Lee Mickelburough

Lee Mickelburough, Head of Australian Equities, discusses the lessons learned from 2018 and the themes shaping the team’s 2019 outlook.

What are the key themes likely to shape markets in 2019?

We expect some of the dominant themes of 2018 to persist into 2019. The strong growth we’ve seen in the United States, which has been pushing up interest rates and inflation pressure, will continue.

On the political side, the trade tension between the United States and China, and the resulting slowdown in Chinese growth will also likely persist. In Europe, moderating growth and potential risks arising from the Italian bond market are also significant, adding to a backdrop of potential risk events for 2019.

Where do you see the most important opportunities and risks within your asset class?

In Australia, the main area of focus for us has been on the slowdown in the housing market and the tightening of credit standards. This is particularly important for Australian equities given the dominance of banks in the benchmark and we are very cautious about this sector. Additionally, the Banking sector currently has very low levels of bad debts in the system, which is on the one hand is positive, but from such a low base, means we are likely to see an increase in bad debts in 2019.

Mining, the other dominant sector in the Australian market, is one we are wary of due to the slowdown in China. Interestingly, while this slowdown has been occurring, iron ore prices have been consistently strong, which has been encouraging from a cash flow perspective for businesses like BHP and Rio Tinto, within which we have select investments.

Given the headwinds for the banks and miners, which together make up about half of the Australian equity market, we’re looking outside these sectors for other opportunities. These include Consumer Staples players, like Woolworths. While this company hit a little bit of an air pocket the middle of the year with a slowdown in sales, it is now re-accelerating. In our view, it is a very well-managed business, a dominant player in its market, and the balance sheet is very strong. We also anticipate some capital return at some point in the early New Year, so strong cash flows and capital returns are very positive in the context of a cautious backdrop.

We also like the outdoor advertising sector and have holdings exposed to the sector. Outdoor advertising is coming back into vogue as part of an advertiser’s marketing mix given how it complements other forms of media. This is especially the case with the digitalisation of the sector, which is reducing the production costs associated with printing and installing advertisements, as well as enabling advertising to be more dynamic and varied by geography and time of day.

The outdoor advertising sector has also consolidated from a five player market down to a three player market, so we think returns and growth will be strong.

In a cautious market, we’re looking for interesting bottom-up opportunities and generally if they’ve got some defensive characteristics or they’ve done a reasonable acquisition, we’re interested in taking a closer look. We added Amcor, a packaging company, in the second half of 2018 as it is mainly exposed to the fast-moving consumer goods segment – a relatively defensive opportunity, which also benefits from a strong economy as well. Amcor has good US exposure and also just completed the acquisition of US competitor, Bemis. While Bemis has been very strong on product development and product innovation initiatives, it was not as strong on the manufacturing side, complementing Amcor, which was the opposite case.

Aside from defensive stocks, the Q4 market correction is throwing up a lot of really interesting opportunities from a bottom-up valuation perspective. With the market now trading closer to 14 times earnings, even though the backdrop is cautious, we think a lot of it is priced in and we’re finding really interesting opportunities in the market. Since the Global Financial Crisis we haven’t really seen that type of attractive earnings multiple.

Which chart do you think will be a key indicator for 2019?

I think the best indicator that you can focus on for 2019 is US 10 Year Bonds. It reflects what is going on in the interest rate markets, inflation and growth and also some of the geopolitical tensions that may occur in 2019.

If the bond yield is tracking higher, that would suggest inflationary pressures are building and we should be more cautious, growth will obviously be pretty strong in that environment. If it’s chugging along and we’ve got good moderate growth and moderate inflationary pressures, that is an ideal situation for staying long stocks and if yields start to fall rapidly that is obviously where there has been a hiccup somewhere, growth has deteriorated or there’s been a political issue.

Jay Sivapalan

Jay Sivapalan, Co-Head of Australian Fixed Interest, discusses the key themes, risks and opportunities for Australian fixed interest in 2019:

What are the key themes likely to shape markets in 2019?

As we look forward to 2019, we see further divergence of what the US Federal Reserve (Fed) will be doing relative to other central banks in terms of tightening the various forms of monetary policy that have been employed over the last decade. The Fed will continue to tighten monetary policy toward neutral policy settings over 2019. One key theme we’ll see is the impact from the unwinding of Quantitative Easing (QE) at a time of higher treasury bond supply.

A reassertion of inflation, especially wages inflation, will likely occupy the market’s focus and will dominate the broader commonly assumed disinflationary themes of the past decade, such as demographics, technological change and disruption.

For the US, the markets will grapple with properly pricing in tight monetary policy that is above neutral cash rates. It has been forgotten over the past decade that monetary policy has two sides, easy and tight.

Overall we continue to expect yields to rise further in 2019 and for the yield curve to become flatter as this occurs, but the broader trend is for a higher rates structure. Ultimately this is good for investors, but we do need to manage the journey along the way.

Where do you see the most important opportunities and risks within your asset class?

The key risk that needs to be watched and managed for fixed interest investors is interest rate risk, or more specifically, duration in a rising rate environment. In the case of Australian fixed interest, whilst we think this risk is relatively low given the Reserve Bank of Australia (RBA) is likely to be on hold over 2019 at a cash rate of 1.5%, Australian bond yields can lift in the short term on the back rising US yields. This creates for us both a risk that needs to be managed, but also great opportunities to add duration to capture higher yields that may not ultimately be sustained in markets.

In credit markets on the other hand, participating in the income remains an important source of excess return for investors. But the manner in which we participate is important at this more mature phase of the credit cycle. Whilst we don’t see credit markets as imminently risky, it is worthwhile continuing to be prudent when investing in corporate debt, favouring defensive sectors and being biased towards the higher credit quality spectrum. There have been some pockets of the Australian credit markets that have underperformed this year where we’ve had minimal exposure. One example is Australian AAA rated residential mortgage backed securities for obvious reasons. But at some stage, pricing is likely to get to levels where the breakeven returns are very much in favour of investors. This is an area we’ll be watching with interest over 2019 and looking to exploit.

How have your experiences in 2018 shifted your approach or outlook for 2019?

In many ways, 2018 was a year when we witnessed the shift in market thinking from the past decade where ultra-easy monetary and fiscal policies had supported economies to one where, at least in certain economies like the US, the degree of policy accommodation needed to be reined in. We think this paradigm shift will accelerate through the course of 2019. As such, our portfolio strategies will take this dynamic into account and we think a very flexible approach when dealing with both interest rate and credits risks will be paramount in navigating 2019 and beyond.

Which chart do you think will be a key indicator for 2019?

The one chart to continue to watch in 2019 will be the wages inflation in each economy. It is the ultimate validation of the effectiveness of monetary policy – of course, this comes with long and variable lags.

Markets had incorrectly assumed in the post-GFC era that relationships, like the Philips Curve, are no longer applicable. 2019 should confirm that they are indeed valid relationships, where economies operating above full employment will in due course produce wages inflation, which the central bank will ultimately need to respond to.

Clearly this is very relevant in the US, but even in economies like Australia which of course is lagging the US in terms of the monetary policy cycle, it is important to watch wages as a barometer of the positive offsets of consumption, infrastructure and exports relative to the slowing housing construction story.

Even in Australia, markets could at some stage in 2019 start grappling with some form of tightening monetary policy cycle over the subsequent two to three years (2020 and 2021). These dynamics need to be managed and will likely create opportunities for active managers.

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Lee Mickelburough

What lessons have you learned from 2017?

Markets have grinded higher in 2017: volatility is low and the performance and correlation of high volatility stocks and low volatility stocks has been almost identical. There have been a handful of stocks that have performed strongly to the upside or downside, but the vast majority have traded in a highly correlated fashion.

Regulatory risk in Australia is on the rise: to date, 2017 has seen a notable increase in regulatory risk, with the creation of the Australian Domestic Gas Security Mechanism, further APRA lending restrictions and the Federal Government bank levy.

The Chinese economy has stabilised at a lower overall growth rate of 6.0% to 6.5%: the focus is now on broadening that growth to the services sector.

What are the key themes likely to shape the markets in which you invest in 2018 and how is this likely to impact portfolio positioning?

Interest rates are normalising: we are therefore wary of the interest rate-sensitive sectors of the market. Our view is that the retracement of bond prices has generally been a function of the normalising of a number of macro variables, including stronger US growth and a stronger US dollar.

Market valuations are high and volatility is low: in these conditions, markets are therefore vulnerable to geopolitical risks. The election of Donald Trump as US President has created some political turbulence and this will likely continue. North Korean provocation of the US through the launch of intercontinental missiles and nuclear weapons testing is cause of concern.

Domestically, consumer confidence and business conditions are likely to remain patchy as the economy transitions away from resources and will focus on opportunities that the transition presents. Sales data from REITs has shown weakness in comparable specialty sales as consumers remain constrained or opt for online shopping alternatives. The highly anticipated entry of online retail behemoth, Amazon, into the Australian market will likely give this trend further momentum.

Inflation should continue to normalise as commodity prices stabilise and the slack in the labour market is taken up.

Where do you currently see the risks within your asset class and where are the most compelling opportunities?

One particular area of focus is the battery industry. Many countries including France, UK, Norway, India, the Netherlands, Germany and China have taken significant steps towards moving away from cars with conventional internal combustion engines. We feel this is a secular trend that has the ability to drive structural change and believe there are opportunities in the Australian market.

While the market backdrop for equities is positive, growth remains scarce. We therefore remain focused on companies that are investing to grow their businesses and have a positive demand backdrop, such as Star Entertainment (Casino expansions and inbound tourism), Healthscope (Hospital expansion and ageing population) and Aveo (Retirement home developments and demographics).

By Lee Mickelburough, Head of Australian Equities

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