Global And Domestic Equity Strategy: Now What?

This story features COMMONWEALTH BANK OF AUSTRALIA. For more info SHARE ANALYSIS: CBA

By Greg Peel

Markets have moved to a higher level of volatility this past month, driving equity and commodity prices lower and bond prices higher (yields lower). Trading volumes have picked up, notes JP Morgan, as active investors are forced out of positions. World equities have now given back their year to date gains, credit spreads have blown out to year to date highs, and commodity prices are down double-digit percentages.

As has now been the case every year since the GFC, when such bouts of volatility occur, JP Morgan’s global asset allocators have been forced to ask the question: Are these market moves merely technical, implying an unsurprising correction from earlier price overruns, or are they structural, requiring a change in strategy? Or will what has begun as technical bring about structural?

JP Morgan is on the side of technical rather than structural, and does not believe technical moves will become structurally self-fulfilling. A stabilising effect is provided by lower bond yields, lower inflation and, as a factor in the previous, lower oil prices. For equities, the broker has simply downgraded to a global Neutral from Overweight for the time being to ride out the storm (while remaining individually Overweight both the US broad market and small cap indices).

The current panic is largely based on falling perceptions for global growth, and indeed JP Morgan has trimmed its own September quarter global assumption to 2.8% from the 3.3% assumed in July. The broker’s second half forecast remains a percent above the first half result (which included the US weather-impacted March quarter), but the rebound has not been as buoyant as hoped. Global industrial production fell in August after a strong July despite net positive PMIs, while global retail sales were actually quite strong in August. This would suggest a reduction in inventories and thus the potential for September numbers to indicate a bounce.

The OECD’s monthly leading indicators showed a fifth consecutive decline for the G3 economies (US, eurozone, Japan) in August. This is normally a sign to maintain low equity exposures as the bigger corrections tend to occur during such phases, notes Danske Bank. In terms of the global growth picture, Danske believes things could very well turn worse before they get better. But while risk factors suggest investors should remain cautious in the shorter term, Danske remains positive on equities in the medium to longer term.

The analysts note there are still no signs of bottoming for the eurozone and contraction could well last for the rest of the year. Oil prices have been very much a victim of declining global growth expectations (in the face of increasing supply) but this should provide a dampener, particularly supporting consumer spending in the US and eurozone. However, lower oil prices provide a headache for global central banks who are trying to fight deflation, so there are pros and cons.

In its latest monetary policy statement, the US Fed shocked many by making reference to weakening global growth, outside the US of course, and the subsequently strong greenback. The shock derives from such international considerations being supposedly beyond the Fed’s domestic dual mandate of inflation and employment control. But let’s face it, even the world’s largest economy is more and more beholden to the “global world” of the twenty-first century, so to ignore outside influences as feed-ins to domestic issues is to effectively have one’s head in the sand. The RBA spends at least as much time in its statements speaking to global growth, terms of trade and the exchange rate as it does domestic considerations.

The implication from the Fed’s widening of focus, nevertheless, was one of monetary tightening potentially being delayed as a result of global influences, which are specifically reflected in the US dollar index. Saxo Bank has addressed this issue in its investment outlook for the December quarter.

Markets are not going to get what they want in Q4, says Saxo, being an easy and smooth path to an improving US economy accompanied by gentle Fed tightening. The US recovery is going to hit a “low ceiling” set by a runaway US dollar (impacting on US exports and commodity prices). “We will see uncertainty and volatility rise sharply about what comes next” says Saxo. “Bonds will rally one last time and volatility will rise as well”.

Saxo released its investment outlook on Monday, but obviously didn’t write it on Sunday night. We can safely assume the report was being complied ahead of this last week’s jump in the VIX volatility index and plunging bond yields in the US.

Morgans is more sanguine about the current bout of US volatility. Geopolitical uncertainties and the anticipated (one might assume confirmed) winding down of Fed bond purchases has led to increased volatility and a “bull market correction” for equities. But continued corporate earnings growth, particularly in the US, and the expectation global interest rates will remain low, should provide underlying support for equities in Morgans’ opinion.

Current valuations suggest international investments remain attractive, the analysts believe, although one needs to be selective. Morgans continues to advocate value in well-known established businesses across most sectors with the US likely to continue to lead global growth. European growth will likely lag that of the US but ongoing economic stimulus should lead to increased stability and improved industrial investment.

China is very much a factor in the weakening global growth picture. To that end we look to the Westpac economists for an updated view.

The Chinese economy entered a pronounced soft patch in the September quarter, indicating a material loss of underlying momentum in domestic demand, Westpac notes. The analyst community is currently predicting growth to slow further in 2015. But Westpac disagrees, believing China is currently at or near a cycle trough, which will be underscored by an expected weak September quarter GDP result (due next Tuesday). From here the economists suggest it is very reasonable to expect some modest improvement over the next year.

Citi acknowledges that weak Chinese industrial production growth and the property downturn are adding to wider concerns for the Australian economy, including rising bond yields (and thus the diminishment of high-yield equity attraction) and falling commodity prices. The fall in the Aussie dollar is being equally driven by, and encouraging further, foreign capital outflows although a lower Aussie will be supportive of the domestic market over time.

Prior to the sell-off, the Australian stock market had been trading at a 15.1x PE multiple of forward earnings forecasts, the highest level in five years, despite consensus downgrades to growth expectations in the previous few months, Citi notes. So basically the index was ripe for a sell-off. But as the sell-off has played out, earnings forecast have remained relatively resilient. Forecast downgrades have eased off, with analysts more focused than the market on a weaker Aussie providing an offset to commodity price falls and a boost to industrials with offshore earnings.

The de-rating has left the market trading at 14.0x (as of last Friday), a little below the medium-term average, and domestic bond yields have retraced the gains earlier triggered by Fed rate rise anticipation. The fact global bond yields have fallen back again highlights concerns over global slowing, which in turn may play into lower Australian earnings forecasts, but Citi cannot see “inordinate” downside risk. Indeed, the analysts suggest we could see downgrades abate further and even rise if the Aussie declines further.

As is clearly apparent in FNArena’s Broker Call over the past week or more, broker ratings upgrades are vastly outweighing downgrades at present, providing weight to Citi’s claims. Many are upgrades to Hold from Sell, rather than Buy from Hold, but the implication is one of a bottoming pattern in previously over-stretched valuations.

Of particular interest to Australian investors are valuations for the major banks. While the big miners and energy companies have clearly been sold down on falling commodity prices, the Big Four have been suffering a confluence of domestic regulatory concerns and international “carry trade” nervousness. With earnings growth forecasts negligible, bank shares prices have been almost entirely supported by their domestic and global yield attraction, which is diminished if interest rates are to begin rising in the US.

The problem with bank valuations is that there’s a multitude of different ways one can assess their “cheapness” or “expensiveness”, which is what the UBS analysts admit after using two distinct methods at today’s share prices and arriving separately at both answers. It all comes down to what government bond rate one assumes, and hands up who has picked global bond rates correctly this year (anyone?) balanced against an assumed return on equity rate which depends on just what additional capital requirements may or may not be imposed in the wake of the Financial System Inquiry.

Perhaps UBS best sums it up by declaring, “in any case, while the banks are not outright cheap, we think much of the valuation stretch now appears to be removed after the pullback”.

It is interesting to note that Commonwealth Bank ((CBA)) shares, just to pick one bank, have fallen 10% since early August, largely triggered when the US ten-year bond yield jumped quickly from 2.4% to 2.6% on Fed rate rise fear. That yield is now down to 2.1%, but CBA shares have not returned.

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