Download a printable pdf of this CIO market update.
||3 Years p.a.
||5 Years p.a.
|Australian Shares (ASX 300)Capital Stable
|US Shares (S&P 500)
|Asian Shares (MSCI Asia)
|Australian Dollar (AUD/USD)
|Australian Fixed Interest (UBSA Composite)
|Cash (UBSA Bank Bill)
Returns are for periods to 30 September 2012.
Past performance is not an indication of future performance.
“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”
Ben Bernanke, Chairman of the US Federal Reserve, September 13, 2012
Given that central bankers typically pride themselves on being sober enough to take away the punch bowl before the party gets too wild, the above statement from no less than the Chairman of the Fed is quite extraordinary. With such an accommodative stance from the Fed, and no nasty shocks from Europe or China, September saw a continuation of positive market returns. The Australian market recovered from weakness experienced earlier in the month on the back of stabilising commodity prices, particularly iron ore. On 3 October the Australian market received a further fillip when the RBA announced a 0.25% cut in the official cash rate. While the cut took many economists by surprise it was largely expected by the market which is currently factoring another 0.75% in cuts over the next nine months. Notwithstanding the current positive tone to the market, attention remains firmly on China where growth is not picking up as fast as many would like to see. The base case for China remains “soft landing”, although the ranks of the “hard landing” camp are certainly increasing. Suffice to say that no amount of monetary easing by the RBA would offset a hard landing scenario in China.
As an indication of the strength of markets over the past 12 months, all of UniSuper’s investment options with at least 12 months’ investment history, apart from (the more defensive) Cash and Australian Bond options, have recorded double digit returns. Visit our Options and Performance page for performance information on all options.
Against a backdrop of lower global growth expectations, and seemingly endless amounts of bad news from Europe, the strong market returns over the past 12 months appears paradoxical. Such an outcome, however, should serve as a good investment lesson. The correlation between economic growth and asset prices is often non-existent in the short term, and often tenuous even in the long term. Hence the reason why successful investors don’t just look at the economic fundamentals – they look at the financial fundamentals, which is basically the difference between value and price. Indeed Warren Buffett insists that, rather than looking at macroeconomic forecasts when deciding on what stocks to buy, he focuses on the fundamentals of the company and whether or not those fundamentals are properly reflected in the share price.
Accordingly, one can infer that the markets have managed to rally over the past year against poor economic data, because the market was previously factoring in even worse economic data and financial conditions. Furthermore, markets are still factoring in very subdued growth and valuations remain below historical averages. If the global economy does not get any worse, and financial conditions remain accommodative, there is no reason why the markets cannot at least hold the recent gains. Any surprises to the upside could fuel a further rally in asset prices.
Despite the relative calm we have experienced over the past few months, a massive amount of money continues to be allocated to bonds as many investors remain convinced that another major shock is just around the corner. They could well be right, and the level of sovereign debt in major countries certainly weakens the global economy’s immune system. However, whether or not bonds will prove to be the best defence remains to be seen, and the following section picks up on this topic.
Buyer Beware: Bonds may not be as defensive as you think
Over the past three years the best performing Option in UniSuper has been the Australian Bond option with an after tax return of 7.5%. This compares to 5.2% for the Balanced option, 4.1% for the Cash option, and a paltry 1.5% for the Australian Shares option. The Australian Bond option predominantly invests in securities issued or guaranteed by the Australian (Federal and State) Governments, and cash. Such assets are considered to be “defensive” (indeed considered risk-free by some) in nature given that interest is paid, and 100% of the principal invested will be returned on the maturity date of the security.
The outperformance of the Bond option has been driven by the fall in yields (and rise in prices) as inflationary expectations have declined, official cash rates have been cut, and the general flight to safety given the volatile global macroeconomic backdrop.
We are now at a point where sovereign bond yields around the world are at unprecedented levels. You may be astonished to know that:
- in Holland, 10 year yields hit their lowest in 495 years (the longest any historical data extends),
- 10 year US Treasury yields are the lowest since 1790, and
- official base rates in the UK are at the lowest since the Bank of England’s inception in 1694.
The rally in bond prices and unprecedented low yields on offer has not dissuaded many commentators from continuing to recommend greater allocations to bonds in portfolios, as the best protection against economic shocks. The May CIO Market Update discussed the merits of equities versus bonds, and in that report we argued that the only truly defensive asset class is cash. The following attempts to explain why bonds are not as defensive as some may think.
An investor buying an Australian 10 year Government bond today would earn a yield to maturity of about 3%. Therefore, the investment can indeed be seen as “defensive” because the investor is guaranteed to receive a 1.5% coupon every six months, and 100% of the principal in 10 years’ time. However, the defensiveness of such an investment becomes very questionable under certain scenarios, and the following two in particular come to mind:
1. The coupon of 3% per annum, which should be a reliable source of income, is not adjusted for changes to the inflation rate. In a low inflation environment as we are in now, this may not appear to pose any problem. However, if over the course of 10 years inflation increases, the real value of the coupons will decrease. If real income generated by an asset becomes substantially eroded by inflation, the asset could hardly qualify as defensive.
2. The return of 100% of the principal invested is indeed guaranteed, but only if the bond is held to maturity, and 10 years can be a long time. Personal circumstances can change a lot over 10 years and investments may need to be liquidated to provide cash flow. In such circumstances the bond investor, upon selling the bonds, will receive an amount which may be significantly different (higher or lower) than the initial principal invested. The actual amount will depend on market yields at the time, and by way of example, assume that the investor holds the bond for three years, so it has seven years to maturity. Also, assume that market yields have risen from 3% to 6% (which happens to be the average for Australian bonds over the decade prior to the GFC). If the investor had to sell the bond the amount received will be around 83% of the original principal – a defensive asset should not lose 17% of its capital value!
The above example uses a single bond to illustrate the concept that, under certain circumstances, bonds may not prove to be as defensive as investors believe or desire. Of course the UniSuper Australian Bond option invests in many different bonds with various yields, coupons, and maturities. However the same principles apply. While UniSuper is a medium to long-term investor, the Bond option is “marked-to-market” on a daily basis which means each bond is effectively valued according to what the market would actually pay for them if we wanted to sell. This is the only way we can provide a fair outcome to all members in the option, because at any given time some members will be joining the option and others will be redeeming, and we need to process these transactions at a fair market price. However, the downside to ensuring fairness is that the capital value of the option will fluctuate. And as we have consistently said, if excess volatility poses a problem, the only truly defensive asset is cash.
You may be thinking that the chances of bond yields rising from 3% to 6% are quite low, and if current economic conditions persist you will probably be right. However, history shows that bond yields can rise significantly. The graph below shows that the last time US yields were as consistently as low as they are today, was during WWII. Undoubtedly the subdued post-war period would have seen experts predicting low bond yields would last forever – only to see them rise to about 16% over the following three decades. Bubbles and busts are not the sole domain of equity markets – the bond markets can be just as volatile.
Source: Bloomberg and Macquarie
A note on Gunns
Gunns is a Tasmanian forestry company which recently went into administration. UniSuper was a shareholder in Gunns and it is likely that we will be writing off the investment of about $2.9 million, which is far less than some press reports suggested. The holding represents less than 0.01% of the Fund, so there will be negligible impact on member returns.
The investment UniSuper holds in Gunn’s is not held directly, but rather through two external fund managers. The mandates given to these fund managers allow them to invest in stocks listed on the Australian stock exchange and, to ensure full accountability, UniSuper generally will not direct the external managers to buy or sell specific securities. The performance of external managers is judged on a portfolio basis. Of the two external managers who invested in Gunns, one of them has been terminated. However, we continue to support the other manager as their overall record is excellent.
UniSuper also manages a considerable amount of funds using in-house teams, and Gunns was not held in any portfolio managed by in-house teams.
Prepared by UniSuper Management Pty Ltd (ABN 91 006 961 799, AFSL No. 235907) on behalf of UniSuper Limited, ABN 54 006 027 121 the trustee of UniSuper (ABN 91 385 943 850). UniSuper Management Pty Ltd is the Administrator of the Fund and is licensed to provide financial advice, which is provided under the name of UniSuper Advice.
This information is of a general nature only and includes general advice. It has been prepared without taking into account your individual objectives, financial situation or needs. Before making any decision in relation to your UniSuper membership, you should consider your personal circumstances, the relevant product disclosure statement for your membership category and whether to consult a licensed financial adviser.