25 June 2019.

Overview

• Markets have continued to rally with bond equities and bonds pushing to calendar-year highs.
• Surprisingly, prospects for interest rate cuts have shifted yield curves lower in the US and Australia.
• Negative wealth impact from falling domestic residential property prices are still reverberating through the Australian economy.
• Our current position continues to be defensive in Australian equities and overweight cash.

Economic outlook

While the first quarter heralded a swift recovery in global equities following last year’s fourth quarter downturn, bond yields continue to reflect the global phenomenon of stubbornly low inflation expectations. In response, central banks have once again upped their commitment to stimulatory settings to defend the lower bound on price stability mandates. Meanwhile, the 2018 global growth slowdown has mostly run its course, and some green growth shoots are beginning to sprout.

Policy uncertainty

Global political uncertainty sits at high levels, given the US/China trade tensions, uncertainty surrounding Brexit, and Middle East tensions. This has supported concurrent demand for safe haven assets such as sovereign bonds, and US Treasuries in particular. Global bond yields are once again heading towards historic low levels and it is difficult to see the trend reversing in the short term.

Our global investment strategy: are the ageing population and stock market on a collision course?

Amid the current noise of short term sensational headlines, it is worth refocussing on some of the more enduring themes that will continue to drive financial market directions. One key theme is that of the ageing population that challenges most Western economies.

• The exodus of baby boomers from the labour market is likely to lower income growth, which will reduce sales growth among publicly-listed companies over the coming years.
• After-tax profit margins may also come under pressure challenging established long-term return expectations for most asset classes.
• While it is difficult to estimate the magnitude of these effects, our view that ageing will have a moderately negative effect on equity prices is based on the economic research on demographics by the Federal Reserve Bank of St Louis (US), and that of our research provider BCA.
• Even if the headwinds to equities from an ageing population turn out to be minimal, long-term investors are still likely to earn subpar returns given that valuations are fairly stretched.
• In such an environment, a nimble investment approach, which focuses on the business cycle among other things, will be necessary for generating superior returns.
• Whilst shorter term ongoing late cycle returns may still be available, especially with interest rates trending lower, longer term constraints suggest the gradual building of defensive positions across portfolios is prudent.

Earnings outlook

Downgrades to Australia’s earnings outlook have recently lifted from cyclically low levels but expectations remain modest.

Our strategy

We remain underweight Australian equities and defensively positioned across the portfolio with above average cash levels as the Portfolio Manager looks to increase exposure to defensive names with a more sustainable outlook. The notion of investing in ‘value’ has become increasingly problematic as equities sit at elevated levels.

Our Enhanced Cash Portfolio (ECP) is skewed to short dated securities as cyclical lows suggest the reward for taking longer dated instruments is still some way off. In the interim, we have been increasing exposure to floating rate notes to offset the falling interest rate returns as we rollover term deposits. This repositioning will ensure that the ECP continues to deliver, for our investors, the 1.1% return pickup above RBA’s cash rate. The graph below demonstrates the strong relationship between ECP distribution rate and the RBA’s cash rate.

The Growth Portfolio is defensively positioned as we remain underweight Australian equities and overweight cash. We have modestly increased our exposure to International equites with recent additions to the portfolio such as Cisco Systems and Kimberley Clark.

However, our defensive position is under review. We entered it at the beginning of the December quarter in anticipation of the last legs of excessive growth preceding an inflation breakout and a non-market-friendly ratcheting up of interest rates by central banks worldwide. Such a typical cycle has usually led to slower growth, if not outright recession, as monetary policy is a blunt instrument. With earnings momentum already peaking, a downgrading of equities appeared obvious.

As events have transpired, growth has weakened and inflation is once again retreating to levels below central bank targets. The central banks' pivot has once again provided a backstop for equity markets which have continued to rally through 2019. While earnings expectations have been pared back, a lack of suitable alternatives has made equities a preferred asset class albeit with slowing gains.

We will seek greater diversification across risk assets through a higher exposure to international equities as suitable names are discovered. A preference for underweight Australian equities remains given the risk of consumption being materially impacted from the ongoing wealth effect of falling residential property prices.

With lower interest rates, an earnings recession in train, and markets at absolute high levels we anticipate total return performance numbers to be moderate across all asset classes.