Transcript: Five questions for the Chief Investment Officer - February 2020

Theresa Parkinson (TP): Welcome to Five questions for the Chief Investment Officer. My name is Theresa Parkinson, and I'm an employer partnership manager working with John Pearce, our CIO.

John, our members are soon going to receive their December 2019 statements. I'm sure many of them are going to be very surprised, given that 2019 was such a strong year for returns. Is it fair to say not many experts saw that coming?

John Pearce (JP): Well, I certainly didn't, Theresa. Here's a table showing 2019 returns across our investment options, illustrating exactly what you're saying. Nine out of 16 of our accumulation options returned greater than 20%. Even our Conservative Balanced option, with 50% in defensive assets, hit over double-digit returns.

2019-a-great-year-for-growth-assets

It’s a classic case of the share market ‘climbing the wall of worry’.

If you look at 2019, it had its share of worries. There was geopolitical crisis—Iran, US. There was a trade war between the two largest economies in the world. There were fears of a global slowdown, loss of corporate confidence. And in Australia, we had an election and there were fears of implications for the housing market under a Labor government.

Then we have the classic market behaviour—when those fears prove to be unfounded, markets start rallying, and most importantly, the central banks. They kept their foot on the accelerator, low interest rates, ample liquidity. And you find that over a one-year period, it's more central bank policy than economic statistics that will actually drive markets.

TP: We've seen large fund flows into our sustainable investment options, which isn't surprising given their strong performance. But isn't it a risky strategy chasing recent winners?

JP: We've spoken about this before, Theresa, and I think it's worth reflecting on it again because the trends have actually been exasperated over the last few months. Once again, let's refer to a graph to illustrate what you're saying. This graph shows net fund flows (funds in and funds out) for all of our investment options, other than the DBD and Balanced options—we're trying to look at the options where members have actually made a choice. You can see some of the options are actually in net outflow. But over the last three months, the flows into our sustainable options have dwarfed the flows into any other options.

Cash-flows

Now, why is this so? Well, performance has been fantastic, as you pointed out. And it’s not just performance in an absolute sense. Performance relative to other sustainable, ESG-style options in the market has been very strong. And performance relative to the standard Balanced and High Growth options has also been very strong.

Now, it's fair to say that not all members are simply chasing returns, and we've got to bear in mind here that the sustainable options have some very important exclusions. In particular, they exclude investments in any companies that are involved in the production or exploration of fossil fuels. That's a very important exclusion for a number of our members and it could be that they're in those options for that very reason.

For those members, however, who are chasing recent winners, I think it's important to understand the drivers behind the relative outperformance there. There are three key drivers. Firstly, these options are underweight the energy sector, which has been an underperforming sector. They've been overweight the property sector, which has been an outperforming sector. And they've been underweight emerging markets, which have underperformed developed markets. Those three tailwinds might persist for some time, but they don't persist forever. It's just something to be aware of.

TP: We've spoken about the good news, now let's get back to a recent reality. The world is consumed with fears of the coronavirus crisis. Are you able to comment on the implications to the economy and member returns?

JP: In terms of the economy, economists are already saying to downgrade expectations. If you look at China, where the epicentre of the problem is, we've seen 2%, 2.5%, even 3% cut off expected Chinese economic growth. In Australia, we're now seeing economists talking about a negative quarter in terms of growth in Australia. Bear in mind with Australia that this comes on top of bushfires, so we've had a really, really torrid time with things.

Before we talk about the current market response, I think it's worthwhile reflecting on what’s happened in similar situations when we’ve had health scares. In particular, the SARS virus in 2003, which originated in Hong Kong, and Ebola, which originated in Africa. Have a look at the markets. This is during the peak infection periods. During SARS, down around 10%. During Ebola, down around 5% in emerging markets. Look at current. Major markets really haven’t moved.

Equity-market-performance

Clearly, there's been an impact in China and Hong Kong. Our market's pretty flat. The US market is actually up a touch. This belies the fact that within these markets, there are some winners and losers. Our banks, for example, have pretty much remained unscathed, but our energy and resources companies have been hurt quite a bit.

Then you have tourism-related industries. Sydney Airport is a classic example. Our members know the big shareholding we have in Sydney Airport. That's down around 6.5%. At Sydney Airport, 20% of international travellers are from China, so that could be expected. Having said that, back to your original question, if we're looking at impact on member returns—in aggregate, not much.

TP: So, the market reaction has been relatively subdued. What's with the apparent complacency?

JP: Quite frankly, I'm astounded at how complacent the market has been. Typically, when we have these scares, the market tends to settle down and turn up only after we've had peak infections. We're not seeing that just yet. As a matter of fact, in terms of confirmed infections, they're growing by about 4,000 each day. So, we're nowhere near getting this under control.

Confirmed-infections-per-day

Why is the market so complacent? I think there's potentially a couple of reasons. The market is basically saying that the Chinese have this under control. Credit to the Chinese, the way in which they've responded to this crisis is quite different to SARS. They've been so transparent with the World Health Organisation. The actions they've taken have been very swift and tough. Travel bans, closure of events, extending holidays. And then, of course, we have other countries such as Australia banning inbound travel. So, the market is saying that this is going to be a problem that's contained in China, and the worst fears are not going to be founded.

I'm a little bit more cautious. At the end of the day, we have the world's second-largest economy, the world's engine of global growth, effectively in shutdown. It's only a matter of time before this starts impacting on short-term corporate profitability, and I suspect that corporates will soon allude to that. I expect that we'll have some jitters with certain companies. But this crisis will pass as well, like other crises do, but we're on the sidelines at the moment.

TP: Thanks, John. I'd like to finish with a question around the longer-term outlook. Since the GFC, Australia has produced 10 consecutive years of positive returns. So investing in growth assets has been well-rewarded. The consensus is that this can't continue for the next decade. Do you agree?

JP: I agree that getting another 10 consecutive years of positive returns is going to be very, very difficult to achieve. However, when it comes to cumulative returns over the next decade, I'm a bit more optimistic than the consensus, and here's why. Have a look at this graph. Here are the returns over the last four decades, and what do we see about the 2010s? Well, maybe contrary to popular opinion, it's been hardly remarkable. As a matter of fact, it's been the worst-performing decade of the last four. So, we haven't got a really high bar to jump there.

Aus-share-market-performance-1

Let's break down these returns even further, telling my story even a bit more strongly. The components of returns—one is dividends, the other is capital appreciation. Look at the contribution of dividends. It's been very consistent over those last four decades.

Aus-share-market-performance-2

I personally see no compelling reason why that can't continue over the next decade.

In terms of capital returns, the pessimists will say that this has just been driven by four decades of lowering rates. They're absolutely right, we can't have rates being lowered to the same extent over the next decade. But rates can stay low for a very long time, so I'm not one that subscribes to the view that this all has to unwind and that shares are overly stretched.

How about corporate profits? Corporate profits over the long term are actually a function of economic growth. Let's look at economic growth over those last four decades. Not surprisingly, the 2010s were highly unremarkable. It was the poorest performing decade of the last four, which shouldn't come as a surprise as we were recovering from the worst financial crisis in 100 years.

Aus-share-market-performance-3

I see no reason why the next decade can't produce better economic growth than the previous one.

So, when it comes to the coronavirus, yes, I'm a little bit more pessimistic than the consensus. But when it comes to the long term, I'm a bit more optimistic.

TP: Thanks, John. And thanks for answering those questions. If you have any questions you'd like answered, please email us at superinformed@unisuper.com.au. Thanks for watching.

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Consider your situation and read the relevant Product Disclosure statement before making personal decisions about your investments or UniSuper membership. Past performance is not an indicator of future performance.