This technical commentary has been prepared for Network Financial Planning clients with investments held under the MDA Service. It provides an update on the quarterly portfolio performance and some perspective on the economy and the current outlook for investment markets.
SEPTEMBER QUARTER - 2021
Portfolio Performance Summary
The performance of risk assets was moderately positive in the 3 months to the end of September 2021. It is normal for risk markets to become more volatile towards the end of an economic cycle. Fixed interest returns were only slightly positive while Cash returns were close to zero over the period.
The returns of the Strategic portfolios ranged from 0.8% for the Conservative Portfolio to 1.9% for the High Growth Portfolio. These returns were quite close to the returns the Mercer Wholesale (and Retail) Averages for similar funds over the period.
Some of the factors impacting returns were:
Our Australian Equity managers as a whole did well and as a group, they beat the Australian large-cap equity benchmark return of 1.7% by over 1.5%. The best performing manager was Ausbil Active Equity which returned 4.49% for the quarter, this was more than 2.7% above its benchmark. All our large-cap managers beat this benchmark during this quarter with no style dominating in terms of returns. All of the other large-cap managers were fairly tightly bunched return wise over the quarter. Tyndall (former Nikko Australian Equity, a Value manager) returned 3.31% while T Rowe Australian Equity (Quality Growth) returned 3.21%. Note that the Ausbil fund is style neutral and can tilt towards Growth or Value when opportunities arise. Aberdeen Standard Ex-20 Australian Equities (Quality Growth) also did well, returning 3.92%. Our small-cap manager in Fairview Emerging Companies returned 3.67% which was also above the Small Australian cap benchmark which returned 3.44%.
The Australian dollar fell over the period (helping Global equity returns). However, our Global Equity managers as a group finished around 1.5% below the Developed Market Global equity benchmark. One of the major issues here was that Emerging markets and Asia, in particular, underperformed Developed Market equities. From the 1st of January to 18 October this year, Emerging Market equities have returned just 3.4% compared to 19.1% for Developed Markets. Funds that had significant exposure to this sector were not surprisingly laggards. Our worst performer over the period was Aberdeen Emerging Opportunities which returned -4.11%, although this was 0.2% above its benchmark. Platinum International which also has high exposure to Asia (and around 20% in China/HK) had a negative return of -0.69%. Our best performing manager was WCM Quality Global Growth which returned 4.03%. MFS Global Equity (which we regard as a Growth at a Reasonable Price Manager) returned 3.07% while T Rowe Price Global Equity (Quality Growth) returned 2.27%. While we continue to see opportunities in emerging markets, we monitor our international equity regional allocations closely.
This was quite a subdued quarter for fixed interest returns. Our fixed interest managers as a group returned fractionally less than the Australian fixed interest benchmark which returned 0.31%. Global fixed Interest returns were even lower than this with the benchmark returning just 0.05%. Returns were dragged down by rising bond yields in September with the Australian benchmark falling by 1.5% in that month. Our two best performing managers were JCB Active Bond and Janus Henderson Tactical Income which both returned 0.23%. The latter fund also beat its benchmark which is 50% Cash and 50% Australian fixed Interest. Not surprisingly. the laggard was PIMCO Global Bond which returned 0.07%.
Our interest rate sensitive sector managers both produced positive returns, despite the end of quarter sell-off sell-off in fixed interest. The APN AREIT Fund returned 4.65% while Lazard Global Listed Infrastructure returned 0.9%
What Happened During the Period
Global stock markets recorded new highs in August and early September before giving back most of the quarter’s gains in late September. Partly this can be attributed to economic data pointing to slowing rates of growth in the US and China. There were also concerns about the Delta variant which thankfully now shows signs of having peaked in many countries. China was also affected by energy shortages which shut down some factory production as well as financial trouble with Evergrande (China’s largest property developer), which owes over US$300 billion to creditors. Markets were initially spooked by risks to the financial systems in China and elsewhere but we believe have now concluded that the financial risks can be managed. Nevertheless, we believe that the situation in China deserves to be watched closely.
Property has been a big driver of Chinese growth and is particularly relevant to Australian companies such as BHP and RIO, as almost 30% of iron ore in China is used by the property sector. The Iron ore price has now fallen by over US$100 from the peak of US$230 per tonne. This fall is not all property-related though, China has been cutting steel production quotas (to 2020 levels) to lower carbon emissions.
In Australia, Delta has resulted in growth forecast being slashed for this year but markets have largely looked through this as NSW, and soon Victoria exit lockdowns in the next month. The major shift has been that the policy of eliminating Covid is over and moving forward we will have to learn to live with it. This has been made possible by vaccination rates now approaching 80% in most of the states after the initially slow vaccine rollout.
There is an expectation the US Fed will announce tapering before the end of this year. This, as well as persistently high inflation in the US, has caused global bond yields to rise lately. All the concerns set out here finally lead to the US equity market had its first 5% pullback this year although markets have since partially bounced back.
The other major development was Australia being on a path to acquiring nuclear submarines due to the deteriorating security situation in the region. Not only is this an expensive exercise but it may have knock-on effects for relations with China and trade relations.
Australian large-cap equities returned 1.71% for the 3 months to 30 September 2021 while Australian small-cap equities did considerably better with a return of 3.44%. Industrials outperformed resources by a massive 14.05% over the period (4.48% vs -9.25%). Developed Market Global equities did quite a bit better than domestic equities, returning 3.92% for the quarter. They were also assisted by a fall in the value of the Australian dollar. Emerging Market equities were the laggard with a return of -4.36% as Asian markets struggled. Australian listed Property also had a good quarter returning 4.24%. Australian fixed income returns were muted with the benchmark returning 0.31%. Cash continues to essentially produce zero returns with the benchmark returning 0.01% for the period.
Markets feared that there was a possibility Australia could have a technical recession if the economy shrank in the 3 months to 30 June, and the September quarter was negative (as we expected). However, the GDP data for June showed the economy grew by 0.7% which was ahead of expectations. We anticipate that the Australian economy will have begun to grow again in the final quarter of this year as lockdowns end with the associated gains in employment, consumer spending and sentiment.
The annual inflation rate (CPI) in Australia rose to 3.8% in the second quarter of 2021 from 1.1% in the first quarter. This was the highest reading since Q3 of 2008. However, this was influenced by some base effects following the introduction of free child care and a record fall in fuel prices in Q2 of 2020. The underlying inflation rate, which the RBA focuses on, was just 1.6% and this remains below the RBA’s target range of between 2% and 3%. While inflation seems well contained in Australia, markets are still concerned about elevated inflation in the US which is running at 5.4% and the recent surges in global energy prices.
China’s economy has continued to slow with GDP rising 4.9% in the third quarter of 2021 compared with last year. This was below expectations of 5.0% and the 7.9% increase in the previous quarter. Chinese industrial output in September rose by just 3.1% compared with a year prior, this was also below expectations of a 3.8% increase. Some of the major issues here were energy shortages that disrupted industry and caused shutdowns. China has built its economic prosperity on the back of significant debt levels which creates financial risk. Also, China still has zero-tolerance for Covid and is quick to lockdown regions just as the rest of the globe is learning to live with Covid. This action exacerbates supply chain disruptions.
The IMF (October) forecasted a slowing of economic growth. The global economy will grow by 5.9% in 2021 and 4.9% in 2022. The US is projected to grow by 6.0% in 2021 while China is forecast to grow by 8.0% in 2021 and 5.6% in 2022. Certainly, for China, we believe those numbers are on the high side and probably need to come down. China itself is only saying they will do at least 6.0% this year.
Markets and Outlook
The RBA has stated for a while now that there will be no rate hike before 2024 at the earliest. However, futures markets are betting that this will occur sometime around the middle of 2022. We are not sure there is much predictive value in this though. An early lift-off in rates here would be based on elevated inflation in economies like the US rather than on the strength of an Australian economy emerging from lockdowns. Also, while the unemployment rate at under 5% appears low, if you factor in under-employment, it is close to 10%.
The RBA’s October minutes reveal the bank remains dovish in its outlook. From the minutes - members concluded their discussion of domestic economic developments by observing that underlying inflation pressures in Australia were more moderate than in other advanced economies. This reflected a range of factors, including the relatively slow rate of wages growth in Australia. The RBA has also said that it will not begin to normalise interest rates until inflation is sustainably within its 2% to 3% inflation target, which it believes will require wages growth above 3% for several quarters. Wages growth in the June quarter was just 1.7%.
We do expect that the US Fed will announce tapering to its $120 Billion per month bond-buying program before the end of this year and that tapering will be completed by the middle of next year. However, the US Fed chairman has made it clear that there is no connection between tapering (which is almost certain) and possible rate rises, that is a separate decision.
The biggest risk to markets right now is that inflation, particularly in the US, remains elevated for some time, The most common explanation for high inflation there is that it is the result of supply chain issues due to Covid and reopening. For example, there are not enough truck drivers to ship containers in the port of LA and ships are backed up as far as the eye can see. Shortages in goods are driving up prices. There are also issues around underinvestment in fossil fuels driving up oil and gas prices which feed into inflation numbers.
Inflation certainly bears watching, as at some stage the stickiness of this number may become an issue that disrupts financial markets and causes PEs to rest lower. However, the elephant in the room is that if inflation is mainly due to supply issues, then raising interest rates will do nothing to address this problem. Worries about inflation and tapering have caused global bond yields to rise although they are mostly below levels we saw earlier in the year.
Another concern is the Biden administration’s spending proposals which amount to over $5 Trillion (properly cost over 10 years). It is not just the magnitude of this number, but that it seeks to introduce several new entitlements and taxes that would take the United States to its highest sustained levels of federal spending since World War II. The history of new programs is that once enacted, they are forever. There are currently only two senators standing in the way of its passage. If passed, the risk is that it will result in slower growth for the US economy.
Equity valuations are a risk, but that has been the case for a while now. PE’s have been drifting down slowly with the Global equity PE at 18.5x as of 30 September 2021. The forward PE for the S&P 500 was 20.3x (S&P 500 at 4,308), while the ASX 200 was 17.9x (ASX 200 at 7,332). The global PE is now down around 10% from its recent peak. This is what we would expect as bond yields rise as the world returns to some normality. The US PE is still around one standard deviation above its 25-year average level, but bond yields were much higher than today over most of that period. Providing rates rise slowly (assuming we have steady growth), then they do not have to cause major disruptions in markets. We will just have to wait and see how inflation tracks in the US particularly and how the current reporting season there pans out.
In terms of allocations, negative real interest rates continue to favour Growth assets over fixed interest. Currently, the US 10-year bond yield is around 1.6% while 10-year inflation expectations are at 2.5% (Oct 18). Many stocks have corrected which should provide opportunities for managers. Most resource stocks for example are down by over 15% in the last month. We would not aggressively add to positions right now but suggest investors maintain a mix of Growth and Value styles, the wild swings of the last year showed that that is very hard to time these moves.