Morningstar saw reasonable valuations in domestic credit over 1Q18, while Australian equities remain overvalued as the two largest sectors are unattractive.

After a stellar year for investment markets in 2017, the first quarter of 2018 delivered mixed performance for key global markets. Volatility returned with a bang as the excessive investor optimism that characterised 2017 started to unwind, with the shift in sentiment driven by the threat of a potential trade war, record debt levels in the US, rising inflation and higher interest rates.  

Volatility and divergence in equities

The S&P/ASX 200 Accumulation Index gyrated throughout the first quarter before recording a decline of 3.9 per cent, taking 12-month returns to a mere 2.5 per cent. Relative to its global peers, Australia’s 12-month returns continued to lag, most notably against Asian markets.  

Australian stocks were not immune to the volatility that hit markets in the March quarter. Sector performance was generally weak although the healthcare sector was a clear exception, gaining 6.8 per cent, owing to strong earnings results from key stocks such as CSL (ASX: CSL) and ResMed (ASX: RMD).

Sector performance diverged greatly, with a record 18 percentage-point spread between the best-performing and worst-performing – healthcare and telecommunications, respectively. The materials sector’s substantial share price gains from 4Q 2017 were partially reversed as iron ore prices slumped. 

Companies reported solid half-year earnings, with more companies beating expectations than disappointing, although profit margins contracted. Earnings for the resources sector continued to be significant and were revised higher. By contrast, expectations for bank earnings remain tepid, barely above zero, and the potential regulatory risk related to the royal commission’s inquiry into bank conduct continues to weigh on the earnings outlook. 

Financials, materials on the nose 

We continue to regard Australian equities as overvalued and the two largest sectors, financials and materials, as generally unattractive. 

The impact of the heightened regulatory environment for banks was mixed in 2017, with the surprise bank levy being offset by more palatable capital requirements being imposed by the Australian Prudential Regulation Authority.

Nonetheless, regulatory risk remains, with the steady stream of headlines from the royal commission into banking activities the latest factor to contribute to an uncertain outlook.

In our view, the big four banks remain far from compelling value in aggregate. This is particularly true relative to global peers, which generally offer better value, although this has diminished in recent times. With this, we continue to see better opportunities in other financials, notably in select insurers.

We further struggle to see attractive valuations within the materials sector, as we typically view these companies to be of lower quality (no economic moat).   

While the resource sector’s performance was mixed in the quarter, our view remains that most companies within the sector are still trading well above our estimates of fair value. As such, the two key sectors of financials and materials in the Australian market continue to offer a less attractive reward for risk.

Investors in this market will need to be increasingly nimble to take advantage of valuation opportunities as they emerge, and avoid those assets that are expensive, to deliver superior risk adjusted returns. This involves applying a diligent investment process and an open mindset to moving away from an index-like exposure. We remain underweight Australian equities with more attractive opportunities available in other asset classes.

Local credit outperforms peers

The Australian fixed-interest markets showed resilience in the face of rising global bond yields, with the Bloomberg AusBond Composite 0 + Y Total Return Index returning 0.9 per cent, outperforming most other global bond markets. This outperformance was underpinned by expectations that the Reserve Bank of Australia will keep policy rates steady through 2018 while central banks elsewhere are reducing their stimulus. 

Overall, Australia’s inflation remains subdued and is likely to remain below the target band. This reflects a muted economic picture, with a softer housing market, record high household debt levels, and headwinds to consumer spending. Policy rates are now expected to rise in 2019. 

Notably, the Australia-US 10-year bond yield spread was negative for most of the quarter, reflecting the relatively weaker economic outlook in Australia. Australian credit markets had a softer quarter, due primarily to widening credit spreads from bonds issued by the big four banks. Negative headlines from the banking royal commission, together with increased volatility has led to banks facing slightly higher funding costs. 

Australian bonds a preferred asset class

While bond yields have fallen as expectations of future domestic interest rate rises are pushed back, they remain well above the record and unsustainable lows of 2016. As such, Australian bonds offer reasonable valuations and continue to appeal relative to developed market global bond peers. Indeed, the asset class continues to be especially important for Australia-domiciled investors, with Australian bonds (and cash) remaining among our preferred defensive plays in diversified portfolios for when times become more challenging. Our view extends to Australian credit despite a poor absolute reward for risk trade-off compared to what has been available historically. Relative to other global credit markets, future returns in Australian corporate bonds appear more attractive.

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Glenn Freeman is a senior editor at Morningstar.

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