Rudi's View | Sep 26 2018
In this week's Weekly Insights:
–Quality vs Value, Bond Yields vs Global Growth
–Aged Care: A Royal Disaster Foretold
-Rudi On TV
-Rudi On Tour
Quality vs Value, Bond Yields vs Global Growth
By Rudi Filapek-Vandyck, Editor FNArena
On Monday, AXA Investment Managers held its annual media round table in Sydney which includes open floor conversations with a number of in-house experts who usually operate offshore.
The Global CEO of Rosenberg Equities, essentially the in-house stockbrokerage for the asset manager who thinks and operates globally, Heidi Khashabi Ridley, suggested the house view has now shifted in that increasing exposure to higher quality equities at still reasonable prices seems but the most logical/prudent strategy given the cycle is getting long in the tooth.
Admitting "defensive" today may not necessarily equal "defensive" ten years ago when Fed tightening and an end to the economic cycle triggered an extremely harsh global bear market, the view at Rosenberg Equities is that quality growth at a reasonable price pretty much resembles the best defensive asset in today's context.
Before you ask, Rosenberg Equities' definition of quality is exactly the same as the one key factor that dominates my own research into All-Weather Performers in the Australian share market: it's about the ability, as a corporate organisation, to sustainably grow revenues and profits with relatively little volatility in the uptrend.
One interesting element that rose to the surface during the open conversation between journalists and AXA experts is that research supports the perception that companies of high quality provide lots of numbers and details when issuing guidance and discussing their latest performance with analysts. Companies of lesser quality need to hide behind rather vague statements; or they cannot provide any forward guidance at all.
An equally intriguing piece of research was presented by Kathryn Mohan McDonald, Head of Sustainable Investing at said Rosenberg Equities. According to her latest paper, companies that excel in diversity are better investments than companies with a mere homogenous mono-culture characterised by less diversity.
Findings were based upon extensive data research for the top 1000 companies in the USA, with "diversity" not limited to age or gender, but including cultural backgrounds, levels of education and geographical origin. The AXA research found there is compelling evidence to make the case that more diversity is "economically correct"; it leads to positive outcomes for companies and for their shareholders.
One of the suggestions made is that more diversity in a corporate organisation acts like an "economic moat" in that it might allow the company to engender brand loyalty and encourage innovation. Is this just me, or do I see yet another direct connection to my All-Weather Stocks?
Asset managers at Morgan Stanley highlight just how tough the overall investment climate has become in 2018. Very few assets have produced a positive return since January 1st, an observation that might have escaped investors in Australia given Australian equities are among the happy few this year.
The picture darkens a whole lot if one adopts the angle of a global investment manager based in the USA. Morgan Stanley keeps track of 17 different assets, ranging from US two-year Treasuries to global high yield bonds, to commodities, the S&P500 and MSCI China, Europe and Emerging Markets.
When measured in US dollars, only three out of the 17 assets (Australia is not included), are in positive return territory as September, calendar month number nine, draws to a close. This balance is not only the worst since the GFC, it is worse than in 2008 in the midst of the GFC!
Back then the basket of assets generating positive return consisted of US 10 year Treasuries, US 2 year Treasuries, the US Aggregate Bond Index and Emerging Markets local debt. Today, the list of assets includes the Russell 2000, the S&P500 and Real Estate Investment Trusts (REITs).
Note Morgan Stanley does not separately include the Dow Jones Industrial Average (DJIA) while the S&P US Aggregate Bond Index is designed to measure the performance of publicly issued US dollar denominated investment-grade debt.
At the very bottom of this year's table of investment returns sit (in order of worsening performance year-to-date) Emerging Market equities (MSCI EM), Emerging Markets local debt and MSCI China. The strategists do not think the timing is right to start buying Emerging Markets equities, but are warming towards local debt in Emerging Markets.
Also, the irony hasn't escaped the strategists the best performing asset class thus far in 2018 -US equities- is also the most historically expensive asset class on the board.
The strategists like the fact that gold has relatively held its own given circumstances and suggest this might bode well for the precious metal moving forward. They note the seasonally challenging period for crude oil ths year coincides with predictions of more tightness in global energy markets.
One relationship equity investors might want to keep an eye on is the gap between investment grade corporate debt in the USA and 10 year US government bonds ("Treasuries").
Assuming historical patterns apply in today's context, the above mentioned strategists at Morgan Stanley point out since the late 1980s, yields on 10 year Treasuries have tended to peak some eight months after the spread with investment grade credit bottomed. Morgan Stanley suggests the trough in the spread between the two occurred in February this year, and few would argue with that.
Eight months later is about… now. History also suggests US equities subsequently peak around three months later, which takes the timeline to December. There are no iron clad certainties with these historic patterns, but the strategists at Morgan Stanley are certainly keeping their eyes focused on further developments from here onwards.
The world's focus is on a flattening yield curve in the USA and, in more recent times, on how the yield on 10 year Treasuries has again risen above 3%.
At what point will financial markets genuinely start caring about higher US bond rates? Morgan Stanley strategists point out it's not so much the level in the US bond market that influences other asset classes, as is the level over and above US inflation that matters most.
As such, the strategists make the case that real rates in the US have remained remarkably stable since 2014 and the uptrend since mid-2016 has simply pushed US real yield from the bottom of the range to the top. What happens if there is a real rate break-out?
Morgan Stanley strategists would prefer if the range remained in place with a break-out to the upside suggesting a new regime has started.
Strategists at Citi seem pretty relaxed about the US bond market (more about this further below) but they are equally not confident there is now opportunity in Emerging Markets equities.
"The question now facing EM is whether the outlook for capital flows is so weak that it requires further increases in interest rates", say the strategists. Their gut feel suggests real interest rates in Emerging Markets need to rise more as the rate differential between EMs and developed countries still remains low by historical standards.
As capital continues to flow out of Emerging Markets, the pressure builds for local central banks to raise official cash rates.
Ultimately, point out the strategists, this means a different form of vulnerability might become evident at some point: growth risks are now pointing to the downside and this might expose growing risks attached to the payability of public debt.
Right now, argues Citi, financial markets are demanding emerging countries shrink their external financing needs. This raises the obvious question of how efficiently countries can meet the new demand?
Citi strategists remain rather sanguine about the immediate outlook for US equities. Sure, they share the concerns about capex intentions and overall business sentiment, in particular if the Democrats win the mid-term elections, and then there is downward pressure on margins and corporate profitability on the back of rising input costs, including wages, but it has to be pointed out US economic data remain robust and healthy.
It is difficult to see a major correction for US equities when earnings growth is as strong as the current numbers suggest it is, say the strategists.
Having said so, the risks for global growth are to the downside, that much the Citi strategists acknowledge, on a 18 months horizon. And while the risk for inflation is now a little higher, Citi does not see substantial higher inflation ahead. Irrespective, Citi strategists believe investors should keep a close watch on US corporate margins.
Since 2000, point out the strategists, US firms have struggled to pass through higher input costs onto consumers due to structural changes in technology and global online marketplaces.
On Citi's house view, European equities will become the next outperformers until mid-2019, followed by copper and gold, but the forecast remains for ongoing positive return for US equities. The outlook for oil is believed to be negative with Citi's total return projections putting Brent at the bottom of the table.
Citi's relaxed attitude towards growth, risks, inflation and rising bond yields is probably best illustrated by its projection the yield on US ten year Treasuries should revert back to 2.85% with the Federal Reserve to stop tightening at 2.75%-3% which means four more rate hikes, including this month.
In Australia, Citi strategists see more upside from "value" stocks than from "growth" stocks.
Global assset allocation strategists at JP Morgan are equally of the view that US equities' outperformance is about to end. Investors should prefer non-USD assets instead.
The strategy is conditional though: on the assumption there will be no full-blown escalation in the trade war between the USA and China, and neither will political risks in Washington reach hyper levels, and neither shall the Federal Reserve fail to recognise any of such developments may they arise.
For good measure: JP Morgan is still Overweight US equities but the strategy from here onwards is to gradually start building larger exposure in Emerging Markets equities. If trade tensions ease, as the strategists expect it will, this will also give "value" stocks the opportunity to catch up with secular growth stocks.
For good measure, I also have to add the recommendation by Malcolm Wood, chief investment officer at Baillieu Holst who seems convinced there is enough evidence to suggest growth in the Australian economy is about to slow down considerably as weaker business confidence, slower consumption from households and the drought will take some -0.6%-0.8% directly off GDP growth.
Wood recently reiterated the view investors should look for Australian Global Leaders; companies that benefit from strong global growth and a weaker Aussie dollar.
Aged Care: A Royal Disaster Foretold
I was asked by another medium to share my thoughts on the local aged care sector in light of the next Royal Commission, as suggested by the new Prime Minister. Below are my contributions.
Question: Aged Care stocks have taken a hammering – do you see this as a buying opportunity?
I do think the recent announcement of a Royal Commission and subsequent sharp share price weakness for ASX-listed providers of aged care facilities and services have exposed one major flaw in share market strategies adhered to by many a value investor; by solely focusing on apparent "undervaluation" and not taking into account this sector was clearly positioned for more public scandals, even without yet another Four Corners expose and the subsequent knee-jerk response by the fresh Prime Minister in Canberra, investors had effectively traded in "corporate quality" for hope that more bad news would remain limited, and thus the impact on the share price would too.
A "cheap" looking share price says nothing about why that might be the case. While it is not always easy to determine why a certain share price is not getting any traction or keeps falling while others are not, I'd argue any investor (or his/her stockbroker or advisor) who at the very least had done some research into this sector should have spotted the risks for investing in this sector. It really should have been obvious.
As per always though, the attractiveness of a "cheap" looking share price always draws in a herd of investors who think "business quality" is but a subjective factor and a low Price-Earnings (PE) ratio and high dividend yield are "hard facts". Well, those investors have once again been proven wrong. Just like they have with plenty of prior examples, ranging from Telstra to iSentia and many others.
If the old adage still applies that value investing knows nothing about timing, then the timing of any sustainable recovery for this sector has now been pushed out, potentially for a considerable time. Those hoping it will ultimately still come good must be patient, possibly for a prolonged time.
Investors holding these stocks for prospective income should be prepared for potential dividend cuts.
Question: What affect do you think the commission could have on the aged care sector from an investor's point of view?
If we take any guidance from what other Royal Commissions have brought to the surface, including the revelations from banks and insurers, we can only assume a Royal investigation into aged care, potentially including retirement homes, can get very, very ugly. Anecdotal stories from adult children whose parents have not or are not been treated well suggests there is abundance in sad stories including rorting the system, understaffing, subpar services, unfair contracts, personal abuse and systemic neglect. This list is by no means exhausted.
Some might claim a Royal Commission will separate the better quality operators from the lower quality peers, and expose the fact the sector is essentially underfunded by belt-tightening governments. Those arguments are valid, but they are merely long-term and do not hide the fact that, short term, there is so much potential for scandal and public outrage, any investor in the sector better have a fortified stomach; all indicators available point towards a situation most likely to get worse before it can get better for the sector overall.
Question: Do you think other analysts will follow Macquarie's lead and downgrade aged care stocks?
Stockbroker ratings are usually very much "value" oriented so the fact share prices already are down a lot since the announcement of a pending Royal Commission, plus the fact this sector was already "cheaply" priced prior because of more regulatory scrutiny and changes in government funding, might prevent more downgrades from following Macquarie's move.
I observe that Macquarie's sharply lowered price targets for listed operators remain well above where share prices are trading. Thus other brokers might be more inclined to equally reduce their short to medium term valuations and price targets, while retaining their Hold or Buy ratings, possibly with an extra tag of Elevated Risk.
Question: Do you think a commission was warranted?
Two things need to be taken into consideration here. Firstly, the Royal Commission into banks and financial services has surprised by revealing many more examples of corporate mischief and unacceptable behaviour than the majority of clients and onlookers had expected. Secondly, we now live in a political era that increasingly favours plain populism.
If we consider the first a "success", then it should not surprise the Federal Government is applying the formula elsewhere. The real surprise will be if there are no more Royal Commissions being called after aged care, which seems poised to be "successful" in the same vein as is the current Royal Commission into banks and financial services. I suggest the local power industry looks like the next easy target.
Audio interview from last week Tuesday about the share market in September and the August reporting season:
Rudi On TV
This week my appearances on the Sky Business channel are scheduled as follows:
-Tuesday, 11.15am, Skype-link to discuss broker calls
-Friday, 11.15am, Skype-link to discuss broker calls
Rudi On Tour
-Presentation to AIA members and guests Chatswood, on October 10
-Presentation to ATAA members and guests Sydney, on 18 October
-AIA Celebrity Lunch, Brisbane, on November 3
(This story was written on Monday 24th September 2018. It was published on the Monday in the form of an email to paying subscribers at FNArena, and again on Wednesday as a story on the website.)
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: firstname.lastname@example.org or via the direct messaging system on the website).
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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)