Investment Matters - July 2019 - Macquarie · 2020. 9. 11. · market (helping boost flagging...

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Investment Matters

Trade truce + Easy money = Bullish markets (for now)

JULY 2019

macquarie.com

Trade truce + Easy money = Bullish markets (for now)

Risk assets have had an exceptionally strong first half despite rising growth concerns which have driven strong inflows into defensive assets like bonds and gold. The rationale for this has been quite simple.

Rising economic uncertainty has been matched by expectations of easier monetary policy and, with central banks unconstrained by inflation, they have followed up with a commensurate dovish policy pivot.

Policy easing works with a lag so there is always a high degree of uncertainty around the timing and magnitude when it does come. What we do know is that key central banks appear intent on sustaining the (global) economic cycle and when there is intent, it generally pays not to bet against them even if you are not prepared to bet on them.

On this basis, we remain with a modest pro-cyclical asset allocation stance of favouring equities over bonds and cash. It is too early to determine whether another round of global monetary policy easing (the 4th such episode since the end of the GFC) will be sufficient to drive equity markets meaningfully higher, but the potential for policy easing to stem growth weakness is enough to avoid moving more defensive, despite ongoing concerns around elevated valuations and slowing earnings growth.

Without clear evidence of reflation, equities are more likely to grind their way higher. This is because they are already incorporating the benefit from easier monetary conditions. On the other hand, the bond market is taking the opposite view and is pricing in a growth deterioration with no accompanying improvement. We think bonds are most at risk if reflation does gain any traction and this is reflected in our underweight to global sovereigns.

However, any bond market sell-off is likely to be relatively minor with long rates anchored by the likelihood of an eventual recession or growth slowdown in coming years. We recognise that falling interest rates are driving a hunt for yield within fixed income (almost at any price if flows into negative yielding bonds are an

indication), but we don’t see this as sufficient to prevent long rates rising if inflation or growth picks up.

Domestically, the investment backdrop has been a beta play on international trends with both equities and bonds outperforming global counterparts over the last 12 months. This is unusual and was not expected particularly for equities. Looking ahead, the combination of an investor friendly government, a recovering housing market (helping boost flagging consumer spending) along with further interest rate cuts by the RBA should provide a positive tailwind for equities, particularly those areas most interest rate sensitive, having been battered for the past 2 years.

We accept that the coalition government along with the RBA have a large task on their hands, not only in stemming the growth deterioration, but in driving a positive trajectory when global growth is tracking so modestly. Macquarie are now forecasting the RBA to cut the cash rate to 0.5% by 2021 and for long bond yields to barely budge from around 1.5% for the next few years.

However, this low rate backdrop supports valuations for cyclically depressed sectors as well as for interest rate sensitive areas, high growth stocks and by association, the market. It is a misconception to believe that high valuations are self-correcting. Consequently, we believe equity valuations are broadly justifiable, at 16x forward earnings, even if this has historically proved to be the ceiling. Admittedly an earnings recovery will take time to emerge but determining the strength and timing of a recovery is secondary to whether there is confidence that growth is bottoming. If growth bottoms, we are prepared to wait for a recovery but in the meantime, to remain prudent in when and where to take profits.

While uncertainty remains high, we still prefer equities over bonds which is a reflection of our belief in the cycle which is old but dying slowly. The need for diversification, within and across, both equities and bonds are rising in order to reduce risk and leverage areas that might see a cyclical upturn. Investors should be vigilant about using unproductive cash balances to enhance yield as deposit rates continue to decline.

Jason and the Investment Strategy Team

Asset class preferences

Quick takeaway

We have slightly reduced our overweight to cash as we increase our Australian equities and REITs positions.

Recommendation

We are overweight REITs. Lower short and long-term interest rates and easing credit conditions in the housing market should provide a supportive backdrop for residential while office remains solid. Falling rates will continue to support valuations despite having moved a long way towards normalizing post the Federal election. An attractive dividend yield along with dividend stability underpins our overweight recommendation

We maintain our neutral allocation to fixed income and still favour credit markets to developed sovereign markets in general. Domestic government bonds remain our preferred exposure for interest rates as we see less potential for yields to back-up compared to other developed sovereign markets . We do not think that higher rates in the long end have the potential to move meaningfully higher while offshore government yields remain so low, particularly in the Eurozone. The coordinated accommodative stance by global Central Banks should underpin credit spreads.

We are underweight Alternatives to provide funding for our overweight Australian equities. We view equities as having the greater risk-adjusted returns at this time. Within hedge funds, we continue to prefer strategies with low beta to global equity markets. Fund selection remains critical given return dispersion across hedge funds.

We maintain our overweight to Australian equities. The RBA delivered a second consecutive rate cut (and is prepared to do more), iron ore and gold prices continues to surprise to the upside, while lower bond yields continue to support defensives and rate-sensitives. Housing data continued to strengthen while near-term tax cuts will support the struggling retail sector. Economic fundamentals remain fragile but improved sentiment with greater policy support should allow further multiple expansion in selected (cyclically depressed) industries such as banks, retail, building and construction and residential housing exposed areas.

We maintain a neutral allocation to global equities. The G20 proved pivotal with a US-China trade truce helping sentiment. Our overweights to emerging markets and Australia provides leverage to a potential successful deal. Central banks also reiterated their clear intent to support the cycle which boosted risk appetite. Within developed markets, we continue with our preference to US equities ahead of European and Japanese equities. While the US economy is slowing, the Fed appears poised to cut rates which should provide market support over the near term.

Source: MWM Research, July 2019

Economic update Global & Australia 4

Global economics – Increasingly dependent on monetary stimulus

• US growth weakness to be met by monetary policy easing;

• China slowdown continues but has not reached a level requiring more aggressive stimulus;

• Trade war resolution hopes rekindled at G20 meeting, but the likelihood of a permanent “deal” remains low for now.

Global growth is again weakening after signs of stabilisation in the first quarter of 2019 with weakness coming through via both manufacturing (PMI’s) and trade volumes. PMI measures suggest that global GDP growth has slowed to around 2.0% pa in Q2 from 2.5% in Q1. The May headline and new orders components of the global manufacturing PMI were weak with the risk on the downside given survey timing and additional tariff impacts to flow through.

US-China trade tensions, which have been a key driver of rising uncertainty, took a positive turn at the G20 meeting with an agreement to renew negotiations. Despite this tentative truce, latest global trade volume data for April suggests that the early year recovery may have already begun to fade. Export growth has been particularly weak, now down 3.1% since October although Chinese exports bucked the trend due to frontloading to beat the threat of additional tariffs.

The last two months have seen a significant rally in global short and long bond markets as growth clouds darkened. The short end moves reflects the expectation of a coordinated policy response of rate cuts and the potential for a return to QE, while long rates have been anchored by pessimism around the ability of easing to reflate growth. Macquarie believe that while bond yields are pricing in the end of the current economic cycle, a near-term recession remains unlikely. Short rates will potentially retest the zero bound as we approach the next growth slowdown/recession.

PMI suggest global GDP will weaken further

Source: Macquarie Research, MWM Research, July 2019

United States: Window of vulnerability

As the length of the US expansion moves into unchartered territory, economic vulnerabilities will inevitably increase. Rather than households being the key risk, this cycle the worrying trend is US corporates taking advantage of record low interest rates to engage in financial engineering and use cheap debt to buy back stock. This has resulted in high leverage with businesses increasingly winding back capital spending in order to maintain leverage ratios rather than be downgraded by credit rating agencies. An example of this dynamic is new durable goods orders contracting at a -2.8% annual rate in May

While growth has been slowing, key recession indicators are not flashing red. Credit spreads are trending higher, yield curves lower, the ISM PMI manufacturing index has dropped to 52.1 and weakness across regional and Fed surveys suggest that the weak May employment print of +75,000 may not be an isolated event. The household employment survey suggests employment weakness is becoming more pronounced with employment in May now down around 200k from the peak in December 2018.

The US economy has moved out of this ‘vulnerable zone’ twice during this expansion, avoiding further deterioration in 2012 and 2016. 2012 was relatively early in the post-GFC economic recovery and was in no small part assisted by a significant Chinese stimulus program. The 2016 recovery was again assisted by Chinese stimulus followed by a significant domestic fiscal stimulus from Trump’s tax cuts. As the US economy moves into its 121st month of expansion it is more reliant than ever on monetary stimulus to extend its record period of growth. While signs of recession are not yet present, growth is slowing but stimulus will prolong the cycle.

US employment growth slowing

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

2012 2013 2014 2015 2016 2017 2018 2019

12-month growth in EmploymentCurrent Population Survey

0.7%

Average 1.5%



China: Double dipping

China’s economy appears to be faltering again after the boost gained from the credit stimulus earlier this year. The Chinese manufacturing industry remained in contraction in June with the NBS PMI index flat at 49.4. However, despite this weakness, Macquarie’s China economist believes that while growth is slowing and likely to deteriorate, it is not bad enough to drive a higher-level of stimulus.

While these announcements are positive for sentiment and any resolution on tariffs would be a clear positive for the Chinese economy, we think it is the beginning of a much tougher environment for Chinese exports with political hostilities and distrust are on the rise between many developed nations and China. Economically, it’s reasonable to expect some ongoing fallout from continued political hostility regardless of the outcome of the tariff discussions, although we remain confident that China has the tools at its disposal to boost growth (albeit temporarily) when called upon.

Chinese manufacturing PMI remains in contraction


Europe: More of the same

Fears of a Eurozone recession have abated in recent months with Q1 GDP bouncing 1.6%, up from a recent low of 0.5% in Q3 last year. Macquarie believe that final domestic demand has been more stable than GDP and indicates that Q2 GDP growth should moderate from the recent high. Real retail sales has been an area of weakness, particularly in Germany, falling by 0.4% in April.

Global growth risks and subdued Eurozone inflation provided Mario Draghi the backdrop to argue that more monetary stimulus is likely to be required. He highlighted at a recent ECB forum that further cuts remain “part of our tools” and renewed asset purchases are an option but may require raising self-imposed limits. The Eurozone inflation rate remains entrenched below the ECB’s goal and a 1% economic growth rate may be as good as can be hoped for over the medium term.

Australian economics – Policy easing underway

• The RBA has cut rates twice in a month as it works to offset deteriorating growth momentum;

• Macquarie forecast the cash rate to decline to 0.50% by the end of 2021;

• Sentiment around housing has rebounded strongly but construction activity still presents a downside growth risk alongside weak income growth

• Without a strong fiscal pulse, the economic trajectory is likely to remain modest even with the help from tax cuts.

Despite a positive market reaction to recent domestic events our economist believes the path forward for the Australian economy will be difficult, with interest rates on pause before heading lower. Macquarie’s forecast is now for the cash rate to hit 0.50% by the end of 2021 and for 10-year bond yields to reach as low as 1.25%. GDP is forecast to remain below potential with only a gradual improvement in the unemployment rate. Household income growth is forecast to remain challenging notwithstanding lower interest rates and modest tax relief.

Australia is in a unique position having avoided a recession for 28 years and counting. However, over this time, Australian households have taken the opportunity to leverage up resulting in one of the highest household debt to income levels in the developed world at ~190% of disposable income.

GDP growth remains tied to trading partners


Australia’s economic path has brightened in the short term following recent events. The continuation of the Coalition government, RBA rate cuts and the Australian Prudential Regulation Authority’s (APRA) proposed relaxation of minimum interest rate hurdles for mortgages have all contributed to an easing of negative


sentiment on housing and potentially easier credit conditions. In addition, the iron ore price continues to defy the slowdown reflected in other commodity prices such as copper and other industrial metals.

Key highlights:

• Labour market – unemployment above NAIRU:Unemployment remained at 5.2% in May, wellabove the RBA’s NAIRU estimate of 4.4%.Employment strength over the year to May hasbeen relatively concentrated in industries suchas professional services, education and publicadministration.

• Wages – adjustment continues: Householdincome growth remains weak and continues toweigh on consumer spending. The economycontinues to undergo a slow adjustment tolower commodity prices and resourceinvestment.

• Inflation – below target for the foreseeablefuture: Soft wage growth and subdued housing-related inflation imply inflation will continue totrack below the RBA’s 2-3% target band for theforeseeable future. This level of inflation won’tbe a barrier to further RBA rate cuts.

• Consumer spending – downside risk has eased:Macquarie now expect the risks to consumerspending to be more balanced after recentdowngrades to expectations on the back ofhousing related risks to discretionary spending.Spending should get some support from H2 taxrelief assuming it is legislated.

• Housing – price stabilisation follows easingcredit: Sydney and Melbourne have recordedtheir first monthly house price growth for 2years. Lower interest rates and improvedsentiment post-election have led to a boost inthe two largest capitals while the national indexstill recorded a fall.

Public sector employment has been robust


Sentiment surrounding the Australian economy has swung to the positive in recent weeks, reflected in a strong equity market and stabilisation in the housing market. Iron ore prices remain supportive of terms of trade and a fall in the A$ could lessen any further deterioration in economic conditions. The RBA has cut interest rates for the second time in a month which should provide further support to the housing market.

Discretionary spending remains weak


Asset class outlook International equities 7

International equities – Rates and trade supporting sentiment

• We retain a neutral allocation to global equities;

• A trade truce and central bank easing will supportvaluations in the short-term, but the end-game forthe trade-war remains uncertain;

• Our overweight to Australian and EM equitiesprovides leverage to optimism around trade, whilewe continue to like US equities for upside fromeasier monetary conditions.

Central bankers have made it clear that they will attempt to extend the current cycle with further monetary easing. The Fed, ECB and BoJ all hinted at rate cuts or asset purchases in the last month which proved enough to dampen volatility and more than reverse the losses of the prior month.

The G20 US-China trade truce was broadly in line with expectations, but also clearly positive for risk appetite. Tariff increases have at least been delayed (for now) and good intent has been shown by both sides (agri purchases, Huwaei ban reversed). Negotiations appear to be progressing for the moment which should drive improved newsflow over the next month or so. However, the renewed focus on Europe (US$4b tariff increase) is a reminder tariffs are still the preferred weapon of choice for the US.

We expect global equities to trade tentatively higher from current levels as trade resolution hopes rebuild. The risk of negotiations falling apart will keep animal spirits in check and we expect defensive assets (gold, treasuries etc) to remain well bid as growth concerns linger.

Equity market preferences

Allocation

Australian Equities

International Equities

US

Europe

Japan

EM

Str

ong

Ove

rwei

ght

Str

ong

Und

erw

eigh

t

Und

erw

eigh

t

Neu

tral

Ove

rwei

ght

Source: FactSet. MWM Research, July 2019

Emerging markets remain our largest overweight with performance improving ahead of the G20 as US-China tensions thawed. We expect this to remain a typically volatile position as trade talks continue. However, an easing of global financial conditions, China stimulus and undemanding valuations support our overweight. The improving outlook likely encouraged allocators with EM equity inflows surging US$12.6b during June.

Our next preference is for US equities, particularly for growth-biased investors. While valuations are elevated, they are still below the peaks of last year, providing scope for a modest re-rate. The S&P 500 and Dow Jones have once again hit all-time highs which alongside rate cuts should support sentiment in the short-term.

The US 2Q19 reporting season will likely prove choppy with tariff disruptions and ‘tough comps’ driving negative year-on-year earnings (current estimate -2.6%). We don’t see this as a major hurdle as guidance commentary will be the focus e.g. during 2Q18 earnings were +24% but guidance commentary softened and ultimately proved to be the market top.

Expect a soft US reporting season

-15%

-12%

-9%

-6%

-3%

0%

3%

6%

EPSg % S&P 500 earnings growth, 2Q19Current 31-Mar-19

Source: FactSet. MWM Research, July 2019

We continue to prefer fully unhedged international equity positions. Recent A$ strength will be disappointing for the RBA, following two consecutive rate cuts, but there is clear scope for further easing. In reality, a lower iron ore price will likely be necessary to drive the next leg lower.

Stick with Australian and EM equities for leverage to improving growth momentum. US equities are best placed to benefit from easier monetary policy while European equities still require more aggressive Chinese stimulus to trade sustainably higher.

Asset class outlook Australian equities 8

Australian equities – Stimulus trumps earnings weakness

• We maintain an overweight to Australian equitieswith ongoing monetary stimulus supportingsentiment;

• Valuations are full and earnings momentum poor butthe market is looking through the trough;

• Cyclical sectors will require some signs of animproving earnings backdrop if they are to providemore consistent leadership for the market fromhere.

A combination of the Coalition’s federal election victory, RBA rate cuts, ongoing M&A, falling bond yields, thawing global trade tensions and a lower Australian dollar support an improving outlook which has boosted sentiment and valuations.

Underlying fundamentals remain weak, but that is the necessary evil to force monetary stimulus. The debate will continue around how supportive policy easing will be for equities given poor economic and earnings fundamentals. Ultimately, the market will require some improvement in earnings momentum for the cyclical and/or rate sensitive areas if the rally is to continue.

The upcoming August reporting season will confirm a tough backdrop but clues to the outlook will be more important. Industrials earnings growth for FY19 (ex banks, resources, REITs) is now negative. The improved policy support is yet to be flow through to earnings e.g. East Coast house prices appear to have bottomed out in June, but turnover remains very low – a negative for retailers, online portals etc. As such, investors should be prepared for overall soft FY19 results, but more upbeat guidance FY20 guidance.

Midcaps have seen worst of downgrades

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Jul-18 Oct-18 Jan-19 Apr-19 Jul-19

index pts Earnings per share - next 12 monthsS&P/ASX 50 S&P/ASX 50 MidCap

BLD, IPL, PDL

CGF, LNK, RWC, SGR


The iron ore miners will be the likely standout for reporting season potentially delivering significant

earnings growth. The outlook into FY20 is supported by current pricing around $120/t, well above analyst forecasts for ~US$80/t, providing plenty of upside to current earnings forecasts (see chart).

Iron ore earnings upside at spot

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FMG MGX CIA MIN RIO BHP

% Iron ore - FY20 earnings upside at spot


At the opposite end of the spectrum, our bank analysts remain unenthused by the sector as RBA rate cuts are detrimental to sector profitability. Deposit pricing can only reduce so much before forcing a margin squeeze (deposit rates of zero won’t go negative). All else equal, the RBA’s July rate cut will reduce earnings by 3-4%, creating a further challenge to sector earnings growth.

For yield investors we believe bank dividends are mostly sustainable at current levels, albeit with no growth. Westpac (WBC) is the exception with the group’s 93% FY19 payout ratio presenting risk of a modest rebasing. Our long-held preference is to prioritise dividend growth within income portfolios, despite lower starting yields (or second, high but stable yield). Companies such as Amcor, Sonic Healthcare and Transurban are forecast to deliver dividend growth of at least 5% over the next few years while still offering an upfront yield of ~4%.

Elevated valuations is arguably the most common pushback to our overweight positioning. The 12-month forward price/earnings multiple of 16.4x is approaching previous peaks valuations of ~17x. However, it is normal for the market to trade expensively when earnings are cyclically weak (as they are now). We see scope for selected domestic cyclicals to re-rate from undemanding levels while the miners are also on relatively low multiples. Ongoing rate cuts and low bond yields will also provide support with the equity risk premium (earnings yield spread to 10-year bonds) at multi-year highs.

Asset class outlook Fixed interest 9

Fixed interest – Easy

• We are neutral fixed income;

• Our preference remains for credit spread productover a 6 to 12-month horizon;

• Sovereign yields are likely to remain rangebounddespite accommodative central banks. We see lessdownside risk in Australian vis-à-vis global developedsovereigns.

Developed Sovereign yields – likely higher from here

Yields on sovereign bonds continued to slide in June as pessimism intensified and Central Banks moved to reassure the markets that they stood ready to act if required.

The market is currently pricing in around 80bps of cuts to the Fed Funds rate between now and February which seems overly aggressive to us in the current environment. If we are proved correct, then long yields should move higher throughout the remainder of this year.

Globally, inflation and growth expectations remain low and this is what we are seeing in the long end of developed market yield curves. In particular, the Eurozone outlook appears bleak, with signs that a broad-based slowdown is underway.

The European Central Bank (ECB) committed to leaving rates unchanged through the first half of 2020 however, recent data leaves little doubt that easier monetary policy is now required. ECB policy rates are already negative and to cut further into negative territory increases pressure on the banking system via further compression on net interest margins. Aside from forward guidance, restarting the asset purchase program remains a likely option particularly given inflation expectations are back at lows. Alongside German yields which are deeply negative, we think that this will act as a cap to the upside risk to US long bond yields despite the Fed’s accommodative stance.

The key risk is that central bank easing is too little too late and that inflation expectations continue to soften despite the dovish stance of the Fed causing long bond yields to fall even further.

Corporate bonds – to remain supported

We remain comfortable with our preference for credit spread product relative to sovereign bonds over a 6 to 12-month horizon. Credit spreads and markets shouldremain well bid given the rhetoric of central banks. Certainly, primary issuance in the high yield space is

again strong as borrowers move to take advantage of low rates. Dealogic data shows total issuance year to date is at U$105billion compared with U$84billion at the same point last year.

While spreads have largely retraced much of the widening seen in December 2018, BB-B non-financial spreads are close to the five-year average suggesting that there is further room for spread to narrow. Absent any deterioration in corporate earnings relative to the amount of corporate debt growth – we expect the market to remain well supported while financial conditions remain loose.

High yield spreads at five-year average level

250

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550

600

650

700

750

Jul-14 Jul-15 Jul-16 Jul-17 Jul-18

ICE BofAML Global Non-Financial BB-B Option Adjusted Spreads

Source: FactSet, MWM Research, July 2019

Macquarie economists’ forecasts updated

Macquarie forecast the US 10-year yield will remain anchored by the likelihood of an eventual recession or growth slowdown in coming years. It is forecast at 1.9% by year end 2019 and 1.5% by year end 2020.

Global Fixed Income Preference

Allocation

Duration

Australia

Develop. Sovereign

Global Credit Spread

Investment Grade

High Yield

EM Hard Currency

EM Local Currency

Ove

rwei

ght

Str

ong

Ove

rwei

ght

Str

ong

Und

erw

eigh

t

Und

erw

eigh

t

Neu

tral

Source: MWM Research, July 2019

Asset class outlook Alternatives 10

Alternative assets – A way to hedge the tail

• We maintain a slight underweight to alternatives;

• Private markets should remain well supported asallocations to equity and debt raisings remain strong;

• We continue to prefer strategies with low beta tolisted equity and credit markets.

We maintain our slight to underweight alternative asset despite our expectations that volatility will remain elevated across sectors and all financial markets. While volatility is expected to remain high, we are not expecting to see a sustained downturn in risk assets while central banks are easing in a co-ordinated fashion. Consequently, we think risk-adjusted returns will be greater for Australian equities – our largest overweight. Within alternatives, we continue to favour fundamental long/short strategies, diversified macro and trend following strategies as well as relative arbitrage strategies. We think fund selection will continue to prove more important than overall asset class allocation given recent return spreads.

Private markets – Interest levels remain high

Private equity Dry powder levels continue to get headlines as do the size of some of the deals announced. This has prompted some to rethink their expectations of returns from so-called “mega funds” (those that raise U$10billion or more). Research published by Cambridge Associates is that returns from mega funds are more like those available in public markets than they are to private equity funds of other sizes. Also, the correlation between the returns of mega funds versus public equity funds is greater than 60% - double that of PE funds with less than U$1billion.

Mega fund size does not equal mega returns

0%

3%

6%

9%

12%

15%

18%

3 year 5 year 10 year

Returns on modified Public Market Equivalent basis

Mega funds Russell 3000

Source: Cambridge Associates, MWM Research, July 2019

Private debt activity continues in both domestic and global markets as traditional lenders exit the market. Private debt opportunities are presenting themselves across many aspects of the financing space from trade finance, asset financing and operating leases in the global transport sector and more traditional loans to SMEs. Much of this opportunity has been driven by banks exiting the lending due to changes in the regulatory environment and the risk weighted cost of capital. Data released from Preqin forecasts the assets under management in private debt strategies to double over the next five years to U$1.4trillion. Certainly, we continue to see opportunities in this space from both domestic and global fund managers. Yields on offer are sitting around 8-12% after fees depending on the market segment and the liquidity terms, making this attractive relative to yields available in developed public debt markets.

Hedge funds – continue to prefer low beta strategies

Within hedge funds, we continue to prefer strategies that have low equity market beta. Merger arbitrage strategies remain our preference however, lower interest rates can result in lower deal spreads. Fundamental macro and systematic strategies are also typically low beta, although fundamental macro strategies may find the increasingly accommodative stance of central banks difficult to navigate. We continue to like systematic macro/trend follower strategies as an effective tail risk hedge, however, expect some volatility in upcoming return numbers due to the sudden shifts in macro policies that have driven rapid changes in market direction and positioning. Irrespective of the strategy, however, return dispersion between hedge fund managers means that fund choice is critical to ensuring the fund benefits the overall portfolio in an asset allocation.

Fund selection is critical in hedge funds

-10

-5

0

5

10

15

20

25

1 year 3 year 5 year 10 year

Return dispersion in Absolute Return Funds(Universe: Australian Absolute Return WS Funds)

Median

Source: Mercer, MWM Research, July 2019

Asset class outlook Real assets 11

Real assets – Targeting stability and income generation

• We maintain an overweight to REITs. Valuationnormalisation (P/NTA) and the risk of a bounce inbond yields will cap near term outperformancepotential but “look through" appeal remains highgiven yield attraction and low price volatility;

• Residential sentiment has bounced sharply, and thisis reflected in auction clearance rates and pricemomentum. Upside to fundamentals will follow;

• Retail remains mired in a structural downturn drivenby rising competition (foreign and online), weakincome growth and changing consumption patterns.This downcycle has further to play out.

Falling bond yields remains the dominant driver of performance for Australian REITs and long duration real assets such as infrastructure. We expect this to continue and for relative performance to ebb and flow as expectations around economic growth oscillates.

Investors must be willing to deal with volatility in the capital value of their real asset investments if they wish to maintain exposure to this sub asset class. However, on the other hand, the absolute level of the yield available (4-8% depending on the investments), as well as the stability of this yield, is a substantial positive that should be weighed up against macro factors impacting overall sentiment.

Performance over recent months suggests that a lot of the capital appreciation and valuation normalisation due to falling bond yields has been front end loaded into sector returns. Going forward, we expect returns to be much more aligned with the dividend yield plus earnings growth. This remains attractive in an environment where cash returns are trending to zero and where elevated valuations for other asset classes make them susceptible to more severe downside.

Dwelling price picked up in capital cities

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Per centMonthly Dwelling Price GrowthAnnualised, seasonally adjusted

Sydney

Melbourne

Brisbane

Perth

Adelaide

5 capitalcities


Scratching below the surface of rate driven performance, the fundamental backdrop for Australian REITs remains varied. Sentiment towards the residential exposed REITs has dramatically improved following the recent Federal election and RBA rate cuts with latest June figures released by CoreLogic showing a slight positive uptick for prices in both Sydney and Melbourne for the first time in nearly 2 years.

Over time, stronger demand should show up in improving developer operating margins. Easier access to credit should also benefit sales volumes and reduce the probability of defaults, which has been gradually picking up. However, the overhang of supply as well as falling valuations for off the plan apartments will still need to be worked through the settlement process. We are not expecting this to drive a systemic increase in defaults as a result of unwillingness to settle, but the potential for ongoing negative news flow remains high for at least the next few quarters. Under coverage, the preferences to leverage this improving housing thematic are Lend Lease (LLC), Mirvac (MGR) and Peet Ltd (PPC).

REITs dividend yield spread to Bond yield

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2

4

6

8

10

2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

Per cent REIT DPS yield vs 10Y bond yield

Average spread

+/- 1 Std Dev

Source: FactSet, MWM Research, July 2019

Retail: While the election result and potential tax cuts are positive for the retail sector, it remains mired in a cyclical and structural downturn that is only partially complete. Business conditions for retail are amongst the weakest of any sector within Australia as it deals with increased foreign competition in both food and non-food segments, declining foot traffic and operating margin pressures. We see no near term respite even in the face of an improving housing sector.

Office: Office remains solid, with comparable NPI, incentives and occupancy trending in the right direction. Given upcoming supply pipelines, we believe metrics will likely moderate from here (lower rental growth, higher capital intensity, etc.), but we believe this will be a gradual slowdown and fundamentals will remain positive within the context of ongoing retail headwinds and a gradually improving residential outlook.

Monthly performance 12

Monthly performance - June 2019

Australian equities The Australian share market posted another strong return in June, driven higher by RBA’s cash rate cut announcement last month and the increasing probability of US Fed rate cut. The S&P/ASX 200 Accumulation Index closed June trading +3.7% higher, whereas the S&P/ASX Small Ordinaries added 0.9%. The best performing S&P/ASX 200 sectors were Materials (+6.4%) and Industrials (+5.4%) while Consumer Discretionary (-1.5%) was the only sector that ended in the red.

Amongst larger companies the best returns were from Goodman Group (GMG, +13.3%) and diversified miner BHP Group (BHP, +9.0%), while the underperformers were South32 (S32, -4.2%) and Wesfarmers (WES, -2.4%), the latter of which saw a large sell-off after aweak performance update on Kmart Group.

The S&P/ASX Small Ordinaries Accumulation Index (+0.9%) underperformed the S&P/ASX 200 Accumulation Index (+3.7%), despite the contributions from strong performers Silver Lake Resources (SLR, +56.9%) and Clean TeQ Holdings (CLQ, +38.2%). Theworst performer was gold miner Dacian Gold Ltd (DCN,-66.6%) which was slashed after it downgraded its 5year outlook.

International equities The global stock markets in June performed exceptionally strong, thanks to the accommodative tone from Central Banks and growing optimism for progress in US-China trade talks. The US stock market has had a remarkable run, with the Nasdaq (+7.4%) led the sharp increase, followed by the Dow Jones (+7.2%) and S&P 500 (+6.9%) both of which experienced a strong rally.

European stock markets regained steam, with market participants calming down after the European Central Bank reassured more stimulus is possible. The best regional market Italy (MIB 30) advanced 7.2%, followed by France (CAC 40, +6.4%), Germany (DAX, +5.7%), UK (FTSE, +3.7%), and Spain (IBEX 35, +2.2%).

In Asia, Hong Kong’s Hang Seng (+6.1%) bounced sharply from the half-year trough, claimed the prior territory lost in May. Japan’s Nikkei and China’s Shanghai Composite index gained +6.1% and +3.3% respectively.

Property Australian REITs sector, widely regarded as bond proxies, extended its strong momentum since last November to finish 4.2% higher for the month. Goodman Group (GMG, +13.3%) and Abacus Property Group (ABP, +9.5%) led the strong bounce, while Unibail-Rodamco-Westfield (URW, -5.3%) and Stockland (SGP, -2.7%) were underperformers.

Fixed interest and cash Thanks to the constructive result of the US and China trade talks at the G20 summit, the US 10-year bond yield finally stabilised and surpassed the 2.0% yield level. Similarly, the falling trend of Australian 10-year bond yield since last November has stopped, ending the month at 1.3%. The Bloomberg AusBond Composite 0+Yr Index climbed higher by 1.0%, with Government bonds (+1.1%) outperformed Corporate bonds (+0.9%). The long-term bonds (+10-year, 2.2%) gained more favour from risk-aversion investors than the short-term (0-3-year, 0.4%), due to the higher premium in exchange of longer maturity.

Currency The $A/$US remained rangebound between 0.685 and 0.70, and managed to close at $0.7022 with a 1.2% gain. Within the other trading pairs, the $A strengthened against the Japanese Yen (+0.9%, 75.78), UK Pound (+0.8%, 0.5532), but depreciated against Euro (-0.5%, 0.6177) and New Zealand Dollar (-1.4%, 1.0454).

Market Performance – June 2019

3.7

0.9

5.3

4.5

4.2

1.0

1.3

0.1

11.5

1.9

10.0

4.0

19.3

9.6

7.3

2.0

0 5 10 15 20 25

Aust Equities

Aust Small Companies

Int'l Dev Mkt Equities (Unhedged)

Int'l Emerg Mkt Equities (AUD)

Australian Listed Property

Australian Fixed Int

Int'l Fixed Int (Hedged)

Cash

Return %

1 month 12 months

Source: IRESS, Bloomberg, MWM Research, July 2019

Monthly performance 13

Market performance – June 2019

Market Indices 1 month %

3 month %

YTD %

1 year %

3 year %pa

5 year %pa

30-June-19

Australian Shares S&P/ASX 200 Accumulation 3.70 7.97 19.73 11.55 12.88 8.85

S&P/ASX 200 3.47 7.09 17.22 6.85 8.14 4.17

All Industrials Accumulation 3.01 8.70 18.36 10.45 10.26 8.94

All Resources Accumulation 6.43 5.21 25.23 15.97 26.11 8.04

All Industrials 2.73 7.59 15.86 5.70 5.42 4.09

All Resources 6.43 5.20 22.71 11.46 21.95 4.19

S&P/ASX 100 Accumulation 3.97 8.57 20.21 12.63 13.10 8.86

S&P/ASX Small Ordinaries All Accumulation 0.92 3.75 16.81 1.92 10.66 9.26

International Shares MSCI World Index Hedged in A$ 5.71 2.86 15.14 4.28 10.45 7.19

MSCI World Index (A$ Unhedged) 5.26 4.91 16.16 9.96 11.86 10.93

MSCI Emerging Markets (A$ Unhedged) 4.51 1.20 9.73 4.02 10.34 6.18

Regional Markets (local currency returns) Dow Jones 7.19 2.59 14.03 9.59 14.05 9.59 S&P 500 6.89 3.79 17.35 8.22 11.91 8.46 NASDAQ 7.42 3.58 20.66 6.60 18.24 12.68 STOXX® Europe 600 Net Return 4.47 3.04 16.46 4.28 8.25 5.28 German Dax 5.73 7.57 17.42 0.75 8.60 4.75 FTSE 100 3.69 2.01 10.37 -2.77 4.51 1.94 Nikkei 3.28 0.33 6.30 -4.61 10.95 7.01 Hang Seng 6.10 -1.75 10.43 -1.42 11.13 4.24 Shanghai Composite 2.77 -3.62 19.45 4.62 0.56 7.78

Property S&P/ASX 200 Property Trust Accumulation 4.22 4.07 19.42 19.32 8.13 13.63

Cash and Bonds Bloomberg Composite Bond All Maturities 1.04 3.05 6.59 9.57 4.23 5.06

Bloomberg Bank Bill Index 0.13 0.45 0.97 1.97 1.86 2.08

Citigroup World Government Bond Index Hedged 1.33 2.86 5.47 7.27 2.77 5.02

Citigroup World Government Bond Index Unhedged 1.03 4.84 5.71 11.06 3.02 7.00

Source: IRESS, Bloomberg, MWM Research, July 2019

The Wealth Investment Strategy Team

Jason Todd, CFA Leah Kelly, PhD Aaron Lewis, CFA

Head of Investment Strategy Team

Senior Investment Analyst Senior Investment Analyst

Stephen Ross, CFA Lizette Mare, B Com (Hons) Fred Zhang, CPA

Senior Investment Analyst Investment Analyst Investment Assistant

References

Aussie Macro Moment – RBA cuts, keeps easing bias…now waits, 2 July 2019

Aussie Macro Moment – The economy through a labour market lens, 21 June 2019

Aussie Macro Moment – Unemployment remains well above NAIRU, 13 June 2019

Can global interest rates fall further? – End cycle + diminished policy space = yes…, 20 June 2019

Global Economic Growth … - Slip sliding away…, 11 June 2019

Uncertainty vs Calm and Consistency – Navigating chaos while investing & surviving, 26 June 2019

Australian Equity Strategy – Still positioning for an improving cycle, 25 June 2019

Australian Equity Strategy – Following the Fed (and the RBA), 21 June 2019

Listed Property Sector – News not super in supermarkets, 18 June 2019

Investment Matters July 2019 was finalised on 3 July 2019.

Recommendation definitions (Macquarie - Australia/New Zealand)

Outperform – return >3% in excess of benchmark return

Neutral – return within 3% of benchmark return

Underperform – return >3% below benchmark return

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Investment Matters - July 2019 - Macquarie · 2020. 9. 11. · market (helping boost flagging...

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