In the past week we have seen very high volatility in financial markets including shares, bonds, currencies and commodities. This has been driven by the convergence of several issues including concerns over the state of the Chinese and other emerging country economies, rapidly falling commodity prices, speculation about the possibility of an interest rate rise in the US in the near term and lingering concerns about Eurozone debt related issues including Greece. On balance reporting season results both internationally and in Australia have been good but investor expectations appear to have got carried away and more companies haven’t met these than have, and this has also contributed to the negativity.
The build-up of these issues reached an inflection point last Friday when worse than expected economic data relating to industrial production was released in both China and the US, which created a catalyst for the large global sell off that continued through to the earlier part of this week. These strong movements clearly reached the status of panic (selling just because others are selling) aided by some hysterical media commentary and aggressive trading strategies such as short selling.
Whilst this appears to have subsided for the moment and there have been some very large rises in some markets we expect that further volatility will be experienced driven by these issues and diverging global policy action. The US Federal Reserve (Fed) is trying to exit supportive policies as, on balance, the US economy continues to perform better and other central banks are in the midst of programs to support weaker conditions. This is likely to drive an uneven flow of capital around the world which will impact currency and investment markets, and potentially economic growth. Given the significant falls in commodity prices the countries that may be most impacted by this are those that rely on income from selling these such as Australia, but particularly emerging countries such as Brazil (iron ore) and Russia (oil). Apart from oil the key drivers of these falling commodity prices has been increased supply and slowing growth in China, and particularly property and infrastructure construction sectors where there have been high levels of exuberance that have accounted for significant portions of commodity consumption in recent years.
Given these risks and issues global monetary conditions look set to remain easy for a long while. Whilst there remains a chance the Fed may raise interest rates by year end, they will still remain very low (likely between 0.25% to 0.5%) and the Fed is likely to signal that any further moves will be gradual, unlike in past tightening cycles. A policy response from Chinese authorities that focuses on the economy more broadly is also possible. This and very low returns in bank deposit and bond investments globally should continue to be supportive of high quality shares where the underlying businesses have strong recurring revenue that are less susceptible to commodity price, and other, volatility. Also, valuations are not stretched they are what we would describe as fair.
How are we positioned?
We have undertaken a review of all investments in our client portfolios in light of these issues. In particular this has involved an assessment of the sustainability of the dividends of each company and the level of debt sitting on their balance sheets. This exercise has re-enforced our comfort with most positions in the portfolio, but also identified a few opportunities for us to reduce exposure to certain investments which may be more susceptible to further volatility.
We have relatively high exposure to ‘defensive’ investments including cash, term deposits and interest rate securities. The latter are ASX listed loans to very high quality Australian companies that pay a floating interest rate and consequently there capital value should be very stable (their perceived worth should not change with movements in interest rates as the amount they pay will change accordingly). We do not have any exposure to fixed interest bonds where the capital value is volatile and current returns unjustifiable.
We have reasonable exposure to high quality international companies via investment funds and ASX listed companies who derive the majority of their earnings from offshore. Whilst the underlying companies are multinationals that are impacted by global economic conditions the majority of their business is done in the US and Europe and we are invested on an unhedged currency basis. This means that any further depreciation in the Australian dollar, driven for example by further falls in commodity prices, should assist with protecting the capital value of these.
Generally speaking we have much more limited exposure to commodity exposed companies such as resources and highly leveraged companies such as banks than the average Australian portfolio. Having said this we may reduce exposure in some of these areas if we feel that further protection should be taken. Capital protection is always our priority.
What is the investment strategy?
We intend to use further market volatility to continue to build and reallocate funds in your portfolio/s to less cyclical businesses. The market may provide us with prices that are attractive relative to what we perceive to be a fair value for the returns and riskiness of underlying earnings and dividend streams. Broadly speaking there will be a focus on investments with the following characteristics:
- Companies that provide exposure to developed foreign economies, with a focus on the US and to a lesser extent Europe, and have relatively reliable revenue streams. Generally these pay a lower dividend than Australian companies but provide diversification away from Australia and access to economic sectors that are not prominent here such as pharmaceuticals and sophisticated manufacturing.
- Companies in Australia that have reliable revenue streams and pay a reliable dividend. Specifically this may include sectors such as healthcare, infrastructure and property trusts with particular types of tenants.
- Increase exposure to loans (debt) to high quality companies where the terms and interest rate paid are attractive versus the risk that is taken.