Archive for category: News & Insights

Bonds have been unrelenting in 2019, rising in stark defiance of investors who called a fade to the rally in late 2018, when the US Fed appeared determined to hike rates. This insatiable appetite for bonds has seen yields plummet to record lows in several markets, while the quantum of negative-yielding debt is climbing ever higher.

As the chart below shows, the market value of bonds tracked by the Bloomberg Barclays Global Aggregate Index has risen to nearly US $14 trillion and pushed above its 2016 peak. Negative-yielding bonds now make up around one quarter of the index. European safe-havens like Germany and France make up the lion’s share (if you can call it that), with more than 80% of Germany’s federal and regional government bonds in the red.

The value of negative yielding bonds has rocketed in 2019

Source: Bloomberg

Market fears of a faltering US economy are becoming more evident with the Fed taking out some insurance with a 25 basis-point cut to the funds rate at the end of July. The question is will there be another? The yield on 10-year US Treasury bonds has fallen from 3.24% in November 2018 to 1.71% in early August, amounting to an almost 40% rise in the value of long-duration Treasury bonds. The bond market continues to track a deterioration in global growth but so far there are few signs that more aggressive action is required by the Fed.

Unsurprisingly, most other developed nation yields have also come under pressure amid gathering storm clouds. We have observed a discernible shift in appetite, with many global managers actively seeking to diversify risk within portfolios. Going forward it is expected that global yields will continue to suffer a downward trajectory as the global economy weakens. Lonsec continues to favour global bonds over Australian bonds largely from a valuation and diversification perspective.

The prospect of various central banks providing additional support to financial markets is once again up for discussion, although there is no consensus view (noting in recent times Malaysia, New Zealand, Iceland and Sweden have all cut interest rates). With stubbornly low inflation in the US, geopolitical tensions with China and to a lesser degree Iran, a move by the Fed to ease pressures would not be surprising.

In Australia the rhetoric of the RBA has also changed, moving toward a more conciliatory tone, signalling there is still some room for further action if required. Looking forward, low inflation remains a key issue, as does spare capacity in the labour market. Pleasingly house prices have appeared to stabilise in Sydney and Melbourne, and the impact of further stimulus in the form of tax cuts and loosening a key constraint on mortgage credit are yet to be fully felt.

Lonsec views Australian 10-year bond yields as expensive at 1.3% and our DAA signals continue to favour other asset classes over domestic bonds. Domestic bonds rallied significantly during the quarter on the back of two RBA cuts and weakening economic data spooking local investors. The Australian dollar also proved volatile over the quarter, breaking out of the tight trading range of the past year. Going forward the Australian dollar is expected to come under increasing pressure as lower rates begin to bite.

Credit remains popular with active managers still favouring a bias to corporate bonds within portfolios, albeit bell-ended with more defensive positioning in sovereign bonds or cash-like assets. For the domestic market, it appears like more of the same going forward: tight spreads and limited opportunities. Once again, the popularity of relative value trades is noticeable, picking up extra basis points as and when they can.

Over the quarter, Lonsec has decreased Cash allocations from a slight overweight to a neutral position for portfolios with exposures to Alternatives and has moved the very overweight recommendation back to overweight for our traditional portfolios (excluding alternatives). We remain slightly underweight Australian bonds and neutral on global bonds. The sharp fall in US government bond yields during the June quarter was notable, but in comparison to domestic bond yields they remain attractive from a relative valuation perspective.

Lonsec has been working with financial advice firms for over 20 years and during this time we’ve observed a wide range of investment committee structures. The thing that stands out for us is the clear link between high-functioning investment committees and investment outcomes, with people and processes being the most essential elements financial advisers and dealer groups need to get right.

While it’s tempting to think of your investment committee as serving a narrow governance function and therefore requiring a narrow set of skills, the success of your investment committee depends on its ability to draw on a broad set of skills and backgrounds, including those who can bring an outsider’s perspective to your organisation.

So what are the critical things you need to consider to set up your investment committee for success? These are our top three:

1. There must be a critical mass of members

Determining the right size for your investment committee depends on the size of your organization and the types of investment decisions you’re making. For example, if you’re making asset allocation and security selection decisions, you must have people involved in your investment committee with the appropriate skill set and expertise. Having a small, tightly-controlled committee is not appropriate if you’re managing dynamic, multi-asset portfolios or where you’re taking an active role in selecting stocks. Its also essential that your committee allows for a diversity of views and opinions. The more voices you have on your committee, the more robust your investment decisions are likely to be.

2. Clearly defined roles are essential

It’s important for each member of the investment committee to have a defined role to ensure they’re contributing to their full capacity. Each role may be linked to a member’s area of expertise (e.g. asset allocation, equities, fixed income, alternatives, etc.). If there’s a knowledge gap in your investment committee, consider whether you have the internal capability to fill this role or whether it’s worth bringing in the right expertise from outside. Clearly defined roles help to ensure greater accountability and allow members to contribute in ways where they are adding the most value to your investment decisions.

3. External expertise can enhance performance (and credibility)

Most investment committees will draw upon external experts. This may be to fill in a gap in expertise but more importantly external experts will bring different perspectives and may even challenge the views of your organization. Within Lonsec’s own investment committee process we have two external experts on our investment committee who bring significant experience and a different set of skills to the management of our portfolios. Importantly, they contribute an ‘outside’ perspective and fill in potential blind spots. We don’t pretend to know everything, and our clients would probably be concerned if we claimed otherwise. If you’re offering your clients a high-quality, actively managed investment solution, then having external decision makers involved in the process can bring peace of mind and add intrinsic value to your service.

There is no one-size-fits-all approach that can determine exactly what your investment committee should look like, but there are things you can do to improve your investment decision making and the value of your advice. Ensuring that your investment committee consists of people with relevant experience, bring a diversity of views, and have a clear mandate should be at the core of your process. Ultimately, you want to harness the specialized skills of your own investment professionals while balancing these out with a broader range of views and perspectives to avoid group think or missed opportunities. Even the most hardened practitioners need to be challenged once in a while.

The ECB’s announcement of further rate cuts was the last thing Europe’s banking sector wanted to hear. Since the depths of the eurozone crisis in 2009 and the sovereign and banking crises that followed, Europe’s banks have struggled to get back onto the right footing. Despite the introduction of new capital requirements and rules to reduce the risk posed by too-big-to-fail institutions, the equity value of banks has been in steady decline.

For Germany, the banking problem is embodied by Deutsche Bank, whose failed attempt to merge with its smaller competitor Commerzbank has forced it to abandon its long-standing dream of becoming a major Wall Street player. Its only choice now is to drastically scale back its operations. The story throughout the rest of Europe is not much better. European bank PE ratios relative to the overall market are at the lowest levels since the early 1990s.

Europe’s banks are under pressure

Source: IBES, Heuristics

The IHS Markit Eurozone Composite PMI suggests that, while the services sector has seen some pickup, manufacturing remains under pressure, and in Germany has fallen into contraction. The survey indicates that GDP in the eurozone is rising at a 0.2% quarterly rate. France and Germany are likely growing at 0.2%, while Spain is slowing to 0.4% (from around 0.7%) and Italy is contracting at a 0.1% rate. Business expectations over the next year have fallen to the lowest level in around four years.

While recent market gains may be predicated on the assumption that more monetary accommodation will help avert slowing economic growth, the situation possibly spells further pain for the banks. Central banks are now in easing mode once again, and while the Fed has yet to cut rates officially, this is the market’s strong expectation – and they don’t see the Fed stopping with just one.

12% of respondents believe the Fed will cut by more that 150 bps by 2021

Source: BofA Merrill Lynch FX and Rates Sentiment Survey

What this means is that investors looking for financial services exposure need to tread carefully. For the banks, lower rates tend to mean more pressure on lending margins, which acts as a headwind to growth. While a beaten down banking sector can spell opportunity for investors, from a portfolio perspective it’s essential to think carefully about what sort of exposure you’re looking for. For those seeking value in the banks, be prepared for a period of pain if the low rate environment continues.

It’s been an eventful month for markets. The Coalition’s Federal election win, the RBA’s rate cuts and a continuation of the US-China trade tensions have all impacted markets during the month of June. Domestic markets reacted positively to the Coalition win with some of the pessimism surrounding the housing market subsiding. The RBA’s rate cut was not unexpected with most analysts having already priced in the cut and potentially another.

Interestingly, the market narrative has turned to the possibility of the RBA undertaking a quantitative easing (QE) program domestically in a similar fashion to what we have seen in Europe and the US, whereby the RBA would buy government and corporate bonds using cash on its balance sheet. This would result in effectively flooding the market with liquidity while keeping rates low. Should rates continue their downward trajectory and QE become a reality, it may force investors into equities providing a tailwind for markets, as we have seen in Europe and the US in recent years. This is particularly relevant for retirees who may be forced into increasing their exposure to Australian equities as a source of income. The trade tensions between the US and China continue to adversely impact markets contributing to bouts of volatility. The longer the ‘trade wars’ the higher the probability that we will see longer-term impact on global growth.

These factors make it a challenging period for investors where factors other than market fundamentals are having a material impact in the trajectory of markets. In such an environment, we believe selective valuation opportunities will present themselves for long-term investors, however ensuring that your portfolio is diversified will be very important in navigating an increasingly volatile market environment.

The possibility of the RBA undertaking a quantitative easing program could have major ramifications for retirees, who may be forced to increase their exposure to equities if interest rates continue to spiral downwards.
It’s been an eventful month for markets – the Coalition won the federal election in a surprise upset, the RBA cut rates to record lows, and US-China trade tensions re-emerged with a vengeance. Domestic markets reacted positively to the Coalition win, with some of the pessimism surrounding the housing market subsiding. The RBA’s rate cut was not unexpected, with most analysts having already priced in the cut and potentially another.

Interestingly, the market narrative has turned to the possibility of the RBA undertaking a quantitative easing (QE) program domestically, similar to what we have seen in Europe and the US. This would involve the RBA buying government and corporate bonds using cash on its balance sheet, effectively flooding the market with liquidity while keeping rates low. Should rates continue their downward trajectory and QE become a reality, it may force investors into equities, providing a tailwind for markets as we have seen in the US and Europe in recent years. This is particularly relevant for retirees, who may be increasingly forced to lift their exposure to Australian equities as a source of income.

While it’s difficult to know exactly what the relationship is between large-scale asset purchases and the stock market, evidence in the US and Europe suggests there is a positive correlation. The launch of QE in the US resulted in significant share market gains, in part because the market anticipated an improvement in macroeconomic conditions. Proponents of QE tend to be critical of the US Fed for undermining the effectives of the program through its forward guidance (which made the program less open-ended by emphasising the eventual exit from QE), as well as not going hard enough for long enough. Critics of QE claim that large-scale asset purchases inflate asset values, which can lead to a stock market bubble and greater inequality. Yet others believe that monetary policy is entirely fruitless, and fiscal policy is the only effective mechanism.

The precise effect of QE is difficult to determine. While some claim it has been responsible for lowering interest rates, the evidence suggests it might in fact have led to an increase in yields during those periods where it was in effect (see chart below). Bond purchases raise the price of these assets, resulting in a fall in yields, which negatively impacts the return of safe assets like Treasuries, high-quality corporate debt, and cash. This is bad news for retirees who rely on these safe assets to preserve capital or generate a secure income stream. However, if QE manages to raise expectations for long-term growth, this would lead to a rise in longer-term yields, reflecting the prospect for higher growth and inflation.

QE episodes in the US have coincided with a rise in the 10-year yield

Source: FRED, Lonsec

How seriously the RBA is considering QE is unknown, but given the challenges facing conventional monetary policy with interest rates nearing zero, it must be something the bank is thinking about. If the RBA does go down the QE path, it will be difficult to satisfy the critics on both sides of the QE divide. According to economist Stephen Kirchner, the US experience with QE suggests the RBA would need to buy securities equivalent to around 1.5% of GDP to achieve the same effect as 25 basis point reduction in the official cash rate. This would represent a QE program of significant scale for Australia.

If retirees are worried about QE, the RBA is likely just as reluctant to pull the trigger. The not-so-subtle comments from Phillip Lowe and others about the need for structural reform should be heeded by Canberra to avoid placing too great a burden on monetary policy. This is critical given the challenges facing the global economy, including the current trade tensions between the US and China, which continue to adversely impact markets and are contributing to bouts of volatility. The longer the trade wars drag on, the higher the probability that we will see a longer-term impact on global growth.

This is a challenging period for investors, where factors other than fundamentals are having a material impact on the trajectory of markets. In such an environment, we believe selective valuation opportunities will present themselves for long-term investors, however ensuring that your portfolio is diversified will be very important in navigating an increasingly volatile market environment. It’s also a timely reminder that complex macro issues can play a large role in determining the right asset allocation in retirement portfolios, which requires an experienced investment committee with a range of skills and knowledge. This is especially important when it comes to the construction of retirement portfolios, where complex macro issues can have dynamic effects on outcomes.