Despite two steep selloffs in equity markets (in February 2018 and October through November 2018), valuations on global stock markets remain high. Australian equity valuations are more reasonable but still moderately expensive.

However, we see a cluster of significant risks on the horizon that threaten to knock the Australian market lower, including weakness in the local housing market, slowing economic growth in China, and rising global interest rates. 

Equity investors are rightly wondering where to place their capital in these uncertain times.

We advocate a value approach to equity investing, which means seeking out stocks that are underpriced relative to our valuation of them. We also take into account a broad range of factors, from the economic environment to the track record of management.

We believe it is an approach that has particular resonance at this stage of the market cycle. If there is a downturn, it is our view that it will be overpriced stocks that will be hit the hardest.

Catch the tide of rates

Given that interest rates have been increasing, it makes sense to us to look for value stocks in sectors that are resilient in this environment, or indeed, stand to benefit from rising rates.

General insurance is one stock area that has in the past benefited from rising rates. There are two ways this has occurred. Firstly, higher interest rates increase the returns the general insurer receives from the fixed income portfolio, in which it invests its policyholder premiums.

Secondly, higher rates reduce insurer’s liabilities due to the accounting practice of “discounting” future claims costs. The largest liability on most insurer’s balance sheet is the likely cost of future claims, which are reached by estimating future payouts, and then discounting that amount by the risk-free interest rate to estimate its present value.

The upshot is that higher rates increase the discount rate, and hence decrease the present value of liabilities on the insurer’s balance sheet, even for a short tail insurer. Higher interest rates may also indirectly support insurance premiums as investors have higher returns on offer from bonds and therefore provide less capital to insurance markets. While the link between interest rates and insurance premiums is indirect, the leverage insurer’s earnings has to premium growth means the impact can be powerful.

Infrastructure a safe haven

Some infrastructure companies are also looking interesting, particularly, toll-road operators and electricity utility funds. The stable revenues of many of these companies mean they are usually less susceptible to the economic cycle than other stocks. As global growth slows, we are comfortable such stocks will maintain revenues and continue to pay good yields.

While resources companies are often relatively volatile, we consider diversified miner Rio Tinto, and oil and gas producer Woodside to be at the high-quality end of the sector and may offer some defensive characteristics. Both currently have excellent balance sheets, and should continue to have good cash flows and pay good income that justifies their value even in a tough phase of the commodity price cycle.

Housing a risk for banks

One place we currently don’t see a great deal of value is in the banking sector. Our team has been underweight in the banks for a long time now, particularly in 2015 when they appeared very overvalued. While the headline valuations are much more reasonable now, even attractive on traditional headline metrics, we remain concerned about some of the headwinds they face, especially if weakness in the housing market escalates.

There is little doubt that credit growth will be very low for the banks due to tightening of regulations, especially in the wake of the royal commission into the financial services sector. Beyond that, we consider there is a clear risk that things could get even worse for the banks if falling house prices cause people to cut their spending, which would weigh on economic growth. 

If the economy weakens substantially, a downside scenario is that banks could experience large debt write-offs and may need to raise capital. That’s not our central forecast but it’s an obvious risk on the horizon that we think should be factored into portfolio risk considerations. This scenario would also come with implications for the broader economy and share market.

Cash is a powerful tool

Investors are naturally concerned when they experience falling, or volatile, equity markets. One way to reduce exposure to the market volatility is to use cash as a safe haven when markets are overvalued.

By increasing weighting to cash when markets appear overpriced, we aim to minimise our losses when markets fall.

Investors are right to be cautious. If we are going into a tough time, it pays to be invested cautiously in companies that have robust cash flow, and are not overly geared.