Ready for what’s going down
06/12/2018
THIS REPORT IS SPONSORED BY FTSE RUSSELL
Volatility and downturns lie ahead, nearly all analysts agree. As a defensive stance becomes more common, superannuation funds also need to leverage their long-term horizons to cash in on opportunities.
“May you live in interesting times” is a well-known curse that seems apt for the financial context foreseen for 2019. After a long period of low volatility, many events are set to take their toll. Macroeconomic effects from the winding back of US and European monetary policy, and geopolitical impacts including US President Donald Trump’s tariffs, Brexit, and China’s slowing economy will cause ripple effects on markets, experts say.
The end of quantitative easing in the US and the Fed’s new cycle of interest rate hikes is the equivalent of “quite a big rock being thrown into the pond, and the ripples will be big”, says Philip Lawlor, managing director, global markets research, at FTSE Russell.
This year, investment sentiment has rotated from heightened risk appetite (considering the opportunities) to heightened risk aversion (focusing on potential risks). “When we start looking into 2019, there are clear questions that need to be addressed,” Lawlor says.
“Have we already seen the peak of the economic cycle, and what does this imply for the corporate earnings revenues and valuation cycle? Now is the time to consider the second-order consequences of the tightening of US conditions. Everyone needs to be very systematic in how they appraise that.”
Chris Trevillyan, director of investment strategy at Frontier Advisors, also cites the impact of the US Federal Reserve reducing its balance sheet and raising interest rates but notes that markets are pricing in only two or three more rate rises.
Inflection point
“Frontier believes we are at a key inflection point where either the traditional drivers (i.e. labour capacity) will exert upward pressure on inflation or a new paradigm of technology, and its impact on labour markets, will mean inflation remains low and central banks will not be compelled to tighten significantly,” Trevillyan says. “The European Central Bank has been tapering its QE program. It is still injecting liquidity into the market and monetary conditions remain highly accommodative but this tightening has been coincident with slowing growth in 2018. It has advised it will halt QE at the end of 2018.”
As a result, superannuation funds will have to focus on their strengths and react to changing conditions accordingly, said Michael Winchester, head of investment strategy at First State Super.
“We came out of a period with fairly low volatility and fairly strong returns for growth assets,” Winchester says. “Going forward, we don’t think that can continue. We think volatility will return to normal levels, and the returns for growth assets will no doubt be lower. It’s not news here but being diversified is really important.”
Superannuation funds are longer-term investors and should focus on that horizon, Winchester says.
“I don’t think we really have a big edge in short-term trading, so we really should not second-guess short-term trading, but focus on the longer term,” he says. “We need to understand the risk appetite, reduce exposure at the margins where the long-term prospects aren’t really compensating you for the risk.”
Eyes on the growth rate
FTSE Russell’s Lawlor notes that, using a two-year moving average, the US nominal GDP has grown at 4-4.5 per cent a year over the last few years, contrasting with an average closer to 6-6.5 per cent a year in the 10 years prior to the GFC. With US consensus real GDP and inflation pointing towards lower nominal growth in 2019, it looks as though Trump’s tax cuts have not succeeded in delivering a higher, sustainable growth trajectory.
“I think everyone should be looking very diligently at the rate of growth. In our presentations, we link the leading indicators to the excess that equity can return over bonds,” Lawlor says. “Equities have massively outperformed bonds over the past few years. If the rate of change declines, the excess returns of equities over bonds will follow suit.”
He also points out the apparent dichotomy in the US, where economic indicators are “doing very well” but the US dollar bond yield curve is “flattening dramatically”.
Trevillyan points out that earnings growth in equities has been strong, particularly in the technology sector.
“There appears to be a secular change in industry dynamics from technology – market leaders are obtaining increasing market share, growth is less capital intensive and labour is receiving a diminishing share of output,” Trevillyan says. “Margins are at historically high levels and, in the US, earnings are now above long-term trends, including the correction of the GFC. Equity valuations globally are not overly expensive and after the October correction, some sectors appear undervalued (e.g. emerging markets).”
He notes that US equities are the “most expensive”, but earnings growth has been strong, while credit spreads are near historically low levels and prices continue on an upward trend for property and infrastructure assets. He says US economic and earnings growth have been supported by President Donald Trump’s fiscal policy, and, “although this will start to fade”, it will continue to be supportive in 2019.
The slowing Chinese economy is a key uncertainty – resulting moves by Chinese authorities to stimulate the economy have yet to show impact on economic activity, Trevillyan says.
So what should the response be from institutional investors? The “knee-jerk reaction” in 2018 to increased market volatility was to get defensive, Lawlor says.
“If you look at global sectors, that rotation began in April, and it became quite a pronounced rotation,” he explains. “Even though the US was powering ahead, still, the underlying view was getting quite conservative from about April. When you get the real turbulence, you go to healthcare, telecoms and the utilities, and we saw all that happening.”
If the US technology sector has peaked, the market will search for new leadership. Lawlor points to the financial sector as one of interest.
“What we need to see is a steepening yield curve,” he says. “If the Fed raises rates and the yield curve steepens, financials will do well. This has an impact on the high valuations of the tech stocks, and that’s why we have to be very focused on what the yield curve does.”
There might be potential for more tactical trading in sectors as well, Trevillyan says.
“Potentially, it’s being more tactical to move in and out of markets as opportunities present,” he says. “With the volatility in October, equities were down almost 10 per cent in such a short amount of time. Ideally, you would have been selling down before and considering buying in on the dips, as the markets have rebounded quite strongly in the past week or so.”
Investors could also consider selling high-yield bonds and, in property portfolios, selling lower-quality assets.
“For many of our clients, super funds are in the enviable position of having strong cash inflows,” Trevillyan says. “What it can mean is allocating more capital towards the core lower-risk end of the spectrum. There’s also the alternative of option overlays, and it is about putting in place strategies that hopefully perform in a downturn and provide protection in the portfolio; foreign currency has also historically done that.”
Be ready to pounce
If major markets have peaked and the downturn is coming, it could be advantageous for funds to keep liquidity, to be opportunistic as assets reprice.
“Given the stage of the cycle we’re at, you also want to make sure you have some dry powder,” Winchester says. “At some point in the next few years, we’ll have a recession in the US at least, and that’s typically not great for markets anywhere. You don’t want to reach that stage of the cycle and not have the ability to take advantage of opportunities as they arise, because at some point, we think we’re going to have the opportunity to deploy capital, to achieve really attractive returns.”
Winchester also notes that the strategies for portfolios differ, depending on whether they’re for members in the accumulation stage or the decumulation stage.
“We manage money for people in the accumulation stage and also people in the retirement stage, and we manage money differently because clients have different risk profiles,” he says. “A retiree is going to need to draw from their capital to fund their lifestyle on an ongoing basis. For accumulation portfolios, we tend to be more focused on the long-term opportunities. For the retirees, we’d need to think about shorter-term risks and that colours the approach to asset allocation. We’re about at strategic levels for growth asset exposure for the accumulation portfolios but for the retirement portfolios we’re a little bit underweight because we want to make sure we manage risk appropriately.”
