March 2018

Investment Strategy Update  

Q1 proved to be a difficult period with the ASX 200 returning -4.27%, the worst quarter since the GFC. The negative performance was attributed to a number of factors including the Sino-US trade war and the introduction of tariffs, the return of market volatility, higher US bond yields. In addition, the announcement of Facebook’s privacy issues sparked consolidation within the Technology sector and last but not least the Labour party’s proposed changes to imputation credit rebates.  

In early February we executed our strategy of increasing cash levels within portfolios by selling down stocks trading at high price/earnings ratios with proceeds to be progressively reinvested as/when suitable. Ultimately, we take a positive view on global equity markets, however are aware that valuations may have become stretched in many sectors, posing significant downside risks. 

In this quarter’s investment update, we seek to provide a summary of the affects that some of the above factors have had on returns as well as how we are positioning your portfolio during these volatile times. 

Trade Wars and the return of Volatility 

In March we saw President Donald Trump announce the intention to impose tariffs of up to US$60 billion on Chinese imports and to intensify restrictions on China’s investment into the US. Subsequently, China responded with tariffs of their own with $3bn of US exported goods including pork and wine. 

The escalation of trade barriers by both countries raises the risk of a dangerous spiral of ever increasing retaliatory measures that potentially leads to a stagflationary outlook for the global economy. Ultimately, we believe that any trade will not be carried out immediately and both sides will use this platform to negotiate a deal for their respective countries and iron out their trade differences. For Australia the impacts of a full-blown trade war between the US and China would be nasty, but not dire. The prices of Australian exports such as coal and iron ore would fall, hurting Australian incomes. But this would be partly offset by a lower Aussie dollar. We will be looking at domestic opportunities to benefit from the trade discussions. 

In equity markets we have seen a return of volatility as outlined in the below chart with large gyrations being experienced across all sectors as markets now pay more attention to the risks associated with an extension of protectionist policies. 

Looking at the economic backdrop, we think it’s possible that stock markets will make new highs this year, but also that volatility will remain higher than we became used to in recent years. Given supportive global economic conditions, we remain cautiously optimistic about the prospects for growth assets. Even in light of recent market volatility, equity valuations based on price-to-earnings ratios in developed markets appear attractive relative to other asset classes.  

However, the volatility events we experienced in February and March may have lasting portfolio positioning implications for a broad range of longer-term investors. At this stage, we’re continuing to focus our attention on defensive ways to protect against volatility and to capture growth. 

Changing the goal posts on franking credit cash rebates – The impact on hybrid securities 

Bill Shorten’s $59bn proposal to scrap the cash rebate when franking credits exceed tax paid is estimated to cost an average $1,200 per year in tax refunds for more than 610,000 low income Australians. While the knee jerk reaction in the market over Q1 created weakness in securities paying high levels of fully franked dividends such as bank shares and hybrid securities, there are a number of hurdles which need to be cleared before such a policy is ever implemented including: 

  • Bill Shorten needs to win the election: Shifts in policy that create adverse outcomes and uncertainty could harm Bill Shorten’s election chances; 
  • Implementation of new legislation unlikely before 1 July 2020: With the Coalition likely to announce the June 2020 Federal budget before the next Federal election, implementing this policy appears unlikely before 1 July 2020; 

Crossbench in Senate unsupportive of current proposal. With the 76 seats in the Australian Senate currently consisting of 30 Coalition, 26 ALP and 20 Cross Bench senators, this proposal will need Cross Bench support where the policy is already unfavoured. 

Hybrid securities have experienced considerable weakness with the median trading margin now at its highest since late 2016. There is still much uncertainty regarding the proposed changes and acknowledge that there are still many variables to play out before an outcome is clear. We continue to recommend exposure to hybrid securities and will continue to look to exploit opportunities by purchasing securities offering attractive yields to maturity and trading below face value. 

Portfolio Positioning: 

As we enter the second quarter we continue to take a cautious approach by ensuring allocations to defensive assets (cash and fixed interest) will weather the rising levels of volatility and geopolitical concerns. Historically April has proved to be the best month of the year for equities markets as banks accounts are flush with dividends which are reinvested. Furthermore, US reporting season commences this month with expectations of 25% earnings per share growth following US corporate tax cuts announced in Q1. History has shown that April’s gains have been eroded by May’s losses and June’s tax-loss selling, therefore we intend to be prepared and take a flexible approach over the upcoming quarter. 

Our current House View includes: 

  • Focus on stock picking – It is our view that equity markets will trade sideways over the next quarter, placing more emphasis on stock picking. We continue to take a disciplined approach, holding key names within the portfolio that are trading at fair valuations, and hosting strong growth outlooks, positioning them well in volatile markets. 
  • Overweight defensives – We believe that infrastructure and utility stocks offer the best line of defence during times of increase volatility; 
  • US banks are offering attractive relative value following the recent market weakness with the sector down over 11% in the month of March. US banks are overcapitalised and beneficiaries of rising US interest rates of which at least 2 more rate hikes are expected this year. We will use the recent weakness as an opportunity to initiate exposure to the sector once we see the market stabilise; 
  • Overweight Asian equities – As outlined in previous investment updates, we take a positive view toward Asian equities and look to benefit from selected routes to market.