The S&P/ASX 300 Accumulation Index trended higher over the financial year ending the period up 11.4%. Rising commodity prices, symptomatic of a maturing economic cycle, benefited the resource sector which was among the best performing areas of the market. Industrials ex-financials continued to trade at historically elevated levels whilst the banking sector remained in the spotlight for much of the financial year owing to the government’s decision to undertake a Royal Commission. Interestingly, we observed a shift in the behaviour of the banks following the many revelations of the Royal Commission and looking forward, we remain keen observers of the future of vertical integration in wealth management. Our value investment style has struggled in the current investment climate where a low interest rate setting has resulted in an underappreciation of market risks. Companies with strong balance sheets are being overlooked and little consideration is being given to the price paid for securities.
At Perpetual, we recognise the importance of valuation in determining future returns and understand that it is fundamentals, not headlines which drive share prices in the long term. The Perpetual investment process and philosophy delivers a portfolio of well researched, differentiated ideas versus the “herd”. Importantly, we are maintaining the investment process, philosophy and discipline over the long term and continue to search for investment opportunities in high quality companies that are out of favour or facing short-term earnings headwinds.
The financial year was dominated by ongoing changes to US policy settings as the Trump administration settled into office. On the one hand the revival in confidence, cemented by large tax cuts at the end of 2017, helped drive economic activity to new highs despite the longevity of the current business cycle and allowed the US Federal Reserve to lead other central banks into tightening policy. The good news on the economy was tempered by rising concerns about trade protectionism.
The revival in growth, combined with still low interest rates, saw growth stocks continue to outpace value stocks over much of the year. The continued dominance of a handful of large technology platforms meant that the tech sector delivered the best sectoral returns. Energy and Materials stocks benefited from the continued reflation theme in the global economy. The threat of rising interest rates caused yield proxy and leveraged sectors like Telecommunications, Consumer Staples and Utilities to underperform.
Looking forward, we continue to search for quality businesses with solid balance sheets at reasonable valuations, which are often temporarily mispriced by the market due to short-term news. Our quality value style has performed relatively well despite the challenging environment of ultra loose monetary and fiscal settings, but we believe it will do even better as we edge closer to the mature end of the business cycle in which value investing performs best. In the meantime, we remain invested in a suite of high quality businesses at a discount to market valuation multiples.
The global economy has grown at a robust pace in the past year led by the two biggest economies, China and the US. This is boosting profits globally (most notably in the US where the company tax rate has been cut as well), yet there is a tension between the strength of this economic growth, how much has been priced in by the market, and the reduction of monetary support (higher interest rates).
Extraordinarily low interest rates over the past decade have spurred what is now the second longest bull market in the US, but rising interest rates are often responsible for ending the cycle. Of course, central banks are very aware of this risk, but ‘taking away the punch bowl’ at the right time is an imprecise science. Too soon and the economy will slow, possibly abruptly. Too late and the economy could experience higher inflation which could scare bond investors. Investors should invest in well-diversified portfolios, rather than assume that policy makers will be able to engineer it precisely.
Over the long term, Australia’s economy gives us a lot to be optimistic about. Government debt is low, our floating currency helps our economy adjust to shocks, we have strong trade links with the growing markets of Asia, and we enjoy very high asset prices which underpin consumer confidence. However, asset prices are variable and household debt is fixed (i.e. debt must be paid off even if house prices fall), so it is worth considering the risks to the economy of record high household debt if house prices fall significantly.
Likewise, Australia’s high trade and financial exposure to China has been a huge advantage as China’s economy surged ahead. It now presents a challenge as the Chinese authorities continue their pursuit of reducing financial leverage.
The question at the centre of every investment decision we make is whether our clients will be adequately rewarded for the risk they are taking. Taking risk is important to generate returns which exceed that of the safety, and very low returns, from holding cash. Prices (or valuations) are currently high and markets go through cycles. Managing the late stages of an economic cycle is when diversification and risk management is critical. While the current market environment favours being selective, investment opportunities will be plentiful again at some point in the future. It pays to focus on “value” and investing in portfolios which are genuinely diversified.
Following another financial year of strong performance for Perpetual’s suite of cash and fixed income funds, our overall outlook for corporate credit has shifted to neutral.
Our valuation indicators are benign as corporate spreads now trade tight relative to their long-term averages across major credit markets. We continue to actively seek out and buy attractively priced securities on a relative valuation basis.
The macroeconomic outlook remains supportive of credit spread tightening. The improvement in US, European and Asian developed country economic data augment this positive view. Supply and demand dynamics are also supportive of the credit outlook with elevated market cash levels seeking out our new issuance for reinvestment.
Broader market technicals remain generally positive although any future spikes in market volatility may temper positive technical dynamics.
Near term risks include uncertainty around rising interest rates, inflation and the pace of unwind of Quantitative Easing by both the US Federal Reserve and the European Central Bank.
Should market volatility in credit markets increase in the coming year, we have the ability to take advantage of attractively priced and appropriately risked opportunities that may arise. Through stringent research and careful diversification, we remain poised to take advantage of securities offering superior income with less risk than many other assets.