September 2018

Q1 2019FY Round-up:

Q1 2019FY proved to be a transient period for markets with the ASX300 reaching levels not seen since the Global Financial Crisis during July and August, whilst in the US, equities continued to build all-time highs driven by the technology sector. September however proved to be a more difficult month, particularly in Australia where the Index gave up its entire gains for the period with the ASX 300 closing out the quarter with a -1.08% return. The US S&P 500 returned 7.73% and the Nasdaq 9.07%.

The 3-months to October saw US bond yields rise to 7-year highs as the 10-year yield surpassed the 3.00% resistance level on strong economic data. During the quarter we also saw continuing discussions between the United States and its trading partners including China, Mexico and Canada, ongoing Brexit negotiations, Apple make history becoming the first ever US$1tn company, the Royal Commission into Financial Services and on a stock specific level the focus was on FY18 reporting season.

Pleasingly, results mostly shrugged off the systemic risks that posed a threat to earnings, yet forward looking momentum was mixed. Overall small/mid-caps were the stand out with 20% beating consensus expectations, but 20% also missed. Large caps disappointed with 4% beating consensus and 19% missing, given regulatory risks facing key sectors including Financials and Utilities.

Overall FY19 corporate profit growth was revised lower by 0.70% to 7.20% given cost inflation with profit margins coming under pressure from higher energy and interest costs. As we saw over the period, the flurry of mergers and acquisitions highlights that companies are finding it easier to acquire growth rather than grow organically.

The Oil Price rise

During the quarter we saw the crude oil price build on gains to reach US$75, levels not seen in more than 4-years. Three factors contributing to this rise include:

  • The United States withdrawing from the 2015 nuclear deal and re-imposing sanctions on Iran, including secondary sections on those countries which buy oil from the world’s fifth largest crude producer.
  • OPEC producers have decided against increasing oil output despite mounting pressure from President Trump.
  • Venezuela’s oil production output has been sinking due to economic mismanagement and US sanctions.

Whilst higher oil prices may be beneficial for producers; they have historically translated to less spending and slower GDP growth and preceded many recessions. Although geopolitical developments have helped boost the oil price, supply and demand fundamentals point to longer term downside risks. For this reason, we prefer companies with diversified portfolios of assets when positioning portfolios to benefit from rising prices.

Domestic Housing Market Declines:

Over recent months we have seen a rise in mainstream publicity around falling house prices and lower than average clearance rates. After a 52% home price boom between 2012 and 2017, Australian home prices fell c.3% over the year to August with many analysts forecasting a further 15-20%. Concerning for many is the fact that falls are coming at a time when interest rates have been at record low. Whilst it may be premature to call the end of the “housing boom”, it is clear that price pressure is likely to be extended given the catalysts to stem the weakness, including interest rate cuts and strong income growth – appear unlikely.

Despite a rising population, factors that we see could lead to ongoing price pressure include:

  • Oversupply – Approvals have averaged 225,000 over the past 5-years, 43% above the long-term average and 25% above current underlying demand.
  • Extreme Valuation – CoreLogic estimates that the house price-to-income ratio is still 6.8x. The data showed that on average it takes 9.1 years to save a 20% deposit for the average home and the servicing of an 80% loan-to-value mortgage takes 36.30% of income.
  • Record Leverage – Household debt-to-income sits ant an unsustainable 190% of income putting Australia in the top quartile for OECD countries. We believe that this could be a significant risk to dwelling prices considering that many interest-only loans convert to principle & Interest repayments.

Whilst many of the above factors are a concern, we do believe that the ongoing weakness will take time to materialise and, in any case, improve affordability. From a portfolio management perspective, we have maintained our nil exposure to real-estate investment trusts (REITS) and are cautious on housing-related securities including domestic retailers and domestic banks, were we have been reducing our exposure.

Portfolio Positioning:

Our view on the Australian Dollar remains unchanged from that presented in our July 2018 quarterly update, and we continue to position portfolios to benefit from a falling Australian dollar by increasing portfolio weightings to unhedged international equities and domestic companies with offshore earnings. The AUD fell 2.44% against the USD over the last quarter.

  • Domestic Equities – Qualitatively, we maintain our overweight exposure to sectors and individual stocks that benefit from attractive long term structural growth with the added benefit of favourable foreign exchange movements in particular those operating in the Healthcare sector.  We have also been reducing our weighting to domestic Financials and adding to the Materials sector. As always, we will continue to take profits where suitable and buy the dips in selected stocks.
  • International Equities – We continue with our targeted approach to international equities with a focus on the US technology sector and the Asian region. Asian stocks have experience downside pressure over recent months on the back of trade concerns, however we are comfortable with our allocations and maintain our view that the region remains the best structural growth story and provides a significant longer-term opportunity for patient investors.  We have been introducing exposure to US Financials, a sector that we believe is well positioned to benefit from rising interest rates, tax cuts and reshaping of regulation.
  • Fixed interest – We continue to favour financial hybrids offering attractive fully franked yields and those trading at discounts to face value. We will continue with our rotation strategy where appropriate.
  • Property – And outlined above, we are underweight sectors exposed to a slowing domestic housing market. This tactical decision remains.