While investors expect rate cuts offshore next year, Pendal’s head of cash strategies Steve Campbell sees our cash rate unchanged in 2024.
AUSTRALIAN mortgage-holders were spared further pain this week when the Reserve Bank left the cash rate unchanged at 4.35%.
The decision was in line with market expectations, which had a rate hike at around 5% probability.
In its statement, the RBA retained a tightening bias against a background of much uncertainty.
Domestically, total household consumption has been sluggish, though the distribution is uneven.
Some households have benefitted from rising house prices and interest income, while others have struggled from higher interest costs and negative real wages.
Much like the experience globally, goods inflation is declining while services inflation remains too high and persistent.
The RBA was a reluctant hiker in November, boxing itself into a corner with a low tolerance for higher inflation — which ultimately proved the case following the release of the third-quarter inflation number in late October.
Since the November RBA meeting there’s been no smoking gun to warrant further policy-tightening — in fact, it was quite the opposite if we look at offshore markets.
Bond yields rallied aggressively in November, largely unwinding the carnage that bond investors experienced in preceding months.
In the United States, the short end rallied by around 50 basis points. The market is now looking for the US Federal Reserve to ease monetary policy by more than 1 per cent in 2024.
Market pricing also has the European Central Bank, Bank of England and Bank of Canada easing multiple times.
So, where to from here?
The RBA
The next RBA meeting in early February will be influenced by fourth-quarter inflation data released in late January.
We expect Q4 headline CPI to come in around 0.8%, taking annual headline inflation rate to 4.2%.
The RBA’s forecast for 2023 annual headline inflation is 4.5%.
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We can’t see how the RBA can achieve its 4.5% forecast — and 0.3% would be a considerable miss.
If we’re right, talk about Australian rate cuts in 2024 will gather momentum.
That would be getting ahead of things.
The RBA hasn’t been as aggressive in hiking and was slower than other central banks to move.
Inflation is likely to come down to 3.5% in 2024. But unless we see significant weakness this will remain too high to warrant a rate cut.
We therefore see the central bank leaving the cash rate unchanged over 2024.
Though this won’t stop the market periodically pricing rate cuts in — opening opportunities to trade duration with a long bias into early 2024.
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.
After the GFC investors generally had to chase greater risk to achieve targeted returns. But that looks to be changing, argues Pendal’s ALAN POLLEY
- Overly austere government budgets have hurt investors over past 15 years
- More normal monetary and fiscal policies good for outlook
- Find out about Pendal’s multi-asset funds
SINCE the global financial crisis, investors have generally had to chase greater risk to achieve returns.
Part of the blame lies with overly austere governments, says Alan Polley, a portfolio manager with Pendal’s multi-asset team.
“For the past decade and a half, government Treasury departments have been nowhere – they’ve been chilling out,” Polley argues.
“The lack of fiscal policy meant monetary policy needed to take up the slack via non-conventional tools such as quantitative easing.
“The resulting wall of money increased valuations, decreased prospective returns and risked asset bubbles.
“Now that’s unwinding, there’s descent prospective returns for equities and bonds – and that makes balanced funds more attractive.”
What happened
In the aftermath of the global financial crisis, many governments implemented austerity measures, which involved cutting spending and raising taxes in an effort to reduce budget deficits and debt levels.
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Austerity policies were controversial. Some argued they were necessary to stabilise the economy and restore financial stability.
Others argued the measures were harmful to economic growth and disproportionately impacted the poor and vulnerable.
The austerity measures were also bad for investors, who generally had to chase greater risk to achieve returns.
“Europeans took it way too far and that killed their economy – which is why they’ve had basically no price returns on the stock market,” Polley says.
Compounding the challenge has been ultra-low interest rates which reflect monetary policy — not fiscal policy — doing the hard work stimulating economies.
A return to fiscal support
But the Covid pandemic was a turning point.
“The pandemic has been a major turning point in many aspects, and one of them is the realisation from governments and finance departments that monetary policy is out of bullets and so fiscal policy needs to fire up,” Polley explains.
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“The transition to fiscal policy is good for investment returns, because governments will now do some of the work to bolster aggregate demand.
“Issuing more debt at a time when central banks are decreasing their balance sheets, creates a more normal supply-demand balance for government bonds – and more normal bond yield levels.”
While governments (notably the US) have spent money in recent years, as a long-term secular trend fiscal policy hasn’t been pulling its weight supporting economies, Alan says.
“Looking forward, we finally have fiscal policy back which means monetary policy can start to normalise, which is what’s happening,” he says.
Normal fiscal policy and normal monetary policy means we can get back to normal investment returns.
“Fiscal and monetary policy are supposed to work together.
Monetary policy is such a blunt instrument but with fiscal policy you can fine tune it a little bit more. You can aim your spending or target you revenue raising to get more productive outcomes,” Alan says.
“The two are designed to work together and we just haven’t had that since the GFC.”
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.
A ‘normalisation’ of economic conditions means it’s time for investors to reassess how they think about risk, argues Pendal multi-asset PM ALAN POLLEY
- Expect ‘more normal’ monetary policy in coming years
- Less need for non-traditional assets in portfolios
- Find out about Pendal’s multi-asset funds
AFTER 15 years of the ‘new normal’, the ‘old normal’ appears to be back as central banks return to more conventional monetary policy.
That’s potentially good for investors, argues Alan Polley, portfolio manager with Pendal’s multi-asset team. But it may mean a reassessment of asset allocation.
“Over the past decade and a half we’ve had what was termed the ‘new normal’,” Polley says. “Now we are back to the ‘old normal’. The way things were before the GFC.”
“The last decade and a half, post the global financial crisis, we had global central banks taking non-conventional monetary policy to the extremes.
“They took interest rates close to zero. Some countries went negative,” Polley explains.
“It means we’ve had very low returns from traditional markets like bonds and equities.”
Valuations were pushed artificially high because interest rates were low, and there was relatively little income, he says.
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“Absolute returns were quite low. Inflation was low too — and of course that was part of the reason why central banks were doing this extraordinary monetary policy.
“But nevertheless, absolute returns were unattractive.
“The whole return environment has been challenging over the last decade-and-a-half.”
Changed capital allocation
The ‘new-normal’ environment forced investors to change how they allocated capital.
“Returns were lower, but investors still had the same return objectives – something like CPI plus three or four per cent.
“It meant that the probability of achieving those target returns were much lower,” Polley says.
“It forced investors to chase risk and go out the risk curve. They shifted out of the traditional markets and put money into higher risk assets and hoped the world didn’t turn against them.
“Investors pushed out into small caps, into high yield credit, into emerging markets, into less liquid investments.
“They sold optionality for income. Private markets became very popular. They took on additional risk in some form, whether it be liquidity risk or market related risk or even complexity risk,” he says.
Style bias
Alan explains low interest rates also introduced style bias – investors started chasing growth.
“Growth stocks with longer duration outperformed value style investing for 15 years. People started using the term TINA – there is no alternative,” Alan says.
“People were changing their asset allocation, drifting away from defensive assets such as bonds and putting more into growth assets such as equities than they probably should have.”
But the world has changed over the past two years. Interest rates are back to long-term, historical averages. The ‘old-normal’, which was the world before the GFC, is back.
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“We think bond rates are now close to normal type levels. Likewise equities valuations have adjusted. Our concern around high absolute valuations for equity markets aren’t as prevalent anymore,” Alan says.
Positive outlook
The good news for investors is the outlook is pretty positive over the next decade.
“There is less need to chase risk with non-traditional assets. There’s less need to shift out the risk spectrum. Chasing of liquidity premiums is less necessary now.
“Investors need to ask themselves: do they need to chase risk when bonds have again yields of around five per cent, and equities have reasonable dividend yields?
“Investors can also start thinking of de-risking their portfolios out of equites, because they had piled into equities out of bonds. Bonds are more attractive,” Alan says.
“Investors can be in quality equities and bonds and have a greater likelihood of achieving their return targets. That’s a great environment for investors versus where we’ve been,” he says.
“So investors should be thinking about leaning back into traditional asset classes out of non-traditional asset classes, de-risking their portfolios and start running a more ‘old normal’ portfolio for this ‘old normal’ environment.”
This is especially important for those in or approaching retirement, having the benefit of de-risking into lower risk and less complex assets but still getting an attractive return and income, Polley argues.
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 $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
Australian bonds are looking attractive, particularly if inflation can be brought under control, says Pendal’s head of multi-asset MICHAEL BLAYNEY
- Aussie bonds attractive against peers
- Low cash rate weighing on A$
- Find out about Pendal’s multi-asset funds
AUSSIE bonds are “somewhat unique in the world” right now, argues Pendal’s head of multi-asset Michael Blayney.
“Our 10-year bonds are yielding more than the cash rate — whereas most other major markets have a strongly inverted yield curve,” he says.
An inverted yield curve is when short-term rates are higher than long-term rates. It’s historically associated with expectations of an economic contraction.
Given the possibility of a slowdown in the global economy, the Aussie bond market is relatively attractive.
“In addition, markets are pricing in inflation in the US and Australia to come back under control.
“And last night’s inflation print in the US was very encouraging, noting of course that it’s still likely we’ll see bumps along the way,” says Blayney.
“From a valuation perspective that makes Australian government bonds attractive.”
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“If the Reserve Bank can get inflation down to 2.5 per cent and you’re getting around 4.5 per cent on ten-year bonds, then that’s a pretty attractive low-risk rate,” Blayney says.
Why it’s happening
The difference in yield curves between Australia and the US is partly due to the transmission mechanism of monetary policy, Blayney explains.
“In the United States, lots of corporates have fixed-rate debt and home-owners have fixed-rate mortgages.
“In Australia there is more variable rate debt, and the monetary policy transmission mechanism is much faster.
“That’s one reason why the Reserve Bank hasn’t been as aggressive as the US Federal Reserve in this tightening cycle.”
That’s meant the local benchmark rate — the cash rate — is now below the US’s Fed Funds Target Rate.
“That’s unusual. It doesn’t happen that often,” Blayney says.
“And it has other consequences. It’s one of the reasons the Aussie dollar is trading at 65 US cents.
“If a global investor can get a higher rate in US dollars than Aussie dollars, and the US is a safe haven, then that’s where they’ll put their 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.
Bond markets believe the RBA will join other central banks in an extended pause after this week’s rate rise. Pendal’s STEVE CAMPBELL explains
IF THE Melbourne Cup was not already a tough experience for some, the Reserve Bank added further pain for mortgage holders when tightening monetary policy by a further 0.25% on Tuesday, taking the cash rate to 4.35%.
When third-quarter inflation exceeded RBA forecasts, it was too much for the central bank to bear.
The RBA acknowledged “the risk of inflation remaining higher for longer has increased”.
In their statement the Reserve Bank revealed some updated economic forecasts, which will be fully revealed on Friday with the next monetary policy statement.
The RBA now forecasts inflation to be around 3.5% at the end of next year (up from 3.3%) and in the high twos by the end of 2025.
Economic growth is expected to remain below trend, which should see unemployment rise (though more slowly than previously forecast).
And a key line in the statement remains: wages growth is consistent with the inflation target “provided that productivity growth picks up”.
I would be hopeful, more than confident on that.
Where to from here?
The RBA retains a tightening bias, though there is nothing in its statement to suggest a follow-up hike will occur in December.
Fourth-quarter inflation is released in late January and will determine if a move to 4.6% is required at the first meeting of the year in February.
We expect a better-behaved inflation number for Q4 – below 1% – which should take pressure off the RBA.
The RBA is a reluctant hiker. They are aware of the lagging impact of monetary policy and they don’t want to overtighten.
They will also be the standout central bank if they continue to raise the cash rate.
The US Federal Reserve, European Central Bank and other developed market central banks are all expected to remain on hold in the near term.
Inflation is expected to remain above the band into 2024, so the RBA is not likely to bring relief to mortgage holders anytime soon.
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It simply isn’t going down without a fight.
What it means for bond investors
Bond markets certainly believe we will join other central banks on an extended pause.
After Tuesday’s announcement three-year and 10-year bonds finished lower in yield, reflecting a more neutral stance in the RBA statement.
We expect a further modest rally in the near term – led by offshore factors more than domestic factors for now.
A more significant rally would require labour market weakness – something we have yet to see.
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.
Investors should be taking the time to review portfolios amid geopolitical tensions and economic uncertainty, says Pendal’s head of multi-asset, MICHAEL BLAYNEY
- Neutral stance on bonds
- Opportunities in equities and real assets
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- Browse all Pendal’s multi-asset funds
HOW should investors be thinking about asset allocation right now, amid Middle East tension and economic uncertainty?
Pendal’s multi-asset chief Michael Blayney is neutral on bonds and slightly underweight equities.
But in both asset classes there are opportunities in selected markets, he says.
And there are opportunities in real assets such as listed infrastructure and property, Blayney believes.
“We’ve seen weakness in equities, though there has been a small bounce back.
“Bond yields have marched upwards as investors price in the likelihood of higher interest rates for longer – but they now provide good compensation for inflation risk.
“Bonds should also fulfil their traditional role as a safe haven asset in the event that the crisis in the Middle East broadens.”
No panic
Blayney says a noticeable feature of the market response to the crisis in the Middle East, is a lack of panic.
“The human toll is tragic, but it hasn’t triggered massive volatility in markets.
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“So far, oil prices have risen but remain below last year’s peak.
“Bonds yields initially fell, but have since risen again. Equities — aside from a modest move down on Wednesday night — have been pretty relaxed.”
Bonds
Pockets of value are emerging in some bond markets, Blayney says.
“Canadian bonds have started to become quite cheap. Australian and US bonds have also been heading into cheaper territory.
“For investors looking to add defensiveness to a portfolio, current government bond pricing is pretty attractive.”
Global equities
Blayney’s multi-asset funds are still underweight US equities.
“It’s a very small underweight in our balanced fund. Equities are priced based on a soft-landing scenario in the US.
“Equities will be sensitive to any bad news, and there’s downside risk associated with that.
“Outside the US, valuations on equities aren’t egregious, and even within the US it’s the large caps that are really expensive.
“There are a few markets in Europe which are a bit expensive, but places like the UK and Japan are relatively cheap.”
Real assets
There are opportunities in real asset classes, Blayney believes.
“Right now you can buy on a 20 to 25 per cent discount to net asset value, things like operating renewables. That gives you quite a bit of margin if discount rates go up.”
Part of the reason for the discount is rising interest rates, but Blayney points out that some of the assets have inflation indexed cash flows.
“In those assets, rising rates haven’t been as bad for net asset values as what otherwise would have been.
“Also, last time we saw a spike in energy prices, assets with a linkage to those prices did well. However there is always a risk of government interference in the market.”
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.
Sustainable investors often exclude commodities because of their ESG-unfriendly reputation. But there are ways to hold them sustainably, argues ALAN POLLEY
- Commodities play an important diversification role
- Commodities can be consistent with ESG
- Find out more about Pendal’s multi-asset funds
INVESTORS who exclude commodities from sustainable portfolios are missing out on an important source of diversification, argues Pendal PM Alan Polley.
Commodities — typically metals, energy or agriculture materials — are highly correlated with inflation and can hedge geopolitical and environmental risks, making them an important part of a balanced portfolio.
But many are inconsistent with ESG principles. A nuanced approach may be necessary to screen out unsustainable holdings while still including those that are consistent with the low-carbon energy transition.
“A sustainable portfolio needs to have diversification just as much as a non-sustainable portfolio — so it’s important to think about non-traditional asset classes,” says Polley, a portfolio manager with Pendal’s multi-asset team.
“We hold commodities in our sustainable multi-asset funds and have done for quite some time.”
Inflation hedge
Commodities tend to be highly correlated with inflation and have a return distribution with a positive skew, meaning returns on the upside tend to be bigger than returns on the downside.
“That’s because commodities are sensitive to supply shocks which can cause the prices to shoot up. That can be useful to hedge geopolitical and environmental risks.”
These features are particularly useful in the current market.
“We think inflation is going to be higher than in the past. We think there’s going to be more inflation spikes. We also think geopolitical and weather-related risk is going to be higher,” says Polley.
“That suggests commodities have more of a role to play in a balanced portfolio going forward than they had in the past last decade or two.”
The problem for sustainable investors is that many commodities look questionable through an ESG lens.
“If you’re a sustainable investor, you can’t just go and invest in all the commodities that make up the standard commodity indexes — energy, base and precious metals, agriculture, livestock.
“That leaves sustainable portfolios not being as broadly diversified as they should be.”
Positive screening
So, how can commodities be included in a sustainable portfolio?
Polley says investors should not only screen out commodities that do not meet ESG criteria, but also actively seek out commodities that do support ESG goals.
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“In terms of negative screening, we don’t want to invest in commodities that are inconsistent with the transition to a low carbon economy. In practice that means we won’t invest in fossil fuel-related commodities in our sustainable funds.
“We also screen animal welfare issues. Livestock is not consistent with the ethics of sustainable investing. In addition, cattle is highly carbon emissions intensive.”
But plenty of commodities are consistent with sustainable investing, he says.
“There are two considerations to be balanced — the utility of a particular commodity in terms of helping to transition to a low-carbon economy versus the externalities like the carbon-emission intensity of production.
“There’s no right or wrong answer, but they do need to be considered and balanced.”
Polley says three considerations are important:
1. Demand tailwinds
The first factor to be considered is whether there is a demand tailwind for the commodity.
“The world needs to transition to a low carbon economy and there’s some commodities that have a positive demand tailwind to that transition. We want to include those future facing commodities.
“Good examples are copper and nickel, which are critical to the to the energy transition.”
2. Hedging factor bias
The second consideration is finding commodities that can complement the factor biases in screened equity portfolios.
“Sustainable equity funds often screen out fossil fuels — and there’s not a whole lot you can do about that within your equities portfolio.
“But within your commodities portfolio, you can hedge some of those factor biases. Underweight oil stocks can be hedged by taking an exposure to commodities that have a positive correlation to energy like corn and sugar beets, which are two of the main feedstocks into biofuels.”
An underweight equities position in the materials sector can be similarly hedged by exposure to the industrial metals complex.
“We want to try and hedge those equity screens induced factor biases, as well as bias towards those critical minerals consistent with the transition to a low carbon economy.”
3. Protection from climate change
A third factor to consider is how to use commodities to protect a portfolio from the effects of climate change like higher temperatures and increased weather volatility.
“If we believe we’ll have heightened weather volatility, that will affect agricultural supply, so it makes sense to own a basket of agricultural commodities — wheat, soy bean, corn, etc.
“We already have warnings of a potential El Nino later this year.”
Nuanced approach
Investors should avoid simplistic, binary thinking about commodities and instead take a more nuanced approach, argues Polley.
“Many just buy the broad commodity index which has all the fossil fuels and livestock and is not consistent with ESG. Others think ‘commodities is mining, and mining is bad’.
“But you have to think beyond that because the world’s transition to net zero is materials and resources intensive.
“And if we don’t enhance the supply of those commodities that facilitate the green transition, then we’re just not going to transition.”
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.
The RBA has again left the cash rate unchanged at 4.1% — which is where it’s likely to remain for the rest of the year, argues Pendal’s head of cash strategies, STEVE CAMPBELL
PHIL LOWE spared mortgage holders any further pain at his final meeting as RBA boss, leaving the cash rate unchanged at 4.1%.
The decision wasn’t unexpected after rates were left on hold last month.
Apart from adding uncertainty to recent credit concerns in the Chinese property market, there was little change to the accompanying statement.
The RBA believes further policy tightening might still be required — but this will depend on the data and how risks evolve.
No catalyst
There was no clear catalyst that would have caused the RBA to tighten at this meeting.
A glance at key data released since the August meeting shows unemployment rising from 3.5% to 3.7% in July.
The Australian Bureau of Statistics cautioned against reading too much into that.
The last time unemployment rose was in April, which happened to coincide with school holidays.
The bureau also “continued to see some changes around when people take their leave and start or leave a job. It’s important to consider this when looking at month-to-month changes.”
Meanwhile annual inflation fell from 5.4% to 4.9% — weaker than the expected 5.2%.
Taking a deeper dive on the numbers and excluding volatile items (fruit and vegetables, automotive fuel, and holiday travel and accommodation) annual inflation rose 5.8%, down from 6.1%.
Annual rent inflation continued to reflect the tight state of the market and strong demand, rising from 7.3% to 7.6%.
Electricity prices rose 6% in July and 15.7% over the past year. A surge in July was due to annual price reviews that occur each July, though these were partially offset by the introduction of rebates from the Energy Bill Relief Fund.
In all it was a mixed bag, as is often the case.
What it means for investors
Inflation is moving in the right direction and it’s likely the RBA will end the year with the cash rate still on hold at 4.1%.
But any talk of rate cuts in the first half of next year should be discarded (barring a big, external shock).
Inflation has peaked and the move lower will provide comfort for the RBA. But services inflation remains uncomfortably high.
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It’s where the sticky level of inflation sits that is key and that will only become apparent in time.
The RBA’s forecasts do not have inflation back within the 2-3% target band until mid-2025.
This is predicated on slowing economic growth, resulting in higher unemployment and easing wage inflation.
Further policy tightening most likely requires these factors to not play out as quickly as the RBA expects.
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.
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
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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.