Can we immunize the portfolio from Brexit or Bremain risk?
Robert Swift – Head of Global Equity Strategies
Much has been written on the referendum on June 23rd when eligible UK citizens will be able to vote on whether to remain in, or begin to negotiate an exit from, the EU. You’ll be glad to know we won’t be making arguments for either choice in this article, and that this article will be brief.
It is a fascinating, and unprecedented, spectacle not least because the protagonists on either side transcend their traditional divisions. There has been much nonsense spouted, but by the Remain side in particular, and it is perhaps some of their insulting and patronising drivel that has caused the outcome to become closer than initially thought? We don’t trust polls but the bookies, who tend to be better predictors, have certainly shortened the odds on a Brexit. Consequently, if markets are sort of efficient, the closeness of the vote predicted by the bookies, should be discounted in the equity markets? Theoretically what only remains as a risk is if the vote is a resounding victory for one side or the other?
We’re not so sure and a narrow victory either way as well a resounding victory either way needs to be considered. While the numbers don’t warrant a big reaction (Total value of ALL trade and services between the UK and the EU accounts for around 1% of global GDP. Nobody for one minute is suggesting this will disappear overnight) there may well be one since markets love to overreact. Since we can’t predict what will happen we need to try and reduce portfolio exposure to a deleterious outcome. We think we can do this without going to cash by selling all UK exposure.
Here is what we have done. We own 3 UK stocks of which only one may be exposed to a shock in the UK economy and changes in interest rates and legislation. Two of the companies we own are multinational businesses, Glaxo, and HSBC which happen to have their main listing in the UK. They could just as easily be listed in New York, Shanghai, or indeed Frankfurt. If Sterling falls on a vote to Brexit they should benefit. Their US$ earnings are substantial so they are also a hedge against Euro risk. On a decision to Remain, they are quite likely to be favoured if investors wish to take on equity risk in a relief rally. Given the UK’s very large twin deficits we don’t think a vote for Remain causes a permanent and painful increase in the value of Sterling. Any such relief rally in Sterling is likely to be short lived.
The ‘pure’ UK company is National Grid which owns regulated electric and gas transmission assets. It also owns assets in the USA which actually comprise about 1/3rd of its asset base but it is overwhelmingly considered a UK company and its shareholders are predominantly UK based.
We find the company attractive because it has a stable and strategically important business, and has a high and growing dividend yield. This is a much better investment option than a UK bond or gilt at current interest rates. National Grid is unlikely to be affected by a close vote or an overwhelming vote either way. The UK is running seriously close to full utilisation in energy; NG is investing, and is being encouraged to invest by the regulator. The dividend yield will become really attractive if the Bank of England has to cut interest rates on a Brexit vote, to boost the economy. On the other hand if there is capital flight and an increase in interest rates to protect the pound Sterling, funding for capex is more likely to be directed TO this company than removed given the UK’s imminent energy shortages.
We believe these kinds of companies are attractive regardless of the outcome on June 23rd. We will be watching and relaxed doing so!
This week our Global Equity Growth Portfolio investment manager Calamos Investments, reviews the equity market and the sectors that are believed to be safe havens. Are we placing false hope in our belief that we are being conservative in our investment strategies?
This week our Global Equity Growth Portfolio investment manager Calamos Investments, reviews the equity market and the sectors that are believed to be safe havens. Are we placing false hope in our belief that we are being conservative in our investment strategies?
As investors, we naturally aim to understand what is and what is not discounted by financial markets. Of course, this is a difficult feat as it implies we know something about our stocks that others do not. Since the turn of the century, markets have become more informationally efficient and rapidly incorporate new information into stock prices. Rather than just ask “what do we know that others do not?”, our Global Equity Growth Portfolio team likes to explore the deeper questions about investor beliefs. These determine how investors incorporate information into the investment problem itself and thus, how they arrive at their decisions.
We all bring all kinds of beliefs to the investment task. For example, some believe that value investing works and valuation inputs should be paramount. Others prefer to invest in growth stocks and dismiss the value of dividends. Some believe that technical analysis is superior to a fundamental approach and so forth. But how do investors arrive at these beliefs and what is the evidence for such?
One commonly held assumption is that today’s financial landscape is dangerously fragile. This is the outcome of the trauma of the Global Financial Crisis and its aftermath in particular. Are investors correct that unforeseen risks lurk around every corner? Only time will tell. But one sanguine perspective is illustrated below, the Overall Index of Systemic Vulnerability constructed by the Federal Reserve. This implies that the structural risks, which culminated in the Global Financial Crisis of 2008, are no longer present.
Figure 1. The Financial and Economic Landscape: Stronger than Many Believe? Overall Index of Systemic Vulnerability
Source: Federal Reserve, quarterly data. The Overall Index of Systemic Vulnerability is constructed using inputs for Risk Appetite and Asset Valuations, Financial Sector Vulnerability, and Nonfinancial Sector Imbalances; more detail can be found here: https://www.federalreserve.gov/econresdata/notes/feds-notes/2015/mapping-heat-in-the-us-financial-system-a-summary-20150805.html
If investor belief in economic fragility is misplaced, as the chart above implies, is everyone overpaying for “safety stocks”? For example, many consumer staples stocks trade at premiums to the market and to their own history despite negligible growth. Investors appear to be paying for the stability and defensiveness of these companies rather than their long-term potential.
Another widespread belief is that the S&P 500 Index is “overvalued” and thus, lacks upside potential. As shown in Figure 2, the median P/E for the S&P 500 is higher today than its average of the past 50 years. That said, stocks have been sustained near today’s valuations for long periods, including the bull market of the 1990’s.
Figure 2. Is the S&P 500 Overvalued? S&P 500 Index, Monthly data 3/31/1964 to 3/31/2016 (Log Scale)
S&P 500 Median P/E with Historical Median
Past performance is no guarantee of future results. Source: Ned Davis Research. Median Price/Earnings ratio is calculated by Ned Davis Research. SD: Standard deviation. Copyright 2016 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
Figure 3 below compares S&P 500 sector valuations in 1992 versus today. Why 1992? Because it is hard to believe that U.S. equities were “overvalued” in the early 1990s, the preamble to the equity gains of the subsequent 8 years. In 1992, the S&P 500 traded on an average P/E multiple of 14.3x. In the first quarter of 2016, the S&P 500 traded on an average P/E of 16.4x, which assumes earnings of about $120/share.
Figure 3. P/E Multiples by Sector (x)
Quarterly Data, 3/31/1947 to 12/31/2015, Log Scale
Past performance is no guarantee of future results. Source: UBS and Factset; multiples are calculated as 12-month average.
The bulk (80%) of this valuation difference is accounted for by the “safety” sectors (32%) plus energy (37%) and financials (11%). For example, consumer staples and utilities traded on multiples of 16.1x and 12.0x respectively in 1992 versus 20.6x and 17.4x today. While financials and energy also trade on higher P/E multiples today, this reflects their compressed earnings base. On a price/book basis, for example, financials are trading cheaper today: 1.3x book value versus 1.6x book value in 1992.
What does all of this imply for what we should be thinking about?
If investors are “overpaying” for stability in sectors like consumer staples and utilities, how quickly could that sentiment reverse?One insight may be the energy MLP stocks. These had been regarded as safe “bond proxies” when investors were reaching for yield. After peaking in 2014, these stocks lost more than half their value as their underlying business models proved far less defensive than investors had supposed.
Is overvaluation a headwind for the S&P 500, or is it more the pace of future earnings growth?We think the resumption of the earnings cycle is the critical variable and will overcome investor concerns about valuation. This is why the debate over secular stagnation versus normalisation of global growth is worth monitoring.
Treasury bonds are regarded as the ultimate safe asset. How vulnerable are fixed income markets to a modest return of confidence in the economic outlook?If U.S. inflation drifts mildly higher, we see the potential for nominal GDP growth of 4%. As Treasury yields tend to equal growth in nominal GDP over the long term, the upside from current yields (1.78%) is significant.
Getting markets right is as much about formulating the right questions as knowing the right answers.
Happy investing,
This is a great example of a typical investment for the TAMIM Australian Equity Value portfolio, a situation where a former market darling goes through a number of profit warnings and is aggressively sold down by market participants. These situations quite often culminate in a company that is under followed and unloved. Management effect a turn around and this is not realised by the market. These are the type of investments we enjoy in the TAMIM Australian Equity Value portfolio.
James Williamson, the portfolio manager of our TAMIM Australian Equity Value portfolio discusses attractive characteristics in companies.
This is a great example of a typical investment for the TAMIM Australian Equity Value portfolio, a situation where a former market darling goes through a number of profit warnings and is aggressively sold down by market participants. These situations quite often culminate in a company that is under followed and unloved. Management effect a turn around and this is not realised by the market. These are the type of investments we enjoy in the TAMIM Australian Equity Value portfolio.
Over the 12 months to the end of April the fund underlying the TAMIM Australian Equity Value portfolio has delivered a 19.1% return versus a market that returned -4.9%. If you would like to discuss how TAMIM can help you with you retirement portfolio’s in this low interest environment, then please contact us at ima@tamim.com.au.
This weeks stock pick is from the manager of the TAMIM Global Equity High Conviction portfolio. Bank of Montreal shows significant value for shareholders from its low volatility, growing earnings stream. Dividends have increased in line with earnings and are kept at a sensible level of around 40-50%. This is far more reasonable compared with the dividend overpaying of Australian banks where the average payout ratio is around 78%.
The TAMIM Global Equity High Conviction IMA works on a quantitative scoring system which ranks each company in our universe on its Value, Momentum and Quality rankings.
This month we focus on the highest weight position in the High Conviction Portfolio, and also amongst the strongest performers, Bank of Montreal.Bank of Montreal, or BMO Financial Group (BMO), is a Canadian bank and financial services company. It was founded in 1817 and is the oldest bank in Canada. It carries out retail, commercial investment banking and wealth management activities, principally in North America and also has operations throughout the world through its investment management subsidiaries, Lloyd George and Foreign & Colonial. It is the fourth largest bank in Canada by market capitalisation and amongst the ten largest in North America.
Like the Australia, Canada is highly regarded as having one of the world’s safest and well-managed banking systems. It is dominated by the ‘Big 5’: Royal Bank of Canada, Toronto Dominion Bank, Bank of Montreal, Bank of Nova Scotia and the Canadian Imperial Bank of Commerce. This makes it highly attractive to us, providing a similar, but diversified exposure to banking operations that are familiar to Australian investors, particularly as a high quality source of capital growth and dividend income.
VMQ Analysis
Bank of Montreal, ranks very highly on the VMQ model, both amongst all banks and the whole investment universe, averaging around the 98th percentile over the last 12 months.
*Quintile Ranks: 1 = Best 5 = Worst ^VMQ_Score = API Capital standardised company assessment with values distributed between -3 (highly unfavourable) and +3 (highly favourable).
BMO ranks in the top quintile (20%) of companies for both Value and Momentum measures. We evaluate price/book by adjusting the book value for the incremental return earned over the cost of capital for the company, called the economic value added. On this basis the company remains attractive relative to its peers. The Price/Book, Price/Forward Earnings and Loan/Deposit ratios are also sound relative to peers and the bank maintains sensible levels of doubtful debt provisioning.
Momentum reflects both the price return over various time periods, plus the change in analysts assessment of the company. The quintile ranking of the analyst review model reflects a degree of sell side caution that Canadian banks doubtful debt provisions will increase due to pressure from lending to the Oil & Gas sector. The price momentum reflects the strong returns of the company, particularly since we acquired it in early February.
Banks tend to be marked down in the VMQ process because of balance sheet leverage is different to normal companies – and we make other adjustments that takes this into consideration. The important factor that arises from the Quality factors is the standard deviation of earnings per share growth, which is very stable and reflects value for shareholders from a low volatility earnings stream.
Qualitative Analysis
We like the bank’s strategy around increasing market share across its different businesses. There is a slow and steady roll out of simple personal and commercial product lines. It has a significant market share of retail and commercial banking in Canada and also operates in the USA mid-west through BMO Harris Bank. BMO’s acquisitions are consistently of a digestible size, the latest was the GE transport equipment financing business.
We like the bank’s profit mix: retail, commercial and investment banking along with wealth management through its ownership of investment managers Lloyd George and Foreign & Colonial, both of which are not capital hungry businesses. Tier 1 capital is sound at 10.7% prior to the GE deal.
We believe that the market will continue to focus on the stock’s valuation and it’s quality/defensive attributes. The bank has has conservative loan loss provisioning and is acquiring businesses in areas we like such as infrastructure financing.
There is significant value for shareholders from its low volatility, growing earnings stream. Dividends increase in line with earnings and are kept at a sensible level of around 40-50%. This is far more reasonable compared with the dividend overpaying of Australian banks where the average payout ratio is around 78%.
Any catalyst for share price appreciation will be from the realisation of adequate capital and recognition of growth in fee income business. The next company earnings call for Q2 2016 (April, based on 31 October year end) is on 25 May.
The TAMIM Global Equity High Conviction portfolio continues to benefit from its holdings in companies like Bank of Montreal. Over nearly 5 years since its inception the portfolio has delivered 19.7% annualised returns after fees
The Pain Report will provide you with a weekly independent and objective commentary on the global economy, in an attempt to help you identify the key forces which will shape the world in the years ahead. For example, I believe that the most significant and defining economic phenomenon of our time is the rise of the Asian middle classes. I urge you to beware the prism through which you view the world, and to be aware that much of the western media’s negative and sensationalist coverage is biased against the so-called emerging nations. In my view, the decades ahead will see an era of prosperity, enlightenment and opportunity that very few today are predicting. If any of the above resonates with you then please read “The Pain Report”.
My goodness there is a lot to talk about. When I started this weekly version of The Pain Report I envisaged writing a snappy, relatively brief update. That, it seems, is impossible. There is simply far too much going on to be snappy, so please forgive me.
Incidentally, and before I get lost in the maze of markets, you are allowed to circulate my weekly without my permission…a number of you have asked…thank you.
I know many of you will want to talk about Donald Trump and also that ‘sizzling’ Australian GDP report, and perhaps even the overnight non-farm payroll report. We will. But before we do let’s look at the charts and see for ourselves how impressive and powerful the ‘bounce’ has been.
Two weeks ago, on Saturday 20 February, I wrote: “In times such as these I rely on the charts. Listen to what the market is telling you.They are looking forward, not backward.
Right here and now equity markets look like they want to move higher. Not surprising given how far we have fallen. The two charts below (Dow Jones Transportation Index and the Russell 2000, tell me that markets want to go higher) Don’t forget it was these two markets which led the broader indices lower.”
First up the Dow Jones Transportation Index.
That’s a 19.55% rally from the low! In fact at its high this morning, it was up more than 20%, which qualifies as a bull market, and all in a matter of weeks. The Russell 2000 (US small cap stocks) has seen a similarly explosive rally.
But if you’re talking explosive, then take a look at the Brazilian market.
Ibovespa Brasil Sao Paulo Stock Exchange Index
So what happened in Brazil? The former President Lula da Silva was arrested, and on 3 March we found out that Brazilian GDP shrank 3.8% in 2015. If the consensus 2016 forecast for GDP of a further decline of 3.5% turns out to be right, then back-to-back declines of that magnitude would amount to the longest and deepest downturn since Brazil began keeping records in 1901, yes worse than the Great Depression. You see it’s not so much the numbers themselves that are important, but the way that the markets react to them that is important. The market’s reaction tells you about market positioning and hence investor sentiment. In Brazil, investors were short.
C’mon JP I don’t give a fig about Brazil, what about the rally in Aussie banks?
ANZ.ASX
CBA.ASX
And we’ve still got Donald and ‘sizzling’ Australian GDP to talk about! The suspense is simply overwhelming.
Earlier in the week I stayed overnight on the central coast of New South Wales, about an hour or so north of Sydney.
For those not resident in Australia it looks nothing like South Wales. I decided to leave early in the morning for Sydney, so as to beat the traffic, at about 5.15 am. I got stuck behind a big truck going up a hill. I won’t tell you for how long because it is embarrassing. I couldn’t overtake. It was pitch black and a bit foggy. Poor visibility and all that. But the real reason I chugged up the hill doing no more than 25 km/h was the MASSIVE volume of traffic hurtling along in the outside two lanes. Once or twice I indicated and tentatively nudged out to overtake and a hundred ‘utes’ instantly hooted their indignation. I was a condemned man, trapped in the slow lane, a hostage to the ‘multiplier effect’ of the Sydney housing boom. Electricians, bricklayers, carpenters, builders, plumbers, carpet layers…all hurtling to the great building site we call Sydney. How many people are involved in the construction and sale of a single property then multiply that by 100,000 or so? New houses, new ‘utes’, new tools, new clothes and the ‘multiplier’ begins. Napoleon Bonaparte once said that Britain was a nation of shopkeepers. Australia has become a nation of real estate agents. The banks, the property industry and all the homeware/hardware companies, the construction industry and maybe the fund managers too have all become ‘agents’ of the real estate industry.
It is of course impossible to quantify the full value or multiplier effect from housing.
Some of you will recall my view that America was experiencing a housing and construction bubble in 2005 and 2006.
I said then that America had gorged at the trough of debt for far too long and that they could not forever defy the laws of economics. C’mon JP you can’t compare the Australian housing market with America. And I’m not, and I don’t need to, because the average SINGLE house price to average SINGLE income ratio is, as you know, far, far greater in Sydney than it was in San Francisco, Miami, Stockton, Dallas, Chicago, New Orleans, Memphis or New York. Now that house prices are declining we can debate how far they will fall. We can indulge ourselves in all kinds of statistical wizardry and dismiss declines in median house prices and publish ‘hedonic’ measures that look so much more palatable. A footnote here is worthwhile: CoreLogic published its monthly report showing Sydney home values rose 0.5% last month. CoreLogic, however, also said that the median house price in Sydney in February was $730,000, down from $776,000 in January and much lower than November’s $810,000. Hedonic measures, as you all know, adjust for the changes in the ‘quality’ of the houses in the survey sample.
Let’s stop all this nonsense. The fact is house prices are declining. The sensible debate is about how much further they will decline. If you accept they have fallen about 10% since September 2015, which you probably won’t, then they have in my view about another 20% to go. That’s all I’m saying for now, and as time goes by I reserve the right to say it might be more. The more important issue I believe is how much of a correction in housing construction will there be? Or put another way, when will I be able to overtake that truck without being run down by ‘utes’. Looking at the chart below of ‘Australia building approvals total building value’, you can see that it appears to be rolling over. You hopefully will also see that I have overlaid a 12 month moving average as the data series is ‘lumpy’ to say the least.
Australia Building Approvals
You will also see that we have been here before, back in 2009, but the 12 month moving average looks like it has peaked. This suggests to me, all things being equal, that the economy slows significantly through 2016 and into 2017.
Which brings me to the ‘sizzling’ Australian GDP report. The Australian economy grew 0.6% in the fourth quarter of 2015 and 3.0% over the year. These figures were much stronger than anticipated. In terms of the contributions to quarterly real GDP they were as follows:
Private consumption +0.4%
Private Investment -0.4%
Government consumption and investment +0.3%
Change in inventories +0.2%
Net Exports 0.0%
And for the eagle-eyed amongst you, there was a ‘statistical discrepancy’ of +0.1% to make it all add up to + 0.6%.
So what have we learned so far, and I am keen to get to Donald, Household consumption was strong at +0.4%, comprising two thirds of the growth in the quarter. Also, that the government sector contributed 50% of the real GDP growth in the fourth quarter. In addition we saw a continuation of the ‘national income recession’ with ‘real net national disposable income’ declining by 1.1% in 2015. A trip to the Australian Bureau of Statistics is in order and in the words of the ABS.
A broader measure of change in national economic well-being is Real net national disposable income. This measure adjusts the volume measure of GDP for the Terms of trade effect, Real net incomes from overseas and Consumption of fixed capital.
So to bring our Australian GDP discussion to a close, the best is now behind us and the tailwinds have turned into headwinds, and I’ll leave it there for now.
Now finally to Donald Trump. Donald Trump will win the Republican nomination BUT he will not win the presidential election. He does indeed create good theatre and in an age of social media and bumper sticker headlines he is an extraordinary phenomenon. In the eyes of his adoring fans he can do no wrong. They believe that he will ‘make America great again,’ and that’s all they care about. What that actually means is that we(America) will do whatever we want, whenever we want, to whomever we want. I will leave you to fill in the blanks as to what this means. But let’s be clear on a vital point, the forthcoming election in November does matter. You may not know the name of the Belgian Prime Minister, but everyone knows who the President of the United states of America is. Because it matters who the Commander in Chief of the world’s most formidable military machine is. Yes, I know, the thought of Donald and Sarah in the Oval Office together is not funny…but it won’t happen…
Next week I want to write about Saudi Arabia.
But, before then lets wrap up this longer than anticipated weekly with some thoughts about markets. Across the board you have to be impressed with the price action in markets. Can we go higher still? Of course we can. Perhaps up to the 200 day moving averages across the major market indices. In Australia this means levels on the ASX200 of about 5240.
The trend is your friend. Do I still see a deleveraging taking place across Asia? Do I still see deflationary winds blowing in from the east? Yes I do. I never subscribed to the views of a recession in America and stated that view here in previous reports. The Chinese have stabilised the RMB, for the time being, but will depreciate it further down the road. The oil market has stabilised, in fact oil prices have soared. Sovereign wealth funds have stopped selling for now. So global equity markets having crashed and being very oversold, have now rallied sharply. I have been buying Australia and Japan, for the first time in a long time. But this is not a set and forget market. In conclusion I would use this rally to lighten any overly concentrated positions you may have.
Have a great weekend.
PS The PM of Belgium is Charles Michel.PPS Non-farm payroll rose a stronger than expected 242,000 and yes the US economy is doing fine.
