Welcome to the July edition of the Burrell Blog for 2018.
Seldom can you diarist recall a period where there was such a diversity of opinion on many important investment inputs. On 19th July last, Hostplus chief investment officer Sam Sacilia said;
“If your view is the same as the market then you’ll get the market return. The market believes four things right now: that trade wars are inevitable and will be disastrous for markets; that interest rates are surely going up; that inflation sooner or later will go up; and that equity markets are overvalued and surely there’s going to be a correction. We take a contrarian view in all four of those,” (VIEW 1) Sharemarkets would shrug off any trade war impact, he predicted, while interest rates in Australia were not going up any time soon, with the Reserve Bank “starting to waver on their outlook”. Inflation, meanwhile, would remain low because of the deflationary impact of technology. “Unless you can find a way to switch off technology you’re not going to find a way to generate inflation,” he said.*
Hostplus’s equity exposure, sitting at 53 per cent, is made up of 25 per cent Australian shares, 20 per cent international shares and 8 per cent emerging market shares. The fund is looking at taking a little bit off the table in Australian shares – 1 per cent or 2 per cent at most—and moving it to international shares to gain more exposure to a broader range of industries. The fund holds unlisted assets – property, infrastructure and private equity.
It has zero allocation to cash and a two per cent allocation to fixed interest that it would also soon move to zero, Mr Sicilia said.
Shroders presented their real return CPI + 5% fund update in our offices that afternoon. Let’s compare commentary from Shroders with Mr. Sacilia – including a few Burrell insights.
While there has been much press around the USA Trump trade tariffs, to date there has been no material adjustment to equity markets. Rather the adjustments to date have occurred in the commodities markets.
The Australian standard of living is based to a material extent on our trade flow, particularly minerals, but also tourism, agriculture, education, with our trading partners, the most important of which is now China. Even prior to the Trump tariffs, there was no consensus on Chinese steel production. At the Annual Stockbrokers Association conference in May 2018, one investment manager commented that he had been in the USA during the period of property over-building which lead to the Global Financial Crisis and that his recent trips to China lead to his observation that the current level of over building in China might is many times as serious. He said that the current level of steel production in China is 800 million tonnes (mt), that the USA is 70 million tonnes and in his opinion the Chinese annual steel production should halve to 400 mt. Such an adjustment would materially impact on iron ore and coking coal imports from Australia.
The counter argument is that while China is somewhat of a black box so we tend to see a wide variety of opinions, the fact is that the Chinese GDP growth rate has held at 6- 6.5% over the past decade. While we might distrust a planned economy, when the Chinese decide to replace all the pipes in their cities or build aircraft carriers or commit to the one belt one road project which will connect Europe and China by fast rail, these projects require vast amounts of steel and concrete.
China exports demonstrably more to the USA than it imports from the USA. Some observers would say that China would give its right arm to have access to the US market. If this is the central case, then Trump’s strategy of forcing China to blink and move to ‘fair trade’ may be correct. This remains the highest probability and Burrell’s central case.
But Trump’s psychology profile and the closed nature of US markets compared to Australia mean that neither China nor Trump might feel compelled to quickly adjust their stance. China may see the present situation as an opportunity to replace the USA in direct dealings with other countries in the world, so that the USA could become the loser as no one country, no matter how important, can take on the whole world. The risk to Australia is that we become a casualty of a trade war. While not the central case, let’s hope that Mr Sicilia is correct, as Australia does not wish to be collateral damage.
Interest Rates and Inflation
The US 10 year bond rate fell from 6.5% to a low of 1.8% in May 2016 and is currently around 2.9%. The Australian 10 year bond rate similarly fell from 6.5% to a low of 1.8% in May 2016 and is currently trading at 2.6%. Discussion around short term cash rates is not overly relevant, as the building block for valuing all assets is the 10 year bond rate. There was a 0.5% increase in long term bond rates in January in both Australia and the USA in a period of 6 weeks. There is consensus that while the strong growth in the USA economy is likely to lead to higher interest rates, it is the threat of inflation which will ultimately lead central banks to allow longer term rates to rise. Shroders view per the table below is that inflation is coming. This is contrary to View 1.
There is concern that equity markets are overvalued and surely there’s going to be a correction. This is particularly the concern in respect of the USA with many leading fund managers underweighting the USA and voicing concerns about US valuations. Shroders are included in this majority view, per the table below.
Themes selected each 12 months are useful explainers of market movements. The updated list is below, together with the balance of the commentary. Refer also to the April Blog.
The left hand side of the Shroders table indicates that at current levels, the average 10 year real return for the US stock market is forecast to be zero due to the high level of valuation multiples in the USA (The Shiller PE). The table on the right hand side shows the subsequent ten year real return on US bonds is also forecast to be zero i.e. the statistics are saying the US markets are in for a period of muted returns equal to inflation. Burrells have for some time been concerned about some valuations in the US market. This concern may well have resulted in a correction, were it not for the cut in US corporate tax rates from 35% to 21%. That tax cut has made PE valuation ratios in the US adjust from over 18 to 16 average look reasonable. Mr Sacilia appears to be taking the view that international markets will continue to increase in value as he is looking to increase the exposure to international shares. From the current level of 20% in the Hostplus balanced fund. To date that strategy has been successful, with the US Dow Jones index sitting above 25, 000.
As mentioned in The Australian Business Review on July 23 2018, Platinum is betting big on China – the fund manager has labelled it the “investing opportunity of a lifetime”—its steering clear of the US.
Andrew Clifford, the fund’s chief executive said, “There’s been a very significant narrowing of the markets that’s gone on in the past six months where the only place to be has been in the high-growth tech, biotech stocks, predominantly in the US. We’ve got relatively little net exposure to the US and indeed with rising rates and some pretty extraordinary valuations among some of the high-flyers, we think it’s one of those times that you might want to be avoiding the place. It might cost us some returns in the short term but that’s just what we do.”
Property Trusts and Infrastructure
Views on interest rates and inflation have important consequences for valuations in the Australian Real Estate Investment Trusts (AREITS) and for infrastructure. The chart below indicates that both property trusts and infrastructure are highly sensitive to downward price pressure in the face of rising 10 year government bond yields.
What is a Balanced Fund?
In order to pass exams in portfolio management, the current paradigm is to ascertain whether a client has a balanced, moderate risk or high growth profile. The balanced risk profile started with 1/3 fixed interest, 1/3 property and 1/3 equities. Because most clients have an exposure to property (often in overweight) due to their residential property holdings, Burrells tend to reduce the listed property exposure to under 20% and allocate the difference to international equities. A high growth investor will have minimal fixed interest, while a moderate growth investor would carry 10-30% in the Burrell investor profile risk matrix.
The Shroder real return CPI +5% fund has the objective to deliver an investment return of inflation +5% per annum over rolling three year periods. The fund has no strategic allocation but rather reviews asset markets and constructs a portfolio comprised of those assets that present an appropriate risk premium and align with a performance objective. The fund seeks to achieve the real return objective with as little risk as possible. Shroders representative advised that because the fund has the ability to change asset allocation rapidly, it is not classified as balanced, moderate growth or high growth. Rather the ratings agency classifies the fund as “ALT” for alternative. Based on the concerns above with respect to interest rates and inflation, US valuations and bond proxies being property trusts and infrastructure, the Shroder Real Return Fund currently has an asset allocation of Australian equities 14.1%, Australian small cap equities 1.1%, global equities 9.1% and Asian equities 2.5%. The remainder of the fund is in various types of fixed interest with cash and short term securities making up 26.7%. The consequence of this asset allocation is that the fund is reducing risk/ volatility but not meeting the inflation +5% return objective.
This compares to the Hostplus fund which has a zero allocation to cash and a 2% allocation to fixed interest that it would soon move to zero. It is interesting that the Superannuation consultancy Chant West have allowed Hostplus to be classified as a balanced fund, when it does not qualify as a balanced fund on a conventional view.
Nevertheless Hostplus balanced produced a return of 12.5% which is in line with the equity markets at June 30. It may be seen that there is now an alternate view on asset allocation which takes the Burrell ranges to the next stage. It is dynamic asset allocation. Dynamic asset allocation would occur where clients were prepared to authorise an investment strategy which allowed asset class allocations to move through a broad range depending on the view on markets. Thus where there is current concern on the 10 year bond rate, dynamic asset allocation would allow fixed interest to be set at zero, as Hostplus has done. But it is an ALT strategy, not a balanced strategy.
*Excerpt and quote from The Australian Business Review July 19, 2018 “Hostplus bets against pack wisdom in bed to threepeat”
Table 1, Table 2, Table 3 – Shroders
Disclaimer & Disclosure: Burrell Stockbroking Pty Ltd and its associates state that they and/or their families or companies or trusts may have an interest in the securities mentioned in this report and do receive commissions or fees from the sale or purchase of securities mentioned therein. Burrell Stockbroking and its associates also state that the comments are intended to provide information to our clients exclusively and reflects our view on the securities concerned and does not take account of the appropriateness of the recommendation for any particular client who should obtain specific professional advice from his or her Burrell Stockbroking Pty Ltd advisor on the suitability of the recommendation. Whilst we believe that the statements herein are based on accurate and reliable information, no warranty is given to its accuracy and completeness and Burrell Stockbroking Pty Ltd, its Directors and employees do not accept any liability for any loss arising as a result of a person acting thereon.
This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs ('relevant personal circumstances') of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor. If the advice relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.
Burrell Stockbroking Pty Ltd (ABN 82 088 958 481), a Participant of the ASX Group and the NSX.