By Chris Rylands, Research Manager, Wealth Advisory
Market Update
Cash
- The Reserve Bank of Australia (“RBA”) remained on hold during August and September. The message in August remained “wait and see,” whilst September’s commentary was more cautious, acknowledging the uncertainty unfolding in China and emerging markets.
- The RBA will have noted the weakening trend in Chinese economic data. Indicators of economic activity, such as manufacturing and exports, have begun to slow. It is important to retain some perspective on the “slow down,” as Chinese economic growth continues to hold above 7%.
- The RBA will be hoping the Chinese government can manage the slowdown without causing a major disruption to the Australian economy. It may be international events which prompt the next move in domestic interest rates given Australian economic data has so far been in line with expectations.
- Term Deposit rates have reduces marginally since our last update. The highest term deposit rates currently available are 2.8% across 3 months and 2.85% across a 1 year and 6 months.
Fixed Income
- Demand for “safe haven” government bonds increased during August, as global equity markets corrected. The renewed demand for safety pushed bond yields lower and prices higher. The Australian fixed interest market, as measured by the Bloomberg AusBond Composite Index, was up 0.64% during August.
- The global fixed interest market, as measured by the Barclays Global Aggregate Index (Hedged A$) was down -0.10% for August. The main detractor was US Government Bonds, which decreased in value in the face of an impending increase in US interest rates. US Bonds have since increased in value as yields fell sharply post the US Federal Reserve’s interest rate decision.
- The higher risk areas of the domestic and global fixed income sectors have continued to come under selling pressure. Many investors have been “chasing yield” in these sectors, without fully appreciating the risk to their capital. The global high yield sector declined 1.30% during August and remains under pressure during September.
- Domestic hybrid securities are another area of the market where investors are exposing themselves to unnecessary risk. These securities are higher risk by nature, given they are a “hybrid” of debt and equity. For example, the recent Capital Notes 3 offer by Westpac is now trading at $96.60. The price has fallen 3.4% below the listing price, completely eliminating the extra income which was supposed to be the defining feature of the investment.
- Our fixed income strategy continues to focus on securing a satisfactory return without exposing capital to unnecessary risk. We continue to avoid any material exposure to higher risk sectors such as high yield, hybrids and emerging market debt.
Australian Equities
-
- The volatility in global equity markets overshadowed another reporting season in the domestic market. The Australian market finished down -7.79% in August, with the market trading in a narrow range during September.
- Overall the reporting season was slightly below expectations, with 46% of companies beating expectations and 29% of results below expectations. Whilst the results were reasonable, they were below the results delivered during the February reporting season earlier this year.
- Pressure on company revenues persisted during the reporting season, with profits benefiting more from continued cost cutting. The SP/ASX 200 saw negative earnings growth of -1.8% compared the previous period, with the resources sector once again the largest drag. However, it is worth noting that both Rio Tinto and BHP Billiton are implementing massive cost cuts which will ultimately make them more profitable when commodity prices begin to recover.
- Rising payout ratios remained a positive feature of the reporting season. Companies remained focused on returning excess capital to shareholders, pushing dividends as a percentage of profits to the highest level in seven years. A continued focus on returning capital to shareholders and healthy dividends will provide support to the market given interest rates remain at historic lows.
- Whilst many companies were praised for increasing dividends or returning capital, the big banks experienced how investors react to the opposite scenario. ANZ announced that it would raise $3 billion, whilst CBA confirmed a $5 billion capital raising. These stocks and the banks in general were punished as investors re-assessed the outlook for the sector.
- There is some evidence of bad debts increasing from cyclical lows in the banking sector, however this is yet to be confirmed as a structural change. It is evident that the banks will now need to hold more capital on their balance sheets, which will likely crimp earnings and dividend growth in future years.
- The banks still make attractive investments despite the immediate challenges. With forward dividend yields of 7 – 8% (inclusive of franking) and reasonable earnings profiles, the banks will remain in demand as a core part of Australian equity portfolios.
- Whilst the earnings season was muted, there remains fundamental support for the Australian equity market. The SP/ASX 200 is now trading on a Price / Earnings Ratio of 15.3 post the recent correction, compared to a long term average of 16.2. Company balance sheets remain relatively strong and forward dividend yields will continue to attract interest in a low interest rate environment.
International Equities
- The majority of international markets posted double digit losses before rallying into the end of August. The MSCI World Accumulation Index was down -4.0% during August and global markets also remain in a trading range as investors digest the recent volatility.
- In the US, the S&P 500 Accumulation Index finished the month -2.7% lower despite reasonably strong fundamentals. Almost three quarters of the S&P 500 companies that had reported in August beat earnings expectations according to FactSet.
- Magellan Financial Group, one of our preferred international mangers, anticipated the recent volatility. It has been progressively selling shares and increasing cash reserves in the lead up to the recent interest rate decision. This has allowed the Fund to avoid some of the recent decline in equity markets, limiting losses to -2.10% for the month. The Fund is maintaining a relatively high cash weighting of 15%, compared to around 2% at the same time last year.
- The Chinese equity market has remained volatile since our last update, with the Shanghai Index declining -11.79% during August. The index has managed to hold above the important psychological level of 3000 during September. Volatility in this market will continue to be the norm as the Chinese Government implement measures to counter the slowing economy.
- An increase in US interest rates has been factored into many markets given the US Federal Reserve’s focus on regular communication with the market. This has led to a strong rally in the US dollar and a decline in the Australian dollar given the divergent path of each country’s interest rates.
- A further delay in increasing US interest rates beyond current market forecasts may lead to some short term correction in the US dollar, resulting in some moderate Australian dollar strength. We expect this correction to be short term in nature and therefore remain unhedged in our international equity exposure to benefit from a continued fall in the Australian dollar over time.
Market Returns
Reporting date 31 Aug 2015
| RETURNS (%) |
1MTH |
6MTH |
1YR |
3YR |
5YR |
| AUSTRALIAN EQUITIES | |||||
| S&P/ASX 200 TR Index AUD |
-7.79 |
-10.1 |
-3.16 |
11.25 |
8.16 |
| S&P/ASX Small Ordinaries TR Index AUD |
-4.87 |
-9.08 |
-9.62 |
0.38 |
-0.72 |
|
|
|
|
|
|
|
| GLOBAL EQUITIES | |||||
| MSCI World ex Australia NR Index AUD |
-3.14 |
4.06 |
27.49 |
26.28 |
16.5 |
| MSCI Emerging Markets NR Index AUD |
-6.56 |
-8.02 |
0.78 |
10.33 |
3.51 |
| S&P 500 PR Index USD |
-6.26 |
-6.29 |
-1.56 |
11.93 |
13.5 |
|
|
|
|
|
|
|
| FIXED INTEREST | |||||
| Bloomberg Ausbond Composite 0+ YR Index AUD |
0.64 |
0.68 |
6.29 |
5.15 |
6.39 |
| BarCap Global Aggregate TR Index (AUD Hedged) |
-0.1 |
0.2 |
4.81 |
5.61 |
6.82 |
|
|
|
|
|
|
|
| EXCHANGE RATE | |||||
| AUD/USD Spot Rate |
-2.65 |
-8.65 |
-23.5 |
-11.6 |
-4.28 |
Source: Bloomberg
Fixed Income Focus | Part 2
In our previous update we touched on some core principles of fixed income investing. The key principle covered was the concept of interest rate risk. Interest rate risk refers to the risk that value of your fixed income investment will change when interest rates change. This is important for investors to understand because the value of their fixed income investment can fall when interest rates rise. Bonds which pay fixed coupons and have longer maturity dates carry the most interest rate risk. In this update we will introduce “default risk”, discuss the different types of bonds and how to manage these risks in a portfolio.
The most straightforward way minimise interest rate risk is to invest in floating rate bonds. Floating rate bonds are less sensitive to changes in interest rates. The problem with this strategy is that many issuers of floating rate bonds carry a higher probability of default. Default risk refers to the risk that you may not receive some or all of your investment back at maturity. The bonds with the lowest default risk are long term fixed rate bonds issued by the largest global governments. On this basis, in order minimise default risk investors must accept some interest rate risk. The table below summarises the different types of bonds and associated risks.
Source: Schroder Investment Management
Another problem with floating rate bonds in the current environment is that the return on offer does not reflect the associated risks. Low interest rates around the world have forced investors to look elsewhere for income generating investments. This has caused many investors to purchase higher risk bonds because of the attractive income on offer. Investors have purchased these higher risk bonds to the point where the yield on offer does not satisfactorily compensate a new investor for the risk. Higher risk bonds also have lower liquidity. Liquidity is the ability to sell or buy or bond in the market when required.
In conclusion, we want to avoid higher risk bonds because the yield on offer does not adequately compensate an investor for the risk of default. This leaves our portfolio largely focused on government bonds, semi-government bonds, high quality corporates and cash like investments. The portfolio will remain exposed to interest rate risk because most of these investments are more sensitive to changes in interest rates.
This risk is greater when interest rates increase because the price of a bond will fall. This risk is mitigated in the current environment given an unexpected increase in interest rates is unlikely due to the slowing global economy. This was confirmed at the last meeting of the US Federal Reserve where the US opted not to increase interest rates, whilst in Australian the RBA is considering reducing interest rates again.
The next edition of Fixed Income Focus will be the final in the current series. We will bring the previous discussions together to summarise our current investment strategy and how we are implementing it through our preferred investment managers.
