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Insights – Institutional investor

Foot on the Gas? Key Forward Drivers of the Energy Sector

By Insights - Financial adviser, Insights - Institutional investor

The Energy Sector has suffered more than most in 2020, as a global collapse in the oil price and economic activity set share prices on a plunge from which we have only seen a small glimmer of a recovery.

But what are the prospects now for this sector as we come to a key signpost in the coronavirus crisis, with lockdowns starting to ease globally?

Figure 1: The chart below displays Year to Date (YTD) and 1 Month (1 mth) total returns for selected ASX listed Energy stocks as at close 7th May 2020. (Source: Refinitiv, Resonant Asset Management)

Many Levered Up Balance Sheets

Amplifying the misery has been an overly aggressive capital structure in many of the stocks, some of which may need to raise capital should the commodity remain at historic lows.

Figure 2: Net Debt to Equity (High indicated highly geared) and Interest Cover ratios (High number indicates increasing cover from EBITDA for interest payments) for selected ASX listed Energy stocks (source: Resonant Asset Management, Refinitiv)

What now for the sector ? If the oil price were to gravitate back towards the 40-50 US$ range, then all manner of financial leverage risks would suddenly be put on the back burner – a scenario that could see the stocks double.

In this note we look at the key issues driving the oil price, which whether we like it or not, is the key factor in deciding whether or not as investors we should think about adding these stocks to their portfolios.

April Madness

April was a historic month – never before have we seen oil futures fall into negative territory. How this event occurred, and the future outlook for the oil price, holds the key to understanding its trajectory over the next few months

Figure 3: WTI Futures front contract (source: Refinitiv)

Modern commodities markets are a largely symbiotic relationship between speculators, hedgers and producers.

Producers care about storage deeply, particularly when inventories are running sky high in an environment such as this, with demand so low.

Speculators haven’t historically considered storage, their focus is more geopolitical and global macro-economic.

Hedgers are merely looking to manage an existing exposure in their books, so typically price insensitive, and motivated by neutralising risk.

What happened at the futures expiry in mid-April is that some speculators suddenly realised that producers were deeply focused on storage, to an extent they had not considered possible or likely. In fact so focused, that there were no buyers a day before expiry.

Will this repeat next month?

Speculators have already modified their approach to tackle storage in a more considered way.

We know this because the major vehicles for speculators, ETFs that purport to track the oil price, have switched from buying the front to spreading across multiple future expiries, and announcing that the roll will take place over a ten day period rather than in the immediate run up to expiry (for details, see: USO Portfolio Changes).

We can therefore expect a smoother ride as a staggered and incremental roll takes over a prolonged period.

In part however this is necessary because we have seen breathtaking inflows into these ETFs, and therefore into a long oil futures position. The NTAs of many of these funds has risen dramatically (3x since year end), especially when you consider that the price of these instruments has fallen dramatically (10x unit creation in end of February).

Figure 4: US Listed USO ETF Net Tangible Assets (Source: Refinitiv/Lipper)

Figure 5: US Listed USO ETF Equivalent Number of Units (Source: Refinitiv/Lipper, Resonant Asset Management)

What this suggests to us, is that the mean-reversion trade is very well supported already, and likely priced in already into the futures market. An end to the lockdown, and something of a return of demand, is largely anticipated. So how does demand look?

Figure 6: Indicative US Oil Demand (Source: Refinitiv Eikon , EMI Gasoline US Total Sales Volume) by Year – Dip down is 2020, other lines are 2014-2019

The problem for storage, is that, with every surplus in supply over demand there is incremental pressure on storage. How is production shifting to the new environment?

OPEC has already been squeezed diplomatically to cut production by around 20% – but the main swing factor, will be US domestic production. This may be why storage is less of a concern in May than in April:

Figure 7: North America Oil Rig Count (source: Refinitiv Eikon, Baker Hughes)

Rig count is now down more than 50% in record time: suggesting that the industry is adapting to new realities.

How we are playing this in portfolios

Our exposure to the Energy sector remains modest, because we feel that despite the production cuts, considerable risks still lie to the downside, and exceed current upside risks.

This is especially true when you consider how quickly speculators have moved back to a bullish position, as evidenced by the extreme buying of ETFs and other products in the US which is essentially a mean reversion trade.

We are sitting this one out, looking to play a recovery in other ways – for our portfolios, risk management remains a critical component, we will reconsider once the situation in energy markets becomes clearer, and we can benefit from a less pronounced recovery.

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.

Stable Cashflows ? Time to Rethink Infrastructure and Property

By Insights - Financial adviser, Insights - Institutional investor

Infrastructure & Property

One of the key defensive cornerstones of multi-asset and equities portfolios since the end of the GFC has been the use of property and infrastructure securities. The typical structure is a trust, holding assets or part ownership of assets, an optimal quantity of financial leverage, an delivering a stable and consistent income.

We will argue in this note that selectivity and a discerning eye will now be required in this asset class, with the use of ETFs for broad passive coverage now fraught with risks now we have entered a new market paradigm.

What characterises this paradigm and how does it differ from the traditional view of this asset class?

To answer that question requires us to consider what effectively a lockdown means for our assumptions of the stability and predictability of cashflows for these assets. What the lockdown highlights, is that cashflows are far from predictable or certain, when clients and customers are unwilling or unable to utilise the infrastructure once deemed “recession proof”.

Suddenly the utilisation of the asset, and hence the revenue stream, develops a level of risk, perhaps not associated with the business cycle, but more associated with government policy around pandemic risk, and our willingness even in the absence of a lockdown, to mingle freely with our fellow citizens in a workplace or a shopping centre, where there is no exacting requirement to do so.

Sell-side forecasts are already starting to reflect the uncertainties associated:

Figure 1: In the chart below the orange line (RANGE) is the spread of dividend estimates across sell-side analysts – as the line increases, analysts are more prone to disagreement.

The blue line (STAB) is the standard deviation of estimates, a different measure of uncertainty, which essentially confirms the same trend – analysts are increasingly uncertain as to the trajectory of dividends for these assets.

(Source: Refinitiv, Resonant Asset Management)

Why does this matter

Uncertainty never was the name of the game with these securities – investors use them specifically to provide a cushion during times of market turmoil.

In addition, providers of debt capital have not factored in the incremental risk we now see: even if the RBA target rate is at record lows, the cost of debt of these assets certainly is not.
In financial markets, perceptions matter as much as reality: perceptions have now shifted, at least semi-permanently; away from stable to unstable cashflows.

The stability of cashflows and cheap cost of debt is what permits the issuers of these securities to embed financial leverage:

Figure 2: Index weighted Debt to Equity ASX 200 Infrastructure and Property Stocks (source: Resonant Asset Management calculations, Refinitiv data)

The chart above is the weighted average Debt to Equity ratio of these stocks. The series is volatile because of the way the data is reported by specific companies – suffice to say, that over the last ten years, the trend is up – from around 60% net debt to equity to at least 80% and on the latest estimate, over 100%.

Debt in itself can be a good thing for equity holders as it enhances returns. But it also increases risks, risks that are latent, not apparent to investors until they are.

What happens now

A protracted and prolonged de-rating of these securities is inevitable, particularly for assets whose cashflows were assumed immune to uncertainty, and for whom reality is now setting in. As we crunch our asset allocations, what long term risk premiums would traditionally satisfy for this asset class?

Figure 3: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (source: Resonant Asset Management)

The chart above shows the return demanded by investors over cash to invest in the asset class: as you can see we have moved from a near 3% hurdle rate to invest, to near 6%, as uncertainty hits.
What is important, is how this compares to competing asset classes: and in our view, the gap between the risk premia for equities, and this asset class, is inevitably closing:

Figure 4: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (Blue) vs Broad Australian Equities (Orange) (source: Resonant Asset Management)

In fact we would argue that this should not be treated as a separate asset class any longer: it is quantitatively tantamount to equity risk, and offers no exceptional or structural defensiveness, that merits its exceptional treatment.

We advocate selectivity in the main across these assets, as there are securities within the complex that will continue to offer stable cashflows, but the dispersion in outcomes across the investible universe will be large, so passive investing is the least attractive approach at this point.

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.

What’s the Market Worth?

By Insights - Financial adviser, Insights - Institutional investor

The Coronavirus outbreak has blindsided markets since mid February, with equities down nearly 30% off their peak. What investors need at this juncture is a line of sight on valuations, to get a sense of what sort of scenario this sell-off represents. Analysis of this sort is vital to build a profile of the probability landscape around different coronavirus outcomes.

There are two drivers of the sell-off:

1. Projected Earnings hit: the extent to which earnings are impacted is hard to gauge but will be pronounced. The market anticipates a raft of downgrades.

2. Increased uncertainty: we have little idea what to expect in terms of the length or extent of the disruption to the economy caused by this virus. Because we can’t quantify anything, realised financial market volatility becomes extreme; making equities a less attractive investment on a relative basis to alternative investments.

We can look at quantifying the impact of point 1 and 2, to get an idea of what sort of scenario the market is pricing in; and to make a decision, given the virus data that we can track, as to whether equities is likely too bullish or bearish.

Increased Uncertainty

One of the hallmarks of financial markets over the last ten years has been anaemic volatility. Driven ultimately, in our view, by a total absence of inflation, it has been a key driver of making equities incrementally attractive and driving up the market’s fair multiple.

Let’s estimate the relationship of volatility and fair multiple. As fear and risk perception elevates, the fair multiple collapses. Conversely, as visibility and a line of sight appears on earnings and the economic hit, volatility will progressively moderate, and the fair multiple of the equity market rises.

In order to quantify the relationship, Resonant has built a simple model to estimate the sensitivity of fair multiple to the implied volatility index (S&P/ASX 200 VIX Index). Clearly, this is an exercise in educated guesswork, we still feel that a rough estimate is better than no estimate at all.. It is however no substitute for following the markets closely over this period, but it helps enhance the research process.

To estimate our relationship, we look at historical data on the Australian Equities market between 2010, when the VIX series starts, and end of February 2020.

Figure 1: S&P/ASX Australia VIX (LHS, source S&P/Refinitiv) vs Equity Risk Premium (Source: Resonant Asset Management)

Based on the relationship, we have quantified every doubling in VIX, to a 1% increase in the risk premium (ie. The equity market sells off).

Earnings Hit

Volatility and earnings are intrinsically linked. Only now are we starting to see economists quantify the full impact of the virus on the domestic economy. We are looking at two quarters of negative GDP Growth for Australia, should the lockdown succeed and the virus be contained. Citi is forecasting that GDP will contract by 4.4% over 2020 (See: Forecasting the largest percentage change GDP growth contraction in history, 24th March 2020, by Josh Williamson, Citi Economics Research)

If we assume that the stock market is an adequate representation of the economy – then we can project sales revenues (as opposed to earnings, which will be much more pronounced) for companies to fall approximately 5% over 2020. The disparity in outcomes will be huge, with some industries (tourism, travel), impacted far more than others (healthcare, supermarkets, cloud computing).

To translate the sales/revenue hit to earnings we need a sense of where corporate margins sit. And their likely trajectory. Shareholders ultimately should care about Net Margins, which have a cyclical component, and a policy component, amongst other things.

Cyclical Component: We would expect that aggregate margins would fall, as companies face fixed costs of keeping the lights on, regardless of broader conditions.

Policy Component: Governments look to cushion the blow as much as possible, by implementing tax policies and stimulus to minimise the hit to margins.

In addition to the revenue hit, we need to estimate the margin hit, to get a sense of impact on earnings.

Currently the weighted average net margin for an S&P/ASX 100 ex Financials company is currently 13%. As you can see it has fluctuated with Commodity prices in particular – the trough being in late 2015.

Figure 2: Index weighted 12m forward net margins for the S&P/ASX 100 index (source: Resonant Asset Management calculations, Refinitiv data)

Over the next twelve months, what can we possibly expect to happen to Net Margins, Revenues and Earnings?
In order to answer this question, we’ve put together a matrix of outcomes, broadly splitting the economy into V-shaped (12 weeks), U-shaped (2 quarters), and L-shaped (1+ years).

Figure 3: Approximate Revenue, Net Margins under different macro-economic scenarios

Market Projections

We think the VIX will settle around 25-30 at the end of March, and trend towards 20 for the rest of the year, as uncertainty as to the course of outcomes for this virus continues to play out. For us to get to 20, we would need a clear example of a western democracy that has successfully managed to “flatten the slope” and manage the hospital overload. For example, if Italy were to consistently and successfully slow the increase in cases, then that would bring market volatility right down, as it would demonstrate to other countries what is required to achieve this, and on what timeframe.

We suspect that if the social distancing and lockdown policies in Italy have been successful, then we are looking at a U-shaped recovery for Australian corporate earnings.
That means 12 month margins of 10% (from 13%) and a 5% revenue hit, in total a 30% hit to earnings.

Figure 4: What’s the Market Worth Under Different Volatility, and Earnings outcomes

We see our base case described above, where the market is worth 5019 points, a U-shaped recovery, 5% negative GDP Growth, and a volatile equity market to the order of a VIX at 20 from April for the next 12 months, as a price target just a tick above 5000. That would correspond to a yield of around 4.5% plus franking, and an additional 5% upside from the close price on the 24 th of March.

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.

Coronavirus and Markets

By Insights - Financial adviser, Insights - Institutional investor

Finally Politicians are listening to scientists, and pursuing an appropriate strategy to change behaviour and minimise the infection rate. This is not only necessary from a health/humanitarian perspective, but also from an economic perspective. If coordinated properly and effectively across the globe, this could help minimise the economic disruption while simultaneously maximising the humanitarian outcomes.

Market Fragility

Another tumultuous week for equity markets last week, which began on Monday with a huge sell-off and continued throughout the week. Two events coincided to create a perfect storm for Growth assets: Coronavirus and OPEC Oil negotiations.

The signpost for us that the markets had changed to a new regime, occurred on February 28 th . That was the day that the domestic market forgot all about reporting season, fundamentals, and focused on the virus and its effects. The day’s trading sufficiently spooked us to think that a rejig of the portfolios was necessary.

Who Cares about Earnings?

The last time we saw a meaningful regime change such as this in markets was 2008. Over these periods, which naturally occur every ten years or so, the market becomes entirely focused on speculating the future prospects of companies over the next two quarters, at the expense of all else. This means typically a giant unwind of the most speculative active positions towards a more defensive orientation. And that is exactly what we have seen. As ever with these events, hedge funds are leading the charge.

In our portfolios, we looked at our individual stock positions over the weekend of the 29 th February and 1 st of March, and jettisoned any stock in the eye of the storm – first on the chopping block where travel, tourism and education, followed by deep cyclicals such as resources, retail, & media. We rotated nearly 20% of our direct stocks portfolio into cash.
The timing was fortunate, because this week has been the most volatile and unsettling for equities investors since the GFC.

Thank Goodness for Diversification

Our multi-asset portfolios have held up relatively well amongst the carnage. In our International Equities sleeve, we have been conscious of the prospect of a tail event given the strong run equities have enjoyed over the last few years, and have positioned unhedged, and overweight Japan (and most importantly the Yen), and Asia, underweight expensive US and underperforming Europe. Yen strength is an inevitable predictable consequence of a dramatic sell down such as this, given the repatriation of the enormous quantity of foreign invested capital which inevitably occurs.

The advantage from a risk management perspective of using precision instruments such as ETFs is only too apparent in these markets. The biggest delta has been from managing the currency right, just as it was in 2008.

Looking Ahead: Our Base Case

While it feels as though we are currently staring at the abyss, there are now reasons to start thinking of the future.

This morning the US announced that it was stopping any EU visitors for 30 days, a move that is both draconian but necessary. We expect Australia to follow suit – cases in Europe are now expected to escalate and the trend looks quite terrifying. We expect however that these extreme measures are indeed what is required to get this virus under control, along with school closures, minimisation of travel and public gatherings, and working from home.

We are now moving into the step where governments have a clear role to play, pulling massive fiscal and monetary leavers to manage what Boris Johnson described as the “once in a hundred year health crisis”.

The coordinated fiscal and monetary response will be massive in our view. Governments and central banks can ill afford to sit on the sidelines and moralise about cheap money, this is the difference between a transient global recession, which may last a quarter, and a prolonged depression that takes place over a number of years.

To put it in context, we have to think that we are staring down the barrel of sitting at home for much of the next six to 12 weeks, as this virus is contained. If we can successfully navigate this without business closures, job losses, and a total ramp up of unemployment, we can come out the other side of this with a huge ramp up in activity one this has passed, which you would have to think would somewhat compensate for the initial recession.

That is our base case: this is contained, we get an enormous stimulus both fiscal and monetary stimulus, in which case this is a buying opportunity to hold for the long term. Sentiment will whipsaw investors from now and certainly until the end of April, but we feel at this point that the base case is priced into markets.

A Gloomier Scenario

To construct a gloomier scenario, we would have to think that:

  1. Infection rate in developed markets of around 70%
  2. Quarantine lasts up to one year
  3. Massive speight of corporate defaults
  4. Mass unemployment, double digits.
  5. House price crash.

None of this is likely; governments have woken up to the health crisis and steps are being taken.
Under this view, you would currently be selling equities further.

Looking Even Further Ahead

Assuming our base case comes to fruition, how does this change the world?
A few geo-political risks on our radar:

1. Iranian and Middle Eastern instability. The conservative religious government in Iran came into this health crisis with waning popularity, a botched missile launch. Iran was hit harder than most, and struggled, weighed down by inadequate health infrastructure. To rub salt into the wound, the oil price collapsed to $30, likely to trigger an economic meltdown in the country if this persists. The middle east has typically been about two camps, Saudis and Iranians. The collapse of Iran could herald more wholesale changes across the region.

2. Global Supply Chains entail sovereign risks. Back on the political agenda will the repatriation of manufacturing of key products. The electorate has woken to the sovereign risks of outsourcing all of your manufacturing and production offshore.

3. Europe is ultimately re-invigorated. This is less certain but an effective fiscal response to help Italy will dramatically alter the electorate’s perception of the European project. This is potentially a second order factor, not before much economic and political pain.

4. Locally mortgage rates hit zero or thereabouts as we enter QE. Given the cashflow crisis that many over indebted households will face over coming weeks, this effectively reduces interest payments to near zero, and allows Australians to “hibernate” until the virus passes.

These four key factors will drive:

The end of the bond market bubble – we think that the massive deployment of fiscal stimulus combined with onshoring manufacturing and production will possibly raise the spectre of inflation.
A change in behaviour – this will draw a line on the post GFC period and open up the market to more volatility and risk taking behaviour. This will draw a line on income and wealth inequality. The electorate will demand this. The business cycle will return.

More selectivity and active management will be required – the pure passive ETF model will die with low volatility and non-existent inflation. Skilled stock pickers and asset allocators will benefit hugely from the regime change.

A wholesale change in work practices. Work from home, flexible work, and so forth will all become mainstream as we get a sense of our own fragility and mortality and reconsider our priorities – economic growth is not dependent on our ability to attend an office in a CBD for 70 hours a week – software and remote access, teleconferencing, will become mainstream.

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.

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.