Category

Insights – Institutional investor

Desperately seeking hedges

By Insights - Institutional investor

While the future correlation structure of asset classes sounds rather pedestrian, it is in fact key to the outcomes for diversified long-term multi-asset portfolios over the next five years.

In this note we discuss the possible future trajectories for the relationship between rates and equities, focusing on the US market, which tends to drive outcomes for investors beyond its borders.

The long term

Balanced portfolios typically rely on the hedging properties of rates vs growth assets to protect portfolios in times of stress.

To us, this particular market period feels far from a stressed environment, and certainly not what we have witnessed previously in 2008, despite some rather alarmist commentary.

While the US macro data can be best described as lackluster, it is by no means indicating imminent recession conditions at this stage. In fact, we would broadly categorise the current environment as “mid-cycle”, in stark contrast to the environment in 2007 with the shadow banking system funding diverse high risk projects way beyond what could be considered a rational decision.

What does concern, however, is where the economy goes to from here. In particular, for managers of diversified portfolios, which asset classes are likely to provide suitable hedging properties should we shift from mid-cycle to peak cycle over the next while.

The relationship between rates and equities

Figure 1 above highlights the long-term relationship between equity market allocation decisions and cash rate policy expectations.

The equity risk premium is the long-term return in excess of the risk-free rate, that investors in aggregate demand to invest in growth equities at the expense of defensive cash. It reflects investors aggregate appetite for risk.

As you move up the chart, investors become increasingly reckless, taking risk for a lower demanded return. Perhaps the best example of investor recklessness was in September 2000 at the height of the tech bubble – the equity risk premium was negative! While a negative risk premium may run counter to logic, human behaviour in aggregate is rarely as rational as you might be led to believe.

In stark contrast to this, the peak level of conservativism in the equity market was around late 2011. So while surprise is expressed as to sheer explosiveness of the S&P return since that point, in the context of a normalisation from peak conservativism, it should make more sense.

Broadly speaking, there are two distinct and opposing drivers of the equity risk premium:

  • Economic conditions: As the business cycle approaches peak activity, the equity risk premium compresses, as investors demand a lower annualised return to take equity risk, driven by their optimism for company earnings to exceed expectations.
  • Rates: As rates are cut, the equity risk premium compresses, as investors are forced up the risk spectrum, and yields on growth assets compress.

Typically central banks are reactive to data, typically focusing on inflation targets, much more so than asset markets such as equities.

In this vein, interest rates are in theory a counter-cyclical tool to smooth the inflation cycle, and hopefully the business cycle, assuming the relationship between inflation and the business cycle holds.

Inflation expectations

Are softening. The common interpretation is that inflation is mainly a cyclical phenomenon, but there is much to suggest that the forces inhibiting inflation in this business cycle are structural, for instance the impact of technology. The answer is probably a mixture of both, though the composition increasingly favours structural over cyclical.

Under this backdrop, will the Fed succeed in generating the desired inflation outcome? If the answer is no, and the business cycle, which is not in retreat, but far from it, with full employment, healthy GDP growth, is twinned with rate cuts, what are the hedging assets of the future that protect balanced portfolios from drawdowns?

If there is a dislocation in the traditional relationship between asset markets and rates (as we have started to see in figure 1 above over 2019), how does this story play out?

Wither the hedging assets

As the situation progresses, we eventually reach an endgame where duration no longer provides the same hedge to economic recessions as might ordinarily be the case. And the central banks are misguided in trying to drive inflation outcomes out of kilter with a modern, increasingly productive, technology-driven economy.

It won’t surprise anyone that under this backdrop, gold and other alternative hedges are being bid up aggressively. We think this situation will persist while and only while the Fed is looking to cut rates, in an environment modest but far from recessionary activity, and lukewarm expected inflation.

Select junior gold miners are the best means of playing this theme, share prices are yet to respond fully to the price levels in the spot market, particularly given the Australian dollar is still languishing below 70c, which means the futures gold price in local currency, is well over $2000 AUD (see figure 2 below).

Resonant Asset Management Pty Ltd ABN 41 619 513 076 (‘Resonant’) is a corporate authorised representative 1261574 of New World Advisers Group AFSL 428451. Resonant is not licensed to provide personal financial advice.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant and NWAG does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

You Need to Understand Some Key Latent Risks in “Quality” Stocks

By Insights - Institutional investor

Quality investing using Return on Equity (ROE) has been a successful strategy in recent years, but requires careful consideration of the risks, which can differ substantially depending on the stock or the industry. In industries with barriers to competition, we believe it to be embedded with latent risk that often is not accurately quantified by measuring the volatility of the share price.

In competitive industries, ROEs mean revert.

In a competitive industry, free market forces drive ROEs to mean revert.

Projects flock to adequately supplied industries with a reasonable ROE. This additional capacity relative to demand will in turn create competitive tension, decrease pricing power, and the return on equity will fall.

Conversely projects are cancelled in adequately supplied industries with a low ROE. This reduced capacity relative to demand will weaken competition for existing participants, increase their pricing power, and the return on equity will rise.

Competitive Barriers are a Trending Force.

Barriers come in many different shapes; regulatory, patent protection, data sample quality in social media, or access to specialised skills amongst them.

Barriers lead to upward trending ROEs, because any positive incremental demand will lead to increased pricing power when the supply does not change – which may well be the case, if there are few participants offering a solution.

Often therefore, these upwards trends in ROEs can be multi-year affairs – driven by increased demand for automation, regulation (e.g. tax digitisation in the UK) or just simply population growth.

Cost of Equity Matters.

When discussing the dynamics of ROE, obviously the cost at which equity can be deployed matters hugely. In fact, we would revise our earlier statement – ROE minus the cost of equity are mean reverting in a competitive market.

The cost of equity is neither static through time nor uniform across the index. It varies as risk perceptions change, as the market in aggregate becomes progressively more or less optimistic on prospects for the business sector, the industry, the economy.

In the cross-section of companies across the index there can be large variability too. Even though base rates are low, we see access to equity capital vary significantly – at times the distribution has been skewed towards stocks that have had the right combination of characteristics, for instance, companies with stable cashflows, low financial leverage, liquid stocks or stocks with defensive earnings.

Further for the companies with cheap access to equity are able to easily fund acquisitions, or buy-back stock, to further grow earnings. This self-reinforcing loop, from the market, towards stocks with High ROEs and competitive barriers, can exacerbate the momentum of high ROE names. This is the environment prevalent in the period 2011-2013 in particular.

Risks for High ROE Stocks Going Forwards

The greatest risks to these high ROE stocks with competitive barriers going forward is a reversal of interest rates, especially a Fed policy error. This seems unlikely at this stage, given stubbornly low inflation in the US and no rate rising pressure in many markets worldwide. Often these risks are not easily measured with the historical volatility of the stock, or any clear fundamental signal, but they can be brutal sell-offs.

As an example, in Q4 2018, even without too much of a change in the outlook for the company, CSL fell nearly 25% between the 31-August and the 25-October, as 10-year US treasury yields climbed from 2.86% to 3.12%.

In Conclusion

This note describes the nature of some of the broad risks associated with high ROE stocks. We believe that the nature of these risks differ substantially depending upon the competition structure of the particular industry.

In highly competitive industries, we see risks of mean-reversion in ROE as new entrants increase investment in capacity.

In industries with competitive barriers, we see a reversal in global interest rates, particularly the US, as a catalyst for derailment in the upwards momentum in these stocks. These risks are not easily quantified from historical share price volatility so may go under-appreciated.

In positioning portfolios, we need to ensure we think about these risks, even in periods where interest rates look to be “lower for longer”.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Reporting Season in Numbers

By Insights - Institutional investor

Source: Bloomberg Estimates, Resonant Calculations

Overall State of the Australian Equity Market

The Aug 2018 Reporting Season overall was relatively disappointing, with a balance of misses, when looking at the ratio of upgrades to downgrades – with 28 upgrades and 53 downgrades.

Domestic Cyclical and Defensive stocks were particularly disappointing, with a strong tilt to downgrades. Financials were also unsurprisingly weak, given the domestic macro backdrop of weaker house prices, slowing credit growth, and weak wage growth.

Structural Growth had a few bright spots, as did Resources, though reporting season tends not to matter as much as spot commodities for these stocks.

Looking ahead there are a number of macro headwinds seemingly converging on Australian equities that leave us a little mixed on domestic equities certainly, and incrementally favouring fixed income in this asset market.

Financials

The big story is Westpac lifting mortgage rates on its residential mortgage book. This is a de-facto rate rise for Australian households, which all but negates any requirement for the RBA to lift rates in lockstep with the Fed. Lower for longer in terms of the base rate seems to be the order of the day for the Australian cash rate.

House prices is an area of concern for domestic investors. Resonant’s view is more of a gradual dribble down in real terms, rather than an outright collapse, given reasonable population growth and a lack of
supply in urban areas in particular.

In Asset Management, results were a little downbeat, as the industry grapples with margin squeeze, index investing, and the persistent low returns delivered by hedge funds and alternatives. In addition, potential regulatory change looms large.

Insurance had pockets of success, though we note the initial enthusiasm around expanding insurance margins when Suncorp published results was quickly dampened when other equivalents such as IAG failed to follow through. Notably though QBE announced earnings above expectations.

Resources & Emerging Market Sentiment

The continued struggles (real and perceived in some cases) in Emerging markets in the face of protracted US Dollar strength, continues to weigh on our Resources sector, through the risk preferences of investors, firstly, and secondly their perspective on what this might mean for Emerging Market driven demand for our raw materials.

Resonant remains constructive on certain select Resources names, without being aggressively positioned one way or another on the sector overall. We also believe that many of the US Dollar related headwinds are coming to a conclusion. Our sense is that while select problems exist in certain jurisdictions (Turkey, Argentina, and to a lesser extent South Africa & Brazil), the exposure elsewhere is nothing like the Asian financial crisis for instance, so repercussions should be limited. In addition, we feel that US inflation is less likely to spike than some commentators would suggest, so we actually think rates may not shift as aggressively as the market is anticipating, and US Treasury bond yields could come off.

In terms of specific names three stocks to struggle over reporting season are Origin, Rio Tinto and Fortescue Metals. Origin’s performance relates to a dampening of expectations around 2019 earnings, and a very specific earnings quality issue, while Fortescue is a function of the grade of Iron Ore they currently export and the increasing discount this product fetches on the market.

Technology Disruptors

Perhaps the greatest theme of our age is the earnings potential of technology and software. Software solutions, particularly in recent years, have become cost effective to the point that integrating these solutions into your business becomes a mandatory proposition. For equity investors, it is more of a case of gauging fair value for these high margin, high profitability businesses, and at what point we start to trim these names in the face of stratospheric valuations. Some examples of stocks that have performed strongly in reporting season include WiseTech (WTC, logistics management software), Appen (APX, language and social technology for companies), Altium (ALU, printed circuit board design).

Stratospheric valuations are justified in terms of the potential for these businesses to 1) bolt on earnings through acquisition 2) be acquired themselves 3) grow their revenues on a relatively fixed cost base to hit the bottom line directly.

That said, Resonant is weary of overpaying at this mature stage for Australian tech names, even though fundamentally we like the story and we see significant upside to margins and earnings as adoption of software solutions becomes essential for cost management.

Telstra and Telcos

Changes in the competitive structure of the Telcos sector has been a key development.

Telstra’s result was in line, no better, but the stock has rallied on the back of the actions of TPG, in securing a merger with Vodaphone Australia, which investors speculated would mean the end of the aggressive price competition in the mobile market.

We remain skeptical. TPG’s CEO has never been conventional or predictable in his approach, and it would seem unlikely that he would settle on a cozy oligopoly in the medium term. Telstra’s earnings profile is ugly looking forwards as the NBN roll out continues, and regardless of today’s yield, looks horrible in tomorrow’s yield. We think this looks unlikely to change dramatically in the future.

“Quality” Stocks

Quality stocks were the big winner this reporting season. This would appear at odds with the performance of low Volatility strategies, which have fared terribly. What this suggests is that when seeking out defensive assets, investors have sought out fundamentals (stable earnings, revenues & ROEs, low earnings accruals, strong balance sheets) rather than technicals in assessing the ability of the company to withstand a tougher equity market environment.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Factor Returns

By Insights - Institutional investor

Factor Returns: August 2018 (Source: Resonant)
Factor Review:

  • Quality factors unanimously did well – Earnings Risk, Management, Earnings Quality,
    Profitability & Balance Sheet.
  • Growth & Momentum investors performed strongly.
  • Revisions & Operating Leverage Performed Poorly: Analysts were progressively getting more
    upbeat on the wrong stocks over reporting season.
  • Speculative and small caps did poorly. Speculative stocks typically have investors with a
    shorter investment horizon.
  • Value investing performed very poorly.
  • Low Volatility was sold off horribly.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.