24 January 2017
In the second half of 2016, as markets began to realise that the bottom for bond yields had likely been hit, a seismic shift started to occur in equity markets. In recent years, quality and growth had been the focus of larger fund managers. “A weight of money came in and so long as these companies were delivering earnings upgrades, they didn't really focus on valuation,” explains Jeremy Bendeich, Chief Investment Officer of Avoca Investment Management. As the reality of rising rates sunk in, attention began to turn from high-priced growth stocks to relatively cheap cyclicals. As the ‘weight of money’ left the small and mid-cap space, it dragged down stocks both with and without downgrades. In this video and edited transcript, he explains why tightening credit conditions pose a downgrade risk for some companies.
Q: What’s been driving the rotation out of smaller ‘growth’ names?
What we saw was a preponderance of large and mid-cap fund managers to chase alpha in this space. A weight of money came in, and so long as these companies were delivering earnings upgrades, they didn't really focus on valuation. They went; "Okay. It's delivering earnings upgrades. I'll buy it. It's going up."
We have an approach that focuses on the underlying valuations, and they seemed to get very stretched. The trigger point for that was prior to the US election; the realisation that interest rates were bottoming and going to go up. As that became more of a concern, the valuations started coming into play.
The relative out-performance of banks and resources was starting to draw the focus some of those larger fund managers, who started saying to themselves; "Well wait up. I'm suffering from (under)-performance because I'm not in those stocks. Maybe the game is up, here in smalls and mids, maybe it's a little bit over cooked, and I need to start that rotation back."
Q: What’s changed with regards to the availability of credit?
It's not too discernible at the moment that credit availability is drying up. There's no credit crisis. It’s just that the delta* on the availability of credit is going to change. Instead of being very easily available, very loose credit conditions, it will start to tighten up. That starts then influencing a lot of risk taking because people will start to think; "Well, this riskier stuff that I was buying, because I could get access to this really cheap credit… Maybe I need to reassess the risk-return balance, and these things aren't as attractive."
We're not seeing any signs of real concern. Now in that, in China in the last week or so the government's trying to tighten up availability of lower quality credit. There's been an increase in the number of Chinese corporates that are defaulting when they've gone into offshore markets in the last year. These are some of little signs we’re seeing.
The higher cost of the credit will potentially drive earnings downgrades to companies who've benefited from the low credit costs inflating their asset values and increasing their ability to raise dividends because the interest costs on those inflated assets are lower.
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