Investment Strategy
Second Quarter 2017
Economic Outlook
The Fed and
interest rates
After the meeting of the Open
Market Committee of the Federal
Reserve on 15 March, the Fed
released its Summary of Economic
Projections. These are the
economic estimates provided by
the Members of the Open Market
Committee, plus all the Fed
presidents, including those who
are not voting at this meeting.
The median level of these
estimates is shown in the table
below.
The Fed thinks that GDP will grow
at 2.1% in 2017. Last December,
they thought the growth rate would
be only 2%. The Fed also thinks
the growth rate will be 2.1% in
2018. This is also up from 2% in
December. They think that growth
will slow in 2019 to 1.9% and in
the longer term real GDP growth
will fall to 1.8% p.a.
Higher growth means lower
unemployment. The Fed thinks
that unemployment will drift down
from 4.7% now to 4.5% at the end
of 2017 then stabilise at 4.5% in
2018 and 2019. In the longer run,
they think it will drift up to 4.7%.
As growth improves, so does
inflation. The Fed thinks that
headline inflation will rise from
1.9% in 2017 to 2.0% in 2018
and over the longer term. The
outlook for core inflation, which
excludes more volatile items,
remains close to the level of
headline inflation. They think that
core inflation will also be 1.9%
in 2017. They believe that core
inflation will accelerate to 2.0%
in 2018. They believe that core
inflation will stabilise at 2.0% in
2019. Interestingly, they provide no
estimate for the longer run.
The reason that growth accelerates
and then slows is because the
Fed is continuing to increase the
Fed funds rate as time goes by.
The Fed thinks there will be three
Fed rate hikes in 2017. They think
there will be a further three Fed
rate hikes in 2018. In 2019 the
Fed sees the Fed funds rate going
up by 90 basis points. This is more
than three rate hikes but not quite
four. By the time this process is
over at the end of 2019, the Fed
funds rate will have achieved the
Fed’s long-term target of 3.0%.
A bridge too near
We think the Fed’s pace of interest
rate tightening is too slow. Its pace
is not a bridge too far, it is a bridge
too near. We think the US economy
will grow faster than the Fed
thinks. We think that investment
in the US economy is recovering
faster than the Fed thinks.
This is at least in part because
of the greater level of business
confidence generated by the
Trump administration. We think
that US GDP will grow by 2.3% in
calendar 2017. We think that US
GDP will grow by 2.6% in 2018.
This means that the actual growth
rate by the end of 2018 will be
0.7% of GDP greater than the Fed
believes. Instead of unemployment
at 4.5%, the Fed could be looking
at unemployment between 4.0%
and 3.8%.
Federal Reserve economic projections – March 2017
Year
2017
2018
2019
Longer Run
GDP
2.1%
2.1%
1.9%
1.8%
Unemployment
4.5%
4.5%
4.5%
4.7%
PCE inflation
1.9%
2.0%
2.0%
2.0%
Core PCE Inflation
1.9%
2.0%
2.0%
–
Fed Funds Rate
1.4%
2.1%
3.0%
3.0%
Sources: Federal Reserve
2 | Investment Strategy – Second Quarter 2017
This very low level of
unemployment has previously
set the limit of growth in the
US economy. At this low level
of unemployment there are no
longer enough qualified people in
the US labour market to support
further growth. The result of
this has previously been a rapid
acceleration of wages growth
and a rapid acceleration of core
inflation.
The result of this faster growth and
lower unemployment (than the Fed
expects), will be that the Fed will
move faster to increase interest
rates. We expect that the Fed will
increase the Fed funds rate every
quarter for the next two and a half
years. We agree that the Fed funds
rate will eventually hit a target
of 3.0% but we think this target
will be reached in mid-2019, not
late-2019.
In its summary of economic
projections released following the
meeting of 15 March, the Fed set
a program for gradual increases
in the Fed funds rate to 3.0%
by the end of 2019. We agree
that the Fed funds rate will get
to 3.0%, however we think these
moves in the Fed funds rate will be
more rapid than the Fed currently
expects.
Outlook for Equity
Markets – S&P500
and S&P/ASX 200
With stronger growth and the
prospect of much better earnings,
it is not surprising that the US
stock market has risen. The
question is has it risen too much?
We model the S&P500 based on
the level of operating earnings per
share and US 10-year bond yields.
The problem is what the model
now tells us. Based on the current
level of earnings per share and
bond yields, our fair value for the
S&P500 in April 2017 is 2,150
points. At the time of writing, the
market is above that at 2,350
points. In the future, earnings will
justify such a level of the S&P500
at a level of bond yields around
where they are now. The problem
is how far in the future it will
be before earnings provide that
justification.
Our model tells us that even
with the much better earnings
expected in the future, fair value
of the S&P500 does not reach a
fair value of 2,338 until the third
quarter of 2018. That means that
the S&P500 is currently trading at
fair value based on earnings that
do not arrive until the third quarter
of 2018.
The outlook for the US economy is
good. The outlook for US earnings
is even better. The US equities
market is now pricing itself very
fully on the prospect of better
earnings in the future. Part of the
reason for that optimism is the
prospect of much lower corporate
tax rates. These tax rates are
guaranteed a noisy passage
through the US Senate. This noisy
passage could give equity markets
a scare.
Right now we think fair value
of the ASX200 as at the end of
2017 should reach 6,070 points,
suggesting that Australian shares
are (similar to US stocks) trading
ahead of fundamentals.
Watch Equity Strategist, Tom Sartor discuss his thoughts on the
Investment Strategy Outlook for Second Quarter, 2017 at
www.morgans.com.au/InvestmentStrategyQ2
US stocks are
trading at fair
value based
on earnings
expectations
for the third
quarter of
2018.
Australian economic forecasts – end of 2017
Morgans Forecasts
Market Consensus
GDP Growth
3.0%
2.5%
Inflation
1.5%
2.1%
RBA Cash rate
1.00%
1.50%
Aussie Dollar
0.75c
0.74c
ASX200 Index
6,070pts
6,000pts
Source: Morgans, Bloomberg
Investment Strategy – Second Quarter 2017 | 3
Asset Allocation
Asset allocation
explained
Morgans approach
explained
Strategic Asset Allocation (SAA)
is the process of allocating funds
between asset classes to optimise
investors’ return objectives and
risk tolerance with long-run capital
market expectations. It is perhaps
the most important, but one of the
most overlooked aspects of wealth
management.
Morgans takes a systematic
approach to SAA. We first
determine where investing
conditions sit within the economic
cycle with respect to the relative
attractiveness of each asset class.
We then apply recommended
longer term benchmark allocations
per asset class. Within portfolios,
actual allocations have scope to
vary by up to 10-15% around
benchmark allocations. These
‘Tactical Tilts’ represent an
investing bias generated by shorter
term drivers. Here we take into
account:
The essence of SAA is
diversification. Spreading
investments across different types
of assets can smooth out higher
and lower return variations that
occur through the economic cycle.
This balances long-term return
and risk objectives.
The asset classes
The four main asset classes are
Equities (shares), Income Assets,
Property and Cash. Within Income
Assets we include Listed Income
Securities (hybrids), Government
Bonds, Corporate Bonds and Term
Deposits. SAA simply provides a
framework for how they should be
integrated within portfolios.
§§ the economic cycle
§§ key forecasts for growth,
interest rates and inflation
§§ risks to these forecasts
Morgans reviews its SAA settings
quarterly in conjunction with
Investment Strategy, thus ensuring
a stable risk profile.
The economic cycle
Inflation rises
OVERHEAT
wth
COMMODITIES
Cyclical
Value
BONDS
Defensive
Growth
CASH
Defensive
Value
REFLATION
Yield curve
steepens
moves belo w trend
STOCKS
Cyclical
Growth
wth
Gro
Yield curve flattens
Gro
mo ves abov e tr end
RECOVERY
STAGFLATION
I n fl a tio n f a ll s
Source: Fidelity, Morgans
4 | Investment Strategy – Second Quarter 2017
The economic cycle
We find it useful to reference
the global economic cycle when
explaining our approach. Fidelity’s
well known ‘Investment Clock’
separates the economic cycle
into four phases based on the
strength of economic growth and
inflation. This illustrates the relative
attractiveness of various asset
classes, which tend to outperform
others at various stages of the
economic cycle. We use this as
a guide only and note that not all
phases of each economic cycle are
the same.
Recommended
asset allocations
and active tilts
Global economic growth and
inflation indicators are showing
signs of improvement. Stronger
economic growth has always
been a positive driver for equity
markets, but rising inflation will
also be challenging for incomeoriented asset classes. Valuations
across most asset classes remain
expensive and are vulnerable to
any unexpected adverse shocks,
especially as investors appear
to be factoring in low levels of
concern about political instability
or Presidents Trump’s ability to
pass his well-publicised campaign
promises. Domestically, there
is still no clear evidence of a
pick-up in economic growth. If
anything, recent data has been on
the weaker side of expectations,
and growth assets (outside of
resources) will need stronger
cyclical conditions to make
meaningful gains.
Despite the inevitability of higher
interest rates from historically low
levels, we still favour a tactical
overweight position in Equities.
However, stock selection should
be honed towards companies
benefiting from an environment of
improving economic activity and
steepening yield curves such as
global cyclical stocks in resources,
industrials and financials.
For the Australian share market,
the deterioration in company
earnings expectations appears
to be slowing on the back of
stabilising commodity prices. The
post-Trump rally has lifted market
sentiment and while valuations
remain extended, we are finally
starting to see evidence of a
positive pickup in earnings growth.
If this trend can be sustained
we can expect some further
acceleration in the index over the
next 6-12 months. However, we
do caution investors to not be
complacent with exposure and
opt for a selective exposure to
Equity markets. We maintain our
tactically overweight allocation to
Equities (4%).
In the context of Trump’s intended
‘business friendly’ policies and
deficit funded fiscal program,
interest rates are likely to be higher
over the next 12 months which
will hurt fixed income returns. The
risk that the improvements in the
US economy will surprise on the
upside may catch the market off
guard if official interest rates move
higher sooner rather than later.
Valuations in property and income
assets remain elevated and we see
risk that support for the yield trade
is likely to fade out in a world of
higher interest rates. We maintain
our underweight exposure to
income assets and property.
We maintain our tactical tilts
as per overleaf to reflect our
preference for Equities (4%) over
Income assets (-6%) and Property
(-4%).
Quick views per asset class
Equities
Company earnings are reasonably stable, however revenue and earnings growth outside of the Resources sector
remains elusive. Sector and stock exposure will be key to returns in 2017 reflecting diverging prospects across the
market. See our Equity Strategy themes and Sectors discussions from Pages 6-11.
Listed Property
Low domestic rates remain supportive however premium valuations and property’s relative appeal as an asset class
will be difficult to sustain in a rising interest rate environment.
Listed Fixed Interest
Appetite for ASX listed securities remains strong helped by high issue margins on offer. We continue to recommend
clients position portfolios with an average term to call of three years.
Government Bonds
The safety of sovereign debt remains in high demand. With 10 year yields below 3%, we prefer term deposits given
the Government guarantee on amounts up to $250k and the lack of capital price volatility.
Global Infrastructure
Appetite for quality yield will not disappear in a hurry given where interest rates are in relation to long-run averages.
The attraction of global defensive infrastructure such as toll roads, airports and utilities remain attractive for income
certainty and stable growth.
Term Deposits
Deposit rates have slowed their decline suggesting that banks are competing hard for deposit funding. Deposits
continue to be an attractive source of risk-adjusted returns.
Cash
Market expectations are for deposit rates to remain at around current levels through 2017. Despite the low return, we
have maintain a higher cash weighting relative to historical levels, to protect against downside risks.
Benchmark long term asset allocations and tactical tilts
Conservative Moderate Balanced
Morgans recommended asset allocations inclusive of tactical tilts
Aggressive
Tactical
Tilts
100%
Assertive
80%
Equities
11%
22%
40%
59%
74%
4%
Property
4%
8%
10%
11%
11%
-4%
Income
Assets
49%
40%
30%
18%
9%
-6%
Cash
36%
30%
20%
12%
6%
6%
Source: Morningstar, Morgans
36%
42%
34%
0%
12%
3%
7%
7%
6%
78%
43%
4%
20%
12%
24%
60%
40%
26%
18%
0%
15%
26%
Conservative
Moderate
Equities
Property
63%
44%
Balanced
Assertive
Income Assets
Aggressive
Cash
Source: Morningstar, Morgans
Investment Strategy – Second Quarter 2017 | 5
Equity Strategy themes
Equity markets remain at the
mercy of abnormal macroeconomic conditions such as
unconventional central bank
interest rate settings and
heightened political uncertainty.
Making bold portfolio decisions
amid such uncertain conditions
is a difficult and potentially
hazardous exercise; hence our
cautious Asset Allocation settings.
Despite these challenges, we think
that enduring investment themes
are worth following in the year
ahead. Our report, 2017 Market
Themes helps to frame our overall
investment and portfolio strategy
and we highlight some of the key
themes below.
A US cyclical
recovery drives
interest rates
upwards
The most important recent event
for equity investors has been the
reversal in bond yields off their
abnormal lows, accelerated by
Trump’s promised US economic
reforms. The transmission
mechanism for higher global
interest rates will result in an
increase in the cost of capital and
lower asset valuations. However
the improving outlook for growth
and inflation should also flow
through into better corporate
earnings, with cyclically sensitive
stocks the key beneficiaries.
Positioning for a
cyclical recovery
The ongoing recovery of cyclical
industrials is likely to be slow,
and interspersed by periods of
investor uncertainty and macro
shocks. Similarly, we expect
interest rate settings to lift slowly
from historically low levels,
providing investors opportunities to
accumulate high yielders that are
oversold in market over-reactions.
We advocate a gradual shift in
portfolio exposure, allocating
slightly less capital to defensive
equities and slightly more to the
cyclicals. This is consistent with
our recent moves in the Morgans
Equity Model Portfolios. Our
focus on quality and conviction
targets stocks which can thrive
independently of the interest rate
environment and/or regardless of
political machinations elsewhere.
Financials a key
beneficiary
The financials sector is arguably
the biggest equity market
beneficiary of rising interest rates.
§§ Banks benefit as a lift in the
yield curve allows them to
charge higher interest rates
on customer loans; meanwhile
the cost of some bank deposit
funding does not really alter
with an upward move in the
yield curve, e.g. transaction
deposits which offer little to no
interest. Banks also hold excess
shareholder capital, as required
by the regulator, which they
invest in fixed interest/liquid
securities providing additional
leverage to rising yields.
§§ Insurers take upfront premium
payments (known as a ‘free
float’) and invest them in bonds
while waiting to see what
payments they must make for
insured claims over the year.
Similar to banks, insurers also
invest excess regulatory capital
in bonds. Higher interest rates
thus benefit their earnings.
§§ Registries (e.g. Computershare)
accumulate float balances
through a variety of activities
like processing and payment
of dividends and trust activity,
which sees them hold a portfolio
of short-dated fixed interest
securities as part of their regular
operations.
Key market themes for 2017
Leveraging the cyclical recovery in US rates
Rising domestic energy prices
Resources cashflow resurgence
Smarter healthcare – the empowered consumer
Diversify internationally
Retail disruption and the Amazon threat
Rise of the Chinese consumer
The push for financial deregulation
Inbound tourism
The digital marketplace
Source: Morgans
6 | Investment Strategy – Second Quarter 2017
Defensives may
underperform, but
solid returns are
still achievable
Defensive equities such as
infrastructure and REITs may
underperform cyclicals in a rising
interest rate environment. This
is due to the resetting of interest
rates on sizable debt loads (albeit
mitigated through staggered debt
maturities, interest rate hedging,
inflation-linked revenues, and
pass-through of interest rates on
regulated assets) and because
their revenues are less sensitive
to an uptick in economic cycles
than cyclical stocks. However, we
still expect these stocks to deliver
solid investment returns over the
medium term and believe they
should be retained within portfolios
given the potential volatility in the
cyclical recovery.
Exposure to a
potential Resources
resurgence?
Commodities are clear
beneficiaries of an improvement in
global growth, and we don’t think
that its too late to gain exposure to
what may potentially prove to be
the next ‘mining cycle’.
We don’t blame investors for
having similarly mixed confidence
in commodities, China and global
growth.
Until early 2016, mining
companies had endured a fiveyear downturn as the onset of new
mining supply drove a correction
in commodity prices. The miners
adapted, often painfully and
largely under new management,
by cutting dividends and growth
while re-focusing on productivity,
cost reduction and cash margins.
Stretched balance sheets were
repaired in protection against a
potential prolonged downturn.
However several factors support
an overweight sector exposure to
Resources:
China steady
China is in robust shape, cycling
GDP growth of 6.5%. With the
mid-term leadership transition
approaching in November, we think
the risk of China’s economy being
allowed to slip in 2017 is low.
Some key commodities then
enjoyed a surprise bounce in
2016 due largely to Chinese policy
decisions (iron ore and coal). The
major miners enjoyed significant
bounces in both earnings and
dividends. With balance sheets
in far better shape, the majors’
rhetoric on capital allocation
very much remains directed at
sustaining higher shareholder
returns (payout ratios, buybacks).
This is pleasing for shareholders,
but also infers poor confidence in
the trajectory of commodity prices,
which should be noted.
Global growth upside
Markets have already shown
their responsiveness to Trump’s
proposed US economic agenda.
A stronger US economy would
support stronger global growth
which is in turn positive for
commodities.
Corporate downside protection
Sector balance sheets are in
strong shape, operating margins
are high and there is no evidence
to suggest that the majors are
about to relax their cost focus.
Investments in the lowest cost
producers offers solid downside
protection should commodity
prices weaken.
Strong investor upside
Traditional investors remain underexposed to commodities in general
as the pain of the ‘bust’ remains
fresh for many. We note that
generalist investors are often late
to any given commodity cycle.
We think that investors can safely
position in our sector favourites
(BHP Billiton, RIO Tinto and Oil
Search) to gain exposure to a
moderate upside scenario for
global growth, without unduly
exposing themselves to company
risk. Our Resources strategy
doesn’t bank, nor rely on 2016
proving to be year one of the next
commodity super-cycles. But if
that occurs, then all the better.
We advocate a
gradual shift
in portfolio
exposure,
allocating
slightly less
capital to
defensives and
slightly more to
cyclicals.
Refer to our report on 2017
Market Themes published
29 March 2017 for more
information.
Australian Equity market yields are likely to remain attractive against current interest rate settings
8%
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
2007
2008
2009
2010
Equity yield premium
2011
2012
2013
ASX200 Div Yield
2014
2015
2016
2017
Australia 10yr Govt Bonds
Source: IRESS, Morgans
Investment Strategy – Second Quarter 2017 | 7
Shares
subdued and we continue to prefer
those stocks exposed to the US
economy.
We highlight detailed Analyst views
on the drivers of the major equity
sectors, their outlook and key
stock preferences.
Companies with defensive qualities
continue to appeal. Orora’s end
markets (food and beverage
packaging) and strong US
presence provides stable earnings
growth with a currency tailwind.
Amcor and Brambles could also
benefit. We rate these businesses
highly and both are leaders in their
respective fields.
Industrials –
backing the US
The market has begun to pivot
away from defensive and high
growth industrials toward cyclically
exposed segments including
commodities. Subsequently, some
services companies exposed to
industrial demand have started to
recover from their cyclical lows.
We advocate some exposure to
cyclical industrials but flag that
stock prices are likely to re-rate
well ahead of earnings. E.g.
ALS limited is a strong second
derivative commodities exposure
which looks expensive now, but
which provides significant front
end cyclical leverage.
Investors need to treat housing
stocks carefully given our view
that we’re close to peak cycle
valuations. Again our favoured
exposure Reliance Worldwide
is US focussed. The company
has a long growth runway as
it penetrates the US plumbing
industry with its market leading
products. Corporate Travel
Management also benefits from a
stronger US economy as the major
source of both organic and growth
via M&A.
Earnings growth for domestically
focused industrials remains
The operating environment
remains tough among industrial
companies. Our preferences
remain with high quality
companies with strong competitive
advantages and defendable
business models.
Healthcare – US
fears pass for now
The healthcare sector has held up
reasonably well, outperforming
the broader market over the past
3 months. However sector
sentiment remains challenging
and valuations are less than
compelling. The 12 month forward
earnings multiple is sitting at
a 20% premium to the 5-year
average.
That said, the US Republicans’
failure to repeal Obamacare
looks to have deferred fears of
aggressive industry transformation
in the US. Trump was looking to
transform the current fee-for-
March Quarter 2017 relative sector performance to date
Healthcare
13.9%
Utilities
9.6%
Consumer Staples
8.8%
Banks
5.8%
Financials
4.9%
ASX200 Index
3.5%
Energy
2.1%
Industrials
2.1%
Consumer Discretionary
1.0%
Resources
0.6%
Small Ordinaries
0.4%
A-REIT
- 1.1%
Telecoms - 7.5%
-10%
-5%
Source: Iress, Morgans
8 | Investment Strategy – Second Quarter 2017
0%
5%
10%
15%
20%
service model into one that
rewards doctors and hospitals for
providing high quality care at a
lower cost. This is a sea change
we continue to believe is vital to
reining in healthcare spending.
We view healthcare providers as
key beneficiaries of this statusquo policy. However, the pricing
of pharmaceuticals is likely to
remain front and centre and the
unravelling of Obamacare isn’t
likely to go away any time soon.
As such, US Biotechnology and
Pharmaceuticals sectors are likely
to remain under pressure, but
the former represents compelling
value at these levels.
On the domestic front, we continue
to maintain our neutral stance
on the healthcare sector and
recommend clients trim any
overweight portfolio positions.
In medical devices we prefer
Resmed over Cochlear and CSL
looks toppy in pharmaceuticals.
Profits may be re-directed into
the hospital providers Ramsay
Healthcare and Healthscope.
Telco – please
call again later
Consumer fixed line
telecommunications is the most
dominant component of the
telecommunications sector and
its outlook is so challenging
that we think investors should
avoid this segment. The National
Broadband Network has changed
the competitive landscape
dramatically and by June 2017
the NBN will account for 30% of
all fixed line internet connections
(home broadband), making future
implications hard to ignore. We
find it hard to be positive about
this space given that the NBN
effectively halves profit margins for
fixed line operators (Telstra, Optus
and TPG Telecom) and that it’s only
just starting to become a material
part of the overall mix.
That said, there are still some
positives worth noting. Telstra will
receive a very large compensation
sectors and maintain Add
recommendations on SpeedCast
and NEXTDC.
package in return for having its
infrastructure removed. However
they still lose nearly 30% of their
EBITDA and are taking aggressive
action to replace these lost
earnings. Overall Telstra should
emerge around 7% worse off,
assuming all goes to plan. On top
of this Telstra gets around A$4bn
in one-offs gains that can be used
to replace earnings via building
out existing earnings streams,
buying more earnings streams
and/or buying back its own shares.
We do expect Telstra will emerge
in a strong position post 2020,
and think that the dividend is
sustainable, but flag that it may be
a rocky ride to get there. History
suggests that sectors undergoing
significant structural changes are
typically best left alone in the early
years.
Banks – looking
fully valued
While the broader market rally
was triggered by hopes of reflation
stemming from Trump’s proposed
US reforms, the rally in the banks
has shown added oomph due also
to hopes of bank deregulation
under Trump.
While there has been much focus
on any changes which may be
made to the repeal of DoddFrank, from an Australian banks
perspective, we are more focused
on whether any changes are
made to the Collins Amendment
provisions of the Dodd-Frank Act,
which effectively set capital floors
for US banks. If these capital floors
are removed or lowered and the
US decides to not sign up to Basel
III reforms, then the chances of
On the positive side we see some
attractive telecommunications
investment opportunities in
the satellite and data centre
Basel III reforms being watered
down or abandoned increase in
our view. Increased speculation
in this outcome has been one
of the factors behind the rally in
Australian banks.
The Federal Reserve’s new head
of banking supervision is still to
be announced and a Bundesbank
board member has suggested that
it may be best to push back the
finalisation of Basel III reforms until
the replacement is announced and
the new head’s position on bank
regulation is understood, providing
more oxygen to hopes of Basel III
reforms being watered down.
Our base case is that Basel III
reforms will proceed and will result
in an ~8% increase in common
equity tier 1 capital requirements
for the Australian major banks
as a whole. However, we are
not forecasting cuts to nominal
dividends for any of the Australian
major banks. The rally in share
prices since the election of Trump
Sector PE multiples: Most sectors are now trading close to their 2 year averages
30
25
25
25
20
15
14
14
13
15
16
17
17
17
18
18
18
19
21
20
19
10
Current Sector PE
2-Yr Avg
e
lin
On
hc
are
ing
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alt
tai
l
Ga
m
Re
&I
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a
nc
Fu
ia
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erv
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s
Ind
us
tria
ls
Tra
ns
po
Ag
rt
,F
oo
d/B
ev
Ho
us
ing
Sta
ple
s
Pa
ck
ag
ing
Se
rvi
ce
s
ks
lco
an
Te
rB
Ma
jo
Me
dia
5
10-Yr Avg
Source: Factset, Morgans
Investment Strategy – Second Quarter 2017 | 9
Shares
has resulted in the sector being
fully valued in our view. Westpac
(WBC) remains our preferred major
bank but investors need to look
offshore to reap the benefits of
financial deregulation (ASX: BNKS).
Diversified financials
– follow the reflation
Difficult weather will impact claims
for SUN and IAG however both
stocks have strong reinsurance
covers which should work to
protect results into FY16 year
end. Suncorp has flagged that it
expects zero costs from Cyclone
Debbie as its aggregate and
catastrophe reinsurance covers
kick in. More positively, both
companies continue to talk to
~3-5% top line rate increases,
which should provide upside into
future years. Nonetheless we think
that all of the general insurers –
Suncorp, QBE Insurance and IAG
– are fully valued at present.
While AMP remains unloved by
the market, we do think it offers
investors good value primarily as
a fund manager trading on ~14
times forward earnings, with its
life business now written down
to only 7% of earnings. We see
a pathway for AMP to re-rate
over the next year as fund flows
rise with improving markets, as a
further potential life reinsurance
transaction is undertaken, and as
the market gains greater comfort
that the worst is behind AMP.
Of the diversified financial
stocks, we continue to prefer
Computershare which offers
macro leverage to rising bond
yields and organic earnings growth
above 10%. purely on cost removal
and recent acquisitions, and before
factoring in macro tailwinds.
Resources and
energy – accumulate
on weakness
Recent coal and iron ore price
spikes have dominated market
attention. The jury is out on how
much residual price strength
can be sustained once current
tightness eases. Regardless,
the price surge has delivered
substantial earnings upgrades and
balance sheet de-gearing in the
meantime.
be a preferred safe haven again.
Remember that gold is often best
bought when no one else thinks
that you need to.
Trump’s US economic reform
agenda has also boosted
expectations for global growth
and inflation which is positive for
commodities, although there are
risks to both the execution and
timing of its potential impact.
It’s important to flag that the
second quarter is traditionally
weaker for commodities and
mining stocks. Therefore we are
accumulators of our favoured
exposures on weakness. Our key
sector picks remain BHP Billiton,
Oil Search, and Evolution Mining.
Despite the uncertainties
around China and Trump we are
comfortable that the worst of the
commodities cycle is behind us.
We see scope for a cooling off in
price among the bulks (iron ore
and coal) but see prospects for
further increases in oil and base
metals (copper, zinc and nickel)
over the course of 2017.
Rising interest rates on other
forms of safe haven investments
(like bonds) is a headwind for
gold and the short term outlook is
uncertain. However if inflationary
forces do pick up momentum, or
if Trump’s promises are replaced
by stumbles, then gold is likely to
ASX200 Industrials aggregate metrics: Share price growth has moved well ahead of profit growth
700
10000
650
9000
600
8000
550
7000
500
6000
450
5000
400
350
Jan-08
Jan-09
Source: Bloomberg, Morgans
Jan-10
Jan-11
Jan-12
Jan-13
Earnings per share
10 | Investment Strategy – Second Quarter 2017
Jan-14
Jan-15
Share prices
Jan-16
Jan-17
4000
Consumer staples &
retail – tough, with
pockets of strength
Retailers are faced with more
difficult trading conditions than
they did in 2016, although
pockets of strength are evident.
Unseasonable weather throughout
has elevated inventory positions,
particularly in the apparel and
department stores. This has
increased clearance activity and
dented gross profit margins in
general. The February reporting
season revealed a real divergence
between retail categories with
traditional shopping centre
retailers underperforming, while
niche retailers showed more
resilience in both revenues and
margins. We continue to watch
the housing market for any signs
of distress (given its importance
as a retail driver) but expect solid
conditions to persist, supported
by historically low interest rates.
such as Amazon Fresh and
Kaufland are also speculated to
be entering the Australian market
over the next 1-2 years.
Online media &
IT sector – In a
position of strength
With growth from the grocery
channel now harder to come by
and structural issues at play, we
are cautious on both Woolworths
and Wesfarmers at current levels.
The retail sector has de-rated
more recently on fears around
Amazon’s potential entry into
Australia. It would be naive
to discount this risk, however
we are also yet to see any
investment in a domestic
distribution. All we can say is
that Amazon are coming, and the
key categories at risk of market
share losses include electronics,
sporting goods/equipment,
homewares, clothing and toys.
Infrastructure –
interest rates and
power prices
Profit growth in the online
media and technology sectors
has slowed since the heady
days of a decade ago when
30-40% growth was considered
unremarkable. But while the
online sector is slowing relative
to industrials, its rate of growth is
still exceptional.
We maintain a cautious view
on the consumer discretionary
sector overall given indications of
a peaking in spending conditions
and increasing threats from
offshore.
Intense competition in the
domestic supermarkets
continues as Woolworths reinvests in cheaper prices and
improved service. After trailing
Coles in like-for-like sales growth
for 29 consecutive quarters, this
investment earned Woolworths
its first outperformance against
its main rival in the latest quarter.
Coles has already brought
forward price investment to
try and combat Woolworths’
turnaround.
International discount players
such as Aldi and Costco continue
to expand. Aldi is a lot more
aggressive with its national
rollout while Costco prefers to
open only a handful of stores a
year. Other international players
The February reporting season
did not unearth any major issues
that would threaten distribution
sustainability for the core
infrastructure stocks. Interest
costs continue to decline while
distributions were sustained or
lifted.
Increasing government bond
rates are generally viewed as a
headwind to infrastructure sector
outperformance. We think this
has less to do with interest rate
rises, given it affects all asset
classes and actual interest costs
for infrastructure stocks are
likely to continue to fall. Instead,
it is due to the lower sensitivity
of infrastructure earnings to an
economic uptick that normally
accompanies interest rate rises
than is seen with cyclical stocks.
Note our valuations assume risk
free rates about 100 bps above
current bond rates.
The power market has been
making headlines, with the
level and volatility of wholesale
prices rising rapidly. This has
been caused by a number
of factors, including thermal
plant retirement, penetration
of renewables, increasing gas
prices, and weather events.
Prices for renewable certificates
have also risen strongly. Key
beneficiaries are AGL Energy and
Infigen Energy.
Morgans keeps a database of
23 global online media and
marketplace companies and
market expectations for revenues
and earnings for the next three
years. This sector is expected to
grow cash operating earnings by
33.4% through to 2019.
The reasons are threefold:
1) transactions and advertising
that were conducted in traditional
ways are still migrating to online
platforms; 2) online platforms
have higher levels of operating
leverage than traditional media
companies as operating costs
tend not to increase as fast as
revenues due to higher fixed
costs; and 3) many online
platforms develop semimonopoly positions where they
have the ability to raise prices.
marketplace leaders cannot
preserve their position through
constant innovation and heavy
investment in new products
and better customer service.
There are plenty of examples
of technology marketplace
companies overseas that grew
fat and lazy and were eventually
superseded or acquired for a
fraction of their former value.
But currently we do not see any
Australian candidates for that
fate.
Sometimes ‘old technology’
companies can gain a new lease
on life if they are prepared to
re-invent themselves. In outdoor
advertising APN Outdoor
is investing aggressively in
converting old-style static
billboards into digital signs,
which can generate up to
five times the revenue of a
static billboard. Digitising the
analogue world was never on the
traditional tech investor’s playlist,
but money chases eyeballs in the
advertising business, and APO
has hit on a way to deliver a lot
more eyeballs.
Of course, all booms must
end. Companies that were the
industry disrupters of a decade
or two ago can sometimes be
disrupted themselves by new and
innovative challengers. But in the
here and now the biggest players
in online marketplaces, and that
includes REA Group, SEEK and
Carsales in Australia, are doing
a good job of making sure that
challengers have to fight every
inch of the way.
We see no reason why
the current generation of
Investment Strategy – Second Quarter 2017 | 11
International
The importance
of international
diversification
exposes investors to suboptimal
diversification, risk mitigation and
returns over the short-to-medium
term.
The Australian economy is facing
challenging headwinds that have
the potential to drag on growth
over the medium term. The
unwieldy political environment is
set to prolong a period of policy
inaction, clouding the economic
recovery. Couple this with the
unwinding of the decade-long
mining construction boom and it’s
likely GDP growth will be stuck in a
sub-trend profile for some time.
The key reason why international
diversification permits an increase
in returns and/or a reduction of
risk is because share markets do
not move together. This is due to:
While pockets of the economy do
show genuine signs of growth,
we think that having a basket
limited to the Australian market
§§ different market compositions;
§§ the lack of synchronisation of
political and economic cycles;
§§ different institutional structures;
and
§§ different levels of market
development
Diversification
The Australian market is financials
and resources heavy, with these
sectors representing almost twothirds of total market capitalisation.
Moreover, SMSF portfolios tend
to be heavily concentrated in
Australian shares and cash/term
deposits (A$160bn, 26%), with the
two asset classes making up 58%
of SMSF portfolios. Home bias is
an obvious concern, with direct
equities investments 98% skewed
towards domestic stocks. We think
this lack of diversification within
the Australian equity market poses
a risk to domestic investors.
Taking the above into consideration,
Morgans’ approach to international
strategy involves:
Advancement
We look for leverage in markets
that provide superior earnings
growth. Current profit growth in
the domestic market is forecast
by Bloomberg at 14% in FY17 and
7% in FY18 driven by a turnaround
in resources. On a relative basis
Australia looks to be a laggard
across global markets.
Demographics
Demographics is one of the few
social sciences where projections
can be made with a high level of
certainty. If we fast forward
10 years we can estimate the size
of the working-age population
of most countries (excluding
catastrophic events) with far more
confidence than predicting the
GDP growth rate over the same
period.
Morgans’ key international themes
Technology revolution and digital disruption
Developing demographics
Rise of the middle class
Digital disruption now has the potential to
overturn incumbents and reshape markets
faster than perhaps any force in history. Simply
put, digital disruption is the effect of digital
technologies on a company’s current value
proposition, and its resulting market position.
The difference between digital disruption and
traditional competitive dynamics comes down
to two main factors: the velocity of change
and the high stakes involved. Digital disruptors
innovate rapidly, and then use their innovations
to gain market share and scale far faster than
challengers clinging to predominantly physical
business models. Few sectors are immune.
Huge opportunities are being won by first
movers into disruptive technologies, online
and ‘e-commerce’ penetrating into traditional
financial services, retail, advertising and
employment markets.
Several developed and emerging nations face
demographic challenges as the post WWII
baby-boomers grow old. It is the combination
of fertility and longevity over the 70s & 80s
that pushed the proportion of working age
relative to the dependant much higher and
created the ‘sweet spot’ for productivity and
growth. What we’re seeing now is an inflection
point. World population growth is expected to
fall from 1.25% now and decline to 0.75% per
annum by 2040, according to the UN. As the
aging process ramps up, so will the demand for
medical services. Health expenditures continue
to rise and, given the sharply increasing
proportions of the elderly, can be expected
to go on rising into the future. The inevitable
structural change will give rise to demand for
medical and financial services and healthcare
products.
In Asia alone, 525 million people already rank
in the middle class, more than total population
of the EU. Over the next two decades, the
middle class is expected to expand by 3 billion.
China’s population growth rate is quite slow.
However, with nearly 1.4 billion people already,
even half a percent of growth adds 7 million
people – roughly the size of the population of
NSW. The end of China’s one-child policy could
possibly accelerate population growth. Official
statistics show China’s urban population
expanding by 18 million–19 million people per
year – closer to the population of the state of
New York. Global luxury brands and franchises
are best placed to capture this opportunity. In
China alone consumers account for 30% of
global luxury goods purchases.
Investment Ideas:
§§ Disruptors with proven revenue models
§§ Online mobile businesses (M-commerce)
§§ Cloud providers
Investment Ideas:
§§ Financial services
§§ Healthcare providers
§§ Aged-care operators
Investment Ideas:
§§ Middle-upper class global franchises
§§ Financial services
§§ Online retailing and M-commerce
12 | Investment Strategy – Second Quarter 2017
Property
Year to date the property
sector has underperformed the
broader market with the recent
reporting season largely in line
with expectations. We expect
outperformance will be harder
this year given increasing bond
rates are a headwind.
We expect cap rates will
moderate implying that NTA
levels may have peaked in
2017. The sector is currently
trading at a premium to NTA
of around 10%. There is still
strong international demand for
Australian real estate assets
given the relative yield on
offer which is likely to provide
some stability despite bond
yields looking likely to trend
up. As a result, direct property
acquisitions remain challenging
given current pricing which
may lead to an increase in
M&A activity (Investa Office
Fund, Charter Hall Retail may
be potential targets) and further
buy-backs.
While balance sheets remain
sound with gearing levels
averaging around 30% for most
groups, we expect groups with
higher gearing levels to look
at undertaking non-core asset
sales to reduce debt levels.
Lower interest costs have been
a tailwind for earnings and while
a majority of interest rate costs
are largely hedged, we note that
interest rates are expected to
increase in the near to medium
term.
Our preferred yield plays include:
Viva Energy REIT with
distributions underpinned by
fixed 3% rental increases until
2025. Viva Energy REIT owns a
portfolio of 425 service stations
valued at A$2.1 billion.
Cromwell Property Group has
an attractive 9% distribution
paid quarterly. While there are
near term challenges on leasing,
we expect an outcome on its
IOF stake could be a potential
positive catalyst near term as this
would reduce gearing levels.
Aventus Retail Property Fund
offers a yield of 7%, with good
organic growth available within
the existing portfolio, as well
as opportunities in a highly
fragmented market. While retail
sales have been slower across
the traditional retail REITs, we
think AVN’s exposure to large
format retail is a differentiator.
For diversified exposure at the
large end we like Stockland
Group.
Property REITs – FY17 forecast distribution yields
9%
8%
7%
6%
5%
4%
3%
2%
GMG WFD IOF GHC LEP DXS MGR GPT SCG FET CHC ABP SGP ARF VVR SCP VCX BWP CQR AJD NSR GOZ IDR TOF CMA HPI TIX CMW
Source: Factset, Morgans
Investment Strategy – Second Quarter 2017 | 13
Income
Fixed Interest
The volatility in government bonds
has continued throughout the
first quarter of 2017 with 10 year
Australian Government yields
hitting a high of 2.98% and then
falling to close the quarter out
at 2.69%. These levels are still
substantially above those seen six
months ago when the yield was
1.90%. We continue to view term
deposits as an attractive alternative
to government bonds for retail
investors given the guarantee on
deposits up to $250,000. Rates
remain competitive with three year
deposits up to 3.05% currently on
offer.
We had expected to see new
issuance come to market and
the year has got off to a strong
start with The Commonwealth
Bank, Challenger, Suncorp and
Villa World all launching ASX
listed offerings. CBA raised $1.6
billion via the issuance of a new
PERLS offering. The security pays
investors gross distributions based
on a rate of 3.90% above the
90 day bank bill swap rate and
has a term to call of five years.
Challenger issued a new capital
note while Suncorp also issued
a capital note with a margin of
4.10% and a term to call of five
years. We have been wanting to
see more vanilla senior bonds
list on the ASX and we recently
got that wish with Villa World
announcing a security with a five
year maturity date. The security
pays cumulative, non-discretionary
coupons based on a rate of 4.75%
above the 90 day bank bill swap
rate which we view as attractive
for investors.
Further new issuance is expected
over the year ahead both from
financial issuers and corporates.
Our current preferred buys are
ANZHA, CWNHA, GMPPA, IANG,
MQGPA, NABPE and WBCPF.
Australian Government bond yields versus the RBA cash rate
7%
6%
5%
4%
3%
2%
1%
0%
Jan-10
Jan-11
Cash rate
Jan-12
Jan-13
Jan-14
10-Year Government Bonds
Source: IRESS, Morgans
14 | Investment Strategy – Second Quarter 2017
Jan-15
Jan-16
3-Year Government Bonds
Jan-17
We expect
another big
year of fixed
interest
security
issuance
in 2017.
Best Ideas
Investment Strategy has stepped
through our top-down macroeconomic views (Pages 2-3)
and how these shape our Asset
Allocation settings inclusive of
Tactical Tilts (Pages 4-5). We have
detailed our current views on each
of the Equities, Property and Fixed
Income asset classes, including a
closer look at the outlook for each
of the Equity sub-sectors and our
preferred stocks in each sector.
Below we summarise our best
current ideas which are updated
via our monthly publications.
The Morgans Research team
maintains High Conviction Stock
lists detailing our best large cap
and small cap Buy ideas over a
12-month timeframe. We also
maintain an Active Opportunities
stock list which highlights higher
conviction trading ideas over
a shorter timeframe, usually
supported by a tangible catalyst.
These lists have consistently
generated positive returns since
inception on 2012.
View our latest monthly
High Conviction Stock list
online and verify our performance.
The Morgans Investment
Committee actively manages a
series of Model Portfolios for use
as guides for various investing
styles across the Equity, Listed
Property and Fixed Interest asset
classes. Investors may use these
Portfolios individually or within
the Morgans Asset Allocation
framework. We are pleased
to report that all three equity
portfolios (Income, Balanced and
Growth) have outperformed the
market over the medium term.
View our latest monthly
Model Portfolio Report online.
We encourage clients to
contact their adviser or visit
www.morgans.com.au
for more details.
Equities: Preferred stocks by sector
Property: Preferred AREITs
Banks
Westpac
AREIT’s
Financials
Computershare, Challenger
Industrials
Orora, Corporate Travel, ALS Limited
Fixed Interest: Preferred securities
Healthcare
Resmed, Ramsay Health Care
Hybrid Securities
Telecommunications
Speedcast, NextDC
Resources
BHP Billiton, Oil Search, Evolution Mining
High Conviction large caps
Consumer Staples
Wesfarmers
Resmed, Orora, Oil Search, Macquarie Atlas Roads
Consumer Discretionary
Bapcor, Beacon, Star Entertainment
Food & Agriculture
Inghams, MG Unit Trust
High Conviction mid-small caps
Infrastructure
Macquarie Atlas Roads
Speedcast, Beacon Lighting, Bapcor
Online services
APN Outdoor
Source: Morgans
Centuria Industrial REIT, Aventus
CBAPD, CWNHA, IANG, NABPE, WBCPC
Investment Strategy – Second Quarter 2017 | 15
DISCLAIMER The information contained in this report is provided to you by Morgans Financial
Limited as general advice only, and is made without consideration of an individual’s relevant
personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies
corporate, directors and officers, employees, authorised representatives and agents (‘Morgans’)
do not accept any liability for any loss or damage arising from or in connection with any action
taken or not taken on the basis of information contained in this report, or for any errors or
omissions contained within. It is recommended that any persons who wish to act upon this
report consult with their Morgans investment adviser before doing so. Those acting upon such
information without advice do so entirely at their own risk.
This report was prepared as private communication to clients of Morgans and is not intended for
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be reproduced in whole or in part without the prior written consent of Morgans. While this report
is based on information from sources which Morgans believes are reliable, its accuracy and
completeness cannot be guaranteed. Any opinions expressed reflect Morgans judgement at this
date and are subject to change. Morgans is under no obligation to provide revised assessments
in the event of changed circumstances. This report does not constitute an offer or invitation
to purchase any securities and should not be relied upon in connection with any contract or
commitment whatsoever
REGULATORY DISCLOSURES CTD: Morgans Corporate Limited was Lead Manager and
Underwriter to the rights issue for Corporate Travel Management Limited and received fees in
that regard. WBC: Morgans Corporate Limited was a joint lead manager to the public offer of
subordinated debt securities by Westpac in June 2016 and received fees in that regard.
CGF: Morgans Corporate Limited is a participating broker to the public offer of subordinated debt
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Limited was a Co-Lead Manager to the prospectus offer by Inghams Enterprises and received
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RECOMMENDED STRUCTURE For a full explanation of the recommendation structure, refer to
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DISCLOSURE OF INTEREST Morgans may from time to time hold an interest in any security
referred to in this report and may, as principal or agent, sell such interests. Morgans may
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