Ian Gillies talks to Will Hamilton how it is all about interest rates at the moment. Official rates have gone down in Australia, were lowered last night in the United States and are flagged to be decreased by the European Central Bank. The result is a rush into risk based assets.
We also discuss the growth in demand for ESG filters in investment mandates.
Ian Gillies 0:09
Hello, and welcome. I am Ian Gillies and welcome to the Hamilton Wealth Management podcast No. 30 for August 2019. I’m joined today by Will Hamilton. Will, you attended the world’s largest global industry conference Fund Forum International, which was held this year in Copenhagen, Denmark. Can you give us some information or some thoughts that came out of that conference?
Will Hamilton 0:34
Thank you Ian. The 2019 conference was dominated by two things. So, the first of all was the ESG, which I’ll talk about later, and that’s become very much mainstream in Europe, and interest rates. So we’ve mentioned in these pages on quite a number of times that investment markets depend on the direction of interest rates. So in that context negative yield in government bonds are going to be a troubling feature for the investment horizon one day in the future. Mario Draghi, who’s the governor of the European Central Bank, or the ECB as it’s known, has opened the door to lower interest rates in Europe, and quantitative easing to be reintroduced in Europe. And at the same time, German and French government bonds are trading, at negative yields. It was recently reported that the quantum of negative yielding debt globally is now more than 12.5 trillion US dollars. So it’s also interesting to note that QE, when it was first introduced, was referred to as non-conventional monetary policy, yet it’s now considered conventional monetary policy, hence the recent announcement by the ECB. So there were predictions at the Copenhagen conference of anywhere between 50 basis points or half a percent to 1% for the fed fund rate cuts. Market and our analysis are not expecting cuts of this magnitude by the Fed over the next 12 months. And that was quite interesting, because last night we saw the first cut of 25 basis points to 2.25% but also signaling that this just might be a one off. The US Q2 earnings season has been mixed, you couple this with ongoing concerns over the China US trade dispute, the Fed’s showing a willingness to get ahead of further slowing in growth. The result has been further strength in equity markets, as people rush to risk based assets in trying to get a yield. And what this is doing is extending what will soon be the longest post World War Two rally with the S&P 500 now about 2,900. Our concern is that the US economy could not handle 2.5% interest rates, which is incredibly low. Look, a lot of people at the conference were referring to this as the “Japanisation” as I call it, countries that have very low growth and low interest rates such as the European and the US economies, falling interest rates and slowing growth. These premature interest rate cuts are the first since 1995. The last time when the Fed cut interest rates while there was still positive growth. Note the Fed has never cut interest rates by 1% without there being a recession also. And I’d say given the signaling last night that that that is not a fear that we need to worry about. One area disagreement in discussions at the conference was over inflation. So, there are those that feared continued disinflation and hence held concerns around this Japinisation of economies as central banks continue to cut interest rates. While there are others that are seeing inflation starting to come in, but yes, at a very tepid degree and higher than central banks are targeting. So, they’re looking at cyclical tightening in US labor markets. So, what they have in their system surpass the previous peaks and tight immigration policies. You’ve seen industrial strikes in the US now they’re highest since the 80s. And so the pricing power is now aligning with the employee. And then you got the structural side, the US is importing higher prices through the tariff war as they increase consumer prices by their own policy actions and the consumer has to pay for this. So, cutting interest rates especially in the US is creating and I believe will continue to create a rush towards equities. Investors are chasing positive yields. The result might be a melt up in global equity markets, we’re definitely seeing the start of that. And as equity markets in the US are at or near record highs, the boost for demand on the back of bond yields, it’s going to further distort valuations which are already high. So let’s be clear, and I think this is what has to be remembered by everybody, equity markets are risk based asset classes. Investing in equities is about investing for capital returns balanced with income not for income alone. Investing in equities for dividends alone risks capital shock at some stage, when the cycle does turn. We are late cycle. And Copenhagen conference goers kept reminding themselves this as well as the fact that we’re in the longest bull market ever. There’s the added concern to the unpredictability of trade wars at the moment. It’s also worth remembering that the best returns are always late in the cycle, melt ups can occur. And for now, central banks are hoping this by their accommodative monetary policies.
Ian Gillies 5:15
Thanks, Will. Another theme at Copenhagen this year was ESG, or Environment, Social and Governnance issues. And this seems to be becoming more mainstream in Europe. Would you comment on how you see this developing?
Will Hamilton 5:31
Over the last four years ESG has been a topic their and I’ve seen it go from being a niche issue to one that now tracks very high levels of interest, it’s essentially become mainstream. So, ESG takes two forms; there is the negative angle about filtering to exclude what are referred to as harm stocks. So those are in industries such as tobacco, gambling, weapons, alcohol, and things like coal. Then there’s the positive angle; biasing towards companies that positively promote their credentials in the areas of the environment, social practices and corporate governance, Mark Carney, Governor of the Bank of England, has actually been talking about ESG a lot lately. In fact, he gave a talk last night at Coutts as well, in the UK, the private bank and what he’s saying is that ESG is crucial, crucial to the pressing need to manage between risk, reporting, and returns. So, we’ve noticed in active funds management in the UK and Europe, the allocation of capital by funds management industry is taken on a societal view. So, what we agree is that ESG is a crucial component of an investment process, we believe that it’s struggling between what I refer to as hopeful ambition and real action. So, what people often argue here, especially in Australia is there is no clear consensus. So, what’s the definition of ESG? Look, there’s been more than 2000 studies completed on ESG, not one of them agrees on what is the definition. So, they can’t compare apples with apples. This has led us to give this a lot of thought and I think that’s because ESG is values based, the values based. There’s impact investing which is positive. And then there are ESG qualities some what our social objective some are financial objective and there’s no agreement whether it’s a constraint versus an objective. But the thing is its values based and what is a value for one person is not a value for another. So, I believe this will never be resolved and will not see a practical one size fits all style definition or approach with ESG. As I just mentioned, that the values for one doesn’t necessarily mean it is for another. We’ve been watching trends globally and notice the time lag in many mainstream UK/EU investment issues coming to Australia. Four years ago, the hot topic in the Northern Hemisphere was funds management fees or any MERs as they called. We would say that issue took three years really to take hold here in and of some magnitude. We have no doubt that ESG will become a big issue in Australia but just not yet. There is definitely without a doubt increased demand from clients to invest here in Australia with do no harm mandates as is the case in Europe. We can only see this trend growing. Interestingly wealth managers we spoke to in Europe said the number one age bracket where the demand is being initiated from is in the 60 to 75 year olds, not the baby boomers. Now that raises questions, why not millennials? But you also have to take into account that that cohort millennials is only growing as an age bracket for investing. So, where we believe many critics lose focus on ESG and sustainable investing is that understanding it is about responsible investing with increased risk criteria. It is not and should never be treated as a donation. It’s about investing that does good. It is still firmly in the market.
Ian Gillies 8:50
Thank you Will. Thanks to Will for today’s podcast. As always, if you have any questions or would like a copy of our Insight, please call us on 039275 8888. I am Ian Gillies and thank you for listening
Ian Gillies talks to John Green and Kane Baranow about the second quarter of the 2019 calendar year.
They also discuss our approach towards markets for the remainder of the calendar year and why.
Ian Gillies 0:10
Hello and welcome. I’m Ian Gillies and welcome to the Hamilton Wealth Management podcast number 29 for July 2019. I’m joined today by John Green in Canberra now. John will discuss recent markets and fixed interest and Kane will talk about equity property alternatives and John will finally comment on our outlook. Market volatility has formed over the last quarter of central banks globally striking accommodating tone, clearly putting the likelihood of further monetary policy easing back on the agenda. John, how do we see this possibility playing out market context?
John Green 0:46
Thanks Ian. Look, despite the calmer markets, there’s no doubt that uncertainty does remain particularly with respect to the ongoing US China trade dispute. And this remains a market risk. The Trump Xi meeting at the G20 gathering and the saga being an important next step and the negotiations. Bond markets are continuing to rally reflecting continued low inflation expectations and concern over the outlook for global economic growth. For now, equity markets are not reflecting this growth concern and they’ve continued to rally also encouraged by the promise from the central bank’s that they will do what they can to keep their economies moving. We often talk about the views of our Economic Advisers Capital Economics in London, who Will visted in June. Capital Economics are not forecasting recession but they are forecasting a significant slowdown in US growth and accounting the Fed funds rate in the US later in the second half of this calendar year. We do need to discuss the impact of the tariff wars. President Trump has been gleefully saying that the US has been receiving billions of dollars in tariffs. But this is patently incorrect. The tariff is actually a tax on imported goods and therefore is being paid by the US importers, not the Chinese exporters, and therefore these are going to result in higher prices for the US consumer. The US has also spent most of the tariffs revenue on agricultural subsidies, effectively ensuring that these tariffs are fiscally neutral. There’s also talk that substitution is now taking place the US buying from countries other than China but at a higher price than the pre tariff imported goods. Capital Economics estimates that the tariffs are directly reduce China’s GDP by point 3%. The US by point 2%, and global GDP by point 1%. Capital Economics also argues that there is an indirect cost of the tariffs, that being deferral of investment decisions tied to credit conditions and reduce business confidence. They believe this will shade and additional 2 points from global GDP. Therefore, whenever with the direct impact, the trade was affected global growth by point 3 points with the global GDP overall having fallen from around 4% to 3% over the last year. The risk of course in Capital Economics views is that the US economy remains stronger than they anticipate. And while this is always possible, it could only occur on the back of productivity improvements. The market remains optimistic on earnings and if they disappoint the equity markets will come under pressure. The further melt up in equity markets would not surprise us in the near term. But we do continue to support the Capital Economics view of a decrease in corporate earnings, which is greater than that anticipated, as growth slows in the US economy. This will lead to move down in equity markets later in 2019. Early in 2020. Capital Economics has revised their end of 2019 target for the S&P 500 up from 2300 to 2500. But listeners should know that this is still nearly 15% below current levels. We will therefore continue to fade equity market.
Ian Gillies 4:01
Thanks, John. Would you like to comment on the outlook for fixed income?
John Green 4:05
Sure. US Federal Reserve Governor Powell’s comments over the last month have signaled that the current rate hike cycle in the US is definitely over. And that rate cuts are back on the agenda provided the economic data warrants them. The market on the Fed Funds rate is pricing in a 100% likelihood of a Fed funds rate cut in July. And it’s also assuming two more cuts by year end. Weaker data at the end of June suggests that US Treasury bond yields can fall further yet. 10 year US treasury bonds started the quarter at 2.5% and ending the quarter at around 2%. Which should also be noted that the US cash to 10 year yield curve remains inverted suggesting the likelihood of recession or at least a notable slowdown within the next year. In Australia RBA governor Lowe has also taken a more dovish stance given no sign of domestic inflation pressures and some early signs of awakening in the labor market. As a result, in June, we saw our first RBA interest rate cut in nearly three years from 1.5% 1.25%. They seem certain there will be another cut in July or August and some commentators expected further cut to by year end. 10 year Australian Government bond yields started the quarter at 1.8%. And they’re ending the quarter around 1.3%. And this is a very significant move. Arguably it’s got ahead of the equity markets and in Australia, we think it’s difficult to see yields falling much further, unless inflation expectations also fall further.
Ian Gillies 5:42
Thank you John. Now to you Kane, how did equity markets progress?
Thanks Ian equity markets have been quite strong they continue to rally on the back of further reductions in interest rate expectations and not because of stronger company fundamentals such as earnings growth. This was most profound in the domestic landscape with ASX 200 rallying approximately 7.6% over the quarter, the RBA signalled that their revised estimate for the non accelerating inflation rate of unemployment known as Nehru is closer to 4.5% than 5%. Now this has led to board members signaling that lower interest rates would be required to reach this lower rate of unemployment and to bring inflation back within the bank’s target range of 2 to 3%. The surprise was out from the federal election so investors returned to equity markets, with banks leaving the gains and as investors bid up high yielding equities and embark in an environment of continually lower interest rate expectations. Global equity markets switched focus over the quarter with less attention paid to trade negotiations between China and the US and more movements been attributed to Central Bank guidance. The US Federal Reserve acknowledge that more uncertain economic outlook would keep them data dependent. while adjusting interest rates and European Central Bank governor Mario Draghi reiterated his whatever it takes comments in response to supporting the Eurozone. In in the face of again falling inflation rates. Emerging markets were mostly flat over the June quarter with trade tensions causing sharp declines in major indices during May only have this recover over June as lower Us rate expectations took the shine off the US dollar and saw flows head back into emerging markets. So we’re true to word with respect to fading the equity market rallies over the June quarter and continued to reduce exposure to small and mid cap Australian equities. Our overall exposure to Australian equities is now neutral. Our view around interest rates means that we prefer equities over fixed income in the short term and shrinking bond yields reinforces argument towards equities.
Ian Gillies 7:54
That’s okay. How have REITs performed recently?
REITs are quite strong in quarter one and this continued into quarter two as lower interest rates domestically and expectations of lower rates globally and lower and valuations higher. The sector has seen an increase in capital raisings over the quarter with firms looking to take advantage of the strong run up in share prices as an opportunity to pay down debt and provide liquidity for development and acquisition opportunities. Those a rates with large residential exposure benefited towards the end of the quarter due to optimism that followed the federal election result which saw labor’s proposed changes to negative gearing dismissed an app was proposed regulatory changes to lower lending service ability buffers along with the RBA cash rate as the main positive drivers. As rate valuations have improved in relative terms and are now attractive compared to real bond yields. Although there was still neutral they are still neutral on a price to book basis. Macro and policy indicators are broadly positive and suggests that a rates could extend their rally further given recent moves in bond yields. Demand for direct property continues to be strong as investors appear to chase anything with a solid yield. I’ve been surprised with the speed at which deals are closing and the level of oversubscription that is occuring. We will continue to be selective and assessing deals and partner with quality groups to provide client exposure to direct real estate. Over the quarter we moved from a small underweight position in property to now being neutral.
Ian Gillies 9:33
Regarding alternative assets, what comments do you have on those?
Well, we commenced discussions with clients late in the quarter on our asset allocation calls for alternatives. We have seen an increase in client allocations towards high quality illiquid assets with these assets having previously been allocated towards one alternatives bucket. So we spent many months working with our asset allocation consultants Heuristic Investment Services, establishing where appropriate for a client the allocations within alternative towards each private equity, direct property, diversified credit and infrastructure. While this is not appropriate for all clients, establishing allocations for each of these alternative asset classes, under their own risk category ensures client allocations for each are appropriate rather than being combined under one risk category. As with all asset classes at tactical asset allocation approach has been implemented, which does consider existing valuations. So, we’ll continue to discuss this approach alternative assets with clients in the new quarter.
Ian Gillies 10:39
Thank you Kane. John, would you like to comment on where we see markets going in the foreseeable future?
Yes, look, there’s really two main forces driving markets and they’re going to continue to drive them for some time, certainly for the end of this year. Cyclical forces, namely, slowing growth and accommodative central banks and structural forces, the US China trade dispute, and the imposition of tariffs. Eventually, both of these are likely to lead to the return of inflation and an unwinding of the bond markets we currently find ourselves in. As a result will continue to fight the rallies and we encourage our clients to maintain their appropriate asset allocations.
Ian Gillies 11:21
Thanks, John. Thank you to John and Kane for today’s podcast. As always, if you have any questions or would like a copy of our insight, please call us on 03 9275 8888, I am Ian Gillies and thank you for listening.
Ian Gillies talks with Will Hamilton about the Capital Economics in London call that they recently pointed out that the rebound in equities is justified based on the strength in corporate profits, especially in the US, but noting that this profit rebound has not been as pronounced in markets such as Europe. They discuss this as well as:
- One of the anomalies at the moment is the Australian Dollar.
- Australian Equity market valuations.
- and, a reminder that cycles always exist.
John Green talks to Will Hamilton, as we near the Federal Election and there are two questions that are dominating discussion:
1. Are we at the start of a global slowdown in growth?
2. Where is Australia positioned if we see a global slowdown?
Before we get to the stage of a slowdown dominating discussion, we could well see a melt up in equity markets. This is on the back of the “dovish tilts” being adopted by central banks, leading to talk of possible interest rate decreases in the United States, Australia, Canada and New Zealand.
Will Hamilton talks to Ian Gillies about the Federal Budget brought down on the 2nd April.
The budget does return to the Black, the big question is whether this is the plan for our country for the fiscal year ahead or will we see a change of government and a “mini budget” early in the second half of 2019.
Ian Gillies talks to Will Hamilton and John Green regarding the bounce in markets as the US S&P500 has rallied over 11 per cent this calendar year and when we say fade the rally what does that mean and why?
February is also conference season for the wealth management industry in Australia, as global economists, strategists and fund managers escape the northern winter and head to the sun and warmth to provide their insights for the year ahead. We discuss as well our observations from having attended conferences last month.
John Green talks to Will Hamilton about market volatility, the UBS Global China Conference in Shanghai and why we saw markets bouncing.
Remember that equity market crashes occur when investors overestimate returns and underestimate risks. Market valuations are attractive, expectations are very low, and an awful lot of bad news is priced in.
Ian Gillies talks to Will Hamilton, John Green and Kane Baranow about our Asset Allocation position and outlook as we head into 2019.
We believe 2019 will be about the change from quantitative easing or QE to quantitative tightening or QT, with the balance sheets of major developed market Central Banks contracting.
London-based Capital Economics reported that for the first time in over twenty-five years, 2018 was the year when all ten major asset classes have delivered negative returns, therefore as we enter 2019 asset allocation becomes absolutely crucial.