October 2017 Investment Update of a Cautious Position

chartIn my July update, I noted that we were cautiously optimistic having an overweight position in growth stocks (i.e. shares, property and infrastructure). This position has played out well over the last few months with strong returns for investors in growth stocks. However, we now believe we should be cautious going forward, as valuations in New Zealand and overseas markets are fully priced (as noted by Graeme Wheeler of the RBNZ recently).

As 2017 nears the end, the cautious seldom err…

Over the last few months NZ shares have performed well, with Fund Managers generating returns of between 8% and 17% year to date. International shares (in developed and emerging markets) have returned between 15% and 23% for the last nine months. The performance of infrastructure funds has also been similar. Consequently, clients with a higher weighting to growth assets have been well rewarded.

Conversely, those with conservative portfolios have seen returns for cash and bonds (fixed interest), remaining low, ranging from 2% to 4% (excluding currency hedging). As such, conservative investors have struggled to see a fair return, forcing investors worldwide to seek yield in more risky assets.

Going forward, we remain cautious as growth assets reach higher values. This position is highlighted by AMP Capital who commented, “We recently reduced our exposure to developed market equities, reflecting rich valuations and a likely more volatile period ahead. We are not negative on the outlook for equities, but thought it prudent to take some profit and reduce our exposure to neutral. That leaves our biggest position in the income side of the portfolio as underweight bonds and overweight cash, reflecting the expectations of higher interest rates ahead”.

So on the one hand; we have to be cautious about shares in the developed markets, and the possibility of rising interest rates on the other hand. Therefore, constructing a client portfolio has to take in to account these conflicting scenarios. (I will comment  later on how we may manage this).

In relation to NZ shares, Salt Management has recently concluded “… New Zealand equities continue to be expensive against historical norms. This in itself need not drive a reversal as the nine consecutive monthly advances so far in 2017 would attest. However, the forces driving the market’s surge appear to be running out of steam and record valuations leave New Zealand equities vulnerable to any external shocks. At a company level, high valuations have been validated so long as the company meets or beats expectations, but woe betide the savage reaction upon any miss.”

Therefore, a heavy reliance on fund manager performance is important, in addition to  not over exposing clients to the NZ shares market.

Internationally, we are seeing a shift in performance from the United States to Europe, Japan, and China. While I agree with AMP Capital’s position on emerging markets, in that this sector has possibly run its course, holding positions in other sectors of the market remains compelling. As Mercer research has commented, the main reason the US has performed well since the Global Finance Crisis in 2008 is that “The differential in performance between US and European earnings can be explained by several factors:

  1. US corporations were faster to restructure and cut costs in the wake of the financial crisis;
  2. the US economy has performed better;
  3. European financials were forced to raise substantial capital, diluting shareholders and reducing earnings per share;
  4. US buybacks reduced outstanding equity, increasing earnings per share and;
  5. industry mix — the US has larger weights in sectors with better earnings growth over this period (for example, technology versus financials).

The question is whether the earnings outperformance by the US will persist”. (Mercer)

Furthermore, Mercer comments that “Earnings outside of Europe have been better. Japanese earnings are up 16% from pre-crisis levels, not far behind the US. Earnings for the Pacific region excluding Japan have returned to pre-crisis levels”. Therefore, as the US reaches higher valuations and a possible full pricing position, there are other opportunities still out there. Hence, “investors with patience and a bias toward opportunistic investing could consider underweighting the US in favour of non-US-developed stocks through portfolio shifts or through overlay strategies”. (Mercer)

A worrying trend highlighted by Deutsche Bank is that, “there are more Exchange Tradeable Funds (ETF’s) now in the US than there are real stocks to invest in. This brings back the nasty spectre of the Collateral Debt Obligations of 2008 that caused the Global Financial Crisis” Hence, bond and share positions have to be carefully managed.

So how are we managing these issues? We do not want to be over allocating to shares to seek yield at full valuations, nor do we want to over subscribe to cash to avoid problems in the bond market. In rebalancing client portfolios, we have used a dynamic approach, where the fund manager can manage this risk for us. We have used the AMP Capital Global Multi Asset Fund (GMAF) where appropriate for client portfolios. The GMAF fund  uses, two fund managers (Schroder and AMP Capital), who take dynamic positions that allows them to move between cash and growth assets where market conditions dictate. This is allowing us to hedge our position while taking equal positions between fund mangers that have different investment strategies. For example, we have a short position on bonds and positions on Japan and China over the US. The aim is to minimise risk, while at the same time obtain an acceptable return for clients.

A final comment should be made in regard to ongoing geo-political issues. The obvious issue is North Korea. This issue remains problematic and could cause  instability in the markets,  if this situation escalates. In other words, we remain conscious of geo-political issues, as they remain something we have to be weary of in the background.


My final quote is from Harbour Asset Management. While this quote specifically refers to income generating portfolios, the principle still remains pertinent for all investors: “Similarly, investors seeking income should hold a well diversified range of income generating assets, which may include term deposits, Corporate bonds, high yield securities, loans or loan products, infrastructure, listed property, and dividend yielding equities. These need to be chosen by following a careful investment process, to avoid the danger that they are all highly correlated with each other and act more like risky equities in times of stress. These are the types of principles used in diversified income funds”. (Harbour Asset Management)

In other words, the principles of diversification and holding positions that protect, as well as obtain a return, are not equally correlated, and remain central to protecting client funds. It is becoming increasingly important to have a return of capital over the need for a return on capital as the markets become challenging in the months ahead.