The pace of the rally since March has left many investors with a severe case of FOMO, questioning whether chasing equity markets is the right approach. Simon Doyle, Head of Fixed Income and Multi-Asset at Schroders Australia, warns that the bull case for equities is “brave”, and rests with the US Federal Reserve successfully controlling the yields on governments bonds.
“The market’s scenario gear shift from economic Armageddon to a “V-shaped” recovery seems highly optimistic. From a valuation perspective, the US market is now trading on multiples above pre-crisis levels with considerable ambiguity around future earnings and their trajectory. On this basis, we’d be loath to chase the market up.”
In this Q&A, Simon discusses the biggest risks for markets and economies in the months ahead, explains why he’s been deploying cash in Australia rather than overseas, and shares which asset classes he believes offer the best risk to reward ratio today.
Do you take a more dynamic approach to asset allocation during periods of high volatility?
Periods of high volatility tend to reinforce my belief in the importance of process. Without a process it’s too easy to get caught up in emotion which inevitably leads to bad investment decisions and poor outcomes for our investors. Having a disciplined process gives us an unemotional filter to screen the exponential rise in “noise” that occurs in these periods and to properly inform our decisions.
One of the key principles of our process is that valuations do matter. This is something that many have questioned in the quantitative easing (QE) world, and while the influence of other factors (like liquidity) may have increased, this hasn’t negated the importance of the information contained in asset valuations. Generally speaking, the link between valuations and returns is stronger the longer the investment horizon and is therefore a good place to start. In the current context, we entered the COVID-19 crisis defensively positioned, not because we foresaw the crisis unfolding as it did, but because our screens indicated minimal risk premiums in key assets (equities and credit). This meant markets were priced to perfection leaving little room for error. The COVID-19 pandemic was the trigger, but the problem was that markets had no buffer for any shock let alone one as substantive as the economic shutdown triggered by COVID-19.
Volatility can drive opportunities, and this may result in more frequent changes in positioning, but it’s certainly not the case that we aim to be more dynamic in periods of volatility. It's simply the case that rapid changes in price change the risk/return dynamics more often (and often significantly) and this is what we seek to exploit.
For example, we entered the COVID-19 crisis defensively. While in practical terms, catching the lows in markets tends to be more luck than good management, we were able to add back as prices fell and valuations improved. The volatility presented some good opportunities to exploit.
With equity valuations at elevated levels and stocks carrying significant momentum, is it better to ride the rally for all it’s worth?
There are plenty of investors questioning the voracity of the equity market rally, particularly in the US. I’d put myself in this camp. That said, it’s worth thinking about why the markets rally to be better able to address the path forward.
The rally can be attributed to a combination of factors including: the voracity of the sell-off on the back of the economic shutdowns (and the improvement in market valuations even if we at not sure by how much given the uncertainty around the hit to profits); the rapid and substantial policy response, particularly with regards to the US Federal Reserve, including the extension of its QE program to the purchase of corporate bonds; the “apparent” stabilisation in COVID-19 infection rates; and the reopening of the US and other economies. More fundamentally, the big US tech companies have to some extent been winners from the crisis given the boost to technology and the online economy.
To a large extent, the durability of the rally will be dependent on how well-founded these assumptions are. The market’s scenario gear shift from economic Armageddon to a “V-shaped” recovery seems highly optimistic (a “U” or a “W” would be more reflective of our central case) and the risk of a second wave (particularly in the US) seems high. From a valuation perspective the US market is now trading on multiples above pre-crisis levels with considerable ambiguity around future earnings and their trajectory. On this basis we’d be loath to chase the market up.
For the brave, the bull case rests with the Fed and its increasing penetration out the risk curve. Its actions and timing do suggest that its targets extend beyond liquidity and proper market function to outright support for market levels beyond the Fed funds and treasury markets.
With the AUD rallying to 70c, have you adjusted your mix of Australian/international allocations?
The AUD’s rally has been highly correlated with the broader recovery in risk assets (any asset which carries a degree of risk) and this is neither unusual nor unexpected in this circumstance. Likewise, as risk assets peeled away in February and March, the AUD declined quite sharply. Its role as an effective risk hedge remains strong and vitally important against a backdrop of very low and distorted sovereign bond yields which has effectively reduced the effectiveness of sovereign bonds and duration to fulfil this role as well as it has historically.
As institutional investors, we decouple the currency decision from the equity decision, allowing our fundamental view on each plus the necessity to diversify in a portfolio construction context to drive our positioning. On this point our preference from an equity market perspective is Australia. Valuations look better (therefore prospective returns look better) and the economy and the management of COVID-19 look to be on much better footings than in key markets offshore. Recently, we’ve actually been adding to Australian equities not offshore.
What’s the biggest risk the Australian economy faces right now?
In the short run, the end of the government's stimulus programs will reveal the underlying and longer-term damage to the economy from the COVID-19 crisis and the impact of the lockdowns.
Prior to the recent COVID-19 shock the Australian economy was in poor shape, with the only growth emanating from population increase, with wages and per capita income stagnant. A key risk is that the economy returns to this disappointing outcome once the pandemic is over.
This would be particularly troublesome given the increased debt burden, as a lack of growth will limit the ability to bring it down to a more appropriate level. A lack of political will to institute productivity-enhancing reforms has been a problem in a system where political parties have been more focused on internal control (represented by the revolving door of Prime Ministers), than on managing the economy effectively. Whether or not this dysfunction continues will be a key question about the post-COVID-19 recovery.
In a medium-term context, I think our trade relationship and dependence on China needs close attention. The political relationship is being tested and this has the potential to extend into the trade sphere in a much more material way than it has so far. We clearly sell a lot to China, but we rely heavily on China to supply the economy. To the extent we become a proxy for US/China tensions, we run the risk of this spilling over into a very damaging trade problem.
Could high-grade government bonds still play an important part in portfolios given the very low yields on offer?
The rapid and aggressive action of the central banks to cut rates sharply to support the economy and financial markets has clearly come at a cost to income for savers and investors. In the case of Australia, the RBA’s targeting of 3-year bond yields at 0.25% and this has compounded the challenge, pulling yields down across the curve. To some extent, investors should be grateful as it’s supported the capital value of their portfolio, but income has been hit and a rethink of the role of government bonds in portfolios is inevitable.
That said, there are some valid arguments supporting the inclusion of high-quality government bonds in investor portfolios.
Firstly, yields are incredibly low everywhere. The alternative of shifting into high quality corporates could be moderately positive in a carry sense but comes with the challenge of spread volatility and capital risk. Moving further out the risk curve into equities materially changes the risk profile of a portfolio at a time when market valuations are far from cheap.
Secondly, that in the not improbable event of deflation, current low yields could decline even further (0% is not the lower bound for sovereign bond yields). The capital gains resulting from the change in yields in this context would help mitigate some of the losses from more risk-seeking assets in this environment. Thirdly, it remains a reasonable diversifier against general market volatility – and we’ve seen plenty of evidence of this in 2020.
In April, you said you were watching four key indicators – economic news flow, clarity about the shape of the recovery, corporate profits, and stabilisation of the virus. Could you provide an update on these?
The rationale for laying out these areas of focus was to reflect the lack of precedence and uncertainty as to the development of the virus and its direct and indirect impact on the economy, corporates and markets. We knew at the outset the impact would be significant but with a multitude of variables such as economic and health policy responses and progress on vaccine development, predicting the path forward would be precarious. That said, we doubted the potential for a “V” shaped recovery and felt that both the economy and COVID-19 would take some twists and turns before it was resolved.
The news flow has been varied, but in broad terms not as bad as feared but not as good as many had hoped. I’d also caution about interpreting data that is heavily distorted by policy measures, many of which will be transitory or misleading, particularly with regards to the labour market. Likewise, while countries like Australia have had considerable success in suppressing transmission of COVID-19, as we’re currently seeing in Victoria, declaring success early (even here) is dangerous. The risk of a second wave is high (witness the outbreak in Beijing) and in the US, case-counts are accelerating, suggesting the first wave may be far from over. This is also consistent with a more difficult recovery – at best a “U” but potentially a “W” or a hybrid of the two. The bottom line for markets is that the economic path forward is still fraught, and this means downside risk to profits and this may take some time to properly play out – June and September quarter numbers will bear close attention and they are still some way off.
Which asset classes offer the best risk/reward right now?
It’s hard to make a strong case for any core asset class today on the basis of fundamentals. Cash rates are very low and short-dated sovereign yields are similar. Longer-dated sovereigns offer some yield but are hardly cheap and at risk given fiscal expansion and explosive money supply growth. Corporate bonds are in the Fed’s sights and the compressed spreads to margins are at levels below that commensurate with the risks associated with highly levered corporates in a recessionary environment. While equity markets (particularly in the US) have rebounded solidly since March, prices have decoupled from earnings, stretching valuations.
The positive for equities is that the central banks won’t turn the liquidity taps off any time soon so there remains upside should the economic damage remain contained. Within equities, we prefer Australia where policy still has room to move and where the pandemic is seemingly under relative control.
The implication of the above is the importance of thinking about portfolio construction in this environment. We have been averaging back into equities (mainly in Australia) but also raising cash at the expense of investment-grade credit. This “barbell” approach (where half of the holdings are short-term instruments, and the other half have long-term holdings) lets us participate in the upside should equity markets rally continue, whilst giving us both protection and liquidity should risk assets start to reconnect the macro-environment with pricing. We expect more volatility, and this will bring opportunity.
We also think finding a diversified source of return is important. We’ve been looking at Asian corporates and emerging market debt, as well as direct lending to areas of the market where banks have withdrawn due to capital requirements and a structural risk and a liquidity premium, exists.
Take advantage of opportunities wherever they exist
With the flexibility to invest across a broad range of asset classes, Simon aims to help investors grow their wealth with reduced risk of losing money when markets fall. Stay up to date with his latest content by clicking the follow button here.
Great interview thanks Pat. Insightful as usual.