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Equity allocations – time to move abroad?

In this article we look at the rationale and drivers for moving further away from the large allocation to Australian equities relative to global equities on a medium-term view.

25th September 2018 / 10 mins read
Jeremy Wilmot
Head of Advisory Consulting
Matthew Griffith
Head of Portfolio Construction & Risk
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Background

Historically, Australian institutional investors have had a large bias towards Australian Equities within their overall listed equity exposure. However, over more recent years this bias has reduced in favour of greater exposure to global equities. This Note looks at the rationale and drivers for moving further away from the large allocation to Australian equities relative to global equities on a medium-term view (say 7 years).

Historical Rationale

There are a number of reasons for the historical bias towards Australian equities, including:

  • Economic / policy factors driving strong performance for Australian equities over the very long term. Historically this has been driven by a range of factors including relatively peaceful society, common law and property ownership rights, stable “rule of law”, gold, wool, agriculture, economic reforms of the 1980s (financial services), commodities and demographics (favourable population/migration).
  • Ease of access – In the 1980s and 1990s it was less common for investors to have significant exposures to global equities and as such, there was less infrastructure / product choices available to access global equities. As global investment management firms have recognized the size and growing retirement savings pool in Australia this has changed dramatically in the past two decades.
  • Strong dividend yield – In more recent decades the Australian stocks have provided a higher dividend yield relative to global stocks.
  • Familiarity – Allocating based on familiarity and the perceived “comfort” that this provides e.g. Australian stocks covered in the media (Big 4 Banks, BHP, Woolworths & Coles, Telstra) and visibility of large Australian corporates.
  • Tax benefits – Dividend imputation was introduced in 1987 whereby Australian tax payers get the benefit of company tax already paid, as well as a favourable capital gains tax treatment. This made Australian equities more attractive to Australian investors from a tax perspective (to the extent the tax benefit is not priced into markets).
  • Linkages to the growth economies of Asia – The resource stocks have a direct benefit from the growth in global trade which has enable countries like China to have stronger economic growth than other parts of the globe.

 

Historical Equity Risk Premium

The chart below shows the long-term real equity risk premium for a range of countries/regions.

Image 1

 

The table shows that Australian equities have produced a high equity risk premium relative to the rest of the major developed markets.

Historical Return Experience

Over the very long term (since 1900), Australian equities has been one of the strongest performing equity markets globally as shown in the table below (in local currency).

Image 1

 

The chart below, shows the long term historical performance of Australian equities relative to global equities since 1969 (in local currency terms).

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As can be seen from the charts above, Australian equities have outperformed global equities by 1% p.a. over the past 50 years. However, it is important to note that the global return does not include the benefit of currency hedging.

Due to Australia tending to have structurally higher interest rates than most other developed economies which leads to positive carry from hedging (i.e. additional return pickup), this is understating the return of MSCI World series in the chart, which would likely be higher than Australian equities otherwise. For example, based on the longest hedged time series we have available, over the past 20 years, hedged global equites has outperformed local currency global equities by 1.2% p.a.

The table below shows performance by decade in local currency terms.

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Since the 1970’s, Australian equity investors have not been consistently rewarded for their home country bias, rather they were rewarded over just one period (from 2000-2009) before consideration of the effects of hedging. This one period corresponded with the mining boom driven by China’s entry into the WTO and the rapid urbanisation this brought about. The chart below shows the strong growth in China’s Urban Fixed Asset Investment from 2000 that also corresponded with a strong decade of performance for Australian equities.

Image 4

 

With Chinese urbanisation came demand for iron ore and coal, materials of which Australia has in abundance. This was reflected in strong share price gains for Australian Resource companies. Over the 10 years to the end 2009, the S&P/ASX 300 Resources Index returned 17.7% p.a. compared to the S&P/ASX 300 Industrials Index which returned 6.9% p.a.

In addition to the benefits of China industrialising flowing through to Australian equity returns, there are potentially some other factors which have also likely benefited overall returns, although they are harder to quantify, including:

  • Structural economic reforms in the 1980s setting a platform for growth thereafter.
  • Demand side forces attributable to the growth in the pool of investment capital within Australia looking for market exposure due to the growth in superannuation. The pool of superannuation in Australia has grown from $300B in 1997 to $2.6T today.
  • Oligopoly-like market structures in several sectors that arguably allowed successful domestic companies to create barriers to entry and leverage their market position to generate higher than normal returns. Sectors where this is potentially evident including banking (Big 4), non-discretionary retailing (Woolworths and Coles) and Telecommunications (Telstra).
  • Population growth exceeding forecast, mostly attributable to migration.

 

Looking Forward

Economic Perspective

Global Economic Growth Outlook

The global economy is growing above its post-GFC trend as growth in the advanced economies has progressively gathered momentum, and with growth in emerging economies remaining solid or improving. Growth continues to be supported by historically low interest rates, rising employment and confidence levels and more recently, a pick-up in business investment. Whilst inflation remains below central bank targets across most developed economies, there are nascent signs that price pressures may be picking up.

Image 5Image 6

 

The outlook is promising. Business surveys for all major developed economies indicate optimism in both the manufacturing and services sectors and point to continued solid expansion in overall economic growth. GDP growth now exceeds long-term potential growth in many economies and will place further pressure on capacity as output gaps continue to close. Inflation is expected to grind higher through 2018. Central banks will gradually tighten monetary policy, with the US Federal Reserve continuing to lead the way on the interest rates front.

The threat of trade tensions has escalated with President Trump’s recent announcement of steel and aluminium tariffs. This represents a key near-term risk to market sentiment and an intermediate term risk to global growth given the likelihood of retaliatory measures from targeted countries.

JANA Conclusion: Strong outlook, but some tightening of monetary policy presents some short term risks.

Australian Economic Growth Outlook

In contrast to the general global uptrend, Australia’s annual rate of growth slowed to 2.4% in the December quarter, although temporary factors including slower net export growth and softer business investment (engineering construction) appear to explain the softness. Business sentiment remains upbeat in contrast to consumer sentiment which remains subdued. This appears to be partly a function of low wages growth, notwithstanding strong employment growth and unemployment of 5.4%, its lowest in 3½ years. A rebound in household consumption supported by employment growth contributed positively to growth, but the combination of high debt levels, low household savings rates and signs of house price weakness poses risks to sentiment and future spending.

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Monetary policy looks likely to remain unchanged for the foreseeable future. The RBA maintains some optimism on growth prospects with March’s statement by the RBA Governor noted that their “central forecast is for the Australian economy to grow faster in 2018 than it did in 2017. Business conditions are positive and non-mining business investment is increasing. Higher levels of public infrastructure investment are also supporting the economy.” Accordingly, the RBA cash rate is widely expected to remain on hold at 1.5 % over coming months.

If we accept the mining boom is behind us and China’s appetite for raw materials will continue to slow as they move further along the urbanisation path and transition a more consumption focused economic model, then this suggests Australia’s favourable terms of trade position (as shown in the following chart on the left) has the potential to weaken further. The question then becomes “what will drive Australia’s future economic growth?”.

Following the mining boom, the Australian economy benefitted from residential housing construction upswing (see chart below on the right), and this has transitioned into an infrastructure investment cycle.

Image 9Image 10

 

Looking forward, the growth drivers for Australia are likely to continue to be closely linked to the growth in the Asian middle class perhaps through tourism, education, agriculture, etc.

JANA Conclusion: Combination of high debt levels, low household savings rates and signs of house price weakness present some risks/headwinds.

Market Composition

The table below outlines the key sector attributes of both the ASX 300 and MSCI AC World Index.

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Unsurprisingly, the global opportunity set is much larger and also much more diverse. The Australian equity market is dominated by Financials and Materials. This is primarily at the expense of IT and Consumer Discretionary relative to the global markets. The charts below show the market/index composition of the Australian and global index through time.

Image 12Image 13

 

The chart above shows the relative diversity of global equities has been consistent over time, as has the concentrated nature of the Australian market. Another way to look at Australia’s equity market concentration is to consider the aggregate weight of the largest holdings in the index. As the chart below shows, the top 10 stocks in the Australian market have consistently made up 40-50% of the market. This compares to 10% for global equities.

Image 14


While Australia’s economic growth has historically been higher than most other developed economies and may well be in the future at different times, there are also likely to be a large number of economies that consistently grow faster than Australia, particularly in emerging markets. Having revenue exposure to this growth is likely to be a key driver of equity performance going forward. The following charts shows revenue exposure by geography. Once again, the diversity in global equities is clear. This suggests one is not as reliant on one economy/market to drive returns in global equities (although the US is still a large component).

ASX 300

Image 15Image 16

MSCI AC World Index

Image 17Image 18

 

As the analysis above suggests, the Australian equity market is quite narrow and concentrated. However, the analysis also shows that this is not a new phenomenon. So why should investors be more cautious now?

As outlined earlier, the outlook for commodities, particularly those that are closely linked to Australia’s economic prosperity and equity market, being iron ore and coal, is not as strong as it was 15 years ago. China is slowing and its growth profile is changing. Commodity prices are still above their long run levels. The other exposure in the Australian equity market is financials, primarily the Big 4 Banks. They have benefited hugely from deregulation, falling interest rates over the past 30 years, and Australian housing investment.

However, there are potential headwinds to bank earnings. As the chart below on the left shows, Australian banks have out earned their global peers through time. With Australian banks highly levered to the Australian household sector through residential mortgages (c.60% of loan books) and household debt in Australia at record highs (chart below on the right), and among the highest in the world, it is difficult to see how Australian Big 4 Banks can maintain their historic growth profiles in the absence of significant cost cutting to maintain earnings/margins.

Image 19Image 20

 

Additionally, the current Financial Services Royal Commission may further crimp growth if it results in tighter lending requirements. Of course, the Big 4 Banks do still currently operate in an oligopolistic environment which is a positive.

JANA Conclusion: Global markets provide more diversification than the Australian market, which is dominated by Financials which face headwinds from high household debt, low savings and high house prices.

Other factors

There are other areas that should be considered including:

  • Cost – Australian equities have historically been cheaper from a funds management perspective. Any large reallocation from Australian to global equities will have the potential to impact on overall diversified option fees.
  • Alpha – Australian equity managers seem to have generated outperformance within the Australian equity market to a greater degree relative to global equities’ managers based on JANA’s experience from our client portfolios. Based on eVestment data, the median long only Australian equity manager has delivered 1.87% p.a. outperformance (gross of fees) over the past 10 years. This compares to 0.97% p.a. in global equities. If you assume higher fees in global, the level of outperformance in Australia is probably close to double that of global equities.
  • Franking Credits – for a taxed investor, franking credits are attractive and are an additional return source to the extent are not priced into markets.
  • Population growth – according to Treasury (from the Australian Intergenerational Report in 2010), Australia population growth will slow from 2.1 per cent in 2008–09 to 0.9 per cent in 2049–50. But, it is important note that Australian has overshot growth forecasts. The 2013 Australian Bureau of Statistics forecast of 24.9 million people by 2051 will be reached in the next few years, 33 years early! The biggest growth factor that has blown out previous population modelling has been due to Australia's net overseas migration. As the chart below shows, Australia’s rate of net overseas migration is well above longer term averages.

 

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While this does have some negative implications (i.e. infrastructure congestion, downward pressure on wages, housing affordability, etc), it is positive for many Australian corporates who benefit, such as non-discretionary retailers, health care providers, telecommunications companies, from the overall increase in demand. While immigration remains at above historic levels, areas of the domestic equity market are likely to benefit.

Global population also has headwinds. Fertility rates are declining, and the average age of the population in Europe, China and Japan is rising. According to a McKinsey study, by 2064 India’s employment could expand by 54%, while China’s could shrink by 20%. The number of employees in the United States is expected to continue to rise, but at a slower rate than in the past. The UN predicts that global growth will also slow out to 2050, to around 0.9%p.a.

JANA Conclusion: Most of the above factors are arguably favourable for Australian equities.

Valuation

Although this Note outlines some longer structural reasons as to why the domestic country equity bias should be reduced it is also important to take into consideration valuation when making this decision.

The following chart shows the longer-term premium/discount that the ASX 300 has traded relative to the MSCI World.

Image 22

 

As can be seen, from a P/E perspective the ASX 300 is broadly in-line with the MSCI World, however, from a P/B perspective it is trading at a material discount. However, this is primarily due to differences in market composition, with historically high P/B sectors (IT, Healthcare and Consumer Staples) having a higher weight in the global index.

Longer term sector P/E and P/B valuations are shown in the charts below.

Image 23


Some observations from the charts above:

  • With Australian Financials trading at longer term averages this is masking a number of other sectors that are trading at excessive valuation from both a P/E and P/B perspective;
  • Conversely, from a P/E perspective, the relative valuation of most sectors in global equities is on the expensive side of historical averages, however, the level of ‘expensiveness’ is consistent across sectors.

Given the relative concentrated nature of the Australian equity market, another way to look at relative valuations is to use the MSCI World sector weights to construct an equivalent ASX 300 valuation metric. The charts below show P/E and PB valuation metrics using this approach.

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On this basis, Australian equities have been more expensive relative to global equities through time and are currently trading at higher premium relative to global equities compared to their long term averages.

Finally, as the chart below shows, earnings growth expectations in Australia continue to lag global markets.

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JANA Conclusion: Overall, from a valuation perspective the case to reduce Australian equities is compelling at the current time.

Conclusion

This Note analyses whether the long-held bias to domestic equities within Australian equity portfolios is remains valid. The analysis set out in the Note is summarised as follows:

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Overall, JANA places a high weight to valuation and diversification factors. Although the Australian economy has the potential to continue to capitalise on the growing Asian middle class through services and agriculture, it is unclear how this will flow to domestic equity investors given the heavy concentration in Financials and Materials in the equity market.

JANA believes a greater relative allocation should be made to the more diverse global equity market. Unless there is a major change in the structure of the Australian equity market, the trend of reducing the Australian equity bias in portfolios is likely to continue.

On balance, JANA’s view is that investors should favour global equities over Australian equities on a medium-term outlook.