Beware the ‘recency effect’ as the bull market draws to a close

A key premise behind the Real Return strategy is to disconnect investment returns and the risk around them from the equity cycle. That’s not to say we don’t want to take equity risk, but rather that we don’t want to be beholden to the equity cycle to determine the absolute quantum of our returns. Breadth of opportunity, structural flexibility, and the willingness to reflect the conclusions of our investment process in the portfolio with a focus on delivering a “5% real” target, as consistently as possible through time, our primary considerations.

We recognised at the outset that towards the end of an equity bull market, the ‘recency effect’ – an order of presentation effect that occurs when more recent information is better remembered and receives greater weight in forming judgement than does earlier presented information – would test investor resolve in the strategy. This is because investors give greater weight to the upswing in the market cycle and discount (or even forget) the downside – one of the fundamental problems objective-based strategies like ours were set up to solve. The fact that we’ve only seen half a cycle over the past 10 years, even if it is an elongated one, adds to the risk here.

To some extent this challenge is surfacing now. While 2018 was a rough year in markets, it has been quickly forgotten due to the rampant rally across asset markets broadly this year. The single biggest influence on markets has been central banks, particularly the US Federal Reserve, with its pivot on policy in January driving sovereign bond yields lower and equity markets higher as equity investors repriced earnings to a lower yield environment. Weakening economies amid trade wars and the lagged effect of 2018 rate hikes have been brushed aside in this new “bad is good” environment.

It is entirely possible that this trend may continue for some time (markets rallied on in 1998 after the US Fed cut rates following the collapse of LTCM despite extremely stretched valuations, not peaking for another two years). What appears clear is that central banks remain pivotal in fostering market confidence and encouraging risk-seeking behaviour among investors. Our recent focus has been on what may cause this nexus to break. While there is potentially a long and largely unknowable list of potential events, they broadly fall into three key areas: rising inflation, recession, or some sort of financial crisis (bank or systemic failure).

Currently, markets have dismissed the idea of inflation reasserting itself. We’re less prepared to dismiss inflation as a risk. The US labour market is relatively tight, fiscal policy is expansionary and we will soon again have lower rates and more QE. The lags may be longer than thought previously, but the preconditions are in place.

More likely though is the potential for recession to derail the party. While recession forecasting is problematic (to say the least) there are plenty of indicators suggesting the risks are building. The NY Fed’s own model (mainly based on the US yield curve) is flagging elevated risks in this regard. Earnings, which are more important for equity markets are currently holding up well, but factors that normally lead earnings (like global PMIs) are fading and the outlook looks more uncertain than it has for some time – and importantly, the gap between “bottom-up” forecasts and our “top-down” models looks large on a one to two-year view.

As for a systemic issue, there’s always this risk in an overleveraged and geo-politically charged world.

In reconciling this to the achievement of our objectives, we fall back to some key ideas:

• The risks to equities from here are somewhat asymmetric. Further gains are possible (particularly if yields continue to fall), but the cycle breaks as either economies or earnings falter or the nexus between central banks and asset prices breaks, then the downside could be much more significant.
• The timing is, as always, uncertain.
• We see ourselves as investors, which means making investments where the odds of success are stacked in our favour.

In practice this means the following:

• The level of risk in the portfolio remains modest and below what we’d deem to be an average level of risk. While we added risk through Q1, we’ve reduced this again as markets rallied in Q2
• Within equities, our preferences remain Australia and Japan (over the US)
• Within credit, we prefer higher quality to higher risk (more for income than capital gain)
• We’ve been adding (and are likely to continue to add) sovereign risk/duration on the basis that Central Banks are easing policy again and this also helps provide recession protection.

Equity

Equity markets posted solid gains in June and across the June quarter, but it was far from a smooth ride. For global markets, gains in April were reversed in May before rebounding strongly in June on renewed expectations about imminent central bank stimulus via lower official interest rates and additional QE. This capped off a solid six months for equities after a much more turbulent end to 2018.

The relationship between the business cycle and equity market performance has always been complicated and tenuous. In the current context however, the key linkage is what the business cycle means for monetary policy, and any sign of softer growth that fuels the case for lower rates and more QE has been met positively by investors across the board – but especially in equities. Bad news is good news has been the theme. Consistent with this, value as a style factor has continued to struggle. Growth and momentum continue to benefit from markets re-rating to higher multiples in search for yield as the interest rate ‘denominator’ continues to compress.

Significantly, while Australian equities lagged a little in June, they have been among the strongest performing markets so far this year, despite rising concerns about the macro-economy. Rate cuts and surging iron ore prices have clearly helped. Australia remains amongst our preferred markets and the US our least preferred.  

Fixed income

Sovereign bonds had a strong June, which capped off a strong quarter and a strong year. The Fed’s backflip on monetary policy at the beginning of the year, together with clear evidence of the US/China trade dispute hurting global production, trade, and growth, gave central banks almost universal support for lower official rates and the consideration of additional QE (especially in Europe). Rate cuts were delivered in Australia in June (and again in early July) for the first time in three years with cash rates in Australia now at record lows. While significant easing of monetary policy is now priced in global yield curves, in the current environment the risk to yields seems to remain skewed to the downside.

Credit has also performed strongly, benefiting from both lower yields and narrower credit spreads for similar reasons that have driven equities. Like equities, it wasn’t plain sailing over the quarter with a difficult May wedged in between strong April and June performances.

With spreads narrow and yields low, the upside potential is likely to be limited with ‘carry’ (ie income) broadly the ‘best-case’ outcome. Our preference is for good quality, investment grade credit but, like equities, we believe the risks are rising. Any deterioration in corporate profitability could be quite problematic for credit risk.

Currency

Shifting interest rate, growth and political risks have had some impact on currency markets in June and through the June quarter. Our positive, medium-term view on GBP has been impacted by the machinations around the UK Conservative Party’s leadership tussle and the rising rhetoric around the political acceptance of a potential ‘hard Brexit’. Our view holds, but the protracted uncertainty around what Brexit will look like isn’t helping in the near term.

The AUD has traded in a relatively narrow range, just south of 70 cents, ending June towards the upper end of this range. While near-term support is potentially coming from stronger iron ore prices and expectations of lower global rates, we hold to our view that the risks to the AUD are to the downside.

Largest Contributors

Sovereign bonds, credit and equity markets gained ground in both June and the June quarter, although the strong start and end to the quarter was punctuated by a weak May. Positive contributions to performance during both the month and quarter were widespread. Australian equities, global equities, global Australian corporate bonds, emerging market debt and Australian higher yielding credit were among the main positive contributors, with the debt assets capturing both narrower credit spreads and lower yields. Currencies were also a slight contributor to returns over both June and the quarter.

Largest Detractors

Unsurprisingly, there were few detractors at an asset allocation level in both June and over the quarter apart from some money “left on the table” through our equity and bond futures positioning where we have positioned the fund cautiously. Stock selection in large cap Australian equities and in the main QEP Global Blend strategy also detracted in both June, and over the quarter.

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