Investment Strategy Review – July 2017
This is a special report for Elemental Wealth clients looking at the year ended 30 June 2017.
We outline our latest thoughts on world events, stock markets and what this means for your investment strategy for 2017 and 2018. We start by looking at the performance of major economies around the world and how they affect Australia and then drill down into what this means for Australian investors.
United States
The US market has continued to rise since Trump’s election late last year. The Down Jones index rising 16% for the year ended 30 June. While the market is now at a record high, it remains around fair value with a current PE ratio 16.8x versus the long run (50yr) rate of 15.9x.
The recent scandals around Trump’s Russian connections may affect his ability to get key reforms through, which could reduce US growth going forward and moderate the rise in interest rates.
That said, current data shows the US economy continues to grow with both employment and wages growth remaining favourable.
US interest rates are expected to continue to rise, but at a fairly slow pace. One of the key risks to US markets are how quickly interest rates rise, with higher rates being negative for stock valuations.
Europe
Most European markets performed well to 30 June. The FTSE 100 was up 11% despite the backlash from Brexit. The German index was the standout performer, up 21% for the year, as sales of equipment and automobiles jumped on increased optimism.
Europe is still feeling the impact of the GFC however, with the unemployment rate being more than 9%, compared to 4.4% in the US and less than 3% in Japan. Bad loans are still haunting Europe’s banking system with recent bank bailouts in Spain and Italy.
As a consequence, interest rates are still very low for most of Europe, with some countries still seeing negative interest rates (this means you pay the bank to have money on deposit).
The outlook is for growth to accelerate in continental Europe, with Britain expected to miss out because of the impact of Brexit.
The key risk here is the effect of rising interest rates or an unexpected blow-up of one of the Euro’s weaker economies.
Asia
Most Asian economies posted below-average growth for 2016/17, led by China posting sub-7% growth for the 3rd year in a row.
High levels of corporate debt in China pose a major risk to world economic growth.
Many of the most indebted are so-called ‘Zombie’ companies – State owned enterprises that are operating at a loss and are effectively being propped up by the government. These are a hangover from the large scale stimulus packages rolled out in the last few years, promoting inefficient practices and overcapacity problems.
However, it is not all bad news in China. Overall debt levels are sound with Chinese households being extremely good savers. The Government also holds trillions in foreign currency reserves, so there are adequate funds available, should a Zombie bailout be required.
A key focus for the Chinese government will be keeping economic growth at levels that improve jobs growth and prosperity. Generally 6% pa or higher is what they will be targeting.
Australia
Australia has continued to surprise in 2017, staving off a potential recession over Christmas and continuing on its 26th year of uninterrupted growth.
The stock market finished the year up 8.5% with the best sectors being Resources (up 16.5%), IT (up 12.2%), Healthcare (up 11.8%) and Financials (up 11.86% for the year despite falling 10% in May).
The worst performing sectors were Property Trusts (falling nearly 12% on the threat of higher interest rates) and Consumer Discretionary (feeling the pinch of household’s lower disposable income).
The market average PE is 14.9x versus the long term average of 14.4%, so remains fairly valued. The average stock yield remains excellent at 6.2% (including franking credits), which is in line with long term averages.
The outlook for 2018 is still uncertain with a number of issues becoming apparent.
Wages growth is a continuing problem with a large impact on the economy.
Wages are falling and growth is currently less than the inflation rate, reducing disposable income and translating into lower savings and consumption.
Rising costs are adding to the stresses that households face, with recent electricity and gas prices rises a major concern. From July 1, electricity prices in South Australia will rise by 20%, with a 16% rise in NSW.
Property prices are another major risk factor, as stressed households cannot afford to continue pay ever higher prices. The average property price in Australia is more than 8 times annual income (up from less than 4 times in the 80’s and 90’s).
A combination of lower growth, lower spending and a falling property market is the biggest risks to the economy in 2018.
Commodity prices are expected to remain low, reducing the positive impact they have had on the economy in recent years. Australia narrowly avoided a technical recession (defined as 2 consecutive quarters of negative growth) in December 2016 due to a timely bounce in iron ore and coal prices.
Interest rates are likely to remain on hold with the RBA caught in a catch-22. Rising inflation suggests that interest rates should start to rise in 2017/18 but the perilous situation of indebted households will force them to keep rates down. A recent survey suggests that just a 1% rise in interest rates would cause significant problems for nearly a third of mortgage holders.
Commodities
Even with the OPEC states recently agreeing to production cuts, the oil price has remained low (under $50/barrel), mainly due to US shale production continuing at a good pace.
We think that the oil price will stay around $45 to $60 a barrel going forward. This provides a boost to most developed economies by reducing transportation costs and helping to keep inflation at bay.
Gold prices are under pressure as rising interest rates make commodities exposure less appealing. However, it is an important hedge against market volatility. While the market remains complacent about the risk of a correction or crash (with volatility at all time lows), risks still remain.
Iron ore and coal prices staged a good rally over Christmas – it was higher prices over this period that kept Australia out of recession in December. However they remain under pressure from 1) increased supply from new mines and 2) reduced demand from China.
Bonds
Over the past few months we have seen signs that interest rates will continue to rise, but the increases will be modest and take longer than originally expected. This strengthens the case to hold bonds in your portfolio – they still provide a reasonable income with important diversification benefits.
Market Sector Comments for 2017/18
Property Trusts, Utilities & Telcos
A slower, steadier rise in interest rates is good news for this sector. As mentioned previously these stocks are highly dependent upon debt financing to operate and have been used as an alternative to fixed interest exposure (ie bonds) to provide additional income in portfolios. Higher interest rates mean traditional fixed interest products will become more attractive over time and higher debt costs could crimp profits of these companies.
Property stocks are continuing to be under pressure not so much from interest rates, but from valuation concerns. There is no doubt that property prices are inflated at the moment and there are signs that this is a bubble that could burst.
We continue to hold property trusts for income, but remain cautious on the sector as a whole.
Banking Stocks
Banks are expected to be under some pressure in 2017 and 2018. Households are already at full debt capacity and with flat wages growth, can’t afford to borrow more. This slows credit growth which will crimp bank profits.
The biggest risk to the sector is that the slowing Australian economy precipitates a property downturn which then becomes a full-blown property crash. This a small possibility at this time, but not impossible. Under this scenario, rising bad debts will seriously impact bank balance sheets, dividends and profits and hence banks will see a large fall in share prices.
While the banks will continue to provide solid dividend yields, profit growth will be low or negative for the next year or so. We prefer to be underweight the bank sector at this time.
Healthcare
Healthcare stocks will continue to be boosted by demographic trends. The ageing population and advances in medical technology are the keys to growth in this area. Even with lower economic growth, we expect this sector to perform well.
IT/Technology
An emerging theme is disruption of existing businesses, made possible by advances in technology. Think of the effect that Uber and Amazon have had on the taxi and retail industries.
Early adopters of technology establish a competitive advantage, which existing players find hard to combat.
This sector will provide investors with above average growth, albeit with higher risk. Unfortunately the Australian market does not provide many opportunities to invest in quality IT companies, so this exposure is mainly found offshore.
Globally Exposed Stocks
Based on our outlook for 2017 and 2018, we still have preference for stocks that have exposure to the global economy and generally will benefit from a lower Australian dollar.
We think that there is a better chance of growth with exposure offshore than with the local economy. A falling Aussie dollar will also give these companies an additional boost.
Key Stock picks for 2017/18
Given all of the above information, we have distilled these economic thoughts into recommendations for your investment portfolio. The recommendations are driven by these main themes:
- Growth with continue in the US and continental Europe
- Interest rates will rise globally, but at a slow pace than first predicted
- The Trump government may be handicapped by the growing number of scandals
- The Australian economy will continue to be weak for 2017 into 2018, meaning better investment opportunities are found with overseas exposure
- The most favourable sectors in the Australian economy are those underpinned by demographic trends
Brambles (BXB): BXB is a supply-chain logistics company operating in more than 50 countries, primarily through the CHEP and IFCO brands. BXB’s global presence and depth of network gives it high barriers to entry. It is an important part of the supply chain for many industries, particularly food, retail, manufacturing and auto. BXB offers a solid earnings stream with growth driven by penetration into new markets, like Asia, and general economic activity in the key markets of the US and Europe.
- Strong market position, high barriers to entry.
- Good growth prospects
- 2018 EPS Growth of 7.2%.
- Yield 3.7%.
Challenger (CGF): Challenger is the only specialist provider of annuities in Australia. The medium term outlook remains strong and supported by an industry leading position, broadening distribution footprint and macro tailwinds including an ageing population, growing superannuation balances and government policy supportive of retirement income products.
- Leading market position.
- Growth profile supported by ageing population, compulsory super and Government policies.
- Expanding distribution platform and tailwind from rising interest rates.
- 2018 EPS Growth of 11%.
- Yield 3.7%.
CSL Limited (CSL):
CSL provides exposure to a quality growth company with a strong industry position in the global plasma market. We expect that increasing demand for blood-plasma products over the next decade to lead to steady earnings growth for the group over the long term.
- Strong global market position with high barriers to entry.
- The plasma market is expected to grow steadily over the next decade.
- Weakening A$ should benefit earnings.
- 2018 EPS Growth of 20.4%.
- Yield 1.4% (at least as good as cash rates).
Link Administration (LNK): LNK operates Australia’s second largest share registry and is the largest fund administrator to the Australian superannuation industry. Most large super funds remain internally administered so the trend to outsourced administration supports the medium term growth outlook.
- Defensive, contracted revenues provides good revenue visibility.
- Scope for market share gains from smaller providers.
- Leading player, beneficiary of outsourcing trend.
- 2018 EPS Growth of 8.1%.
- Yield 2%
Mantra (MTR): MTR is a leading Australian accommodation operator with the second largest network of hotels, resorts and serviced apartment properties in Australia. The Australian accommodation industry is expected to grow steadily over the medium term, supported by favourable themes such as increasing short-term visitors from Asia and the growth of low cost airlines. Aside from acquisitions, the key growth drivers for MTR include growing revenue per room, yield management, and distributions channels/partners.
- Strong market position in Australia.
- Fragmented market provides opportunity for growth through M&A.
- Positive top-down drivers.
- 2018 EPS Growth of 9.6%.
- Yield 5.3%.
Nanosonics (NAN): NAN is a medical technology company with operations in a number of countries and locations. NAN’s primary product, the trophon EPR, is a complete ultrasound High-Level Disinfection (HLD) system that’s superior to traditional methods (soak, spray or wipe). Globally, the installed base of trophon EPR has grown to 10,000 units, represents around 8% of the estimated 120,000 unit installed base potential.
- Strong market position
- Fragmented market provides opportunity for growth
- No debt, strong earnings growth
- 2018 EPS Growth of 39%.
Ramsay Healthcare (RHC): RHC provides exposure to a growing healthcare company that is set to benefit from the expected continued increase in demand for private hospital services. This is underpinned by favourable healthcare sector fundamentals, including growing and ageing populations and increasing medical treatment capabilities.
- Leading hospital operator in Australia.
- Positive top down drivers (ageing demographics, higher health standards sought).
- International expansion with a successful track record to date.
- 2017 EPS Growth of 12.3%
- Yield 2.8%.
Conclusion
There are still risks in the global economy but the US & Europe seems to have seen the worst for now. Our economy has challenges for 2017/18, mainly around debt and property.
Our key picks are companies that are less exposed to the Australian economy or are supported by solid demographic trends. Stocks that have overseas exposure also benefit from a falling Aussie dollar, driven by interest rate differences between ourselves and the US.
For more information on our economic outlook and how this may affect your portfolio, please call me on (07) 5494 0650.