Pausing for breath

September was a tough month for investors and a timely reminder that markets don’t always go up. It was a bit of a shock to the system after 11 consecutive months of gains for the Australian equity market. The relatively modest pullback in September can be linked to several factors, ranging from concerns around Chinese property (Evergrande, more on that below), the pending renegotiation of the US debt ceiling, the US Federal Reserve’s considerations for policy tapering, moderating global growth following a stimulus-laden bounce back and, in Australia’s case, sharp declines in the iron ore prices and extended lockdowns in the key eastern states of Victoria and NSW.

A pause after such a strong run is not unusual and is arguably welcome, particularly to the extent that we see a more balanced view of risk reflected in pricing. The critical question is where to from here, and whether the factors coinciding with this modest pullback become more endemic forcing a broader de-rating of asset prices.

The pessimistic scenario

The bear case for risk assets from here is relatively easy to make – bear cases often are, but in the brave new world of heavy intervention by policymakers in financial markets, they are also often wrong. That said, there are some sound reasons to be cautious.

Firstly, valuations in both equity and credit markets are relatively demanding, notwithstanding the fact that the strong recovery in profits has seen many equity markets grow into their multiples. However even optimistic profit forecasts leave multiples in key markets like the US stretched by historic standards and therefore vulnerable. At a sectoral level, growth stocks (largely technology related) require unrealistic growth ad-infinitum and are suffering disproportionately as growth momentum moderates.

Secondly, the concerns about Evergrande (the large Chinese property developer) bring to the surface an issue that’s been largely brushed aside in recent years – namely, debt. Evergrande has too much debt, can’t service it and needs to be bailed out. This will probably happen as it’s too big and too indebted to fail fully, so some form of bailout by the Chinese government seems likely. However, this is not unlike the US government which will also be bailed out soon (by an extension of the US debt ceiling and a complicit US Federal Reserve).

Finally, this highlights why the risk of inflation is important and why the market is worried about tapering. The reality is that the Fed can’t afford to taper in any way other than moderately and gently. If a structural rise in inflation forces their hand, then it may be difficult for them to engineer a modest and gentle tapering without markets overreacting. There’s too much debt for interest rates to rise too far.

We’re more optimistic

The more constructive case (and in fact our base case) is that the broader confluence of ongoing global economic recovery, which is supported by central banks that are unwilling to disrupt the economic recovery process (or capital markets) by aggressively tightening policy, will continue to provide a tailwind to asset prices. The most likely beneficiary in this environment will be equities. This is partly because profits are likely to grow, alleviating pressure on valuations and offering some upside to investors. This upside can, and will, likely come through both broader earnings growth but also rotation away from the expensive “growth” stocks, to those more likely to benefit from ongoing re-opening. This is in contrast to credit markets, where the rally of the past 18 months has suppressed both credit spreads and yields offering limited further upside potential. Given these low yields, credit markets offer little safety margin and face  significant downside should the cycle turn or the bear factors outlined above permeate through. Reflecting both a moderate pullback in equities generally, and strong profit growth, our forecasts for equity returns have improved moderately in absolute terms, but particularly compared to cash, sovereign bonds and credit.

Our portfolio

The strategy we’ve followed over the past 18 months has been to be both a cautious participant in the recovery in risk assets, but to also shift risk away from assets offering very  suppressed yields (RMBS, sovereign bonds and even investment grade credit) into higher yielding and diversifying assets which still offered a risk premium. This strategy has been a positive contributor to performance – particularly in September when strategies such as private debt and direct commercial lending, insurance-linked securities and commodities all contributed positively while more corporate related exposures moderated. That said, we are re-evaluating this strategy following the broader rally in asset prices and have made some adjustments to positioning and expect to make more.

Consistent with the arguments above, the most notable change is that we have effectively sold out of global high yield credit on the basis that low yields and narrow spreads means it offers only moderate yields with limited upside but significant downside. For similar reasons we have also sold down our emerging market hard currency debt positions. Some of this risk has been allocated to equities, but we’ve held some back pending the potential for further volatility in equity markets and a preference to add equities on any re-pricing. At the margin we’ve added a small amount of duration (+0.25 years) and added modestly to our USD position to help protect should the downside risks eventuate. We’re continuing to actively manage our option positions looking for low-cost downside protection, but have also implement an option strategy that gains exposure to a rebound in equities.

A position we’ve noted previously is our exposure to Asian credit through the Schroder ISF Asian Credit Opportunities Fund. Importantly this strategy has no exposure to Evergrande but with some contagion to Asian credit more broadly, credit spreads have moved higher. While not without risk given the precarious situation of the Chinese property sector, from a valuation perspective this exposure continues to look attractive, and we are holding firm on our position here.

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