Last quarter I wrote about unusually low investment market volatility in 2017, and the likelihood that 2018 would not pass so calmly. On cue, a wave of volatility hit at the beginning of February, caused by a tantrum in the US bond market, and has continued since. Clearly, this year will be defined by more frequent ups and downs, so investors should remain wary.
There has been a trend change in interest rates, reflected in slightly higher global long-term rates, and a widening of Australian credit spreads and fixed income trading margins. There has also been a small reversal of residential real estate prices in Australia, but construction approval data remains strong.
Positive indicators include the economic multiplier effect of construction and infrastructure activity, relatively good job creation conditions in most major countries, a continuing trend of higher corporate profits and some surprisingly robust global manufacturing settings. These positives are contending with trade war rhetoric and concerns about elevated debt in setting the market direction for the remainder of the year.
There is also the very odd policy status in the United States. By necessity the US Federal Reserve is beginning to normalise interest rates and must be close to exhausting its money printing capacity, whilst at the same time the US government has embarked on massive fiscal stimulus, including trillions of dollars of unfunded tax cuts and debt funded budget deficit spending programs. Higher debt and deficits at a time of rising interest rates normally doesn’t end well.
In the first quarter of 2018 the Australian stock market, as measured by the S&P ASX200 Index, fell by 5%, or negative 3.9% when dividends were included. Dividend payments and corporate profits were generally satisfactory, so the market decline was mostly caused by international instability, rather than domestic economic or profit concerns.
Australian share valuations, specifically the price investors are prepared to pay for a unit of underlying profit, and the average dividend yield, has barely shifted for nearly ten years now – a reflection of a relatively low unpredictability beta, and a market with sectoral concentration, the index constituents being dominated by mature sectors such as banking, retail and property.
This benign period has seen neither a strong upswing caused by rampant expansion of valuation margins, nor a market collapse due to a contraction. As corporate earnings, interest rates and economic activity seem likely to continue their predictable trend, the stock market outlook remains much the same - some upside potential from solid profits, tempered by some occasional volatility induced downside risks.
Within our managed portfolios we’ve persevered with a relatively cautious approach by generally holding a higher than usual cash balance. In recent weeks, with the market weakening, we have begun some tactical investing, believing that decent value exists at an index level below about 5800 points. We have increased our investment in Westpac and Ramsay Healthcare and added InvoCare as a new portfolio stock.
Some of our preferred stocks underperformed in the March quarter, notably Amcor, Qube and Telstra, whilst others including CSL, Macquarie and Sonic Healthcare performed relatively well. Woodside completed a capital raising in February, and Santos was the recipient of a takeover offer, causing their share price to rise markedly in early April.
Looking forward, our stock market valuation model suggests fair value of about 6200 points by this time next year, which indicates the likelihood of improved returns after this period of volatility eases.
The major world stock markets suffered a weak start to 2018. In the first quarter, America’s Dow Jones index fell by 2.5%; Britain’s FTSE index fell by 8.2%; Germany’s DAX declined by 6.3%; Japan’s Nikkei index dropped by 5.7%; and China’s Shanghai Composite dropped by 4.2%.
Global share prices first stuttered in early February following an upwards spike in US interest rates, then suffered more volatility due to retaliatory trade and tariff pronouncements in the US and elsewhere. The negative start to the year should stabilise as the trade war rhetoric eases, but we expect 2018 to be a far more volatile year than last.
Many of the world’s largest companies are in the technology sector, so the market sensitive issues associated with data privacy and potential anti-trust risks are adding to market instability. Consequently, valuations of technology companies are again under the spotlight with some analysts questioning the high price to earnings multiples. Such concern has some merit but should be considered in conjunction with very high rates of annualised growth in the technology sector and the stock favourable metric of enterprise value to pre-tax earnings.
The listed property A-REIT sector had a very weak March quarter, due mainly to the effect of the sharp rise in global bond yields in late January. Whilst higher interest rates will weigh on unit prices, the income distributions should remain favourable, as commercial property occupancy rates remain high and many leases contain rent escalation clauses.
Shopping centre REIT’s have some operating pressures, primarily the combination of higher e-commerce penetration, slack wage growth and high household debt. The recent decline in the security prices of Scentre Group and Stockland reflect this pressure. The takeover of Westfield is scheduled to complete in the coming quarter which will lead to a significant rebalance of the REIT sector constituents.
Commercial real estate, particularly premium offices in Sydney and Melbourne, have been enjoying an extended period of good occupancy and rental growth. An increase in supply is looming but an oversupply is unlikely for at least a few years, so market valuations are likely to remain solid. Quality large scale industrial property and logistics distribution facilities remain in strong demand, most particularly if well located.
Demographics are supportive of growth in the retirement, aged care and health care real estate sectors, so this is emerging as an alternate and popular investment category.
Lower REIT prices have caused the sector distribution yield to increase to about 5.5%, which is an attractive return whilst commercial interest remain low.
Global interest rates jolted higher in January, an unsurprising event given the well telegraphed withdrawal of US money-printing support. The shift higher in US rates initially caused some market consternation, with concerns that that this trend would continue and lead to some market dislocation, but after the short sharp rise rates have stabilised, and even declined a bit in some countries.
Corporate credit spreads and trading margins, being the inferred borrowing cost of a business relative to a bond benchmark, have widened, causing capital prices to decline in a variety of fixed coupon and interest-bearing securities. This is most apparent in the higher risk area such as bank and corporate hybrid securities, which suffered March-quarter capital declines of about 5% for the longer duration instruments.
The Reserve Bank of Australia (RBA) continues to maintain the cash rate at 1.5%, the last reduction being in August 2016, and they have not raised rates since 2010. The RBA continues to cite weak wage growth and benign inflationary risks as their primary justification for their long-standing neutral policy. Meanwhile, the US Federal Reserve has increase rates and forewarned of several more rate rises this year. Consequently, by year-end US rates are likely to be about half a percent higher than Australia, which might cause a weakening in the Australian dollar and a deterioration in our current account – perhaps prompting the RBA to change policy and commence a very modest rate raising cycle.
The Australian long-term bond yield moved a bit higher in January, following the global lead. Consequently, the domestic yield curve (the difference between long and short rates) has steepened marginally.
The early months of 2018 have provided a reminder of how markets can react to a combination of higher interest rates and unpredictability risks. Further financial market volatility is likely as the year progresses.
Despite this erratic period, Australian share investors should be sanguine, as prices have retraced to a level that represents reasonable value, from both a corporate profitability and dividend perspective. Overseas stock markets are more problematic as valuations have tended to stretch higher in recent years. Domestic interest rates remain low and stable; however, a more meaningful trend change could become apparent by the end of the year. Investors in real estate should expect an easing in residential market conditions, but an improved return from the property securities sector. Bond investors should heed the risks of higher rates and maintain relatively short duration.
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