Challenges remain after record-setting rally
While the November equity rally drove healthy gains for our portfolio, that doesn’t mean the challenges for risk assets are over. Without earnings growth, we can expect today’s lofty valuations to be tested. And with 90% of the global fixed income market yielding 2% or less, defensive investors continue to face their own dilemmas. We’ve responded by modifying our asset allocation to harness opportunities in equity markets, while diversifying some fixed income exposure into higher yielding assets.
In October we documented our concerns around the challenges to returns posed by the low interest rate environment. Somewhat ironically, November’s return of 3.6% on the back of a record monthly gain in equity markets was the third highest monthly return since inception of the Schroder Real Return CPI Plus 5% Fund in 2008.
In the face of this, it’s fair to ask whether we are being too cautious about the future challenges for returns. We don’t think so. In our view, the strong rise in equity markets reflected three broad factors:
- Optimism around a vaccine and the potential return to a more normal economic environment in 2021 as the vaccine roll-out gathers pace globally.
- Policy settings remaining firmly pro-growth and pro-markets. With bank deposits and sovereign bonds offering little or no interest, investors are buying the idea that central banks (and to a lesser extent governments) want robust asset markets to underpin confidence in the recovery story. Therefore investors are looking to equities to provide both income and some optionality for growth.
- The real economy sectors where returns lagged for some time, are now benefiting from the renewed optimism in a broad economic recovery as investors are rotating from technology to industrials.
Testing the limits of optimism
While these factors may endure in the short run, there are some limits to how far equities can provide such strong returns without evidence of strong earnings growth. Just as investors started buying equities in the depths of the uncertainty around COVID-19, it is possible that optimism is close to peaking and markets are more prone to disappointment.
Furthermore, valuations will matter at some point. Multiples are historically expensive (particularly in the key US market) and require strong earnings growth to be validated. Broader valuation metrics show a growing misalignment between the real economy and the equity market. In essence, there are plenty of companies that need to grow into their lofty valuations.
Finally, the idea that equities will continue to re-rate in a zero-rate world is not supported by history. However, there is clearly more upside potential in equities than bonds, but it is not unlimited.
The challenge facing investors who have a more defensive orientation is simpler and highlighted by data from Bank of America Securities showing that less than 30% of the global fixed income market yields more than 1%, and only around 10% of the global fixed income market yields more than 2%. While fixed income returns have been reasonable to date, this largely reflects a pulling forward of future returns, with capital values increasing as market yields for sovereign and corporate issuers have declined (towards zero, in the case of sovereigns). Clearly this can’t be repeated indefinitely.
Actively seeking high quality yield
We have been responding to the challenge in several key ways.
First, the return of market volatility has provided some more opportunities to modify our asset allocation. Indeed, we’ve been significantly more active in 2020 then we have been for some time.
Second, we have become more targeted in where we’re investing. Our research has identified key segments of the fixed income universe where better returns are available and we are targeting these areas with more concentrated exposures. For example, Asian corporates, direct commercial lending and securitised credit (lending to consumers rather than corporates) all offer better yields for their underlying risks compared to investment grade corporates or sovereign bonds. Consistent with this theme, we have been selling very low (<1%) yielding Australian mortgage backed securities and diversifying into quality but higher-yielding debt investments.
We’ve also increased our equity exposure, back to pre-COVID-19 highs, which helped us capture more of the November rally. Within equities, patience has to some extent been rewarded, with the rotation back towards equities that score highly on valuation metrics and away from equities that score highly on growth metrics generating strongly positive stock selection returns, particularly from our active Australian equity portfolio. If this normalisation between value and growth stocks continues, we expect it will be positive for the fund’s returns.
In summary, we have and continue to be transparent around the challenges for investors in this environment (even if months like November can leave us a touch red-faced). While many things are uncertain, there are some realities that complicate the challenge of delivering consistent stable real returns to clients going forward. At the top of this list is the fact that 90% of debt securities globally are yielding close to zero or negative in real terms. Australia is no exception to this, as anyone who has tried to roll-over a bank term deposit can attest.
With a transition to a Biden presidency now underway and positive vaccine announcements from Pfizer, Moderna and the AstraZeneca Oxford consortium, global equity markets surged in November. As the market priced in a quicker return to normality in 2021, some of the underperformers through this year rebounded more strongly during the month. Value stocks performed particularly well (the MSCI World Value Index was up 15.1% for the month), while European and UK markets were the standout performers from a regional perspective. Yet this strong market performance took place against the backdrop of several European nations remaining in lockdown, while COVID-19 cases continued to rise in the US, which may impact Q4 equity earnings.
Early in the month, we increased our equity weight by 3.5% to target 31%. Regionally, we added to broader Australian and global equities exposures. We also increased our exposure to emerging market equities and smaller capitalisation companies in the US, as we believe these sectors will benefit most from a broader economic recovery underpinned by successful distribution of vaccines.
At the same time, we reduced some of our December S&P 500 put option protection prior to the US election. Equity market volatility was very elevated in the lead-up to the election and this enabled us to capture very favourable option pricing to exit. After the election, when it became clear a “blue wave” with Democrats controlling the House, Senate and Presidency was unlikely, volatility declined sharply and we re-entered a new S&P 500 put spread strategy for the first half of 2021. This provides us with some downside protection for a more moderate fall in equity markets in the first quarter of 2021.
Global bond markets were mixed, with the Australian market selling off slightly as 10-year yields increased moderately over the course of November. This is on the back of a positive macro environment, with strong employment figures, rising business and consumer confidence, and a rebounding housing market, in addition to the vaccine news. These factors offset the RBA’s quantitative easing program and a rate cut to 10 bps earlier in the month. Credit spreads were also buoyed by the news on vaccines, with spreads tightening across investment grade (IG), high yield (HY)and emerging market debt. Australian IG spreads ended the month at multi-year lows, while HY spreads on US corporates tightened by almost 100 bps for the month.
During November we made a few changes to our fixed income positions, though overall portfolio duration remains at 1.75 years. We’ve continued to sell down our Australian residential mortgage holdings, while also letting some of our Australian inflation-linked bond holdings mature, effectively reducing our positioning in some of our lower yielding and less liquid holdings. Instead, we have moving capital to catastrophe bonds, where we made an initial 2.5% allocation; this is an asset class where yields are typically in the 4%-5% range and are generally uncorrelated with the business cycle, thus providing diversification from corporate bonds. We also added to our holdings in securitised credit by 1.5%. In US treasuries, we closed the position that benefited from a steepening in the US yield curve, where longer dated maturities underperform shorter dated securities. This position tends to reduce the impact of long duration, which we want to maintain for downside protection.
The US dollar sold off during the month as a rally in commodities like iron ore, copper and oil meant that commodity currencies like the Australian dollar, Canadian dollar and Norwegian krone performed very well. Our overall foreign currency exposure remains unchanged, but we did switch some of our Japanese yen exposure into emerging market currencies. Nevertheless, we are still maintaining some USD and JPY exposure as a portfolio hedge as we expect them to perform well against the Australian dollar during periods of equity market stress.
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