Asset Allocator INVESTMENT STRATEGY. Extreme Underweight

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1 27 June 2018 INTERNAL ONLY CHIEF INVESTMENT OFFICER Malcolm Wood mwood@baillieuholst.com.au Asset Allocator INVESTMENT STRATEGY Reducing Australian equities; adding to International Year-to-date major asset class performance has been mixed. Equity price indices in the US and Australia are modestly higher, but down low-to-mid single digits elsewhere. Bond yields are 50 bps and 90 bps higher respectively in the US and Italy, but largely sideways elsewhere, implying low total returns. The US dollar has generally strengthened, particularly versus the AUD. Oil is up strongly, but most other major commodities are lower. In this note, we update our Tactical-Dynamic Asset Allocation views. The combination of lower prices and/or strong earnings momentum has improved equity valuations. Strong US growth and solid fundamentals in the other major markets should ensure solid earnings growth. In our view, the trade war bark is likely to be much worse than the growth bite (see our note, The good, the bad and the ugly: Part 2 ). Outside the Fed, no other major central bank is lifting rates. We reiterate our overweight International equities, with a focus on Europe and Japan. After the recent surge, we reduce our position in Australian equities, adding to International by increasing our US exposure. We remain underweight fixed income, seeing further upside in bond yields. Despite their flat-to-down performance, we still see bonds as expensive, vulnerable to strong growth and firming inflation, as well as deteriorating supplydemand dynamics as central banks taper or unwind QE. Rising bond yields should again pressure the A-REITs, with structural challenges for Retail REITs. We remain underweight Property. Whilst the AUD has fallen against most currencies, and especially the US dollar, we see further material downside. Drivers of a further decline include Australia-US interest rate spreads being at year lows, Australian growth back at-or-below US and European levels, a lack of reform highlighted by a relatively high company tax rate, and slower China growth which should soften commodity prices. We continue to leave our offshore positions unhedged. The key risks to our outlook would be a sharp rise in bond yields and further escalation in trade tensions, which could again unsettle equities. Solid earnings growth should limit downside risk. Summary of changes to Balanced Tactical-Dynamic Asset Allocation (including update for benchmark weight changes): Australian Equities -1.5%; International Equities +1.5%, including US +3.5%, Europe -1.7%, Japan -0.1%, Emerging Markets -0.2%. We have also added to our active US exposure MFF +1.5%, trimming active Europe TGG 0.4% and active Asia-EM PIXX -1.1%. FIG.1: Tactical-dynamic Asset Allocation recommendations Asset Class Australian Equities Large Cap Small-Mid Cap International Equities United States Europe Japan Emerging Markets Property & Infrastructure AUS Property & Infrast. Fixed Income Australian Fixed Income Australian Credit & Hybrids Cash Cash Currency AUD Source: Baillieu Holst Extreme Underweight Underweight * orange boxes show prior positioning. Slight Underweight Benchmark Slight Extreme Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 1

2 Reducing Australian equities; adding to International Year-to-date, equity markets are mixed, with returns much more muted than in Excluding income returns, the US S&P 500 is up ~2%, partly recovering from a selloff in late- January-February, while the ASX 200, helped by a sharp recent rally, is also up ~2%. Trade fears have hit Hong Kong (-3%), but also impacted Europe (-3%) and Japan (-5%). The US dollar has strengthened, rallying 5% against the Australian dollar, 3% versus the euro and 2% against the pound, though it is almost 3% lower against the yen. The strong US economy and gradual Fed tightening has lifted US 10-year bond yields almost 50 bps to just under 3%, while other major bond market yields are almost flat (AUS +0, GER -10, JPN -1bps) though political instability has lifted Italian yields by ~90 bps. Amongst major commodities, Brent oil is up 12.5%, while gold is down 3%, iron ore -8% and copper -9%. Our tactical calls to underweight the Australian dollar, cash and bonds have worked well. While we have been correct to overweight growth assets, our calls to slightly underweight Australia and the US versus other major markets have not so far worked. Our positive view on oil has continued to perform. In this note, we update our Tactical-Dynamic Asset Allocation views. Equities: International offers solid earnings at fair-to-attractive valuations Earnings expectations have been mixed in recent months, a contrast to the broad-based strength of the past 6- and 12-months: - US +3.3% over 3 months, 15.4% over 6 months and 20.2% YoY; - Europe has lagged: -1.4%, +5.1% and +12.5%; - Japan is positive: +0.6%, +9.0% and +19.1%; - Emerging Markets have slowed: -0.6%, +6.6% and +16.4%; and - Australia has recently improved: +1.6%, +5.2% and +5.0%. The drivers of this earnings growth and the key divergence have included: - the US$1.5 trillion US tax cut, which directly lifted US earnings estimates by ~8% (see jump in Figure 2), a larger benefit than for other markets; - strong US growth momentum, added to by the tax cut; - better-than-expected 26% YoY rise in 1Q18 US earnings ~8% betterthan-expected driven by ~8% YoY revenue growth, ~8% from margin expansion, the tax cut adding ~8% and buybacks adding 1.5-2%; - A slowdown in indicators in Europe, Japan and China, albeit from multidecade highs for Europe & Japan, to still healthy levels (Figure 3). FIG.2: The US ISM Manufacturing New Orders index is at very high levels, driving strong US earnings growth, up 20% YoY FIG.3: European Business Sentiment has moderated but remains at a high level, supporting earnings growth up 12.5% YoY US ISM New Orders and S&P500 EPS 70.0 ISM- Manufacturing New Orders (3MMA, Left) 65.0 S&P500 EPS (Right) Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 Jan-13 Jan EUR MSCI EPS vs Business Sentiment 60.0% % % % % EUR MSCI 12MF EPS YoY% (Left) % EUR Business Sentiment z score (Right) % Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-15 Jan-18 Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 2

3 Fears of a large trade war have recently impacted markets. In our Strategy Insight, The good, the bad and the ugly: Part 2, we argued that US$50 billion of tariffs on China-US trade would be immaterial to growth, but that US$250 billion of tariffs on China would hit its growth by %, a hit that could be moderated by a policy response. Already China has eased Reserve Requirements by 50 bps. Altogether we expect the trade bark to be worse than the bite. For the US the combination of rising earnings and the sluggish price index has pushed the forward PE from a recent peak of 18.5x to 16.5x, still above-average, but only moderately so (Figure 4). Australia has re-rated to 15.8x, also an above-average valuation, and a narrower-than-usual 5% discount to the US. By contrast, Europe is just below the long-term average at 13.8x, while EM at ~11x and Japan at ~13x are wellbelow average. When compared to bonds or cash, equity valuations remain very attractive, particularly outside the US (Figure 5). Overall, using our range of preferred valuation metrics, the US market has returned to around fair value, and Australia is also around fair value, whilst Japan, Europe and EM all appear attractive. Liquidity conditions in most markets outside the US remains very accommodative. That said, the ECB recently announced it will stop its Quantitative Easing (QE) program at year-end, but leave rates around record lows until at least mid Japan is continuing with QE via yield curve control and is much further away from lifting rates. Some small parts of Emerging Markets with structural challenges, like Argentina and Turkey, have been forced to lift rates. To a lesser extent Indonesia and India have also lifted rates. In the US, whilst the Fed is tightening it is doing so at a moderate pace (75- bps pa) and the real cash rate is still negative (-0.3%), though the yield curve is now much flatter than normal. Overall, in our view international equity markets offer solid returns, given solid earnings growth and fair-to-attractive valuations. We prefer Europe and Japan, but also see good upside in the US. FIG.4: The forward PE s for the major markets have moderated into a range of x Forward PE (12MF) 6 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-15 Jan-18 US AUS EUR FIG.5: US equities still appear attractive relative to bonds, albeit much less so than Europe or Japan (latter not shown) US AUS EUR Bond Yield-Earnings Yield Gap -8.0 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-15 Jan-18 Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 3

4 Fixed Income: risks remain high in long-term bonds Major market bond yields have been flat-to-higher in 1H18, with 50 and 90 bps increases in US and Italian yields on the back of strong growth and political instability respectively. Sluggish growth and on-going easy monetary policy, as well as some flight-to-safety in Europe, has kept yields about flat elsewhere. Looking ahead, we see five continuing sources of risk that are likely to push yields materially higher: - Expensive absolute valuations: real yields are well below average levels, with the US real 10-year yield of 0.7% low compared to the long-term average 2.1%, Europe at 0% versus an average 2.2%, Japan -0.3% versus an average 1.6% and Australia 0.6% versus an average 3.2% (Figure 6). - Relatively unattractive valuations: bonds remain very expensive when compared to equities (see again Figure 5). In our view, this means that equities can absorb at least some of the rise in bond yields. - Growth outlook: despite a loss of global economic momentum, business activity indicators remain at healthy levels, especially in the US, a negative for growth assets. - Inflation outlook: US inflation is rising, albeit very gradually, driven by rising wages on the back of the tightening labour market. - Deteriorating bond market supply-demand: the supply-demand balance is deteriorating as the Trump tax cut lifts US budget deficits, the Fed gradually accelerates its balance sheet normalisation program and the ECB winds down its asset purchase program. In our view, this combination will drive US bond yields solidly above 3.0% in 2H18, lifting yields another ~20-40 bps. The further rise in US yields may pressure yields elsewhere US-German spreads are already at 30-year highs (Figure 7), the ECB is moving to end QE, and Australian-US spreads are at 37-year lows (Figure 10) and/or propel the US dollar higher. Given this outlook, we expect the sluggish-to-weak performance of fixed income to continue. Within our asset allocation we have a strong preference for floating rate securities, which offer protection against duration risk (long-term bonds have a relatively high duration, a technical term which means that their price declines relatively more when interest rates rise). FIG.6: The US real 10-year yield at 0.7% is still well below the longterm average 2.1% Year Real Bond Yields US 10Y Real BY JPN 10Y Real BY EUR 10Y BY Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Jan-12 Jan-16 FIG.7: US-German bond spreads are at a 30-year high 255bps 10-Year Bond Yield Spreads US-GER 10Y Spread Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Jan-12 Jan-16 Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 4

5 Property: risks from rising bond yields and retail headwinds The ASX A-REITs have rallied strongly since late-april, enjoying a significant re-rating (Figure 8). In line with our call for higher bond yields, we see renewed risk to the A-REITs from this source. For property, a rising risk-free bond yield typically increases the discount rate or cap rate used to value a property, lowering its valuation. For example, other things equal, an increase in the cap rate from 4% to 5% would lower the valuation by 20%! The largest sub-sector within the A-REITs is retail. We remain concerned about this subsector for two key reasons: - The household sector is being squeezed by flat real wages, rising interest and debt burdens, rising energy prices, the depleted savings buffer and falling home prices. Retail sales are up just 2.9% YoY (Figure 9). For specialty stores within the major mall operators, sales are sluggish: Scentre +1.4% YoY, Vicinity +0.4% YoY, GPT +0.9% YoY and Stockland +2.8% YoY, though Mirvac is up 4.5% YoY. - Intensifying online competition, with the launch of Amazon Prime and ebay Plus in Australia. This should ensure that the growth rate of bricks and mortar retailers is below that of total sales. FIG.8: A-REITs have rebounded as bond yields have moved sideways FIG.9: Sluggish Retail Sales a headwind to retail A-REITs 20.0 ASX200 Real Estate PE & PE Rel % AUS Retail Sales & Consumer Confidence % 8.0% 7.0% ASX200 Real Estate 12MF PE (Left) ASX Real Estate PE Rel (Right) 6.0 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan % 5.0% 4.0% 3.0% 2.0% AUS Retail Sales 3M YoY% (Left) 1.0% AUS Consumer Sentiment (Right) 0.0% Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Jan-12 Jan Currency: Downside risks for the AUD continue to build The Australian dollar has begun to move lower, a trend we expect to continue given: - Falling relative interest rates: the Australian-US 2-year yield has fallen to -50 bps, a 17-year low (Figure 10). With the RBA on hold and the Fed continuing to tighten, the 2-year spread should reach a 34- year low of -90 bps later this year. - Deteriorating relative growth: over the past 27 years Australia has outperformed its advanced economy peers by ~1.1% pa. This gap has largely closed, with Australian GDP growth averaging 2.6% YoY over the past year, in-line with the US and the Eurozone. - Deteriorating relative reform: Australia s appetite for pro-market reform has stalled. As an example, the company tax rate of 30%, unchanged since the early 2000s, was at that time as low as any G7 economy. With US and French tax reform, it will soon be the highest. - China slowdown and growth mix shift: China is tackling its shadow banking and corporate debt issues, with 3-month Shibor around the prime lending rate of 4.35% over the past year, M2 Money Supply growth a record low ~8.3% YoY and TSF broad credit growth ~2 ppt slower at 10.5% YoY. In May, Fixed Asset Investment and real retail sales (excluding the SARS epidemic in early-2003) fell to 22- and 24- Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 5

6 year lows respectively. On top of this, the US-China trade war threatens China s export sector. Australian commodity prices are yet to strongly react to these threats. FIG.10: AUS-US interest rate spreads have moved negative for the 1 st time since 2000 FIG.11: Australian commodity prices have moved sideways over the past 18 months AUD vs 2Y and 10Y Bond Spreads AUS-US 2Y Spread (%, Left) AUS-US 10Y Spread (%, Left) AUD/USD (Right) Jan-94 Jan-98 Jan-02 Jan-06 Jan-10 Jan-14 Jan-18 AUD vs Commodity Prices AUD/USD (Left) 0.65 Commodity Prices- RBA Index (Right) 0.60 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan Updating our Tactical-Dynamic Asset Allocation signals In our initiation piece we outlined eight key TAA signals that we use. Updating these signals: - #1: Relative Valuation: equities appear very attractive versus both bonds and cash (Figure 5). While the US bond yield-earnings yield gap has narrowed, it is still below pre-gfc levels. Japan and Europe remain close to extreme lows. - #2: Absolute Valuation: even with higher US yields, bonds remain very expensive. US equities have de-rated to modestly above-average levels, which should improve further with strong earnings growth (Figure 4). Australia is also at above-average valuations, but ex-us international markets appear fairly-value-tocheap. - #3: Slope of the US Yield Curve (the difference between 10-year bond yields and 3-month rates): the US yield curve is a reliable recession indicator. The yield curve has flattened from post-gfc extremes to a below-average ~60 bps, in part due to unusual interbank rate spreads, as well as trade war and Italy concerns (Figure 12). - #4: Liquidity Conditions: while the US faces a slight headwind from Fed tightening, this is a far more cautious and gradual Fed than in prior cycles (Figure 13). Europe, Japan and Australia remain ultra-accommodative. - #5: Credit Spreads (the yield difference between the same maturity corporate and government bonds): spreads have widened slightly but are just above post-gfc lows, a negative for credit but positive for equities (Figure 14). - #6: Business Activity Expectations: business surveys in the US, Europe and Japan have moderated but are still at robust levels (Figure 15). By contrast, confidence in Australia is back at average levels. - #7: Consumer Expectations: consumer confidence in the US and Europe is at 18- and 17-year highs respectively. Australia is back at around average levels (Figure 16). - #8: Unexpected Inflation: US implied inflation at ~2.1% pa is around the current core CPI inflation of 2.2% YoY. Bonds appears vulnerable to a rise in inflationary pressure, presumably from a surge in wage costs. Conclusions: : International equities, especially non-us; underweight Bonds and Credit; and underweight Australia versus International equities. Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 6

7 FIG.12: US Yield Curve: gradually flattening, and now flatter than average FIG.13: Liquidity Conditions: The Fed s slowest tightening cycle US Yield Curve (10Y - 3M) 4.00 US Yield Curve Jan-87 Jan-91 Jan-95 Jan-99 Jan-03 Jan-07 Jan-11 Jan Fed Tightening Cycles Since = Starting Fed Funds level and Zero Month of Tightening Cycle Dec 15- Current Jun-04-Jun-06 Jun-99-May-00 Feb-94-Feb-95 Mar-88-Feb-89 Dec-86-Sep-87 Mar-84-Jul-84 Source: Datastream, RBA, Baillieu Holst FIG.14: Credit Spreads: AUS credit spreads are just above post- GFC lows FIG.15: Business Expectations: off 30-year highs, but still robust Australia Credit Spreads A-Rated 3Y Spread to Swap (Left) 250 BBB-Rated 3Y Spread to Swap (Right) Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan US ISM Mfg & EUR Business Sentiment EUR Business Sentiment z score -2.5 US ISM Mfg Comp z score -3.0 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Jan-14 Jan-17 FIG.16: Consumer Confidence: US at 18-year high; AUS is slightly above-average FIG.17: Unexpected Inflation: US implied inflation of ~2.1% pa is around the current 2.2% YoY core CPI Consumer Confidence: AUS vs US US Expected Inflation AUS WBC-MI Consumer Sentiment (Left) 70.0 US Conf.Bd Consumer Confidence (Right) 60.0 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Jan-12 Jan US 5Y Bond Yield- 5Y IL Bond Yield 0.5 US Core CPI Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 7

8 Investment implications: In our view, the combination of the rally in the local market and the still above-average Australian dollar offers an opportunity for Australian investors to perform a switch, reducing Australian and increasing international equity exposures. Australia is trading at an unusually low 5% PE discount to the US (Figure 18), and in absolute terms just below a 16x forward PE that has proven difficult to sustain in the past (see Figure 4). In terms of earnings momentum, while improving since mid-2016, Australia s earnings expectations have languished behind the US (Figure 19), something we expect to continue given Australia s muddle-through domestic economy. Summary of changes to Balanced Tactical-Dynamic Asset Allocation (including update for benchmark weight changes): Australian Equities -1.5%; International Equities +1.5%, including US +3.5%, Europe -1.7%, Japan -0.1%, Emerging Markets -0.2%. We have also added to our active US exposure MFF +1.5%, trimming active Europe TGG 0.4% and active Asia-EM PIXX -1.1%. We would continue to underweight fixed income exposures, particularly long-term bond yields, and listed property. In our asset allocation models, for international exposure we recommend a combination of ETFs and LICs, including: - Europe: Vanguard FTSE Europe Shares (VEQ) and Templeton Global Growth (TGG); - Emerging Markets: Vanguard FTSE Emerging Markets Shares (VGE) and Platinum International Fund (PIXX); - Japan: ishares MSCI Japan (IJP) and PIXX; and - US: Vanguard US Total Market Shares (VTS) and MFF Capital investments (MFF). FIG.18: Australia is at a relatively low 5% discount to the US market FIG.19: Australian earnings expectations continue to languish against the US given a muddle-through economy and no tax cut 20.0% 10.0% 0.0% AUS-US PE Rel S&P500 12MF EPS (Left) MSCI AUS 12MF EPS (Right) 12MF EPS US & AUS % % -30.0% % 20 0 Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 8

9 Tactical-Dynamic Asset Allocation: detailed recommendations FIG.20: Tactical-Dynamic Asset Allocation recommendations Extreme Asset Class Underweight Underweight Australian Equities Large Cap Small-Mid Cap International Equities United States Europe Japan Emerging Markets Property & Infrastructure AUS Property & Infrast. Fixed Income Australian Fixed Income Australian Credit & Hybrids Cash Cash Currency AUD Slight Underweight Benchmark Slight Extreme Source: Baillieu Holst. Note: colour scheme illustrates BH s TAA views on the different asset classes and sub-sectors within the asset classes, with orange boxes showing prior positioning. FIG.21: Tactical-Dynamic Asset Allocation detailed recommendations by investor type Asset Class ASX/mFund Code Conservative Moderate Balanced Growth High Growth Australian Equities 6.0% 10.0% 18.0% 27.5% 27.5% Aus Direct Equities - 6.0% 10.0% 18.0% 27.5% 27.5% International Equities 18.0% 29.5% 41.5% 52.5% 72.5% US Equities VTS* 6.0% 9.3% 12.7% 15.5% 20.7% European Equities VEQ 3.1% 5.1% 7.5% 9.4% 12.8% Japanese Equities IJP* 1.5% 2.7% 3.9% 5.0% 6.9% Emerging Market Equities VGE 2.0% 3.4% 4.9% 6.4% 8.8% Active Exposure US MFF 2.4% 4.1% 5.7% 7.3% 10.5% Active Exposure Europe TGG 1.6% 2.7% 3.8% 4.9% 7.0% Active Exposure Asia PIXX 1.4% 2.3% 3.2% 4.1% 5.9% Property & Infrastructure 0.0% 3.0% 4.5% 5.5% 0.0% Aus Direct Property & Infrast- 0% 3% 4.5% 5.5% 0% Fixed Income 19.0% 25.0% 22.0% 10.0% 0.0% Australian Fixed Income IAF 5.5% 7% 6% 2% 0% Active Domestic Diversified PMF04 5.5% 7% 6% 2% 0% Australian Hybrids - 8% 11% 10% 6% 0% Cash 57.0% 32.5% 14.0% 4.5% 0.0% Cash 57% 32.5% 14% 4.5% 0% Source: Baillieu Holst. Note: * means cross-listed. Baillieu Holst Ltd ABN Please read the disclaimer at the end of this report. Page 9

10 BAILLIEU HOLST RESEARCH This document has been prepared and issued by: Baillieu Holst Ltd ABN Australian Financial Service Licence No Participant of ASX Group Participant of Chi-X Australia Pty Ltd Participant of NSX Ltd Disclosure of potential interest and disclaimer: The document may contain information on companies, research on macroeconomics, currencies, commodities and portfolio strategy including asset allocation. It is not intended to constitute personal advice to any retail client. There has been no consideration of the investment objectives, financial situation or particular needs of any particular person or entity and the recipient of this information must not rely on the veracity of the information in making any investment decisions. We will only give personal advice to you if you secure the services of one of our advisers and we specify that we are giving you personal advice. 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