Allocating in an uncomfortable market
In the last year, headwinds became crosswinds but what we all want to know is when will we see tailwinds in Australia, both in markets and financial services more broadly. From good performance at the end of the first half of 2018, markets were down June to December 2018 only to roar forward again in 2019. Three major headwinds in the first half of 2019 – tighter financial conditions as a result of the US Federal Reserve’s (Fed’s) tightening bias, high oil prices and the strong US dollar, combined with the sentiment impact of a trade war, have now given way to crosswinds. These came in the form of easing from the Fed, the Reserve Bank of Australia’s (RBA’s) surprise 25bps cut and ‘Super Mario’ in Europe now adding to the dovish rhetoric in markets.
At Fidelity, we remain cautiously optimistic; while we are late in the economic cycle and valuations are stretched, with US$13.4 trillion of bonds now negatively yielding across the globe and paltry returns from cash, investors have no option but to move out the risk curve to achieve positive real returns.
We believe Developed Market Equities and Emerging Market Equities offer the best opportunity for this on a medium-term view.
Emerging from the storm
The dust is beginning to settle post the Royal Commission and we can begin to make out the advice structure that will emerge and persist into the future. It is not our view that aligned advice models will completely disappear; there is a significant cohort of society that needs this channel to help them invest. The more individuals who invest, the better for society overall. What we will see is a general upskilling among both advisers and asset managers as service providers and this can only be in clients’ best interests.
Australian equity market outlook: Paul Taylor, Head of Australian Equities
Markets are very curious at the moment. The economy is weak, and earnings growth is almost non-existent, but stock market prices keep going up. The market seems to be having an internal battle between weak earnings growth and higher valuations, with higher valuations, at least for now, winning out. Higher valuations are being achieved due to a broad- based cost of capital readjustment. A low cost of capital means a higher valuation, as a company’s future earnings are discounted at a lower rate, creating a much higher value.
Interest rates right around the world are at very low levels. Central banks tried to increase interest rates to a more normalised level but were unsuccessful and are now having to lower interest rates given weaker economic conditions. Previously low interest rates were seen as a temporary measure but are now increasingly being viewed as a more permanent feature, especially given central banks’ unsuccessful attempt to raise interest rates.
As low interest rates are seen more and more as a long-term phenomenon, markets are now pricing in a more permanent low cost of capital and much higher valuations.
Investors normally link growth to valuation metrics – that is, high earnings growth means high valuation metrics, low earnings growth means low valuation metrics. Structurally lower interest rates and cost of capital will have a much more significant impact on valuations than changes to growth assumptions, which is why markets are going up with weak economic conditions and low earnings growth.
The Australian economy has achieved approximately 30 years’ of uninterrupted economic growth. This is a world record that no other country has been able to match! But while growth continues, it remains low. In fact, the only thing saving Australia at the moment is an increasing population. Two per cent growth now seems to be the norm and I think this will continue while middle Australia struggles.
Real incomes aren’t growing, debt levels are high, and with flat to weak residential house prices it’s increasingly difficult for middle Australia to take equity out of their homes to supplement flat real wages. Central banks seem to believe that the non-accelerating inflation rate of unemployment (NAIRU) has been lowered due to technology and shifts in the work force. A lower NAIRU means unemployment needs to be much lower to stimulate any wage inflation. While the coming technology revolution will be unambiguously positive for the world in the long term, in the short term technology will destroy industries and jobs, particularly through automation. And this short-term technology disruption will affect middle Australia. For me, this means we’re in a low-growth world and will be for a prolonged period. That means low inflation, low interest rates, weak economic growth and weak earnings growth. I think it also means higher volatility as small changes in variables can create large swings.
I have categorised the environment as low growth, high volatility with a low cost of capital.
In a low-growth world, growth is a rare asset and will be bid up by the market. Sustainable yield will be a large part of returns. As I have previously spoken about, within this context I have structured the portfolio in a barbell-type structure. At one end are cash flow businesses with good management teams, large moats around their businesses, attractive industry structures and excellent dividend yields. These cash-flow type businesses are the foundations of the portfolio and represent the largest part of the portfolio. At the other end of the barbell are growth businesses. The growth end of the barbell adds the ‘oomph’ to the stable cash flow end of the barbell with the intention of delivering strong returns in a risk- controlled manner.
The other trend that is likely to continue in 2019/20 is that, as interest rates go down, the equity market looks better value relative to other asset classes. At the moment, investors have high cash levels as the fears around weak economic conditions and earnings growth keep them out of markets. Interest rates are low, cash is earning next to nothing, equity markets keep going up due to the cost of capital readjustment and a fully franked dividend yield of 4% becomes very attractive in this environment. Investors are likely to add to equity market positions during the year as fear of losses makes way for fear of missing out.
I continue to believe that equity markets are the place to be in 2019/20. While growth is likely to remain weak, cost of capital adjustments are likely to continue to push equity valuations higher. Investors will need to put cash to work in 2019/20 and I believe adding to equity positions will be their best option. Within this framework it will be the sustainable yield and growth businesses that will deliver the best returns in the market. In this low-interest-rate world, I’ll give the final quote to Robert G. Allen who said:
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”
Global Equities: Amit Lodha, Fidelity Global Equities Fund
Global equity markets have performed positively over what has been a volatile 12-month period. Early on, healthy corporate earnings provided support while rising US interest rates, trade tensions, political uncertainty in Europe, and concerns about emerging markets led to volatility. Markets came under pressure in the fourth quarter of 2018, as concerns over global economic growth intensified. However, investor sentiment rebounded in 2019 in view of positive signs on US-China trade talks and the accommodative monetary policy stance in major economies. The US Federal Reserve’s decision to pause its cycle of interest rate hikes in early 2019, signs of stimulus measures and some stabilisation in economic data in China and other developed markets supported global equities. However, the relative optimism on the trade issue reversed in May, when the re-escalation of trade tensions between the US and China, a slowdown in global growth concerns and a deceleration in earnings expectations for 2019 dampened investor confidence.
Overall, caution is warranted towards risk assets in the current late-cycle environment.
Underlying fundamentals have not improved along with the rebound in markets, as risks in the global economy persist. The current market scenario seems to be one where investors need to tread cautiously in terms of portfolio construction, with greater emphasis on finding stocks that lose less, rather than gain more.
The Fund is well diversified across a range of industries and sectors, with no regional or sector bias. At a portfolio level, I remain focused on attractive communication services franchises with solid business fundamentals in the defensive telecommunications, media and entertainment industries. These companies are supported by a variety of factors, including upcoming fifth-generation (5G) deployments, expanding product offerings and opportunities to improve monetisation that can deliver growth and strong free cash flow. Against a volatile backdrop, the Fund continues to invest in long-term ideas in the health care space, with a solid product portfolio and pipeline opportunities. I also hold relatively defensive equipment and supplies businesses with a tailwind of demographic trends that provide stable revenues and cash flows.
In energy, my preference is for oil and gas companies focused on cost and capital reinvestment to improve efficiency and counteract weak profitability and challenging business conditions. The Fund’s financials exposure is through a combination of diversified financials (exchanges that are most resilient in volatile market conditions), insurers (beneficiaries of niche business lines and under penetration in emerging markets) and banks (strong balance sheets).
Overall, I believe that stock-specific fundamentals will remain the key driver of equity returns.
Consequently, the portfolio continues to focus on companies that demonstrate strong pricing power, are led by talented management teams and are available at reasonable valuations.
Asian Equities: Anthony Srom, Fidelity Asia Fund
The last 12 months have continued to be a volatile period for Asia’s markets. Whilst this has been a tricky period to navigate, this volatility has offered stock-picking opportunities amid periods of indiscriminate selling.
Volatility has primarily stemmed from US-China trade war rhetoric. However, we have found it best to avoid the noise of daily news flow and instead focus on hunting for companies that can weather this storm. As a result, we have continued to find ideas linked to the structural domestic opportunities in Asia, such as consumption, that have been sold off due to blanket dumping of stocks by investors. This is particularly the case for a number of Chinese A-share companies, which were among the hardest hit in 2018, whether having any skin in the trade war game or not. In the first half of 2018 China was a significant underweight but was a significant overweight by the fourth quarter as the Fund purchased domestic-focused names such as Midea, Angel Yeast and Dongfeng Motor that were dumped during the fallout. Bouts of volatility like this can throw out good businesses at attractive valuations to patient investors.
The paradox is that while I find stock-picking opportunities in China, the macro picture looks challenging.
The currency is one factor we continue to monitor. The markets are fixated on the renminbi (RMB) hitting seven to the US dollar, but I believe if that is your view you need to factor in further depreciation within financial models and sensitivity analysis to understand how each investment will hold up – and I do not think the renminbi depreciating deeply beyond seven is outside the realms of possibility.
China’s money growth continues its long-term downward trend. To counter this, China will need to provide some form of stimulus packages, quantitative easing (QE) or money printing, which will put downward pressure on the currency. An alternative is outright devaluation to increase global competitiveness. Any significant devaluation will likely be a shock to the economy in the short term and ugly for markets, yet in the longer term it should prove positive for China due to improved competitiveness. Within this scenario, I am happy to own companies that have a significant competitive edge versus peers, a strong balance sheet and growth in the domestic market, as these have a better prospect of riding out any volatility over a multi-year time frame.
Away from China, we continue to hunt for any ideas across the region that we believe can make money for investors. India offers great long-term opportunities linked to its ongoing development. The market currently looks a little expensive, especially after the elections, but is an attractive hunting ground. HDFC Bank remains a significant holding in the portfolio. It is a very well-managed bank with a strong track record in delivering growth while maintaining the best asset quality within the sector. Its adoption of technology for business operations and customer offerings is unsurpassed and helps the bank gain more customers in an increasingly digital-savvy market.
Global emerging markets: Alex Duffy, Fidelity Global Emerging Markets Fund
Emerging market (EM) equities have experienced 12 months that could be broadly defined by a tale of two very different halves. After a brutal drawdown in the second half of 2018, the first four months of 2019 illustrated how quickly sentiment can change within the asset class. While a strengthening US dollar, slowing economic growth in China and rising interest rates in the US led to negative sentiment in 2018, a much more supportive backdrop emerged as we entered 2019 as the tone of the US Federal Reserve (Fed) turned dovish.
Today, we are cautiously optimistic on the outlook for emerging markets.
Pressures on emerging markets’ currencies appear to be abating after a protracted period of US dollar strength. Generally, inflationary pressures across emerging markets are muted and fixed income markets offer reasonably attractive carry versus US dollar rates. As the Fed seems to be entering a period of quantitative easing, or at least putting interest rate rises on hold, emerging markets’ currencies are more supported than they’ve been for the last four to five years. In terms of the US-China trade war, in our view, trade is not the major issue. The real threat is its second-order impact on the stability of the renminbi.
Through these macro gyrations, the longer-term backdrop for EM equities remains relatively constructive. We continue to invest in businesses with an ability to deploy excess capital at accretive rates of return and operate in markets where penetration rates remain low. Investment in innovation and technological adoption is also enabling businesses to access consumers with increasingly attractive products at a lower cost of service – all of which creates a relatively robust level of underlying growth.
The portfolio remains focused on businesses with strong franchises and an ability to consistently generate attractive returns across all economic environments. We continue to pay very close attention to valuation levels, which means we have reduced certain exposures in the technology space. Our view remains that our single stock exposures within financials and consumer sectors with selective exposure in IT and materials offer the best risk-adjusted return profile for our investors.
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Alva was appointed as Managing Director of Fidelity International’s Australian business in 2016. Alva is accountable for ensuring that Fidelity’s global investment strategies deliver the best outcome possible for Australian clients.