Financial Planning

Volatility and opportunity

11 March 2019

Jayson Forrest

Jayson Forrest is the managing editor of Money & Life Magazine.

Having come off a 10-year bull run, Aussie Equities are heading into a period of greater volatility, but where there are challenges, there are opportunities. Money & Life asks four sector specialists for their thoughts on how Aussie Equities will hold up over the next 12 months.


Reece Birtles, Chief Investment Officer, Martin Currie Australia

Mason Willoughby-Thomas, Portfolio Manager for the Ausbil MicroCap Fund

Arden Jennings, Co-Portfolio Manager for the Ausbil MicroCap Fund

Dougal Maple-Brown, Head of Australian Equities, Maple-Brown Abbott

Q. How do you think Australian Equities will track in 2019?

Reece Birtles (RB): The key issue we see going forward for markets is the sustainability of world profit growth.

A year ago, global growth had been accelerating but had probably peaked in December 2017, while the U.S. remained strong. During 2018, the Purchasing Managers’ Index (PMI) numbers around the world weakened.

The U.S. has continued to show remarkable growth, and while this remains strong, the country is nearing full employment with limited spare capacity, and is seeing a lessening effect from the fiscal stimulus. However, if the inflation numbers keep on rising and the economy holds together, it’ll be hard for the Fed not to raise rates again.

Global profit growth has almost halved. With PMI numbers around the world weakening, there are question marks about whether, globally, we are in a profit recession, or whether it’s just a slow-down.

Despite this, the Australian economy is in a relatively good position. It is at an earlier stage of its economic cycle than the U.S., both in terms of the Philips curve (the relationship between the unemployment rate and inflation) and the size of government stimulus, and thus we see the Australian equity market with more room for improved earnings per share (EPS) growth.

Australia is just now starting to move into its stimulus cycle (via personal income tax cuts). We believe this will be positive for consumption and particularly the cyclical sector of the market.

Australia’s economic growth also benefits from the growing population, and strong growth in employment and wages. We expect to see signs of this emerging this year in the form of higher household incomes and a bigger capex spend by companies. We also see that the lower Australian dollar, relative to the U.S. dollar, as beneficial and stimulatory for Australia, particularly for the tourism sector and for exporters.

Mason Willoughby-Thomas (MWT): We’re cautiously optimistic about the outlook for small and micro-cap equities in 2019. Micro-cap equities are typically less mature, and in a faster growing stage of their development. Consequently, many will be quite dependent on external sources of capital to fund their growth. Micro-caps, therefore, tend to perform best during strong markets when investor risk appetites are healthy, access to capital is reasonably cheap and readily available, and market liquidity is supportive.

Towards the end of 2018, conditions for micro-cap investing deteriorated sharply. Growing fears of a slowdown in global growth, combined with the U.S. Federal Reserve appearing intent on continuing to drain liquidity from the global monetary system, resulted in a spike in risk aversion, contraction in the availability of cheap capital, and the evaporation of market liquidity.

However, entering 2019, the U.S. Fed performed an about-face, recanting its previously hawkish policy approach in favour of a far more market-supportive stance. In the face of increasingly volatile asset markets, and the risk that losses could weigh on consumer confidence, the Chair of the U.S. Fed revealed an intention to adopt a far more flexible and patient approach to monetary policy tightening, with a slower pace of interest rate increases and a more measured unwind of the Fed’s balance sheet.

As a result, markets rallied hard in January, with micro-cap companies delivering strong gains as risk aversion fell, market liquidity improved and confidence lifted.

Whilst we would argue that the economic outlook remains challenging, we also take comfort that the major developed economies continue to grow (although at a decelerating rate), with healthy levels of employment. Inflation remains contained and central banks maintain an accommodative stance with respect to monetary policy.

Whilst we expect volatility to continue to feature in 2019, barring a significant negative event, such as a messy Brexit or an escalation in trade tensions, we see current conditions as supportive of positive returns for micro-caps over the next 12 months.

Dougal Maple-Brown (DMB): We would see a flat Australian equity market as a good outcome for 2019, given the 10-year bull run we have just enjoyed and reasonably full valuations, particularly at the high P/E end of the market.

Whilst that doesn’t sound very exciting, the market is yielding around 6.5 per cent gross (i.e. including franking), so that’s not a bad return in the context of a cash rate at 1.5 per cent and Aussie long bonds yielding about 2.5 per cent.

Q. What are the key themes likely to shape Aussie Equities in 2019?

RB: As a result of global economic uncertainty, revisions to Australia company consensus EPS forecasts by broker analysts have been particularly weak over the past few months.

However, we see that these revisions reflect a lower confidence in global economic growth, rather than any real issues with the underlying fundamentals driving company profits in Australia. In fact, actual good business conditions and consumer confidence data doesn’t appear to reflect the weak EPS revisions.

However, significant tail risks for 2019 are high. This includes household debt and restrictive household lending from cautious banks, driven by APRA and the Royal Commission. It remains to be seen whether these risks create a contagion that may result in house prices starting to move into a more downward spiral.

Our base case is that less than 15 per cent of house price falls would be quite manageable, especially considering Australia’s population growth, where there is plenty of demand for new housing. If it goes beyond that level, there’s much bigger risks in terms of spending patterns on households, and with household confidence, which may cause people to delay further purchase decisions.

We believe it’s likely the Government will bring tax cuts forward – no matter which party is in power after the next Federal election. We also see a greater spend on infrastructure to support the growing population, which will also be stimulatory. Australia’s trade surplus and fiscal surplus position is going to be strong for the next government, and a positive for the economy.

Local growth risks, however, are heightened by the U.S.-China trade tensions, leading to slowing China growth. Tightening U.S. and emerging market monetary conditions, and divergent growth and central bank policies globally, may also impact Australia.

Current economic growth data remains far more bullish than global financial market indicators suggest, such as the U.S. 2-year/10-year spread, alluding to a rising risk of a U.S. recession. The U.S. Fed is likely to continue raising rates in 2019, to a point where its monetary policy is no longer stimulative.

DMB: Ignoring all the global macro issues (Trump, trade wars and Brexit), I think there are two key domestic themes.

Firstly, house prices. It’s no longer a question of will they fall, but now how far will they fall. While Sydney prices are now down about 10 per cent over the last year, they were up 70 per cent in the prior five years. Beyond the potential impact on the banks’ mortgage books, admittedly, this will take a while to work through. So, the next issue will be to what extent does this start to impact consumer spending?

The second domestic challenge is politics. If the Federal Government changes, then you have to think how Labor’s stated policies (on CGT, negative gearing and imputation) might impact equity markets.

Arden Jennings (AJ): The macroeconomic environment will be a key theme and driver of returns in 2019. The extent to which the larger global risks develop favourably, will have a significant influence on the performance of markets, and micro-caps in particular, in 2019.

We think there will be a greater focus on quality in 2019, as investors reposition themselves after a volatile 2018, and with unresolved risks carried into the current year. Early-stage companies with unproven business models, heavy dependence on markets to fund operations, questionable balance sheets and weak management teams, will probably struggle for investor attention in the current environment.

Over the course of 2018, we noted a distinct deterioration in the quality of IPOs coming to market, as well as overly-inflated pricing expectations by vendors. So, 2019 will likely be a more challenging year for IPOs, with only the highest quality names likely to attract investor attention, with those that make it to market being more realistic in their price expectations.

Q. What are the key considerations investors should be making when allocating to Aussie Equities?

RB: Household consumption makes up over 60 per cent of Australian GDP, so consumer confidence is critical to the economy. However, we think this area is being underestimated by many investors, who are too focused on recent falls in Australian house prices. In fact, we don’t see this drop as being as big a risk as others do. Because of employment and wages growth starting to come through, consumer confidence is actually holding up.

A lot of market participants have also been too focused on the saving rate in Australia, but we see that the savings rate is very backward looking and focuses too much on historical income growth. In fact, we have found that the ‘wealth effect’ from higher house prices was not evident in the early stages of this cycle and therefore, not a risk to consumption. People didn’t spend more when house prices went up, so it’s unlikely they will spend less when they fall.

With stronger wages and employment growth, a growing household income will reduce stress on the consumer. Add to that the strong fiscal position of the Government, and we should see tax cuts or rebates that will help household income more. This points to a supportive position for the consumer in Australia.

In the current environment, we believe investors should avoid paying too much for growth/quality style stocks that have outperformed and appear overvalued on our metrics, but retain some flexibility to take advantage of opportunities and exposures further into the cycle.

DMB: We would always say that valuations are the single most important factor, as they will have a big bearing on the subsequent return you earn. In relation to valuations, we would point out that the dispersion between the highest rated stocks and the lowest rated stocks is very wide. Therefore, we are generally avoiding those very highly rated stocks.

Q. Where are you seeing investor opportunities?

DMB: I’ll give you one opportunity and one to avoid!

The first is what not to own: highly rated industrials (CSL, COH, REA and so forth). Whilst they have come back a tad, the highest rated industrials are still very expensive by historical standards (at least one standard deviation expensive).

In terms of what to own, I think there is a good chance that the banks will get very cheap during 2019. To be clear, as at January 2019, we are currently modestly underweight the banks. However, the housing issue, the political issue and the Royal Commission’s final recommendations are all likely to weigh on the banks in 2019. With valuations starting to look attractive, I think there is a reasonable chance we could be overweight the banks by the end of 2019.

RB: The cheap stocks in the market are a lot cheaper than they were 12 months ago, and the spread of how much cheaper our portfolio is relative to the market is at very high levels compared to what we’ve seen in the past. Similarly, the forward income yields of our income portfolio are very attractive compared to the market.

The opportunity set for quality stocks with attractive valuations and growing earnings is better than ever. We currently see opportunities in sectors that are leveraged to the consumer, such as consumer staples and strongly positioned consumer discretionary and energy stocks, which now have attractive valuations.

Cyclical sectors have attractive valuations compared to a year ago. Cyclical sectors have had a big PE de-rate, while the PEs for growth stocks are still way above normal. It’s too late to buy the super expensive names, but we also suggest to not be fully allocated just yet to cyclicals and retain some dry powder in safer real asset, defensive exposures to deploy later into the cycle.

Another area of interest to us is in energy sectors. Oil is currently undervalued and also underinvested in Australia. For example, there are a number of new projects in the works in Australia at a time when the oil price is well below its long-run average. Coupled with a lack of capex in the past, the Australian energy sector will benefit as oil appreciates again and production growth increases.

Q. What are your best high conviction positions and why?

DMB: Our highest conviction positions remain amongst the resource stocks. Our single biggest position is BHP. Today, BHP has divested non-core assets, trimmed capex, taken costs out and is returning surplus capital to shareholders. Whilst clearly not as cheap as it was, BHP remains our highest conviction position.

MWT: One micro-cap stock that remains a high-conviction choice in our portfolios for 2019 is Nearmap. Nearmap is an aerial imaging company that produces high-resolution digital images using sophisticated cameras mounted in light aircraft. Nearmap offers a vast and updated content database on a relatively low-cost subscription basis.

Its technology has significant global potential, and it has established a successful business in the United States. Beyond geographic expansion, the vast amount of data that Nearmap is capturing in its digital images supports the development of sophisticated analytical tools based on machine learning and artificial intelligence applications, which underpin another longer term source of earnings growth.

AJ: Another micro-cap stock we like is Service Stream (SSM), which is a provider of development and maintenance services to the teleco and utilities infrastructure market. The acquisition of critical utility infrastructure firm, Comdain Infrastructure, further diversifies SSM’s capabilities into the growing Australian east coast utility market.