Investing in this uncertain world

Daniel Needham

Investors in recent times have gravitated towards the safety of cash and the pursuit of yield in an effort to navigate their way through a trying environment. With this in mind, Daniel Needham has a look at which asset classes are the most attractive right now.

At the heart of investing is the goal of growing purchasing power over time. Most investors’ key investment objective is achieving long-term real returns (that is, after inflation but also transaction costs, fees and taxes). The investing environment feels more uncertain than ever before and it is important to look at the challenges and opportunities of developing your investment strategy. Investment markets are dynamic, so your investment portfolios should be managed in the same way.

Dynamic investment strategy

We dynamically allocate across assets using long-term economically justified relationships between asset prices, valuations and fundamentals. There are times when the reward for taking risk is low relative to history, and at these times portfolios should reflect this by holding more cash or lower-risk assets. While we are not confident in our ability to predict markets, we believe that using a patient and disciplined approach provides superior long-term real returns. Determining the most appropriate investment strategy is about trading off wealth appreciation with capital preservation over the investor’s time horizon. This means we will adjust our risk depending on the opportunity set.

This trade-off between risk and return is the most important step in determining the investment strategy specific for each individual. When referring to risk, we do not mean the volatility of an asset as volatility doesn’t do a great job of predicting losses, which is generally what investors worry about. Risk of loss should only be taken with an expectation of sufficient reward. What matters ultimately is valuation – the price of an asset relative to its underlying fundamental value. We believe returns and losses are conditional on valuation, without which it is difficult to determine whether an asset should be included within any portfolio.

In constructing our portfolios, we use valuation to determine the fair value return of each asset class over a five-to-10-year period. This gives us a good indication of where we feel the reward for investing is likely to be and provides enough time for capital markets to mean revert.

Markets generally move around more than justified by changes in fundamentals, so we don’t have to wait that long to buy or sell investments, but we use a patient long-term approach. To supplement this we also monitor investor sentiment, seeking to avoid the crowd, as well as identify contrarian opportunities.

Global deleveraging and policy responses

The current state of the global economy is reasonably well known and saved for another discussion. Suffice to say, global debt-to-gross-domestic-product (GDP) levels are at worrying levels and are likely to decline over the next decade. According to the Bank of International Settlements, the median debt to nominal GDP for developed nations is 314 per cent, up from 167 per cent in 1980.

Exactly when this level of debt will come down is difficult to predict, but government spending in developed nations needs to fall as it is unsustainable. Central banks are offsetting necessary austerity with easy policy and money printing. This sees us in a world with very low interest rates and central banks increasing their holdings of financial assets into the trillions. Whether this is effective longer term is highly questionable, but it does seem to be having an effect on market prices and increasing asset values, however artificial.

The primary macro risks around the world stem from excess of debt, trade imbalances and the government policy responses. As is fairly consensus, growth is likely to be lower and more volatile over the next 10 years, and one should not expect a repeat of the disinflationary growth surge of the late 1980s and early 1990s. Forecasting is difficult at the best of times, so investors should recognise the investment world is far too complex to be modelled accurately. To use a great expression from Howard Marks, “the future is to be prepared for, not predicted.

Investing in a low-yield world

A major consequence of low interest rate policies and money printing is that investors are being penalised for holding cash. The search for yield is driving investors towards lower-quality securities and credit. Many mistakenly think that because asset yields are high relative to bond yields, assets are cheap, however, it is more to do with low bond yields than cheap assets. We have found no historical relationship between the ‘Fed model’ (the US equity market earnings yield minus the US 10-year government bond yield), and future five-year real returns from US shares. We think the push for additional return due to low bond yields clouds investors’ thinking and increases risks in financial markets.

Sometimes, holding extra cash and waiting for better opportunities is the most sensible approach for a long-term investor. We do not currently see very attractive valuations across most equity or credit markets, despite some pockets of opportunities.

Term deposit rates are generally ranging between 4 per cent and 4.5 per cent, depending on maturity and provider. While these are certainly lower than rates over the past five years, they provide investors with both positive returns and capital preservation. The risk is locking in low yields, should inflation spike above Reserve Bank of Australia rates and term deposit spreads. The risks seem manageable and at positive real yields, Australian investors are the envy of many retirees around the world.

Australian 10-year bonds are currently yielding 3.3 per cent – not very enticing given the consumer price index has ranged between 2 per cent and 3 per cent in the past three years. Inflation and policy rates may well be lower in the future, but current pricing is not compensating the investor for the range of potential outcomes. These yields are still at least 1.5 per cent better than other developed markets, so Australian bonds are better value than international bonds. Negative real yields across most international bond markets make this an unattractive proposition. Corporate yields are falling, and while more attractive than governments, are now less compelling.

Given term deposit rates are higher than Australian bond yields, favouring cash and term deposits makes sense. However, our fair return estimates suggest a marginally positive real return and government bonds should perform very well in difficult times, so a small allocation is suggested.

In aggregate, despite the Australian share market being around 30 per cent below the 2007 highs, we do not think the S&P/ASX 200 is cheap. We think market valuation is currently indicating below average medium-term returns. This is coming largely from the financials ex-real estate investment trusts (REIT) and resources sectors.

Looking at banks, the past 20 years’ credit growth has been stellar – supported by declining inflation, high employment, falling interest rates and surging house prices. This has left Australian banks with high returns on equity (ROE), an average around 15 per cent since the mid-1990s. However, with this higher ROE comes a higher price to book – around 1.9 times for the four big Australian banks against 0.9 times for the large US banks. These institutions are not without their issues, however, negative news on fundamentals has occurred or, more accurately, been handled by the Federal Reserve’s balance sheet.

For Australia, concerns over the sustainability of bank ROEs and payout ratios, with low credit growth, high residential property prices and household debt to disposable income sitting near 150 per cent, leave Australian banks looking overvalued and unattractive.

Resources, the other large sector, has been a key driver of Australian growth. Currently, mining investment accounts for around 5 per cent of nominal GDP (compared to an average of around 2 per cent over the past 50 years). Profit margins are high for the mining sector (sitting well above 10 per cent) and capital investment has been huge. History suggests profit margins in the mining sector are highly cyclical and investors in mining stocks are best to own the sector before large capacity expansion, not afterwards. Profits are likely to decline as commodity prices normalise. Valuations for resources do not look attractive on reasonable through-the-cycle profit margins and with the increased supply coming, this could lead to sharp declines in margins.

Industrials ex-financials look better value, while still having issues on the back of a strong Australian dollar and relatively high interest rates relative to other global manufacturers. The margins in these sectors look reasonable, at close to 5 per cent, and valuations, while not table thumping, are reasonable.

Australian REITs look to be reasonably valued on acceptable gearing levels, sustainable payout ratios and solid fundamentals. There are some potential supply issues around the corner for office and retail, however, valuations are compensating investors somewhat, but the the rally in 2012 has reduced attractiveness.

The opposite is true for US REITs, which represent 50 per cent to 70 per cent of global REIT portfolios. We suspect investors are overpaying in search of higher yields with considerably greater risk than US treasuries.

Valuations for global equities are also not highly compelling, although within the regions some are better valued. US equities look very expensive, while Europe and Japan are relatively attractive, although both have their challenges. Last year saw non-US equities catch up to the US to some extent, however, we still favour the non-US category. For an Australian investor, we think global shares are better value than Australian shares, and with the exchange rate very high relative to almost all currencies, a largely unhedged exposure makes sense. Unhedged exposures mean that if the Australian dollar falls, your portfolio value increases and this provides additional downside protection for portfolios.

In summary

Many asset markets are not priced for great returns over the next five to 10 years. However, it does not make sense for investors to be fully invested in cash, as rates are low and some markets could significantly outperform cash over the medium term. Long-term investors can still hold large cash balances when the opportunity set is unattractive and it makes sense for investors to be reducing exposures to assets that have performed well (such as equities) to build up cash.

Despite this reduction, a reasonable exposure to equities and REITs is still appropriate, but much less than that warranted in 2009 and 2010. As highlighted, a bias away from Australian shares is justified as the major Australian sectors are not attractively valued. Investment opportunities in Japan and Europe remain attractive, while US equities in aggregate look overvalued. Global equities are more attractive relative to Australian equities. Remaining unhedged provides good entry prices to global shares and also provides downside protection for Australian investors. Meaningful allocations to Australian REITs and defensive global listed infrastructure provide more defensive assets to offset lower equity exposure.

This is the time to be more defensive and cautious, so larger exposures to cash, term deposits and Australian bonds are justified. The time to take risk is when investors are defensive and markets are falling. Markets move around much more than fundamentals and patient investors normally get the chance to invest at decent valuations, but the timing as always is uncertain. Patience is an investment virtue in an uncertain world.


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