Why some institutions are derisking
Summary: After a strong period for shares, the market may be starting to cool down.
Key take-out: Australian Super and Macquarie are lowering their exposure to equities.
Â
With shares now at higher levels, those worried about stock markets have a wonderful opportunity to lower their equity components. This is not a decision everyone has to make, but the opportunity was emphasised to me this week when our largest superannuation fund, Melbourne-based Australian Super, announced it would lower its equity content.
Australian Super is a colossus, with a staggering $140 billion under management. Its strategy has been to invest aggressively in equities – Australian Super has 25 per cent of its money, or $35 billion, invested in Australian stocks and 37 per cent, or $51.8 billion, in international equities.
That total of 62 per cent equity was above the fund's 55 per cent benchmark and, as you can see, the emphasis has been skewed towards international equities, which was a good call. Over the next year, the equity content will be reduced below the benchmark, because Australian Super fears three forces: trade wars, the turn of the property cycle and the US Federal Reserve's interest rate calls – all of which are bearish for stocks.
In particular, the US Federal Reserve has already raised short-term rates by 50 basis points and is tipping another two hikes this year, which is made more likely by the US stock market rise. Australian Super says when the Fed is raising rates, it's time to wind back equities.
Macquarie has adopted the mirror image of that strategy and so, given the Australian Super move, the Macquarie view of the world is worth a more detailed look.
Macquarie says it started reducing risk last month (It moved too early). This month, it is raising more cash by selling equity and taking an overweight position in real assets, like property.
Macquarie believes now is the time to observe developments rather than make large bets on them, because the outlook for markets is asymmetric – i.e. if everything goes well, the upside is small, but should things go poorly, the downside is significant.
Risks are rising, and as a result, markets are increasingly vulnerable to shifts in sentiment and more susceptible to violent reactions. Confidence in the economic outlook does not translate into the same level of confidence for financial markets.
The low volatility environment of 2017, which saw the Volatility Index (VIX) reach all-time lows, does not exist in 2018. Also gone is the period of strong synchronised global growth momentum, which started in early 2016, as well as the backstop provided by ultra-accommodative monetary policy, and the willingness of markets to absorb political and trade ructions with nothing more than a short-term hiccup.
US Volatility index 2017-18
Â
Â
Â
Â
Â
Â
Â
Â
Source: https://www.macrotrends.net/2603/vix-volatility-index-historical-chart
Of course, the current rise in markets shows these trends do not go in a straight line.
Investors have enjoyed a spectacular period of positively correlated asset class returns, where the tailwinds were broadly strong enough to offset headwinds no matter where they emerged. In essence, markets have been in a nine-year cycle in which bad news was good news because it elicited a positive policy response, and good news was even better because it came against a backdrop of low inflation and limited the need to taper stimulus.
However, all cycles must eventually come to an end, and with investors becoming accustomed to a high return and low volatility environment, the pain threshold for a return to a more normalised backdrop is driving a significant degree of uncertainty.
The positive is that markets are not collapsing and have withstood a number of hits so far this year. The negative is that tightening liquidity, trade war and political leadership risks, slowing growth momentum and rising emerging market vulnerabilities due to a rising US dollar and higher US dollar funding costs are unlikely to moderate in the foreseeable future.
Macquarie says fortune favours the sensible, and preservation of capital has taken a step up in importance versus the return on capital, because central banks are no longer underwriting the asset price cycle.
While global financial conditions generally remain ‘easy,' there is a substantial drain on liquidity via the combined impacts of quantitative tightening, higher oil prices, substantial US treasury issuance, rising policy rates and pockets within credit markets in which spreads have risen dramatically.
Traditionally, Australia has been a relative safe-haven into global equity market weakness. However, if falling risk aversion comes at the same time house prices are weakening, then it loses some of its relative appeal.
Nearly 50 per cent of Australian returns since 2012 have been generated by rising valuations as a result of falling bond yields. If bond rates rise, part of the gain created by the previous fall is in danger of being lost. With rates likely to rise, Macquarie sees little upside from this point, despite recent market rises. This week, the market began to come around to the Macquarie point of view.Â
So, there you have it. Our largest fund and one of our more successful investment banks are calling the bear card. Note they are not quitting everything and running, but merely adjusting their portfolios to a lower equity exposure.
The importance of stock selection
Now, let me take you on a different path. Above, we are looking at overall market trends, but I was alerted this week by the chairman of the Pact Group, Raphael Geminder.
Over a long period, Geminder has been a good judge of markets and he believes rates will remain relatively low for some time – one day they will rise but they are not likely to rise sharply in the short term.
In that situation, he believes there are considerable gains for companies via strategic acquisitions, where they can add on a company and substantially reduce costs and increase market share. This particularly applies to middle ranking and smaller companies, and of course, such strategies are what Pact Group is all about.
The Geminder view is another way of saying that index investing might not be as profitable as careful stock selection. The companies that will do well are those with growth prospects and/or those that can engineer and manage profitable takeovers, plus those of course which are taken over.Â
For Geminder to be right, there must be a reasonable market. It was interesting that Australian Super – even though it is looking to reduce the amount of equity in its portfolio – was not in any way anxious to sell its Healthscope stock. It believes the second takeover bid was not high enough, because this company has a long-term growth future, so Australian Super wanted to retain the stake.Â
Stock selection is going to be important in the possible future market conditions outlined by Australian Super and Macquarie.Â