Listed property trusts: primed for a rebound

Listed property trusts: primed for a rebound

Property was possibly the worst affected sector when governments around the world pulled the plug on their economies in 2020. Not only did workers stop going into office buildings and shoppers stopped going to malls, but landlords were forced to shoulder the added burden of rent holidays and eviction moratoriums.

Little wonder real estate indices plunged. Locally the Australian Real Estate Investment Trust (AREIT) index fell 39% between the end of January and March last year, while the global benchmark, the FTSE EPRA Nareit Global index (GREIT), dropped 28% (in USD terms).

However, lingering concerns about both delays in returning to work combined with the effect the new paradigm of working from home will have on valuations for commercial property, as well as the impact of the accelerated migration to online shopping on retail values, have seen real estate indices lagging behind the broader share markets’ recoveries following the COVID crash.

The AREITs index is still 14% below its high of last year, while the ASX200 is only 1% away. Likewise, GREITs have managed to get square with last year’s high, but they’re a long way behind the 19% increase in global shares.

These differences offer smart investors the opportunity to buy what some strategists are describing as the only cheap sector left. Tim Farrelly, a highly regarded asset allocation consultant, recently wrote “Despite pretty severe assumptions on the outlook for rental growth, such as a fall in real office rents of 45% and a fall in real retail rents of 20% over the next decade, the overall impact on 10-year returns is not nearly as catastrophic as might be expected, as markets appear to have priced in these falls and more.”

Indeed, Farrelly’s 10-year return forecast for AREITs is 6.8% per year at current levels, while the forecast for Australian shares is 4.8%. Likewise, Heuristic Investment Systems, another asset allocation consultant, has a 10-year forecast return of 6.25% and an overweight recommendation.

While AREITs do offer compelling long-term value at current levels, our domestic market does suffer some limitations. It is highly concentrated, with the top 10 companies accounting for more than 80% of the ASX 300 AREIT index, and just three sectors, retail, industrial and office, making up more than 60%. The superstar of Australian property trusts, Goodman Group, alone is almost one quarter of the whole index.

By contrast, global REITs not only offer the compelling value, plus, at more than A$2.4 trillion, the total market is more than 19 times bigger than Australia’s. The top 10 companies account for less than 25% of the index and the biggest single company is only 5%.

Most importantly, there is abundant diversification, including to sectors that offer leverage to some of the most important structural themes in global markets. If you want to gain exposure to growing digitisation, 3% of the index is data centres; or e-commerce, 12%  is industrial; for demographics, healthcare is 7%, and for urbanisation, 18% is residential.

According to Vanguard, global property was the best returning asset class in the 20 years to 2020, with an annual return of 8.5%. Resolution Capital, an Australian GREIT manager, also points out the asset class enjoyed lower earnings volatility than global equities.

Despite that history of strong returns, 2020 was its worst year since the GFC at -17%. By contrast, however, this time the fall was not because of excessive debt or weak balance sheets, it was a classic exogenous shock. With the progressive relaxation of government restrictions, conditions are in place for a strong rebound.

An added attraction is that historically REITs have been a terrific hedge against inflation, since both rents and property values are typically tied to it. This may sound counterintuitive if you’ve come across the popular misconception that REIT valuations are inversely affected by bond yields, that is, when yields rise, values fall.

Chris Bedingfield, co-portfolio manager of the Quay Global Real Estate Fund, points out that, “Over the long-term, there is actually no correlation at all between REIT valuations and bond yields. However, over the short-term, it seems there are enough investors who believe it that it becomes a self-fulfilling prophecy.” Notably, over the March quarter, GREITs returned more than 7% despite bond yields rising sharply.

To gain exposure to GREITs, you can buy an index fund, such as the VanEck Vectors FTSE International Property ETF (REIT.ASX), or, if you’re wary about the potential for COVID risks, you can choose an actively managed fund from the likes of Quay Global Investors or Resolution Capital.

Resources stocks will benefit from a commodities supercycle

Resources stocks will benefit from a commodities supercycle

Analysts and fund managers have recently been lining up to explain why commodity markets are on the cusp of a potentially multi-year bull market. Rockstar analysts Jeff Currie, global head of commodities at Goldman Sachs, and Marko Kolanovic, macro strategist at JPMorgan, go so far as to describe it as the beginning of a ‘supercycle’.

In the last two commodities bull markets, which happened either side of the GFC, major global resources companies rose four to five-fold, far outstripping the broader share markets, though it should be remembered the fall in between was precipitous.

Analysts describe the conditions as being in place on both the demand and supply side across almost the whole commodities complex.

Multiple drivers of demand

In the near term, the almost explosive post-COVID recovery some economies are seeing, fuelled by massive government spending and access to cheap credit, has already seen commodity prices respond. Copper has doubled since its lows of March last year, and now trades at nine-year highs, iron ore has more than doubled and is at 10-year highs and, after falling spectacularly to below zero in 2020, oil is back above US$60 per barrel. The Bloomberg Commodities Index has risen 44% from its lows of 2020.

As well as expectations of an ongoing rise in commodities-intensive infrastructure spending and construction activity, Currie points out the inexorable shift toward green energy underpins huge increases in demand for energy related metals. Already, lithium, a foundation element of most modern batteries, has risen 45% since the start of this year, and cobalt is up 58%.

The European Commission has estimated its Green Deal will require more than €1 trillion (A$1.5 trillion) to be spent over the next decade, and both China and the new US administration have endorsed a move to being carbon neutral by mid-century. With the three largest economic blocs in the world moving in the same direction, the implications for commodities demand are enormous.

Supply will struggle

COVID has also impacted the supply side of the equation, with production out of South America, which accounts for one third of global copper and iron ore production, suffering significant falls. James Stewart, co-lead portfolio manager of the Ausbil Global Resources Fund, argues in addition there has been the typical underinvestment in bringing on new mine production that you see in the aftermath of a commodities boom.

“In 2012 total mining capex was about US$75 billion, and then it fell like a stone to hit US$20 billion in 2016. While it’s picked up since, in many areas the mining industry is nowhere near where it needs to be just to replace annual consumption, let alone expand production,” he said.

For example, copper requires around 300,000 tonnes of new production per year for supply to remain constant, which translates to around $10 billion of capex, and there are no new large mines slated to come into production for at least the next year.

Currie describes most commodities as facing structural deficits, and Stewart agrees, “The process of getting even a small mine up and running, from finding the resource, to defining reserves and then building the infrastructure, can easily take four or five years, and for a big mine it can be 10.”

Stewart’s fund has been investing heavily in mining companies that supply the battery industry, where Bloomberg forecasts demand for nickel and aluminium will rise 13-fold to 2030 and lithium carbonate by nine times.

Longview Economics argues commodities, relative to equities, are as cheap as they have been in more than 50 years, lower than before the start of previous supercycles in 1969, 1987 and 1998.

A hedge against inflation

A further argument in favour of investing in resources stocks is as a hedge against the frequently cited possibility of a rise in inflation, driven again by the sharp rise in post-COVID demand. Commodity prices tend to rise with inflation, driving earnings for mining companies, which could offset concerns about the effects of rising bond yields on a portfolio’s growth stocks.

It’s not often there is such strong consensus among analysts and fund managers. Obviously a smart investor should always consider the counterfactual, but the fundamentals of demand and supply are stacking up to suggest resources stocks could be entering a multi-year uptrend.

What are the prospects of a post-COVID boom?

What are the prospects of a post-COVID boom?

This article appeared in the Australian Financial Review.

After news of a promising COVID vaccine hit financial markets on 9 November, those sectors that had been shunned like last week’s fish dinner while economies were at risk of ongoing lockdowns suddenly became flavour of the month.

Investors pounced on the stocks that should benefit from people returning to ‘normal’, which saw sectors like energy, banks, retail property trusts, hospitality and travel shoot up. At the same time, the companies that had starred during lockdown, that benefited from people shopping, working and exercising from home, surrendered some of their astonishing gains.

This has left smart investors facing the usual challenging questions: has the market already priced in the return to normal? Should you be erring on the side of caution and selling into these strong markets?

We continue to advise clients to remain fully invested in the allocation to growth stocks their risk profile allows.

Strong outlook for the economy

There are several indicators pointing to the possibility of a strong economic environment in the year ahead. First, the Australian government injected stimulus equivalent to 13% of GDP in the form of JobKeeper, JobSeeker and other direct payments. The $34 billion worth of early super withdrawals added another 2.5% to that.

A lot of that stimulus has already been spent, which was the whole idea, but much of it has been saved, with Australia’s household savings ratio hitting 19.8% in the June quarter, almost eight times higher than a year ago and only 0.5% below its peak of the last 60 years. That’s a serious amount of spending power.

And spending is exactly what it looks like Australian consumers are doing after confidence levels jumped to 10-year highs. The Commonwealth Bank reports its credit card data showed spending in the week to 13 November was up 11% compared to last year. Restaurants in New South Wales enjoyed seated dining numbers 55% higher than a year ago, while Queensland was a whopping 79% and even shellshocked Victoria was up 54%.

Retailers will be eyeing off that pool of savings in anticipation of a bumper Christmas and companies in general should expect a lot of that money to work its way around the economy for a while yet.

The US is in a similar position, with a 13% stimulus package pushing the personal savings rate to almost double what it was at the start of the year. Although a fresh stimulus package has been trapped in a political standoff for the time being, it is expected the new Biden administration will make it a priority. Meanwhile, record low interest rates have ignited the housing market, with home values at record highs, homeowners’ equity at record levels and monthly new home starts challenging their all-time highs.

If the new vaccines are as effective as they appear, the Chinese economy has shown how quickly things can bounce back. China’s manufacturing and services sectors have rebounded strongly, pushing annualised GDP growth to 5% and retail sales are almost 5% higher than a year ago.

What about the markets?

Whoever would have thought the US share market would already be at a record high the day a COVID vaccine was announced? Let alone that it would hit that high amidst COVID cases being reported at record rates across the globe. And that strength is being seen in stock markets around the world, with 52-week highs in China, Europe, the emerging markets and even Japan is at 30-year highs.

2020 has been a great reminder that share markets do not necessarily follow economies, so it’s entirely possible we will see an economic rebound and poor markets. And there are plenty of sceptics ready to point to elevated valuations as a warning signal.

So how do those valuations stack up? Australia’s ‘forward PE (price to earnings) ratio’, so based on earnings forecasts for next year, is at 19 times compared to a 32-year average of 14, and the MSCI World Index is at 21 times compared to 16.

On the face of it, that makes shares look pretty expensive. However, I’ve argued for a long time that low inflation supports higher PE ratios. 30 years ago, Australia’s inflation rate wasn’t far off 10% and it’s been trending downwards ever since. So, with inflation currently below 1%, it makes perfect sense that the PE ratio would be higher. In fact, comparing today’s PE ratio to any period as far back as 40 years ago, when inflation peaked at close to 18%, is like comparing the proverbial apples and oranges.

Further, high growth companies such as the tech sector have defied any gravitational pull of lower PE ratios. I’ve argued before that it makes little sense to value a software company whose earnings can grow exponentially without requiring any further capital outlay the same way you’d value a company whose earnings can only grow in proportion to how much they spend on building new factories.

Bond yields have also been steadily declining and, likewise, it’s well established that falling bond yields underwrite higher equity valuations. The typical way to value a share is by working out what a company’s future cash flows are worth today by applying a ‘discount rate’, which is normally based on the 10-year bond yield. The closer bond yields get to zero, the more valuable are those future cash flows in today’s money.

With interest rates at levels designed to punish savers and prospects of a vaccine unleashing a post-COVID spending spree, it’s little wonder global equities just saw the biggest week of inflows ever. Now is not the time to be sitting on cash.

Want some help with your investments?

To discuss how we can help call Steward Wealth today on (03) 9975 7070.

Bubble Trouble Brewing

Bubble Trouble Brewing

This article by Jason Todd, a strategist at Macquarie Wealth, takes a measured look at whether the Australian share market is overvalued, and whether the tech sector is in a bubble.

The bulls versus the bears

When equity markets began to rise back in late March, we had no problem thinking that liquidity would do the ‘heavy lifting’ as long as COVID-19 cases were not still rising and economic expectations were not still falling. It was right to take this stance. Now the equation seems much harder to solve. COVID-19 cases are rising again but markets do not seem particularly concerned even though valuations have expanded by an extraordinary amount. There appears to be two schools of thought emerging to explain the current backdrop.

The first, suggests that markets are becoming irrational and are in the midst of a liquidity-fuelled rally that is fast taking on bubble-like characteristics. This view argues that investors are being driven by the fear of missing out (FOMO), paying an unjustified scarcity premium for earnings growth and that momentum rather than fundamentals matter. 

The alternative view is that markets are pricing in a combination of record low bond yields, an unwavering commitment by policy makers to keep economies and the financial system afloat and the willingness to pay a premium for structural growth. This is pushing valuations higher in areas where COVID-19 has accelerated change such as technology while pushing valuations lower in areas under downward pressure such as traditional retail and property.

It is hard to say which view will ultimately prevail as we think there are elements of truth to both sides. The risk-reward for certain pockets of the market are becoming hard to justify, but in general, we do not see broad signs of “bubble trouble” across equities. Traditional warnings signs such as speculation activity are not broadly evident even if tech valuations are looking troublesome.

Are equities in a bubble?

A ‘bubble’ is defined as a rapid rise in the price of an asset that is not supported by fundamentals. A typical sign of a bubble is a sharp increase in valuations to extreme levels. For the Australian market, valuations are high but outside of a reversion in the drivers supporting risk assets in general, we don’t think they have reached a self-correcting level.

The 12-month forward P/E multiple for the Australian market has risen sharply since 23rd March and now sits at a near-record high of 19.1x. However, the P/E multiple has been boosted by the COVID-19 induced collapse in earnings which we think is not a permanent hit. In addition, the CAPE is only 15.9x. This is well below previous peaks and is below its long run average of 16.6x. So far so good…right?

Bubble Trouble Brewing image1
Source: Factset, IRESS, MWM Research, July 2020

Is there bubble trouble in pockets of the market?

We do not think Australian equity valuations are anywhere near bubble territory and nor do we think other traditional indicators of bubble-like behaviour are evident. However, we cannot say the same for Australian technology stocks which are now trading on an eye watering 60x forward earnings!

These valuation metrics look even more concerning when only the WAAAX stocks are considered (Wisetech, Afterpay, Appen, Altium and Xero). These 5 stocks have seen prices rise more than 500% over the past 3 years versus the broader ASX200 index which has barely risen above 0% over the same period. This has pushed 12-month forward P/E valuations for WAAAX to a new all-time high of 168x versus a paltry 19x for the ASX200.

Bubble Trouble Brewing image2
Source: Factset, IRESS, MWM Research, July 2020

Part of the extraordinary price appreciation and valuation re-rating has been due to a much stronger and less cyclical earnings outlook, but it has also been fuelled by record low interest rates which disproportionately benefit high multiple/long earnings duration stocks. In fact, the WAAAX stocks have seen earnings grow 2.5x over the last 3 years – an impressive outcome versus the broader market which has seen earnings decline. However, this has been dwarfed by the near 6-fold increase in share prices over the same period!

Bubble Trouble Brewing image3
Source: Factset, IRESS, MWM Research, July 2020

To put this in context, the WAAAX stocks have seen earnings increase by A$181m and their market cap expand by a staggering A$41bn. Back in 2017 investors were willing to pay 71 for each $1 of earnings and now these same stocks are commanding 168 for each $1 in earnings. In other words, investors have been willing to ‘pay up’ for the superior earnings performance of WAAAX stocks but at an increasingly higher and higher rate.  

Is there a global growth stock bubble?

The re-rating of growth stocks is not unique to Australia. The WAAAX ‘bubble’ is part of a larger issue relating to the willingness of investors to bid up stocks which have a strong, structural, and/or transparent earnings growth outlook. ‘Growth’ stocks (of which WAAAX is a component) have been fiercely bid up as one of the few sources of structural earnings growth in the Australian market.

In other words, in a world where earnings growth is scarce, any earnings growth has become more valuable. This has also been seen in the recent performance of the FAANG’s (Facebook, Apple, Amazon, Netflix and Alphabet – formerly Google). This collection of stocks has also seen valuations ratios explode in recent years with momentum rising even faster in recent months because of an acceleration in their earnings outlook thanks to COVID-19. 

Bubble Trouble Brewing image4
Source: Factset, IRESS, MWM Research, July 2020

The other big factor, ultra-low interest rates, has also played a part. All other things equal, a lower discount rate would not only increase the fair value P/E multiple of the market generally but would also increase the dispersion between high and low P/E stocks. However, the current unprecedentedly high P/E dispersion exceeds the extremes seen during the Tech bubble of late 1999/early 2000, which suggests caution may be merited.

What’s the right price for “scarcity” value?

In a world where earnings growth is scare, what is the right price for the rarest of structural earnings stocks like technology, which the market is assuming can access that growth? Is it 50x future earnings, 100x future earnings, an eye watering 168x future earnings or something even higher? Only time will give us the right answer, but we think it is worthwhile trying to determine what conditions would need to prevail in order for these stocks to maintain these multiples (or the alternative – what would need to change for these stocks to suddenly lose their scarcity premium?). Gavekal’s Louis Gave believes there are 4 factors that would drive this reassessment:

  • An improvement in the macroeconomic growth outlook and higher interest rates.
  • Markets stop seeing technology companies as having scarcity value (i.e. government regulation).
  • Another scarce asset becomes popular (i.e. gold? Bitcoin?); and
  • Technology stocks disappoint.

We think equity markets are optimistically priced and waiting for economic fundamentals to catch up, but they are not at an extreme (bonds are even more expensive). Similarly, retail sentiment is bullish but not exuberant, cash levels have come off their highs, but remain exceptionally elevated and capital raisings are still being gobbled up (predominately by institutional and not retail money). On the other hand, there have been some anecdotal signs of rising market ‘madness’ in the US with investors fiercely bidding up bankrupt companies, retail account openings have exploded (in part because many have been stuck at home) and some daily price moves have been extreme.

The technology sector is another kettle of fish. In the US, valuations are high but nothing in comparison to our own WAAAX stocks. On the other hand, there are still few signs of speculative activity stretching more broadly into financial assets and the scale of global (and domestic) liquidity injections is nothing we have seen before. We are not saying that fundamentals don’t matter because in the end they always do, but it is quite possible that the combination of easy money and a slightly better cyclical outlook push multiples for both technology and the broader market even higher!

Over the coming 12 months, we think investors should maintain a pro-growth portfolio allocation (overweight equities versus bonds and cash) and be prepared to look through any near-term fluctuations or use weakness to reallocate back into the equity market. Despite near-term risks, we think the downside risks are more likely to slow the recovery rather than put the cyclical recovery at threat. This could lead to a more drawn out rebound, but if economic growth and corporate earnings continue a path back to trend, then, in combination with record low interest rates, this will be sufficient to propel markets higher. In addition, while valuations for equity markets are not overly appealing, they are even worse for the bond market with yields not far from their lower bound and as a result bonds continue to give away a substantial yield premium to equities.

Lessons from previous bear markets

Lessons from previous bear markets

There’s an old saying that the stock market goes up by the stairs and down by the elevator, except this time it’s been more like jumping out the window. The ASX 200’s gut-wrenching 30% plunge from its late February peak was clocked up in a brutally quick 17 trading days and has left punch drunk investors wondering if things will ever get better and occasionally even wondering if they can continue to bear the pain. Let me assure you, things will get better, regrettably, however, nobody knows when. 

Every investor needs to have a plan, or a strategy, that reflects their ability, willingness and need to take on risk. If share markets didn’t face the risk of falling, they would not offer long-term returns above cash. While bear markets will always test an investor’s resolve, hopefully some historical context will be helpful, not just in terms of how bad it can feel at the time, but the inevitability of recovery afterwards.

Notably, this hasn’t been the sharpest selloff we’ve ever had in Australia, that ignominious title goes to 1987, a near five month correction that saw the All Ordinaries almost halve and included Black Monday (which was actually a Tuesday when the tsunami of selling hit Australia) where shares dropped 26% in a single day.

Then there was the GFC, where the All Ordinaries fell 55% over an excruciating 14 months from its peak in November 2007 to its final bottom in early March of 2009.

All up, if you use the rule of thumb that a bear market is a fall of at least 20%, over the past 60 years Australian shares have experienced seven of them, including the current one. The average time it took to recover the losses was 53 months, though it’s varied between 15 in the mid-1990s to more than 10 years after the GFC (the length of the recovery period is highly influenced by how overvalued the market was going into the selloff). That means the average return over the recovery period has been better than 10% per annum, or almost 13% if you exclude the GFC as an outlier.

Again, for some context, in the US there have been 12 bear markets since 1965 with an average fall of 31%, and an average recovery period of 21 months (less than half Australia’s). That means once the bear market is finished the average returns over the recovery period have been more than 23% per annum.

The question everyone’s asking is when will the current correction stop, and the honest, but entirely frustrating, answer is nobody knows. The analysts at Heuristic Investment Systems have looked at the history of US share market corrections and concluded that mid-sized recessions have typically resulted in the market falling 25-30%, which is where we are now. Deeper recessions, like the GFC tend to see falls of 40-50%, so arguably the market’s pricing in a 60% chance of a deep recession.

Looked at another way, company earnings typically fall 15% in an average recession and the ‘forward price to earnings multiple’, that is the PE ratio the market trades on based on forecast earnings for the year ahead, can go down between two and seven points. From where the US market was immediately prior to this correction starting, a 15% cut in earnings and the PE dropping to 15 would take the S&P 500 to 2,250.

An alternative way to assess how share valuations stack up is the ‘equity risk premium’ (ERP), which measures the extra return shares are offering compared to a risk-free investment in bonds. Even after accounting for expected cuts in earnings forecasts, for the ERP to be as high as it was during the GFC and the European debt crisis would imply 2,600 on the S&P 500.

What those estimates tell you is the share market is already pricing in a serious economic slowdown. Even though there are some commentators arguing this slowdown could be worse than the GFC, we’ve had 10 years of slow but steady growth in between, so don’t expect the index to retreat all the way back to the same level. Plus, central banks and governments, having learned from the GFC, are coordinating their efforts to throw the kitchen sink at supporting economies.

For those that have not sold their shareholdings, there is arguably a lot of value in shares at current levels and to sell now would simply lock in a loss, and for those lucky enough to be holding cash, you have the kind of opportunity that comes along maybe once a decade to build a great, rest-of-your-life portfolio.

If you’re wondering when to invest, don’t for a minute think you’ll be able to pick the bottom, the odds on that are about the same as winning the lottery. And remember, the market will start to turn when the odds of recovery are 50.1%, as opposed to 49.9%, so if you wait for certainty, the market will have taken off well ahead of that point. You should also bear in mind, you don’t have to be all in or all out so you can hedge your bets: if you think there’s a 30% chance the market has bottomed, then you can invest 30% of your resources.