Fundamentals ignored as central banks rule the roost: Escala

Investors are operating in a world of ‘administered markets’ where price discovery is virtually impossible, according to Escala Partners.

Escala CIO Tracey McNaughton with CEO Pep Perry. Picture: Aaron Francis

Investors are operating in a world of “administered markets” where price discovery is virtually impossible and where clients need to “dial down tactical positioning”, according to the chief investment officer of the $6bn boutique wealth management firm Escala Partners.

Tracey McNaughton, a former long-serving UBS executive who joined Escala late last year, said while company fundamentals were still important, they had been “relegated to the back seat” with the US Federal Reserves’ balance sheet bloated with over $7 trillion worth of US bonds.

Current buying suggests this will blow out further to around $10 trillion by the end of the year.

“Central banks are not buying assets based on fundamentals. The market will be driven more by the actions of central banks than the results of companies because the central bank has a bigger balance sheet than any company in the world,’’ she wrote in Escala’s latest client newsletter.

“In our view, this is the kind of environment we can expect for the next few years. In short, periods of exuberance interrupted by bouts of tantrums, calmed down by central bankers before once again the period of exuberance starts again.”

On Monday, the benchmark S&P/ASX 200 Index fell 2.2 per cent to 5719.8 points, marking its worst three-day fall since March 19.

Ms McNaughton urged investors to think about how the two drivers of the market interacted.

“The fast moving, liquidity-driven, central bank-induced, high-frequency trading driver versus the slow moving economic fundamentals driver. We are in a period where the fast and furious liquidity driver will outpace the slow and steady fundamental driver from time to time until realisation hits and a pullback ensures,’’ she said.

A similar scenario occurred between 2013 and 2016 when on average the market experienced a “tantrum” twice per year.

But Ms McNaughton said such an environment was not necessarily bad for equities — “ it is just bumpy”. Between 2013 and 2016 the US equity market averaged 12.5 per cent gains.

Magellan chairman Hamish Douglass said at the weekend financial markets were trading under “the greatest asymmetry I have ever seen”, and predicted that while the world would likely “just muddle through”, there was every chance of a five-year recession.

Ms McNaughton said the current market was incredibly difficult to time.

“Only make tactical decisions when there is a clear and large disconnect. Otherwise, stay close to your strategic benchmark. Stay diversified. Having as many different levers working for you in your portfolio at times like now is always better,’’ she said.

She also urged Escala’s clients to stay with active fund management.

“Beware of blindly following a benchmark. Many of the slower-moving structural shifts that were evident prior to COVID have been exponentially accelerated today. There will be clear winners and losers. More than anything else — have a process and be true to it.”

Escala is backed by Focus Financial Partners, a New York-based partnership of wealth management firms backed by private equity giant KKR, and run by a group of former UBS advisers led by Pep Perry.

It is chaired by former UBS and Citigroup banker Brett Paton.

Ms McNaughton said the firm’s current list of “conviction stocks” was led by defensive stocks that should perform well if the economic recovery ahead is weaker than anticipated and offered reasonably predictable dividend payments. These include Amcor, Brambles and Telstra.

The list also includes growth-orientated companies that have good long-term prospects and valuations underpinned by a lower interest rate environment, including CSL, Aristocrat Leisure and James Hardie.

Escala’s conviction list also has exposure to cyclical stocks such as JB Hi-Fi, which are well-placed to participate in an improving environment as the economic recovery plays out, and resources stocks such as Rio Tinto.

“While Rio Tinto has a diversified commodity mix and a suite of long-life, low-cost assets, iron ore remains the key driver of profitability.

“… the medium-term outlook for earnings and dividends is bright,’’ Ms McNaughton said.