‘Forecasting is the art of saying what will happen, and then explaining why it didn’t’
We didn’t think the final quarter of the financial year could be explained any better than through this quote. Throughout the period we were provided with further evidence as to why both opinion polls and economic forecasters should be given little heed and why it’s important that investors do not adjust their investment approach before an ‘expected’ or ‘guaranteed’ event occurs. The most obvious case in point was the Coalition election victory in May, which polls suggested was unwinnable, but eventually saw sectors ranging from infrastructure to private health insurers, the banks and hospital operators rallying on the back of a status quo government.
In the lead up to the election the noise in the media and throughout the financial industry was immense. Our office seemed to be a revolving door of investment managers selling listed investment companies investing into high yield (and high risk) debt, property development or unrated corporate bonds as alternatives to high yielding shares. As you would have noticed, not one of these ‘unique’ opportunities was of sufficient quality to meet our due diligence process, yet most have seemed to have raised hundreds of millions of dollars without us. We aren’t sure what their investors are thinking now, with many trading at a discount to the value of their portfolio and high yielding Australian equities having delivered the strongest return of all markets around the world for the first half of 2019.
As we outlined in previous issues of UWJ, the additional yield provided by franking credits either in the form of a refund or tax saving, could not easily be replaced without moving further up the risk scale. On this basis and given the growing concern throughout the country about this and several other proposed tax policy changes, we did not believe it was prudent for clients to sell down higher yielding (but more importantly high quality) companies solely because they wouldn’t provide the same income as before. The market reaction the day after the election was telling, with most banks up in excess of 5% and now signs that the property sector may be recovering.
The failed predictions continued in the forecasting of interest rates, with the majority of economist calls made as recently as a few months ago proven wrong as the RBA elected to hold rates in May and then eventually cut in June. This comes just 12 months after most experts were predicting rate hikes to occur amidst a booming global economy. All these events do is solidify the central tenet of our approach to investing your capital, which is to invest for many scenarios, and not assume the expected will happen. In fact, we know that as investors you will need to do with the unexpected occurring regularly.
Worried about growth
There were some concerning signs creeping into the market in the June quarter which suggest to us that there may be a little too much money floating around the ASX. Whilst merger and acquisition levels are not at pre-GFC levels, management and boards appear to be chasing growth at any cost in looking at what appear to be purchases and investments in non-core businesses. There were several cases in point, the first being Wesfarmer’s sudden decision to seek investments in the growing but speculative rare earths and battery industry and secondly, AGL Energy’s decision to lodge a big for Vocus Telecommunications (only to withdraw the bid within a few weeks). Then there was the continued push into private equity and takeover activity by the industry fund sector who are increasingly concerned about the outlook for growth.
We admit that we fall on the conservative side of investing and find it difficult to justify investments in loss making companies trading at astronomic multiples. It has been these companies that seem to defy gravity and have been leading the broader index higher. Yet Australian companies have a chequered history of pursuing growth through acquisitions, with our largest miners a case study in how to buy assets at the top of the market. We also have a track record for our ‘growth’ companies to be valued at 2 to 3 times what a more sophisticated market like the US values similar companies. It is at times like this that we stress the importance of sticking to your investment policy and not capitulating to momentum or positive sentiment.
Our approach has and will always be predicated on Bucket allocation, particularly ensuring your portfolio holds sufficient Capital Stable assets to withstand an extended period of market weakness. Further, we seek to ensure your portfolio is constructed of high-quality assets, trading at reasonable multiples or valuations and which offer exposure to the most important themes occurring around the world. At times our recommendations may seem contrarian, or unwilling to embrace the most popular themes, this is because we are seeking to deliver consistent returns over the long-term rather than chase risky short-term gains.
The US-China Trade War was the primary driver of volatility during the beginning of the quarter. It was then the Federal Reserve and other global central banks that took the reins and pushed both bond markets and sharemarkets around the world to all-time highs and lows. It is that interesting paradox where the outlook for the global economy is sufficiently weak to warrant cuts to global interest rates and continued stimulus, yet sharemarkets continue to move towards multi-year highs with little concern for corporate profits. Perhaps this is why gold bullion has delivered one of the strongest returns over the last two years.
In the table above we have provided a summary of the major investment indices for the quarter and financial year:
As you can see, the highlights were the Australian and US markets which delivered the strongest financial year returns after continuing to rebound in the final quarter. The European and Chinese markets showed signs of recovery but remain well behind due to the continued political impasse and trickledown impacts of slowing Chinese imports. The table provides an interesting insight into the why the first six months of 2019 have seen the fastest growth in over 20 years, a core reason being the heavy sell- down experienced at the end of 2018 which means financial year results are well below those levels.
At this point the global economy and sharemarkets are in unfamiliar territory. One of the most important inputs or factors that must be considered when making investment decisions for today and for the next 10 years is where you expect interest rates to move throughout this period. It is interest and bond rates that determine the availability of debt to fund investments, the return required to warrant further investment in Risk assets like shares and the pain that comes with continuing to hold excess funds in cash. It is this pain that tends to send sharemarkets higher as investors need to do something with their capital.
If you believe interest rates will fall further over the next decade, or at least remain at all-time lows, than an aggressive investment approach targeting higher yielding investments would be warranted. Falling interest rates would suggest assets like property, infrastructure, Government bonds and utilities will increase further in value. Increasing interest rates suggest a more inflationary and higher growth environment, in which case cyclical business-like mining, materials, those facing consumers and even gold bullion will benefit, and the likes of property and utilities will struggle.
Increasing interest rates will lead to lower valuations of most assets and businesses around the world but particularly those whose incomes have already been couponised. Looking short term, however, we believe there remains substantial further downside in rates as some of the world’s overleveraged developed economies, like Australia, come to terms with a slowdown in global growth. The result is a portfolio that is positioned for both events to occur and a plan to navigate this unfamiliar period whilst keeping your capital intact.