ART stays bullish on equities

By Elizabeth Fry

Equity markets will always move higher over the long term despite the current uncertainty about interest rates, monetary policy and inflation, says Australian Retirement Trust head of investment strategy head Andrew Fisher.

The $230 billion fund is slightly overweight equities. "We have repriced markets for higher interest rates, and on balance, we still find equities slightly better value than bonds at the margin," he adds.

Equities will continue to be a core growth asset for the $230 billion fund. As a long-term investor, ART will always hold a large allocation of equities since it has a relatively young membership.

While many strategists remain bearish, Fisher says there is a compelling case for holding equities.

Indexes show that equities deliver sustainable growth over time. "For a young member, the only way we can mess it up is by not owning equities and being wrong," he states, adding that he sees falling markets as a buying opportunity.

Fisher now thinks equities are fairly priced, with valuation multiples implying an appropriate reward for risk.

Equities are trading on a valuation multiple of around 15.

This implies an earnings yield of over 6 per cent, which Fisher reckons is about fair value.

And given that bond yields are between 3-4 per cent, a 2-3 per cent earnings yield premium over bond yields is about right.

"While the longer-term multiples are as neutral as valuations get, everything feels scary because inflation is high, and there is so much short-term risk associated with that.

"But there are grounds for being positive as forward-looking returns look pretty good relative to the last ten years," he adds.

While the Australian equity market has proven quite resilient this year, US equities have slumped 15 per cent during a global sell-off that has wiped trillions of dollars from financial markets.

But Fisher argues that share prices are falling because investors are just repricing the discount rate - not because they fear a recession or that higher interest rates will trigger corporate stress.

The strategist notes that the jump in interest rates from zero to four has been incredibly swift and painful.

And what's happening with interest rates continues to be the most significant market dynamic.

Grounds for optimism

For the first time in years, Fisher is starting to get excited about bonds.

He says there is no doubt that rates are driving the market, which means the equity story is more of a bond story.

"Generally, fixed interest is not the most exciting part of the investment universe. But all of a sudden, it has become the epicentre of excitement because we're just not used to a world where rates move this quickly."

Despite the debate over inflation and policy tightening still raging, earnings projections still paint a relatively rosy picture for the equity market. However, he warns that shares might fall out of bed if bond yields 'gap up.' and multiples reprice further down in response.

Still, he concludes that while equities might look bumpy over the next three years, the short-term pain will give way to longer-term gains.

That said, Fisher does not entirely discount an inflation surprise on the upside over the long term that would push interest rates higher than everyone thinks for longer.

And while optimistic about economic prospects, Fisher warns that it all hinges on the central bankers as they seek to maintain or restore credibility.

"The Fed's objectives are to keep people employed and inflation under control, not protecting corporate profits. That could result in a bad outcome for equities and a good one for debt holders and interest rates.

"This could pose a major structural risk to equities."

Fisher says for the past 25 years, almost all of the economy's productivity gains have gone to capital or equity holders, with real wages stagnating.

"With a tight labour market and high inflation, this dynamic is shifting, and we may need to reset expectations of what to expect as an appropriate and sustainable return on equity," he continues.

"This doesn't mean equity is a bad investment, but we may need to temper long-term expectations.

"Perhaps I'm an optimist, but I like to think there is a path that doesn't end in a global recession."

Fisher points to low unemployment, with real interest rates remaining negative.

While central bankers will invariably talk up the risks to curb consumer enthusiasm, inflation is already beginning to fall, and the global economy has taken the interest rate increases in its stride thus far.

"So it isn't that hard to imagine a gradual reversion back to trend and a soft landing from here."

Betting on bonds

As for bonds, Fisher says while bonds look attractive, buying bonds is tricky while central banks are still raising rates.

"No matter how smart you think you are until rates get higher than inflation, you are taking a leap of faith in buying bonds because yields can and likely will move higher," he cautions.

"It's like catching a falling knife - you don't want to buy bonds at four per cent yields if they end up at 6 per cent.

"But if something happens and bond yields start heading down and never come back up, you don't want to look stupid and miss the opportunity."

Fisher says investing has never been harder although he concedes that most investors have been saying that for as long as he has been working in the industry.

Looking back, he says it has been difficult for funds to differentiate themselves because interest rates have dropped, and asset prices have risen with limited dispersion.

Most importantly, he adds, it has been an easy environment to deliver on our promises to members but a more challenging one to differentiate from other investors.

"By contrast, it's now near impossible to make money because interest rates are rising, and everything else is going down."

But now, there is an expectation of more volatility and an expectation of dispersion between markets, assets and currencies, which will help investors.

"Arguably, it's an easier environment, I think, to differentiate," he concludes.

"Plus, there's yield now back in the market."

"And if interest rates do what they did for the last 20 years and go from four per cent down to zero again on a gradual trend, that'll be an easy environment to make money again."