July marked our first full year of live investment as Nucleus Wealth. We started the year with a view that with Australia at the tail end of historic mining and housing booms, and the US in the middle of a tax-cut driven boom was that the best strategy was to invest heavily in offshore assets. Results so far have vindicated this view. The highlight of the last year has been the performance of our international fund, up 21.9% after fees, followed by our tactical growth fund which was heavily overweight international shares and finished up 14.4%.
Over July we continued to see positive returns across our portfolios, our International fund was up 3.6%, Australia up 2.8% and the tactical funds up between 0.4% and 2.4%. These returns came despite a rise in the Australian dollar, which detracted from performance in July.
The returns above include trading costs and maximum administration fees – clients with higher balances will have better performance. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. Benchmark returns for tactical portfolios are inflation + a margin. Benchmark returns for international is the Vanguard MSCI World ETF (ASX:VGS) , Australia is the SPDR S&P ASX 50 ETF (ASX:SFY), both with dividends re-invested. Past performance is not an indication of future performance. See performance section below for more details.
The dilemma we are trying to address in the portfolios is how to get enough exposure to the final leg of the bull market while maintaining downside protection in case markets unravel earlier than expected. As a result, our portfolio is a little bi-polar at the moment, with a range of higher quality stocks that are exposed to continued US growth offset by a larger number of defensive holdings. As many traditionally defensive sectors (utilities, REITs, infrastructure) are expensive, our defensive holdings stretch across a range of consumer staples sectors.
August so far has presented both sides of the argument:
- Positives: US profits continue to boom and economic activity is robust, but US wage growth is constrained. China looks to be actively increasing debt levels to spend more on housing and infrastructure. There is the possibility that the current cycle gets extended by US and Chinese debt.
- Negatives: The rising US dollar might spark an emerging markets crisis – Turkey has made a cameo as the first domino, US/China trade war continues to escalate, Europe continues to weaken.
We are sitting on a considerable cash balance in all of our Tactical portfolios – our Tactical Growth fund targets a 10% exposure to cash and bonds, our weight is currently 35%. We have even more cash in the more conservative funds. We had been holding part of that cash in a range of international currencies and so benefitted from the falling Australian dollar, but have closed most of those positions – we will benefit from a falling Australian dollar through our international holdings.
World share markets rebounded from the prior month – trade tensions remain high but growth in earnings for US companies have been impressive. The Australian share market added another 2.9% – in spite of weakening Australian fundamentals and (as Australia is a small, open economy) greater exposure to a trade war.
Australian shares are now up around 10% in 3 months, a peculiar outcome over a period where the Australian dollar has fallen 6% and Australian forward earnings have been downgraded by 5% (vs upgrades of 6% in the US). This means Australian valuations are now 10% higher than the world average. Over the past 15 years or so, Australian valuations of 10% more than the world has represented a limit for the Australian market and a sell signal:
Now, this valuation method is pretty simplistic, but it illustrates what we are seeing across a range of other metrics. A counter-argument would be that if earnings growth and the outlook was stronger in Australia then the higher valuations could be justified. This is not the case – in fact, Australia earnings continue to diverge lower vs world earnings:
So, this begs the question: is the stock market seeing some other strength that isn’t being reflected in analyst forecasts or foreign exchange markets?
Our take is no. The fundamentals are moving largely in the direction that we have discussed on many occasions: US strong, Europe weakening, Chinese growth slowing, Australian earnings down and further downside risk from a slowing China, declining property market and slower mortgage growth.
From time to time markets will dislocate from fundamentals before regaining their senses. In our view, the last few months are a mispricing rather than a sign that Australia is turning around.
Turkish Crisis or Emerging Markets Crisis?
A strengthening US dollar accompanied by strong US economic growth has been the cause of a number of emerging market crises over the years, just three years ago equity markets fell around 20% following a Chinese growth scare, in the 1990s it was the Asian Crisis, the decade before it was Latin America.
The path is typically that an emerging market country has borrowed extensively in US dollars, has continued financing needs and slowing growth. As the US dollar rises, the debt burden becomes larger which then slows growth more, investors start pulling money out of the country and so the currency falls further. Then the process continues spiralling, usually until there is some form of central bank intervention or IMF bailout.
A single, smaller country undergoing this process is usually not a major issue for world growth and stock markets. However, if there is contagion then other emerging markets countries also see capital outflow and weakening currencies and then world growth will be hit. Typically stock markets fall 20% or more when emerging markets crises occur – so it is potentially a major issue.
Turkey is undergoing a currency crisis. On its own, Turkey is not large enough to create global issues, so the key will be whether the contagion spreads.
On the positive side, Turkey has been sliding towards a currency crisis for a number of years and so investors should not be shocked. Contagion is more likely to occur when a country previously thought of as (relatively) safe has a (relatively) sudden currency crisis – in these cases, investors are more likely to second guess the risks in other emerging market countries and sell indiscriminately.
On the negative side, contagion is more likely to spread when there is a lot of leverage and unforeseen linkages. For example, the Asian crisis led to a collapse in the oil price which led to a Russian crisis which created a crisis in the US via a US hedge fund, Long Term Capital Management. Long Term Capital Management had made financial bets on the US bond market using debt and derivatives that were so large that the losses eventually required the Federal Reserve Bank of New York to organise a bailout by the major creditors to avoid a wider collapse in the financial markets. There is an unprecedented level of debt in the world at the moment.
We aren’t making a bet in either direction, but we are watching the leading indicators closely – for more on this topic see our recent webinar.
Our key themes are undergoing some changes. Investment markets are late in the cycle, the issue is that no one knows how late. A crisis could bring the economic cycle to an imminent demise, or debt-driven stimulus in China and the US could extend the cycle for another few years.
So, there are a number of flashpoints we are watching :
- Europe: The major long-term issue is still the significant imbalances between Germany and most of the rest of the Eurozone. We note that recent issues in Italy are a symptom of the underlying problem – not the actual problem. Growth is also clearly weakening.
- China: We are questioning the rebalancing thesis. Given the escalation of the trade war, it looks as though China is going to embark on a renewed round of debt-driven growth to offset the weakness from higher tariffs. We have been making some changes to our portfolio weights to recognise these changes.
- Trump: Tax cuts are now impacting economic statistics which are looking strong, add to that an increase in US oil drilling and wage inflation showing minor signs of life. These are both one-off gains and so the key risk is that the Fed over-reacts to the signs of strength.
- Emerging Markets: We are watching closely for signs that the crisis engulfing Turkey is spreading
Tactical Asset Allocation Portfolio Positioning
In our tactical portfolios, we own cash, bonds, international shares and Australian shares. We tend to blend these portfolios for clients so that each investor receives an exposure tailored to their own risk and income requirements.
The broad sweep of our asset allocation over the last 18 months was to ride the Trump Boom, switch into Europe in March / April last year as the US became overvalued and then switch back into the US as the Euro rallied and the USD fell.
We have been using rallies in stock markets to reduce our holdings.
We remain underweight shares in aggregate, overweight international shares and significantly underweight Australian shares.
Over / Underweight positions by portfolio
Tactical Foundation Portfolio
Our tactical foundation portfolio is designed for investors with lower balances, it uses exchange-traded funds for its international exposure rather than direct shares. The reason for this is parcel sizes, you can’t buy half a Google (Alphabet) share directly and so we use exchange-traded funds which buy baskets of stocks instead. The tactical foundation portfolio is a balanced fund, not as aggressive in its holdings as the growth fund nor as conservative as our income fund.
In July this fund increased by 1.1%. The fund continues to be underweight Australian stocks.
We have a reasonable tech / IT exposure. The rising spectre of a trade war has seen significant volatility in the sector, and we have been using price falls to pick up more of the stocks that we like. Over the month we picked up Facebook after the stock fell 20% on lower growth expectations.
We are currently holding a larger than usual number of consumer staple stocks in our portfolio – traditional defensive sectors like Property Trusts, Utilities and Infrastructure are generally very expensive and so we are using a group of more stable industrial stocks like Kelloggs, Johnson & Johnson, Unilever, Kimberly-Clark plus a range of smaller stocks as an alternative. As a group these stocks have been performing well and offset some of the risk from the tech/IT exposure.
We are underweight energy. In particular oil producers. This was not a good call over the first six months of 2018, and our outperformance has been despite the underweight to oil rather than because of it. Over the last two months the oil price has fallen around 15% and so we have benefitted from this underweight. This remains a major investment call. The broad overview is:
- Oil demand remains strong, and with (relatively) synchronized global growth we expect this to continue.
- The supply side is stronger. US production continues to reach new highs, Libya and Nigeria’s production recovered from interruptions. The lone negative is Venezuela continuing to decline. The ability of US shale oil to react quickly to higher prices means that supply is much more responsive than its been in the past. The US has now become an exporter of oil.
- On the political side is where we see most of the action. OPEC and Russia are withholding supply to keep the price high. Trump is reinstating sanctions on Iranian production.
So, the question from here is whether we hedge our risk to political events by buying oil stocks in the face of fundamentals that suggest the oil price should be materially lower. If the risk were greater or the oil price lower, I would probably hedge. Given the current situation and current prices, we are going to stay underweight oil. But the debate rages on.
Our sole holding in the energy sector, Neste Energy is up around 70% over the past few months, which has shielded our portfolio from the rising oil price. Neste is a Finnish oil refiner, making a significant investment in green technologies and is well regarded by a number of sustainable rating firms including being in the Global 100 most sustainable companies, the Dow Jones Sustainability index and CDP.
Individual Stock performance
In July Google (Alphabet) was the stock that keeps on giving, up again this month despite the FAANG wobbles seen toward the end of July. Otherwise, it was the Drug Manufacturers on the upswing. Detractors were a mixed bunch internationally, with Tyson Foods hardest hit after lowering guidance due in part to uncertainty in trade policies and increased tariffs negatively impacting domestic and export prices.
Domestically there was a rotation out of defensives while stocks with significant overseas earnings like Treasury Wines and Brambles outperformed.
Performance to date
Portfolio performance can be cut a number of different ways. At its most basic level, you should care about the total return. At the next level, you should care about the total return relative to some sort of benchmark.
As you dig deeper, you should also be interested how the return was achieved – for example if your fund manager is taking lots of risk but only performing slightly better than the market then you should be concerned. Similarly, if you can get market returns but at a much lower risk then that may be an appropriate trade-off.
Our portfolios to date have been taking less risk and in most cases out-performing benchmarks. The disclaimer is that they have only been running for twelve months, and that is not enough time to make definitive judgements.
We manage our portfolios for investors through separately managed accounts, which have a host of benefits including transparency, individual tax treatment, direct ownership, customisations (including ethical overlays) and low trade costs.
However, because separately managed accounts are either subtly different (due to slightly different stock weights) or explicitly different (due to ethical screening) for every customer, there is not one performance figure that we can quote.
The table below shows performance for a benchmark client paying the maximum administration fee. We have not added in any benefit for franking credits or for withholding tax credits.
The returns above include trading costs and maximum administration fees – clients with higher balances will have better performance. Note that individual client performance will vary based on the amount invested, ethical overlays and the date of purchase. Benchmark returns for tactical portfolios are inflation + a margin. Benchmark returns for international is the Vanguard MSCI World ETF (ASX:VGS) , Australia is the SPDR S&P ASX 50 ETF (ASX:SFY), both with dividends re-invested. Past performance is not an indication of future performance.
In summary, our view continues to be that Australian investors are better off holding international investments at this point in the cycle.
We retain relatively large cash balances to hedge against volatility and to look for a cheaper entry point. If markets continue to be weak then we will look to buy more equities. We are concerned about the potential for trade wars or an emerging markets crisis. These will be a key focus for us over the next few months.
Our intention is that our portfolio is positioned to take advantage of our key themes but minimise risk in the event that our themes take longer than expected to resolve themselves.
We usually find that big picture macro themes take a long time to resolve themselves in financial markets, but when macro theme resolve themselves they do so quickly – usually too quickly to reposition your portfolio if you are not already invested.
Postscript: Message of thanks
Starting a new investment fund is a difficult task. I want to especially thank all of the early adopters who backed us to manage your investments – in particular the 80 investors who backed us in the initial months before we had any performance statistics to support our case and everyone else who has signed with us since. We are now opening accounts on a daily basis and, based on pre-registrations, we expect to roughly double the number of investors in our funds once we launch our retail super product.
I apologise for the delays in retail super – shortly after launch our platform provider (Linear) was taken over by a larger company and our retail super product has been delayed. Unfortunately, this has been out of our control, however, we are hoping for some big news on this front before the end of August.
A largely unknown feature of our product is our investment portal which gives unprecedented transparency into our investments. Typical platforms give you historical information about your portfolio, ours gives you detailed information about the future – how is the portfolio positioned, which stocks or bonds do you own, why do you own each stock, which stocks have you chosen to exclude due to ethical concerns and what do we expect to happen.
Our product has not gone unnoticed in the industry. We were a finalist in the fintech business awards as “Financial Advice Innovator of the Year” and have recently been announced as a finalist for the IFA excellence awards “Innovator of the Year”.
Over the last 15 years, Australia has been through a historically large mining boom and historically large property boom. The after effects are far from over. If you have not yet invested with us, we would appreciate the opportunity to help your investments deal with the transition to a new investment environment. If you want more detail, or simply want to talk to a financial adviser about how we can work with you, book a call with us by clicking here. We also have conferences in Sydney and Melbourne next month and hope to see you there.
Damien Klassen is Head of Investments at Nucleus Wealth.
The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.