Rebalancing can materially improve outcomes for investors when done thoughtfully. But it’s a surprisingly complex subject.

Here Pendal senior portfolio manager Stuart Eliot (pictured above) offers some practical, plain-language tips.

REBALANCING is a surprisingly technical subject.

There is no shortage of articles out there that discuss the topic using a load of formulas and heavy-duty number crunching.

Instead, here we’ll explain in plain language the practical aspects, illustrating with examples based on the recent market volatility.

Why rebalance?

Advisors invest considerable time with their clients to determine an appropriate investment portfolio based on important criteria such as risk tolerance, income, stage of life and return objectives.

This is ultimately expressed as a set of strategic or neutral asset allocations to various asset classes or as a risk profile (say balanced) which drives the choice of investment portfolio.

In either case the optimal portfolio expresses assumptions about long-term risk and return behaviour of asset classes. Once the portfolio is established, the relative weights between asset classes will change due to market movements, taking the portfolio away from the optimal asset allocation.

Eventually these changes build up to the point where the investment begins to exhibit risk characteristics different to the optimal portfolio – warranting a rebalance.

For example, let’s say the optimal portfolio holds 50% equities because the client can tolerate a mark-to-market loss of 10% if equities fall 20%.

After a strong market rally, equities now comprise 60% of the portfolio which would result in a mark-to-market loss of 12% in the same scenario. (In addition, diversifying investments have fallen from 50% to 40% of the portfolio, offering less than the intended amount of protection.) This is more than the client would be willing to accept – therefore rebalancing would be required before this point was reached.

Rebalancing is an essential part of managing a portfolio to ensure it remains consistent with a client’s objectives.

How or when to rebalance?

There are three general ways of managing the rebalancing of a portfolio. Each comes with pros and cons.

1. Calendar-based rebalancing

Often portfolios are rebalanced at the end of each month, quarter or after a regularly-scheduled portfolio review. The benefit is they can be planned in advance and can facilitate the bundling together of trades to achieve economies of scale.

However, they tend not to be able to take advantage of large intra-period market movements and can potentially result in significant drift from the optimal portfolio.

(Fun fact: if an investment process was developed or back-tested using monthly data for example, it would be implicit in the investment process that rebalancing was performed at the end of every month.)

2. Trigger-based rebalancing

This means rebalancing the entire portfolio, or an asset class/investment within the portfolio, when a trigger level is reached. A trigger could be the distance of a single investment’s weight from the target, the sum of all absolute differences from target, or an estimate of tracking error relative to the optimal portfolio.

This approach has the benefit of keeping the actual portfolio sufficiently close in character to the optimal portfolio while taking advantage of large intra-period market movements.

However this method is more operationally burdensome because it requires regular monitoring to check whether rebalancing is required.

3. Flow-based rebalancing

There are various approaches to flow-based rebalancing. The following approach is representative. The cash balance in the portfolio goes up and down due to deposits, withdrawals, purchases, sales, income and expenses.

When the cash balance is too high the surplus is used to top up the most underweight investments. When the cash balance is too low additional cash is raised by trimming the most overweight investments.

The main benefit here is that transactions costs are minimised. But if cash movements are small and market movements are large, the portfolio can move a long way from its target.

Which approach is best?

The most appropriate rebalancing strategy depends on an investor’s specific circumstances.

At Pendal Group we manage the rebalancing of our diversified funds using a blend of the second and third approaches.

Each day we monitor the weight of each investment in a portfolio (generally unit trusts for asset class and strategy exposures and futures contracts for active tilts). When an investment gets too far from its desired weight we rebalance back to the target.

As an extra tweak – in asset classes where it makes sense to do so – we often rebalance using futures contracts because these tend to have lower transactions costs than unit trusts or the individual securities they hold.

Apart from staying close to the desired asset allocation, this also imposes a robust discipline to managing the portfolio when things get wild, as they have done recently.

We naturally believe all investments we hold will deliver a positive return over time, although we can’t know when. Therefore as the price of an asset declines, through the rebalancing process we gradually buy more as it becomes cheaper while reducing the holdings of other assets as they become more expensive. Our choice of rebalancing approach is driven by a combination of the structure in which we happen to operate combined with our own research.

Our basic insight is that markets tend to:

1. Trend over days

2. Mean-revert over weeks

3. Trend over months

4. Mean-revert over years.

Trigger-based rebalancing capitalises on the first two of these timeframes. We find that doing so results in better expected returns through time than calendar-based approaches. The latter two timeframes are the domain of our active asset allocation processes.

Rebalancing in volatile times

We’ll conclude with a few insights from the recent volatility which may help in setting up portfolios to benefit from future volatility – when it inevitably arises again.

The first is using flexibility to reduce transactions costs.

As mentioned above, Pendal makes use of futures as part of the management of diversified fund rebalancing. This was particularly useful in March when the equity market was experiencing huge intraday moves on a regular basis – resulting in regular and sizeable rebalancing flows. By trading futures – rather than unit trusts or individual securities – we were able to trade with materially lower market impact.

This also gave us the ability to choose our time and price if desired, rather than being captive to the end-of-day price. Not everyone is able to trade futures, but a near identical outcome can be achieved by holding a portion of the investment in relevant asset classes in highly-liquid ETFs or other passive vehicles – of which there are many to choose from. In fact we do exactly this in our multi-asset SMA portfolio models.

Another insight relates to transactions costs – though in a different way. During the worst of the March equity market plunge, the natural systematic rebalancing flow across the market was to buy equities (which had become under-weight as the price declined) and sell fixed income. In Australia, many fixed income mandates are managed to a government plus credit benchmark. Because of this, redemptions from generalised fixed income placed pressure on already-stressed credit markets, causing some funds to widen their bid-ask spreads. At the same time our longer-term valuation models were telling us credit was attractively cheap and we should be adding exposure in our portfolios – which on the surface would seem expensive given the wider spread.

Fortunately in most of Pendal’s diversified funds we hold government and credit exposures separately within the fixed income asset class. So we were able to “buy” the credit exposure almost T-cost free by executing the rebalancing through selling just the government bond holding. The net result is an overweight to credit without having to pay the wider spread.

Pendal senior portfolio manager Stuart Eliot has day-to-day responsibility for the monitoring and management of all portfolios within the Multi Asset team.

Find out more about Pendal’s investment capabilities

Which factors are likely to impact Australian equities in coming weeks? Here’s an outline from Pendal’s head of equities Crispin Murray (pictured above). Reported by portfolio specialist Chris Adams.

THERE are a number of things to watch for in terms of potential market impact in coming weeks:

1. Policy

There may be some risk of disappointment on the policy front in coming weeks, as we move through the era of “peak policy”.

The rate of balance sheet expansion is likely to decelerate, while agreement on additional fiscal programs in the US will become increasingly difficult.

The market may also start to look through to the end of June when some of the initial measures start to roll back.

2. Geopolitics

There are also some noises on the geopolitical front. The US has dialled up the rhetoric around China’s role in the coronavirus pandemic — and followed up with restrictions around Huawei’s access to American technology.

China, for its part, has been sending messages to Australia as various government officials call for an inquiry into how China initially handled the outbreak. Sanctions have been announced against Australian barley and beef.

Despite some noise we think material restrictions on iron ore are unlikely given the impact it would have on the Chinese economy. Nevertheless, further tension here could shake market sentiment.

3. Oil

We are nearing a roll-over in futures contracts of the kind that prompted a sharp fall in oil prices last month. Fundamentals have improved as some production has been shut in and the outlook for demand improved.

At this stage a re-run of last month’s volatility looks unlikely, but this week could prove to be a key test.

Key indicators of market sentiment

We think there are four areas that are helping gauge the market’s current sentiment:

1. Gold continues to climb higher. In some ways this is serving as an each-way bet. It is a hedge on central bank policy and the potential longer-term risks that come with massively expanded balance sheets.

However if it transpires that the policy response has not been enough and we start to see widespread bankruptcies, then it is also seen as a hedge in a risk-off environment.

2. Negative rates have been raised as a possibility in the US. The Fed says it isn’t required – while not ruling it out either. The US two-year note is still trading at a premium to cash rates, which indicates the market is not yet expecting negative rates – but this remains an area to watch.

Rates moving negative would suggest the economic outcomes are much worse than expected – and would also be very negative for sectors such as financials.

3. Corporate bond yield spreads serve as a good proxy for expected bankruptcies. These have stabilised after central banks stepped in to back-stop the corporate credit market.

Another blow-out here would indicate the market thinks things are moving beyond the control of policy makers.

4. The US Dollar was volatile through February and March but, like corporate spreads, has settled down and stabilised in recent weeks. Any signs of the USD breaking materially higher against other currencies could be a sign of increasing risk aversion and be negative for equity markets.

China’s experience

As restrictions roll back in Australia and overseas it is useful to track China’s trajectory as a potential guide. China retains material restrictions at a national level, while individual cities have seen lockdowns dialled back up in response to outbreaks.

China’s economic rebound was initially quite sharp, before slowing in recent weeks and then seeming to stall at about 90% of its previous level.

Persistent weakness in some areas of discretionary spending is holding the economy back from reaching its previous level.

It will be important to see if industrial production can continue to hold up if people are buying fewer discretionary items. Services (such as eating out) have been slow to respond. In the US there are expectations that 15% to 30% of restaurants may shut.

Durable goods and industrial production has recovered quite well. Auto sales, in particular, have seen a sharp bounce given an aversion to public transport.

This is feeding through to traffic, which is picking up and may move to higher levels than pre-COVID-19. This will be a key area to watch here and in the US.

It is becoming clear that some parts of the economy will pick up faster while others may see longer-lasting, deeper structural damage. This has important implications for portfolio construction.

Find out more about Pendal’s investment capabilities

What’s the outlook for negative rates? Pendal’s Head of Bond, Income and Defensive Strategies Vimal Gor gives a snapshot here in a new video interview with online business channel Ausbiz.com.au.

Watch the video above or read the transcript below.

TRANSCRIPT

AUSBIZ.COM.AU INTERVIEWER: Is the Fed continuing to backstop equity markets going to end in tears at some point in your view?

VIMAL GOR: Yes. I don’t think this negative rates thing is about back-stopping equity markets. I think it’s more borne out of necessity.

The problem the Fed has is that interest rates are at zero, 10-year Treasury is, call it 50 basis points, and we’re going to enter into a period of quite pronounced deflation in the US economy.

And that’s because the inflation rate is largely driven by the economic cycle.

We know the economic cycle is being curtailed because of what’s happened with the virus. So we’re going to have deflation in the US of somewhere between 2 per cent and 4 per cent over the coming months.

The problem is when nominal interest rates are at zero and you get deflation, it means you get rising real yields.

Now the economy is driven by real yields, not nominal yields.

So the problem is we’re in this terrible situation where we’ve got really weak growth and we’re going to see rising interest rates in the US.

So the Fed needs to counter that somehow. But the problem is they have limited tools now.

They’d like quantitative easing, but as I said, 10-year Treasury are only 50 basis points and moving them to zero is going to do largely nothing.

They’re doing all this funky stuff. We’re buying ETFs and high yields and stuff, but that’s largely trying to throw a lot of liquidity at what is ultimately going to be a solvency issue.

So now they’re thinking about cutting interest rates negative. And I think it’s a great idea and they should do it the way Rogoff talked about it in his Project Syndicate article over the weekend.

They should do a short, sharp shock that would take rates to -2 per cent or -3 per cent quickly and force the financial institutions to have to deal with it.

They need the banks to be ready and the banks in the US are not ready. But I’m sure they’re working with the banks to make them ready, were this to become an eventuality.

INTERVIEWER: One of those tools they do have left in their arsenal is just rhetoric and the mouthpiece. And that’s what the Fed’s (Federal Reserve Chair Jerome H) Powell has effectively been trying to do — push that message onto Congress: ‘We want that fiscal assistance’. He’s doing everything in his power, it would seem, verbally to avoid those negative rates. Just how long can he keep trying to play that game?

VIMAL GOR: I think Powell has zero credibility left now anyway. Yes, we need fiscal. But fiscal is, as I said, a stop gap. It’s a liquidity issue that isn’t going to affect the long-term solvency of these companies. They’re still going to go under.

Also how much more fiscal can we do? Yes, there’ll be an infrastructure package and yes there’ll be a few more after it, but we’re already staring down the barrel of budget deficits of 20 per cent in the US.

You can throw more money after it again and again and again, but it’s the same old thing. We have this growing problem in the US since the GFC around quantitative easing, pushing up financial assets and benefitting Wall Street but not helping Main Street.

And they’re doing the same again. That’s what’s happening now. You’ve got unemployment north of 15 per cent, heading to 20 per cent in the US, and the S&P is not far off all-time highs.

This disparity needs addressing at some point.

By doing negative interest rates it actually helps Main Street and it kind of hurts the richer demographic part of the population. So it works on a number of levels.

Obviously the lobby groups and the banks will be strongly against it and people will have a tough time getting their head around it.

But ultimately when you realise that real yields in the US have been positive and negative a lot of times over the last 50 years, it’s not that much of a departure anyway.

INTERVIEWER: Donald Trump, the US president, would be happy to hear your reasoning on negative interest rates. He’s definitely in the pro camp. What’s a time-frame? You say that it should be done in a snap reaction, get things going, get things moving. So when are we likely then to see this coming to fruition?

VIMAL GOR: Well we’re going to see the unemployment numbers get worse in the short term. We’re going to see the inflation numbers — we saw CPI this week which was bad. We’re going to see that get materially worse over the next few months.

So the time is now. Whether operationally they can move before year-end I’m not too sure. The RBNZ gave the banks till the year end to fix their problems with operation and be able to handle negative interest rates. It doesn’t mean they can’t pre-announce though.

Ultimately whether the Fed does move to or not, the fact that they’re considering it is what’s important here, because the markets will now start pricing it.

As we saw this week, that markets started pricing negative interest rates already in the US and that opens up a part of the distribution that hasn’t existed before.

So therefore now it means the market will now price positive and negative interest rates.

Whether the Fed actually delivers on them or not — it’s important, but the market was already starting to price it. So that’s a really key thing.

The fact they’re having these discussions is material and given the fact that they didn’t want to counter the idea of negative rates just a few months ago.

The way they introduced negative rates in Europe, Japan — they did it incorrectly with hindsight. They did it too slowly and they did it too weakly, too slowly.

They cut rates a small amount sub-zero, then they increased it a little bit, a little bit, a little bit. You don’t deal with the underlying malaise in the economy and therefore you get the problem still there.

You get the back-end of the curve rallying, the yield curve flattens, which crunches your banks and it destroys credit creation. It makes the problem worse.

But if you’re to go in and move interest rates quickly and materially negative, we should hopefully not have those problems because you force the banks and financial institutions to lend money.

Which is ultimately the whole point of negative interest rates.

Important Updates

Pendal MicroCap Opportunities Fund (APIR: RFA0061AU, ARSN 118 585 354)

Effective 14 May 2020, the Pendal MicroCap Opportunities Fund (Fund)’s buy-sell spread will decrease from 1.40% (with 0.70% payable on application and 0.70% payable on withdrawal) to 1.20% (with 0.60% payable on application and 0.60% payable on withdrawal).

The buy-sell spread is an additional cost to you and is generally incurred whenever you invest in the Fund. The buy-sell spread is retained by the Fund (it is not a fee paid to us) and represents a contribution to the transaction costs incurred by the Fund such as brokerage and stamp duty, when the Fund is purchasing and selling assets. The buy-sell spread also reflects the market impact of buying and selling the underlying securities in the market. Importantly, the buy-sell spread helps to ensure different unit holders are being treated fairly by attributing the costs of trading securities to those unit holders who are buying and selling units in the Fund.

The reduction in the Fund’s buy-sell spread reflects continuing improvement in trading conditions. Pendal will continue to monitor market conditions and review and update the buy-sell spread regularly as required. You should therefore review the current buy-sell spread information before making a decision to invest or withdraw from a Fund.

Please refer to our website www.pendalgroup.com and click ‘Products’ for the latest buy-sell spread for each Fund.

Which way will equities markets go from here? Here Pendal’s head of equities Crispin Murray (pictured above) outlines the case for both bull and bear scenarios. Reported by portfolio specialist Chris Adams.

At the end of last week the ASX 300 had rebounded 20% from its low, recapturing just over a third of the drawdown from the February high. However this lagged the 31% bounce in the S&P 500, which has retraced about 60% of its fall.

It is tough to make a high conviction call on market direction from here.

As we have mentioned previously, the scale of the two opposing forces – economic downturn and policy response – is material.

This is why we continue to position the portfolio to perform across a range of scenarios, rather than making a heroic call on the outcome.

The bull and bear cases for equities at this point can be summarised as follows:

Bear case

1) Risk of a second wave of infection

There is a widespread view that the US is re-opening too quickly. The risk is that a second wave of infections could prompt a return to restrictions, hitting the economy and market sentiment.

There is some mitigation from the scale of testing, which can help identify and contain outbreaks on a localised level. There have been flare-ups in China and South Korea which will provide some indication of how successfully this can be managed. Case numbers therefore take on added significance in coming weeks.

2) The economic rebound is overstated

A US survey suggests 80% of people laid off in recent weeks believe they will soon been re-employed. The usual ratio is 10-15%. This reflects a high degree of optimism that there will be jobs to return to. In the meantime the government is back-stopping incomes.

The risk is that changes in consumer behaviour are reduced, but ongoing social distancing restrictions dampen the rebound. This could mean more precautionary saving, softer demand, business closures and fewer jobs –which could feed through to areas such as housing, creating another feedback loop.

3) Valuation

BY the end of last week the ASX 300 was down only about 18% year to date despite FY20 earnings revisions of -20% to -30%, suggesting markets are not that cheap. We are also seeing the relative performance of some growth stocks quickly break back to all-time highs.

An additional factor to watch here is the view on whether US rates go negative. Various technical factors highlighted this debate last week. However the two-year note continues to trade at 16bps yield, suggesting it is not yet a foregone conclusion.

The prospect of negative rates might provide some short-term support for equities – in the sense that they become relatively attractive. However there are also implications for an economic outlook which is worse than the equity market is currently factoring in.

4) Technical resistance

The rapid and almost two-thirds retracement in the S&P 500 has now neared an important technical resistance level.

5) Politics

While the market is not yet focusing on the US Presidential election, in coming months it may start to pay attention to what is shaping up as a close race.

One factor to consider is that if the Democrats do win, they will control the White House and both Houses of Congress. We may start seeing talk of tax reform – rolling back Trump’s corporate tax cuts, which could reduce earnings by as much as 20%.

The other factor is China trade. The election is likely to focus on maximising the turnout from a candidate’s base, rather than swaying a marginal voter.

This means increased China-related rhetoric and the risk of some issues on trade, which could also feed through to corporate earnings. It is fair to say the bear case is easier to make, given how quickly the US market, in particular, has run.

That said, there is a cogent rationale for the market’s rebound – and the possibility of it continuing.

Bull case

1) Policy

This is the lynchpin. The Fed’s balance sheet has surged from $US4 trillion to $US6 trillion in short time with more to come. This effectively underwrites the investment grade credit market and funds government debt.

The combination of monetary and fiscal response is estimated at around 25% of US GDP.

At a global level, the “free liquidity” – surplus liquidity relative to GDP growth – is estimated at around 9% of global GDP. This is not yet the scale reached at the depth of the GFC. Nevertheless, this liquidity is finding its way into financial asset markets and continues to fuel outperformance of long-duration growth stocks.

This is important because governments and central banks are effectively saying they will continue to pull the policy lever as long as it is needed.

2) Health breakthrough

There is nothing concrete here yet, however vaccine trials have been brought forward and we may have a result sooner than many anticipate.

There is also mounting evidence that a combination of existing drugs and therapies have had some success in helping reduce the length and severity of infections. This is important in helping manage stress on medical systems for countries pursuing herd immunity.

3) Economy

There are signs an increasing number of companies think the economy may have troughed in April. As recently as two weeks ago only 25% of US companies thought the economy’s trough would be in April. Now it’s 40%.

A sense of having turned the corner is good for market sentiment.

4) Sentiment

The market remains bearishly positioned. Cash levels are as high as during the GFC. Surveys suggest most people expect the market to go down from here. It is not a euphoric market.

There is also a sense the market may have accepted near-term earnings will be terrible – and are looking through these to FY21. This means near-term earnings announcements may not be as relevant as usual – particularly given the dispersion in the range of S&P 500 earnings estimates is at 15% versus 3-7% in normal times.

The analogy here is that we are in the doctor’s waiting room and haven’t yet had the test results. Until then we can choose to be optimistic or pessimistic.

Find out more about Pendal’s Australian equities investment capabilities

Important Updates

Pendal Dynamic Income Fund (APIR: BTA8657AU, ARSN 622 750 734)

Pendal Enhanced Credit Fund (APIR: RFA0100AU, ARSN 089 937 815)

Pendal Fixed Interest Fund (APIR: RFA0813AU, ARSN 089 939 542)

Pendal Monthly Income Plus Fund (APIR: BTA0318AU, ARSN 137 707 996)

Pendal Sustainable Australian Fixed Interest Fund (APIR: BTA0507AU, ARSN 612 664 730)

 
Effective 7 May 2020, the buy-sell spread for a number of Pendal funds (the Funds) will decrease as set out in the table below:

Table 1: Old and New Buy-Sell Spreads

The buy-sell spread is an additional cost to you and is generally incurred whenever you invest in or withdraw from a Fund. The buy-sell spread is retained by the Fund (it is not a fee paid to us) and represents a contribution to the transaction costs incurred by the Fund such as brokerage and stamp duty, when the Fund is purchasing and selling assets. The buy-sell spread also reflects the market impact of buying and selling the underlying securities in the market. Importantly, the buy-sell spread helps to ensure different unit holders are being treated fairly by attributing the costs of trading securities to those unit holders who are buying and selling units in the Funds. 

The further reduction in buy-sell spread reflects continuing improvement in market liquidity for Australian issued investment grade securities.

Pendal will continue to monitor market conditions and review and update the buy-sell spread regularly as required.  You should therefore review the current buy-sell spread information before making a decision to invest or withdraw from a Fund.

Please refer to our website www.pendalgroup.com and click ‘Products’ for the latest buy-sell spread for each Fund.

They are the perennial questions for investors — when, where and what to buy. Here Pendal’s head of Multi-Asset Michael Blayney (pictured) runs through the outlook for major asset classes.

NOW that markets have rebounded somewhat, the questions of when, where and what to buy take on a greater significance.

It is not unusual to get a sharp rally in stock indices during a bear market. The key feature this time is how quickly equity markets fell and then rallied — and how quickly the economic situation has evolved.

This means investors need to look a bit harder to find fair value and they need to be comfortable taking a longer-term view.

Equities

The outlook for the world’s leading equities market — the United States — is mixed.

Large caps, defined as those in the S&P500, have generally rallied hard. The price-to-earnings trailing multiples are just under 20 times earnings and those earnings are forecast to fall.

Purely on a valuations basis, large caps are expensive, particularly when you throw a deteriorating economic backdrop with a massive increase in unemployment into the mix.

Not helping the outlook for large US companies has been a decade-long trend of increasing leverage, in part through corporations regularly undertaking buy-backs. Over the last decade, median US company leverage has almost doubled (measured by the ratio of debt-to-earnings before interest, tax, depreciation and amortisation for the constituents of the MSCI USA Index).

High valuations, increased leverage and deteriorating earnings make up a pretty unattractive combination. The US mid-caps — the next 400 companies by size — look much more reasonably valued.

Although they have increased leverage over the last decade, these are higher-quality companies than small caps in terms of leverage and reliability of earnings. For the US equity market, this is our preferred exposure.

At the small cap end in the US, companies are less profitable, more highly geared and more cyclical. They tend to be lower quality and as such we believe mid caps offer a better risk/return trade-off at this point of the economic cycle.

Aussie equities look reasonable value, but there is a caveat. The big four banks are a large part of the index — around 18 per cent — and there are obvious risks faced by that sector given the deterioration in economic activity and consequently significantly increased risk of bad debts.

Further, the banks are expensive compared to overseas banks. However, overall, the Australian market is reasonable value.

Asian markets still look reasonably valued, though there are red flags are among less-developed nations that lack the ability to manage coronavirus. India, for example, doesn’t have the infrastructure to cope with COVID-19.

As a result, we prefer the more developed economies in the region.

European markets are trading around fair value. The pick of them are Germany and the United Kingdom from a valuation perspective.

The overall picture on equities is they were quite cheap, and now they’re not as cheap, though pockets of opportunity remain.

Real Estate Investment Trusts

REITs have been hit hard by the coronavirus pandemic. Many have suffered from their high exposure to shopping centres and to a lesser degree office space. REITs with exposure to logistics haven’t suffered as much.

The Australian REITs index almost halved last month. For long-term, patient investors, A-REITs look cheap.

As the economy re-emerges and restrictions are relaxed, A-REITs should benefit. They could be very good value for the investor with a 3-5 year time frame.

In a low interest rate environment, yielding sectors are very important for people trying to generate income. Buying into A-REITS is sensible, though the ride may be a little bumpy.

Debt

Government bond yields are very low. While they still have a place in a portfolio — providing some ballast — their expiration date is getting closer.

As bond yields fall, their ability to help protect portfolios in equity market declines reduces because there is less scope for yields to fall further.

It doesn’t mean it is now time to offload all bonds — but investors need to be aware they won’t be providing the returns of the past.

The question becomes whether their defensive qualities make up for the lack of return — and this latter feature is not what it once was.

There are opportunities in investment grade credit.

When economies slow and defaults increase, the magnitude of lost repayments in respect of higher quality borrowers is not normally large.

Meanwhile, the spread in the US between government bonds and corporate bonds is 200 basis points. The long-term median is 110 points.

Given the premium available, and the likelihood that defaults will be relatively benign, investment grade credit provides opportunities for investors.

Conclusion

There are opportunities for investors.

A portfolio of Australian equities where the valuations are fair, some European and Asian equities, mid cap US equities, some foreign currency exposure and investment grade debt looks like a reasonable portfolio in the current climate.

Michael Blayney manages Pendal’s Multi Asset Target Return fund. Michael has more than 21 years of investment management and consulting experience. He is a qualified actuary and holds a Bachelor of Laws (Hons) and a Bachelor of Science from the University of Queensland. 

Find out more about Pendal’s Multi-Asset capability here and Multi-Asset products here.

As social distancing restrictions ease, focus is turning to economic recovery. But what shape will it take? Portfolio manager Tim Hext from Pendal’s Bond, Income and Defensive Strategies team explains

“It’s a recession when your neighbour loses his job; it’s a depression when you lose yours.”

So said President Harry Truman after World War II — and it holds true in 2020, as the coronavirus triggers an economic crisis not seen since before his time.

The global economy is expected to contract by 3 per cent this calendar year, though some market economists expect it to be more.

Unemployment is soaring. Businesses are closing. The only question is whether it’s a recession, a depression or something completely new to economics – a “hiber-cession”.

But what about the recovery? When will it come and what will it look like?

Emerging from a severe economic downturn isn’t a predictable event, particularly when the shock hits both the demand and supply sides of the economy.

That’s what makes the 2020 economic crisis different from most others since World War II. It also makes predicting the path to recovery much tougher.

On the supply side, the shut-down of thousands of factories across China and the rest of Asia — and the closure of borders — stopped the production and distribution of goods.

The supply of finished goods was halted, along with the parts that go into other manufactured products.

For example, most of the glass used in Australian buildings is manufactured in China. With production and distribution halted, local builders can’t get glass.

On the demand side, it is self-evident that individuals and businesses are not spending money on a range of normal activities — from air travel and tourism to eating out, shopping in malls and buying new whitegoods and TVs. (Though there are exceptions — telecos, do-it-yourself retailers and supermarkets have all reported strong revenue growth.)

The double shock has hit all economies hard. Most recessions occur on the demand side. People and businesses cut back their spending. In these classical cases, the government uses fiscal or wages policy, and/or the central bank uses monetary policy, to boost demand.

But how do governments and regulators kick-start economies when both the supply and demand sides are hit?

That’s the $US9 trillion question. ($US9 trillion is what the International Monetary Fund expects to be wiped off the international economy over the next couple of years).

There are three, possibly four, trajectories that the economy could take, though admittedly there are variations within each.

V-shaped recovery

A V-shaped recovery is when economic growth plunges and then soars almost as soon as it hits the bottom. This is a possibility if you don’t think there’s much structural change in global economies as a result of COVID-19.

In this case the health crisis is more akin to a natural disaster — such as the recent bushfires in eastern Australia on a bigger scale.

Once the health crisis is over people get back to work. There’s pent-up demand among consumers and businesses, and everyone starts spending again.

A V-shaped recovery can only occur if Australia’s big trading partners — China, Japan, South Korea — power through and keep buying commodities.

This argument received a significant fillip from the IMF which said the Australian economy would shrink 6.7 per cent this calendar year and then rebound by almost as much next year.

The United States, the Euro area and emerging and developing Asia will all follow similar trajectories, the IMF forecasts.

The IMF says COVID-19 will trigger a 3 per cent contraction across the globe in 2020 — much sharper than the 2008-09 financial crisis.

Based on the pandemic fading and social distancing being unwound in the second half of this calendar year, the IMF expects the global economy to grow 5.8 per cent in 2021, led by China.

The argument for the V-shaped recovery is also aided by history. Recessions in the US in 2001, 1990 and after the oil crisis of 1973, all ended up in V-shaped recoveries.

But those recessions were either demand side, or in the case of the oil shock, supply side-induced recessions — not both.

L-shaped recovery

It is a bit of a misnomer to suggest an L-shaped recovery is a recovery. It’s more like a floor. Activity takes years to return to trend levels.

This will occur if infection levels continue to climb, death tolls keeps rising, and there is a protracted period of rolling lockdowns.

An L-shaped recovery is not a likely scenario, given the trajectory of the disease in nations that got hit first. The province of Wuhan in China is re-opening. So are nations in Europe that were hit earliest and hardest.

It is possible some emerging markets will experience an L-shaped recovery — particularly those without adequate health resources to handle the virus, government finances to cushion the economic hit or exports to earn income from offshore.

U-shaped recovery

A U-shaped recovery is a more likely growth trajectory.

As economies fall into recession they will take a couple of quarters to begin growing again after bottoming out.

Governments will gradually relax social distancing rules — and economies will slowly begin to re-open — but businesses may still be reluctant to employ and train new people. Individuals and businesses may remain gun-shy and take longer to start spending and investing.

Re-opening of the economy is likely to occur in stages. School may be first to open, while overseas travel will likely be last.

The full economy won’t be firing on all cylinders for many quarters — it will stutter forward before picking up consistent momentum.

Unemployment is likely to be a prime concern for a long period because many companies will use the COVID-19 to restructure operations and in some cases reduce workforces. There will still be jobs available, but they may be different, or take longer to re-emerge.

Key to whether the economy experiences a V or U-shaped recovery is the damage inflicted on corporate balance sheets. The more damaged, the longer it will take to see a rise in corporate profits and employment.

Investors will try to anticipate the eventual recovery but the slow pace will likely lead to ongoing volatility in financial markets.

Australia’s relatively high household debt also augurs against a quick rebound. In a market where a person’s home is his castle, and house prices are high, there isn’t much left in the bank for tough times.

W-shaped recovery

This style of recovery is sometimes called a double-dip recession. As lockdowns are eased, activity picks up — but the effects of high unemployment and corporate bankruptcies kick in and the economy slides back into recession.

In the worst case the coronavirus gets a new life, infections start to rise again, lockdowns are put back in place and the economy goes backwards.

The risk of a W-shaped recovery is why lockdowns are likely to last longer than many individuals and businesses think necessary. They are very damaging to confidence and ultimately exact the highest economic cost.

The 1980 US recession, bought on by sharply higher oil prices, is an example of a W-shaped recovery. The world’s biggest economy recovered and then went back into recession in 1981.

Why the RBA and federal government will determine the recovery

The shape of the recovery will depend primarily on how and when governments remove restrictions; interest rates and other monetary policy measures; and assistance packages.

Certainly, no-one has been shy about using monetary and fiscal policy (with the possible exception of the Euro zone).

The Reserve Bank of Australia’s response was swift, and seemingly long term. By targeting yields on three-year government bonds, the RBA has extended its direct control further out along the yield curve than ever before and better anchored yields across semi-government and corporate debt.

Strictly speaking, targeting yields on three-year government bonds is not quantitative easing because a price, not a quantity, is being targeted. But the mechanics are the same.

By operating in the secondary market to purchase government bonds, the Reserve Bank is pushing money into the system.

The central bank has also made clear it will keep capping the three-year yield until it begins achieving its legislated charter of heading towards full employment and its stated inflation target.

The Reserve Bank has said it will wind back non-conventional policies first, so the official cash rate won’t change until after the central bank removes its yield target.

This has the dual effect of putting money into the economy while anchoring yields for corporate debt at lower levels than otherwise.

While spreads between government bonds and corporate debt can blow out, the starting point is still lower. So corporate borrowers will continue enjoying lower interest payments than they otherwise would have faced.

The Reserve Bank has also set up a Term Funding Facility (TFF). Its objective is to lower funding costs for the entire banking system, which will flow through to the costs of credit to households and business.

This facility provides an incentive for banks to lend to business — especially small and medium businesses — at discounted rates.

The funding from the TFF is at a fixed interest rate of 0.25 per cent for three years. That’s much cheaper money for the banks than available else.

The Reserve Bank has made clear it doesn’t expect rates to rise anytime soon and inflation is not part of its central case scenario in the foreseeable future. As a result, while it has lowered the starting point for the yield curve, the risk of any near-term back-up in yields appears remote.

Japan and Europe have never emerged from their zero rates and the US took almost seven years — so it may be mid-decade before we see a rate hike. Investors agree. Measures of inflationary expectations in Australia, the US and Europe are near record lows.

These certainly are extraordinary times when so much government spending doesn’t trigger inflationary fears.

Modern Monetary Theory appears to be accurate when it says inflation is not a money supply issue but an excess of real demand over real supply in the economy.

The effect is that during the next few quarters government bonds — which always provide ballast in a portfolio — may not underperform as much as expected when economic recovery gains traction.

We continue to believe massive excess savings will keep real yields very low, providing support for nominal bonds even at these historically low levels.

On the fiscal side, the Morrison government will spend beyond $200 billion paying wages and providing pay-as-you-go tax refunds to businesses as part of its support packages.

The goal is simple: keep people in jobs and keep businesses operating. If the government is successful, households will spend, businesses will invest and the eventual recovery will be somewhere between a U and V-shaped.

Public debt in Australia is low compared to governments around the world. Ahead of COVID-19 spending net debt was forecast this financial year to be $361 billion, or 18 per cent of GDP.

This is low and a dividend from nearly 30 years of growth and fiscally conservative budget policy.

The banks, which ANZ chief executive Shayne Elliott called the intensive care unit of the economy, were in good financial shape entering the COVID-19 crisis.

Tightened lending standards over the past five years improved the quality of bank assets. The banks’ liquidity position was stronger than previously. Slower credit growth meant they didn’t need to issue much debt immediately ahead of the COVID-19 outbreak.

Also, much of the corporate sector had relatively low levels of gearing and most have significant liquid assets which will help them manage the downturn.

The signs to look out for

Keep an eye on the real economy, not just financial markets.

Look out for when businesses start to re-open — and probably more importantly — which ones re-open first. This doesn’t refer to government rules. It’s about management decisions.

Many travel agents, for example, will simply never open their doors again. Some franchisees, regional newspapers, cafes and restaurants won’t be seen again.

Management in professional services and education will take this opportunity to rethink their business models, with an eye on efficiency.

Perhaps the most unpredictable industry is the airline sector. Cruelled by travel bans offshore and internally, all major airlines are suffering.

The Australian government says it wants a duopoly in the air. Why? Because a lack of competition in that sector, in a country the size of Australia, would lead to much higher prices.

But how do you ensure sustainability? Which routes will airlines start flying again and which will they abandon?

Some sectors of the economy — notably mining, parts of agriculture and manufacturing, supermarkets and healthcare — have withstood the crisis well.

It would be a concern if any of these sectors felt second-round effects and started to stand down staff and reduce production.

Are people still building homes? Are the malls around the country filling up again once the government restrictions start being lifted? Is small business re-opening?

This latter question is important. The sector employs almost 5 million people, or two out of every five working Australians. It is why the federal government is ploughing so much money into its JobKeeper package and other support measures for the sector.

Unemployment is critical. People without jobs don’t spend money. If the unemployment rate hits 10 per cent, which is probable, then how fast does it drop again? Are people finding full-time work or part-time work?

This economic crisis will have a lasting legacy for the employment market. Many over 50-year old workers made redundant may never work again. The career path of school leavers and university graduates will change.

Conclusion

Unemployment holds the key to the shape and speed of any recovery.

If people can find jobs again relatively easily, they will spend again. If the JobKeeper package in Australia saves people from losing their employment, then it’s done its job of averting the greatest ongoing cost of the crisis.

Employment is also critical to fixed income markets. The Reserve Bank charter says its goal is full employment and keeping prices in check.

Only when the central bank sees that happening is it likely to pull back from capping three-year bond rates and eventually lifting the cash rate.

There are no indications the central bank is in any hurry to do that.

The search for yield will soon resume as Australians — like so many citizens of developed economies — get used to a world with rates stuck at the lower bound.

It is a world where there are still good reasons to own bonds.

The COVID-19 crisis has highlighted the critical role Environmental, Social and Governance factors play in evaluating companies.

Here Regnan’s head of advisory Susheela Peres da Costa explains what investors should look for.

Watch this video or read the transcript below:

TRANSCRIPT

A lot of Environmental, Social and Governance (ESG) is about risk management. 

And at the beginning of every year when we get asked by the press what are the ESG themes that we’re focused on for the year, we always resist answering because we don’t really think about it as a fashion.

Instead, we’re focused throughout on whether or not companies are prepared for whatever the world might throw at them — whether that happens to be a crisis in their own industry or the kind of global crisis we’re seeing with COVID-19.

What we look for is whether or not there’s appropriate attentiveness to the kinds of things that might become problems.  [We look for] appropriate resilience within the company’s structures, especially its governance structures, to make sure the company’s in a position to respond.

That means, for instance, having enough capacity on the board and enough skills on the board. [It means] directors who have enough time, so if a crisis is affecting a number of the companies they sit on — including the not-for-profits and others they might have responsibilities for — they’re able to devote adequate time to making decisions on this company.

There’s a whole range of factors like that that really speak to resilience and are in tension with the idea of efficiency.

One of the paradoxes in the corporate form is that efficiency often comes in tension with resilience. Optimising, by taking as many costs as you can out of the business, often leaves you with not enough capacity to respond when a crisis arises.

That crisis might, for instance, be a significant part of your workforce being unable to work because they’re ill or because they’re quarantined.

Or it might be that your directors don’t have enough time to devote to the thorny problems they’re facing right now.

Some of these things go to structures as well.

So having the right kinds of governance in place means people know who it is that needs to make a decision where the delegations sit.

All of these things can seem like overkill during normal times, but their metal is really tested when a crisis arises.

Susheela Peres da Costa is head of advisory at Regnan, a global leader in long-term value, systemic risk analysis and responsible investment advice.

Last year Pendal appointed a London-based impact investment team to launch a Global Equity Impact strategy in late 2020. 

Regnan is wholly owned by Pendal Group.

Important Updates

Pendal Dynamic Income Fund (APIR: BTA8657AU, ARSN 622 750 734)

Pendal Enhanced Credit Fund (APIR: RFA0100AU, ARSN 089 937 815)

Pendal Fixed Interest Fund (APIR: RFA0813AU, ARSN 089 939 542)

Pendal Monthly Income Plus Fund (APIR: BTA0318AU, ARSN 137 707 996)

Pendal Sustainable Australian Fixed Interest Fund (APIR: BTA0507AU, ARSN 612 664 730)

Effective 30 April 2020, the buy-sell spread for a number of Pendal funds (the Funds) will decrease as set out in the table below:

Table 1: Old and New Buy-Sell Spreads

The buy-sell spread is an additional cost to you and is generally incurred whenever you invest in or withdraw from a Fund. The buy-sell spread is retained by the Fund (it is not a fee paid to us) and represents a contribution to the transaction costs incurred by the Fund such as brokerage and stamp duty, when the Fund is purchasing and selling assets. The buy-sell spread also reflects the market impact of buying and selling the underlying securities in the market. Importantly, the buy-sell spread helps to ensure different unit holders are being treated fairly by attributing the costs of trading securities to those unit holders who are buying and selling units in the Funds.

The Funds’ buy-sell spread previously increased on either 19 March 2020 or 20 March 2020 due to substantially reduced market liquidity for Australian issued investment grade securities as a result of COVID-19. The reduction in the Fund’s buy-sell spread reflects an improvement in market liquidity for these assets.

Pendal will continue to monitor market conditions and review and update the buy-sell spread regularly as required. You should therefore review the current buy-sell spread information before making a decision to invest or withdraw from a Fund.

Please refer to our website www.pendalgroup.com and click ‘Products’ for the latest buy-sell spread for each Fund.