It’s time to think differently

Patrick Poke

Livewire Markets

For over a decade now, interest rates have been suppressed and money has been cheap and free-flowing. This has produced outstanding returns for traditional asset classes as the prices of both equities and bonds have repeatedly bid to new highs. But as exciting as it is to see large double-digit returns year after year, the inescapable fact is that higher prices now means lower returns in future.

But as any experienced investor would tell you, this situation is hardly new. So, what’s different now? According to Kerry Craig, Global Market Strategist at J.P. Morgan Asset Management, the key difference is inflation.

“Inflation pressures are becoming more evident, but they'll also be stickier than they have been in the past.”

In this roundtable discussion, I speak to Kerry and David Wright, CEO of Zenith Investment Partners about current market conditions and why they’ve created an ideal situation for alternatives. 

Consider the alternatives beyond traditional assets

In part 2 of this interview, Kerry and David explain where alternatives sit in an investor’s portfolio, some of the risks and downsides, and why investors are making the switch today. We even discuss whether crypto assets are attractive as alternatives. For more insights from Kerry, follow his profile here – and David, here.

Find out more about J.P. Morgan Asset Management's Alternatives capabilities.

Edited transcript

Patrick Poke

Kerry, David, good to be chatting with both of you.

David Wright

Good to see you Pat.

Kerry Craig

Thanks for having us.


We're here to talk about alternatives, but I wanted to start by setting the scene and understand why we're talking about alternatives.

My question, to begin with, is around bond yields and the role they have on other asset classes. Why have bond yields been so low for so long?


There are really two reasons. The first is there's not been a huge amount of inflation for the last decade or so.

Debt comes from a lot of the structural factors we see in the economy around the world: globalisation, lower wages.

You've had unions that have become less impactful on driving that wage growth, and also technology change, which makes inflation a little bit lower as we become more productive.

And then there's the response to that low inflation: central banks want to create inflation. So the economy runs and they have this idea that a warm inflation creates warm growth. And they haven't been able to achieve that.

So after we saw in 2008, to try and generate that inflation and that growth, they've been throwing everything they can at it. And it's led to this quite ugly phrase: financial repression.

It basically means bond yields are going to be lower and lower as they try and stimulate that inflation and growth and the economy.

They've opened up that toolkit of policies they have used, and as governments have increased the size of their debt levels, there's now an issue around the sustainability of that debt.

That means borrowing costs need to stay low to make it more affordable for governments to try and do all that stimulus they have been doing for the last two years in response to the pandemic.


Do you see this situation changing in the foreseeable future? It feels as though we've been in the mode for what — 10, 12, maybe even longer years? Why would it change now?


There is going to be a change in this cycle when it comes to inflation. Inflation pressures are becoming more evident most immediately, but they'll also be stickier than they have been in the past.

And some of those things that have caused lower inflation in the past, such as globalisation, have shown signs of reversing.

And there's also more of a question mark about exactly what impact things like climate change will have in terms of the way it hits pricing and what it means for inflation.

But we do know it's not going to be outright, outrageous inflation that's going to be a problem, but it may be a little bit higher, leads that to bond yields being a little bit higher.

I think the issue is the response from central banks to that higher inflation has also changed, and so while we do think inflation and yields can move up from where they are today, they're probably not going to go back to those levels where they were in the past.

There simply won't be the allowance for them to do that because central banks are holding yields down to make borrowing cheap.


What do you see as being a neutral rate for bonds now? Obviously, it seems at the moment, we're at an expansionary rate. Where do you see it going over the next few years?


If you look at something like our long term capital forecast, where they look over the next 10 to 12 years at what they think the equilibrium rate will be for cash rates and treasury yields, it's around about 2% in nominal terms.

If we think about real terms, it's likely to be a lot lower closer to zero, and that's the world we're in.

And that creates some serious problems, we think, about what bonds do in a portfolio and the role they're meant to play, if we are thinking about real rates that are flat or even negative, and particularly the attractiveness that makes of bonds compared to other assets in that environment.


I must admit, Kerry, it feels sitting here today when we're trying to employ people — all people, not just financial services, especially admin people, the salespeople, the whole works — the labour market is super tight.

It's as tight as I've seen it in our industry in 30 years and you've got really rapidly rising house prices. You've got supply chain issues.

And even the central banks have stepped back a little bit from saying yes, inflation is transitory, but that period's going to be probably a little bit longer, and as Kerry said, it's going to come back to a level that is higher than what we probably originally first thought.

Sitting here today, it doesn't feel like it's going away quickly.


No, it's definitely lingering. And it is part of the fact that the experience of the last year and a half is very unknown.

The scars the COVID pandemic is going to leave on the economy are only just starting to show. But as we do know, scars fade.


What does this all mean for investors who hold bonds? What role can they still play in a portfolio?


It's a great question. Clearly, at the levels they're at, they, unfortunately, can't play the same defensive role that they've played previously, particularly in equity market corrections and so forth.

That's not to say they can't play any role, but I think we need to be careful at this point in the cycle of not having all of your fixed interest exposure at long-duration assets.

And we have seen in the benchmarks themselves, the fixed interest indices themselves, that the duration — which is a measure of, really, in crude terms, the sensitivity of indices and bonds to changes in yields and interest rates — has become a lot longer.

It's become a lot longer because both governments and corporates have been taking advantage of the lower interest rate environment and borrowing for longer.

That in itself makes the indices more sensitive to changes in interest rates and bond yields, which has been terrific on the way down. Passive funds have done exceptionally well in that environment.

If we start to get bond yields clicking up a bit, that could be quite painful in the short to medium term for some of the passive exposures and long-duration fixed-income funds.


The roles that you think about bonds playing in the portfolio as a provider of income and a diversifier have become more and more challenged.

These things were the safe harbour for many investors in their portfolios — they provided the balance to the equity risk they were taking on, and that balance has just become a little uneven as we think about what bonds actually offer in terms of protection.

I think that's very different from saying you shouldn't own bonds, because I do believe you should, and they do still have that negative correlation with equities, but as a diversifier, they're just not as strong as they once were.

That's why, when we think about how are you going to provide ballast in your portfolio, you need to look across a range of assets that aren't just in fixed income, that aren't just in, say, other defensive assets, as you think about building a robust portfolio.


What about alternatives? Do you think they form an important role in an investor's portfolio?


We think they form an important role, particularly now, because looking forward, it does look like an uncertain investment environment.

Let's hope the end of COVID plays out. It's been a long period, as both you and Kerry have said, Pat, about central bank intervention and that's starting to pare back somewhat.

We don't know the outcome of governments bringing back their fiscal response to COVID.

So we really the inclusion of alternatives and having different sources of return, different correlation to other major asset classes and also defensive qualities.

Some of the alternative strategies, what we call non-directional, do not rely on markets going up all the time to generate returns.

There are some shorting abilities, where if you have market corrections, you can generate returns. For all of those reasons, I think alternatives are critical to the exposure in portfolios going forward.


Tell me more about those strategies and how they can meet the needs of bond investors.


It's a good question, because "alternatives" is a bit of a catch-all, and that's a problem, right? There's a broad range of alternative strategies, such as global macro — JP Morgan has a strategy in that space.

There's managed futures; there's market neutral. And then you look at some of the real assets, like timberland assets, transport assets, infrastructure, direct infrastructure, water. It's not a homogenous asset class.

Some of those are reasonably volatile, and that can scare some investors, while others are not priced daily. In fact, they're priced infrequently, and so in some ways there's artificial low volatility.

I guess some of those real assets, direct assets, could be a substitute for some of the defensive allocation in portfolios.

Managed futures, global macro, tend to be allocated within the growth component of your portfolio rather than defensive.


For us, it's all about the fact that it's so difficult to generate the same levels of alpha, income and diversification from public markets now compared to the past.

If you look at our long term capital market assumptions over the next 10 to 15 years, back in 2008, a typical 60:40 portfolio was going to give you over 7% return over the next decade. You roll forward to what we just did in terms of the long term capital markets, that same portfolio of traditional assets gives you just over 4%.

So it's about how you get alpha/income diversification in your portfolio.

You look at the alternative assets and those same characteristics and where they lie — whether it's in the more liquid strategies, whether it's in the real assets that Dave mentioned there in the income and diversifications — and you try and supplement them into your portfolio.

Our view at least, and that's what we're hearing from our clients, is something that does replicate what you used to get from public markets.

There are challenges there — there are fees, there's transparency, there's liquidity. So it's not an easy journey, but this is the reality that's facing investors today.


It is interesting, Pat, because if you look at the recent Your Super, Your Future legislation or regulation, the way that the government or APRA is wanting super funds to classify alternatives is 50:50 defensive and growth.

But that is quite unsophisticated and there's a lobby at the moment to talk about, well, let's not just be that crude, let's talk about what are defensive alternatives, what are growth alternatives.

Maybe, as an example, a measure of volatility is a basic measure of allocating which are the growth alternatives and which are the defensive alternatives.

That's playing out in the super-fund space as we speak. What happens there tends to find its way into investor portfolios as well.


What attributes make a good alternatives manager? How do they compare with more traditional asset managers?


Obviously, we want quality, experienced people. Managed futures is a great example. That is very heavily quantitatively driven. But you still need experienced, well-qualified people to drive those quantitative models.

It's certainly about great people; experience through different cycles. Since the GFC, we talk about the growth investment style outperforming value for the longest period ever.

There're some professional investors in the market that have never lived through different market cycles.

We really are looking for people that have experienced different market cycles and have great confidence in the investment process and style and applications through those different market cycles.

As Kerry said, perhaps some of the differences are that because a lot of these models are pretty quantitative, they're very heavily academically based. Some people call them black-box.

You really are wanting transparency — I mean, you want transparency in all managers, but it has been historically a space where there has been probably less transparency in terms of what managers and investors are doing with their process and under the covers, so to speak. We're looking for true-to-label; what you see is what you get.

As I mentioned before, there are, say, managed futures and global macro that can be higher volatility investment styles. That's okay, as long as they're delivering the investment objective over the period of time they're designed for.

These are the things I think investors should focus on when trying to assess.


That's an important point because the experience you can have as an investor in alternatives can vary greatly, depending on the manager you choose.

If you think about, say, a global equities manager and you compare the different managers and their performance, there's not going to be a huge difference in what they all return.

They're looking at the same data, the same public markets, and assessing them. Granted, they'll have different methodologies, but the dispersion of returns is relatively narrow.

If you apply that same metric towards core alternative managers, it's going to be very, very wide, because they're going to be very different.

Core alternative managers have different ways of approaching the market and different underlying assets they're looking at as well, so manager selection becomes a hugely important fact, and the due diligence you do on that selection is going to ultimately impact your experience with alternatives.

In the Australian context, in the past, that may have been detrimental to some investors, who have perhaps gone with the wrong manager and have a different experience of alternatives.

But that's going to be a key thing to thinking about how you add alternatives to your portfolio.

If you're thinking about a core alternative which is going to be lower volatility, maybe higher income, versus something that's non-core, more opportunistic, maybe a bit more volatility and a bit higher risk, it's all going to have a variation in terms of thinking about what it does in your portfolio.


I think that's a really good point, because, as Kerry said, most people will understand there is a share market index. A lot of people understand there are bond indices.

With a lot of the alternatives, there aren't recognised benchmarks. So a lot of the managers are managing to an absolute return target and/or volatility target.

I think that keeps a lot of people away from alternatives because they don't understand, "What am I to expect from this fund or manager?"

It's not like an equities manager. I can at least expect they'll be somewhere around, above or below — hopefully above — the share market index.

But there aren't recognised indices. There are industry indices, but the average investor, the advisor, they're not familiar with those.


It's not like S&P/ASX 200, for example.


Completely, yeah.

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Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.


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