MB Fund January Performance

Given the events of the last week, it feels like performance for January is largely irrelevant.

The headline is that the US market is down 10%+ from its peak a few short weeks ago, punctuated by two ~4% down days.

But, the headline doesn’t mention the rapid rise in January, or that for Australian investors the Australian dollar shock absorber has been hard at work – from the start of the year the MSCI World in Australian dollars is only down 2%. Our portfolios didn’t chase the market higher in January, and then didn’t fall as sharply in February – largely due to the quality and value tilts.

The foremost question is what to do from here. We are sitting on a considerable cash balance in all of our Tactical portfolios – our Tactical Growth fund targets a 10% exposure to cash and bonds, our weight is currently 34%.  Its much higher in the more conservative funds.

So we have a lot sitting on the sidelines, waiting for the right moment.

Has that moment arrived?

Fundamentals

On the supportive side are earnings are looking strong for next year – especially in the US:

Earnings Revisions: World

Source: Factset, Nucleus Wealth

Earnings Revisions: US

Source: Factset, Nucleus Wealth

Earnings Revisions: Eurozone

Source: Factset, Nucleus Wealth

Earnings Revisions: Europe x EZ

Source: Factset, Nucleus Wealth

Earnings Revisions: Japan

Source: Factset, Nucleus Wealth

We also have low inflation, government stimulus in the US, plenty of central bank stimulus globally and, quite frankly, little in the way of alternative investments.

The big fear is that wage growth might finally reverse its decline.

Wage Growth

Then, the increased wages will eat into company profits:

Global profit margins

Source: Factset, Nucleus Wealth

But, in its initial stages, wage growth is going to flow through to increased demand, offsetting any fall in margins.

Further, we believe there are still structural issues in wage growth which mean that wages growth will remain low including:

  • labour market globalistion allowing for outsourcing to cheaper emerging markets;
  • automation;
  • the decline of trade unions;
  • excess supply born of excess savings in emerging markets (mainly China), and
  • increasing wealth inequality leading to demand deficit

So, improving fundamentals are supportive of higher prices for stocks.

Valuations

Not as supportive of higher prices are valuations.

Global Forward PE

Source: Factset, Nucleus Wealth

Shiller PE

Source: Factset, Nucleus Wealth

Some argue that the 10 year chart above is misleading as it takes in the depressed earnings from the financial crisis. A seven year chart looks marginally better, still very expensive:

CAPE 7 P/E Ratio

Source: Factset, Nucleus Wealth

There are lots of other ways to cut valuations, some look better than others but none suggest the market is cheap.

When you dig into different sectors and markets, while there are some segments that are cheaper than others, there are no standout regions that are universally cheap.

Price/Earnings by Region and Sector

Price/Earnings by Sector

Source: Factset, Nucleus Wealth

Investment Outlook

So, fundamentals look good, valuations don’t.

Which, despite all of the ups and downs of the last week is exactly where we have been for the past year.

There are two ways to “cure” high valuations: higher profits or lower stock prices.

Our tactical asset allocation continues to be based on getting as much exposure as we dare to over-valued equities that continue to get even more over-valued while maintaining protection in case it all unravels.

Undoubtedly over the next 6-12 months, we will either regret (a) not owning enough stocks if the stock market careens higher or (b) owning too many stocks if the day of reckoning arrives earlier than we expect.  For now, we are of the belief that our portfolios have the right mix to minimise both regrets.

To be clear, we don’t think that we have reached the end of the current investment cycle, especially so as the long-awaited Trump tax cuts are on the verge of triggering a late-cycle US boom.

January Performance

January Performance

Source: Linear, Nucleus Wealth

The returns above include fees and trading costs on a $500,000 portfolio. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. The benchmark returns do not include fees.

Global Synchronised Growth?

The crucial question (as usual) will come down to China.

Chinese growth from 1990 to 2005 was driven by increasing trade, increasing urbanization, improving demographics and prioritization of capital expenditure over consumers. All of that is changing (see our primer for more details).

Since the financial crisis, China has relied on the same drivers of growth, but rather than being a consequence of economic need it has been driven by increases in debt. So, synchronized global growth is a huge opportunity for China to rebalance its economy.

The question is will China use the strength in the US and Europe to rebalance its economy?

If No

If the answer is no, then we are probably headed for an epic boom/bust. Europe emerging from the depths, US turbocharged from tax cuts, Japan showing signs of life, if China keeps it foot to the debt accelerator then it could all add up to boom-time economic performance. Until the debt runs out. And the sugar hit from US tax cuts wears off. And European/Japanese structural problems re-emerge.

This is not our base case, but it is entirely possible. If this is the case then resources stocks are the place to be invested, the Australian dollar will stay high and the lucky country will stay lucky.

In summary the high will be higher for Australia, the crash will be more severe – but the crash will be a fair way off.

Our portfolios are probably going to increase in this scenario, but not as fast as the market.

If Yes

This makes the most sense for China – use the economic strength in Europe and the US to rebalance the Chinese economy. This is our base case. We expect that China will make a gradual transition to more consumption and less capital expenditure, and our portfolios are positioned for this outcome.

The danger is that the Chinese economy slows too quickly – which would see share prices fall – basically a re-run of 2014/2015.  While our current portfolios have some protection from this event, under this scenario we would be reducing our shareholdings further.

I note that this is the most uncertain of the assumptions that are driving asset allocation at the moment. It is our key focus currently – particularly as winter shutdowns are distorting statistics.

 The Way Forward

As a reminder, we look at the key themes facing our portfolios as being:

  1. China: Rebalancing is occurring, the question is how fast Chinese authorities allow it to occur.
  2. Trump: Taxes are through as we expected. Our expectation for the USD to increase on the back of this has so far proved wrong.
  3. Europe: Grinding recovery. We are not expecting great things, but note that the number of political risks has reduced in recent months. The major long-term issue is still the significant imbalances between Germany and most of the rest of the Eurozone.. The next flashpoint is the March Italian election but that is not bothering markets for now.

US

Our core position is that Trump is trying to engineer a boom. It will not be sustainable and will likely be followed by a bust that leaves the US economy in a worse position but that is a future problem – positioning the portfolio for the boom is the current issue.

The proposed tax cuts are badly targeted by giving most of the benefit to the rich and to companies, trickle down is unlikely to work, the tax cuts are unsustainable, and they are only a short-term “sugar hit” for the US economy.  But it is going to be such a huge stimulus that you don’t want to stand in the way of it as an investor.

So, we want to play the boom, keeping a sharp eye on the bust.  Our portfolio positioning on this basis remains:

  1. overweight international stocks from an asset allocation perspective
  2. overweight stocks with US exposures – subject to valuation. The practical implementation of this has been buying non-US stocks that are exposed to the US.

China

In China data continues to be muddied by winter/pollution shutdowns. Our view is:

  • the shift to consumption-led growth rather than investment-led growth will require a greater shift than many recognize. This shift will be a significant negative for commodities/the Australian dollar
  • current growth rates are unsustainably high, inflated by rapidly increasing Chinese debt. The increase in debt has been required in order to hit the growth targets, so removing the growth targets will help refocus local party officials to more sustainable policies
  • activity still seems to be slowing, although the next few months are going to be more difficult to get an accurate read on economic activity as the Communist Party Conference in Beijing has led to the shutting down of a considerable amount of industrial manufacturing, in particular, steel production. We would expect that some of the strength in commodity prices in July/August reflected the bringing forward of production in front of the shut down. Then, the weakness in September represents the shutdown. Finally, there is likely to be a bounce in Q1 2018 due to “catch-up” production. So, the true trajectory is going to be difficult to ascertain accurately until we are through this period.
  • the Chinese housing market appears headed into a soft landing thanks to macroprudential tightening so a possible path ahead for rebalancing is a muted not busting housing cycle that supports consumption while weighing on investment;
  • we are probably 6-12 months away from being able to see whether the removal of growth targets makes a big difference or not – they have the potential to foreshadow a seismic shift to a more sustainable growth model. I suspect the outcome will be that with the Communist Party Conference done now the impetus will switch to slowing the economy as much as possible, but with any sign of unrest the debt taps will be turned back on.

Our expectation is that China is going to continue to “glide” lower to try to normalize the capital expenditure to consumption in-balance that we discussed in our recent webinar.

China Capex to GDP

It is our view that the Chinese economy will continue to slow over the coming years – Japanese style lost decades, and low inflation/deflation remain more likely than a dramatic bust, which means a grind lower for commodities and the Australian dollar.

Our portfolio positioning on this basis remains:

  1. considerably underweight Australian stocks from an asset allocation perspective
  2. underweight resource stocks within equity portfolios

Tactical Asset Allocation Portfolio Positioning

In our tactical portfolios, we own cash, bonds, international shares and Australian shares. We tend to blend these portfolios for clients so that each investor receives an exposure tailored to their own risk and income requirements.

The broad sweep of our asset allocation over the last 12 months was to ride the Trump Boom, switch into Europe in March / April as the US became overvalued and then switch back into the US as the Euro rallied and the USD fell. Most recently we reduced our international holdings after an almost 15% rise in 4 months and the Australian dollar falling to $0.75.

Over the month our bond holdings detracted from performance, as investors priced in synchronised global growth. However, they came to the rescue in the past week as the stock market fell.

We remain underweight shares in aggregate, overweight international equities and significantly underweight Australian.

Over / Underweight positions by portfolio

Asset Allocation

Source: Nucleus Wealth

Tactical Foundation Portfolio

Our tactical foundation portfolio is designed for investors with lower balances, it uses exchange-traded funds for its international exposure rather than direct shares. The reason for this is parcel sizes,  you can’t buy half a Google (Alphabet) share directly and so we use exchange-traded funds which buy baskets of stocks instead. The tactical portfolio is a balanced fund, not as aggressive in its holdings as the growth fund nor as conservative as our income fund.

In January this fund increased by 0.7%.  The fund continues to be underweight Australian stocks.

Equities

Our international holdings underperformed in January, and so far have outperformed in February. Basically, with the USD falling, the oil price rising and the lower quality stocks leading the market higher our portfolio did not rise as fast as the market in January. Conversely, as all of these themes reversed in the first 10 days of February, our portfolios outperformed.

Our biggest call is underweight energy. In particular oil producers. We have blogged a lot about the oil price,  the thumbnail sketch of the sector is that:

  • the short term is not positive for the sector with oversupply and OPEC needing to cut production to try to prop up the oil price.
  • the long term is not positive with increasing electrification of cars and falling battery prices limiting the upside
  • the mid-term might be good if an undersupply emerges and before electric cars put a dent in oil demand and assuming US shale costs don’t keep falling

Meanwhile, oil stocks are pricing $60-$70 oil prices in perpetuity. The mid-term is going to have to be spectacular to justify current share prices, let alone getting any share price growth.

Having said that, it is a big risk to our portfolio being underweight energy. If there are geo-political ructions, particularly in the Middle East, we would probably underperform. October saw the oil price rise once more, largely on the back of hurricane-related supply constraints, but we remain comfortable with our holding and expect much of this to be a short-term issue.

Our sole holding in the energy sector, Neste Energy is up around 50% over the past few months, which has shielded up a little from the rising oil price.  Neste is a Finnish oil refiner, making a significant investment in green technologies and is well regarded by a number of sustainable rating firms including being in the Global 100 most sustainable companies, the Dow Jones Sustainability index and CDP.

We are underweight financials – mainly as we can’t find US financials that are cheap enough to justify purchasing. We have been trawling the European banks for value. Insurance continues to be a sore spot, there was some bounce back in insurance company share prices in October after a hurricane-affected September, but shareprices have been weak since then. We are looking to continue to build holdings in the sector with the view that after such severe losses in 2017 that insurance premiums will rise significantly.

We have a reasonable tech / IT exposure. There are a number of smaller tech stocks that we own, in particular, a range of semiconductor stocks where we like the growth outlook. It is worth noting that part of the reason for Apple increasing the price of its latest phone is an increase in memory and components. This is a positive for semi-conductor stocks more generally, especially if a “feature war” breaks out in the smartphone space. We current hold a range of stocks that should be helped by this trend (Lam, Applied Materials, Skyworks, and to a lesser extent Cisco).

Performance to date

Portfolio performance can be cut a number of different ways. At its most basic level, you should care about the total return. At the next level, you should care about the total return relative to some sort of benchmark.

As you dig deeper, you should also be interested how the return was achieved – for example, if your fund manager is taking lots of risk but only performing slightly better than the market then you should be concerned. Similarly, if you can get market returns but at a much lower risk then that may be an appropriate trade-off.

Our portfolios to date have been both out-performing benchmarks and taking less risk. The disclaimer is that they have only been running for six months.

For the sake of comparability, we have used the Vanguard MSCI World ETF (ASX:VGS) to compare to our international portfolio – VGS is an index fund investing in the same stocks that we do. Note that the data is up to 12 February.

Risk/Return stats

Source: Factset, Nucleus Wealth

Epilogue

In summary, our view continues to be that Australian investors are better off holding international investments at this point in the cycle.

We retain relatively large cash balances to hedge against volatility and to look for a cheaper entry point. If markets continue to be weak then we will look to buy more equities.

Our intention is that our portfolio is positioned to take advantage of our key themes but minimise risk in the event that our themes take longer than expected to resolve themselves.

We usually find that big picture macro themes take a long time to resolve themselves in financial markets, but when macro theme resolve themselves they do so quickly – usually too quickly to reposition your portfolio if you are not already invested.

Register your interest now (if you haven’t already):

Damien Klassen is Head of Investments at Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

Comments

  1. 300k sitting in the bank, waiting for property prices to dive before buying our first home. Banks paying stuff all intrest and now finding out the deposit guarantee doesn’t mean squat. Wife is in panic mode thinking she will lose her hard earned savings due to a bank collapse. Mentioned this fund she seems pretty keen. What do you recon?

  2. Exact same situation and cash balance. I’m concerned how the fund might hold up considering the drop and volatility in the last weeks which might be the tune throughout this year.

    • Punish the savers! It like they are forcing our hand, prices at the top and now the missus is freaking out about her saving s going to the banks, she for the first time started saying we should buy but out $600k price point you don’t get much, I know it seems crazy.

      • I seriously would not worry about the deposit guarantee. Chances of the banks going insolvent in very low and most likely would be bailed out in any case. Without doing any searching, I think the guarantee is 250k per person per bank so there are ways to spread the risk if your that concerned

      • TailorTrashMEMBER

        that government gaurantee is pretty specific ….( as per the APRA site) and I don’t think even the docile or comatose strayans would let any government not honour it with out ripping the joint apart …..
        …as DPM says spread your $300k over two banks ( that are not subsidiaries of each other ) and keep a sharp pitchfork to join the revolution if the government tries to dishonour it ……..of course they could give notice that they are going to discontinue it , but if that happens suspect a lot of people would want to withdraw their savings as trust in the banks is at a pretty low ebb at the moment ………and expect it to get worse depending on allowed revelations at the RC

      • Mining BoganMEMBER

        I spread it over four banks with no more than $100k in any one just to play it safe.

        Bloody ING is going to make me start using my card five times a month to get the higher interest. Musta learned that from ME Bank. I’m too tight to spend that much…

      • A former principal researcher at bank regulator APRA has revealed in a submission to a Senate inquiry that, contrary to government reassurances, Australian bank deposits are not guaranteed.
        This explosive revelation shreds the government’s repeated assurances that its new bill to give crisis resolution powers to the Australian Prudential Regulation Authority (APRA) will not allow the “bail-in” (confiscation) of bank deposits, because they are guaranteed up to $250,000 by the Financial Claims Scheme (FCS).
        In the cover letter to his submission to the Senate Economics Legislation Committee’s inquiry into the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017, Dr Wilson Sy asks Committee chair Senator Jane Hume: “As a matter of urgency, I need to ask: are you prepared to have your savings in bank deposits confiscated to save insolvent banks? What about the millions of voters you represent? How would they react if you allow this to happen to them?”
        Dr Sy charges that the bill “gives the Government and APRA new discretionary powers to confiscate bank deposits”, and that it should be rejected.
        (Dr Sy’s submission, “Protect Deposits Not the Fraudulent System”, is the first submission posted on the Senate inquiry’s website, and can be accessed here.)
        As a Principal Researcher at APRA in 2004-10, during which time he was briefly acting Head of Research for a time, Dr Sy is one of the most qualified people to comment on APRA and the powers it will be given by this bill. Both the 2008 global financial crisis and introduction of the Financial Claims Scheme occurred while he was at APRA.
        FCS guarantee not activated
        The essential point that Dr Sy makes is that the FCS is not an absolute guarantee. He quotes the FCS website, which makes clear that the FCS will only take effect if the government activates it when an ADI (Authorised Deposit-taking Institution—a bank, credit union, building society etc.) fails. “That is, when a bank fails, i.e. becomes insolvent, the Australian Government or APRA then has the discretion to decide whether or not to activate the FCS”, he says. “Hence, it should be emphasised that:
        “Bank deposits are not protected or guaranteed at all.”
        Under the Banking Act 1959, Dr Sy explains, APRA is responsible for two potentially conflicting objectives: the protection of depositors AND the promotion of financial stability. This depositor protection is “illusory”, he asserts, because the Banking Act doesn’t state which objective has priority.
        Under the new bill, however, APRA will have the discretionary power to decide which objective has priority; alarmingly, it will be able to make such a decision “in secrecy”. Dr Sy references Subdivision D, Section 11CH (p.24) of the bill, which states that APRA may decide that its orders must be kept secret if it is “necessary to protect the depositors of any ADI OR to promote financial system stability”. (Emphasis added by Sy.) The replacement of “AND” with “OR” confirms that the objectives are in potential conflict. “Therefore”, Dr Sy continued, “it is important to recognise that the Bill allows APRA discretionary powers to decide secretly whether to protect depositors or to promote financial system stability.”
        Quoting a 2012 Reserve Bank of Australia paper, which stated that the priority of regulators, mandated under Commonwealth legislation, is to “pursue financial stability”, Dr Sy concludes:
        “Therefore, the evidence collected here strongly suggests that the Bill is designed to confiscate bank deposits to ‘bail in’ insolvent banks to save the financial system.”
        Can’t be funded
        Dr Sy’s revelation is further, damning evidence that the FCS is not a real guarantee. The Citizens Electoral Council had already exposed in 2014 that, by the regulators’ own admission, the FCS doesn’t have the money to guarantee deposits in any of the Big Four banks, which hold 80 per cent of all deposits! This was first acknowledged in a 19 June 2009 meeting of Australia’s Council of Financial Regulators, comprising APRA, ASIC and the Reserve Bank, which noted in its minutes that a failure of one of the Big Four banks would “exceed the scheme’s resources”. Later, the Financial Stability Board in Basel, Switzerland, which is in charge of imposing a bail-in regime worldwide, noted in its 21 September 2011 “Peer Review of Australia” that the government’s $20 billion provision per bank “would not be sufficient to cover the protected deposits of any of the four major banks”, which each have more than $400 billion in deposits. The CEC presented this evidence in its submission to the Senate committee inquiry.
        Defeat the APRA bill
        Most members of parliament are assuring their constituents that the APRA bill—which virtually none would have read—does not mean deposits will be able to be bailed in, because deposits are guaranteed under the FCS. Dr Sy’s revelation explodes that myth. This is not an academic question. With all signs pointing to a near-term collapse of the so-called “everything bubble” comprising property markets in Australia and elsewhere, the US stock market, Bitcoin, and the US$1.2 quadrillion global derivatives trade, a looming global financial crisis threatens Australia’s banking system. It is urgent, therefore, that Australians demand their MPs reject this bill outright, and go with the Glass-Steagall banking regulation instead, which guarantees deposits and financial stability by separating commercial banks with deposits from all forms of financial speculation. As Dr Sy says in his submission: “The global financial system needs fundamental structural reform which many countries believe is the restoration of the Glass-Steagall legislation which had worked well for many decades until it was corruptly or mistakenly repealed at the turn of this century.”
        What you can do
        Before Christmas, upwards of 800 everyday Australians flooded the Senate committee inquiry with submissions opposing the APRA bill and demanding Glass-Steagall. The Committee is expected to hold hearings in either late January or early February, by which time it is imperative that every MP and Senator is confronted with the truth about this bill.
        1. Forward this release, the CEC’s submission (download here) and Dr Sy’s submission (download here) to your local federal MP and Senators before the end of the month. If possible, print copies and deliver them in person.

      • I’ve posted that twice AI & all I heard was the ringing in my ears both times……?

        If they can’t cover it & they’re forced to make a choice between financial stability & saving our deposits, which will it be? Trusting it in OS banks I’m guessing is also an unknown if it really all blows up too…..?

  3. Diogenes the CynicMEMBER

    That is a good wrap Damien – thank you.
    As for the government guarantee on bank deposits if you are really worried you can always hold some physical gold or buy some Australian government bonds.

  4. is it still a 30k buy in? I’d be in for five and willing to increase over time. I’ve had the reasons explained to me though and understand why it wasn’t like that at launch.

    • Damien KlassenMEMBER

      The custodian is not really a layer of risk, more of a layer of risk mitigation. What happens is that your investments are held by the custodian in your name and we instruct them what to buy and sell, but the custodian limits what we can invest in. The reason for having this structure is that in a lot of the big fraud cases (Astarra, Madoff) investors gave their money directly to the managers and then the managers could do what they wanted with it. The custodian is there for your protection – i.e. we are not allowed to instruct the custodian to deposit the money into anyone else’s bank account or HnH’s cousin’s startup – we can only buy large cap shares, government bonds and cash, and only in your name.

      Some absolute funds are good. Many aren’t. There are three main issues you need to deal with when investing in an absolute fund:
      (1) Downside protection comes at a cost. What typically happens is that investors give up some upside in order to cap the downside, so the average return is lower over the cycle. As an example, the HFRX Absolute Return Index is up only 2% per annum over the last 3 years (2) Many of the strategies are complex, sometimes your manager may not fully understand the risks they are taking. There are plenty of absolute funds heavily invested in CDOs pre 2007 and inverse VIX products before last week (3) partly due to the complex strategies, and partly due to not being able to deploy lots of money into one strategy, management fees are high.

      • What exactly is HnH’s cousins startup? Is it lucrative? Does it involve leveraged p2p lending? I mean I’m keen I just need a bit more information.

      • @Mark – HnH’s cousin here. I’ve come up with a new paradigm that synergises the massive throughput of horizontal scaling with the massive efficiencies of vertical scaling. By leveraging leverage and aspirationally focusing on our core competencies while making effective use of tiger teams, we believe we can buy-in to the next set of best practises and take offline any issues that come as a result of a hard stop. Our solution is a robust, bleeding edge ‘stays in the swim lane’ Web 2.0 game changer.

        In short Mark, its an app. You give us money (lots of it), and we throw it all naked into long vol using massive leverage, all in your name. The app is a slide show of smiley faces. The more money you make, the bigger the smile. There is only 1 known bug and our developer assures us he is working assiduously to remove it. Apparently when our XIV ETNs tanked the smileys were replaced with an eggplant picture. Weird huh? Anyway, invest early, invest often, in the hottest app of 2018.

        $100,000 minimum buy-in.

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