Market Commentary

kk
Market Commentary

Market Commentary – March 2019

Global equity markets extended 2019’s gains in March (+1.4% in AUD, +1.3% USD), albeit at a slower pace than January and February. Stocks rallied on growing optimism that a trade agreement between the US and China may be imminent as well as further central bank accommodation. Real Estate, Information Technology and Consumer Staples outperformed with investors showing a stylistic preference for “momentum” and “growth” over “value”. Financials lagged given lower bond yields and a flattening of the yield curve, followed by Industrials. High beta, cyclicals and expensive growth stocks continued to perform well year to date in what has been a broad beta rally.

Focus during the month was on the large repricing across bond markets following the dovish Fed meeting and the ECB downgrades to forecasts. The moves were further exacerbated by soft economic data, in particular the PMI’s. US 10yr yields (-28bps) fell sharply, yield curves flattened and the US 3mth-10yr spread inverted for the first time since August 2006, which was closely watched as a good predictor of recessions in the past. This saw markets closing off the months’ highs.

China broadly outperformed on signs that recent policy easing measures having an impact of growth stabilisation, exemplified by the PMI data. US equities ground out marginal gains amid optimistic signs on the economy and trade discussions. Europe underperformed on growth concerns post a series of weak economic data points and the Brexit overhang with no signs of a resolution. The rally in oil continued and gold traded lower.

Against this backdrop the Antipodes Global Fund fell in March, whilst the Antipodes Global Fund – Long and Antipodes Asia Fund delivered a return despite underperforming their benchmarks. Contributors to performance included our Consumer Incumbent, Software Incumbent and Healthcare clusters, while our Domestic and Global Cyclical exposures were the key detractors as well as our shorts..

For further information, please refer to our Monthly Fund updates.

Market Outlook

Socio-Macroeconomic Overview

Social conflict
Simplistically, over the long-term globalisation has led to growing wealth inequality and political polarisation, as the benefits of liberalised trade, labour, capital and technology transfers accrued disproportionately to the owners of capital. In the decade post the Global Financial Crisis, the real income of the bottom quintile of US households fell ~3%, whilst the proportion of wealth controlled by the top 1% continued to grow and is now over 33%. Having lost the ability/willingness to pursue reforms, in a classic negative feedback loop, governments’ sole reliance on central bank stimulus intensified this growing inequality/anxiety as QE:

  • inflated asset prices, including making housing affordability even more challenged, rather than encouraging broad activity; and
  • facilitated a forgiving funding environment for new technology/business models and accelerated workforce disruption.

The failure of political leaders to level the playing field by providing affordable entry level housing, health and education options, even if the rewards to effort remain skewed, has fed growing concerns regarding wealth differentials. The positive outcomes of free trade and markets in rationing scarce capital and skills have been lost to the increasingly negative reality of globalisation and capitalism.

Social conflict almost always results in less regulatory certainty and looser fiscal policy, often at the expense of productivity enhancing longer-term reform. The US fiscal deficit is case in point, which at ~3.5% is a level last seen in times of war or recession. Further, if the European Union was less dysfunctional, markets would be more focused on the US government’s EM-like sovereign risk profile (Figure 4) and increasingly limited fiscal firepower. With the populist locomotive now set in motion, increasing social instability has the potential to stress nation states that have rapidly accumulated public/private debt, are reliant on external capital and/or have weaker institutional frameworks. Against this backdrop, tail risks will remain elevated.

Tail risk
Studies of financial crises10 have shown that rapid debt accumulation, whether it be by sovereigns, corporates or households, contributes more to systemic risks than the absolute level of debt. Figure 4 shows the most extreme “credit gaps” today, i.e. the difference between credit to GDP and long-term trend. Hong Kong and China stand out in a global context, driven largely by their corporate sectors, followed closely by the US government and property-driven debt cycles in Canada, Singapore and Scandinavia.

Source: BIS, Antipodes Partners

Another defining characteristic of the current cycle is the growth in US and European non-investment grade (“high yield”) debt, with the stock of debt outstanding and the average leverage ratio high relative to the recent “goldilocks” combination of low base rates, tight credit spreads and elevated profit margins (Figure 15). In stark contrast to this general deterioration in the quality of corporate debt as measured by average credit rating, large technology/internet platform companies (the FAANGMs and BATs11) have generally not required debt to fund growth. Tending to dominate early niches, they generated enormous value via network protected moats and now comprise a very high proportion of global market capitalisation versus history (Figure 5). Accordingly, the ongoing success of these companies is leading to an increase in broad competitive and regulatory risk. Our focus here is the competitive environment.

Source: Antipodes Partners

The sheer scale of the largest platform/technology companies is increasingly threatening anyone caught in the middle. For example, in media, the spending on scripted drama by the “OTT disruptors” (Netflix, You Tube, Amazon, Hulu) is close to overtaking the global aggregate spend of the conventional TV and cable competitors. Worryingly, the growth in lower quality debt has occurred in businesses that are increasingly under competitive pressure from the largest platform/technology companies. AT&T, post the acquisition of Time Warner Media (carrying $171Bn in net debt at 3.1x EBITDA), and Kroger, via buybacks (carrying $13.6Bn in net debt at 2.9x EBITDA), are two of many examples. In summary, due to the leverage taken on by poorly positioned companies, we believe investors are underestimating the rising sensitivity of corporate credit to the overall economic cycle.

Outlook
Our view has been that the US banking systems’ structurally higher requirement for reserves would make it difficult for the Fed to safely reduce its balance sheet without provoking asset market volatility. After December’s liquidity driven turbulence, the Fed has responded with a policy change far sooner than we expected, including:

  • QT ends in September 2019;
  • external weakness is part of its rate calculus; and
  • unofficially, it would allow a period of above average inflation as a payback for periods of sustained below average inflation.

With policy turning more dovish, the market has extrapolated the status quo i.e. a continued flattening of the yield curve and a stylistic equity preference for “structural growth” or “quality” at any price. Hence, the violent bounce since December has been led by stocks offering strong near-term growth momentum (as measured by three year forward sales growth) irrespective of valuation or balance sheet quality. This has meant the extreme level of multiple dispersion both within and across markets (Figure 10) has become even more extreme. Given the disappointing performance of the funds this quarter, clearly we weren’t positioned for this outcome. Whilst not wanting to make excuses, Figure 6 captures just how extreme the outperformance of these growth stocks has been.

Source: Antipodes Partners

So, where to now? Chinese policy stimulus (Figure 7) has led to a rebound in property prices and household consumption, especially amongst affluent households in luxury expressions, but is poised to broaden out. However, as has been the recent pattern, we would expect this cyclical rebound to be met by policy tightening in 2020 as deleveraging and the maintenance of housing affordability remain policy goals. In the US, the fall in mortgage rates should lead to a rebound in new housing starts where we see reasonable pent up demand due a lack lustre recovery post Global Financial Crisis (Figure 12). This will provide some offset to the now fading effect of the Trump tax cuts. Switching to Europe, fiscal stimulus remains on hold, and hence activity indicators are for now underperforming the rebound apparent in China and the US. Growth in the EU will continue to remain highly dependent on exogenous factors unless the Member States embrace an expansionary fiscal policy. Offsetting this risk, European domestic facing equities (Figure 9), are priced attractively even relative to the most tepid of rebounds.

Source: Morgan Stanley, Credit Suisse, FactSet

Over the past 12 months domestic and globally exposed cyclicals underperformed as concerns around tighter global monetary policy gripped markets, compounded by protectionist and populist rhetoric. Putting aside trade wars and policy missteps, whilst the US growth environment is unlikely to accelerate much from here, the stabilisation in the Chinese data should sustain global growth at current levels for longer. Further, with the ability of the ECB and BOJ to exit QE now in doubt, two key questions arise:

  • Given US nominal growth running at ~5.5% and ten year nominal yields at ~2.5% (Figure 11), US long rates in isolation could be rationalised higher, does the flattening yield curve reflect a falling money multiplier implying the Fed needs to ease and/or reverse QT now in order to avoid another bout of asset market volatility?
  • In Japan and Europe, if the current form of QE is deemed to have officially failed, what would replace it? There is some evidence of the policy debate is slowly iterating towards greater fiscal stimulus and a form of yield curve targeting or reverse operation twist, i.e. buying the short-end, selling the long end in order to steepen the yield curve to actively take pressure off the banking systems – a discussion for another time.

Source: Antipodes Partners

Against this backdrop, and in a market that is currently giddy for structural growth at any price, the conundrum facing value investors is how to balance increasingly attractive cyclical valuations with risks regarding the durability of the cycle, that is, is it time to rotate into cheaper more cyclical growth opportunities (Figure 9). Given the apparent stabilisation in the Chinese data, investors should be more open to this idea. Even more powerful would be owning stocks perceived to be cyclical that are actually structural growth opportunities – and most of our “cyclicals” fall into this category.

Regional & Sector Return Expectations

Note: Expected Market Return (EMR), Cyclically Adjusted PE, Sector and Factor definitions can be found in the Glossary

Table 5 and Figures 14-15 apply some of our proprietary quantitative tools to determine the broad geographic sector and factor exposures that are most or least prospective for future returns. We use these as a contextual framework (or peripheral vision) rather than a deterministic tool for allocating team resource. Furthermore, if multiple dispersion is high across sectors or factors, as it is today, a competent stock picker will find attractive investment opportunities regardless as to whether the broader group appears expensive. Above all, the analyst will have the benefit of the broader contextual thinking of the CAPE analysis, sector/factor heat-maps and industry/company level screening before commencing any deep dive analysis.

To the extent that we describe a sector or factor as cheap/attractive or expensive/unattractive we’re referring to a historical mean reversion relationship. Clearly, there are limitations to such a framework, i.e. this is not a statement regarding absolute value as this can only be made after performing industry/stock level analysis to generate an assessment around the longer-term profit margin potential. However, at a large sample size and in the right hands, such a framework still has merit.

In terms of the broader outlook for equity markets, we find it useful to examine long-term empirical data in terms of what starting multiples imply for expected future returns. Given broad differences in the timing of earnings cycles across both regions and sectors, we prefer to measure expectations for future returns based on “Cyclically Adjusted PE” (CAPE) valuations.

Source:Antipodes Partners

In this sense, broadly both North American and Developed European equities look expensive. Given that these regions represent ~75% of the MSCI ACWI, investing in the global index is unlikely to lead to a great long-term return outcome. Comparatively, both Developed Asia (Japan, Korea and Taiwan) and China (a subset of EM ex Korea/Taiwan) stand out as regions with greater return potential.

Source: Antipodes Partners

We would stress that much of the difference in regional return expectations is driven by compositional differences in industry exposures. From an industry perspective, globalisation has resulted in valuation multiples that are relatively similar within industry sectors across regions. In this sense, with reference to Figure 9, we broadly observe:

  • Financials remain cheap by historical standards with sentiment and profitability expectations weighed down by macro-concerns, low rates and yield curve compression. In fact, all domestically exposed sectors are cheap by historical standards (right hand side of Figure 9). In a world of growing geopolitical instability, investors seem to be fleeing country specific risk in preference for larger more defensive multinational exposures. From a factor perspective, this is also reflected by the chase for “Quality” at any price.
  • Interestingly, in a market that until recently has paid up for Yield – most intensely reflected in the North American Infrastructure sector – traditional yield sectors such as Telecommunications have de-rated, coinciding with the apparent value of Good Yield (funded through cash flow).
  • Whilst Technology appears expensive on a more structural view of valuations, we guard against comparisons to the 1999/2000 tech bubble – Growth as a style is currently pervasively expensive across the global market, not just in Technology.
  • Consumer Staples were the ‘expensive defensives’, once enamoured for their perceived Profitability and Growth characteristics, that have now underperformed since the beginning of 2016. However, they still remain one of the most expensive DM sectors and in many cases structural pressures, such as substitution by private label, are intensifying.

Accordingly, Figure 10 applies our proprietary quantitative tools to determine how expensive various factors have become relative to the last 30 years (expressed as a Z-Score) by comparing the valuation of the most profitable (highest growth or lowest multiple) stocks to the least profitable (lowest growth or highest multiple) stocks.

Factor Valuations

Source: Antipodes Partners

  • The market is celebrating stocks that display high Growth and Profitability independently of starting multiple. Further, it’s noteworthy that the market’s willingness to pay up for Growth and Profitability is approaching the heady days of the late 1990’s tech bubble. More specifically, extreme policy settings in developed markets have led to severe investor herding, evidenced by the extreme overvaluation of Growth and Profitability in these regions. One can also observe the subsequent derating that occurred as high Growth and Profitability attracted competition and these stocks lost their allure, a clear example of how a high starting multiple was predictive of future sub-par returns.
  • Encouragingly, Multiple Dispersion is evident across all regions, however low multiple stocks continue to underperform high multiple stocks.

10 “This Time Is Different: Eight Centuries of Financial Folly”, Carmen Reinhart and Kenneth Rogoff, 2009
11 SFAANGM: Facebook, Amazon, Apple, Netflix, Google and Microsoft; BAT: Baidu, Alibaba and Tencent
12 The Antipodes Partners Region-Sector Valuation Heat-map provides a more granular illustration of valuation clustering across sectors and regions. Cell colouring indicates the degree to which a sectors’ enterprise value to sales multiple (price to book for financial sectors) relative to the world is above or below its 22-year relative trend (expressed as a Z-Score, the number of standard deviations from the mean). The warmer the colour, the greater the relative multiple versus history; vice versa for the cooler blues, with extremes highlighted by the boldest of colours.
13  Valuations reflect a ratio of the median multiple of the upper to lower quintile, expressed as a z-score. Our approach to measuring valuation has evolved from a single multiple, EV/CE, to an equal weighted composite of EV/CE, EV/Sales, forward PE and EV/normalised EBIT.