Archive for category: News & Insights

The Australian property securities market has seen most prices continue to recover during the September quarter 2020 as the reporting season was better than expected. However, the bifurcation between sub-sectors is similar to the global property securities markets. Industrial/Logistics, specialist, funds management, large format, and non-discretionary retail sectors have outperformed in calendar 2020. Discretionary retail and office sectors underperformed.

The Retail sector has had to deal with forced store closures (excluding supermarkets and essential provisions), with the Melbourne metropolitan region still under lockdown restrictions. The government mandated Leasing Code of Conduct has shared the pain of reduced revenues for eligible small-to-medium enterprises, although some larger retailers have been attempting to withhold rents and renegotiate based on a revenue-linked model.

Overall, rent collections in retail have been around 55% for the June 2020 quarter, with dividends cut or omitted by the likes of Scentre Group. Retail rents for discretionary stores are likely to continue to come under pressure. In contrast, non-discretionary retail centres anchored by supermarkets have traded strongly, as have large format centres with Bunnings Hardware, Officeworks, and JB Hi-Fi as tenants. Property valuations of the latter have remained firm, while discretionary mall valuations have fallen.

The Office sector has continued to collect a high level of rents and valuations have seen limited reductions given the level of local investor interest in high quality Australian property (albeit international interest is more subdued given that travel is not possible for inspections). Medical and tech-related space is also well sought after by smaller investors. However, rental incentives are rising and sub-lease space in Sydney and Melbourne has grown by 100,000 square metres.

The Industrial/Logistics sector has been led by Goodman Group, with a strong FY20 earnings result and reaffirmed positive outlook based on its global development pipeline and recurring funds management fees. In Australia, logistics developments are expanding to cater for the ongoing shift to online networks with some vacancy increase on the east coast.

The Residential sector has received significant government support from the JobKeeper and JobSeeker programs and other incentives by various state governments. Further easing of lending criteria by APRA, in addition to loan repayment deferrals by the major banks, has lent support during the pandemic period. However, these measures are scheduled to unwind over the next six months (excluding the $25,000 Homebuilder program and easier lending requirements), which is likely to expose the residential sector to high unemployment. While Australia’s international in-bound travel is severely limited, migration numbers will be down significantly relative to previous years and the outlook for new residential property sales from this source is likely to be subdued.

Several Australian REITs (A-REITs) had capital raisings during 2020, so balance sheets are well-positioned with average gearing around 27%. At the same time the cost of debt has reduced with interest costs for new debt down from around 3.0–3.5% to 2.0–2.5% over the last year.

Pricing in the A-REIT sector has Industrial/Logistics (+71%), Hardware (+33%), and Service Centres (+13%) at premiums to net asset values (NAV). Sectors at a discount to NAV are Office (-17%) and Retail, although discretionary malls are at -54%, but non-discretionary centres at a 1.0% premium. Capitalisation rates have reduced over recent years and have now started to ease (for retail discretionary) or steady out (for office) but remain firm for Industrial/Logistics and Specialties (including Hardware).

Lonsec believes the Australian real estate market, which was already late in the cycle pre-COVID, has extended its late-stage duration as a result of ‘lower-for-longer’ monetary policies. Despite deferrals and cancellations of dividends by some REITs, Australian property securities still offer attractive yields relative to both bonds and cash (holding at a 3.0–4.0% yield differential). Sectors with structural tailwinds (logistics, industrial, and specialised) are expected to enjoy more resilient cashflows and distributions, and as a result will continue to trade at a premium. Until the COVID-19 pandemic is brought under control, the way forward remains unclear. However, value investors will be tempted to look at heavily sold-off sectors at some stage.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

If the May 2019 Budget was all about back to black, this year’s Budget is all about rescuing and repairing the economy.  

Last year’s Budget forecast a small surplus of 0.4% of GDP in 2019-20, the first surplus since the GFC. In fact, a small surplus of 0.4% of GDP was indeed achieved in 2018-19, but budget deficits as large as -4.7% was forecast for 2019-20, and -10.2% for 2020-21. This compares to the -3.7% deficit at the height of the GFC, making it the deepest since World War II. 

Budget net operating balance (% GDP) 

Source: Treasury, Lonsec 

How did we get here? 

We’ve had a tumultuous year since last year’s Budget, with bush fires, drought, and a global pandemic. Those negative shocks sank our economy into the first recession since 1991, with GDP contracting 7% in the June quarter. 

With reduced economic activity, tax receipts have reduced. Income taxes collected have fallen on the back of lower employment and hours worked. Company tax receipts have also fallen as many businesses remain shut or operate below capacity. GST revenue declined too, with fewer sales of goods and services. Tax receipts fell across the board, with the one notable exception being—perhaps appropriately—taxes on the sale of spirits. 

Commonwealth revenue and expenses (% GDP) 

Source: Treasury 

On the spending side, the government has put in place significant stimulatory measures to support the economy and employment. These include: 

• $120 billion over 2019-20 and 2020-21, primarily for the JobKeeper payment. 
• $46 billion mainly in the Coronavirus Supplement, economic support payments to households, and increased JobSeeker payment. 
• $40 billion to provide further support for apprentices, trainees, hospitals, aviation, and the infrastructure sector. 

Source: Budget papers 

Overall, compared to the government’s Economic and Fiscal Update in July 2020, where a small surplus of $12 billion was forecast for 2020-21 (0.6% of GDP), this Budget shows an estimated deficit of –$198 billion (-10.2% of GDP). Contributing the most to the deterioration is around $127 billion in additional spending, followed by $42 billion less in expected revenue due to reduced economic activity. 

How are we going to pay for all this?  

The short answer is, with debt. And a lot of it. Commonwealth Government net debt is forecast to rise to 36% of GDP in 2020-21, and even further to 43.8% in 2023-24. This compares to 19% in 2018-19. 

This may sound high, but by international standards Australia’s net government debt level is relatively manageable. Prior to the COVID-19 pandemic, the average net debt level among developed economies was 43% of GDP. The US and UK both had net debt of around 77% of GDP, while Japan had the highest at 155% of GDP. Ratings agency S&P has confirmed Australia’s AAA rating with negative outlook, with Fitch and Moody’s reserving judgement for now.  

With interest rates at historic lows, financing the debt should be a secondary consideration, with the primary focus being to get the economy back on track.  

What are the key Budget measures? 

• $26.7 billion temporary investment tax incentives: Businesses with aggregated annual turnover of under $5 billion can deduct the full cost of eligible capital assets acquired from 6 October 2020 and first used or installed by 30 June 2022. 

• $17.8 billion of income tax cut: Bringing forward the second stage of the Personal Income Tax Plan by two years to 1 July 2020 as well as a one-off additional benefit from the low and middle income tax offset in 2020-21. 

• $15.6 billion in additional spending on the JobKeeper Payment: Eligibility has been expanded largely In light of the prolonged restrictions in Victoria. 

• $10.7 billion in infrastructure spending: Including $6.7 billion in grants to the states, $3 billion for roads and community infrastructure, and $1 billion for water infrastructure. 

• $4 billion for a JobMaker Hiring Credit: To give businesses incentives to take on additional employees aged between 16 and 35. 

• Additional measures: Including $1.2 billion to support 100,000 new apprentices and trainees with a 50% wage subsidy and undoing $2 billion cuts to R&D incentives. 

When will we get out of the recession? 

The Treasury forecasts economic activity to pick up from late 2020 and into early 2021. The recovery is expected to be driven by a further easing of restrictions and improvements in business and consumer confidence. Economic activity will be further supported by Government stimulatory measures, both fiscal and monetary. The RBA has also hinted at further easing, with another rate cut or announcement of further QE widely expected at its November meeting.  

The IMF in its June 2020 World Economic Outlook forecast Australian GDP to decline by -4.5% in 2020 before rising by 4% in 2021. While this is our first recession since 1991, Australia’s experience with containing the virus outbreak means the economic is faring relatively well by international standards. For example, the IMF forecast US GDP to contract by -8% in 2020, -10.2% in the UK, and -12.8% in Italy and Spain. 

Yesterday’s Budget forecasts GDP to fall by -3.75%—better than the IMF forecast—before growing by 4.25% in 2021. It also forecasts unemployment to peak at 8% in the December quarter of 2020, before falling to 6.5% by June 2022 as economic activity recovers. Both the GDP and unemployment forecasts are more optimistic than many leading economists believe. 

While the COVID-19 pandemic should be a severe but temporary shock, the path to recovery remains a gradual and uncertain process. This Budget has taken important steps to support the economic recovery, but the speed and magnitude will depend on many other factors, including international health and economic outcomes, as well as domestic business and consumer confidence. 

Broad measures such as income tax cuts and investment allowance will support overall business and consumer confidence, but more targeted measures might be welcomed by more severely affected sectors such as education and tourism. The government also failed to take the opportunity to enact structural reforms such as reforming the tax system or improving overall labour productivity, which would benefit economic growth in the long term. 

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

Global equity markets in 2020 had a promising start to the year as the S&P 500 Index reached a new record peak of 3,380 on 20 February 2020, backed by better macroeconomic data and the prospect of reduced geopolitical headwinds (particularly on the US-China trade front).

However, the progressive realisation across financial markets that COVID-19 represented an existential threat to society necessitating the shutdown of whole swathes of the economy triggered a sharp sell down in mid to late March, sending the S&P 500 index falling by 34% to a low of 2,237 on 23 March 2020. The US equities market tripped circuit breakers four times in two weeks (March 9, 12, 16 and 18). The circuit breakers pause trading for 15 minutes in the event of a sudden 7% fall.

Key indices were hit hard as the coronavirus spread globally

Assets with any risk were sold off. Equities expectedly suffered steep drawdowns with the US and Australia, for instance, entering bear markets. This also marked the close of the longest bull market in US history which lasted some 11 years. Credit also suffered heavy losses with high yield nursing a drop of some 20%. US Treasuries retained their safe harbour status with yields collapsing by nearly 30%. The same cannot be said about Australia’s government bonds which experienced rising yields and casting a cloud over fixed income portfolios.

The sell-off was exacerbated by an oil price collapse after Saudi Arabia launched a price war. Oil prices experienced their worst quarter in history with prices dropping by close to 26% in the US on March 9 after Saudi Arabia dissolved a pact with Russia to curtail production. The prospect of reduced global demand due to COVID-19 forced the oil prices to enter in negative territory in April 2020 for the first time ever, as producers ran out of space to store the oversupply.

This rekindled fears for the solvency of the US shale industry from 2015/2016 when the world was last awash with oil. There was concern in markets then that there would be mass failures which would particularly rattle high yield bond markets. The worst concerns weren’t then realised but have re-emerged with COVID-19 and Saudi actions.

Investors are venturing out of safehaven assets

The deep recession in Q1 2020, fuelled by public health, economic, and energy crises, caused investors to start piling into expensive defensive and growth sectors like healthcare, information technology and consumer staples. In contrast, cyclical sectors such as banks, airlines, energy and travel stocks were hit hard.

As the economies went into hibernation to stop the spread of the coronavirus, major central banks slashed rates and restarted asset purchases, while G20 governments promised $5 trillion stimulus packages to moderate the economic impact of the pandemic. Such aggressive measures by policymakers globally boosted the safehaven assets such as government bonds and Gold. US Treasuries had their best quarter in Q2 2020 since the GFC and Gold price reached an all-time high of close to $2000/ounce in August 2020.

In Q2 2020, investors’ risk appetite gradually returned with the easing of COVID-19 lockdown restrictions and excessive monetary and fiscal stimulus measures announced across the world. This led to the recovery of equity markets with S&P 500 officially entering a bull market on August 18, reaching an all-time high of 3,500. While the S&P 500 index has returned to pre-pandemic levels, there is a sharp contrast in the gains of various sectors, with only 38% of stocks (primarily healthcare and information technology) in the index reporting gains over that period.

Which strategies worked?

Lonsec monitored a number of strategies within the global equities sector during the depths of the crisis that were deemed higher risk due to their market exposure, central bank or government policy intervention, market volatility, and illiquidity or possible high volumes of redemption requests.

While the market has now settled, we saw funds operating within hedged variation strategies, Emerging Markets, Quantitative, Natural Resources, and Fundamental Value, posting deep declines in the first quarter of 2020. Unsurprisingly, COVID-19 induced discrepancies in the wider sectors favoured growth managers over value (and the benchmark).

Value-style funds have endured a long period of underperformance relative to growth-biased peers in a long bull market favouring large technology firms. Lonsec notes that the Value managers under its coverage are not necessarily buying ‘junk’ stocks and that a volatile downturn such as this can be used as an opportunity to buy well-capitalised businesses at cheaper prices. While this sub-sector returned 3.7% for the June quarter, ranking at the lower end of the global equity spectrum, this remains a positive sign for those dogmatic value-oriented managers.

Lonsec notes that the funds management industry had been refocusing on systematic strategies which offer the promise of consistent and repeatable alpha but with scalability and cost advantages demanded by investors. Sadly, the average product in the Quantitative cohort experienced similar weakness to Fundamental Value due to a heavy dose of ‘value’ in addition to momentum in their quantitative models’ building blocks.

Quantitative strategies in general have struggled to price assets in current markets, as their processes are designed to function in ‘normal’ market conditions, when the market is operating according to fundamentals and long-term observations. The uncertainty, volatility, and leverage are causing pain generally across the sector. Performance for the average systematic product over Q1 2020 was -15.3%, compared to -3.0% per annum over the 12 months to 30 June 2020. Pleasingly, the average Managed-Volatility strategy outperformed its vanilla Quantitative peers, collectively returning -8.6% over the March quarter.

Typically emerging markets-oriented strategies tend to get caught up in a flight to quality, although Lonsec notes the Asia sub-sector (-7.6%) held up better than developed markets during Q1 2020 due in part to the relatively fast and well-organised response to COVID-19 within the region, presumably as a result of lessons learned in the past. The same cannot be said of regional India strategies (-20.8%), which suffered heavy losses given the country’s less successful containment efforts.

Other factors at play include the greater cyclical exposure generally within emerging market regions due to the greater exposure to commodities and energy from countries within the Latin America and Middle East regions, as well as Russia. As mentioned, dispersion has also considerably widened among stocks as the market punished companies exposed to discretionary spending (i.e. travel) and in highly cyclical sectors (i.e. energy), while rewarding those stocks that were unaffected or ended up benefiting from the new environment, most notably technology firms. Such dispersion is, however, an attractive environment for active managers to add considerable alpha.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

When we think of the most important components of our portfolio, it is easy to overlook cash. Investors seeking to diversify their investments will typically keep a portion of their funds in cash or enhanced cash funds to ensure a readily available funding source for expenses or to allocate to other assets. Despite the importance cash plays in our portfolio, we tend not to focus heavily on the risks that enhanced cash funds can pose during periods of market stress.

As the Covid-19 pandemic rolls on, with further lockdowns and more stringent social distancing measures in some parts of the world, it is critical that we learn the lessons of the dislocation that hit credit markets in March. This means taking a close look at the risks inherent in enhanced cash products and how to mitigate them to create a more robust portfolio, especially during bouts of volatility.

As a relatively low risk, defensive asset, investors typically expect their cash to provide regular income and capital stability within their diversified portfolio. Some investors, in order to generate enhanced returns relative to cash funds, invest in enhanced cash products that carry greater risks that some investors may not always be fully aware of. These risks have come to light in recent months and emphasized the need to carefully manage the cash component of your portfolio.

Enhanced cash products in the past few months have been impacted by the Covid-19 health crisis, which has caused financial market volatility the magnitude of which was last seen during the Global Financial Crisis (GFC) in 2008-09. This volatility has caused the Reserve Bank of Australia (RBA) to reduce the official cash rate to a record low 0.25% and hold the yield curve out to three years in a range around the same level.

Record low interest rates have significantly reduced the income received by investors, and this problem has been further compounded by capital stability concerns as financial markets turmoil has seen the price of some cash assets fall and yields rise relative to the RBA cash rate. As a result, some enhanced cash funds in this record low yield environment surprised unit holders by producing negative absolute returns during the March quarter, while other enhanced cash funds continued to produce positive returns, albeit with relatively low yields.

This has served as a timely reminder that you need to look at not only the returns but also the risk characteristics of individual enhanced cash products. This is critical in order to understand the impact of financial market volatility on the risk of your cash holdings.

Enhanced cash funds are exposed to credit risk, term risk, and liquidity risk. These refer respectively to the risk of losing capital due to default by security issuers, the changes in interest rates that adversely affect the price of the securities, and the inability to convert the securities into cash without any loss of capital. Given these risk factors, the returns for enhanced cash are sourced from each of these risks accordingly (i.e. credit premium, term premium, and liquidity premium). Among all the premiums, credit premium is typically the main contributor of enhanced cash fund returns when compared to cash fund returns.

Enhanced cash products typically invest in high quality investment grade securities and cash accounts with an average credit rating of A+ or A1, where the probability of losing capital or suffering delayed payments is very limited. These investments may include overnight cash accounts, bank bills, promissory notes, asset-backed securities such as registered mortgage-backed securities (RMBS) and floating rate notes (FRNs) issued by semi-governments, and corporates, all of which are common constituents of enhanced cash strategies.

Of these securities, RMBS and FRNs are assets that are sensitive to price movements, which in the current Covid-19 situation are at risk of becoming stressed if credit and liquidity conditions deteriorate. As a result of stressed market conditions, some of these security prices are adjusted lower. Enhanced cash fund unit prices become materially impacted and those investors looking to redeem their funds may find the fund product’s sell spread has widened or redemption price has risen materially.

This sell spread change considers the increased trading costs during such a volatile period, which is passed on to the investor redeeming their funds, rather than impacting unit holders that remain in the fund.

These lower unit prices and increased transaction costs caught investors unawares in March and caused some enhanced cash funds to achieve short-term negative returns. A stressed liquidity and credit experience with enhanced cash funds also occurred during the GFC. The severity and duration of the GFC was different to the current crisis, and many enhanced cash funds recaptured their underperformance relative to cash funds following the GFC. The lesson is that the search for additional return beyond cash rates, which comes with increased risk, must be done cautiously.

On average, enhanced cash products usually have within the fund securities with a longer weighted average life or maturity than traditional cash funds. This longer maturity profile exposes enhanced cash funds to greater interest rate risks and therefore an expected higher term premium. When interest rates are falling, enhanced cash funds with their longer maturities benefit from the rise in securities prices and receive a capital gain greater than a cash fund. However, when interest rates are rising, enhanced cash funds are at a slight disadvantage because of this interest rate risk when compared to cash funds.

Overall, given current financial market conditions, it is important to take a closer look at enhanced cash funds and make prudent assessments based on the different risks they are exposed to. Compare the credit risks, maturity profile (also known as duration), and liquidity, both across individual enhanced cash products and compared to cash funds and understand the trade-off that is being made to achieve a higher return. It is important to critically assess these differences, especially during downside scenarios and periods of heightened uncertainty.