Asset Class Update
Central bank cash rates have lifted off zero but remain very low. As such, cash returns remain very low. Heightened inflation also means that the purchasing power of cash is significantly less than it would otherwise be – eg. headline inflation in the US is more than 8% whilst in Australia it’s more than 5%. Cash continues to provide downside protection versus falling asset prices and option value when it comes to taking advantage of opportunities and deploying cash into lower asset prices.
Interestingly, term deposit rates have risen significantly. This is less about where the RBA cash rate is likely to head and more about the sharp increase in funding costs for banks. The concern with term deposits from here is heightened break or penalty costs if they’re not held to maturity given how quickly forward expectations of rate rises may change.
Have suffered some of the biggest price falls we’ve seen for decades due to sharp increase in central bank interest rate hike expectations which have flowed through to rising bond yields. Importantly, these losses are paper losses as opposed to a permanent loss of capital as the default cycle remains very benign. That is, the losses seen and experienced are all a function of movements in yields higher and hence prices lower. This means a significant portion of bonds in the market now trade below their $100 maturity value. As long as credit quality remains high, these bonds will mature at $100 with potentially higher yields. That is very attractive in the forward period.
Another thing worth noting is the yield increase within many bond investments. As bond yields have risen, bond managers have been reinvesting distributions and maturing bond proceeds into higher and higher yielding bonds. In a short period of time, many bond funds now have running yields and yield to maturities 3-5 times higher (eg. 1% vs 3-5%) than they had 12 months ago.
Whilst we agree inflation is a problem in most jurisdictions, hence the need for higher rates, it’s worth noting that financial conditions are tightening very quickly. Fiscal stimulus is gone, central banks are raising rates, and central banks are reducing the size of their balance sheet. Whilst there is both demand and supply imbalances, demand destruction has already begun, and given the surge in the amount of debt over the last 2 years, and higher borrowing costs hitting home, it won’t take much tip economies into recession or recession like conditions.
The turning point for bonds will either be nearing recession and/or a realisation that central banks can’t take rates as high as the market is currently implying. In either of those environments, bonds do incredibly well. Even putting that aside, the healthy yields now available within bond investments means you at least now get paid to wait in bonds.
Lastly, whilst we’re never happy with negative returns, there’s been a lot of rhetoric that bonds aren’t working. Yes, bonds haven’t provided the positive return they usually provide when equities turn down. However, bonds haven’t fallen anywhere near as much as equities, thus still providing
relative downside protection. In addition, the yield buffer that has been built in bond investments means a significantly reduced likelihood of negative returns in the period ahead.
We’re looking to potentially increase duration or interest rate risk in portfolios (in the absence of any active fund managers doing this for us) whilst being somewhat cautious around credit risk in light of a potential default cycle in the period ahead if central banks go too hard on rates rises.
Property & Infrastructure
Both asset classes are interest rate sensitive whilst both provide elements of inflation protection. Both can also act or be seen as “defensive equities” in times of heightened equity market fears. We like both asset classes in the period ahead for a combination of the factors just mentioned. But there’s a heightened need to be very selective within both asset classes as the world adjusts to the post Covid period (eg. work from home, online retailing, use of VCs, etc) and how much of the Covid period trends remain. We currently have a preference for infrastructure over property. Infrastructure is generally less interest rate sensitive than property, the underinvestment in infrastructure in most jurisdictions over many years, the likelihood that governments will need to restart fiscal stimulus if financial conditions get too tight with infrastructure investment highly stimulatory and politically positive, and the world’s push to more cleaner energy and more efficient use of resources which plays firmly into infrastructure investment, are all massive tailwinds.
We continue to generally prefer to access property and infrastructure exposure through a listed (vs unlisted) and global (vs Aussie) lens – ie. investments that are daily liquid/priced and can invest in both international and Australian securities (but through a global lens). The Australian listed property and infrastructure markets are incredibly small, especially the latter, which means sub-sector and stock concentration can be high.
The asset class has come full circle from the previous gripe of not having enough technology and growth stocks (ie. an old industrials heavy market) which hurt returns relative to the US equity market over the last 5-10 years, to now being loved for being packed full of financial and resource stocks benefiting from higher bond yields and higher commodity prices. Whilst that trend might continue for a while longer, already tightening financial conditions and rising recession risks may bring an earlier end to that trade than is currently expected. Banks and insurers, which benefit from higher rates and bond yields, may not get a long enough cycle to take full advantage whilst rising costs, particularly labour costs, hit these companies hard given they are labour-heavy businesses. Resource stocks, whilst benefiting from higher prices due to demand and supply imbalances, are price takers (not price makers), are very sensitive to the economic cycle, and have historically underinvested in their businesses. So a word of caution on this trade.
Overall, Australian equities are trading around their historical long-term averages, which looks attractive versus current cash rates and versus where we think cash rates end up (ie. lower than the market is currently implying). The critical question for Australian equity investing from here is which parts of the market you want to own – cyclicals vs defensives, growth vs value, large vs smalls. In the short term, these are not easy calls as they a quite macro-outcome dependent. But over the medium to longer term, our preference remains cyclicals over defensives, growth (with valuation sensitivities) over value, and small over large.
Has been a tough place to be over the last 4-5 months. US equities impacted by rampant US inflation, European equities impacted by the Russia / Ukraine conflict, Asian and emerging market equities impacted by China’s regulatory crackdown and Covid-zero policies. Interestingly, most to all the price declines have been sentiment and momentum driven with earnings growth holding up pretty well thus far. This has meant that valuations have fallen incredibly fast and sharp, with US equities now roughly in line with their historical average, whilst Europe, Asia and emerging markets are now largely trading below their historical averages.
There are 3 key questions from here for global equities:
1. Earnings trajectory – ie. are earnings growth expectations still too high at roughly 9-11%. If inflation stays higher for longer and/or cash rates move too high, then the answer is more than likely yes. If inflation settles quicker than expected and/or cash rates don’t move that high, then the answer is no. The longer inflation remains high and/or the higher interest rates get to, then the greater the risk to forward earnings. Even within those broad statements, there are plenty of individual stocks which can benefit from either environment.
2. Chinese regulation and economic growth – Covid-zero policies, along with significant ramp up in regulation, with little to no stimulus wasn’t the best combination for Chinese economic growth. Whilst Covid zero policies look set to continue, regulation has already softened and looks likely to soften further, whilst stimulus has started to ramp up but from very low levels.
3. Russia / Ukraine – general risk off sentiment, implications for European economic growth, implications for global energy security and supply, implications for broader manufacturing and supply, etc. Trying to guess when the war might end is almost impossible given the number of actors involved. The 2nd order effects of sanctions are even more of a minefield.
We remain positive on global equities, particularly with a 2-3 year focus, and particularly with regard to active management.
Have largely performed well over the last 3-4 months, but it’s been a long time coming. In saying that, the rebound has been sharp, particularly in those funds that have been long commodities and short bonds, with leverage (eg. trend following). More defensively orientated alternative strategies have provided reasonable downside protection to both falling bond and equity prices, but some more aggressively oriented alternative strategies haven’t provided as much downside protection due to their equity bias. Equity market neutral results have been mixed through this period. Private assets (equity and debt) have performed well given assets here aren’t marked to market regularly (ie. lag in valuations) and given the strong flow of money into this part of the market. In saying this, the lag in marked to market valuations will come through in softer returns in the period ahead whilst the strong flows into these asset classes could reverse rather quickly creating adverse liquidity events. Word of caution.
We don’t have a strong view here for model portfolio / SMA inclusion. But there are some equity market neutral and private equity and debt funds we like, with a long-term holding period in mind, held outside of the model portfolio / SMA structure for suitable clients.
for some time we have been mostly to all unhedged to across growth assets held in portfolios. The benefit of being unhedged in global assets remains and includes:
1. Diversification of currencies and revenue sources.
2. Diversification away from the highly volatility Australian dollar which trades as a “risk-off” currency – ie. it falls when risks are rising
3. Lower portfolio volatility
The recent period is no different when it comes to the volatility of the Australian dollar, starting the year at US72c, rising to US76c, falling to US68c, and then rising again more recently.
The questions from here are:
1. How quickly does the USD fall given rising rates and twin deficits (budget and current account)?
2. How much support does the AUD receive from high commodity prices and improving risk sentiment (if any)?
It’s fair to say both are incredible tough calls to make. As such, we’re staying unhedged for now but are seriously considering putting on some currency hedging. Alternatively, we could increase exposure to Australian dollar assets but this would largely involve crystallising losses elsewhere in the portfolio which would prefer to avoid.
General Advice Warning
The information in this article and the topics and strategies discussed are of a general nature. It does not take your specific needs or circumstances into consideration, so you should look at your own financial position, objectives and requirements and seek financial advice before making any financial decisions.
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CB Wealth Australian Pty Ltd T/As HH Wealth is a Corporate Authorised Representative (No. 1283595) of Axies Pty Ltd ABN 38 136 704 446 AFSL No 339 384. Chris Holme is an Authorised Representative (No. 1004793) of Axies Pty Ltd ABN 38 136 704 446 AFSL No 339384.
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