This time last year, I warned investors that there were good reasons to consider lightening exposure to equities. Equity markets experienced a significant sell-off in the months that followed, so Livewire got in touch and asked me to review my thesis, provide my current views on equity exposures, and share some indicators that I use to inform my views.
Reviewing the thesis
Although equity markets had been buoyant in the 6 months leading into the December quarter of 2018, there were increasing signs that share price growth was becoming more and more concentrated around a selection of U.S. stocks.
At the same time, the trade dispute between China and the United States was becoming more serious and the prospect of ongoing interest rate increases in the U.S. was very real as indicators of wage and inflationary pressures potentially committed the Federal Reserve to an extended tightening program.
Locally, the Commonwealth Government was holding onto to a wafer thin balance of power with a new leader presiding over an economy characterised by decelerating credit growth and a potentially serious housing led downturn.
Given this combination of risks, our view at the time was to reduce equity market exposure. This was to be primarily executed via a lower Australian exposure, due to the potential for a weaker dollar to help insulate the impact of a fall in global equity valuations. Proceeds were allocated to Property & Infrastructure, with infrastructure valuations appearing attractive on a relative basis at the time.
The view to lower equity market allocations last September proved to be beneficial, with global equity valuations (hedged) dropping 14% over the December quarter and Australian equities falling 8%. Concerns over rising U.S. interest rates and the trade dispute did appear to be factors contributing to this correction. However, the equity downturn was briefer than expected as a result of the change in approach from the U.S. Federal Reserve. Indications that the U.S. central bank would end its tightening program and once again become accommodative (the Fed “pivot”) were sufficient to set the stage for the next equity market rally.
So, where to from here?
We remain cautious about the outlook for equity markets, with our tactical program being slightly underweight.
Although equity markets are not excessively overvalued, evidence of a slowing global economy will challenge earnings growth in the period ahead.
We also believe that the market remains too complacent over the potential medium to longer term impact of the US-China tariff escalation. Should trade between the world’s two largest economies decline materially due to higher trade barriers then the impact on global growth and the general level of company earnings is unequivocally negative.
Also contributing to our cautiousness is the extent to which equity market valuations have been underpinned by ever decreasing bond yields. Each of the recent corrections on equity markets has been short-lived, with positive sentiment restored by a refocus on supportive monetary policy and falling bond yields. However, at some point the “music” must stop. Longer term bond yields appear to have overshot and will ultimately revert higher. If this reversion takes place under any scenario other than one of positive earnings revisions, then the impact is likely to be negative for equity markets.
With longer term bond yields in Australia and the United States below current levels of inflation, buying a long dated bond today implies a belief inflation will fall and remain at very low levels for an extended period of time. Should inflation unexpectantly pick up, then the logic of holding longer dates bonds erodes. Further, as was demonstrated by the U.S. Federal Reserve early this year, the capacity for central banks to raise short term interest rates is now somewhat limited due to high levels of debt. Therefore, the capability to manage inflation, should it emerge, may be compromised. So just as bond markets are implying today that central bank policy will be unsuccessful in normalising inflation, this view may switch to one in which the markets lose confidence in the ability of central banks to manage rising inflation and a sharp steepening of the yield curve ensues.
There are few signs of this scenario playing out in the short term; however, inflation has not been completely eradicated from the global economy and its presence suggest we should be near or past the bottom of the bond yield floor.
How we determine asset class weightings
Our preferred approach to determining the relative asset class weightings is to compare the underlying earnings yields across asset classes and assess the appropriateness of the risk premium that this earnings yield implies. The assessment of the fairness of the risk premium is ultimately subjective, but takes into account macro influences and risks related to company earnings, market sentiment and momentum, as well as potential changes to policy settings and inflation.
Directional forecasts on currency are also an important determinant of global allocation decisions and we have invested in the development of a quantitative forecasting model to assist with currency assessment.
Of particular importance currently is the understanding of the approach of central banks, given that core inflation targeting may have run its course to some extent. Monetary policy is always evolving and the tools (and their success rate) being used in 5 to 10 years time could be very different to those being used in the past. This may have significant implications for both bond and equity markets.
Thanks Brad - quite sensible. The bull case most espouse for traditional risk premia really rests on merely just one thing - low rates and inflation (for a long time), and more central bank intervention (without a loss of confidence in these, and despite their admissions they're now 'pushing on a string'). The bear case has a huge number of different arguments. Certainly seems prudent to emphasise much more diversification than what most are. The real trick is how do you get this diversification - this requires real skill with product choice, skilled active management and implementation.
Thanks Jerome. I agree. With real interest rates negative, portfolios need to have a broader set of return sources to maximise the probability of real wealth accumulation and capital protection.