Pendal MicroCap Opportunities Fund

Important Updates

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

Effective 26 March 2020, the Pendal MicroCap Opportunities Fund (Fund)’s buy-sell spread will increase from 0.70% (with 0.35% payable on application and 0.35% payable on withdrawal) to 1.86% (with 0.93% payable on application and 0.93% payable on withdrawal). 

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

Due to the impacts of COVID-19, investment markets have experienced substantial increases in volatility. For ASX listed micro capitalisation equities, this has resulted in higher trading costs.

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.

THE spread of COVID-19 is exacting a great humanitarian and economic toll across the globe.

At times of heightened uncertainty there is an even greater need for patient, active and transparent investment management to help clients navigate this challenging situation.

A key component of this investment process is stewardship, in particular engagement with investee companies.

An active engagement program is an important way to identify investment opportunities as well as manage risks.

Fundamental to this is a long-term focus – beyond the rapid velocity of market moves such as those now occurring in response to COVID-19.

At this time we want to continue holding companies to account while preserving value in a manner that is constructive and focused on the most material issues.

Often these include environmental, social or governance (ESG) matters.

Last year Pendal fully-acquired specialist ESG research, engagement and advisory team Regnan, to enhance our responsible investment and stewardship practices.

The wide-ranging social and financial challenges associated with COVID-19 highlight a number of important ESG topics which will continue to form part of our investment and stewardship practices in the coming weeks.

Here, Regnan experts share their view on how this crisis is impacting existing and emerging ESG issues:

What we’re looking out for

The COVID-19 crisis is unique because its implications are truly economy and society-wide.

Government, business and not-for-profits all experienced financial stress during the Global Financial Crises — but the current COVID-19 risks are more widespread.

This outbreak brings multiple challenges such as business continuity planning, workforce planning and supply chain disruption.

These are all aspects we are researching and raising with companies where we have concerns.

The current crisis is stress-testing these policies, procedures and overall governance, including with respect to ESG.

Here are some of the key areas to watch during the COVID-19 crisis:

Board function

Right now company directors need capacity – particularly in maintaining critical business services such as delivery of health care and medical supplies and non-discretionary consumer goods.

The economy-wide implications of the COVID-19 crisis elevate risks for most sectors, posing unique challenges for corporate leadership.

This will test individual directors to respond in ways that address immediate business challenges and longer-term strategy.

These are the types of circumstances Regnan has long considered a risk for companies with over-committed boards.

It may give further weight to the case for companies to mandate fewer board roles.

Management decision-making

How quickly and appropriately companies respond to the crisis will provide insight into company decision-making processes.

We watch for the companies that get on the front foot and mitigate business risks and those that fail to act quickly with necessary actions. This includes the less obvious interdependency risks.

Brand protection

Customer-centric strategies may come under strain as companies face competing pressures.

It is not clear how much any brand value created by a company’s response will translate into future loyalty.

But it is likely any major mishandlings will create reputational risk.

For example, the extent to which banks relax loan repayments for stressed businesses may have longer-term consequences for future business relationships, particularly in the Small and Medium Enterprise segment.

Unsurprisingly this is an area where we have already seen an industry-wide response, given the reputational strains already faced.

Supply chain

The temporary shutdown of supply routes, significant illness among employees, or pressures placed by panic buying will stretch supply chain management for a range of businesses.

Without careful business continuity planning this can elevate ESG risks.

For example, businesses may need to switch to lesser-known suppliers or sub-contractors that have not been through the adequate screening processes.

This raises the risk of lower-quality goods or failure to meet modern slavery or environmental performance standards.

Together with the recent Australian bushfires, the COVID-19 crisis provides lessons for longer-term issues we know are likely to bring supply chain disruption, such as physical disruption from extreme climate change events, either locally or offshore.

Will this make us do things differently?

There has been some discussion on whether the changed behaviours we are seeing with air travel and videoconferencing will lead to a change in practices once the situation passes.

Most of our meetings with company directors have been easily moved to the virtual world for example.

This will partly depend on how long the situation continues and the experience of users during this time.

In the meantime, it will be interesting to see how smoothly large corporates can continue with business-as-usual.

What’s next

Regnan will continue to factor these and other developments into our analysis during this unique time.

We will incorporate these into our company engagement program where material and we will continue to provide further updates on our observations and activities.

As history shows, crises are often associated with new regulation and technological responses along with changes in business and consumer behaviour.

Some of these changes are temporary (eg implementing working-from-home policies or re-tooling production lines to manufacture respirators and masks) while others may be more relevant to ongoing business practices (eg team-orientated communication tools or infrastructure solutions that provide care for elderly members of society – especially in countries with older demographics).

The combination of wide-ranging and rapid change with high uncertainty creates significant challenges – but also investment opportunities.

A disciplined, long-term investment approach focused on anticipating change is key to identifying these investment opportunities and delivering strong risk-adjusted performance.

Pendal’s investment teams have deep experience and insights formed over many market cycles.

Together with Regnan’s ESG analytical capabilities and engagement expertise, we feel confident in continuing to meet client needs despite these uncertain times.

We look forward to providing updates to our clients as this situation progresses.

In the meantime, please do not hesitate to get in touch with your Pendal account manager or learn more about Regnan here.

Investors with well-diversified, well-designed portfolios should stay the course amid the COVID-19 volatility, says Pendal Head of Multi-Asset Michael Blayney.

Michael explains why in this short video. Or read the transcript below.

Transcript

I’m going to provide you here with a brief update on our views on portfolio construction and current market conditions in light of the COVID-19 related volatility we are experiencing.

The first point is it’s always important to maintain a diversified portfolio and there’s multiple ways in which people can diversify their portfolios at a basic level.

It’s having both equities and bonds — but also within equities it’s having a blend of Australian and global equities.

Even though they might move together on a day-to day basis, over an investment time horizon of a balanced investor — which would be five years or more — they can provide substantially different returns over those longer-term time horizons.

In addition, it helps in a portfolio to have some alternative assets and also some foreign currency exposure.

The foreign currency exposure is usually achieved by holding a reasonable proportion of the global equities on an unhedged basis.

In the first part of the recent market correction that we have had, we saw that bonds provided nice diversification to equities with yields falling at the same time that equity markets were falling, resulting in capital gains for government bonds.

In the most recent leg of the market sell-off, we have, however, seen bonds and equities providing negative returns at the same time.

Now the key thing about portfolio diversifiers is they don’t necessarily always diversify in every market condition, so it’s important to have more of them.

And that’s why, for example, foreign currency has been extremely valuable — because the Australian dollar has continued to depreciate and this has helped to cushion the portfolio.

In addition, alternative assets can provide a degree of portfolio diversification as well.

We’ve seen mixed performance from alternative assets in the large selloff that we’ve had. However, even when negative returns have been achieved by the alternative assets, they have generally been better than equities.

So if you put together a portfolio of equities, bonds, alternatives and some foreign currency, that has smoothed the path of returns — even if they’re still negative for an investor.

Spreads on corporate bonds

We also note that in the current environment spreads on corporate bonds — which are essentially the excess yield that a corporate needs to pay to borrow in excess of the government — have widened quite a lot.

We now have spreads in investment-grade bonds, if you look at the US corporate index, of approximately 285 basis points. High-yield spreads also widened considerably.

If we look at the long history of investment-grade bonds, even through world wars, depressions, recessions and financial crises, default rates on investment-grade bonds tend to be very, very low.

So the spread that you get on investment-grade bonds is largely compensating you for what your liquidity is.

That’s a big part of the reason why spreads have blown out so much now.

While we may see some defaults come through, particularly in the energy and leisure sectors, the current buffer on offer on investment-grade bonds well and truly compensates for even an adverse default cycle.

If we were to, however, look at high-yield bonds, the default cycles there can be significantly worse.

And if we see significant defaults on energy, which represents a reasonable proportion of the high yield market, then the current spreads on offer might not be sufficient to compensate for that.

So we’d prefer investment-grade exposure in this environment.

Long-term valuations

While earnings and dividends will take a hit, the current market reaction has exceeded where we believe the impact on long-term valuations should be.

We think it’s probably about about double that impact.

Of course coming into this some markets were very expensive, for example the US. Whereas a lot of the Asian markets were already actually reasonably undervalued.

So some of those markets do represent extremely good value in the current market environment.

In addition, once the crisis eases somewhat and investors start to look around for ways in which they can generate returns on their assets, a quarter of a per cent official cash rate would most likely not be a particularly attractive return.

Even though we are likely to see dividends get cut on shares, the dividend yield on shares is likely to be significantly better than that very low cash rate.

Yields on corporate bonds — in particular investment-grade given those blowouts and spreads — are also likely to become attractive to investers again.

As a result, we believe that in this environment investors should stay diversified, increase exposure where appropriate to particular circumstances of a portfolio, and very much stay the course and do not panic.

We know that while it’s impossible for anyone to predict the exact bottom of a share market, if people do bail out after very large falls, that tends to be quite destructive to long-term wealth.

We know it’s far better to stay the course with a well-diversified and well-designed investment strategy.

A quick overview of government COVID-19 responses from Pendal Head of Bond, Income and Defensive Strategies Vimal Gor.

Watch this short video recorded at Vimal’s home office, or read the transcript below.

TRANSCRIPT:

I’ve spoken at length over the last few months about the situation we’re finding ourselves in, in terms of markets and economics.

The bottom line is — the world economy was slowing and was susceptible to an exogenous shock that would slow us further.

Unfortunately, we’ve seen one of those.

The problem is, there’s no real precedent to the shock we’re seeing. Most crises we’ve seen over the last 100 years have been financial crises which have gone on to affect the broader economies.

If you look at the GFC, it was a housing sub-prime problem which caused a run on financial assets, which then fed into main street.

This one is very, very different. This is a health crisis which is affecting the economic growth patterns of so many economies, which are then feeding into the financial sector.

That’s why it’s very difficult to monitor and model and get an understanding where it might go in the future.

There’s no good time for a pandemic such as this to hit economies — but arguably this is one of the worst times you could have imagined.

The world economy was already beginning to slow — and that was on the back of three reasons.

Firstly, our strong belief is the Fed had over-tightened at the end of the last cycle and hiked rates materially more than they needed to.

Secondly, the de-leveraging we’ve been seeing out of China.

And thirdly the trade tariffs and the trade wars we’ve been seeing which is slowing global growth.

All of this comes at a time when there’s been significant monetary stimulus across the world, which has pushed risk assets up to unsustainable levels.

As the true impact of the pandemic comes through in economic data this has caused monetary authorities to respond as quickly as they can.

Unfortunately there was limited room for them to do so, because interest rates across the world are pretty much at zero anyway.

We have seen what they can do — as the RBA and other central banks across the world have slashed rates to zero and committed to leave them there for a prolonged period.

But the focus has to be on fiscal authorities — and we’ve seen massive fiscal responses across the world already.

We’ve seen huge packages out of Australia and the UK and the US — but we still believe these packages will continue in size and will get to near unimaginable levels, maybe 20% of GDP or north.

This is effectively the role of governments. Governments have to back-stop the economy and back-stop people’s livelihoods.

This is what we’re seeing in the UK —where they are effectively paying people’s wages for those who can’t go to work.

When you have to make a choice as a government between stopping the economy or saving people’s lives, there is only one choice.

You have to save the lives as quickly as you can and then do everything you can to try and help the economy through the situation.

And that’s what every government in the world is trying to do right now.

This is not the time to panic about your portfolios. This is a time to trust in your managers.

This is why you invest with us, and this is the period we’re supposed to help you and work for you.

Whether you’re clients or not, if there’s anything that me or anyone at Pendal Group can do to help you or your business in these troubling times, please do not hesitate to get in contact.

RESERVE Bank Governor Phil Lowe may be cautious by nature but he can recognise when decisive action is required.

The RBA has today delivered a rate cut to 0.25%.

Exchange Settlement balances interest (what the RBA pays for cash parked with them) should have been 0% (25 below) but is now set at 0.1%.

More importantly, in the Quantitative Easing (QE) arena the RBA is targeting 25bp for Government 3-year bonds.

Technically the money will come back to the RBA so it’s not Modern Monetary Theory. And it’s price, not quantity-targeted — so not Quantitative. But effectively it’s QE.

The RBA will be in the market buying government securities as long as the 3-year rate is above 25bp.

They will focus on Commonwealth Government Loans around three years while also leaving the option open for longer.

They’ll also be buying semi-government bonds.

The market was at 50bp going in and is still marked at 35bp.

It is priced-based but they are not open to any volume any day. They will keep going at their own pace as long as the 3-year rate is higher than 25bp.

There should be a big one to start tomorrow.

The RBA also announced a Term Funding Facility – 3-year funding to Authorised Deposit Taking Institutions (ADIs).

This is a good step although it does not solve the problem of banks extending credit to businesses. (That solution is likely to be fiscal).

My thoughts 

This is massive Quantitative Easing.

It will solve Government Bond liquidity and to a lesser extent semi-government liquidity. 3-years will be anchored around 0.25bp. Long-end should still be captive to global moves but panic should subside.

Some will complain it’s not enough to solve credit markets and other dislocations, but keep in mind this is step one.

There is likely more to follow.

Basically they are flooding liquidity into the system and this will be a big help.

I suspect markets will be slow to appreciate how big this is, but I believe in months to come it will be seen as the first step to stabilisation.

Notice of Termination: Pendal Global Fixed Interest Fund (APIR: RFA0032AU, ARSN: 099 567 558)

We are writing to advise you that the Pendal Global Fixed Interest Fund (Fund) will terminate effective from Thursday, 28 October 2021.

As an investor, you are affected by its termination.

Why is the Fund being terminated?

Given the declining size of the Fund, our ability to manage it in accordance with its investment objective and investment strategy has been impacted. As a result, we also consider that the Fund has little prospect of significant growth in funds under management in the foreseeable future.

Accordingly, we have concluded that it is in the best interests of investors to terminate the Fund, liquidate the assets and return the net proceeds to investors.

How this affects you?

We will terminate the Fund on Thursday, 28 October 2021 and as soon as practicable, we will begin winding up the Fund. The assets remaining in the Fund will be realised and the proceeds distributed to all investors in proportion to their unit holding.

Applications, transfers or withdrawal requests received after 2:00pm (Sydney time) on Wednesday, 27 October 2021 will not be accepted.

What does this mean for you?

The cash proceeds from the termination of the Fund will be paid directly to your nominated bank account on or around Tuesday, 30 November 2021.

If there is a final distribution for the Fund, this will be paid directly to your nominated bank account prior to the cash proceeds from the termination. The details of the final distribution will be included in your December quarterly statement.

You will also receive an annual tax statement following the end of the financial year during July/August 2022.

Questions?  

If you have any questions, please contact our Investor Relations Team during business hours on 1300 346 821.

Notice of Termination: Pendal Enhanced Global Fixed Interest Fund (APIR: WFS0005AU, ARSN: 088 841 972)

We are writing to advise you that the Pendal Global Fixed Interest Fund (Fund) will terminate effective from Thursday, 28 October 2021.

As an investor in the Fund, you are affected by its termination.

Why is the Fund being terminated?

Given the declining size of the Fund, our ability to manage it in accordance with its investment objective and investment strategy has been impacted. As a result, we also consider that the Fund has little prospect of significant growth in funds under management in the foreseeable future.

Accordingly, we have concluded that it is in the best interests of investors to terminate the Fund, liquidate the assets and return the net proceeds to investors.

How this affects you?

We will terminate the Fund on Thursday, 28 October 2021 and as soon as practicable, we will begin winding up the Fund. The assets remaining in the Fund will be realised and the proceeds distributed to all investors in proportion to their unit holding.

Applications, transfers or withdrawal requests received after 2:00pm (Sydney time) on Wednesday, 27 October 2021 will not be accepted.

What does this mean for you?

The cash proceeds from the termination of the Fund will be paid directly to your nominated bank account on or around Tuesday, 30 November 2021.

The termination will result in a final distribution of the net income of the Fund. The details of the final distribution will be included in your December quarterly statement.

You will also receive an annual tax statement following the end of the financial year during July/August 2022.

Questions?  

If you have any questions, please contact our Investor Relations Team during business hours on 1300 346 821.

Important Updates

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

Pendal Enhanced Fixed Interest Trust (APIR: WFS0365AU, ARSN 099 765 947)

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 20 March 2020, the buy-sell spread for a number of Pendal funds (the Funds) will increase as set out in the table below:

Table 1: Old and New Buy-Sell Spreads

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

Due to the impacts of COVID 19, investment markets have experienced substantial increases in volatility and substantially reduced liquidity in some markets, resulting in increases in trading costs in fixed income markets. The increase in the buy-sell spreads is related to substantially reduced market liquidity for Australian issued investment grade securities. This change does not reflect a deterioration in the credit quality of these assets.

Pendal has determined an increase the buy-sell spread for each of the Funds as set out in Table 1 above. The buy spread is payable on application to a Fund. The sell spread is payable on withdrawal from a Fund.

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.

Pendal Dynamic Income Fund

Important Updates

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

Effective 19 March 2020, the Pendal Dynamic Income Fund (Fund)’s buy-sell spread will increase from 0.14% with 0.07% payable on application and 0.07% payable on withdrawal to 1.02%, with 0.07% payable on application and 0.95% payable on withdrawal.

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

Due to the impacts of COVID 19, investment markets have experienced substantial increases in volatility and substantially reduced liquidity in some markets, resulting in increases in trading costs in fixed income markets. The Fund invests primarily in Australian issued investment grade corporate bonds and the change in buy-sell spread does not reflect a deterioration in the credit quality of these assets.

Following a review by the Responsible Entity, Pendal has determined to increase the Fund’s buy-sell spread to 1.02%, of which 0.07% is payable on application and 0.95% is payable on withdrawal. 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 the Fund.

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

Pendal portfolio specialist Chris Adams presents a wrap of COVID-19 market observations, likely scenarios and portfolio positioning insights from the Pendal team

WE ARE now seeing the market price in economic disruption caused by government efforts to contain the coronavirus spread and “flatten the curve”.

We’ve seen from China, South Korea and Singapore that economic lockdowns can be successful in limiting the increase in infection rates.

Such actions reduce mortality rates by ensuring healthcare systems are not overwhelmed — and appear to have brought the virus spread under control in those countries.

But the question for investors is: how much structural damage is done to the economy as a result of measures to halt the virus’s spread.

There are two parts to this question:

1. How long will the economic disruption last?
2. How successfully can monetary and fiscal measures compensate?

Uncertainty about these questions is reflected in the extreme volatility of equity markets of the last two weeks.

There is stress emerging in credit markets. Constant dialogue with our Bonds, Income and Defensive Strategies team, led by Vimal Gor, has helped us maintain a relevant and granular view of this issue.

Spiking credit spreads reflect the fear that this period of economic disruption will result in widespread business closures.

However unlike the GFC or previous crises, this episode is not the “fault” of irresponsible behaviour in a particular industry.

The stress is caused by understandable government actions to prioritise the health outcome over the economic outcome.

This notion is reinforced by the view that the health system has not been adequately prepared to deal with a pandemic. This means governments should be more inclined to back-stop industries under stress.

This contrasts with previous crises where governments were less willing to intervene in troubled industries, citing the “moral hazard” of irresponsible activity.

As a result we are likely to see governments go to unusual lengths to put a firewall between the economic disruption they are causing now and the potential structural consequences that could result.

Industry-based interest free loans, tax holidays, debt guarantees — and central bank purchases of commercial paper and even equities — are all on the table.

The goal is to reduce the risk of widespread business closure and unemployment.

Business impact

That said, the possible impact on businesses and the broader economy should not be understated.

Businesses are likely to shut down and some will go bankrupt. There are likely to be redundancies and workers on unpaid leave which will have knock-on effects on consumer demand.

While industries such as travel, energy, some retail and hospitality are feeling the first-order effects, few industries will resist some level of impact from policy measures.

That might be impact on financial companies via lower interest rates, impact on the infrastructure names via reduced traffic rates or potentially lower subscriber growth for some of the WAAAX names.

Some companies and industries will be less sensitive to social distancing measures, or may even see some benefit. Telecommunications, for example, or supermarkets while hoarding goes on. However these are relatively few.

The key factor is the market’s confidence that government measures will prove sufficient to underpin vulnerable sectors and see them through the worst of the economic disruption.

Possible outcomes

Pendal is fortunate to have a team with deep experience that has weathered several episodes of this nature.

Each crisis has its own characteristics but the challenge is the same: protect capital as much as we can and position ourselves to take advantage of the opportunities.

It is important to acknowledge that we do not know the outcome.

We are experts in analysing companies — not in virology. We have no special insight here that gives us an edge in determining the likely outcome for the spread of COVID-19 and social distancing measures to combat it.

What we do is provide a framework in how to think about probabilities, position the portfolio to perform in the most likely outcome, and make sure we are hedged against the less likely — but still possible — scenarios.

The outlook here will be determined by the virus spread and the success of measures to combat it.

We group the potential outcomes as follows:

1) Worst case: A widespread global pandemic, provoking a sustained global recession, zero rates, unconventional policy responses and further material falls (>20%) in the equity market. We think this is a lower probability outcome, particularly given the moves made in recent days to contain the virus.

2) Rolling outbreaks globally: Short-term economic downturns of 2-4% followed by quick recovery. Policy responses include zero rates and targeted fiscal stimulus. This scenario could see further markets falls — potentially of up to 10% or so — with a bounce-back by year’s end.

3) Milder outbreak: Containment measures and the northern hemisphere Spring curtail the spread. This could see a short-term slowdown, with rate cuts and limited fiscal stimulus. The market may already have seen its lows if this is the case, with a good chance of a 10-20% bounce.

4) A quick resolution: A medical breakthrough could see economic acceleration, a reversal in rate cuts, bonds falling sharply and a 20% or more rally in equities. Like the negative extreme, we see this as a low probability outcome.

Portfolio framework is important

Experience has taught us it’s important to focus on what you can control.

We cannot control the outcome of this health issue. We cannot control the market’s reaction. But we can control the framework we think best positions the portfolio.

And we can control our view on which are the best companies to hold within each of the framework categories.

The portfolio’s framework in this environment is designed to weather the more likely outcomes — scenarios two and three — and to take advantage of the buying opportunities that emerge.

We also need to be mindful of protecting the portfolio in the case of one of the more extreme scenarios playing out.

In this context, here’s how we consider the portfolio’s structure:

1) Recession insurance: We want stocks with the potential to hold up well if economic conditions deteriorate. We have some gold exposure — and also hold positions in bond-sensitives that should do well if sentiment worsens.
In terms of the traditional defensives it is important to be selective. We want to hold A-REITs backed by good assets with low gearing, avoiding those with a high exposure to consumer discretionaries.
In infrastructure, it is important to recognise that traditional correlations to bond yields may be swamped by fundamental factors — for example, Sydney Airport is likely to see a hit from travel restrictions, while we also need to be mindful of a material fall in commuter traffic for the toll roads.

2) Quality defensives: Companies that combine strong balance sheets, good management and low sensitivity to the near-term economic dislocation, with relatively limited impacts on revenue.

3) Beneficiaries of fiscal stimulus: While central banks have already moved to cut rates, governments are also increasingly expected to inject stimulus to help companies and the economy bridge the expected slowdown.
The iron ore price has held up reasonably well, helped by weather-related supply disruption in Australia and Brazil and a gradual increase in confidence that China has brought the situation under control.
We think the iron ore miners would benefit from stimulus in China, while we also see housing as a natural area for governments to inject stimulus, with James Hardie a likely beneficiary.

4) Franchise winners: These are good businesses that may see a near-term hit but are well positioned in terms of balance sheets and competitive position to withstand a slow-down. They look attractively valued on a two-to-three-year view.

5) Resolution insurance: There are several stocks we expect to surge quickly on any sign of slowing infection rates or a medical breakthrough. Qantas is our key position here.

6) Areas to remain cautious: If this was just a short-term hit to demand then the sharp drop in the oil price might make energy look more interesting. But the break between Russia and OPEC on production cuts over the weekend has complicated the issue.
If we are entering a grab for share — with some signs that Russia is looking to put pressure on the US shale industry — then the risks here are elevated relative to other commodities.
We also remain cautious on the banks. Dividend yields remain attractive, but additional rate cuts just bring further margin pressure to bear.
A stimulus package could also include some measures to allow struggling businesses to defer interest payments — although there is speculation such a measure may include the quid pro quo of cheap funding for the banks.

How we’re positioning

Within this context, as we stand today, we have a skew to the defensives and recession insurance and beneficiaries of stimulus.

We are being opportunistic around the franchise winners. We are broadly neutral in terms of those companies that we consider resolution insurance.

Given uncertainty about the duration of economic disruption, we need to understand how the first, second and third-order effects of an extended disruption would impact companies.

The size of our team means we are doing this for every stock under our coverage, which includes every stock in the ASX 100, plus a material portion of the Small Ords.

The goal is to identify vulnerabilities that the markets not thinking of now, but which may emerge if the situation deteriorates.

We are modelling companies on the basis of what we think would happen to revenues and earnings if the disruption lasted three months, six months, nine months or longer.

What does that mean for revenues, for working capital, for balance sheets and debt covenants? This has been the key focus this week.

It provides concrete insight which then feeds into our framework — helping select the very best stocks to fit each bucket and help the portfolio perform in an uncertain environment.

Market observations

Markets are now starting to price in the risk of a material downturn in earnings and recession.

It is worth mentioning that equity market volatility has probably been exacerbated by people hedging credit market exposures. Credit ETFs have created an expectation of liquidity that has not been the case now we are in a period of stress.

We are seeing signs that equities are being used to hedge illiquid credit positions in some instances, contributing to volatility.

The influence of ETFs and passive investing is clearly apparent in the indiscriminate nature of the market sell-off.

This has been exacerbated by the effect of risk parity strategies and other systematic approaches needing to de-risk.

The market’s sell-off is rational, but indiscriminate selling has led to outcomes which are irrational — such as the poor performance of traditional hedges such as gold.

We are mindful of heightened near-term uncertainties and second-order effects.

But when stocks with limited or even positive sensitivity to near-term economic environment are sold off to the degree we have seen, there is no doubt there is mis-pricing and opportunities for active managers.

At this point the market has been hit by a valuation de-rating.

Several companies have withdrawn earnings guidance, though we are yet to see widespread earnings downgrades.

These will come. But it’s only once companies and investors start to understand the duration of economic disruption and the softening effect of policy that we will start to gain a sense of the full market effect.

Key factors to watch

Key factors to watch here include the rate at which infections spread and when they peak, as well as the scale and focus of fiscal and monetary policy measures.

We’re likely to face further volatility until we have a handle on how long the economic dislocation will extend — and until we gain confidence that government actions will underpin the economy during this period.

At that point, we expect investors will start to recognise the undoubted value that is emerging in parts of the markets on a three-to-five-year view.

In this environment active portfolio construction and risk management is crucial.

The ability to weigh risks, recognise the opportunities as mis-pricing surges, and provide a clear and disciplined framework to account for an uncertain range of possible outcomes has paid dividends thus far.

We believe will continue to do so as the current crisis unfolds and the path to recovery becomes clear.