Chad Padowitz

As US market volatility, as measured by the VIX index*, touches lows not seen since early 2007, an extraordinary calm has fallen over US markets, says Chad Padowitz, Chief Investment Officer at global equities manager Wingate Asset Management.

“The big unsettling dynamic in US markets is volatility. Since late 2011, as markets moved higher, volatility has trended lower.

“The market’s extraordinary calm is illustrated by the S&P 500’s daily return, which has not exceeded +/- 1% for 51 consecutive trading days up to 30 June 2014, a period of some two and a half months.

“This is the longest period of calm since 1995. Though low volatility is not by itself a requirement for future market weakness, we believe it is a good barometer of elevated market risk.

“Only time will tell when world markets will see an upswing in volatility, but there is plenty in the mix to suggest its near-term possibility.

“One source may be disappointing US corporate earnings later this year. Consensus expectations anticipate earnings per share to increase approximately 14% for both 2014 and 2015. Given the long-term trend is around 6%, we see this as an unlikely outcome, especially with the backdrop of a rising rates environment,” Mr Padowitz says.

Whether they are assessing market volatility, or assessing regions and sectors, it is important for investors to think differently and look through the immediate data, and take a smoother, less risky approach to international investing, Mr Padowitz says

By way of example, he cites the recent renaissance in the US energy industry, which has been driven by growth in shale oil and other unconventional sources, as an area where many investors are not undertaking a critical “look through” of the available data.

The dramatic upswing in US shale oil production is having a significant impact on the global energy market, he says.

“As well as the related domestic economic benefits, advantages include geographic wealth diversity, reduced foreign policy risk and increased local manufacturing competitiveness. If not for this supply change, our view is that oil prices would have risen significantly, as conventional production has declined over this period.

“Despite the good news on production growth, we believe the immediate investment opportunity is less compelling.

“In this instance, it is critical to understand that the characteristics of the shale oil wells used in production mean capital requirements to achieve growth are significantly higher than for conventional production”.

Mr Padowitz explains that the average decline rate of a US shale well ranges between 35 to 60 percent a year, therefore, within four to five years, most wells become almost obsolete.

“Faced with such high decline rates, it’s a challenge to continue increasing production and producers are consistently drilling more and more wells to maintain and grow supply.

“A secondary feature, and a compounding one from an investment perspective, is that the bulk of new shale oil growth is coming from smaller companies. By their nature, these have less diversified sources of cash flow and inferior access to capital. So it’s no surprise that debt levels are more elevated in this industry.”

He says this creates an unsettling investment dynamic.

“Because every spare dollar of cash flow has been thrown at capex, overall production has rapidly grown. But the industry, we believe, will ultimately approach a tipping point, where production growth must slow as the declining existing inventory starts to exceed the growth rate of new wells.

“Call it an ‘emperor has no clothes’ moment, but it’s difficult to see earnings doing anything but declining, particularly with relatively leveraged balance sheets.”

Despite this, analyst ratings do not on the whole reflect this inevitable long term decline, he says.

“The take out for investors is this: be it prolonged levels of low market volatility or increasing capital intensity in the US shale oil industry, risk never takes a permanent holiday. This is why investors need to take a smoother, value-orientated approach to their international investment portfolios,” Mr Padowitz concludes.

*The VIX index is the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.

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Chad Padowitz

Boutique international equities manager Wingate Asset Management has appointed Lyndsey Hancock in the newly created role of chief operating officer, as the company focuses on the next phase of its development.

Ms Hancock has over 20 years’ experience in the financial services industry and was COO and later CEO of boutique investment manager, 452 Capital, between 2005 and 2010. Prior to this she was business manager, research and alliances at Challenger Financial Services. She has also held senior positions at Colonial First State Investments and JP Morgan Investment Management in Australia and Singapore.

Wingate CIO, Mr Chad Padowitz, said Ms Hancock’s skills and experience make her an excellent fit with the business as it enters a new phase of development.

“This appointment is about preparing for our next phase of growth and ensuring our clients receive the best possible level of service. Lyndsey’s experience is broad, and includes business management and administration, client relationship management and reporting, sales and investment support services and compliance and risk management.

“Lyndsey has a proven track record in engaging with retail and institutional distribution teams and senior decision makers, and brings a strong skill set to Wingate Asset Management,” Mr Padowitz said.

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Chad Padowitz

Australian Unity Investments’ equities fund manager partners agree that while the overall outlook for markets – both domestically and internationally – looks positive, investors need to be selective.

Chad Padowitz, chief investment officer at global equities manager Wingate Asset Management, said 2014 will be a more challenging year than 2013 for investors, although there are still good opportunities around.

“There was a bit of investor complacency in 2013, as the lack of alternative investment options and low volatility enticed investors back into the equities market. Yields have been attractive and valuations have largely been an afterthought.

“This year, investors will need to pay more attention to valuations in order to pick the best opportunities.

“There will also be significant differences in how various economies perform in 2014. For instance, the US is looking very strong, with an improving labour market, oil/shale revolution, manufacturing renaissance and strengthening housing markets. However Europe is treading water, and China is making the difficult transition from investment to consumption, and may experience a credit crisis.”

Mr Padowitz said in addition to the energy sector and selected cashed up corporates, some of the best opportunities for international equities are likely to lie in healthcare, where investors can benefit from improving efficiencies.

Mr Padowitz added that the introduction of “Obamacare” in the US will create both winners and losers for investors.

“Companies with scale and low costs – such as large insurance companies and service providers – will benefit from Obamacare, while those with high profit margins and minimal product differentiation will find the new environment much more challenging. This includes hospitals and medical professionals.

Donald Williams, chief investment officer at Australian equities manager Platypus Asset Management, agreed with the opportunities in healthcare and said there are also a number of positive signs for the domestic market.

“We are now seeing the lagged impact of low domestic interest rates, which are starting to have the effect the RBA was looking for, and the declining Australian dollar is generally positive for earnings.

“Consumers are more optimistic; the property market is improving, resulting in a wider wealth effect among Australians; and the IPO market is back which is often a precursor to M&A activity.

“All these indicators lead us to be reasonably bullish for Australian equities, though the February reporting season could be tough, reflecting the ongoing weakness in the economy last year.” Mr Williams said.

In the Australian healthcare sector, Mr Williams said that there are a number of positives for companies such as Resmed, Ramsay Healthcare, Healthscope and CSL.

“The falling Australian dollar combined with the defensive earnings profile of companies such as Ramsay, Virtus, Resmed and CSL suggest a good outlook for such companies.

“We also anticipate a number of healthcare IPOs in 2014 which will create good opportunities for investors.”

Mr Williams added investors will need to pick and choose where to put their money very carefully.

Chris Smith, head of healthcare and retirement property at Australian Unity Investments, said like the rest of the world, growth in healthcare property and services in Australia is pretty much guaranteed because of the aging population.

“Our aging population and greater longevity, combined with generally increasing prosperity, will lead to greater demand for healthcare, both facilities and services.

“Both the government and the private sector will need to step in to meet this demand over the next few decades,” Mr Smith said.

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Today’s pre-retirees faces a different landscape.

With the investment world getting more and more complex, ‘vanilla’ solutions are unlikely to help investors achieve their aims – particularly those approaching retirement, says Chad Padowitz, chief investment officer at Wingate Asset Management.

“Today’s pre-retirees are faced with a reality that is quite different to any operating environment in the last two or three decades.

“For example, following a 30 year bull market in fixed income, coupled with the zero interest rate policies adopted by major central banks, the risk versus return dynamic on bonds is now decidedly negative.

“Therefore investment strategies trying to include the three aims of low risk, maintaining living standards, and dealing with longevity, are blending incompatible aims.

“The reality is that in retirement risk must be maintained or even increased. This may sound concerning for many retirees, however the risk of an underfunded pension should be more alarming.

Mr Padowitz said equity markets are amongst the most suitable asset class to achieve these objectives.

“Against the backdrop of lower interest rates, equities remain one of the few asset classes that can generally provide the returns required.”

He pointed to several reasons for this:

· Capitalism works – return on equity is a long term proven model
· Dividend yields now often exceed long bond rates – an historically rare occurrence i.e. selling equities to buy bonds actuallyreduces expected cash returns
· Quantitative easing and low interest rates support equity prices, albeit this support is declining
· Corporate share buybacks and dividends support returns in the absence of earnings growth
· Cash and fixed income rates are supressed by deleveraging and central banks
· Many other asset classes suffer from liquidity issues, making them incompatible with a decumulation phase.

“However given equity markets’ inherent volatility, sources of return that are not based purely on capital growth – such as option premiums and dividends – should be considered.

“Such strategies can reduce the volatility of returns and thus reduce sequencing risk.

“For investors that are close to retirement, the trade-off between reducing risk and generating returns needs to be carefully managed; nonetheless, in the current environment of low interest rates, this equation has moved decidedly in favour of taking more equity risk.

“In a low growth environment and a fairly valued market, relying purely on capital growth to achieve returns may be somewhat optimistic over the medium term, so adding additional sources of return like dividends and option premium are appropriate considerations.

“For example, the equity market allows investors to collect option premiums, similar to an insurance premium, for agreeing to buy shares. These premiums can serve as very useful sources of return.

“Like any insurance policy, option premiums are determined by risk of loss and the volatility of that risk. For this reason the relatively high volatility of equity markets is well suited to generating outsized option premiums.

“However, this strategy is only suitable if the major risks are removed, principally removing all leverage, but also by applying certain mitigants such as only selling put options on shares you want to own at a price you want to own them.

“Investors therefore need to keep in mind that in a world that is not “vanilla”, the solutions can’t be either,” Mr Padowitz said.

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Risk in global markets continues.

Considerable risks still remain in international markets, and investors shouldn’t assume that the recent strong performance will continue, warns Chad Padowitz, chief investment officer at Wingate Asset Management.

“At Wingate, we are surprised that the market isn’t pricing the very high level of economic and financial risk around the world into equities valuations,” Mr Padowitz said.

“While there are undoubtedly opportunities, many investors seem to be assuming that global equity markets will repeatedly produce the kinds of returns they did in the last financial year, which at Wingate we believe is unlikely.

“In reality, there are four unprecedented fiscal and monetary experiments happening around the world at the moment, of which the consequences are still unknown, and Wingate is focussed on responding to these.”

Mr Padowitz said Wingate sees the activities in the US, Europe, China and Japan as experiments aimed at restoring growth and financial stability but with uncertain outcomes.

“There is no precedent to what is happening in these financial markets and their economies, and each has come up with an approach that can really only be described as an untested experiment.

“The US is applying a transparent form of extreme monetary accommodation alongside increasing fiscal restraint, while Europe is desperately trying to keep monetary unity amongst countries with differing fiscal and competitive positions. This is forcing ‘on-the-fly’ solutions to each unique crisis with no well-defined broad approach other than ‘whatever it takes’.

“Meanwhile, in Japan we are seeing a frantic attempt to conjure up long-lost growth through its ‘three arrow’ initiative – essentially, spend more, print more, and add flexibility to the economy, and China, while regarded as the growth engine of the world, appears to be doing anything but grow. Turning around a $5 trillion machine, weighted in favour of investment spending over consumer spending, is a difficult proposition.

“Each of these activities are basically massive quantitative easing experiments taking place in nearly every major financial market, with policy makers themselves acknowledging that they are uncertain about their efficacy and whether there will be unintended consequences.

“On top of this, these experiments are occurring concurrently in a world where equity market correlations have increased from 50 percent to 70 percent over the last 10 years. Only one experiment needs to fail for the impact to be felt globally.

“Neither we nor the policy makers know what the benchmarks are for success or failure of each of these,” Mr Padowitz said.

He said in light of this, it is surprising that the market is pricing in double digit earnings growth rates for the US and Western Europe, and even stronger growth in Japan.

“Personally, I am uncomfortable with many of the assumptions underpinning these growth forecasts, and my view is that the risks surrounding quantitative easing and corporate earnings growth are being mispriced.

“There are opportunities available but investors have to be very selective and really do their homework.”

“The Wingate approach is to be prepared for valuations to come down, while remaining selectively invested in companies that possess legitimate competitive advantages.

“Even if we are wrong, there is still little scope for valuations to increase, and we are comfortable leaving something on the table for the ‘fear of missing out’ crowd,” Mr Padowitz said.

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Louise McIlwraith – Executive Director – Wingate Asset Management

Boutique international equities manager Wingate Asset Management has appointed Louise McIlwraith as executive director.
 
In the newly created position, Ms McIlwraith will have overall responsibility for general business management at Wingate, including business development and client and investor relations, playing a key role in promoting Wingate and building strong relationships with a range of stakeholders. In these areas, she will work closely with Wingate’s joint venture partner, Australian Unity Investments.
 
Ms McIlwraith has over 20 years’ experience in the financial services industry, most recently with Perpetual where she was general manager – sales performance and operations.  She has also worked at BGI (now known as Blackrock) and Prudential in senior client relationship and business development roles, with a particular focus on training and education.
 
Ms McIlwraith has a diploma in financial markets from the Securities Institute of Australia and a diploma of teaching from the Victoria University.  She is a member of the Financial Planning Association and an affiliate of the Securities Institute of Australia.

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Australian equities manager Platypus Asset Management; international equities manager Wingate Asset Management; and fixed interest manager Altius Asset Management all agree that the economic, investment and financial world has continued to change over the past seven years and many rules that previously held true will need to be reassessed if investors are to see positive returns this year.

Mr Donald Williams, chief investment officer at Platypus, said that since the global financial crisis there has been a number of further shocks, including the current European debt crisis but he believes things are now beginning to look better for equity investors.

“The second half of 2011 was a very difficult time for equity investors. However, 2012 has already shown more positive signs.

“The data from the US is upbeat and we are about as certain as we can be that there will be no ‘double-dip’ recession.

“China’s inflation appears under control and while the problems in Europe remain serious, it seems governments there are at last treating the issues with the urgency they need.

“At home, we think the Australian dollar (AUD) will remain uncomfortably high this year, and in the short term it could make new highs against the US dollar (USD), as it has already done against the Euro.

“This will continue to affect a number of industries directly and make USD/Euro revenue earners less attractive. The only positive to come from this is that the Reserve Bank of Australia (RBA) is likely to be more aggressive on rates to keep a lid on the AUD. Most of last year they were cheering on the AUD strength – now it is a policy problem.

“However, the RBA has done the right thing by cutting interest rates at the end of last year, and overall we believe the Australian economy is in a solid position.

“Our view is that the Australian market will stay relatively subdued for the next six months while overseas issues play out and Australian investors achieve a level of comfort with what is happening there.

“After that, and assuming there are no more major shocks to the system, we believe the market could end the year having overcome the 5000 point milestone,” Mr Williams said.

Mr Chad Padowitz, chief investment officer at Wingate, agrees investors now need to take a new look at investment options and approaches they may previously have disregarded.

“It can be easy for Australian investors to dismiss international equities as too risky, too exposed to the downturn in the US and Europe, and look to the past 10 years’ subdued performance as justification.

“Certainly there are some serious adverse overseas considerations that must be taken into account. Global deleveraging is continuing – as it should, with debt having been built up for over 50 years in most developed countries that now needs to be repaid.

“Additionally, the risks from Europe have the potential to create a ripple effect around the world, in the same way the Lehman collapse did. Another failure by a major organisation such as a bank, or a major shift to the hard left – or for that matter extreme right – in politics could create global problems.

“But at the same time, many top tier global companies have good earnings and strong balance sheets, despite the difficult economic environment. Therefore they should be very attractive to investors, particularly because of the yield being offered on current prices.

“On top of this, many companies are buying back their own shares as opposed to over-investing in potential future growth, which by itself will create better returns for investors in those companies. Home improvement retailer Lowes is a good example of this,” Mr Padowitz said.

Mr Chris Dickman, senior portfolio manager at Altius, said bond markets are also an example of how many of the traditional axioms of investment markets no longer hold true.

“The exceptional level of interest in Australian bond markets by international investors and central banks surprised many investors in 2011, who did not expect our market to perform as well as it did.

“We believe this interest from off-shore investors will continue in 2012. The Fed has announced it will be keeping US rates at very low levels for the next couple of years. In this light, Australia continues to offer high yields compared to other developed economies, which will act as a magnet for ‘carry trades’.

“This is in addition to the benefits of being seen as a safe haven, having a relatively strong economy, one of a diminishing number of AAA-rated, and a hedge against the risk of a Chinese slow-down,” Mr Dickman said.

Altius also believes 2012 will see some positive activity in bond market issues added Mr Dickman. “Globally there is something of a log jam of issuers who have been waiting for the ‘right’ time to issue but at some point during the year they will simply have to push the button.

“The success of the Commonwealth Bank’s covered bond issuance, followed quickly by Westpac’s, demonstrates the appetite among investors for different types of funding. We think it is likely that corporates, who would usually have used bank loans for financing, will instead consider corporate bonds. This brings corporate bonds to the fore,” Mr Dickman said.

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