Turning to the second half

How will equities perform in the second half of the year? Harbour Asset Management discusses the prospects in this month's commentary.

Tuesday, July 15th 2014, 6:30AM

by Harbour Asset Management

Fund performance was disappointing over the month and quarter as the rally in bonds led markets to focus on yield and value rather than growth.

Investment managers have been concerned with global deflation risks in recent months. Bonds rallied and bond sensitive equities have performed very strongly. This implies the economic cycle is dead or that risk is non-existent – both dangerous assumptions to make. Looking into the second half of 2014 we expect this trend to wane with investors increasing exposure to more cyclical sectors as global growth and inflation expectations continue to firm.

Growth equities have under-performed, locally and globally over the last quarter. This has been somewhat surprising with growth indicators improving and if anything inflation data has picked up in many countries. For instance in the US, UK and China inflation measures are creeping up. Policy makers seem okay with this. Astonishingly the IMF has just published a paper saying that inflation at 4% should be seen as a long run target, which would clearly make our Reserve Bank very uncomfortable. However, markets don’t seem to believe this will happen with inflation index bonds showing no real inflation shock priced-in. This is worth watching carefully as the range of higher surprises on inflation data rises. For instance the CRB commodity index is up significantly (led by oil, food and more recently metals), the US Philly Fed prices paid index had a marked jump, the US headline rate was higher than expected, and hourly earnings are also accelerating.

Closer to home, in NZ, housing sector inflation continues to lead the indicators, but a stronger exchange rate is quelling other pressures for now. As illustrated in Figure 1 global equities tend to outperform treasury bonds during periods where US inflation is increasing.

Figure 1. US Inflation moves support equities over bonds

Source: Absolute Strategy Research

However, if policy makers are more inflation tolerant, it opens the door for yet further equity out-performance over bonds. Some have likened this to an extension of the golden weather experienced in the 1950s and 1960s. This optimism comes on the back of a five year bull run in equity markets that many seem to have missed. With the benefit of hindsight, the 1950s and 1960s were also characterised by large technology and business management productivity gains. To fully replicate the growth and profits experienced in that era, companies now need to accelerate their adoption of technology to overcome the negative drag of demographic effects.

If as we think global interest rate expectations creep up in the second half of 2014, history suggests that more cyclical markets ought to provide better returns. Indeed Australia and Canada were two of the top performing markets in previous periods of rising interest rates as illustrated in figure 2. Moreover at a sector level capital heavy industrials, basic resources and oil and gas industries out-performed Telcos and Retail sectors, also illustrated in figure 3.

Figure 2. Market relative Correlation with 12 month change in US Inflation

Source: Absolute Strategy Research for the period 1996-2014

Figure 3. Sector relative Correlation with 12 month change in US Inflation

Source: Absolute Strategy Research for the period 1996-2014

The global thirst for defensive yield/safety is resulting in some valuation extremes. For example as illustrated in Figure 4 the S&P300 Resources forward dividend yield is currently equivalent to the Australian 10 Year Government Bond yield. Yes Chinese growth is slowing and bulk commodity prices have been volatile over the last few months but this yield equivalency between resources and bonds is an unusual occurrence – as shown in Figure 4 it has only happened three times in the last decade including the GFC.

Figure 4. Yield from Resource stocks equivalent to 10 Year Bond yield

Source: Harbour and Bloomberg

Australian resource stocks are being priced cheaply relative to defensive stocks, relative to their underlying asset values and relative to the improved corporate governance being exhibited by some of the large Australian miners. We sense that just a little better data, macro or stock specific, may support a closure of the valuation disparity between Australian resource stocks and defensive stocks.

In New Zealand, the past quarter has seen a rather dramatic out-performance of income over growth equities, with Telecom, property securities, and utilities driving the performance of the New Zealand benchmark index.

Andrew Bascand, Craig Stent and Shane Solly

IMPORTANT NOTICE AND DISCLAIMER
The Australasian Equities Commentary is provided for general information purposes only. The information is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of publication and are subject to change without notice. To the extent that any such information, analysis, opinions or views constitute advice, they do not take into account any person’s particular financial situation or goals and, accordingly, do not constitute personalised advice under the Financial Advisers Act 2008, nor do they constitute advice of a legal, tax, accounting or other nature to any persons. Investment in funds managed by Harbour Asset Management Limited can only be made using the Investment Statement, which should be read carefully before an investment decision is made. The price, value and income derived from investments may fluctuate in that values can go down as well as up and investors may get back less than originally invested. Where an investment is denominated in a foreign currency, changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Reference to taxation or the impact of taxation does not constitute tax advice. The rules on and bases of taxation can change. The value of any tax reliefs will depend on your circumstances. You should consult your tax adviser in order to understand the impact of investment decisions on your tax position. No person guarantees repayment of any capital or payment of any returns on capital invested in the funds. Actual performance will be affected by fund charges. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this presentation or its contents.

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