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After the GFC, investors generally had to chase greater risk to achieve targeted returns.
A lack of fiscal support from overly austere governments meant monetary policy had to take up the slack via non-conventional tools such as quantitative easing, says Pendal multi-asset PM Alan Polley.
“The resulting wall of money increased valuations, decreased prospective returns and risked asset bubbles,” says Alan. “But that’s now unwinding.”
Post-pandemic governments have realised monetary policy is out of bullets and fiscal policy needs to fire up again, he says.
“The transition to fiscal policy is good for investment returns, because governments will now do some of the work to bolster aggregate demand.
“There’s decent prospective returns for equities and bonds, and that now makes balanced funds more attractive.”
After 15 years of the ‘new normal’, the ‘old normal’ appears to be back as central banks return to the kind of conventional monetary policy not seen since before the GFC.
It’s potentially good for investors with a more positive outlook over the next decade, argues Pendal multi-asset PM Alan Polley.
But it may mean a reassessment of asset allocation. Faced with lower returns from bonds and equities, many investors pushed into small caps, high-yield credit, emerging markets and less liquid investments in recent years.
“Now investors need to ask themselves: do they need to chase risk when bonds have again yields of around five per cent, and equities have reasonable dividend yields,” says Alan.
“Investors should be thinking about leaning back into traditional asset classes, de-risking their portfolios and running a more ‘old normal’ portfolio for this ‘old normal’ environment.”
Aussie bonds are “somewhat unique in the world” right now, argues Pendal’s head of multi-asset Michael Blayney.
“Our 10-year bonds are yielding more than the cash rate – whereas most other major markets have a strongly inverted yield curve,” he says.
An inverted yield curve is when short-term rates are higher than long-term rates. It’s historically associated with expectations of an economic contraction.
The possibility of a slowdown in the global economy helps make the Aussie bond market look relatively attractive.
“In addition, markets are pricing in inflation in the US and Australia to come back under control, and Wednesday’s inflation print in the US was very encouraging, noting of course that it’s still likely we’ll see bumps along the way,” says Michael.
Investors should be taking the time now to review portfolios amid geopolitical tensions and economic uncertainty, says Pendal’s head of multi-asset, Michael Blayney.
Michael is neutral on bonds and slightly underweight equities, though he believes there are opportunities in both asset classes.
He also sees opportunities in real assets such as listed infrastructure and property.
A noticeable feature of the market response to the crisis in the Middle East is a lack of panic, he says.
“The human toll is tragic, but it hasn’t triggered great volatility in markets.
“So far, oil prices have risen but remain below last year’s peak.
“Bonds yields initially fell, but have since risen again. Equities – aside from a modest move down on Wednesday night – have been pretty relaxed.”
Commodities perform an important role in portfolio diversification.
They tend to be highly correlated with inflation and have a return distribution with a positive skew, meaning returns on the upside can be bigger than returns on the downside.
But commodities – typically metals, energy or agriculture materials – are often excluded by sustainable investors as ESG-unfriendly.
Pendal multi-asset PM Alan Polley argues it needn’t be that way.
A nuanced approach that weighs up the benefits and drawbacks of individual commodities can offer advantages over a simplistic commodity index approach or just negative screening, he says.
“Many buy the broad commodity index which has the fossil fuels and livestock and isn’t consistent with ESG.
“Others think ‘commodities are mining, and mining is bad’.
“But you have to think beyond that because the transition to net zero is materials and resources intensive.”
Got money in a global bond index fund? Pendal’s head of multi-asset Michael Blayney has a note of caution for you.
Indexing bond investments appeals to many investors because it’s a low-cost way of incorporating diversified, defensive assets into a portfolio.
But global bond index funds have a hidden risk that may undermine their role in providing stability and defensiveness in portfolios.
That’s because global bond indicies tend to allocate higher weightings to the most indebted countries, which is a fundamental flaw, argues Michael.
“In bonds, it’s how indebted you are that determines your weight. Essentially, we are lending more to the people that owe the most money.”
Global bond benchmarks could be overweight to countries like China, Italy and emerging markets that might not pass a quality screen.
Underperformance in some sustainable strategies may leave investors hesitant about ESG from time to time.
But research from Pendal’s multi-asset team suggests ESG investment risks can be quantified and mitigated – and in the long run, a sustainable approach is likely to outperform.
“Investing sustainably is the right choice in the long term,” argues Michael Blayney, who leads Pendal’s multi-asset team.
“But investors need to understand how much and for how long their performance could differ from unscreened portfolios – and be comfortable with that,” he says.
Pendal quantifies the level of risk inherent to ESG portfolios by comparing the tracking error of representative ESG indexes with unscreened indexes over eight years.
Tracking error is a measure of how closely a managed fund tracks its benchmark index.
The data suggests ESG funds deliver “something like half the risk you would get from an active manager, simply from negative screening”.
Investing in “real assets” – tangible things such as roads and office buildings – provides diversification and in some case a hedge against inflation.
But complexity and lower liquidity can put off some investors.
“Investing in infrastructure is complex because it depends on a range of variables like the type of asset, the regulatory regime, how it is structured and financed, and to what extent income is inflation-linked,” says Michael Blayney, Pendal’s head of multi-asset.
But that diversity allows investors to design portfolios that better suit their needs, argues Michael.
Pendal’s multi-asset team focuses on infrastructure assets that are directly or indirectly linked to inflation, have low sensitivity (or beta) to equities and have a better environmental footprint.
Interest rates may be nearing their peak, but investors will need to manage the impact in their portfolios for the next few years, says our head of multi-asset Michael Blayney.
“Increases in interest rates usually flow through to the real economy and corporate earnings with a one-to-two-year lag,” says Michael.
“As such there may still be more negative “surprises” to come – and at least an elevated risk of recession in the second half of 2023.”
What does that mean for portfolio construction and asset allocation?
“We are slightly bearish on equities, neutral on government bonds, slightly negative on credit, but selectively positive on listed real assets.
“Global equity market valuations are broadly reasonable, and risks to financial stability appear to be contained for now.”
The first half of 2023 surprised markets with better-than-expected economic conditions.
But a key model used by Pendal’s multi-asset team is now signalling that rate rises are starting to bite the services side of the economy.
“Our economic cycle model has pretty much got it right up to this point,” says Pendal multi-asset PM Alan Polley. “Now it’s turning negative.
“That makes us more cautious on the second half of this year, so we’re slightly underweight equities in response.”
Pendal’s economic cycle model analyses the level and rate of change of economic indicators such as consumer and business surveys, while also examining how economic data surprises either positively or negatively.
The model is one of three key indicators that inform the team’s active asset allocation process – alongside a valuation model and a model that analyses market trends – and has a long-term track record of picking turning points in the economic cycle.
No matter your opinion on climate change, there’s no doubt we’re undergoing an energy transition – a global shift away from fossil-based energy to renewable sources. The evidence is in renewable power growth, electric car adoption, regulatory and policy change, public sentiment – and yes, investment trends.
There are two main reasons an investor might show interest in the energy transition: aligning a portfolio with their values and making money. And it’s not just about identifying innovative companies with strong pricing power and a growing addressable market, Michael says. Sustainable investors must also “participate across multiple asset classes as part of a broader diversified portfolio”.
That might include infrastructure or sustainable bonds for example. “Just like you don’t put all your money into one asset class, investors shouldn’t put their whole portfolio into one thematic or indeed access a large thematic via only one asset class.”
The strength of global equities continues to surprise as we near the halfway mark of 2023 – but some markets make more sense than others.
Pendal’s head of multi-asset Michael Blayney is cautious on the mega-tech-driven Wall Street rally.
“The US remains one of our less-preferred markets given stretched valuations and the heightened risk of recession,” he says.
“AI is clearly an important thematic for the next decade, but markets have a habit of getting overly exuberant in the short term when a new theme emerges – and this appears to be one of those occasions.”
Michael prefers Japan, which is up some 20 per cent this year, compared to 1 per cent for the S&P/ASX200.
“We’ve liked and been overweight Japan for some time. Japanese companies have been more profitable recently and are relatively under-leveraged, putting them in a better position as rates rise.”
Overall Pendal’s multi-asset team is “marginally underweight equities and close to neutral on bonds, while holding a little more cash and liquid alternatives, which also gives some exposure to inflation hedging assets”.
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