Murray Ackman, Anna Hong and Thomas Ciszewski (l-r) have joined Pendal’s Bond, Income and Defensive Strategies team

PENDAL’s Bond, Income and Defensive Strategies team is excited to share details of three new appointments and a promotion.

The new hires will focus on areas of growth in the boutique and support our ambition to be a leader in Environmental, Social and Governance (ESG) fixed income investing while providing objective-based income solutions and defensive strategies.

Assistant Portfolio Manager

Oliver Ge, a portfolio analyst who has been with the team for six years, has been promoted to Assistant Portfolio Manager in recognition of his increased experience and responsibilities.

Volatility Analyst

Thomas Ciszewski has been appointed a Volatility Analyst. He will work on the Active Long Volatility Strategy Fund as well as structuring defensive strategies across a range of funds. Tom joins us from SouthPeak Investment Management where he successfully implemented volatility risk premia and delta one strategies. Prior to this Tom held a number of positions in a trading capacity for Deutsche Bank in Hong Kong and Sydney, managing global equity derivatives, delta one, ETF and cash facilitation trading teams.

Tom has also worked in Chicago for Actis Capital as an equity options Volatility Portfolio Manager. He holds a Master of Applied Finance with a focus in derivatives valuation, exotic options and risk and portfolio management from Macquarie University, Sydney. He also has a Bachelor of Arts in Economics and Business Administration from the University of Vanderbilt, Nashville.

Assistant Portfolio Manager

Anna Hong is joining the team as an Assistant Portfolio Manager working on the Australian Composite and Cash Funds. She is currently a Portfolio Manager at Uniting Ethical Investors for their enhanced cash and fixed income funds. Prior to this Anna held positions at BlackRock and Challenger and was responsible for investment analytics and quantitative solutions. Anna holds a Master of Business Finance from the University of Technology, Sydney and a Bachelor of Science in Mathematics from the University of New South Wales.

Credit/ESG Analyst

Murray Ackman has been hired into the team as an ESG Credit Analyst. He will work across our range of credit funds with a particular emphasis on Pendal’s new Credit Impact Fund (CRIMP). Most recently Murray worked as an independent consultant for Australian private equity firms reporting on ESG measurements of Australian companies with less than $1 billion market cap.

Prior to this Murray was a Research Fellow at the Institute for Economics and Peace where he led research for the Institute on SDGs, violent extremism and engagement with business which included projects determining the strategic priorities and direction of clients such as UNDP and the OECD. Murray holds a Bachelor of Arts in Politics and International Relations, a First Class Honours degree and a Bachelor of Law specialised in International Law from the University of New South Wales.

 

Finally, Arpit Mathur, one of our quantitative analysts, has resigned to join a friend’s business. We wish him well for his next role and thank him for his contribution and the hard work he has given Pendal.

 

 

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Find out more about our investment capabilities:

https://www.pendalgroup.com/about/investment-capabilities

Contact a Pendal key account manager:

https://www.pendalgroup.com/about/our-people/sales-team/

 

 

 

How will the journey from deflation to inflation impact portfolio construction, defensiveness and income in this zero-rate world?

On May 28, 2020, Pendal’s Head of Bond, Income and Defensive Strategies Vimal Gor and senior team members Amy Xie Patrick and Tim Hext and outlined the implications for investors in their half-yearly “Lighthouse Series” live webinar.

This is a recording of Amy’s presentation which addresses fixed income investing in a zero-rate world.

Watch the video above or read the transcript below.

 

This presentation will focus on what bonds are supposed to do in your portfolio.

What do we want from our fixed income portfolios and how do we make sure that in this disappearing yield world, your fixed income allocation is still able to do the jobs that you need it to do?

Looking at the chart below, this really is what underlies the income problem we are all having.

What we’ve shown here is starting yield at the beginning of every crisis you’ve had since the tech crash in 2002.

In the yellow bar is the starting yield in Australian government bonds. The 10-year part of the curve.
In the purple is the US. Obviously what happens in Australian yields is governed quite a lot by what goes on off shore as well.

Now, time and time again, and especially in the more recent crises, you’ve seen that all these yields have come down and it’s a structural trend that’s been happening for a long time.

But what it means is that at the beginning of every crisis, we’ve got seemingly less and less room to play with.

So a lot of investors that we’ve spoken with, not just over this most recent period, although this most recent period has clearly accelerated things further, but over the last three, four, five downmarket cycles in equities, what use really is bonds to me, when yields are this low? Can bonds still be defensive?

And the answer to this is, even through that period in 2018, when the Fed was incredibly belligerent about that hiking cycle, when push came to shove, when you saw stress in the equity markets that negative correlation still comes through.

But what’s really obvious at these very low yields is that there’s just a glaring asymmetry in terms of where yields can go. Not to say that we don’t think they can go into negative territory.

Quite clearly they have gone into negative territory in certain parts of the world, but with yields being quite so low, what we say is that now more than ever, you need your fixed income allocation to be constructed in a very active way.

Active not only in terms of the direction that you face, and whether you’re long or short bonds, but also active in the way that you think about your overall fixed income portfolio composition as well.

Now, as yields have come all the way down, the role of fixed income is to be a defensive part of your portfolio, but it’s also supposed to generate income, because led by risk-free yields, income levels have been coming down across the world, what you’ve seen is our response to it, which has facilitated this to happen.

The chart bellows illustrates the growth in global debt, that’s been issued mostly by way of bonds through a multiple of different sectors.

As you can see, post the GFC debt was growing all over the world anyway, during the GFC, but post the GFC, you had a massive shift down in global rates equilibrium.

And all of a sudden, you had this massive savings glut.

It’s normal to see savings books come out at the end of every crisis, every pandemic, and every war.

And so all of these were looking for yield and income — at first relatively safe and good yield and income, but eventually as yields continue to fall, we look for more and more.

Most of this debt expansion in the world has been taken up by corporates, not so much government debt.

Government debt has obviously grown as well, but a lot of the growth in bonds and bond debt that we’ve seen in the world has essentially been us investors saying to these corporates, please give us more. Please issue more and more because we have certain return targets, we have certain income targets.

If it means that we need to be holding less high quality portfolios, if it means that we need to reach further out on that liquidity and that risk curve, then so be it.

Probably for most investors that consideration of having gone down the quality spectrum, isn’t front and centre in their minds, because that is buying the overall return hurdle or that overall yield hurdle has been front of mind.

A key problem with the way that fixed income portfolios shifted in the pre versus post GFC era. In the pre GFC era fixed income was largely considered to be a purer asset class. The dominant sub asset class of your fixed income piece was really high quality government bonds.

But obviously as yields continue to drift lower, they don’t offer you enough income. They don’t offer you enough yield. So you reach further and further up the curve and off shore, especially what you’re seen is that investment grade no longer is synonymous with that same high level of quality that you used to see before the GFC era.

Now that means a very important key difference in terms of the way your fixed income portfolio behaves. In the pre GFC era when investment grade as an asset class was truly viewed as quite a safe haven asset class. What you saw in times of equity market stress was slightly negative correlation to equity markets.

So investment grade belonged with that high-quality government bucket in terms of offering that safe haven portfolio, that safe haven allocation. But now, as we have seen, these investment grade entities become victim to this quality drift, this ratings drift down the quality spectrum.

In the post-GFC era, what you get with investment grade credit is actually positive equity beta, and on top of this, what a lot of global asset managers also been happy to do is to harvest more carry, more yield, more return in their portfolios, by sacrificing liquidity in those portfolios.

Here on this chart, what we show you is that both in equities portfolios in the yellow line and your bond portfolios, asset managers have generally not prioritised liquidity. Apart from when the crisis hits like the GFC you can see in the purple line all of a sudden managers go to the defensive part of the portfolio, that fixed income part of the portfolio, looking for liquidity.

And it’s not there.

It’s a wake-up call to go back and restore liquidity in that part of their portfolio. But again, since that crisis was a long time ago, this longer term trend of wanting to sacrifice not only quality, but also liquidity in their portfolios, has polluted traditional fixed income allocations with more and more problems as time goes on.

Now, all of these problems with going down the quality curve, and going up the liquidity curve is all the more exacerbated in Australian portfolios. And on this next slide what we show you on the left-hand side, how much Australia remains a global outlier in terms of just how much we don’t like fixed income.

We see no use for it in our portfolios, we like equities and we like property.

And so the key point to make here is that even within that small fixed income piece in the average Australian portfolio, what most investors probably don’t realise or don’t want to think about too much, is how much of that truly behaves like fixed income and how much of that has morphed slightly into the land of equity beta.

And then to the portion that is truly pure fixed income, that is truly defensive, how much of that is really active?

Portfolio Construction within Fixed Income

We mentioned that when yields are this low, you need that active lever to be able to pull, because of that asymmetry, in where yields can go when they’re this low. If all of that pure fixed income allocation is in passive, then you’re not really able to retain a very nimble fixed income portfolio as uncertainty remains quite high.

So in Australia, I think we have an even bigger conflict within ourselves. On the one hand our portfolios, the way we position them, tell us that we want risk, and not so much for the sake of risk, but we want returns, we want yield.

But then when crises hit, we complain that our fixed income allocations don’t do the job that they’re supposed to. But all the while we’ve positioned them to look more and more risky.

So all of that is probably a big spoiler to how I’m going to talk about the way that we approach constructing fixed income portfolios. Particularly with this idea of wanting to test this by a certain threshold in this very low-yield environment.

Now, necessarily we look at fixed income buckets along this risk-reward spectrum like everybody else.

But we do pay a lot more attention to what is the inherent liquidity characteristics of each of these buckets of fixed income.

Because yields are so low, high-quality government bonds, their main job in your portfolio these days, while they do still exhibit some positive carry, because that traditional sense of being able to get, carry and roll out of a pure government bond portfolio is long gone and we don’t think it’s going to come back any time soon.

So high-quality government bonds live in your fixed income allocation, not because they’re your primary yields generator, but because they still act as that defensive part of your portfolio, that pure fixed income part of your portfolio.

So naturally you go up the risk spectrum a little bit, but you stay in what we think is quite important to prioritise -good quality investments. So when you go into the land of corporate credit, while acknowledging that these days, by going into investment grade credit you are naturally taking on more equity beta, nevertheless, you need that allocation to be as high quality as possible.

Why? Because if you’re constructing a fixed income portfolio, presumably you want to be able to rely on that income. And if you’re putting a lot of, let’s say hybrids, into this part of the portfolio, well hybrids aren’t fixed income, bank hybrids exist in the part of the capital structure so that the bank can access that capital when they most need it, and when they most need it, is probably when you, as the security holder, wants your income the most.

And it’s when they’re most likely to switch off the coupons on those hybrids.

So as you go out the quality spectrum, the less you can count on that stability of income from those assets. So here being high in quantity really does matter. High in quality in this piece though, one point to stress, not because you think that this is also supposed to provide you liquidity in times of crisis.

Since the GFC, we haven’t really been able to find liquidity anywhere further than high-quality government bonds anytime the equity market’s been through significant stress. It’s just not the way the world works anymore.
Liquidity in terms of secondary market trading liquidity, all those incentives by banks to provide that liquidity has significantly changed, because of the GFC and all the banking regulations that have come on board since the GFC.

Because yields are so depressed because spreads have been crunched before this Covid crisis you naturally had to reach out that quality spectrum further and go into the land of maybe high-yield, maybe offshore, maybe loans.
A lot of investors talked to us about liking private debt, because there’s no live mark to market. So it seems like it’s not very volatile. I think all of that comes with very obvious risks.

But here we say that when you’re reaching for the higher risk assets, while acknowledging that you need boosters in your portfolio, be mindful of how much that makes up of your overall fixed income allocation.
You want it to complement not dominate your fixed income portfolio.

And more of the point you want to be able to implement it in such a way that when you start to get concerned that the market’s are no longer benign, that you can turn this off very quickly.

So, when push comes to shove, do I want to sacrifice liquidity for quality or quality for liquidity?
I would argue that when constructing an income portfolio and you’re going out the risk spectrum, you actually need to prioritise liquidity.

What are the Opportunities?

Crisis brings about dislocation. One of the areas that we do prefer is Australian investment grade.

On the table below very simplistically illustrates the current market spreads in each of these major fixed income asset classes from Australian investment grade, to US investment grade, emerging market sovereigns and US high yield.

What is the implied five-year cumulative default rate at current spreads?

As you can see Australia is a massive stand-out. What this chart is really telling you is that the sell-off we’ve had is about liquidity premiums spiking. It’s about everyone wanting to hoard cash.

It’s not necessarily the case that the market is pricing market genuinely thinks that in Australian investment grade 10% of the index is going to default in the next five years.

Relative to the worst-realised default rates in the history of each of these asset classes Australia clearly remains a stand-out. And unlike some of those offshore investment grade indices, we’ve not seen quality drift to nearly the same extent in Australian investment grade.

Another one to highlight on this slide for us is emerging markets sovereign.

It does belong in that higher risk bucket that we just showed you, but it retains features that are unlike corporate credit, and it’s worthwhile thinking about in terms of making your fixed income portfolio mix if you are going to reach for more risk in that way.

In terms of what’s implied for the next five years for default rates, very high compared to the worst that’s ever been realised in emerging markets.

But to highlight a point, which is perhaps misleading, just because the spreads are so high, is US high yield. Trading around 600 basis points at the moment. Seems amazing in a world of zero rates and cash rates…

But what we see on the left or the right hand side of the slide is that just taking it on face value, Moody’s base forecasts the US high-yield default rates, you can see that even though the market’s widened out a lot, for their base case, and even their optimistic case default rate forecast, the market hasn’t moved nearly enough.

Not nearly enough risk has been priced in and similarly when you look at current breakevens to see how much cushion in available there simply isn’t enough for the potential risks.

Markets have already moved a lot and at current spreads they’re forging another level of cushion. Different thickness of that cushion in different markets, again in Australia, particularly attractive.

And when you compare that with what’s the typical end cycle, move that whole widening move in all of these asset classes in previous historical cycles, you can see relative to what’s going on in the past, what we’re currently going through right now, break evens that are currently embedded look quite attractive, especially for Australian investment grade.

And the last exercise we did here was just taking the most liquid representation of Australian investment grade, which is iTraxx, to look at previous episodes of crises and say, nobody can time getting into the markets at the wides, but let’s say after the first say, 100 basis points worth of widening in that index, had you gone long then, in the GFC, in the European sovereign crisis, and after the China crash in 2015, what would your total return outlook have been like over the next three months, six months, one year and two-year?

And these returns are not been annualised, they’re just total returns. And it’s really just to highlight that outside of the GFC, on a medium-term outlook, these are incredibly attractive medium-term return opportunities to be looking at right now.

And the last point I wanted to highlight is just that, why don’t we think this is like the GFC?

In many ways, this crisis is worse. It’s involving the real economy. It’s a real sort of stop to the global economy and, questions as to whether the policies in place can reignite all of that again. But the crucial difference with the GFC is, in the GFC we had these key points of stresses, that largely pertained to our financial system, that we don’t see today.

And the reason we don’t see them today is partly because of all the regulations that have been put in place since the GFC, but also risk aversion is a little bit higher in the financial world.

So you’re not going to go through this protracted period of forced deleveraging.

This protracted period of forced deleveraging is really what caused those return protocols in the six months to one-year period in the GFC time for investment grade credit and credit as an asset class overall, to underperform for such a significant period of time.

If you don’t believe that the system needs to go through a disorderly and protracted period of deleveraging this time, and it doesn’t seem to be the case, then all the more reason to start engaging with investment grade, a bit more as part of thinking about your income solution.

So going back to my earlier point, because the mix of fixed income portfolios has naturally gravitated to taking on more and more risk, more and more positive equity beta, we’ve got to be cognisant that, all the while you have to be balancing that with still very traditional high quality government bonds and with yields this low, a very active approach to managing those government bonds.

 

Amy Xie Patrick is a portfolio manager with Pendal’s Bond, Income and Defensive Strategies team

Amy joined Pendal Group in February 2017 to focus on emerging markets and global credit indices. Amy is a Multi-Asset Fixed Income Fund Manager with extensive experience and expertise in emerging markets, global high yield, and investment grade credit.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Find out more about our investment capabilities:

https://www.pendalgroup.com/about/investment-capabilities

 

How will the journey from deflation to inflation impact portfolio construction, defensiveness and income in this zero-rate world?

On May 28, 2020, Pendal’s Head of Bond, Income and Defensive Strategies Vimal Gor and senior team members Tim Hext and Amy Xie Patrick outlined the implications for investors in their half-yearly “Lighthouse Series” live webinar.

This is a recording of Tim Hext’s presentation which addresses the end of the Central Bank era and what that means for investors.

Watch the video above or read the transcript below.

 

I’LL HIT the two key themes straight away, and then we can talk more about them.

The first one is that we are at the end of an era. And I’m calling it the era of the central bank. Central banks, as we all know and are now tapped out.

Rates are at zero. And from this, a new economic framework will emerge. Really we’re entering the era of fiscal policy.

The second thing I’ll be talking about is the fact that, of course, under that year of fiscal policy, it’s government, not central banks who need to step up.

My concerns, which I’ll talk a bit about, are the fact that I don’t think all governments are going to be in the mindset that we are in this new era.

And that some of the conventional thinking is going to slip back in as we come out of this immediate crisis. And what that will mean potentially a double-dip recession next year.

So let’s move on to what I’m calling the cult of the central bank.

Now cult might seem a strong word. I doubt we all worshipped our central bankers, but certainly for people like myself, we’ve been in markets for around 30 years, we’ve lived in an era where central banks have been front and centre of everything.

Now I’ve putting a picture of two US central bankers up there. I think Alan Greenspan loved the fact that he wants the high priest of the central banks.

I spent many an early morning trying to decipher what the hell he was saying.

So he certainly pushed that idea. I think Bernanke who ended up being sort of Superman through the GFC and saving the US economy, I put a quote showing he’s a little bit more circumspect about the role of the central bank.

But there is no doubt for all of our careers and I’m not just talking about our careers in markets, but the economic framework we’ve operated under, has the central banks front and centre. To sum it up in one line, the government outsourced cyclical control to central banks.

End of an era

The era of course is now over. It’s just a fact when you’re at zero rates, your arsenal of things you can do becomes very limited.

And there are a few little things they can do, but in terms of shifting the dial significantly, they are out of the game.

So it’s the end of an era. It’s an era from which we’re about to emerge, and we need to consider what the new framework looks like.

I’m just going to quickly recap what happened during that era, because it gives us a good understanding.

So the golden age of central banks, if you like was from ’93 to ’07. I use ’93 in Australia because that’s when inflation targeting came in.

Of course it came in slightly earlier in other countries, particularly New Zealand. Now under this era, fiscal policy was basically resigned to trying to balance the budget through the cycle.

Of course it would go up and down as the economy went up and down.

For the federal government, the two main things of course are taxation and welfare spending. So you would get surpluses and deficits.

But the aim of fiscal policy under this narrative was it should try and balance things through the cycle.
And it was left the monetary policy to be the accelerator and the brake under which we operated.

We had a nice framework targeting inflation and full employment.

And from that came all sorts of other ideas, which we sort of took as second nature and we started to believe were sort of almost like a natural order.

So there’s two concepts.

One was NAIRU, of course, where unemployment starts to become inflationary.

And the other idea was the idea of a neutral rate and I even heard people talk about it over the last 10 or 20 years as the natural rate of inflation.

And I think that speaks to the fact, a lot of people thought we’d finally landed on a framework, which somehow was a natural framework, that the economy was a bit like science.

It had rules that followed and here we had finally uncovered the magic on how to make it work for us.

Of course there was very good economic management through that period from central banks. They didn’t get everything right, but largely they did.

Two tailwinds

But what people only now really looking back realise is just how significant two tailwinds were.

The first was they were operating under very positive demographics.

We all know this story, that through the ’90s and into the Noughties, there was a massive increase in the percentage of the working age population.

Supply and economy was expanding and you could expand it under those circumstances. The second tailwind of course was globalisation, which was a massive move towards goods price deflation, which offset what you were seeing elsewhere. And you put those two together. And it was really the golden age.

As I mentioned, GDP in Australia, averaged 3.75 per cent through this period, inflation almost spot on the 2.5 per cent target, and I think everyone agrees it was a success.

And then of course it wasn’t. The GFC hit.

Now the GFC in a sense should have put some serious dents.

But two things happened. Firstly, fortunately for central banks rates were high enough that they could do massive interest rate cuts to help the economy in Australia.

It was almost 4 per cent worth of cuts.

The second thing, more offshore than in Australia, was the emergence of QE [Quantitative Easing].

The two of them together as we emerged from the GFC appeared to have solved the crisis.

So we entered the next era from ’07 to 2010 where the cult of the central bank in fact was strengthened, not loosened by the crisis.

It looked like they had saved the day. So as we entered this decade, we just finished, central banks were very much again front and centre.

But then the cracks started to appear. Not for a while, but they slowly started ekeing out here in the last decade.

We all know this story, but it’s just good to recap it. For a while there it looked like things were returning to the pre-GFC normal. That we could target growth about 3% and inflation at 2.5%.

What we found as the decade went on, of course, is that we just weren’t hitting those targets consistently.

And despite interest rate cuts, we just weren’t getting there. Fiscal policy should have been balancing. Unemployment was going down.

Yet we seem to have almost structural deficits.

Monetary policy, even though, there were numerous rate cuts through this period, inflation was going down, not up. But, and here’s the important part, the narrative was still held by everyone, including importantly to central banks. In Australia, the Reserve Bank kept forecasting that we were going to get back to these levels.

It was just going to take maybe a year or two years.

But right through this period their forecast always had inflation going back to 2.5% and GDP above 3%.

Of course, what followed were consistent downgrades.

So what started to happen in the second part of the last decade was a few question marks appearing.

Was there something structural coming on and you heard Phil Lowe talk about this.

Was it technology? Was it changes in the workforce that were causing these moves to happen? No one was quite sure. But what we started to see was the realisation that what was going on is far more structural than cyclical.

Now we’ve been going down this path for a long time and all the recent crisis has really done is accelerate it.
I wouldn’t say it’s the crisis we had to have because it did come completely out of the blue.

But in a sense it revealed these cracks, made them wider, and made the whole system come under severe pressure.

So there is no doubt that we need a new economic model.

Conventional monetary policy is exhausted.

Negative rates may be tried in some places. I think the Reserve Bank’s attitude in Australia is they don’t work.

They do more harm than good.

End of conventional monetary policy 

So conventional monetary policy is over. Unconventional monetary policy – well, that’s here to stay.

There’s certainly a lot more they can do. You can expand yield control, you can do a larger QE. But really they are playing around the edges.

Remember the aim of unconventional monetary policy is just to bring term rates down because you can’t necessarily control them without directly controlling them towards zero. And that may yet happen, but that’s quite limited.

It’s not going to save the day. It’s not going to really move the dial a lot.

So we are left with fiscal policy. Now we should, in a sense, be comfortable with that.

We should go ‘well, the government has a lot of power’. Because remember the government, the federal government I’m talking about here, has something that no individual company or even State government has, and that’s the ability to create money.

So they should use that super power that we’ve given them to really help the economy when it’s needed.

But here’s the problem.

Conventional economics has created a strong narrative that debt and deficits are bad things. It’s a narrative which is very hard to shift.

And it’s a narrative which I grew up with studying economics in the 1980s. And there’s a narrative that it’s been reinforced constantly since.

So the minute you start running high deficits, of course, all the worry starts to come out from this group of people and conventional thinking. So back in the ’90s the magic number of debt to GDP, and I’ve put the US debt to GDP here, was 60%.

That’s what you needed to get into Euro.

If you flash forward to the GFC, we had famous papers like Reinhart and Rogoff who told us that if we went through 90%, that you were going to severely impact the economy.

And of course the US has since sailed through that. And that hasn’t happened.

The poster child, of course, Japan, has got a lot higher than this and they are still functioning well.

So you’re going to get this happening in the next few months, and indeed the next few years.

You’re going to get that group of conventional-thinking economists talking about why this is all heading towards doom and disaster. The terms they’ll use I’ve even heard used in the last month by the prime minister himself.

Terms like: how are we going to pay for this? We’re going to burden our children with this debt.

And they really talk about the government as though it’s like a household or something else, which has to sort of live within its means, otherwise people stop giving it money.

The government doesn’t need people to give it money. It creates the money itself.

As Vimal will mentioned, done a whole paper on this so I won’t go into too many details.

So the new economic model where fiscal policy is at the centre, needs new economic thinking, if it’s to be used properly. And unfortunately, a lot of the economic thinking we have is still found in times gone by.

This concern about debt and deficits. Of course, we’ve seen the national debt clock in the US, the Tea Party jumped on the back of that.

And they were very vocal for a long time there, coming out of the GFC, that apparently the government being active and running deficits was going to cause all sorts of problems. Well they’ve gone quiet.

Of course, Tony Abbott has since left the building down in Canberra. Although I fear the ghosts of Tony Abbott still lurk around the corridors, but of course when he got elected in 2013, one of his big slogans was to end wasteful spending and pay back Labor’s debt.

The myth of government surplus

So the myth, I say, is that a government surplus is good policy.

Now don’t get me wrong. It would be great if the government could run a surplus, but a budget surplus should be the result of a strong economy.

It should not be an end in itself. And the fact that last year, as recently as last year, the government was trying to run a surplus, despite a lot of excess capacity in the economy, is just plain ridiculous.

And it’s not just me saying that. I think even Phil Lowe was down in Canberra, voicing similar sentiments.

Now you’ve got to remember the flip side of a budget surplus is a private sector deficit.

A budget surplus means a government is taking more money out of the economy than it’s putting in. You only really want to drain money from the economy if the economy has an inflation problem.

And you only get that inflation problem, if the economy is at or close to full capacity. I think we can all agree it’s a long way from there at the moment.

So what is a budget deficit?

The word deficit sounds terrible, but really a budget deficit is you’re putting more money into the economy then you’re taking out. You’re actually creating a private sector surplus.

And more importantly, you’re creating activity in the private sector, which should see it come back. So it’s entirely appropriate.

You should be running deficits. And in fact, I would argue a budget deficit should almost be the natural state of things when you have the ability to print money. We can come back to that in a minute.

The myth of inflation

So just moving on, the second myth I think I’m hearing a lot more of in the last couple of months after this dramatic escalation in the budget deficit, is that the government printing money directly creates inflation.

It’s the idea that as the government puts all this money in, as the Reserve Bank does QE, all this money enters the system and creates inflation as more money chases goods.

An important thing to remember here, and this is a topic for a whole other presentation, but a couple of key points just for now.

Firstly, the private sector always nets to zero in the money system.

If you think about it, every dollar that we borrow comes from someone else. Every dollar we spend goes to someone else.

The private sector system always nets to zero. So if a government creates extra cash or drains extra cash, it has to do the opposite to offset it.

Now, normally running a budget deficit, what the offset is, of course, is the government then borrows that money back from the private sector, via the AOFM.

But it can choose to do another thing. And we’ve seen this in the last few months. It can choose to actually have the Reserve Bank create the money itself and the money therefore comes back by excess reserves.

Now it’s quite technical, but for those who follow these things, those excess reserves have gone up
considerably. But here’s the important point.

The government printing money does not directly create inflation. Only the private sector who does credit creation can do that.

And we saw that 15 years ago at the peak of the last boom, when we had a massive investment boom.

The private sector was running double digit credit creation. And therefore we got 3% to 4% inflation.
At the time the government was actually draining money via a surplus.

So the only way the government influences is by creating activity, which therefore creates confidence in the economy, which therefore creates investment in the economy, which therefore creates a lot more broad money.

And therefore we can start getting inflation back to where it should be.

So again, entirely appropriate for deficits to be run and if needs be for the Reserve Bank themselves to create that money.
As, as I mentioned, please look at my paper. If you don’t have it, ask for it. It’s a much better explanation that I’ve just given you there.

A new model emerging

So what is the new model that’s emerging?

As I said, monetary policy is basically dead. Now it hurts me to say this.

As I mentioned, I’ve made a whole career out of watching all the movements coming out of Martin Place and Washington and other central banks. We’ve hung on their every word. We’ve lived and breathed everything they’re doing.
And as an investment manager it’s been front and centre of our decision making.

But they’re out of the game effectively. They’re now spectators.

Sure, they’ve got still an important part to play in liquidity and if the crisis were to worsen again. I think the job they did in March and April was excellent.

And they’re still there to do that. But they are not there anymore to create inflation. Only the government can do that.

Now what concerns me, is does the government fully realise this?

The government, of course, again has done a great job in this crisis. A crisis like the GFC brings out this
side of government that they have to act.

They have to do something and suddenly they’re not scared of deficits.
But you can see as we emerge, we’re already seeing this creep back to the old way of thinking.

Not just at a federal level, but at a State level.
People are talking about, wow we have to have budget repair to claw back all this money
we spent. That is not the case.

And if that thinking comes in it virtually guarantees a double dip recession.

Now the themes under this new model, (Amy, as mentioned, will be talking about these), clearly
“carry and roll” are your strong friends.
Income is something, investment grade’s got an important part to play.

Inflation

And of course you can look at yield enhancements. Now for the last part, I’m going to talk about inflation because it’s a question I get asked a lot.

Really with short rates stuck at zero for the next five or maybe even 10 years, the long end will be buffeted around by what’s going on in inflation.

Clearly, the COVID-19 crisis has thrown the whole thing up in the air.
What we’ve seen over the last decade was a lot of merge towards that 2%. It was very little dispersion between various parts of the CPI basket.

Everything seems to go around there.

What we’re going to see now is a lot of dispersion between various factors.
Some will actually be stronger than they were pre the crisis, but a lot will be considerably weaker.

Inflation catalysts

So what are some of the upside catalysts to inflation that we’re thinking about in our framework? The first two, trade disruptions and supply chain reorganisation, would probably go under the theme of the peak of globalisation.
We are seeing some unwind.

Again, that was already happening through the crisis, but the crisis has dramatically escalated that.
Now it’s fairly obvious that if you’re going to source a lot more locally and you’re going to lose some of that benefits of globalisation or specialisation as we were taught back at university.
You will see some inflation emerge in certain product areas. That’s a given.

The second thing, which is actually pro inflation is the cyclical rebound won’t be weighed down by the same de-leveraging we saw after the GFC, particularly in Australia.

Maybe in the US less so. But the third one’s going to be very interesting.

There are certain sectors of the economy where we’ve got to suffer structural supply shocks from this
crisis.
In other words, certain things just won’t be coming back. A lot of marginal businesses will be closed forever. You can even see things like Target stores recently. You can see things like Virgin Airlines. If it were to come back, talk about being a lot smaller scale.

You are going to see some areas where as demand returns it’ll be pushing up against a much lower supply and you will see inflation in certain sectors.

However, those sectors as part of the CPI basket overall are not that high.

Which turns us to what the deflationary factors are.

Unemployment

The first one is obvious across the economy. High unemployment means zero wage growth.

Even the RBA themselves don’t have unemployment coming back anywhere near what’s needed for the next three or four years.

Slowing population growth

The second one is a new one, and this is the first time we’ve faced this in decades.
The population not growing.

Now it is temporary. But it is temporary for at least 12 or 18 months. We’ve seen a lot spoken about this recently.
This has big implications for housing particularly. Not so much house prices, which will be partially
saved by zero rates, but in the areas which actually feed into the CPI basket of rents and building costs.

Now rents, building costs, together with with utilities and rates make up almost a quarter of the CPI basket.
And we’re going to see rents and building costs go negative over the next 12 months.
In the case of rents, perhaps significantly negative. And they’re a huge part of what’s going on.

I actually had a different view the end of last year. I thought we’re starting to signs of a recovery, but it is a massive shift when you go from immigration of the levels we have seen down to zero.

In fact the population will only probably be positive by natural bursts in the next 12 months. That, as I said, will eventually come back, but it is years away.

Government-led zero inflation

The third one though, which really has me concerned, is what I call government-led zero inflation.
This is a version of the paradox of thrift, where all of us save, it might be in our own interest to save, but if all of us keep saving, the economy goes backwards.

Now this is a similar thing with inflation. A lot of government policies during the crisis and emerging from the crisis, all look good in their own right.
For example, the NSW government announced a wage freeze for public servants this last week for the next 12 months.

Now on the surface, that might look good. You might think that the private sector has got no wage growth, it’s the responsible thing to do.
Their budgets have been hit. They need to pull back spending. The trouble is as that thinking seeps into more and more areas, it starts to become self-fulfilling that you get zero inflation.

You can even look at things like the free childcare, which of course is going to cause a negative inflation print for this quarter, but will the government decide to keep that going long or maybe decide to keep some sort of subsidy in place above and beyond the crisis?

No matter where you turn governments seem to be adopting a policy that no growth in rates – and remember we’ve had a healthcare charge freeze as well – there’s going to be a lot of things that used to tick over at 2%, 3% or 4%, are now going to be at 0% possibly for years to come.

This will lock in that zero-rate inflation rate environment and be a big factor.

And it worries me that this thinking seems to be creeping in more and more. Particularly at the federal level
where they should be doing the opposite.

They should be trying to create activity.

Credit creation

Finally sluggish credit creation. There’s hardly an earnings call that goes by, where rather than mention the great opportunity this crisis provides to buy more businesses, people talk about having to shelve investment plans to repair the balance sheets.

All of these things together mean that we very much land on the side of inflation is going to be a problem to the downside. Excess capacity, quite simply is too high.

As you can see here – unemployment. This yellow line is the RBA’s forecast.

You could argue 4.5% for NAIRU was too high anyway. We’re not going to get within cooee of that. So we have a major problem.

And finally inflation, as you can see there has very little chance of getting – this is underlying inflation, not headline – headline will be negative.

Underlying inflation has very little opportunity.

So what we call upon in a sense, and the conclusion I make is that unless we get a rethinking of the framework by the federal government, unless we start to see them truly step up and use fiscal policy to avert the crisis that the RBA previously would have averted, then we’re going to head for a double dip recession, and we’re going to head towards zero inflation.

I hope they wake up to that, but for a fiscally conservative party, it’s going to be a difficult road to trade. So I’ll leave it there now and I’m going to pass on to Amy to talk about how we’re looking at fixed income investing in a zero rate environment. Thank you for your time.

 

Tim Hext is a portfolio manger with Pendal’s Bond, Income & Defensive Strategies team.

Tim joined Pendal Group in February 2017 with responsibility for managing Australian Bond portfolios. Tim has extensive experience in banking, financial markets and funding.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Find out more about our investment capabilities:

https://www.pendalgroup.com/about/investment-capabilities

 

 

Here’s the latest outlook for Australian equities from Pendal’s head of equities Crispin Murray (pictured above). Reported by portfolio specialist Chris Adams.

 

EQUITIES continue to surge, driven by optimism over the pace of economic recovery.

The rotation away from defensives and growth to deep cyclicals and value continues. This is providing better breadth to the market as previous laggards start to catch up. It also continues to squeeze a market which has been defensively positioned.

Last week the S&P/ASX 300 gained +4.2%.

Economy and policy

The equity market seems to be disregarding earnings on the basis that everyone knows the current period will be woeful, while one year into the future is impossible to predict.

As a result, the delta on economic news flow is driving returns – and this remains better than expected.

Last week’s US payrolls are a case in point. Non-farm payrolls rose by 2.5 million in May – versus a consensus expectation of a 7.5 million fall. Unemployment fell from 14.7% to 13.3% versus a consensus of 19%. There is debate around the numbers and classifications used. However, the underlying signal is that re-hiring is better than expected.

While fiscal stimulus is driving better outcomes, monetary policy also remains very pro-cyclical as we are effectively at the zero bound.

A strong recovery leads to less fear of deflation, which means lower real rates, which helps further stimulus and higher valuations, creating a virtuous circle. This could of course turn vicious if we start to see economic expectations deteriorate – however for the moment the fiscal backstop appears sufficient.

The combination of these two effects is driving equity markets and squeezing the broadly consensus bearish positioning in terms of sector allocation.

Digging into the US job data, leisure and hospitality saw the best results, with an increase of 1.2 million jobs in May. However this was against 8.3 million lost in the previous two months. While the delta is good, this sector is still well below its high-water mark. There were an additional 400,000 jobs in construction, which has recovered almost half the jobs lost to Covid-19.

While unemployment is a lagging indicator, more real-time indicators are also constructive. PMI numbers are stabilising. While still signalling a contraction, the market is focused on the positive trajectory versus recent results.

Elsewhere US auto production estimates for Q3 are almost back to the pre-Covid levels. This has a positive read-through for supply chain inputs such as steel and components. Mobility data and trends such as AirBNB searches are likewise painting a picture of an economy recovering faster than many predicted.

The US FOMC meeting this week will shed light on their rate of asset-buying going forward and how they are seeing the economy. The next US fiscal package is expected to be announced in July at US$1 trillion to US$1.5 trillion – with a focus on helping the re-start rather than income support. This will be a more contentious process and could represent a risk to the market.

Markets

There is a view – backed by data on brokerage account openings – that retail money is driving this rally, supported by various government cheques.

We are mindful this market has shrugged off lot of bad news and uncertainty in the form of tensions with China and US civil unrest. ETF flows have been to defensive assets such as bonds and gold – while equity ETFs remain in material outflow since late March. The market is climbing the proverbial wall of worry, which is a constructive factor.

The reflation trade of the past few weeks continues to dominate price action. In equities, we see it in the continued rotation from growth to value, which is broadening the market’s rally. This can continue while the economic data remains supportive.

In other assets it is seen in US 10-year bond yields rising, credit spreads narrowing, a higher copper/gold price ratio and a stronger AUD.

There are a number of near-term issues to be mindful of:

• Valuation: P/E valuations have surged. Many see P/Es as meaningless given uncertainty over earnings and at this point the market does not seem concerned. However, this could change.

• Technicals: The market’s recent momentum has only been equalled 10 times in the last 30 years and suggests we might see some near-term consolidation.

• Put/call ratio: The case for near-term consolidation is supported by a shift in put/call ratios from super-bearish to a more optimistic stance.

The balance of probabilities suggests we might see consolidation – but not necessarily a material fall. But there are two issues that could potentially de-rail the market and need to be watched closely:

• A second wave of infections: The market’s concern here seems to be diminishing – which does leave it vulnerable to any resurgence. In this vein, it is important to understand the improvement in US case numbers is driven by the hardest-hit States of the north-east. Other States are showing flat-to-rising trends, albeit at low levels. Given we are seeing genuine second waves in places like the Middle East – particularly in Iran and Saudi – this needs to be watched.

• US Presidential Elections: Trump has seen support ebb and Biden is now the favourite for November’s election. The odds that Democrats win five seats to take control of the Senate appear even at this point. This raises the possibility of Democrat control of Washington – with policy implications in areas such as tax which could present a risk to equity markets.

 

 

Fixed income impact investment is a fast-growing but still relatively new segment of capital markets. Here Pendal portfolio manager George Bishay (pictured above) takes a deep look at impact bonds and answers questions we often hear from our clients.

EACH year, more and more sustainable bond investments become available, covering all aspects of the environmental and social spectrum.

There are bonds where companies in underlying projects reduce their carbon footprints and bonds that help finance companies with strong gender equality records.

Some bonds finance governments to build railroad and solar power plants, others help build affordable housing.

As the market rapidly grows, debate is intensifying about pricing and returns and how these bonds are trading in high-demand secondary markets.

More than $US465 billion of sustainable debt was issued globally in 2019 — a new record and up 78 per cent from the previous year. More than $US1 trillion in sustainable debt has been issued since the market began.

This growth is driven by soaring demand as investors seek ways to “do good” with their investments amid growing concern about climate change and social issues.

At the same time, corporations and governments are becoming ever keener to behave responsibly and to be seen doing so.

Types of impact bonds

There are two main types of impact bonds:

– Environmental bonds which finance projects that benefit the environment

– Social bonds which address a social need or improve an outcome for underprivileged people

Issuers are usually certified by an independent organisation such as the International Capital Market Association or the Climate Bonds Initiative.

Most of these bonds also adhere to the UN Sustainable Development Goals.

Why do companies issue impact bonds?

A key question we get asked is why corporations and governments issue impact bonds instead of traditional issuances. In our experience, they are issued for a number of reasons.

One reason is to signal confidence in the sustainability of a wider business.

Corporations issuing impact bonds are implicitly inviting scrutiny of their wider business practices and signalling they are confident in their sustainability credentials. This also leads to future benefits.

More and more traditional fund managers are incorporating Environmental, Social and Governance (ESG) factors into their investment processes.

This is partly because ESG risks genuinely affect performance and partly at the behest of end investors such as superannuation funds.

Companies that issue impact bonds are stamping their ESG credentials, which can ultimately be supportive of credit spreads they have to pay down the track.

A third reason is simply to cater for market demand.

Across the world investors are seeking access on behalf of clients to investments that are sustainable or make a positive change in the world.

Issuing impact bonds can also help diversify an issuer’s funding by attracting new types of investors.

Research also shows green bonds get the tick of approval from equity holders.

They can trigger a positive stock price reaction as markets react to expectations the bonds will improve long-term shareholder value by lifting company performance.

Examples of recent impact bonds include a $400 million, five-year bond issued by supermarket giant Woolworths to improve carbon emissions from refrigeration and lighting in its stores.

NSW TCorp, the bond issuer for the NSW state public sector, issued a $1.8 billion bond to further public transport projects and fund a sustainable water project.

Queensland’s QTC allocated bond proceeds to light and heavy rail projects, cycleways and a solar farm.

How do impact bonds perform?

It is true that impact bonds tend to perform well in the secondary market — but the reasons for this are nuanced.

We often say there is excellent secondary market liquidity for impact bonds if you’re looking to sell — but not so much if you’re looking to buy!

There should of course be no difference in pricing between impact bonds and their vanilla counterparts. This is true because the same credit risk applies to non-green bonds issued by the same issuer.

The credit risk is that of the issuer, not the underlying green or social projects.

This is most pronounced in bonds issued by supranationals such as the World Bank. The collapse of an underlying project has no effect on bond holders, who are assured by the triple-A rating of the World Bank itself.

Fundamentally, this also means investors are not penalised for investing in green bonds.

Investors in impact bonds get the same credit spread as if they invested in an equivalent vanilla bond from the same issuer.

Nevertheless, a “greenium” — a premium paid for green bonds — can be observed from time to time in the secondary market.

Often the explanation for the premium is simply an excess of demand over supply.

When Woolworths issued its first green bond last year it found demand five times stronger than its issue size and priced better than initial guidance. It traded even more strongly in the secondary market.

Whether this was demand for the green aspects of the bond — or simply demand for exposure to Woolworths — is difficult to determine.

But this differential can be a benefit for dedicated sustainable fixed income funds buying in the primary market. They are often handed a better allocation than a competing vanilla fund, putting them in an advantaged position in the secondary market.

During increased volatility at the end of the March 2020 quarter we saw one of our impact holdings do very well relative to a similar non-impact bond.

The bonds were issued by the National Housing Finance and Investment Corporation (NHFIC) — an independent Commonwealth entity that operates the Australian Affordable Housing Bond Aggregator.

This organisation provides cheap, longer-term secured finance for community housing providers by issuing bonds in Australia’s debt capital markets.

The funds raised by the bonds were loaned to community housing providers to help finance more than 2000 properties in Victoria, NSW, Queensland, Western Australia and South Australia.

This included supporting the supply of more than 360 new social and affordable dwellings.

The bonds, which typically trade in line with other supra nationals and semi-government bonds, outperformed in March 2020 as can be seen in the chart below.

 

Looking ahead

The truly dedicated sustainable funds are not yet big enough to soak up all the impact bonds issued in Australia.

Some $6 billion of impact bonds were issued in Australia last year and the pure impact funds accounted for only a sliver of that supply.

This has the effect of keeping pricing in line with non-impact bonds.

Vanilla funds are required to fill the book and need to be offered at the same pricing as they would get in an equivalent non-impact bond.

Only when the dedicated sustainable sector is big enough to take out whole books will we start to see some difference in pricing.

Right now, that looks to be some way off.

 

George Bishay is a portfolio manager in Pendal’s Bond, Income & Defensive Strategies team.

George has managed dedicated Sustainable fixed interest portfolios for a decade. He has also worked across numerous fixed income, credit and money market portfolios in portfolio management, credit analysis and dealing roles for over 20 years.

In 2019 he was awarded the Alpha Manager status by Money Management’s FE fundinfo, in recognition of his career-long performance in the asset management industry.

 

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about our investment capabilities.

Our Pendal’s Chief Executive Officer, Australia, Richard Brandweiner discusses why the way we invest can make a big difference to the world around us.

Watch the video above or read the transcript below.

TRANSCRIPT

My name is Richard Brandweiner, and I’m the Chief Executive of Pendal in Australia.

These are very challenging times, but they remind us of just how interconnected our world is, how our economy and our financial markets are intrinsically linked to our human ecosystem.

Also how important it is, the decisions that we make, and how we treat other people, what the ramifications are. That’s perfectly true with our capital and our wealth as well.

The way we invest can make a big difference to the world around us and importantly the world into which we, or our children, are going to retire.

And that’s one of the reasons why we’re seeing such extraordinary growth in sustainable and ethical investing.

Consumers are increasingly demanding different things from their service providers. It’s no longer just about what product or service you provide, it’s also important how you go about it.

Impact investing, in particular sustainable and ethical investing, has become the fastest-growing part of the investment management industry.

Pendal has been in this space for a long time. We launched our first ethical fund back in 1984 and more recently we fully acquired a business that we helped establish called Regnan.

It’s one of the leading institutional providers of ESG research, engagement services, and advisory work.

We’re very keen to support you in the journey towards an increasingly sustainable capital system and towards empowering your clients to invest in positive ways that make them proud, together with growing their wealth and their family’s wealth.

Thank you.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Find out more about our investment capabilities.

Regnan is 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.

Find out more about Regnan.

 

Here’s the latest outlook for Australian equities from Pendal’s head of equities Crispin Murray (pictured above). Reported by portfolio specialist Chris Adams.

 

STOCKMARKET sentiment has been buoyed by a roll-back of restrictions and anecdotal evidence that some parts of the economy are recovering faster than expected – possibly as the result of pent-up demand.

That helped the S&P/ASX 300 to a gain of +1.9% last week. A second wave of infections remains the key risk – however this is too early to call.

The Australian equity market has consolidated earlier gains from the low and has effectively traded sideways over the last 30 days – albeit with material volatility.

It has also seen significant rotation within the market – this is driving investment opportunities.

Economic re-start

The market is now in an optimistic mood around economic recovery as restrictions are rolled back.

There has been talk of V-shapes, U-shapes and L-shapes in terms of recovery. We see a strong possibility of a “reverse square root shape” – a sharp drop and then strong initial recovery, levelling off at a lower range than the initial point.

We are seeing demand recover faster than many expected in several sectors. But there’s a risk that after an initial surge it then falls short of expectations and we see a more protracted economic slowdown.

The key factor is that the recovery is not evenly spread. Sectors such as durable goods, autos, take-away restaurants and housing are proving more resilient here and in the US. Other areas such as tourism and entertainment are likely to face stiffer headwinds.

Some key observations on sectors:

•  Traffic data is very strong in the US as people avoid public transport. We are seeing this start to feed through to auto demand as ride-sharers now opt for their own vehicle. This may have implications for steel.

•  Homebuilding seems to have held up much better than people expected. In the US new orders are stepping up and prices remain resilient. It is important to remember both the US auto and housing sectors were coming off relatively subdued bases, which helps in the pace of recovery.

•  There are signs that retail is quickly bouncing back. Some 75% of Australian retailers have re-opened their doors and, anecdotally, are seeing decent sales. It will be important to see how much of this is an initial surge of pent-up demand.

All this has important implications for the portfolio.

If we return to 90-95% of the pre-COVID-19 economy, there will be some parts at 80% and some at 100% or even higher. It will be important to identify the outlook for each individual company or industry and position accordingly.

We also need to remain mindful that, despite current optimism, the economic data will be awful. The hit to Global GDP, ex-China, in 2Q 2020 could be somewhere in the vicinity of 40% – even with the current bounce.

While the market seems well-supported at the moment, there are medium-term risks.

Longer term we remain mindful of the consequences of current policies and the potential for deflation.

Health outlook

It is too early to draw conclusions about the risk of a second wave of infections. In coming weeks we need to remain focused on case loads as countries open up.

High levels of testing and awareness of social distancing may help alleviate some risk. Warmer weather in the northern hemisphere may also help.

(continued below)

VIDEO: Crispin Murray explains the current market environment

(continued from above)

A surge in optimism over the Moderna vaccine trial may have been premature, but expert opinion seems positive about discovering a vaccine.

A coronavirus vaccine for humans has not previously been found, however focused efforts and widespread use of modern technology platforms are encouraging.

More trial results are expected in June.

Policy

China’s leadership avoided the traditional GDP target at the annual National People’s Congress last week.

Some took this as a bearish signal, on the view that authorities will not feel compelled to stimulate to hit a target. However it also probably has a lot to do with the degree of uncertainty around global demand for Chinese exports.

There is also some disappointment at the scale of bond issuance to fund growth projects – also seen as suggesting less stimulus. We believe Chinese authorities remain focused on job creation and social stability.

The Chinese economy has seen a decent recovery. The smaller scale of stimulus perhaps reflects a desire to pause until some evidence of the effect of global demand comes through before enacting new measures.

Some of the initial US fiscal program are nearing expiry. However there is scope for extension of the Paycheck Protection Program – one of the more important packages – which is critical for small businesses.

Politicians continue to wrangle over the form of the next US fiscal package. The market expects up to a further $US1 trillion in spending – though this may not be until late June.

A key debate here and in the US is how to incentivise workers who may feel better off on government support. This may result in changes to the structure of government programs. 

Markets

Looking at some of the key indicators we flagged last week, gold and the USD were largely unchanged last week, while US 2-year yields rose a little.

The latter remains an important indicator of the market’s expectation of negative rates.

The Australian equity market has been effectively trading sideways since April 13.

This is constructive in the sense that it has held onto gains from the March 20 low and has managed to consolidate. However there has been a material rotation within the market.

Over this period small caps (+13%), resources (+11%) and discretionary (+8%) have all outperformed, reflecting an improvement in sentiment.

Defensive names that did well in the early phases of the crisis – such as health care (-6%) and staples (-3%) – have underperformed.

Financials have underperformed right through the crisis. We have been broadly underweight and have benefited from this.

However we are mindful of the degree to which they have lagged. We remain cautious on the banks, but insurers are starting to look interesting as we think the market is over-discounting the risk of pandemic-linked claims.

REITs (+4.4%), Resources (+6.4%) and Small Caps (+4.4%) all outperformed last week as sentiment remained positive. The banks (-1.3%) dragged.

 

Crispin Murray is Pendal’s Head of Equities. Crispin has more than 27 years of industry experience in equities and a strong track record leading Australian and European equities funds.

He is responsible for managing a number of our flagship funds and leads one of the largest equities teams in Australia. 

Find out more about Pendal’s investment capabilities

 

Pendal’s Head of Equities Crispin Murray outlines his thoughts on the current market environment.

Watch the video above or read transcript below.

 

TRANSCRIPT

Hello everyone. My name is Crispin Murray from Pendal Group. I thought I’d take the opportunity today to share with you our thoughts on the current market environment and how we at Pendal invest and manage money on behalf of clients.

One of the attributes we believe in is being upfront and transparent in our views.

If I was to summarise the current situation, I think it represents perhaps the greatest challenge for investors in many years, but also it presents some of the greatest opportunities we have seen.

This is because we’ve got a combination of a really bad economic situation with perhaps the greatest policy stimulus we have seen — and overlaying this, a huge health challenge and substantial technological change.

In combination this is changing the way consumers and businesses operate.

This leads to three levels of uncertainty — economic, industrial and corporate. We believe the more uncertainty there is, the more mispricing in the market there is, and that is what creates the opportunity.

We also believe this environment plays to our strength. We have a strong organisation. We have a real breadth of resources, a lot of experience across many cycles and strong corporate relationships.

Two key questions for investors

When it comes to investing, there are two key questions to answer.

The first is how you make money for your investors and the second is what is your competitive advantage.

When it comes to making money, we believe that anticipating change is the key. Investing is about what happens next.

When it comes to competitive advantage, ours comes from an information advantage.

We have a large team with a real focus gathering primary information. We think of the team as being similar to investigative journalists. We have a lot of meetings, gathering information we use to make good investments. We believe in a culture not of commentating, but of actually thinking and investing.

Three pillars

There are three pillars to delivering this:

1. The first is the business model.

We are an Australian listed company. We are independent. All the staff are shareholders and we’re very much aligned to our investors. In addition, we have a dedicated management team, which means there are no distractions for those investors. They can get on with the job of identifying good ideas.

2. The second pillar is the team.

We’ve got 18 people in our Australian equities team — 22 years average [industry] experience, 14 years within the group. This means they understand market cycles, they understand the industries they’re looking at and they have a huge list of good contacts.

It’s that experience and understanding that is critical at these types of points in the cycle.

Because it’s remaining calm, focussing on the controllables, identifying opportunities that comes from that, that is the thing that will make a difference.

3. The third pillar is process.

We’ve spoken about the philosophy of identifying what’s going to happen next. We believe that you make money when something is changing for the positive in a business — and [when] the market’s not realised that and it’s not yet in the price.

 

When we do this, we need to then drill down into five key factors that we watch incredibly closely.

I want to highlight two of these.

1. The first one is business innovation.

Take a company like Xero, which is the cloud-based accounting software for small businesses. This is a company that has really been a leader in the industry in driving penetration globally. We believe it’s got a product suite that is still not fully appreciated by the market, that will allow it to drive penetration and increase their revenues from their customers.

That’s a good example of where innovation can drive opportunity.

2. The second category that I’d highlight is the self help category.

These are companies that are doing something themselves to improve their position. Often it comes in the form of cost and productivity.

Santos is a great example of this. They’re in a tough business — oil prices are very low, but they are a low-cost player with a good balance sheet.

They’re very proactive in terms of how they manage capital. We believe that will hold them in really good stead, particularly if you start seeing the economies improve.

So it’s a combination of these factors that we believe have allowed us to deliver strong performance over the long term.

And we highlight our Focus Fund performance. This is our concentrated best ideas portfolio and the basis of the SMA.

Not only has it been able to deliver very strong performance, but it’s also been very consistent performance and it’s been doing it for a long time. 

It’s been through many cycles. It’s been able to be very consistent. Even when there’s been periods of underperformance, they have tended to be limited in terms of the drawdown and the recovery of that performance has happened quickly.

Market outlook

If I turn now to our view on the market. We believe we are in the fourth phase of this market environment.

We’ve gone from the focus just being on China, to an indiscriminate sell-off, followed by strong bounce. Now we’re in what I would call a protracted discovery phase.

How bad will the economies be? How will companies fair? This is a time when information and insight can add a lot of value. You’ll see that we identified the key swing factors. 

The critical issue is the ability to restart the economy and how quickly and sustainably it recovers.

Four scenarios

To better assess this, we’ve presented four scenarios.

The first scenario to consider is the potential for a rapid medical breakthrough whether that be a vaccine or antiviral treatment.

If there was a dramatic breakthrough it would clearly be very positive for the market — and that would happen well before the availability of those treatments because it would impact on confidence.

This is a-low probability scenario, but it does have a very significant potential effect on the market. So it’s something that needs to be aware of.

The other three scenarios are less constructive but are more likely in terms of outcomes.

The most positive scenario one of these is the potential for certain countries such as Australia and New Zealand to actually eliminate the virus and then effectively close down their borders and remain separate until a vaccine was available.

The middle scenario is a more managed mitigation, which allows your economy to ramp up, though perhaps not to where it was before.

The third scenario is the most negative one, if we get waves of re-infection, which really impact on the economy.

Recently I was talking to some of the academic experts who’ve been working with the government. It’s worth noting that the difference between an elimination strategy in Australia, and a managed mitigation one, could be worth $2 billion to 8 billion a month just for our economy.

So it does highlight the variety of outcomes that we could see.

While we spend a lot of time understanding the developments and risks on the medical and economic front, the reality is we know it is really impossible to predict what’s going to happen.

What we need to do is weigh up these different scenarios and position the portfolio for that.

It’s important to stress as investors, we’re not going to be taking binary risks with our clients’ money.

We invest where we have insight and where we expect to get a good return. So we’re positioning our portfolios to find the best stocks for those different outcomes.

The categories of stock that we’re considering:

Firstly, recession protection; stocks that are policy beneficiaries; companies that are good businesses which we expect us to bounce back strongly when the recovery occurs; and finally, recovery plays and stocks that have been discounted the most heavily because they’re most immediately affected by the crisis.

We’re looking for different attributes in each of these categories in terms of the best stocks. But ultimately they do boil down to those factors we identified earlier — which reflect in terms of the quality of the industry structure, but also the quality of the management and their ability to respond to the environment we’re in and their ability to allocate capital well.

I hope that’s given you a taste of how we invest at Pendal. 

Yes, this is a really uncertain time for investors, but that also means it is a time where there are a huge number of opportunities.

I believe the experience that the team at Pendal has can deliver on those opportunities for you and your investors.

Thank you for your time and I wish you all the best.

 

Crispin Murray is Pendal’s Head of Equities. Crispin has more than 27 years of industry experience in equities and a strong track record leading Australian and European equities funds.

He is responsible for managing a number of our flagship funds and leads one of the largest equities teams in Australia. 

Find out more about Pendal’s investment capabilities

 

 

How will deflation impact investors in a low-rate environment?

Pendal’s Head of Bond, Income and Defensive Strategies Vimal Gor (pictured above) explains in this plain language keynote presentation from the Conexus Fiduciary Investors Symposium on May 19, 2020.

 

TODAY I want to run through some of the unprecedented numbers we’re seeing and outline how this economic environment could play out. 

What is the economic outlook?

Let’s put the current situation in perspective. Take the non-farm payrolls number (see below). This graph, which goes back to 1940, puts into context how monumental this slowdown has been.

It’s becoming more of a consensus view that the size of the lockdown — and the commensurate policies that have come with it — have largely been the wrong ones.

We arguably shouldn’t have stopped the economies as quickly as we did. We should have followed a different model and now we’re trying to pull ourselves out of this massive economic contraction we are experiencing.

There is no getting away from the fact that this is a massive shock.

Shocks historically have started in the financial system, for example the dot-com and GFC crises. This one started as a health crisis which flowed into economics then through to financial assets. So it’s a very different beast than the crises we have seen before.

That is why the authorities have had so much trouble dealing with it. 

This chart below shows Germany, but I could have used pretty much any country.

I’ve used the IFO expectations which is a PMI and I’ve just put it up against MSCI world for EPS. We can see how the situation is going to get worse before it gets better.

Global data is awful. The April US retail sales number was down 16% — which puts it down about 30% since February (excluding food).

It is quite clear many businesses will not survive this crisis. High-end restaurants run with a margin of around 5% to 8% and they’re going to be running at 10% to 30% capacity.

Yes, we have dealt with the liquidity issue but we’ve got a solvency issue which is going to come up and hit us later. Do we have enough firepower to deal with that?

We’re going to see a tsunami of bankruptcies — there’s no other way to think about this.

The reason we’re not seeing these bankruptcies already is the government lockdowns and life-support mechanisms are delaying the process.

We can see here that earnings are going to be terrible. But we know the S&P is down only marginally from the levels we came into the year — so what’s happening?

It’s about multiple expansion. P/E multiples expanded on the back of liquidity, but earnings have been decimated — and it’s very clear earnings are going to get hit further.

Central banks responded very quickly. They did the usual: conventional monetary policy, cutting rates to zero. This was followed by unconventional monetary policy, yield curve control and more quantitative easing at a size we’ve never seen before.

Quantitative easing in the US is five times the size of all the quantitative easing we’ve seen in the last 10 years put together — unbelievably large.

The Fed and other central banks then started going into the fiscal policy area — somewhere they’ve not normally gone before.

They start supporting the markets and the economy directly, bypassing the banking system.

The Fed and central banks around the world have thrown every measure they possibly can to get rates down and flood the system with liquidity.

It’s my strong belief they will have to take rates negative. They don’t want to take rates negative — Powell talked about that last week about the fact that they don’t want to do it.

We know operationally the US isn’t ready yet and there is very strong resistance from the lobby groups and the banks.

But when nominal interest rates are 50 basis points in the US and you’re going to get a big wave of deflation, you’ll have real interest rates rising — which is just going to crunch the US economy further.

So, we believe the only material thing the Fed will be able to do is cut rates to negative with a short, sharp shock the way Kenneth Rogoff has recommended.

They clearly don’t want to. But I think there’s no choice — which would mean bond yields across the world would go negative as well.

What are defensive assets today?

While yields are already low, you can very clearly own 10-year Treasuries until they’re at -1%. I think they’ve got a lot of juice left in these markets. People don’t want to be owning them here but they should be.

The more bonds rally, and the lower yields go, the more people will need to buy them.

The Fed has done everything — conventional monetary, unconventional monetary and now they’re doing fiscal policy.

This chart shows investment grade spreads relative to non-manufacturing PMIs:

You can see we’d be off the scale if the Fed wasn’t artificially supporting credit spreads — we’d be at 600 to 700 given the non-manufacturing PMI.

The slowdown in the economy should lead to much wider spreads — but it hasn’t because of the backstopping by the Fed.

Not only is the Fed backstopping investment grade corporates via ETFs, they’re now doing high-yield fallen angels.

They’re effectively doing everything they possibly can to stop the markets dislocating and to plug this hole. But what they’re doing is plugging a solvency hole with liquidity, and ultimately it will fail.

We know the size of the central bank response has been massive, but then we had this coupled with the response by the governments as well.

This chart below shows the change in cyclically adjusted primary fiscal balance, this measure will  give you an idea of how big the government fiscal response has been.

You need to think about this in terms of the US.

I’ll put it in perspective in terms of the US.

We came into this crisis with a fiscal deficit around 5% in the US. That’s ridiculously large on the back of the longest expansion in history. Plus we’re at full employment.

We came into COVID in the worst situation. We had very high debt levels in both government and corporate debt, and investors had portfolios which were pushed out the risk curve as they stretched for yield

So the virus hit us at exactly the wrong time.

Coming into this crisis the US was running a 5% fiscal deficit, we’ve now had support packages in the region of 15%.  The economy has slowed dramatically which will lead to a drop in tax revenue of about 3% to 5%.

Nominal GDP is also going to detract about 5% over the calendar year, so we’re looking in the US for a fiscal deficit somewhere 20% and 25% of GDP.

This next chart shows you how unsustainable this is. The US Congressional Budget Office (CBO) estimates below show numbers back to 1790.

There’s zero chance they’re going to be able to pay this money back.  Zero chance.

So how will they close the hole?

They have to defaults — either implicit default through inflation (the preferred course of every central bank and government in the world) or explicit default (restructuring, tax rises and spending cuts).

We talk about rebuilding the budget in Australia and trying to pull things back.

But there is zero chance across the world this money’s being paid back, so we need to engineer inflation or we need to do some type of debt jubilee, or a combination of the two.

The outlook for inflation

Lots of things drive inflation over the long run.

Factors that have kept inflation down over the last 30 years include the three Ts — trade, tech companies and titans.

Up until recently we had free and growing trade; we’ve had the influence of the tech companies (eg Amazon and its pricing power and ability to push prices down); and the titans (the rise of massive companies with oligopolistic or monopoly positions).

You’ve also had the two Ds — debts and demographics.

All these factors have been weighing on inflation. It’s quite clear here in the next chart showing M2 minus real GDP — but you can put any measure of money supply for any country in the world and the US is the poster child for this.

Money supply is absolutely ballooning.

Initially, the run-up in the money supply was unexpected as corporates drew on their revolving lines of credit.

That increased money supply as the banks were forced to lend to them. Then the Fed began pumping money in the system.

The three-month change in M2 in the US shows it is running at over 100%.

These are numbers you couldn’t even imagine. At some point that will start feeding through to inflation.

When you think of Irving Fisher’s theory of money, on one side you’ve got money supply and on the other side you’ve got velocity. Multiplying the two together gives you nominal GDP.

But the velocity of money’s been falling since 2006-07 because the economy’s been slowing, nominal GDP is coming down and nominal interest rates have been falling.

Now it’s been falling off a cliff because there are no transactions happening in the economy.

The government’s trying its best to slow down the velocity of money by throwing all of these fiscal packages at it. At some point, whether it’s six months or a year when we start coming through this, we’ll see velocity of money stop falling and then probably start rising.

That means you’ve got this massive money supply up against the velocity which isn’t falling. That has to lead to higher nominal GDP and nominal inflation.

There is no question in my mind that we will be hitting an inflationary episode in the US over the coming medium-term — one to three years out.

I think that’s what the governments want. They want to deflate the debt away.

Even before the virus, the Fed told us they wanted to move to average inflation targeting — running inflation above the target to get the 15-year average up.

Now they might have to run this at 3% to 5% — so you’re talking some quite big numbers. The problem is we’re going to hit deflation first, then inflation after.

In the long run you get these structural forces — monetary policy, fiscal policy, demographics, debt, trade, etc — which influence a long-term inflation rate.

In the short run inflation is largely driven by the business cycle. It’s quite clear we’re going to hit GDP growth of minus -5% in the US this year, which will give you a deflationary environment.

The thing that really worries me in the US is the fact that shelter inflation — the part of inflation that has been holding up the inflation rate in the US — is now flat and starting to fall.

Excluding shelter, the CPI number we saw last week was 0.6% and this is falling rapidly.

So we’re going into a deflation episode in the US. I think the Fed has to counter that with negative interest rates.

Then when we start coming back to work and hopefully get a vaccine, that point is going to be super inflationary because I cannot see an environment where the central banks of the world pull back monetary policy anywhere near the pace they need to.

It’s quite clear they and the governments have over-delivered. They’ve filled a solvency issue with massive short-term liquidity.

When we talk about the deflation-inflation picture we can’t forget about the US Dollar’s role as  the reserve currency. They call it the exorbitant privilege.

This shows you what that privilege is worth. You can see on this next chart as currencies weaken you tend to see bond yields fall.

The US can get bond yields falling while the currency strengthens and that’s a massive advantage.

The world certainly doesn’t like that advantage. China, Russia and Europe don’t like it. There will be a move away from the dollar standard at some point — it’s just a question of how long it takes.

I think that will go hand in hand with some kind of debt jubilee over the medium term and some greater role for crypto currencies.

The focus of the crypto world is Bitcoin for me. You can like it and not be part of the shiny hat brigade. All you have to do is accept the fact that crypto is going to be a much greater part of the financial markets going forward.

Most of the world’s central banks are currently working on crypto and some kind of stable coin right now. These are the equivalent of IMF SDRs — there is no doubt it will become more mainstream.

American billionaire Paul Tudor Jones had a note out just a couple of weeks ago expounding the benefits of Bitcoin. Literally, it’s the only tradable asset in the world where there’s a known fixed maximum supply.

You’re buying it because you don’t trust in central banks and governments. You’re buying it because they can’t deflate its value away — they can’t devalue your Bitcoin.

Whether you like Bitcoin as a construct or not, I think you have to accept the fact that the world is moving away from allowing the US to be the reserve currency.

We’re moving to a new regime. How we move away from a US reserve currency and how crypto impacts the long-term inflation-deflation dynamics have yet to be determined, but they will be material.

 

Vimal Gor leads Pendal’s Bond, Income and Defensive Strategies team.

Find out more about Pendal’s 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 22 May 2020, the buy-sell spread for a number of Pendal funds (the Funds) will decrease as set out in the table below:

Fund Name	Old (%)		New (%)
	Buy	Sell	Buy	Sell
Pendal Dynamic Income Fund	0.07%	0.36%	0.07%	0.23%
Pendal Enhanced Credit Fund	0.07%	0.32%	0.07%	0.23%
Pendal Fixed Interest Fund	0.06%	0.12%	0.06%	0.10%
Pendal Monthly Income Plus Fund	0.07%	0.25%	0.07%	0.20%
Pendal Sustainable Australian Fixed Interest Fund	0.05%	0.13%	0.05%	0.09%

 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.