While speculating on the future direction of interest rates, currencies, and monetary policy can generate great headlines, it often raises the question; ‘what does this mean for investors?’ Understanding the implications of the macro environment drives asset allocation decisions, which according to research by Robert Ibbotson and Paul Kaplan, accounts for 90 percent of the variability of fund returns over time, and 40 percent of variation among funds. It’s clear then, that getting this right is key to success.
We recently asked six leading economists, with expertise across equities, fixed income, and multi-asset, for their view on the current economic environment. Find out in this wire how those views are affecting their portfolio decision.
Responses come from Simon Doyle, Schroders; Paul Xiradis, Ausbil Investment Management; Adam Bowe, PIMCO; Jay Sivapalan, Janus Henderson; Chris Rands, Nikko Asset Management; and Scott Haslem, Crestone Wealth Management.
Time to skew towards cheaper markets
We are in a dangerous phase for investors. Low (and lower) rates make it difficult for investors to earn decent low-risk income, tempting investors to step out the risk curve in search of higher yields and ultimately higher returns, yet the reason the pressure on rates is down, is because of heightened risk in the economy and by extension corporates. Importantly, this is occurring against a backdrop of limited risk premium in most assets. In other words, risks are rising and instead of demanding higher risk premiums to compensate (read lower prices), they’re accepting less because the risk-free alternative is so low.
To the extent that low returns are preferable to negative returns, the amount of risk investors hold and where they hold it will be critical in this environment. Markets won’t stay still and investors with liquid and high-quality portfolios will benefit. Now is not the time to be chasing risk, nor the time to be seeking solutions in complexity. While 2019 has started strongly, investors would do well to remember the difficult environment of 2018. Equities don’t always rise.
We think investors should skew towards the cheaper markets. Australian and Japanese equities look OK value to us. While not cheap, good quality Australian corporate bonds and mortgage backed securities (RMBS) offer stable income with limited default risk. We’re avoiding expensive markets like US equities and leveraged loans. We also like good risk hedges such as Japanese Yen, the USD (particularly v AUD) and longer-dated US treasuries. Cash, despite its low (and likely to be lower) yield shouldn’t be shunned either in the near term.
Major opportunities to benefit from structural change
We maintain a view that while global and Australian economies will grow in 2019 and 2020, growth will be at the lower bound of potential. Fiscal and monetary stimulus will extend the recovery and market cycle, though the world waits eagerly for the US and China to resolve their trade dispute.
For these reasons, more than ever, we are focused on earnings quality and growth. While risk remains, there are still significant stock-picking opportunities in resources, quality industrials with global growth potential, selected REITs, and companies with significant global market opportunities.
We reduced our underweight to banks prior to the election and have further reduced it following the re-election of the Coalition Government. While APRA proposes to lower the serviceability requirements, and with a Coalition Government, banks are more comfortable and balance sheets will be less challenged than under the proposed changes from Labor. Earnings, margins and business models have been under pressure; however, lower rates will help take pressure off. This will provide support for property prices; however, the consumer remains stretched and it may take some time for this to pass through to growth in earnings for the banks.
REITs are a case of two markets, retail REITs that are under significant pressure from structural changes in retailing globally, and industrial REITs that are benefitting from the boom in major logistics and warehousing. We think there is opportunity to benefit from structural change in retail through such REITs as Charter Hall and Goodman Group that are benefitting from the expansion of companies like Amazon. However, we are underweight traditional retail REITs.
Finally, resources are enjoying significant growth, and strong EPS growth driven by a lower AUD and global supply constraints. We expect recent failings in the tailings dam at Vale and other resource supply interruptions to underpin the iron ore price over the next few years. This supports a strong earnings growth outlook in this sector in 2019 and 2020.
Increasing the duration of bond portfolios
Regarding our specific macro views, there are three practical implications for our portfolios.
First, we are likely in a much more anchored interest rate environment globally and investors should be much less concerned about the potential of significantly higher interest rates over the cyclical horizon. We have generally increased the duration of our bond portfolios over the course of 2019 and believe the current environment should allow bonds to play their traditional diversifying role in balanced portfolios.
Second, active investing will be critical for fixed income investors with some global government bond yields hitting or approaching zero again. In this respect we view US Treasuries as relatively more attractive than most other developed market sovereign bonds.
And third, we are short a basket of Asian currencies to protect portfolios against the risk of a protracted and potentially volatile renegotiation of trade relationships between the US, China and broader Asian economies.
Two key implications of our macro views
#1 – How low can rates go?
Given the market is now expecting two interest rate cuts, we should ask the question of how low bond yields can go? Over the past 10 years, when the RBA cut interest rates, bond yields typically fell to around 20 to 50 points below the eventual cash rate. If we are to assume that the RBA cuts interest rates twice to 1.0%, this would imply that 3-year bond yields trade down to around 75 basis points. Given 3-year bond yields are currently around 1.10%, this would imply that the majority of the bond rally has now been completed with another 20 – 50 basis points left in the tank.
RBA cash rate and 3-year bond yields
Looking forward, 3-year bond yields typically trade between +/- 50 points over the cash rate, higher than cash when the market expects hikes and lower when it expects cuts. This means that while the RBA keeps cash at 1.00%, the most likely outcome is to see the 3-year bond yield trade between 0.50% and 1.50%.
3-year bond yield – Cash rate
#2 – US/Aus Interest Rate Differentials
The second implication worth pointing out is that the outperformance of Australian bonds relative to the United States now looks mostly complete. Australian bonds have fallen to be about 80 basis points below the United States, after spending almost the entirety of the past two decades above the US. This relationship typically follows the cash rate differential of the two countries. Given the Federal Reserve looks done hiking and the RBA cuts are mostly priced in, both yields look relatively fairly priced for the current cash rate environment.
Australia and US interest rate differentials
Looking forward we believe it will be the Federal Reserve cash rate that can dictate interest rate differentials. If the Federal Reserve is closer to cutting than hiking, then US bonds should outperform Australian bonds, as the US cash rate will move lower towards ours. The exact opposite of what the market expected late last year when they saw Australian yields rising to the US.
Don’t move too far down the risk spectrum
Jay Sivapalan, Janus Henderson
Whilst there is some risk that cash rates and bond yields can undergo an orderly adjustment upwards over the years ahead, it seems clear that the likely magnitude will be small. This leaves investors in a relatively low yield environment in which to generate returns.
There are two important implications for investors and portfolio managers.
First, low yields encompass minimal cushion for adverse movements in bond yields before all the income is wiped away by the negative capital impact. Interest rate management is more important than ever in order to preserve capital for investors.
Second, very high-quality corporate debt, combined with government bonds, is a valuable source of additional return for investors against risk-free assets in a low yield world. The important thing is not to push the boundaries in terms of moving too far down the risk spectrum and ensuring fixed interest portfolios are remaining high quality with their defensive characteristics.
Equities over fixed income – but don’t forget to hedge
The recent move by markets to price further significant central bank rate cuts in the US and Australia has seen bond yields rally to levels we believe are inconsistent with our central case for some type of US-China trade resolution by end year and a moderate recovery in global growth. Reflecting this, we are moving significantly underweight government bonds in our client portfolios. With central banks highly unlikely to embark on restrictive policy over the coming year keeping default rates low, we are also taking a more positive view on both global and domestic corporate credit, where we believe returns well in excess of very low cash yields can be harvested without unreasonable risk.
With global monetary and fiscal policy supportive, our central case for moderate growth to return in the later stages of this investment cycle continues to favour equity returns over fixed income returns. However, while we continue to anticipate a US-China trade deal by the end of the year, the US president’s recent decision to collapse the previous trade deal and seek a better outcome for the US has challenged our confidence.
Reflecting this, we have recently decided to tactically hedge some risk. While staying overweight emerging market equities, we are trimming our position to reflect the rising risk of a damaging trade war escalation and capital flight from emerging markets. While staying underweight Australian equities (given valuation headwinds), we are reducing this underweight as Australia would likely benefit from defensive flows in a further trade war escalation, while recent domestic developments also ease some of our concerns about Australia’s outlook.