Equity Strategy Post Brexit

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This story features AMCOR PLC, and other companies.
For more info SHARE ANALYSIS: AMC
The company is included in ASX100, ASX200, ASX300 and ALL-ORDS

– Brexit views remain polarised
– TINA is the star
– Hunt for yield clouding the picture

By Greg Peel

“This has been an exciting year for investors,” say Morgan Stanley’s wealth managers,” but in a bad way”.

We began the year with China slowdown fears and collapsing commodity prices, particularly that of oil. Markets recovered, before the Bank of Japan’s move into negative rates had markets questioning whether there was no longer anything central banks could do to avoid recession. Then came the Brexit vote.

The fact we saw such a swift recovery from initial Brexit panic suggests to Morgan Stanley markets have been thinking about these political issues more than many pundits have acknowledged. It makes sense given populist movements are neither new nor contained to the UK, and indeed are present in the US. (Read: Donald Trump)

While such political movements can create uncertainty, they are gradual and sometimes glacial, the wealth managers suggest, and here Brexit may prove a case in point.

Morgan Stanley has held the view all year that global growth bottomed out in the December quarter or March quarter and that a weaker US dollar and devalued Chinese renminbi, combined with higher oil prices, would serve as a powerful boost to the industrial, manufacturing and energy complexes which suffered greatly in 2015. In April and May this assumption appeared to playing out.

Political events may lead to uncertainty ahead, but Morgan Stanley does not believe they will derail the nascent economic recovery or block the rally in equity markets that began in February.

That’s one view.

Brexit Omen

As to how one perceives the risks Brexit will bring about from here on appears, at least at first glance, to depend on whether you’re in Europe looking out or somewhere else, such as the US, looking in. Denmark’s Saxo Bank, for example, is worried.

“Britain’s seismic decision to turn its back on Europe will inevitably reverberate thought the third [September] quarter and beyond as it undermines a narrative that has underpinned the continent since World War II.”

So writes Saxo Bank CEO Kim Fournais.

While Fournais expects the impact of Brexit on the UK to be “profound”, he believes the EU must now fear a domino effect as the anti-elite groundswell gathers strength and threatens to send the whole European integration process into reverse. “The ongoing refugee crisis, the fundamental discord between the periphery [eg Greece] and the core [eg Germany] and a burning resentment that had its genesis in the global financial crisis in 2008 makes it a pivotal quarter for the European Union,” Fournais warns. And the same discontent is also fuelling Donald Trump’s anti-establishment presidential campaign.

Trading the markets in the September quarter will be about navigating increased volatility, understanding how populist sentiment will affect social direction, and accepting that the world economy – including the US – is about to renew its flirtation with recession.

On a brighter note, Saxo Bank’s chief economist Steen Jakobsen is not too concerned about Brexit, as past crises have shown these types of events often lead to real changes and sometimes real reforms. “The good news is that the next six to twelve months will see a move towards the much needed mandate for change,” says Jakobsen. “The bad news is that it will come with more volatility and more uncertainty”.

Brexit Shrug

The very shallow US “correction” seen after the Brexit surprise – 5.75% in the S&P500 over two days – makes Raymond James’ investment strategist Andrew Adams wonder just what it will take to make stocks slip under the February low. Mind you, Adams does have a theory on that one.

It appears the US Federal Reserve is making sure stocks don’t drop to levels that may have otherwise been explored without such low interest rates. “Of course, the Fed’s official dual mandate has nothing to do with stock prices,” Adams admits, “but it’s a bit naïve to believe that their continued easy money policy hasn’t at least helped stocks hang in there better than they would have without the added boost and why there’s a good chance that stocks can only fall so far in this type of stimulated environment”.

Raymond James’ view is that the big picture is a bit brighter than many believe it to be, while still admitting the US economy and bull market in stocks haven’t exactly been running on full throttle these last couple of years. But despite the volatility markets have experienced, US stocks have not fallen anywhere near the depths the bears have continually warned about.

The fact remains there just isn’t a great alternative to stocks out there for investors at the moment, notes Adams. The strategist is hardly alone in citing the TINA (there is no alternative) driver. But Adams would be a lot more concerned if investors had the choice to sell all their stocks and put the money in US bonds yielding 6.5%, as was on offer during the 2000 tech wreck, or even at 4.5% which was still attainable as the GFC began to play out in 2007.

At 1.5%, which is lower than inflation depending on which measure one uses, they have no choice. And if even the most risk-averse retail investor has not elected to sell out of stocks over a roller-coaster past two years featuring three corrections of 10% or more, what would make the difference now?

A lot of them sold out post-GFC of course, which is why many an analyst points to ever present “cash sitting on the sidelines”. If low interest rates are providing a floor to just how low stocks can go, were the market to break out to new highs (which has actually happened in the US these past few sessions) a lot of that sidelined cash may come back into the market, Adams assumes.

But should the average investor trust a strategist’s view? The Raymond James strategist himself points out the Bank of America-Merrill Lynch Sell-Side (meaning equity analysts and strategists) Indicator hit its lowest “bullishness” level in three years at the end of June.

BA-ML notes every time that Indicator has hit as low a level or lower, the subsequent twelve months for equities has been positive 100% of the time, with a median return of 27%.  

Tina Australis

For the Australian market, 2016 has featured a recovery in the all-important resource sectors from the February lows, alongside commodity prices, and the ongoing thematic of the Hunt for Yield. This year has seen global interest rates move ever lower, and the Australian cash rate hit a new low.

Defensive yield stocks, such as utilities and telcos, did not fall much during the brief Brexit tumble but have joined in with the subsequent rally as that thirst for yield becomes ever more urgent. In between lie the banks, which in this day and age are both cyclical (linked to the economy) and defensive (pay high yields).

Australia’s banks have had a yo-yo year as result, being swiftly dumped on global macro fears (eg European bank shares crashing twice – earlier in the year on emerging market exposure and recently on Brexit fear) and on domestic fears (eg possible capital raisings required to meet new regulations, revival of political bank bashing). But every time it looks like the banks are in a downward spiral, the yield factor kicks back in.

On the subject of utilities, analysts both here and in the US have been warning all year that the the hunt for yield has pushed these stocks into overbought territory. Yet still they go up. The focus in the US is particularly on downstream electricity distributors in this space but given Australia’s downstream operators are also upstream energy producers, their exposure to the oil price makes them highly cyclical and in no way defensive.

In Australia, popular “utilities” are the REITs and infrastructure funds, the latter focused on toll roads, ports and airports. But they are not vast in number. Given the scarcity of listings, which leads to the demand for yield exceeding the supply of yield, thus pushing prices higher, stockbroker Morgans advises investors it is prudent to diversify their exposure. Advisor Morningstar recommends up to a 5% exposure to global infrastructure in an investment portfolio.

Fortunately, local investors do not have to buy foreign shares directly. Morgans points out there are alternatives available in the ASX-listed exchange traded funds VanEck FTSE Global Infrastructure EFT (ASX code: IFRA) and the AMP Capital Global Infrastructure Fund (GLIN), and in the listed investment company Argo Global Listed Infrastructure (ALI). Of the three, the VanEck is currency hedged.

On the subject of banks, Morgan Stanley notes that the Brexit rebound has led to some stretched PE multiples on the local market but notes the banks have so far lagged. “Should the the banks join the Hunt for Yield, the upside risk to the index is 5-10%,” the MS equity strategists suggest, “something consensus may not be positioned for”.

Bank underperformance has been driven by increasing concerns as the housing boom begins to recede and ongoing concerns the banks will need to raise further capital to meet whatever new requirements APRA finally settles on, Morgan Stanley believes. Add in weak margins in a low interest rate environment, increasing competition for deposits and worries about a possible sovereign credit rating downgrade, and the overall concern becomes one of whether dividends, and thus yield, are actually sustainable at current levels.

Morgan Stanley’s view is that investors have a right to be concerned, and that relative performance will remain subdued. But were faith in dividends to be underpinned, the Hunt for Yield could lead to a catch-up rally that would push the bank index much higher and, given the 27% weighting of banks in the index, the ASX200 much higher.

It’ a fair argument, but not one Macquarie’s strategists are not touting. They do not believe the Brexit rebound signals the start of a sustained period of equity outperformance, maintaining the view investors should remain cautious and defensively positioned.

The strategists cite three issues that lead to their lack of confidence. Firstly, global bond prices have rallied alongside global equity prices (albeit some selling has emerged this past week), meaning the rally in cyclicals is being matched by a rally in defensives, somewhat against the laws of nature. Secondly, the big rally-back for the materials sector has largely been gold-price driven. Metals and minerals are cyclical but gold is defensive. And thirdly, if the Fed is “back in play” because the world did not collapse on the Brexit result, higher US rates means a stronger greenback means renewed pressure on commodity prices.

The strategists nevertheless admit there are a number of reasons the market should trade higher.

Firstly, and this harks back to the above argument, the banks are cheap and offer solid yield support. Secondly, supply cutbacks across the globe are driving a new upcycle for the materials sector. And thirdly, defensive yield stocks may look expensive now on historical comparisons, but never before in history have global interest rates been so low, hence this argument has no foundation.

Macquarie would nevertheless like to see actual Australian economic growth, implying the current rally has no fundamental basis. The strategists do not believe the upcoming local reporting season is going to offer much upside.

At the sector level, Macquarie’s strategists are Overweight REITs, consumer discretionary, industrials and telcos and Underweight resources, diversified financials and consumer staples. At the stock level, they prefer Amcor ((AMC)), Fairfax Media ((FXJ)), Mantra Group ((MTR)), Nufarm ((NUF)), oOh!media ((OML)) and Rio Tinto (RIO)).

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