Is the equities engine slowing?

Australian equities have helped drive another year of positive of superannuation returns but, as Damon Taylor reports, investors should adjust their expectations to the reality of a lower growth environment over the months ahead.

Sitting at the core of most Australian superannuation allocations, domestic equities are the one part of a portfolio of which fund members are constantly aware.

Indeed 12 months ago, any number of industry executives would have breathed a sigh of relief that sentiment was improving and yet for Paul Taylor, portfolio manager for Fidelity’s Australian Equities Fund, market performance has been dampened by more global concerns.

“To be honest, I think we’ve had a bit of everything over this last year,” he said. “Obviously, we’re steadily recovering post the global financial crisis (GFC) and from a global perspective, there’s no doubt we’re heading in the right direction.

“But while we’re growing, it isn’t high growth,” Taylor cautioned. “On the back of central bank policy and money supply, we’re now in a lower growth world and that’s something investors have to get used to.”

In fact for Taylor, the key influence in the last few months had been the Federal Reserve’s monetary policy change from quantitative easing to tapering. 

“After a strong 2013, the last month or so has been weak on the back of that change,” he said. “We hit APRIL and that change to tapering started to cause lower expectations, a bit more nervousness and general unease in the market.

“But that changed again as we went through the reporting season,” Taylor explained. “We saw a pretty solid set of numbers, good cost control, reasonable dividends - and so markets reversed on the back of that.

“So what we continue to see is this interplay between macro and micro - at a micro level, the signs are good but at the macro end, people are worried about exactly what impact tapering will have.”

Offering a similar perspective on local equity markets, Donald Williams, CIO for Platypus Asset Management, said that the market improvement flagged 12 months ago had been far from fully realised.

“But in saying that, the market broke to new levels last year so there’s definitely been an improvement in the way the market has traded,” he said. “We seem to be holding gains and that means that the underlying fundamentals have actually improved.

“So in the core industrial stocks, for instance, earnings for the last three to six months have held up reasonably well,” Williams continued. “There are still potholes, obviously, with mining services and the natural resource sectors not being as attractive as some of the industrial sectors.

“But there’s enough going on in the market that we should see earnings growth accelerate over the next year or two.”

And while investors need to come to terms with the realities of a lower-growth world, Taylor was quick to point out that the Australian market was in a fortunate position.

“Yes, we’re in this lower growth world but there’s still reasonable growth in Australia,” he said. “We’re a growth market but we’re a high yield market as well and that’s the place investors throughout the world have gone.

“In a low growth world, growth and yield are rare commodities and we’ve got both of those,” Taylor continued. “And if you can deliver growth, yield, dividends or a combination of those in a low growth world, that is a rare asset indeed. 

“You’re naturally going to be bid up by the market.”

Yet while the Australian market outlook appears relatively sound, it is not without its long-term issues. On the back of a mining boom in decline, it seems the nation’s economic drivers must fundamentally change and for Taylor, that transition is far from over. 

“That’s the big issue for Australia from an economic perspective, that movement from an economy that was driven by mining investment to one that’s driven by the rest of the market,” he said. “And I guess you’ve got people out there in the market who are worried about it because of how unlikely a perfect change is going to be, because of the chance that sector profiles won’t match and because of exactly how long it’s all going to take. 

“So what you’re looking for is evidence that the move from mining investment to non-mining investment is already taking place,” Taylor continued. “And yes, interest rates remaining low will help that and the Aussie dollar will help as well. 

“But is that enough?”  

Picking winners 

Taylor pointed to the Australian tourism sector as the example. 

“When the Aussie dollar was high, Australians were going offshore for holidays but, by the same token, people weren’t coming to us for holidays for the very same reason,” he said. “But we’re starting to see that reverse now - you’ve seen strong Chinese growth into Australia, better signs out of tourism on the Gold Coast and in Far North Queensland, and I think that’s what we need to be looking for this year. 

“You’re looking for domestic consumption to step up and fill the hole that mining investment will leave,” Taylor added. “Because while mining investment isn’t going to suddenly disappear, it’s definitely slowing and that means that the transition will be key. 

“If it works well, if the rest of the economy grows into that hole, we’ll do very well but if it doesn’t, people might get a little bit nervous.” 

Of course, the transition that Taylor alludes to is one that could have very real ramifications for super fund investors. This is, after all, an industry already overweight to domestic equities compared to pension systems globally - but for Fraser Murray, senior consultant for Frontier Advisors, there are good reasons for funds’ current allocations. 

“If you go back a decade or two, the starting point of Australian super funds was a quite natural bias towards domestic equities,” he said. “The imputation system in general and franking credits in particular made that the case and in a way, it’s been this sort of catch up process taking place ever since. 

“You start off investing more in your home market and then, as time passes, you realise it’s probably a good idea to invest more and more outside your domestic market,” Murray continued. “You realise more and more that the global market has a lot more to offer than your fairly narrow domestic market in terms of diversification, investment opportunity and so on.  

“But that was certainly the starting point and so funds exposures have just been on that very slow move ever since.” 

Breaking down those exposures into specifics, Jody Fitzgerald, senior investment specialist at Australian Unity Investments, said that according to Towers Watson’s most recent research, the average Australian balanced fund had anywhere between 20 per cent and 45 per cent allocated to domestic equities. 

“So Australia certainly does have a heavier allocation to Aussie equities for all the reasons that we know, including franking benefits and so forth, but I think there are a couple of other interesting things going on as well. 

“Firstly, there really is a trend developing in terms of the bigger industry funds needing to look offshore,” Fitzgerald continued. “It’s come about due to their size and the sheer volume of assets that they have, but a clear pattern developed last year with funds moving out of fixed income and cash and going into global equities instead.” 

Some things won’t change 

Yet despite that trend, Fitzgerald’s second observation was that the overall size of domestic equities allocations was unlikely to change. 

“While global allocations are increasing, I don’t think we will really see much of a change in terms of how much super funds are actually allocating to domestic equities, at least not in terms of downweighting or upweighting,” she said. “And I say that - even though Platypus is of the belief that we’re entering into the early stages of a secular bull market run. 

“So what that probably means for super funds is not necessarily increasing their weight to Australian equities but rather changing their allocation within Australian equities,” Fitzgerald explained. “Most of these funds have significant allocations to value-style stocks or investment managers but we think that sort of approach has had its day.

“If we are moving into a bull market run, then growth stocks with quality earnings and managers that focus on that segment of the market are what funds will be focusing on - they won’t be increasing their allocation to Australian equities, they will simply be changing it.” 

Echoing many of Fitzgerald’s sentiments, Tim Unger, head of investment strategy for Towers Watson in Australia, said the allocation split between global and domestic equities would inevitably change, if only for the benefits to be gained from diversification. 

“Within equities allocation, we still think a 50/50 split represents too much of a bias to domestic equities,” he said. “So we encourage our clients to think about having a bigger allocation to global and a smaller allocation to domestic, and that’s not because we have any great conviction about the return being better in global equities. It’s simply about the greater diversification and therefore risk reduction that you get from holding a more diversified basket of shares. 

“But I’d also point out that as the emerging world becomes a bigger part of the economic pie, bear equity markets will become a bigger part of the global equity market as well,” Unger continued. “So having a larger exposure to emerging markets, either through emerging market equities themselves or even just through developed market equities, is one way to get more exposure to what’s happening in developing countries.” 

However for Unger, domestic equities allocations have not been affected by shifts to global markets alone.

“We run a survey at the end of every year comparing the allocation for pension funds in different parts of the world and if you look at how the average Australian super fund’s allocation has changed over time, the single biggest factor is alternative assets,” he said. “It’s increased quite substantially from around 8 per cent to around 25 per cent as at the end of last year. 

Alternatives the new black 

“There’s two things going on here,” Unger continued. “One is that there’s been a reduction in funds’ allocation to equities, but the second is a similar reduction in bonds allocations as well. 

“The major trend going on is an increase in the allocation to alternatives funded mostly out of bonds, partially out of equities - but when it’s been coming out of equities, it’s been domestic equities more often than not.” 

Yet if super funds’ domestic equities allocations are changing according to the diversification benefits provided by global equities and alternatives, the prospect of them changing on the basis of cost is an interesting one.  

A fund’s decision to adopt active investment over passive investment has ever been important in terms of performance, but for Fitzgerald, the introduction of MySuper means it is just as important in terms of cost as well. 

“So with the industry funds, because they’ve got fairly competitive cost structures already: MySuper’s just a status quo for them,” she said. “They don’t really need to go down the passive route. 

“What you’ll find with a lot of the bigger industry funds is that they’re looking to internalise their lower alpha investments - those with indexing or any sort of enhanced indexing - because it’s simply more cost effective to do so,” Fitzgerald continued. “They’ll then look to appoint managers externally but when they do that, they’re looking for managers who have specific skillsets. 

“They want that manager to have skills and expertise in a particular area as more of a satellite play.”

However, Fitzgerald admitted that the philosophy was somewhat different for mid-level super funds. 

“The difference with the mid-level superannuation funds, and some of the platform businesses that are competing within the MySuper space as well, is that it needs to be a low cost product,” she said. “And that’s pushing a lot of players down the index path. 

“That covers the cost angle, but does it achieve the risk and return profile that they’re looking for as well?”

MySuper impact 

Indeed for Unger, there is no question that MySuper has prompted super fund executives to examine their investment costs in far greater detail. 

“So because of MySuper and the greater degree of scale that now exists within super funds, the focus has changed,” he said. “Its lead to a focus on, a) how do we reduce our fees?, and b) are we sure that we can get positive alpha from allocating to active managers? 

“I think a combination of those two things has definitely lead to an increased focus on passive or passive-enhanced type mandates,” Unger continued. “The initial focus has probably been within global equities, but I can see similar considerations taking place with regard to domestic equities as well.  

“And, if anything, the pressure to do so is only going to intensify.” 

Yet as the super industry continues its journey through 2014, funds’ domestic equities focus will almost certainly be fixed on performance. And regardless of whether allocations change or shift, it is Unger’s belief that funds need to moderate their expectations. 

“What we’ve been saying for a couple of years now is that returns going forward are almost certainly going to be lower than they’ve been in the past,” he said. “Now obviously we had a very good year from equities last year but if anything, that exacerbates the message. 

“The problem with all asset classes - cash, bonds, equities - is that nothing looks cheap,” Unger explained. “Everything looks slightly expensive and over the next five years, it’s very difficult to see where high returns are going to come from. 

“So what we’ve been saying to our clients is that their return expectations need to be lower, but what they do in response to that really depends on a number of things.” 

The question, according to Unger, is whether a fund was focused on managing to a certain level of risk or managing to a certain level of return. 

“If you’re managing to a certain level of risk, then there’s not a great deal that you can do other than finesse things at the margin to try and increase return without increasing risk too much,” he said. “On the other hand, if you’re managing to a return target, then you’ve got to look for either other sources of risk or take more risk to get that same level of return. 

“But that’s clearly not going to be the more common response.” 

Alternatively, Taylor said that while managing expectations would be essential, the market would continue to have its fair share of opportunities. 

“So in a low growth world, I think companies that can deliver are those that will be bid up by the market and I think we’ll see greater differentiation because of it,” he said. “So pre-GFC when there was blue sky in the investment world, you’d get huge differentiation between companies because investors believed everything companies were saying.

“But as we went through the GFC, you moved from this ‘no skepticism’ world to this world with incredible skepticism with people not believing anything anyone was telling them,” Taylor continued. “So what tends to happen is valuations compress right down and everything trades on a similar valuation - whether it’s a good quality company, a bad quality company, high growth, low growth, whatever. 

“It doesn’t matter because the market is skeptical. People say, ‘I don’t care what you’re telling me, I don’t believe it, I think the whole world’s low growth, every company’s low growth and I won’t believe differently until I actually see it.’” 

However for Taylor, both domestic and global markets had moved well beyond that point. 

“As we’ve been recovering out of the GFC, we’re again going through this process where valuations are spreading again,” he said. “And all of a sudden, we’re seeing quite clearly a number of good management teams who delivered on their strategies and we’re seeing any number of companies that are actually growing their business. 

“The companies that are growing versus the companies that aren’t have suddenly become that much more obvious - and it’s in that increasing ability to differentiate that the opportunities will lie,” Taylor continued. “We’re in that process of greater discernment between companies now, and not just in this year but over the next few years I think we’re going to see more of that. 

“You’ll get a greater spread in the market and the market will need to be increasingly discerning at what is an individual company level.”