44.5%) and Alphabet (ie. Google, +24.7%) – delivered exceptional returns. The S&P500 Index closed at record highs 59 times this year. In contrast, the UK (+6.4%) was a distant laggard while the euro zone (+12.0%) was backed for early signs of economic recovery.

We continue to believe that the tailwinds over the last five years which have rewarded indiscriminate broad market exposure are becoming headwinds. This approach is unlikely to yield as market valuations become less compelling and monetary support is ratcheted back. Moving into 2018, the market environment will be best suited to selective ownership of quality companies that are well positioned to withstand a higher interest rate environment and an uncertain geopolitical landscape.

“Share prices are unlikely to continue moving ahead in unison. The changing market environment means investors need to be conscious of valuation, conscious of franchise strength and cautious on cash flow”
Ashley Pittard
Head of Global Equities

Fixed Interest

Australian fixed income posted reasonable returns in 2017, with little differentiation between the Government and credit sectors. Markets began pricing in expectations of rate hikes early in the year before pushing out the theoretical tightening timeline. Returns across the major overseas bond markets ranged from -0.9% to +2.0%, with the global fixed income asset class as a whole returning -2.7% . The Australian dollar appreciated 4.8% against the US dollar but weakened against the euro and British pound over the year. Although returns were muted across the government sector, credit investments performed well as they benefitted from strong share market performance. Strong appetite for risk also transferred to the high yield market, where the yield premium over investment grade credit tightened to levels not seen since 2014 when the market began to correct.

“Looking to the year ahead, we are wary that the goldilocks environment that kept yields range-bound and risk assets supported in 2017 will not be sustainable. We believe a defensive fixed interest allocation remains a critical component of an investor’s portfolio.”
Vimal Gor
Head of Income & Fixed Interest

Factors like an unprecedented unwind of accommodative central bank policy and a leadership-directed shift in the composition of Chinese growth highlight the risks facing credit and government bond markets. This in turn threatens to spark the return of volatility, as well as imbalances like the strong run from high yield credit to correct in 2018.

Investment implications

Investors need to be resilient to market gyrations and ensure risks are appropriate within their overall investment portfolio which is less likely to replicate the path set in 2017. Asset allocations need to be balanced to reflect the inherent shifts in market leadership on many levels. Interest rates are more likely to increase than decrease, albeit in a trajectory that follows evidence of sustainable economy recovery. Investors should also maintain an allocation within a multi-asset portfolio to the Alternatives sector through a selection of strategies that have a low correlation to equity and bond markets and therefore offer additional diversification with the potential for enhancing returns.