One of the topics asset allocators are grappling with at the moment is whether asset class valuations are expensive or not. Whether you’re an active asset allocator or an active bottom-up stock picker, valuation will most likely form the core or at least a significant part of your analysis when making a decision to enter or exit an investment.
Equity markets in general, and in particular growth companies expected to grow their free cashflow in the future, have benefited from the low interest rate environment as they tend to be more sensitive to interest rates, similar to a long duration bond. It could be argued that if interest rates remain at low levels (and possibly lower) risk assets will continue to benefit. Despite this we believe that at some point markets will focus on fundamentals and the market will need to demonstrate earnings growth to sustain valuations. Furthermore, studies suggest that the relationship between interest rates and valuations is not linear, meaning that markets benefit from low interest rates to a point.
From an asset allocation perspective, valuation remains an important tool to help make active asset allocation decisions. We believe that in the current environment you also need to consider medium-term signals such as where we are in the cycle, levels of liquidity, and market sentiment, as these factors can influence the extent to which asset prices can remain elevated or depressed for periods of time.
Australian shares managed to reclaim some ground in September which saw the S&P/ASX 200 Index post a modest 1.8% return before falling in the first week of October. Energy was the top performing sector, returning 4.7% and clawing back some losses from the previous month. Oil price spiked in September, the result of major disruption to the oil market, which favoured energy producers like Santos (+7.2%) and Beach Energy (+3.3%). The financial services sector (+4.1%) saw broad growth over the month. Shares in IOOF (+26.0%) rose as the wealth manager completed its sale of Ord Minnett during the month and the Federal Court dismissed a case brought against it by APRA that accused executives of failing to act in its members’ interests.
The materials sector (+3.1%) also saw significant gains for some members, led by Western Areas (+25.0%), which benefitted from a rise in the Nickel price after the Indonesian government announced a ban on exports of raw ore. Nufarm shares (+17.0%) shot higher following the announcement that it was selling its South American business to Japanese conglomerate Sumitomo. Large cap shares rose 2.0% with solid gains from major banks and miners, but were outshone by their small cap peers, which returned 2.6%.
Global markets adjusted to renewed geopolitical risks, including the US-China trade dispute, growing tensions in the Middle East, the threat of impeachment, protests in Hong Kong, and the ongoing Brexit saga. A drone attack on a major Saudi Arabian oil facility, which wiped out 5.7 million barrels of production per day, or around five percent of the world’s supply, wrought havoc on oil markets. Economic indicators point to a rise in the risk of a US recession and a possible turning point in equities, but so far markets appear satisfied with the low rate of US unemployment, and the bullish trend since the start of 2019 remains intact.
Developed market shares outside Australia rose 1.8% in Australian dollar terms as investors tentatively reentered equities following selling in the previous month. In the US, energy shares (+3.6%) were boosted by the spike in oil prices. Marathon Petroleum (+23.5%) jumped higher, but this wasn’t enough to placate major shareholders disappointed with its recent underperformance. European shares had a positive month, with the STOXX Europe 600 Index rising 3.6%, led by financial services, auto and energy sectors. In Asian markets, China’s CSI 300 Index was mostly flat at 0.5%, Hong Kong’s Hang Seng Index rose 1.9%, and Japan’s Nikkei 225 Index rose 5.9%.
While equities were choppy, it was the bond market that revealed the full extent of investor indecisiveness. September began with a sharp sell-off in bonds as markets, which may have been partly due to high-than expected US inflation, along with evidence of robust consumer spending. The US 10-year Treasury yield jumped from 1.50% at the start of the month to 1.90% on 13 September, before falling back down to just over 1.50% in early October. The result was a capital loss on 10-year bonds of around 3% over a 10-day period, making the pace and magnitude of the sell-off among the most severe.
Over the course of September, global bonds, measured by the Bloomberg Barclays Global Aggregate Index, fell 0.6% in Australian dollar hedged terms, while Australian bonds fell 0.5%. The 10-year minus 3-month portion of the yield curve has been inverted since May, raising concerns for some Fed members. While not the only indicator on the ‘recession dashboard’, at the very least it indicates that investors are nervous about future growth. It could also be a sign that Fed policy is too tight and that rates need to be reduced further. September also saw a spike in the overnight lending rate between US banks, which jumped to levels not seen since 2008, prompting cash injections from the Fed to support liquidity.
September was a trying month for listed property as the S&P/ASX 200 A-REIT Index lost 2.7% as a temporary rise in yields undermined values, but the broad low-rate environment is likely a positive for property as investors continue their hunt for yield. Commercial managers Charter Hall Group (-7.9%) and Dexus (-7.5%) experienced the largest drops over the month, while retail and shopping centres also struggled. The improvement in house prices since June may now be flowing through to an improvement in housing finance.
However, from an activity perspective, what is important is the trajectory of dwelling construction and the associated flow-on to retail spending on household goods and furnishings. It is difficult to envisage a recovery in housing construction any time soon given supply issues and the projection of ongoing subdued wages growth. While credit to housing has improved, credit to developers and businesses is appears to be affected by the royal commission. Globally, REITs had a positive month in September, rising 3.0% in developed markets. US REITs were positive in September, returning 1.5% in US dollar terms, with gains from shopping centres (+8.4%), regional malls (+5.6%) and hotels (+5.2%).
The Australian equity market (as measured by the S&P/ASX 200) started the December quarter the same way the September quarter ended, with a sea of red as stubbornly high inflation and rising bond yields placed pressure on current and forward-looking company earnings. November and December came roaring back as positive inflation data (i.e. lower inflation numbers) and sudden falls in bond yields created an air of optimism and the potential end of central bank tightening. The share market closed at near record highs.
2023 made for another very interesting year in investment markets as macro / regime driven events resulted in extreme shifts in investor sentiment on an almost monthly basis. Investors chose to shoot first and ask questions later in what can best be described as a year of maximum noise.
The Australian equity market (as measured by the S&P/ASX 200) started the September quarter with a flurry but ended up in the red as the global “higher-for-longer” narrative (interest rates) coupled with the ever-increasing cost of living concerns caused consumer confidence to wane.