Archive for category: News & Insights

There is a powerful maxim best suited to the current predicament faced by markets, and that is, there are decades where nothing happens, and there are weeks where decades happen. The advent of 2020 has brought with it unprecedented volatility, with markets whipsawing erratically and appearing to have detached completely from the underlying fundamentals. No sooner had investors been beaten into submission from depression era plunges in equity markets, were they then riding a jubilant wave of euphoria on a spectacular relief rally. Unfortunately, there is no investing rule book which outlines how to effectively manoeuvre your portfolio while the global economy is placed in suspended animation and a deadly viral pathogen wreaks havoc. However, if there was ever an opportunity for active investing to shine, this is it.

In the midst of a lethal pandemic gripping markets, investors have also been dealt a one-two punch of a brutal collapse in oil prices amid a price war between Saudi Arabia and Russian. As such, the price of West Texas Intermediate (WTI) has plummeted from US$62/bbl to a low of US$20/bbl, and now seriously threatens the viability of a highly leveraged global energy industry. While lower oil prices translate into lower transportation costs, this is less relevant given large swathes of the globe are in lockdown and the airline industry has drastically curbed output.

Source: Bloomberg

Importantly, with the price of oil well below break-even, exploration and production will come to a standstill and untold numbers of jobs will be lost. Bizarrely however, in a market gripped by panic, the mindset has inexplicably shifted from selling anything (barring safe-haven currencies and US Treasuries) to a dramatic reversal bordering on irrational exuberance. This is perfectly exemplified by the FOMO (fear-of-missing-out) driven bull market rally, where investors are piling in despite the IMF now predicting the deepest economic downturn since the Great Depression of the 1930s. Astoundingly, the S&P 500 has now notched a 25% return from the depths of the recent bear-market low.

Source: Bloomberg

So, this leaves the pundits questioning, has a technical bottom been found in the markets, or are we witnessing a textbook bear-market rally? In the case of the former, perhaps it’s the invisible hand of the market looking through to a solid economic and corporate upturn. Conversely however, the rally could simply be driven by over-optimism around global governments and central banks being ‘all-in’ amid past condition to ‘buy-the-dip’. Given the magnitude of the uncertainties we’re faced with, intuition favours the latter. This has tended to be the consensus view held among Australian equity portfolio managers when posing the same question during meetings as part of Lonsec’s annual review process over the course of the first two weeks of April. Moreover, some Managers are bearishly predicting a re-test of the lows experienced in March.

Historically, downward trending bear markets have frequently been plagued with sharp relief rallies, only to run out of steam and reverse course. Logic likely dictates that given the magnitude of the deteriorating fundamentals and economic data, a sustained recovery from here is likely over-optimistic. This was evidenced throughout the latter stages of 2008 where the S&P 500 was in the grips of a death-spiral despite numerous surges ranging from 10-25%, to ultimately bottom in March 2009. Furthermore, if using weekly jobless claims in the US as a proxy for the health of the global economy, the outlook appears dire. Jobless claims continue to skyrocket and take the cumulative total number of people who have lost their job since March 2020 to almost 17 million. In the singular month of March these jobless claims have already far outstripped the devastation witnessed during the Great Recession of 2008.

The dislocation in the credit markets has likewise been pronounced, and counterintuitively, this has spread to sovereign bonds which are typically immune from indiscriminate selling. Perversely, the US Federal Reserve has resorted to not only purchasing sovereign debt, but also sub-investment grade bonds through high-yield credit ETFs. In a sign of how distorted capital markets have come, the Fed is now extending credit to cash-starved corporates in attempts to stymie a systemic economic contagion in which credit markets freeze and liquidity evaporates. Once again, this type of intervention is without precedent and has significantly stabilised markets through keeping these companies on life-support whilst the ‘risk-off’ sentiment remains heightened. However, both credit spreads and trading in credit default swaps (CDS) remain elevated which suggests a marked disconnect between the ‘blue-sky’ scenario priced into equity markets, and fixed income securities languishing in the doldrums. Consequently, in the face of such ghastly economic data, one would imagine that the ‘Fed-Put’ is starting to weaken. Alternatively, perhaps we’re witnessing the last vestiges of blood being wringed from the retail investors with quantitative trading driving momentum higher before a swift ‘pump and dump’ ensues. So, for those telling themselves that this time is different, a word of caution, as history does not repeat itself, but it does rhyme.

Source: Bloomberg

The global economy is now likely wrestling with a complete paradigm shift in how globalisation is viewed. The longer we remain in lockdown limbo, the greater the push will be for a secular and structural de-globalisation of the world economy in the post-crisis landscape. Not only has the world been devastated through the effects of a global health catastrophe, but Orwellian impositions on our personal liberties have been thrust upon us that would have been utterly inconceivable barely months ago. Moreover, the chasm between the ‘haves’ and the ‘have-nots’ has radically deepened as a wider dispersion between the working class and the inner-city elites has been exposed. Given the increasing social unrest we’ve already witnessed unravelling in supermarkets, it’s not a stretch to see this playing out on a broader scale. Likewise, the America First mantra now appears less xenophobic as countless other countries have adopted even more radical shifts to protectionism in a fight to survive. A likely consequence of this would be the return of innovation and manufacturing to many countries, where previously this function had been outsourced to China. Case in point being the world’s reliance on China for life-saving pharmaceuticals. Australia imports approximately 90% of medicines, where an outsized reliance is placed on China to meet these needs. As such, given the supply chain vulnerabilities exposed by COVID-19, a re-assessment of Australia’s sovereign capability to meet our domestic pharmaceutical consumption is warranted. Secondly, corporate vanity and window dressing will likely take the back seat as companies are forced to re-focus on their core stakeholders when staring down the barrel of economic ruin.

The exogenous COVID-19 shock has exposed significant vulnerabilities in the financial system yet has also created potentially lucrative investment opportunities for rational investors. Whilst it might be difficult to maintain a dispassionate outlook at this juncture, remember that it isn’t the end, and that markets will bottom well in advance of a positive shift in investor sentiment. If history is anything to go by, you should never let a good crisis go to waste and use this opportunity to dollar-cost-average, as this could be our March 2009 moment. With that said however, the market always delights in humbling the masses, so proceed with caution.

The performance of the Alternatives universe during the recent market downturn has been widely dispersed, albeit skewed to the downside. Systematic Risk Premia strategies have been an area of poor performance with long running statistical relationships breaking down in current market conditions. Sharp spikes in volatility and the speed of asset price reversals have tested many strategies.

Exposure to risk premia such as value and carry, specifically short volatility, have been key points of pain. Momentum or trend following within Systematic Risk Premia strategies were positioned largely risk-on going into February this year, and during the initial market sell-off, signals were slow to react and re-position the portfolio or reduce risk. Meanwhile, dedicated trend followers with shorter trend horizons and faster twitch signals have generally fared well through the period.

Systematic Risk Premia products encompass a wide range of investment styles and strategies, although they are largely designed to offer liquid, transparent and cost-effective solutions for accessing hedge fund-like return streams.

The rise of Systematic Risk Premia strategies shares similarities with the shift towards passive investing in more traditional asset classes, spurred in part by the general underperformance of higher-fee fundamental investment managers.

These strategies are generally rules-based, multi-asset, and utilise a long-short approach with leverage and derivatives forming a key part of portfolio construction. Fund managers within Lonsec’s Systematic Risk Premia sector seek to provide long-term absolute returns through a variety of replication techniques or by employing other commonly used (or ‘classic’) trading strategies used by active hedge funds (this may also include exposures to more commonly recognised ‘factors’).

Performance of Systematic Risk Premia strategies during the COVID-19 pandemic

In February and March 2020, as the COVID-19 outbreak worsened and many major growth asset classes suffered severe losses, many Systemic Risk Premia strategies came under pressure. Underperformance within Lonsec’s universe of rated funds has largely been driven by carry factors such as short volatility, although value also detracted across many asset classes, as did momentum/trend.

Portfolio construction and risk management processes for many Systematic Risk Premia strategies rely on the back-tested assumptions that risk premia are uncorrelated, or at least lowly correlated. That said, recent performance in down-markets has suggested that this may not always be the case, which is when these relationships are needed most.

It is well known that trend factors often suffer losses during sudden inflection points and risk-off events like the current COVID-19 outbreak. Depending on prior signal direction and positioning, this is also the case for merger arbitrage and carry factors. For example, the Lonsec Systematic Risk Premia peer group underperformed in 2018 and most notably in Q4 2018 when most financial markets, including equity markets, experienced a relatively rapid drawdown of greater than 10%.

Overall, this has led to disappointing results in recent down markets. We believe more scrutiny regarding portfolio construction approaches is required, including the reliance on longer-dated statistical relationships that can deteriorate as market regimes shift. This remains a key area of focus for Lonsec during research reviews.

Performance of Systematic Risk Premia strategies (growth of $10,000 since January 2018)

Source: Lonsec

Using Systematic Risk Premia strategies in a portfolio

Lonsec believes that these products, especially those with more conservative risk-return targets, should generally suit moderate risk profile investors with specific liquidity requirements. Investors should also expect limited or no exposure to less liquid hedge fund strategies, such as Event Driven strategies.

That said, some fund managers like GAM have researched and established products with allocations to replicate less-liquid strategies, such as Merger Arbitrage, in a more liquid and lower cost offering. While increased liquidity is ordinarily a good thing for investors, the question also needs to be asked if the push towards more liquid underlying assets comes at the cost of lower returns. Hedge funds have historically benefitted from investing in illiquid assets, where the freedom to leverage into assets holding an illiquidity premium has delivered strong returns.

These types of strategies are not generally possible in a daily liquid vehicle due to the potential for a redemption freeze. Much like the discovery of over 400 factors, the efficacy of the risk premia employed by Lonsec’s peer group are subject to back-test bias. This makes it difficult to assess the performance and diversification benefits of these strategies given limited track records.

While live data is limited, these strategies have so far demonstrated medium-to-low correlation to major asset classes. However, without experiencing many sustained market downturns, through-the-cycle expectations are sceptically reliant on back-tested data. The current market environment will offer further evidence of how these strategies behave.

Correlations between Alternatives strategies

Source: Lonsec

As the chart above shows the correlation between common Alternative strategies including Systematic Risk Premia (SRP) and traditional asset classes based on monthly data from August 2011 to August 2019 (in Australian dollar terms). As can be seen, the reasonably high correlation between SRP, Managed Futures and CTA strategies is not unexpected given the inclusion of trend and momentum factors within SRP strategies. This is the case for a number of SRP managers in the Lonsec peer group, who have a heritage in trend following, meaning this premium can often dominate a strategy’s risk allocation.

The modest correlation to Equities (as defined by the MSCI AC World Index) may mean that the diversification benefits in a balanced portfolio are muted, although this will be dependent on the observation period. As mentioned, there is significant variation in the strategies and risk premia within the Lonsec rated peer group. The correlation to US Treasuries – and to a lesser extent global bonds – may be more sample-dependent and attributed to the synchronised monetary easing exhibited by most global central banks. As such, over the period, persistent declines in global interest rates have benefitted fixed income–oriented premia strategies, in particular those seeking to extract carry, trend, and volatility premia within the fixed interest asset class.

The need for a holistic portfolio approach

Investors also need to consider how best to incorporate Systematic Risk Premia strategies in a holistic portfolio, whether it be as a hedge fund replacement or to complete a balanced Alternatives allocation. Consideration must also be given during the Manager selection stage, as risk premia exposures can vary significantly between strategies.

While not designed as a hedge, diversification is best provided during risk-off market environments, and the inclusion of particular carry risk premia such as short volatility, which potentially experience drawdowns during these risk-off events, may make them unsuitable within a strategy designed to simply provide diversification. Further, there is the potential for some risk premia to already be represented in other parts of an investor’s portfolio (e.g. a strong value bias within an equity allocation) and having a sizeable allocation to the value premia within a systematic risk premia strategy may further reduce diversification benefits.

As the COVID-19 pandemic sweeps across the globe, shutting down countries and closing borders, the Australian Government had to quickly come to terms with the severity of the health crisis and the inevitability of an economic recession.

A series of economic measures has been announced since early March to mitigate the impact on the local economy and people’s lives. The usual May federal budget was delayed to 6 October 2020, while the uncertainty makes formulating reliable economic and fiscal estimates an impossible task. We outline the fiscal measures announced by the government so far and attempt to assess their effectiveness in this highly uncertain world.

First package—12 March

Total: $17.6 billion (0.9% of GDP)

Measure	Cost $m
Increase the instant asset write off threshold from $30,000 to $150,000 and expand access to include businesses with aggregated annual turnover of less than $500 million (up from $50 million) until 30 June 2020.	700
Back business investment by providing a time limited 15-month investment incentive (through to 30 June 2021) to support business investment and economic growth over the short term, by accelerating depreciation deductions. Businesses with a turnover of less than $500 million will be able to deduct an additional 50 per cent of the asset cost in the year of purchase.	3,200
Boost Cash Flow for Employers by up to $25,000 with a minimum payment of $2,000 for eligible small and medium-sized businesses.	6,700
Support small businesses to support the jobs of around 120,000 apprentices and trainees.	1,300
A one-off $750 stimulus payment to pensioners, social security, veteran and other income support recipients and eligible concession card holders.	4,800
Support those sectors, regions and communities that have been disproportionately affected by the economic impacts of the Coronavirus, including those heavily reliant on industries such as tourism, agriculture and education.	1,000

Second package—22 March

Total: $46 billion (2.3% of GDP)

Measure	Cost $m
$550 per fortnight to both existing and new recipients of the JobSeeker Payment, Youth Allowance jobseeker, Parenting Payment, Farm Household Allowance and Special Benefit, paid for the next 6 months.	14,100
$750 payment to social security and veteran income support recipients and eligible concession card holders, except for those who will receive the Coronavirus supplement above.	4,000
Allow individuals in financial stress as a result of the Coronavirus to access up to $10,000 of their superannuation in 2019-20 and a further $10,000 in 2020-21.	1,200
Reducing superannuation minimum drawdown requirements for account-based pensions and similar products by 50 per cent for 2019-20 and 2020-21.	N/A
Reducing social security deeming rates.	876
The Government is providing up to $100,000 to eligible small and medium sized businesses, and not‑for-profits (including charities) that employ people, with a minimum payment of $20,000.	25,200
Guarantee 50% of new loans issued by eligible lenders to SMEs.	N/A
Support for the aviation industry.	715

Third package—30 March

Total: $130 billion (6.5% of GDP)

Measure	Cost $m
Eligible employers (turnover<$1bn with reduction in revenue of 30% or more, turnover>$1bn with reduction in revenue of 50% or more) will receive payments of $1500 per fortnight per eligible employee for up to six months.	130,000
Temporarily relaxing the partner income test for JobSeeker Payment.	N/A

Balance sheet support

Total: $125 billion

The Reserve Bank will provide a three-year funding facility to authorised deposit-taking institutions (ADIs) at a fixed rate of 0.25 per cent. This facility is for at least $90 billion or approximately 4.5% of GDP.

The AOFM’s $15 billion investment capacity to invest in wholesale funding markets used by small ADIs and non-ADI lenders (0.8% of GDP). The government will guarantee up to $20 billion to support $40 billion in SME loans, as part of the second package announced on 22 March (1.0% of GDP).

Keeping the economy alive

The stimulus measures have been designed and announced quickly to address the current economic crisis. The size of the stimulus is substantial, revealing the potential negative impacts the Government assesses as likely to be felt across the economy.

The majority of the measures are aimed at sustaining businesses, keeping people in jobs and protecting the financially vulnerable. Getting money into people’s hands (through measures like the JobKeeper Payment and increased benefits payment) will help people pay rent and keep food on the table. Measures including guaranteeing SME loans and instant asset write-offs will hopefully keep the businesses viable or be in a stable to bounce back once the lockdowns are lifted.

However, pumping more money into an already blocked economic plumbing might not be enough to solve the problems. Given normal production and distribution of goods and services are being disrupted by the extensive lockdowns, simply having money in people’s hands might not be enough to combat both the supply and demand shocks.

While employees may maintain a level of safety net income, their spending will suffer, both as a result of weaker consumer confidence (e.g. not replacing a white good while fearing for job security) as well as an unavailability of what they would normally consume (e.g. movies, eating out).

While the economy remains in lockdown, people are only likely to consume the bare essentials: rent and mortgage payments, food and drinks, toilet paper (possibly in unreasonable quantities), keeping the kids occupied, and maintaining one’s sanity. The businesses and those employed by them in these sectors will do well during this time (e.g. supermarkets, pharmacists), as well as essential services such as healthcare, police and council services including garbage collection. But those outside these ‘essential’ services will continue to struggle for as long as the lockdown remains, and possibly even longer.

Maybe it’s also time the government acted more as a central planner and channelled the idle productive capacity in the economy towards projects that will employ and pay people. This would allow them to keep the lights on and use their collective expertise to increase the economy’s productive capacity in the long term.

Some examples I can think of include: constructing temporary hospitals to care for the potentially higher number of patients, re-purposing manufacturing facilities to make medical protective equipment or ventilators, investing in better communication infrastructure so more people can work from home effectively, rebuilding drought and bushfire-affected communities, providing online training to small town tourism operators and pub owners, and modernising the curriculum to prepare a future-ready workforce. Finally, what better time to think about diversifying the economy from mining and residential construction?

We can’t rely on China to save the day this time

Many Australians born in the 90s and later have never experienced a recession. In fact, we beat the Netherlands and hold the record of the longest economic expansion in the developed world. The last recession to hit our shores was the “recession we had to have” in 1990. Twenty years on, a recession now seems almost inevitable.

Call us the lucky country, but there is unlikely to be another massive infrastructure spending in China this time around, which on previous occasions has driven up demand for our coal and iron ore (like during the GFC). If anything, our reliance on China has meant the tourism and education sectors are taking a harder hit than many other countries. Those affected range from lobster farmers in WA, to luxury shops in Sydney and Melbourne, to struggling higher education providers.

As global borders are closed and trade and tourism take a massive hit, countries are also in a mad scramble to get their hands on surgical masks and other protective equipment, some re-engineering production lines to make masks instead of clothing. It’s looking increasingly likely the last few decades of globalisation might start to unwind once we come out of this health crisis. Maybe it’s time to implement some long overdue structural reforms and set the economy up for the future.

For detailed measures and eligibility, see Treasury’s updated document on the economic response to the coronavirus.