Yield plays show their sensitive side
One thematic that played out in October was the unravelling of the support for “bond” or “yield” proxy investments such as A-REITs, utilities, infrastructure and health care stocks against what is still a relatively modest rise in bond yields and a modest reassessment of the risks around inflation (globally) and central-bank policy. To be clear, the shift in thinking around the broader policy environment is important, even if marginal, due to the extent to which the policy backdrop has supported asset prices. It also highlights how sensitive many of these assets can be to small shifts. There are many “temporary” investors in these assets, temporary in the sense that they’re not long-term holders. However, they have bought the yield story against a low-yield global environment but they are acutely sensitive to the capital volatility that may come with it. To give some idea of the sensitivity, Australian 10-year bond yields have risen by about 0.5% since early September, while A-REITs have fallen by over 15% since early August – more than a correction, but still only back to levels of February this year. Our valuation models are still flashing red and it would likely take another fall of this magnitude to get us interested in these assets.
The flip side of the unravelling of the bond proxy story was the recovery in the resource sector. During October, the S&P/ASX 200 Resource index posted gains of 1.2%, well ahead of the losses of 6.4% (average of S&P/ASX 200 utilities, healthcare and A-REIT sectors) in the defensive sectors. This recovery is something we have been positioned for, from a stock selection point of view within the active Australian equity portfolio as well as through a short A-REIT futures position against the broader market, and through the more recent addition of a long resource futures position (again against the broader market). Netting these trades effectively takes us long resources and short A-REITs.
Outlook and strategy
The issues reflected in the above comments have been brewing for some time. Investors have piled into yield proxy assets as a response to the low- or no-yield environment and are ignoring (at least temporarily) the risks involved in these investments. For a long time now we’ve highlighted these risks and responded by holding an elevated (by most objective standards) cash weighting within the portfolio. We accept that returns on cash are below our objective but note the heightened risk around owning overpriced and under-rewarded assets. The reality, though, is that by and large holding cash over equities has been the right strategy – at least over the past 18 months where vanilla, Australian cash has outperformed Australian equities (including dividends) and been line ball with US equities. The latter have essentially flat-lined in price terms since early 2015 (notwithstanding the significant volatility in equities and risk assets more broadly through the later part of last year and early this year). While investors may have been able to take some advantage of the volatility, long-term strategic holders of equities have not been rewarded for this additional uncertainty.
We do not expect that our cash weighting will be elevated indefinitely – albeit it has been for a while – but corresponding to the extreme distortions in risk pricing facilitated by central-bank policy experimentation. That said, until such time as risk pricing changes – and the moves we’ve seen in A-REITs are only modest in the context of how far these have run – we don’t anticipate it will be changing materially soon. Sure there are many potential volatility catalysts (the US election outcome being one) but until either high rates reset risk premium or recession sees risk asset prices fall, we will remain cautious.
Reflecting this theme, we have begun to reduce our exposure to risk again, but this time through our global high-yield debt exposure. Global high-yield spreads widened significantly through the later part of 2015 and early 2016, offering attractive prospective returns and, with spreads so wide, relatively low risk. However, much of this attractiveness has been realised as spreads have narrowed materially. While there is still some potential for spreads to narrow further, the risks are becoming more asymmetric (limited upside, potentially greater downside).
Adding to the case to remain cautious on risk is the steady upward trend in US inflation (still modest but nonetheless trending up). On the back of this we have modestly trimmed duration (another 0.1 years) and added a US inflation breakeven trade which should pay off should inflation trend higher.
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