Welcome to FY18. I hope it’s another good one for all of us. I will again try my best to forecast accurately what comes next globally and locally in a period where change is extremely rapid.
FY18 is the year when global central banks finally start weaning us off extreme doses of monetary policy morphine. Interest rates will stay low by historic standards, but they will rise at the cash rate level, as will bond yields.
The US FED, ECB (European Central Bank), BOE (Bank of England) and BOC (Bank of China) have all indicated that cash rates are headed up. It’s also fair to assume Australia has seen its last interest rate cut.
I remain strongly of the view interest rates and bond yields have bottomed for our lifetime. You will never see lower interest rates and bond yields and you must think about the ramifications of higher interest rates for your portfolio, if you are to generate strong returns in the months and years ahead.
We need to remember this is the beginning of the end of an unprecedented period of monetary policy support for all asset classes. Bonds, equities and property have all been major beneficiaries of an extended period of unprecedentedly low interest rates.
As cash rates rise and central banks start shrinking their balance sheets, there will be ramifications for all asset classes.
The first will be increased volatility. Central policies have suppressed asset class volatility and driven investors into low volatility and passive products right at the wrong time of the asset price cycle.
Even early in FY18, you can see that volatility, in the form of aggressive sector rotation, has arrived in global and domestic equities. In bonds, it has also arrived in terms of capital losses in duration. In property, global and domestic auction clearance rates are falling and in many jurisdictions prices are falling, albeit mildly.
Rising interest rates make it harder to make money as the easy yards of broad capital gains ease. Similarly, rising volatility from artificially low levels also makes it hard to make money for the average investor.
What we also need to take into account is just how much leverage is built up in the system after seven years of low volatility and asset price gains.
In my view, you are going to have to be active, not passive, to successfully navigate markets from here. I am biased. I am a high conviction active investor. However, my funds return of +17.6% in FY17 beat all global & local benchmarks handsomely, which says to me conditions are starting to favour active investors.
I’m even more excited about FY18 because I can see more and more long and short opportunities opening up globally and locally that should suit our fund’s mandate. If I am right about what comes next in markets as central banks lower the morphine dose, then, as a professional fund manager, you want every tool in the investment box.
In a rising interest rate/shrinking central bank balance sheet environment, what usually occurs is bond yields rise causing capital losses across the bond yield curve, volatility rises, value outperforms growth, and active managers/hedge funds beat passive managers/products.
Personally, I believe the biggest permanent capital loss risks are 10yr bonds, globally and locally. We believe the US 10yr bond yield will rise to 3.50% in FY18 from its current 2.35%, while the German 10yr Bund will rise to 1.25% from its current .48%. We also believe US 30yr yields will rise closer to 4.00% from their current 2.86%.
This may seem a big call, but it’s not. The yield targets above are only where yields were two years ago. It’s not a big call at all but if we are right, it will have major ramifications for sector selection in equities.
Firstly, any equity that has outperformed because of its “bond like qualities” over the last seven years will see those “bond like qualities” become a headwind. That could see 20%+ capital losses in bond like equities. That has already started in US REITS, where we have seen -30% falls in recent months, but could easily come to listed infrastructure, REITS, utilities, consumer staples and healthcare in the months ahead.
These sectors are also widely owned by “low volatility ETFs” which could exacerbate the price falls when they come. Price falls could become self-perpetuating, just as price rises were on the way up.
In an Australian context this means it’s prudent to be cautious on stocks like Transurban, Sydney Airport, Macquarie Atlas, all REITS, AGL, Wesfarmers, Woolworths, Ramsay Healthcare and Healthscope, to name a few large cap stocks.
This will be the start of “the great rotation” from large cap bond like equities and growth stocks to VALUE. The winners will be value and cyclicals, led by financials as “reflation” becomes the key driver of performance.
I say again, in a rising interest rate environment VALUE outperforms GROWTH.
That means the biggest downside market risks lie in the NASDAQ, which is showing signs of becoming the NAS-crack.
I have warned before about the over-ownership and over-valuation of large cap US technology shares. If our bond yield forecasts prove accurate, then I would be certain that the key rotation funding equity index will be the NASDAQ 100, which is dominated by Apple, Amazon, Alphabet, Facebook and Microsoft.
There’s no doubt in my mind the NASDAQ could lose -10-15% in a sharp rotational correction. It may have already started. This selling of multi-year growth winners to rotate to value/laggards is a global event, and you can see financials and cyclicals are already strongly outperforming growth stocks in FY18. This is likely to continue and accelerate.
It always causes some discussion when you say you think the NASDAQ could become the NAS-crack. Nobody wants to hear it as the most-owned stock in the world now is Apple, probably followed by Facebook. But in a rising interest rate environment it will be European and US Banks that lead markets, not Apple and Facebook. That’s exactly what has happened in early FY18.
In an Australian context, our bank and resource heavy index should do ok, due mainly to banks and resources, which represent value. Our very low technology weighting actually works in Australia’s favour under this macro scenario, however, and stock “masquerading” as a technology stock in Australia (DMP, CAR, REA etc.) will be under pressure, as will the bond like equities mentioned above.
I also think Australian investors, like all investors, should prepare themselves for greater bouts of volatility as “the great rotation” starts to happen. In volatility, there is opportunity, but you need to be prepared for it and ready to act during it. In other words, running a higher cash weighting in portfolios is most likely prudent.
It’s also worth noting that higher global interest rates will find their way to Australian households that currently have record borrowings. Having record borrowings when we are passed the low point of global and local interest rates isn’t smart. I remain concerned that Australian households will find themselves in a cash flow squeeze in FY18, as Australian banks raise mortgage interest rates due to increased taxes and increased wholesale funding costs. This rise in mortgage rate rise will be occurring as many mortgagees come off teaser interest only loans onto principal and interest loans, again further squeezing household cash flows.
Outside of my bullishness on global banks as interest rates rise, the fact Australian banks still have this tremendous pricing power means I am not bearish on Australian bank in FY18. I think they will maintain their margins and dividends, while Australians will service their mortgages at the expense of discretionary spending. That means we are positioned short East Coast facing Australian consumer spending exposures and we are starting to build shorts in Australian apartment developers, travel & leisure stocks and shopping mall owners, as the “wealth effect” of rising residential property prices fades.
We are also positioned short the Australian dollar, feeling cash rate differentials and GDP growth rate differentials will work in favour of the US dollar and against the Australian dollar. This is another reason we broadly offshore investment in FY18 as we feel we will get a kicker from a weaker Australian dollar.
My point today is I think a broadly new approach is required in FY18 to generate the best available returns and avoid permanent capital losses. I think it’s time to take profits in bonds, take profits in bond like equities and take profits in the worlds most crowded growth stocks led by Apple and the NASDAQ 100. It’s time to take profits in passive products and switch to active. It’s also time to prepare yourself for volatility as the “great rotation” from growth/low volatility to value and cyclicals takes hold, as interest rates and central bank balance sheets start the path back to normalisation.
Don’t fight the Fed … particularly after seven years of unprecedented central bank monetary policy morphine that drove all asset prices higher and suppressed volatility.
Happy new financial year, let’s make it another good one.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
