Dear Advisers and Investors,
The great investor Sir John Templeton once said, “The four most expensive words in the English language are ‘This time it’s different.’”
People usually say, “This time is different” to justify highly questionable investment ideas. There was plenty of this kind of language during the late 1990s “Internet bubble” era as spruikers explained why it made sense to invest in companies trading at astronomical valuations despite burning cash and having little-to-no prospect of ever delivering a profit.
With that context, I hope you’ll bear with me when I say that “This time really is different!”
How can I justify those words? There are several reasons.
To begin — it’s been more than a century since we had a global pandemic. The Spanish Flu of 1918 was the last health menace that wrought widespread suffering and havoc.
Admittedly, the loss of life from COVID-19 is not comparable to the estimated 500 million infections worldwide, and an estimated 50 million lives lost from Spanish Flu,1 but the social and economic stresses caused by the current pandemic are beyond what any of us have experienced in our lifetimes.
We also appear to be inching towards deglobalisation. This is potentially a sea-change.
Globalisation has arguably been the defining feature of the past four decades as people, capital, products, and even cultural practices have moved around the planet. The idea of sourcing goods and services from the lowest cost supplier, irrespective of location, has become accepted as normal and natural.
However, COVID-19 has exposed vulnerabilities with reliance on global supply chains, especially those centred on China, for everything from medical equipment and protective clothing to industrial and consumer goods. Countries may now emphasise security-of-supply over lowest cost sourcing by “on-shoring” production of what are deemed “essentials” like pharmaceuticals and related products, at least.
The shift could be described as transitioning from “just in time” to “just in case”. That said, the price of safety may be higher costs and that means higher inflation, down the track. Investors, economists, and policy makers have been on the lookout for signs of inflation over the past few decades and not found it. We might find it again, if we do deglobalise.
Finally, there is the possibility of deconsumption, as people may prioritise saving over spending, including assuming ever higher debts.
Consumption, people’s spending, typically accounts for more than 60% of Gross Domestic Product in wealthy countries like Australia and the United States. However, the shock of the COVID-19 crisis may cause us to become more permanently cautious and instead save “for a rainy day.”
If this happens, future economic growth rates could be lower, and the mix of winning and losing companies and industries would likely be different from today. In Australia, assumptions of strong house price growth would need to be revisited with large ramifications for future wealth expectations.
More could be added to the list, but it provides a sample of the themes and risks investment professionals will have to address going forward. They also mean that successfully managing clients’ portfolios requires far deeper thinking than just trying to work out whether economies will return to normal next year or the year after.
As investment professionals, we need to guard against the danger of becoming so consumed with issues immediately in front of us that we fail to pay enough attention to what’s around the corner, which could have even more profound long-term implications for clients.
“Financial repression” is undermining traditional diversification
Protecting clients’ portfolios against market volatility is a perennial issue for investment managers. Traditionally, we’ve done so through diversification — mixing “risk assets” like shares, with “defensive assets” like government bonds.
Unfortunately, “financial repression” brought about by central bank policies have compromised the capacity of defensive assets, such as government bonds, to protect portfolios. Ultra-low interest rates and quantitative easing (QE),2 has squashed defensive assets’ return potential.
Consequently, investors are being compelled to go further along the risk curve in the search for decent sized returns and to achieve diversification.
The prices of “risk-free” or near risk-free assets like government bonds, (and even investment grade corporate bonds), have become so steep that, all else being equal, the relative attractiveness of more risky assets (like shares) have improved. “Equity Risk Premium (ERP)” is the term for describing the attractiveness of shares versus other assets.
Right now, the ERP is about as attractive as it has been over most of the past 12 years, a remarkable situation given the decade-long post GFC bull market. But having shares as the only game in town isn’t a good thing.
Shares are a valuable part of a diversified portfolio, but can’t be the only asset class in a portfolio, especially as share prices relative to their earnings, across many share markets, are steep by historic measures. So, with the usual suspects like bonds less able to fulfil their traditional defensive and diversifying roles, how can investors get some protection into their portfolios?
Required to reimagine diversification
Despite diversification being compromised, responsible investors can’t give up on it. Rather, it needs to be pursued in different ways. Currently our portfolios, while well-diversified across many different assets, have a barbell-like risk profile. Risk is concentrated at either end of the spectrum — cash-like assets at one end and developed market shares at the other end.
One of the things we’ve been doing has been to selectively take profits on strongly performing stocks in Australian and global shares. We seek defensiveness in stocks not through style bias but rather by giving portfolio managers the freedom to control risk in the best way they see fit.
One example being our proprietary defensive Australian shares strategy where the Australian shares portfolio manager uses put and call options3 to manage portfolio risk. By trading away some of the upside in exchange for downside protection on stocks or sectors that may be at risk, we end up with a more predictable return path. This type of defence makes sense in an environment of uncertainty.
We’re also using currency defensively. Historically the Australian dollar (AUD) and global shares have been positively correlated (they move together in the same direction), providing the opportunity for investors to play defence by holding offshore assets in less risky currencies like the US dollar or Japanese yen. The defensiveness works through the offshore currency outperforming the AUD, so if share markets fall, the value of the foreign shares falls less in AUD terms.
Given the limited government bond return outlook, we continue to search for other assets that might protect investors in a scenario where the economic growth outlook remains downbeat and where interest rates may possibly go even lower. We think gold may have a role to play in such a situation, especially as central banks appear determined to supress interest rates by keeping them below the inflation rate.
It seems counterintuitive, but “volatility” can also play a defensive and diversifying role because volatility rises when share markets fall sharply. We had exposure to volatility, through derivatives strategies, in our portfolios during the March quarter sell-off and it was helpful in offsetting some of the losses from share exposures at the time. Derivatives strategies that invest in volatility can deliver investors the protection trade-off required in today’s complicated investment climate.
Diversification across many dimensions has been an MLC investment bedrock that has served our clients’ through changing market environments, including dramatic ones since 1985. We believe that we’re on the right path with our reimagined approach to diversification and have high conviction that it will enable your portfolios to participate in rising markets and cushion them during market falls.
Chief Investment Officer, MLC Asset Management
1 1918 Pandemic (H1N1 virus). Centres for Disease Control and Prevention. https://www.cdc.gov/flu/pandemic-resources/1918-pandemic-h1n1.html. Accessed 28 July 2020.
2 QE, as it’s generally referred to, is form of unconventional monetary policy in which a central bank, such as the US Federal Reserve, Bank of Japan, European Central Bank, buys assets such as government bonds from the open market to inject money into the economy.
3 If you buy an options contract, it grants you the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. A put option is bought if investor expects the price of the underlying asset, such as a share, to fall within a certain time frame. A call option is bought if an investor expects the price of the underlying asset, such as a share, to rise within a certain time frame. Because of this, options are used for hedging purposes to manage risks.
This information is provided by MLC Investments Limited, ABN 30 002 641 661 AFSL 230705 and NULIS Nominees (Australia) Limited (ABN 80 008 515 633, AFSL 236465), together “MLC” or “we”. We are members of the group of companies comprised National Australia Bank Limited, its related companies, associated entities and any officer, employee, agent, adviser or contractor (“NAB Group”). An investment in any product or service offered by a member company of the NAB Group does not represent a deposit with or a liability of the NAB or any NAB Group member. NAB does not guarantee or otherwise accept any liability in respect of any financial product referred to in this communication.
This information included in this communication is general in nature. It has been prepared without taking account of an investor’s objectives, financial situation or needs and because of that an investor should, before acting on the advice, consider the appropriateness of the advice having regard to their personal objectives, financial situation and needs.
Any opinions expressed in this presentation constitute our judgement at the time of issue and are subject to change. We believe that the information contained in this presentation is correct and that any estimates, opinions, conclusions or recommendations are reasonably held or made at the time of compilation. However, no warranty is made as to their accuracy or reliability (which may change without notice) or other information contained in this presentation.