How The Global Environment is Impacting Australian Equities

Having tracked broadly sideways for much of the past year, we see three main factors as being particularly relevant to the near-term outlook for Australian equities.

THESE ARE UNCERTAIN TIMES

The first is the uncertainty has clearly increased in Australia and around the world. The recent Australian federal election was extremely tight with the Liberal-National Coalition only just being able to form a government, the UK has voted to leave Europe, the U.S. presidential election takes place in November, and there are a host of European elections/referenda on the horizon over the next 12 months—all of which is contributing to the general uncertainty currently hanging over global markets. Given this backdrop, it is crucial that investors think about risk management and how best to negotiate the market uncertainty.

POCKETS OF OPPORTUNITY EXIST, JUST HARDER TO FIND

The second consideration is that the areas of attractive opportunity are narrowing. The uncertain environment is beginning to feed through to both the Australian and global economy, with negative implications for growth and activity. As the impact has become more evident, the areas of the market where we feel comfortable investing are diminishing. That said, there are still pockets of opportunity to be found, such as in the digitization of outdoor advertising, which we see as potentially very attractive.

Another area the market appears to have missed, or has so far been unwilling to accept, is the level of improvement seen in China. Compared with last August/September, when the consensus view was that China was heading for a hard landing, the country has surprised on the upside as policy measures have gained traction. This has a positive feed through to Australian commodity stocks.

STEERING A COURSE THROUGH THE UNCERTAINTY

The third factor is how best to navigate the heightened uncertainty that we currently face, and, in our view, there are two ways to tackle this. The first is to focus on structural growth stories—companies that offer something unique in terms of products/services, business models, or market positioning and so tend to be more immune to the vagaries of the economic cycle. Health care is an area where we are finding a number of companies with these characteristics. One of our largest holdings, for example, is an Australian hospital company, which is a pure domestic play on aging demographics and the high demand for hospitals. We like this business for its higher, longer-term growth profile and attractive return on capital. Another health care company we own is a specialist in the field of sleeping disorders—specifically, sleep apnea. Many of the health-related issues that are negative from a consumer point of view are positive for this company’s product offer.

The other way to navigate the current uncertainty is to adopt a more defensive, higher-yielding strategy, investing in sectors like utilities, real estate investment trusts, infrastructure, and telecoms. These are not sectors that we tend to be overweight in, however, as they do not offer the longer-term growth profile we like. Nevertheless, we remain vigilant and invest on a stock-specific basis whenever good opportunities arise in these areas. We may also see these higher yielding sectors, such as infrastructure, despite looking expensive, continue to do well, at least in the short term.

AUSTRALIA’S POLITICAL LANDSCAPE DOES NOT INSPIRE CONFIDENCE

For many years, Australia had a stable government, from either side of the political spectrum. Then, in 2010, the country had its first taste of a minority government, and we have the same situation again after the recent Federal elections. Economically, this is unequivocally bad for the country. Ultimately, this will mean that passing sensible policies and delivering economic reform will be very difficult to achieve, while various minor party interests will be pandered to, and this will also be detrimental to growth. However, the bigger picture issue for Australia is the prospect of losing its AAA credit rating. This moved a step closer when S&P changed Australia’s credit outlook from AAA “stable” to AAA “negative.” Already cautioned by all the major agencies to improve the country’s budget deficit position, the outlook downgrade means that the Australian government now has two years to fix the problem or lose its coveted AAA rating. We do not see this happening as the structure of the parliament means there will be little interest in delivering necessary spending cuts. The preferred option will typically be tax increases, but this alone will not be enough to make a dent in the current budget position. So we anticipate that Australia is on a path to higher debt and, ultimately, to losing its AAA rating within the next two years. This
will likely mean higher funding costs for Australian banks, which we expect will be passed through to the entire economy.

GLOBAL CAPITAL MARKET RISK CONCERNS WILL HAVE KNOCK-ON IMPACT

At a broader level, one of the major risks facing global financial markets, currently, is the low level of bond yields; a significant portion of the world’s government bond yields—roughly U.S. $12 trillion worth—are presently in negative territory.¹ What is immediately worrying about this is the fact that government yields no longer reflect the fundamentals of economies. Gone are the days when a country’s bond yields reflected its nominal growth and inflation expectations. Central bank policy, among other things, has broken this nexus. In the current world of negative yields, bond investors are playing a dangerous game of “pass the parcel” as they try to seek out a positive return. When the music stops, however, we will find out who has been left to crystalize the loss of buying government bonds at negative yields.

The risk in capital markets has increased substantially for investors. There are parallels that can be drawn with the financial crisis in that, at some point, the realization will hit that owning negative-yielding government bonds is a bad investment, and everyone will rush for the exit. So, we see a day of reckoning at some point, and a massive repricing of bond markets. This is the main risk to the near-term outlook in our view, the repercussions of which are likely to be severely felt within the financial system, particularly insurance companies and banks. So the risk around this event remains considerable.

¹Thomson Reuters as of June 30, 2016.

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