To the clients of Ethical Partners and their advisors:
During September 2019 the Ethical Partners Australian Share Fund returned 2.73% versus the S&P/ASX 300 Accumulation Index of 1.91%, outperforming the market by 0.82% (after fees). Over the last quarter the Fund benefitted from overweight positions in the Industrials and Consumer Discretionary sectors and an underweight position in Materials and Property also benefited relative performance. Key detractors for the last quarter included stocks in the Financials and Consumer Staples industry groups.
September started with a perceived improvement in US-China trade talks, better economic data and new stimulus measures from the ECB which all caused a sharp move up in bond yields. Through the month of September the US 10 year bond yield moved from 1.51% to 1.67% and hitting an intra-month high of 1.91%, despite the Fed lowering rates 25bp, indicating that the market had both overestimated the extent of cuts and underestimated the implications of a possible trade deal. The Fed and other central banks have been dictating lower rates in a period of slow growth but if economic growth or inflation take hold, even in a relatively minor way, or a trade deal is announced it will be the market that informs the Fed where rates ought to be.
Bond yields, or the price of money, had been trading near all-time lows pre September 2019 and this had been the pre-eminent driver of the re-rating of low volatility, growth and highly geared equities. According to Goldman Sachs the year to date consensus trades have been:
• Defensives (Bond Proxies) over cyclicals
• Growth over value
• Large caps over small caps
• Gold over copper
• Low volatility and momentum equities over global equities
• 30 year bonds over equities
• USD over emerging markets
• And we would also include passive over active and leveraged equities over companies with strong balance sheets
These trades, being very crowded were extremely susceptible to an upwards move in the US 10 year bond yield. In the first few weeks of September Goldman Sachs research points to the correlation of consensus trades to the US 10 year yield as being the most negative of any time over the last 19 years. That is, consensus trades such as those above were more (negatively) sensitive to a move in US 10 year yields than any other time since the year 2000. The result was a sharp snap back from growth to value - or from more correlated trades to less correlated positions.
Over the last year with the large economic impact of US-China trade disputes and the market fearing a recession, the market has favoured, almost unanimously, growth stocks and those that exhibit low volatility of earnings in a low growth economic environment. This has been regardless of instances of high debt, poor cash flow and elevated valuation.
The result has been a highly correlated set of trades based on momentum. The stocks involved span a wide variety of companies and industries including large caps, technology, utilities, REITS, infrastructure and healthcare. Inflows into passive equities funds have exacerbated these trends as they buy the largest stocks. When these trades unwind the issue for many global equity indexes is that they are now dominated by these highly sought after companies. CSL Limited for example, at an index weight of 5.8% in the Australian index and trading on 35x forward PE, is now larger than the entire Australian Energy sector at 4.9% weight.
The trade dispute has unquestioningly had a material effect on US-China trade and has been net destructive to global trade volumes and economic growth. According to Macquarie Equities, US goods imports from China are down more than -10% over the year to July 2019 and Chinese imports from the US are down around -25%.Trade has not been substituted from other countries either with US imports from the rest of the world down from annual growth of 10% to 3% and Chinese imports from the rest of world down from 20% growth to a modest fall.
The middle ground between a possible recession and a possible trade dispute resolution has fed the momentum trade and we believe there are good grounds for the market to shift to either one of the other outcomes. On one hand markets are showing signs of interest-rate-cut-fatigue and on the other hand September showed that markets are extremely sensitive to a resolution of the trade dispute. Firstly markets now largely expect interest rate cuts to come (as opposed to at the start of CY 2019) and valuations now reflect this plus if economic conditions were to weaken further and there is a recession it is unlikely that companies with zero operating cash flow will survive and those with high PE’s will likely mean revert. Secondly with the trade dispute already having had a meaningful impact on world growth its’ resolution will see a powerful shift and the move in US 10 year yield in September is indicative of the magnitude of change that is likely to occur. We believe value stocks can outperform in these two scenarios.
While we are aware of the macro effects on markets as detailed above, as a value oriented stock picker Ethical Partners continues to search for exposure to individual companies that have earnings, conservative financial positions and attractive valuations. Currently this means that the Fund may be very differently exposed than consensus trades. Our current exposures are:
Bond Proxies - Underweight
Cyclicals (ex Banks) - Overweight
High Dividend Yield - Approx market weight
Small Cap exposure - Overweight
High debt (<4 Interest cover) - Zero weight (No holdings)
High Valuation (> 35x PE) - Zero weight (No holdings)
The portfolio is positioned differently to the market and also from the predominant trades that have, until August this year, been outperforming. Today the market is expecting more of the same with lower economic growth leading to a happy medium of lower interest rates and higher valuations, sans economic consequence or trade policy shift. This benign state of affairs in our view, is unlikely to end without incident for consensus trades. Our portfolio of stocks continues to produce reasonable income and dividend growth and is made up of securities of companies with more upside than downside.
Nathan Parkin Matt Nacard
Investment Director Chief Executive Officer
