Global bond index funds carry hidden risks that undermine their role in providing stability and defensiveness to a portfolio. Pendal’s MICHAEL BLAYNEY explains
- Flawed bond indexes weighting based on indebtedness
- Overweight China, Italy
- Find out more about Pendal’s multi-asset funds
A FUNDAMENTAL flaw in global bond indicies undermines their role in providing defensiveness to a portfolio by allocating higher weightings to the most indebted countries.
That’s the view of portfolio manager Michael Blayney, who heads up Pendal’s multi-asset team.
Indexing bond investments appeals to many investors because it offers a low-cost method of incorporating diversified, defensive assets into a portfolio.
But the practice of weighting bond indicies by the market value of outstanding debt can undermine that defensive role.
“At the heart of it, there’s a core problem in bond indicies — the more you borrow, the bigger your weight,” says Blayney.
“That’s different from an equity index, where generally the better your earnings, revenues and growth prospects, the bigger your weight.
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“Instead in bonds, it’s how indebted you are that determines your weight.
“Essentially, we are lending more to the people that owe the most money.”
A closer look at the benchmark
The main global bond benchmark — the Bloomberg Global Aggregate Bond Index — tracks the performance of bonds from many different countries.
“It is intended to be an investment-grade index,” says Blayney.
“But it does give you exposure to a number of potentially less-liquid markets that could cause you problems in a crisis.”
Key weightings that could cause concern include a 9 per cent exposure to China, a 5 per cent exposure to emerging markets and a 3 per cent exposure to Italy.
“When you buy a bond index, you’re getting 40 per cent weight to the US with pretty good yields and pretty good credit worthiness.
“But you’re also buying a whole bunch of other markets, a number of which have their own idiosyncratic problems that could bite you in times of crisis,” says Blayney.
“One of the big geopolitical risks of our time is China and Taiwan. In the event of a crisis, is an Australian investor going to be easily able to access and liquidate their Chinese bonds?
“Italy is one of the most indebted countries in the world as a proportion of GDP — it is not necessarily a low risk investment.”
The index also overweights Japan at 12 per cent, which drags down the average yield of the index due to Japan’s very low interest rates, says Blayney.
“The key difference between bonds and equities is asymmetric payoff — with bonds, on a hold to maturity basis, the best you can ever do is get paid back, but the worst you can do is lose all your money.
“In equities, the worst you can do for an individual stock is lose all the money, but you’ve got unlimited upside.”
Your Future, Your Super risks
Many big superannuation funds are carrying unnecessary risk in their fixed income portfolios as a result of the underlying index weightings, argues Blayney.
The federal government’s annual testing regime for super funds benchmarks against pre-set portfolios of passive, low-cost investments that include the Bloomberg Global Aggregate Bond Index.
“This index is specified in the Your Future Your Super regulations as the index that has to be used by super funds,” says Blayney.
Funds that underperform due to straying from the index risk failing the annual assessments.
“And the reality is that any time you take a differentiated approach, you’ll go through periods of underperformance,” says Blayney.
Guarding against the index risk
How can investors guard against these risks?
Blayney says one way is to use sustainable bond funds which tend to screen out China and problematic emerging markets.
Another is to lift home bias.
Australian bond indexes are mostly Commonwealth bonds and state government bonds, which are generally low risk.
“There is a strong case for domestic bias in bonds,” says Blayney.
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
Volatility in sustainable strategies may leave investors hesitant about ESG. But in the long run, a sustainable approach is likely to outperform, argues Pendal’s MICHAEL BLAYNEY
- ESG risk underappreciated
- Careful management and mitigation required
- Find out about Pendal Sustainable Balanced Fund
- Browse Pendal’s range of multi-asset funds
VOLATILITY in some sustainable strategies may leave investors hesitant about ESG.
But research from Pendal’s multi-asset team suggests the investment risks of ESG can largely be quantified and mitigated.
Investors should not get too caught up in short-term volatility of sustainable funds as they remain likely to outperform over the longer term, argues Michael Blayney, who leads Pendal’s multi-asset strategies, including Pendal Sustainable Balanced Fund.
New research from Pendal’s multi-asset team highlights the importance of carefully managing the different kinds of risk introduced by an ESG approach to investing — and understanding the biases introduced to a portfolio by sustainable screening.
The research shows a sustainably screened approach delivered outperformance over nearly two decades up to the disruptions of the Covid pandemic, despite multiple periods of short-term underperformance.
“Investing sustainably is the right choice in the long term, but investors need to understand how much and for how long their performance could differ from unscreened portfolios — and be comfortable with that,” says Blayney.
“The truth is that all active management goes through cycles of performance, and often people have a knee-jerk reaction to underperformance.
“But we think that ESG funds will give you the same or better performance over the long term because they have a whole range of structural tailwinds to do with regulation, consumer preferences and the energy transition.”
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Blayney says 2022 has made some investors more cautious on ESG oriented funds, with European data showing slowing inflows into impact funds and outflows for sustainable funds.
The shift in thinking among some investors partly stemmed from a poor appreciation of the risks introduced by a sustainable investing approach as well as how those risks can be mitigated, he says.
Managing unintended risks
ESG screening typically introduces sector, size and style bias relative to an unscreened index.
In more concentrated indices it can also produce stock-specific risk if a large stock is screened out — for example miner BHP in Australia or luxury goods maker LVMH in Europe.
“A typical ESG screen could very easily screen out 20 per cent of the Aussie share universe and 10 per cent of the global share universe — whcih is material,” he says.
Sector risk has been a feature of ESG’s post-Covid underperformance, as energy prices soared on disruptions from the Ukraine war.
“Most sustainable funds are underweight energy or in some cases have zero energy exposure because of the fossil fuel exposure,” says Blayney.
This risk can be mitigated by actively including commodity futures in a portfolio or investing in renewables with exposure to spot energy prices, Blayney says.
Active management
Managing actively at an asset class level in a more sophisticated way than the approach taken by an “ESG Index” can also help.
“A good fundamental equity manager will be thinking about those things.
“If I just screened out BHP, are there other companies or maybe a combination of companies that give me similar exposure to the commodities I just screened out?”
Size risk occurs because many companies making a positive impact are small and medium-sized businesses.
This year, markets have turned away from smaller companies and chased the US mega cap tech stocks.
The tech megacaps are generally not hard exclusions from ESG portfolios, but because of their size and volatility they can have a big impact on portfolio returns if they are underweighted — for example due to a “positive impact” orientation in a portfolio, or even simply active portfolio construction.
There is no obvious hedge for this, says Blayney, but investors should be mindful of the risk and size positions sensibly as a result.
Style risk can also be an issue because many “more sustainable” companies tend to be growth focused, which means they are more sensitive to interest rate changes.
Blayney says this can be mitigated by actively managing bond exposures to compensate.
Tracking error explained
Pendal’s research quantifies the level of risk inherent to ESG portfolios by measuring the tracking error of ESG indexes compared to unscreened indexes over an eight-year period.
Tracking error is a measure of how closely a managed fund tracks its benchmark index.
A low tracking error typically means a fund is very close to its benchmark, while a high tracking error can mean the fund is more volatile and may deviate from its benchmark more often.
Pendal’s research found that for screened Australian equities, the tracking error based on the indices used was just over 2.5 per cent, while for international developed market equities, the tracking error was around 2 per cent.
“To put that in context, a core unscreened Australian equities strategy typically runs a tracking error of 2 per cent to 3 per cent while global equity managers might run tracking errors of between 3 to 6 per cent per annum.
“So, with ESG, you’re getting something like at least half of the risk that you would get from an active manager, simply from negative screening.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
If services inflation remain stickier than the RBA expects, further policy tightening can’t be ruled out, argues Pendal’s head of cash strategies, STEVE CAMPBELL
THE Reserve Bank today left the cash rate unchanged at 4.1% at its August meeting.
The market had priced about a 30 per cent chance of a hike at this meeting.
The RBA has adopted a wait-and-see approach after a 4 per cent increase since May last year – and with economic growth forecast below trend for 2024 and 2025 (at 1.75% and 2% respectively).
The bank expects inflation at 3.25% by the end of next year, falling to the 2-3% target band by late 2025.
With economic growth forecast to slow, the RBA expects unemployment to start rising towards 4.5% by late 2024, in turn reducing wage inflation.
Provided productivity growth picks up, the RBA continues to see wages growth as consistent with the inflation target.
Good luck with that.
Inflation – no victory yet
On inflation, the RBA was not claiming victory just yet.
Certainly, it has peaked and is headed in the right direction.
One of the great remaining uncertainties is services inflation, which the RBA points out has been surprisingly persistent overseas.
It is also a cause for concern domestically.
Annual services inflation is at the highest level since 2001.
It hit 6.3% in the recent second-quarter inflation data released in late July, driven by wage inflation, higher utilities and rents.
What it means for investors
It’s likely that Governor Lowe finishes his seven-year stint with no further change at his final meeting in September.
With the RBA on pause for its past two meetings, “job done” headlines for this cycle will gather pace.
The temptation for investors would be to lock in term deposits in such an environment with the cash rate potentially not changing.
There have been false starts abroad worth considering here.
The Bank of Canada is the one that springs to mind.
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The Bank of Canada paused monetary policy after its January meeting to see what effect the cumulative policy tightening was having.
They ended up tightening policy further in June and July with inflation not falling quickly enough and economic growth forecasts being revised higher.
They have subsequently tightened policy by 25 basis points in June and July.
Should services inflation remain stickier than the RBA expects, further policy tightening can’t be ruled out.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
Infrastructure and property can provide great investment options, but they need to be well understood, says Pendal’s head of multi-asset MICHAEL BLAYNEY
- Infrastructure and property investing can be complex
- Diversity and inflation hedging benefits
- Find out more about Pendal’s multi-asset funds
INVESTING in “real assets” — tangible things such as roads and office buildings — provides diversification and in some case a hedge against inflation.
Complexity and lower liquidity can put off some investors.
But it’s worth understanding the asset class, because it helps provide diversity, allowing investors to design portfolios that better suit their needs, argues Michael Blayney, who heads up Pendal’s multi-asset team.
For Pendal’s multi-asset strategies, Blayney’s team prefers infrastructure assets that are linked to inflation, have low sensitivity (or beta) to equities, and have a better environmental footprint.
“Investing in infrastructure is complex because it depends on a range of variables like the type of asset, the regulatory regime, how it is structured and financed, and whether or not income is inflation linked,” says Blayney.
There is complexity around whether the asset is regulated with prices set, or managed, by authorities.
There are also risks associated with future changes in policy, including in some cases taxes on “super-normal profits” such as occurred recently in Europe with windfall taxes imposed on energy producers in a number of countries.
Assets exposed to the storage and distribution of fossil fuels can also have “stranded asset” risks that need to be assessed.
Types of infrastructure assets
Infrastructure assets come in a wide variety of forms.
Assets might be ‘pure-play’, such as only solar or wind — or they might be a mix, Blayney says.
They might be operational or in development.
Pendal tends to hold infrastructure assets that are predominantly operating assets with some development exposure to boost future returns.
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“While we do have a large focus on renewables, in addition there is a broad opportunity set, including digital infrastructure like data centres and mobile phone towers.
“There are also PPP (public-private partnership)-style assets where, for example, you might have a concession to provide the facilities at a hospital.”
The variety of options allows investors to design portfolios that suit their needs.
What to look for
Blayney’s team focuses on infrastructure assets that are directly or indirectly linked to inflation, have low sensitivity (or beta) to equities and have a better environmental footprint.
The focus on inflation linkage means net asset values in the portfolio have remained relatively robust, or in some cases have increased, Blayney says.
”Our portfolio is greener than a traditional infrastructure portfolio, and when you combine that with the low economic sensitivity of cash flows it’s a great addition to an overall balanced portfolio.”
Opportunities in property
Also falling within the real asset category of investing is property.
“In the global listed real estate sector, there are significant headwinds around the office and shopping centre sectors. And there is industrial property which has significant tailwinds because of e-commerce,” Blayney says.
“Once upon a time industrial property was seen as being a bunch of sheds in the middle of nowhere. These days, the logistics facilities are much higher tech and harder to replicate.
“Overall there are clearly some parts of the property sector which are structurally challenged.
“Across the whole property sector, there are challenges in terms of the higher interest rate environment making valuations look less interesting relative to bonds.
“As such, we’d want a bit more of a margin of safety before getting more positive on global REITs like we were a few years ago when prices where cheaper.
“While both have a place in a portfolio long term, at present as between property and infrastructure we have a strong preference for the latter.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
With global economies slowing, inflation gradually falling and interest rates close to peaking, valuation risks are rife, says Pendal’s MICHAEL BLAYNEY
- Full impact of rates still to hit portfolios
- Bonds and listed real assets favoured
- Find out more about Pendal’s multi-asset funds
INTEREST rates may be nearing their peak but the effects will be felt in portfolios for the next few years says our head of multi-asset, Michael Blayney.
“Increases in interest rates usually flow through to the real economy and corporate earnings with a one-to-two-year lag,” says Blayney.
“So there may still be more negative ‘surprises’ to come, and at least an elevated risk of recession in the second half of 2023.”
What does that mean for asset allocation?
“We are slightly bearish on equities, neutral on government bonds slightly negative on credit but selectively positive on listed real assets.”
Global equity market valuations are broadly reasonable, and risks to financial stability appear to be contained for now, Blayney says.
“But history tells us that monetary policy takes one to two years to have a large impact on both earnings and the economy. As a result, the risks remain skewed on the downside.”
“Globally, Japan and the United Kingdom remain cheap under Pendal’s valuation framework, while US large-caps and some European markets are relatively expensive.
“The Australian market is close to fair value,” Blayney says.
“Global bond yields are broadly in line with our estimated of fair value. Inflation is gradually moderating, with the most recent CPI data in the US being very positive for markets.
“However core inflation remains uncomfortably high,” Blayney says.
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“Nonetheless higher yields now provide a cushion against further downside risk.
Bonds would be expected to provide their traditional ‘risk-off’ portfolio benefits in the event of an equity market downturn — particularly if that coincided with economic weakness that brought inflation down further.”
Credit
Blayney is less positive on credit markets.
“Relative to history, investment-grade and high-yield spreads appear reasonable. But the clouded economic backdrop leads us to a negative view on high-yield bonds given the heightened risk of material defaults.
“We are more neutral on investment grade but would wait for a better entry point for a meaningful long position given the risk of spreads blowing out.”
Real assets
Blayney says there are opportunity within listed real assets linked to inflation and has a preference for infrastructure over real estate.
“Select listed infrastructure assets with inflation linked cashflows provide good insulation in case high inflation is more stubborn than currently priced by markets,” he says.
“Conversely, the key challenge for global real estate investment trusts is that in absolute terms valuation looks reasonable, but relative to bonds they are somewhat expensive.
“We view unlisted real assets with their stale appraisal-based prices as having material downside revaluation risk.
“In contrast, many listed infrastructure assets already trade at large discounts, providing a margin of safety against any declines in underlying asset valuations.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
A key economic model used by Pendal’s multi-asset team is forecasting tougher times ahead. ALAN POLLEY explains what it means for investors
- Economic cycle model turns negative
- Caution warranted for second half
- Find out more about Pendal’s multi-asset funds
A LEADING economic indicator used by Pendal’s multi-asset team has turned negative after being positive for most of 2023 — a sign that tougher times may lie ahead for investors, says Pendal PM Alan Polley.
The first half of the year surprised markets with better-than-expected economic conditions, despite many forecasters earlier in the year anticipating that higher interest rates would have a significant detrimental impact on the economy.
Pendal’s economic cycle model has been one of the few forecasting tools to predict a robust economy, making its move into negative territory an important signal for investors.
“The model pretty much got it right for the first half,” says Polley, a portfolio manager with Pendal’s multi-asset team.
“It started the year suggesting we were in a positive economic environment — which is noteworthy because most people had a more bearish outlook.
“But it has recently ticked over onto the negative side.”
How it works
Pendal’s economic cycle model analyses the level and rate of change of leading economic indicators such as consumer and business surveys — while also examining how economic data surprises either positively or negatively.
The model is one of three key indicators that inform the multi-asset team’s active asset allocation process – alongside a valuation model and a model that analyses market trends. It has a successful long-term track record of picking turning points in the economic cycle, Polley says.
Services show signs of weakening
The key to the economy’s surprising resilience this year has been the strong performance of the services sector which has off-set a contraction in the manufacturing sector.
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“The manufacturing side of the economy has been in contraction for close to a year, so what’s surprised economists this year is that the services sector has been very strong,” says Polley.
“There’s still a lot of pent-up demand for services post-Covid lock-downs and there have been very high household savings rates.”
There are now early signs of that changing.
The household saving ratio — which was exceptionally high during the pandemic due to government payments and limited spending opportunities — has fallen to lows not seen since the GFC.
“The tide may finally be turning for the economic outlook,” Polley says.
“The services side of the economy may have peaked. In in our model, while it’s still in expansion, the rate of change is now on the negative side.
“So, the risk is that we are yet to truly feel the effects of rate increases, which generally take a one-to-two-year lag.
“We think it’s more likely that the services sector moves towards the manufacturing sector, than the other way around.”
Time for caution
The economy’s strength in the face of rate rises has been an important factor in this year’s surprising rally which has left markets largely pricing out the chance of a deep recession.
“The market isn’t the same thing as the economy, but normally they support each other. So, what’s been going on economically has provided some justification for markets rallying so hard,” says Polley.
“If you look back to earlier this year, pretty much everyone got this wrong.”
“Our economic cycle model has pretty much got it right up to this point. Now they’re turning negative.
“That makes us more cautious on the second half of this year, so we’re slightly underweight equities in response.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Investing in the energy transition aligns values and returns – but it’s best to take a diversified approach, argues Pendal’s head of multi-asset MICHAEL BLAYNEY
- Energy transition investing about values and returns
- Multi-asset approach optimal
- Find out about Pendal Sustainable Balanced Fund
NO MATTER your opinion on climate change, there’s no doubt we’re undergoing an energy transition – a global shift away from fossil-based energy to renewable sources.
The evidence is in renewable power growth, electric car adoption, regulatory and policy change, public sentiment – and yes, investment trends.
There are two main reasons an investor might show interest in the energy transition: aligning a portfolio with their values and making money.
“For retail investors, the number-one issue that arises when you survey them is climate change,” says Pendal’s head of multi-asset, Michael Blayney.
“People care about plenty of issues, but climate change is number one.”
The second reason is to make money.
“This massive transformational change in the world is happening fast,” Blayney says.
“It started in Australia with solar rooftops and now you see plenty of Teslas driving the streets.
“The transition is very real and there’s going to be a massive amount of money spent on it.”
Approach to diversified sustainable investing
The bigger question is how best to invest in the energy transition.
It’s not simply about identifying innovative, listed companies with strong pricing power and a growing addressable market, Blayney says.
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Sustainable investors should also “participate across multiple asset classes as part of a broader diversified portfolio”.
That might include infrastructure or sustainable bonds for example.
A diversified approach to ESG
“You want to maintain a robust multi-asset portfolio that’s competitive with any sort of traditional, unscreened investment,” Blayney says.
“It makes sense to participate across multiple asset classes as part of a broader diversified portfolio.
“Just like you don’t put all your money into one asset class, investors shouldn’t put their whole portfolio into one thematic or indeed access a large thematic via only one asset class.
“Investors should consider gaining exposure across many asset classes.
“You can invest in companies that are providing products and services for the energy transition. It might be a manufacturer of wind turbines.
“You can invest in operators of the infrastructure that’s part of the transition economy. And it is worth having some exposure to battery storage opportunities, which is part of the transition.”
A risk-reward approach
All of these investments need to be undertaken using the normal risk-reward framework, Blayney says.
“The sun shines with lower volatility than the wind blows. So solar is slightly a less volatile income stream than wind in many geographies.”
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More generally, the typical portfolio construction principles apply — equities are the top end of the risk-reward spectrum, cash is at the bottom end and renewable infrastructure is somewhere in the middle, Blayney says.
Investing in renewable infrastructure also provides exposure to energy prices via the cash flows which is something normally lacking in other parts of a portfolio when ethical screens are applied.
In debt markets, green bonds provide exposure to the energy transition.
Pendal’s head of responsible investing distribution Jeremy Dean adds more options: “There’s lending money to corporates which have the specific goals of reducing their carbon emissions through increasing energy efficient of their operations.
“And there’s retail bank syndication processes which might fund wind or solar farms.”
Blayney says commodity futures also provide opportunities for energy transition investors, particularly if buying into specific companies has been screened out.
“There are some obviously structural trends. Copper is needed to electrify and a vast amount is going to be needed. That provides a structural demand tailwind,” Blayney says.
“One way to play that, in a small way, is through commodities futures which allows you to participate in some of the upside in commodity prices, which you might miss out if you screen them out of your equities.”
Blayney’s final word: “Ultimately it comes down to developing a well-diversified portfolio that’s consistent with the client’s risk profile.”
Dean agrees: “You can have a high-quality, risk-adjusted returns while playing the energy transition theme.
“There are multiple ways of doing that, but fundamentally it has to be about making money.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
The strength of global equities continues to surprise as we near the halfway mark of 2023 — but some markets make more sense than others, argues Pendal’s MICHAEL BLAYNEY
- AI revolution has spurred Wall Street
- Bonds offer risk-off defence and yield
- Find out about Pendal Sustainable Balanced Fund
- Browse all Pendal’s multi-asset funds
THE rally in big US tech stocks, Japan’s bourse and the performance of government bonds have been among the year’s main investing trends as we near the halfway mark.
Global equity markets have surprised many investors, notes Pendal’s multi-asset chief Michael Blayney — none more so than US tech stocks and the Japanese bourse.
But the two markets tell different stories, he says.
“The rally in US equities has been driven by a narrow number of large cap tech names with the artificial intelligence theme particularly important,” Blayney says, highlighting the run of high-end micro-processing chip maker Nvidia.
Its share price is up 175 per cent so far in 2023. With a market capitalisation closing in on $US1 trillion, it is now Wall Street’s fifth biggest company.
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But Blayney has a word of warning about Wall Street.
“The US remains one of our less preferred markets given stretched valuations and the heightened risk of recession.”
“While AI is clearly an important thematic for the world for the next decade, markets do have a habit of getting overly exuberant in the short term when a new theme emerges – and this would appear to be one of those occasions,” he says.
Japan a strong performer
The Japanese share market has also been a strong performer in 2023, rising more than 20 per cent this year, compared to 1 per cent for the S&P/ASX200.
“We’ve liked and been overweight Japan for some time,” says Blayney.
“Earnings estimates have been relatively flat in the last year whereas they’ve been downgraded in the US and Europe. It has been a case of pricing catching up with the fundamentals.”
Japanese companies have been more profitable in recent quarters than they have been for many years, with the exception of a run-up in earnings immediately before the Covid pandemic.
Japanese companies are also relatively under-leveraged compared to the rest of the world, putting them in a better position as interest rates rise.
“Finally, Japan has been ‘under-owned’ for a long time,” Blayeny says.
“The fundamentals are better than they’ve been for a long time, and so once the Japanese market’s performance improved, it quickly caught the attention of global investors.
“Even after the most recent increase, it’s still cheap.”
Bonds near 2022 highs
Pendal’s multi-asset team is also generally positive on bonds.
“Bond yields have headed back to almost their 2022 highs,” says Blayney.
“We like bonds. The higher yields available now mean they are able to fulfil their defensive function in a portfolio in a ‘risk-off’ environment, and also provide a ‘return cushion’ from further volatility.”
While inflation has come off its highs, it remains elevated, and employment remains resilient. That poses some risk to bonds, he says.
Blayney is more cautious about corporate debt.
“We’re still pretty bearish on credit, particularly high yield spreads. They don’t provide an adequate cushion from defaults in the case of recession.”
“Overall we are marginally underweight equities and close to neutral on bonds, while holding a little more cash and liquid alternatives, which also gives some exposure to inflation hedging assets.”
About Pendal’s multi-asset capabilities
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
These include Australian and international shares, property securities, fixed interest, cash investments and alternatives.
In March 2024, Perpetual Group brought together the Pendal and Perpetual multi-asset teams under the leadership of Michael O’Dea.
The newly expanded nine-strong team will manage more than $6 billion in AUM and create a platform with the scale and resources to deliver leading multi-asset solutions for clients.
Michael is a highly experienced investor with more than 23 years industry experience, including almost a decade leading the team at Perpetual.
The RBA retains a tightening bias after raising the cash rate again today, writes our head of cash strategies STEVE CAMPBELL
THE Reserve Bank retains a tightening bias after raising the cash rate by a further 0.25 percentage points today to 4.1 per cent.
In the days leading up to the meeting, the market was almost 50-50 on whether the RBA would tighten or not.
In its own words, the RBA has a narrow path to a soft landing.
That path is becoming narrower and narrower — and the risks of recession are rising.
As the RBA pointed out, a significant source of uncertainty comes from household consumption, as elevated prices and higher interest costs drain household coffers.
With only a blunt monetary policy tool to reduce demand, the RBA needs to deal with the economy from an aggregate perspective.
There are higher income households with excess savings that can weather the storm more easily. At the other end there are the more vulnerable.
Lower-income households are devoting more and more of their income to meet housing costs – whether higher rents or mortgage repayments – and elevated day-to-day costs.
So why another rate rise?
The RBA does not want to risk expectations that higher prices are becoming embedded.
May’s monthly inflation number had annual inflation at 6.8 per cent.
There were one-offs that pushed this number higher due to subsidies from early 2022 dropping out. But even so, inflation remains too high not to act.
The RBA would sooner a recession than embedded high inflation, as tough as that may sound.
The central bank continues to point out the risks of not doing anything.
“If high inflation were to become entrenched in people’s expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment.”
The rate rise was not due to last week’s decision to raise the award wages by 5.75 per cent and the minimum wage by 8.6 per cent. The RBA sees wages at the aggregate level as consistent with its target.
There is one important caveat here though. This is the case provided productivity growth picks up.
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This is the key issue. Productivity is not picking up, driving up unit labour costs and exerting upward inflationary pressure.
What’s next?
The RBA will now be looking at the global economy, household spending and the outlook for inflation and the labour market.
The global economy is expected to grow at a sub-trend pace.
Inflation has continued to remain elevated and continues to exceed expectations, particularly in Canada and the United Kingdom.
While the Reserve Bank of New Zealand has indicated it expects to leave rates unchanged, the near-term bias from the major European and North American central banks is for higher rates. That is a club the RBA is firmly in.
About Steve Campbell and Pendal’s Income and Fixed Interest team
Steve Campbell is Pendal’s head of cash strategies. With a background in cash and dealing, Steve brings more than 20 years of financial markets experience to our institutional managed cash portfolio.
Find out more about Pendal’s cash funds:
Short Term Income Securities Fund
Pendal Stable Cash Plus Fund
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.
Our multi-asset team uses a tool called r* to get a better idea of where rates are going and what returns we can expect. Pendal’s ALAN POLLEY explains
- The natural interest rate offers a useful tool for investors
- Long-term returns outlook more attractive
- Find out more about Pendal’s multi-asset funds
WHERE next for interest rates?
It’s probably the most important investment question going.
Rates have far-reaching implications for individuals, businesses and governments. They determine the cost of borrowing money and the value of investments — and they impact inflation, economic growth and employment.
Pendal multi-asset portfolio manager Alan Polley believes the key to unlocking the outlook for rates lies in comprehending the concept that there is an underlying or ‘natural rate’ of interest.
“When interest rates are low enough, they stimulate demand. And when they are high enough, they restrain demand,” says Polley.
“That means that somewhere in the middle, there must be a rate that is neither contractionary nor expansionary.
“That’s the natural interest rate — the level of real interest rates when the economy is in equilibrium.”
What is r*?
Known by economists as the r* (and pronounced ‘r-star’), the natural rate of interest is the real interest rate when the economy is at full employment and inflation is stable over a normal business cycle.
It is the reference point for how central banks manage rates across the business cycle.
Since the GFC, the r* has tended towards zero. In the boom time of the 1980s, it tended to exceed 2 per cent.
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Interest rates are fundamentally a factor of the supply and demand for capital. And over the next decade, demand for capital is likely to be higher than it has been since the GFC (though not as exuberant as the 80s), says Polley.
The energy transition and renewables rollout require substantial investment, national security is emerging as an issue that will require higher defence investment, companies are investing in rebuilding supply chains post-pandemic and governments are lifting public spending and running budget deficits.
Demographics will also play a role as ageing populations reduce available labour, forcing businesses to invest in synthetic labour like automation and AI.
“We take the view that a lot of these things mean there will be more demand for capital going forward than there has been since the GFC,” says Polley.
And as demand is rising, capital supply is falling as central banks switch from quantitative easing to quantitative tightening.
“Looking forward, we see the r* around the 1 per cent level — providing a reasonable compensation for the opportunity cost of supplying capital,” says Polley.
A 1 per cent natural rate fits neatly in an historical context, between the near zero rate of the post-GFC period and the 2 per cent rate of the three decades leading into the GFC.
It’s also a return to the very-long term natural rate, which has hovered around 1 per cent since 1900.
And it’s consistent with recent research from the US Fed and the RBA, which both assumed a 1 per cent r* in their long-term outlooks.
Using r* to understand rates
But how does that help with predicting the future of cash rates?
Polley explains that adding the r* to inflation provides a useful approximation of the long-term state of policy rates.
“In Australia, the centre of the RBA’s inflation target is 2.5 per cent. Adding the r*, that means the cash rate should end up at something like 3.5 per cent over the longer term.
“In the US, they have an inflation target of 2 per cent, which implies a long-term cash rate of 3 per cent.”
That provides investors with a powerful insight into the outlook for rates, says Polley.
“The RBA cash rate is currently 3.85 per cent — that’s pretty much in line with neutral.
“But in the US, the Fed cash rate is 5 to 5.25 per cent. That’s very contractionary.”
Potential for better long-term returns
The r* does more than help predict movements in rates, it also provides important information about the future returns for different investments.
“A higher r* means that the forward-looking return environment is higher than it has been since the GFC,” says Polley.
“Interest rates are your starting point — other asset classes’ risk premiums are added on top.
“If your base r* is low, then everything’s low.
“Reverting to a higher level means the base return for all asset classes is higher.
“Another nice aspect is valuations — with r* trending down before the pandemic we had valuations going up. High valuations mean more risk looking forward. Now, we have r* at more normal levels, valuations are back to more normal levels as well.
“These two things together mean that the longer-term return outlook looks more attractive than it was before the pandemic.
“We don’t think it’s a low-return world anymore — we think it’s more of a normal-return world.”
About Alan Polley and Pendal’s Multi-Asset capabilities
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.