Mixing politics with equities

With global political instability, falling emerging markets, and a high-risk, low-return environment, how are super funds viewing international equities? Jassmyn Goh looks at the trends and how equity markets are responding to political decisions.   

The shock outcome of the Brexit vote in June and the political uncertainty that followed caused stock markets around the world to head south, but superannuation funds proved resilient as they still managed to post positive returns for the end of the 2015/16 financial year.

According to a report by research house, Chant West, the financial year ended with significantly lower returns for median growth funds than the previous three years (three per cent compared with 15.6 per cent in 2012/13, 12.8 per cent in 2013/14, and 9.8 per cent in 2014/15), thanks to the uncertain global political and economic environment.

The report said while Australian shares just made it into positive territory and international shares lost ground, the median growth fund still produced a positive return because of diversification.

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According to Chant West's senior investment research manager, Mano Mohankumar, there had been a decrease in super fund allocations to international and Australian shares since 2006 as a means to diversification.

He said at the end of 2006 most default funds had around a 32 per cent allocation to Australian shares and 27 per cent international shares, excluding real estate investment trusts (REITs).

"Over time they've decreased their allocations to Aussie shares and by the end of March this year it's about 26 per cent Aussie shares and 26.5 per cent international shares," Mohankumar said.

"That six per cent and one per cent reduction from international shares have gone to other assets sectors and other alternative sectors."

But since the introduction of MySuper, what you see is a lot of retail funds have kind of taken a step back and they've come up with more lower cost options which has undone some of the good work in terms of asset allocation.

– Mano Mohankumar

He said the reduction in international equities was to further diversify their products and to look for alternative sources that would add value.

"Industry funds and retail funds invest quite differently. In the case of industry funds much of that reduction in shares went to more unlisted type assets, and retail funds would have gone into more liquid alternatives," Mohankumar said.

"But since the introduction of MySuper, what you see is a lot of retail funds have kind of taken a step back and they've come up with more lower cost options which has undone some of the good work in terms of asset allocation.

"They still offer their best ideas and portfolios, but in many cases the retail funds' MySuper options are simplified options and lower cost."

Mohankumar said some of the ways in which funds had looked to reduce costs were by increasing allocation to passive management or by building internal management capabilities.

"We've seen some funds increase passive management within Australian and international shares and maybe reallocate some of that into other asset classes where they might get better alpha," he said.

He noted that most industry fund MySuper default funds would have stayed the same as their previous default fund.

Frontier Advisors senior consultant, Fraser Murray, believes in the last 20 years increasing allocations to international and emerging market equities had plateaued off the back of the franking credit system for Australian equities.

"In the last few years, allocations to global equities or emerging markets have been fairly constant for that reason," Murray said.

"If there was enormous value offshore you'd think those allocations would increase because it would compensate for the additional return for the imputation system you're getting in Australia.

"The message there is that most investors aren't necessarily seeing opportunities offshore as being dramatically more significant to what is available in Australia."

Murray noted that allocating to international equities should not be about whether the returns were better or not, but rather about the fact that it was a tool for diversification.

"The potential to get exposure to different countries, economies, currencies, industries all those things are diversification properties that are valuable relative to investing in the Australian market which is quite concentrated -  four major banks, resources industry and that obviously ebbs and flows," he said.

However, AustralianSuper said it had increased its exposure to international equities and overseas investments over the past few of years.

The fund's co-head of macro, portfolio construction, Alistair Barker, said the increase was driven by a desire for a wider opportunity set of high quality companies and sectors not available in Australia, such as IT and healthcare.

"Second, [it was] to diversify away from Australian equities, as the local market has tended to be more concentrated in a smaller number of stocks and sectors, banks and materials in particular," Barker said.

"Third, it was also due to the shift of the portfolio away from Australia as the mining investment boom slowed down."

Mohankumar noted that apart from the US that delivered a small positive return (1.7 per cent) for FY2015/16, Japan, the EU, and the UK were down in the developed market at -23 per cent, -16 per cent, and -0.3 per cent respectively.

He said in the emerging market region, China did very poorly at -32 per cent.

"If you have a lower exposure to Japan and EU ex-UK, you would have done well, and a low exposure to emerging markets would have definitely helped as well," he said.

US strongest of all?

Murray said the US had been one of the strongest markets globally with its significant IT industry, healthcare, and consumer market.

We're in for a very cautious six months and I wouldn't expect much from equity markets.

– John Coombe

However, he said while the US had significant companies in industries like healthcare and technology, it was not confined to the US market.

There were a number of very successful healthcare businesses in Europe, and a number of significant technology businesses in Asia.

"A lot of leading innovative companies in the consumer space have been US companies," Murray said.

"The question now though is whether they've reached full valuation and if there are better opportunities in other parts of the world such as Europe where valuations are a lot lower."

Currently, the US had the largest regional allocation in terms of a global index.

"Generally the MSCI world index allocation to US hovers around 50 per cent mark, give or take five or 10 per cent and you'll find fairly consistently fund managers have the greatest exposure to the US as well," Murray said.

JANA Investment Advisers executive director, John Coombe, said Europe's lack of earnings growth would put the US under pressure and US earnings would decline with the rise in its currency.

"How do they work in their currency when they're the safe haven currency? If you've got the EU and the pound under pressure then people will naturally flow to the US dollar and that puts pressure on US exports and earnings," Coombe said.

"The S&P500 is dominated by global companies and global sales so if you have a rise in currency that impacts earnings."

Coombe said finding any earnings growth you would require an improvement in earnings around the world.

"The reality is that most companies are struggling to find the next new customer. So it is quite an issue for markets everywhere. The US probably has a better chance, but then the earnings could get impacted by high value etc. so unemployment drops in US has pressure on profitability.

"It's not a great world is it? And I've painted a pretty gloomy picture.

"Maybe Asia is the great white hope here. Maybe the Chinese Government can get their act together and China could lead us out."

Coombe noted that there would not be any clarity in the world equity space until the long-awaited US election in November.

"What the press is writing about anti-establishment of conventional politics is 100 per cent real. Implications and impacts will cause markets to be very cautious," he said.

"We're in for a very cautious six months and I wouldn't expect much from equity markets."

On both the US election and the Brexit vote, Barker said these political decisions highlighted the need to consider the policy direction of governments.

"They have the potential to eat into the confidence of financial markets and those making investment or hiring decisions," he said.

"But that doesn't mean it is all bad news. Central banks continue to run very accommodative monetary policy."

EU and Brexit

With so many eyes on Europe and the surprise outcome of the Brexit vote in June, EISS Super chief investment officer, Ross Etherington, believes the exit vote would only have a negative short-term impact.

He said the leave vote would, however, create more uncertainty for the future and the economy.

According to an EISS report on the vote, the vote to leave had initially resulted in global equity markets tumbling with the UK down three precent, the US down four per cent, Europe down nine per cent, Japan down eight per cent, and

Australia down four per cent.

Mohankumar said it was too early to gauge the real impacts of Brexit, and that super funds had not changed their portfolio structure in any significant way.

"What happened around the vote was that share markets dropped quite a bit over a couple of days and then bounced back over the next few days and that was before the financial year end and then share markets further rallied during the month and July as well," he said.

Coombe noted the uncertain political climate in Spain, Czechoslovakia, and Hungary, along with the UK had highlighted how ordinary the politics were in the region.

He said it was not often that politics were so uncertain that they actually affected markets in a big way.

"It will be interesting to see how central banks negotiate their way through this," he said.

"The interesting thing is EU is cheap relative to the US but has no end growth. So if you think markets basically go up and down based on earnings growth, this political unrest and what's going on in Europe is what's going to make earnings outlook look more vulnerable.

"So since 2012 there has been absolutely no earnings growth in Europe so the market improvement is basically all being a rerating of the price earnings multiple; in other words people's willingness to buy risk assets."

Mohankumar said the challenge now was to find sources of value in a persistent low-return and high-risk environment.

While growth funds managed to finish in positive territory for FY2015/16 for the seventh consecutive year, he noted what helped funds this year was a high exposure to unlisted assets and Australian REITs.

Coombe said people would continue to be very cautious to put money into equity markets in light of the events in Europe and the UK.

"There's just so much fall out from it. I think it's really difficult to not believe that it's going to impact earnings on companies and the UK economy," he said.