The core of any good portfolio

Livewire Exclusive

Fixed interest is a core part of any good portfolio, but just how well is the asset class understood? In this exclusive Q&A with Livewire, Jay Sivapalan, Co-Head of Australian Fixed Interest and Portfolio Manager at Janus Henderson Investors discusses the biggest theme in the market today, where he's seeing opportunities, and his most counter-consensus idea.

Q1: Imagine you are at a dinner party. Please explain what you do in your role and outline the journey you took to get there?

Ultimately, I help savers invest their money in defensive assets. This is not with direct investors per se, but savings pools that originate in the financial adviser arena, as well as large institutions like superannuation funds and insurance companies.

The asset class that I manage money within is fixed interest, which is really about lending our clients’ monies to various entities such as the Australian government, state governments and companies like NAB and Woolworths.

There are two key decisions we need to make when we lend (invest) our clients’ monies.

1: Who are we lending it to? The focus here is on the return of capital (rather than the return on capital), otherwise known as assessing creditworthiness.

2: For what term? In other words, are the prevailing interest rates attractive enough to lock in our clients’ money for one year, or five years?

I’ve always been mathematically inclined and have always had a passion for investments, which really started with playing Monopoly believe it or not! At quite a young age I also learnt the concept of compounding and have always been fascinated by it. To me, it’s mathematical magic.

This passion led me to pursue undergrad and postgraduate studies in a related industry – investments and actuarial sciences. I commenced my career in actuarial, initially within life insurance and then consulting in superannuation, before joining investment management almost two decades ago.

Q2: Please discuss the biggest theme playing out in your market at the moment, where it is heading, and why it matters?

The biggest theme is the very gradual reversal of the ultra-easy monetary policy environment that saw cash rates in many countries head to zero and in some cases negative, which has never been seen before.

It’s also a reversal of the bull market in bonds that started in the early 80s and finished about two years ago, with bond yields reaching hundred-year lows. Looking forward, I expect cash rates, and by extension bond yields around the world, to gradually normalise, which has implications for fixed interest investors.

Firstly, in a gradually rising rate environment, returns can be dampened, so managing interest rate risk (duration) with the flexibility to really preserve capital is paramount.

Secondly, this environment is coinciding with a relatively mature phase of the credit cycle, where the outperformance of corporate debt is also normalising.

Now is the time to manage risk in a prudent fashion, rather than simply chase yield.

Q3: How big a driver is the transition from QE to QT, and what are the implications for your market?

One element of the reversal of this ultra-easy monetary policy phase is the unwinding of the sizeable Quantitative Easing (QE) programs that various central banks had undertaken following the Global Financial Crisis (GFC).

It’s important to keep in mind when assessing the implications of this unwinding that when QE was being implemented it was sudden, big and with stepped changes. This was all designed to arrest a loss in confidence and to make money cheap quickly (i.e. very low rates).

The reversal, Quantitative Tightening (QT), will likely be much more gradual and measured, with central banks re-assessing the feedback loops as it occurs. So while I expect the implications to be higher bond yields over time, it would be incorrect to conclude that it will result in a meaningfully abrupt spike in yields that is sustained.

The implications for investors are unlikely to be as dire as suggested by some media commentators and ultimately higher interest rates are very good for savers and investors.

Q4: What is the first chart you look at each day, and what is it telling you right now?

To assess the bond market against our view of fair value for bond yields, I look at the cash rate expectations for Australia and for the US.

For Australia, the market is firmly of the view (and I agree), that the Reserve Bank of Australia (RBA) is on hold for an extended period of time. While we have a generally constructive view of the Australian economy, there is still some degree of slack in the labour market, low wages inflation and ongoing transition from housing construction to infrastructure spending. This is not an inflationary economic outlook which requires action by the RBA.

Australia’s interest rate cycle is out of sync with the US, which has seen, and is likely to see, an outperformance of Australian Fixed Interest, relative to markets such as the US.

Q5: As an active manager, what are some of the inefficiencies you exploit in the market, and where are you seeing one right now?

The main inefficiency that we seek to exploit is the undue emphasis that markets put on short-term factors when valuing long-term assets.

One current example is the break-even inflation rate on 10-year inflation-linked bonds, which is currently at around 1.8%. Essentially the market has taken the recent low inflation reading and assessed that it will be sustained at these low levels over the next decade.

This pricing also implies that the RBA will fail in its mandate for average inflation to remain in a 2-3% target band.

Q6: What is your most counter-consensus idea?

When economists and markets look at the US economy, and by extension other countries’ economies, there is a consensus view that we are late-cycle simply because we’ve had continuous growth for 10 years since the GFC.

I don’t believe that economic growth dies of old age. It typically finishes when inflation is at the higher end and central banks have raised rates above neutral levels in order to slow down the economy.

So with that lens, it’s arguable that the US economy has perhaps 2-5 years of uninterrupted growth ahead of it, and that many other economies around the world are still in the early stages their economic cycles.

It’s important to understand that this cycle is different to a typical economic and business cycle as a result of the dent left by the GFC and the very long recovery period.

Q7: The spread on the Australian and US cash rate inverted in February, and the AUD has lost nearly 10% since. How much further could this go?

Theoretically, cash rate differentials drive the cross currency rates between the US and the Australian dollar, so it can certainly go a little further.

But for the Australian dollar, commodity prices are also a factor that should be taken into account, which has been a positive influence this year.

Overall, the RBA would be pleased with some weakness in the Australian dollar as it will assist in stimulating the economy through exports in due course.

Q8: How concerned are you by a rise in inflation?

Assuming we are talking about a moderate pick-up in inflation, especially in the US, we have some level of concern because employment in the US is already at above full employment, wages are picking up and fiscal stimulus is hitting the economy.

In terms of very high inflation, this is unlikely given inflation globally is still tepid and there are dampening effects from technological (disruption resulting in reduced costs) and demographic (such the ageing population) factors.

Q9: What was the last article, report or book that really caught your attention? What was the key message/s in it?

While an avid reader of investment literature and contemporary market commentary, my investment philosophy was shaped decades ago by the icons of our industry, such as Warren Buffet and Bill Gross. These are essentially about making sensible investment decisions that are both prudent and practical, taking into account the following:

  • Understand the big picture and invest with a long-term focus (avoiding short-termism).
  • Always question consensus thinking – sometimes it’s right and sometimes it isn’t.
  • Diversify, diversify, diversify... especially for defensive investments.

Q10: Please complete this sentence: Investors should have some exposure to active fixed interest right now because…

benchmarks in Fixed Interest are a flawed concept. In Australia, we now have a bond market that has the highest level of interest rate risk and lowest level of credit income producing assets. This is the opposite of what a fixed interest investor’s portfolio should look like at this point of the cycle.

An appropriate portfolio in this environment should start with a blank sheet of paper and introduce an appropriate amount of interest rate risk and income-producing assets, rather than be shaped by the behaviour of borrowers (the bond issuers) in the market.

Enjoy that?

You can read further insights and analysis from the team at Janus Henderson here.


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