Portfolio roadmap for smarter, longer-term investors
During every one of the 15 recessions since 1950, bonds have returned more than either shares or cash. Even in the “late” economic expansion period prior to the recession, bonds and shares have achieved around the same returns overall. And there is widespread opinion that we are either late stage or even already heading into the end of the cycle.
So it is no surprise that right now one of the leading questions we get is how to invest when conditions are less certain. Here we’ve looked at what investors could or should do if they have a view that we are at the back end of the economic cycle, particularly if they are worried that we are heading into a recession.
Global institutions say shift into corporate bonds and safer currencies
We’ve looked at what the best of the global research houses have said. But we’ve also, more importantly in our view, looked at the “why” they have said this. To this end, ultimately two themes are common regardless of the researchers:
- They all believe that we are at the back end of the economic cycle, so earnings will be less certain, meaning equities will become more volatile; and
- Smart investors should shift from equities to higher quality bonds.
Where the differences lay:
- Is High Yield paying enough? Some say yes and favour High Yield over Investment Grade; others say no and hold the opposite view.
- Currency: While most favour the USD, the reasons vary from a stronger US economy to the more benign “everyone else is doing poorly”.
For Aussie investors, there is a more selective risk at play: China. Globally, only one of our institutions is backing China (Wellington Management). In our next paper we look more specifically at this risk, but in short, the China-related risks are much higher for Aussie investors than for others around the world, simply because China’s economic health directly impacts Australia’s.
Global Researchers Views*:
| Strategy recommended | Assets recommended | Use this strategy if you have the view that…. |
| Increase duration | Bonds with longer dated maturities | …central banks will go too far and leave rates too high for longer, pushing us into a recession, rates will fall further and harder than expected, and anyone holding longer-dated maturities will be left better off than everyone else. |
| Look for excess yield on High Yield | High Yield assets (bonds and equities) paying higher than expected income | …volatility will be higher and higher volatility also means a greater chance of finding excess returns. |
| Reduce exposure to geopolitical risk | Reduce exposure to trade income and increase inflation hedges | …geopolitical risk is rising. This means a rising risk of trade deglobalisation and therefore risk in inflation risk and rise in economic volatility. Driven by the shift to economic protectionism (US, UK, EU and China) and more radical, inherently less global views. |
| Reduce exposure to earnings uncertainty | Shift overall allocation back toward cashflow certainty (toward bonds and away from equities and cash)
|
…we are in the late part of the economic cycle. This is the time that earnings uncertainty rises and directly impacts equities returns. Similarly, inflation uncertainty rises, impacting cash’s real returns – if inflation risk (uncertainty) is higher, the risk rises that purchasing power actually goes backwards.
See this note on infrastructure sector for an example of a sector with lower economic correlation. |
| Look for opportunities in curve shape | Buy bonds at higher yield points on the curve (or back fund managers with these skills) | …the unusual global conditions mean that the yield curve is also going to follow an unusual path. Fund managers will often use more complicated strategies than individuals can/will, e.g. they can trade volatility using options or they can deploy long/short credit strategies. |
| Currencies matter | Currency is not just an investment, it also relates to liabilities | …you have an exposure to a lower AUD. If anything, more than 10-20% of your income needs relate to spending in other countries and if the AUD were to fall, the cost of that spending would rise. So for most of our clients, some investments should be in non-AUD currencies to protect some of their wealth from this fall. The consensus from our global brokers is currently that the USD should be backed over the JPY, EUR and GBP. |
*Best of the brokers reviewed:
– LGIM, Expecting risk assets to underperform over the medium term; favouring bonds, particularly those with duration, and high yield over investment grade due to value. Favouring the USD over other currencies.
– JPMorgan: Favouring corporate bonds over equities due to the favourable carry of bonds; Investment Grade over High Yield on the relative value of IG; favouring USD and Yen over others
– Wellington Management: Underweight equities and growth fixed income; overweight defensive fixed income, with a view that a recession might be looming. The shift toward more geopolitical risk in the major economies increases inflation risk. Interestingly, they remain overweight China and commodities, particularly copper and gold.
– Vanguard (no active management bias): Vanguard is one of the few institutions to have a specific Australian view. At just over 50%, that view shows a higher recession risk than any time other than that the mid-1970s (at nearly 100%) and early-1980s (at 65%).
– Blackrock: Shift equities to Japan; lower economic growth for longer and Emerging Market bonds (in USD) are the key themes for Blackrock, and they are the only one of our institutions with these themes as the headlines. They also back AI heavily, which is also unique.
Uncertainty is the key theme
At this point of the economic cycle, uncertainty undoubtedly drives excess returns. Equity markets will likely continue upwards, but volatility will also rise. In practice this means that markets will test new records, but the falls will get bigger until the penultimate market correction. The further we rise, the bigger that correction could be.
Right now, the uncertainty of global economic risk is very high for all investors. And this is particularly true for Australian investors. As Australian investors we face the same global risks, but we also face Australia-specific risks, namely China’s economic headwinds. Much like Japan’s fall from grace starting in the 1990s, China now faces unprecedented economic challenges stemming from its once-powerhouse property sector.
If these challenges play out as poorly in China as they did in Japan, they could see a severe downturn in global commodity prices and therefore hurt Australia’s mining sector directly, but also hurt the broader, non-mining economies in WA and Qld.
That leads us to another conclusion not specified by the global researchers. These will be covered in more detail in a separate note along with strategies for dealing with the specific risks presented by China.
Conclusion for Aussie investors: The smarter path
This all means that Australian investors face more uncertainty than they have for more than 25 years. The answers to how best to navigate your portfolio through this time depend upon your own views on some of the issues covered above, but the consideration set should at least include:
- Consider de-risking by shifting to higher quality assets
This could mean shifting from lower to higher quality equities; from lower to higher quality bonds; or from equities to bonds. For most Australians, this will mean a shift from high growth sectors like mining and highly correlated sectors like REITs (LPTs), and a shift into more predictable sources of income and returns such as corporate bonds. - Deleverage by overweighting sectors with ‘low correlation’
Continuing with the above strategy, some sectors of the economy have a lower correlation to the overall economy for some very predictable reasons. Non-discretionary sectors like infrastructure assets, childcare and health assets, and financial services (so long as well diversified) are a great example of these. These sectors can come in a large range of returns, including some that are inflation-linked, offering some added wealth protection benefits. - Take advantage of the higher volatility and look for value
The smarter strategy in uncertain times does not have to mean lower returns. One can de-risk and deleverage per the above, but still target the same overall portfolio returns. One strategy that supports this is to look for higher return value e.g. equity or debt offered at lower prices simply because the market is tougher for companies overall. This higher volatility for prices usually means better value for investors with liquidity, and this should be taken advantage of. This should also include a shift in risk from highly correlated or China-exposed sectors to sectors with more predictable earnings, such as infrastructure.
Corporate Bond examples that suit this strategy^
| Issuer | CCY | Sector | Payment Rank | Coupon Type |
Coupon Formula | Current Coupon |
Rating (S&P, FITCH, MOODY) |
Call Date | Maturity Date |
Yield | Margin (TM/ASW) |
Running Yield |
Clean Price |
| AIRSERVICES AUSTRALIA | AUD | Government | Sr Unsecured |
FIXED | 6.000% | 6.000% | AAA,N/A,N/A | 15-Aug-32 | 15-Nov-32 | 5.500% | 0.674% | 5.800% | 103.450 |
| FINEXIA SECURITIES LTD | AUD | Financial | Secured | FLOATING | BBSW3M +6.500% | 10.140% | N/A,N/A,N/A | 29-Sep-26 | 23-Sep-27 | 10.987% | 6.500% | 10.140% | 100.000 |
| LLOYDS BANKING GROUP PLC | AUD | Financial | Subordinated | FIXED | 7.086% | 7.086% | BBB-,BBB+,Baa1 | 31-Aug-28 | 31-Aug-33 | 7.008% | 2.436% | 7.065% | 100.300 |
| MDPRO 1 A | AUD | Asset Backed Securities | Secured | FLOATING | BBSW1M +6.000% | 10.052% | N/A,N/A,N/A | None | 10-Oct-25 | 10.214% | 5.712% | 10.001% | 100.500 |
| TRANSURBAN QLD FINANCE | AUD | Consumer, Non-cyclical | Secured | FIXED | 6.350% | 6.350% | BBB,N/A,N/A | 02-Feb-30 | 02-May-30 | 6.107% | 1.444% | 6.272% | 101.250 |
* Yields for floating rate notes are a guide only. Returns are subject to movements in BBSW over the life of the issue.
** Yields for Tier 1 and Subordinated Debt (Tier 2) are priced to the call date.
*** Returns and pricing shown are indicative and reflect wholesale market pricing plus Income Asset Management’s bid/offer spread
Craig Swanger,
Chief Investment Officer, IAM
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IAM Capital Markets Limited (AFSL 283119) (‘IAM Capital Markets’) is a financial service business and provides general financial product advice only. As a result, this article has been provided without taking account of your objectives, financial situation, and needs. You should, before acting, consider the appropriateness of the advice, having regard to your objectives, financial situation, and needs. The article is not intended to be a recommendation, offer or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decisions in respect to a financial product, you should obtain and consider the product disclosure statement or documents relating to the product and seek independent and specific advice from an appropriately qualified professional. IAM Capital Markets does not express any opinion on the future or expected value of any financial product and does not explicitly or implicitly recommend or suggest an investment strategy of any kind. The article has been prepared based on available data to which IAM Capital Markets have access. Neither the accuracy of that data nor the research methodology used to produce the article can be or is guaranteed or warranted. Some of the research used to create the article is based on past performance. Past performance is not an indicator of future performance. The data generated by the research in the article is based on research methodology that has limitations; and some of the information in the article is based on information from third parties. IAM Capital Markets does not guarantee the currency of the article. If you would like to assess the currency, you should compare the article with more recent characteristics and performance of the assets mentioned within it. Neither IAM Capital Markets, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of any information in the article. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, any information or advice in the article. IAM Capital Markets, its staff and related parties earn fees and revenue from dealing in the securities as principal or otherwise and may have an interest in any securities mentioned. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). IAM Capital Markets does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of the IAM Capital Markets directors, authorised representatives, employees, or agents. IAM Capital Markets does not make a market in the securities or products that may be mentioned.
^An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all an investor’s capital when compared to bank deposits. Any forecasts are predictive in character and based on specified assumptions generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. IAM Capital Markets may quote to you an estimated yield when you purchase a bond. This yield may be calculated by IAM Capital Markets on either A) a yield to maturity date basis; or B) a yield to early redemption date basis. Some bond issuances include multiple early redemption dates and prices, therefore the realised yield earned by you on the bond may differ from the yield estimated or quoted by IAM at the time of your purchase.
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