11 Nov 2016
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A rise in bond yields from extremely low levels has sent jitters through global share markets, with property and infrastructure hardest hit. The initial sell-off represents a justifiable and overdue correction from inflated prices, particularly in sectors most sensitive to interest rates. We’re now seeing value creep back into the market as shares in high-quality companies trade at favourable yields.
Despite the bond yield correction, interest rates remain close to historical lows. In most countries, including Australia, yields remain well below target inflation rates. This has led to a downward revision in the expected returns of our ‘defensive’ investment options, as they typically have a high weighting to bonds. In this month’s update, we explore the thinking behind these changes.
We’ll also take a brief look at one of the month’s biggest headlines—the US election.
Performance of key markets
||3 Years p.a.
||5 years p.a.
|Australian shares (S&P/ASX 300)
|Global shares (MSCI All Country World Local Currency)
|Australian dollar (AUD/USD)
|Australian fixed interest (Bloomberg Composite)
|Cash (Bloomberg Bank Bill)
Returns are for periods to 31 October 2016. Past performance is not an indication of future performance.
*Returns relate to our Accumulation (not Pension) investment options and are published after fund taxes and investment expenses, other than account-based fees.
Changes to selected investment option objectives
Throughout the year we review the return objectives for each investment option to ensure they remain appropriate. The table below highlights the key changes (in green) to individual option return objectives, as well as changes to suggested minimum investment timeframes, where relevant.
PREVIOUS CPI + OBJECTIVE
PREVIOUS TIME HORIZON
NEW CPI + OBJECTIVE
NEW TIME HORIZON
|| CPI + 0.5%
RBA cash rate
| Australian Bond
||CPI + 1.0%
|| CPI + 0.0%
|| CPI + 1.5%
||CPI + 0.5%
| Capital Stable
|| CPI + 2.0%
||CPI + 1.5%
As this shows, we’ve reduced the return objective for our four defensive options. We call them defensive because their underlying assets are heavily skewed towards securities expected to derive most of their return from income, rather than capital growth. At this point we haven’t revised the objectives for our growth-oriented options.
Why the changes?
Aside from the recent spike in bond yields, we remain in an environment where the absolute levels of interest rates are close to historical lows.
Furthermore, market expectations point to more of the same for a long time to come. The following table shows what the market expects cash rates to be in different regions and countries in one and three years’ time.
Expected future cash rates implied by the current yield curve
IN ONE YEAR
IN THREE YEARS
In order to achieve inflation targets of around 2%, central banks around the world need to keep interest rates extremely low as they fight against powerful deflationary forces. The developed world is still in the early stages of a ‘deleveraging’ cycle as households, governments—and to a lesser extent, corporates—pay down the enormous debt built up over the two decades before the GFC. A decline in working age populations is adding to the burden. Technology is also a deflationary force, driving costs of production ever lower.
We are therefore mired in a ‘zero real interest rate’ world—meaning interest rates are generally at or below the level of inflation—and this sums up the need for the changes to our investment option objectives. The bottom line for our defensive investment options, is that it becomes problematic and imprudent to target returns (after fees and taxes) well in excess of inflation rates when bond yields are expected to trade around the level of inflation.
Other points specific to each investment option are outlined below.
We’ve changed the Cash option’s return objective from CPI+0.5% to be in line with the Reserve Bank of Australia (RBA) cash rate. Cash returns should typically offer a small premium above the RBA target CPI inflation band of 2-3%, otherwise there is no incentive to save. However, given current cash rates (at 1.50%) are at historical lows, it’s highly improbable for this to be achieved in the near term. Given that we’re no longer targeting a CPI-based return objective, we’ve decided to reduce the time horizon for this option from three years to one year.
We’ve changed the Australian Bond option’s return objective from CPI+1.0% to CPI+0%. Over the long run, bond returns should compensate investors for inflation plus real GDP growth. The securities held in this option are restricted to government bonds, yielding between 1.63% for a one-year bond and 1.95% for a five-year bond at time of writing (note that the suggested time horizon is four years). These yields compare to the RBA’s target inflation rate of 2-3%, explaining the option’s objective drop.
Diversified Credit Income
We’ve changed the Diversified Credit Income option’s return objective from CPI+1.5% to CPI+0.5%. Once again, the current yields on offer for high-quality credit are low relative to the RBA’s target inflation band, making it difficult to achieve a margin of 1.5% above CPI with any degree of confidence.
This option’s target objective is 0.5% higher than the Australian Bond option because investors can expect to earn a credit risk premium over time, reflecting the fact that investing in corporate debt is riskier than investing in government-backed debt. Importantly, Diversified Credit Income is less exposed to changes in interest rates as the securities held are effectively ‘floating rate’ in nature. This is technically referred to as lower duration risk—the option currently has a duration of about 0.1 years, compared to 5.5 years for Australian Bond.
We’ve changed the Capital Stable option’s return objective from CPI+2.0% to CPI+1.5%, reflecting the fact that 70% of the option’s assets are defensive in nature and are therefore subject to the same pressures as the above three options.
As an aside—after enjoying five years of strong returns, Capital Stable has experienced a few rough months as bond yields have risen (and their prices have declined). Furthermore, the growth component of the option is heavily weighted towards high-quality listed property and infrastructure, and both sectors have been particularly hard hit as the market shifts towards more cyclical sectors like mining. While this rotation may continue for some time, we’re not planning on changing our investment strategy for this option because, over time, we consider the concentration in companies we believe are high quality paying sustainable dividends to be the optimal strategy in the context of the option’s objectives.
Why no changes to the more growth-oriented options?
At this stage, we haven’t made any changes to our more growth-oriented options like High Growth, Growth, Balanced, and Conservative Balanced. Two main reasons underpin our thinking.
Firstly, these options have the benefit of a longer time horizon over which to meet their objectives. Over a longer term there is a greater likelihood that yields will rise from their current near-record lows, although we are not expecting them to get anywhere near historical averages.
Secondly, and more importantly, our expected returns on growth assets have not fallen to the same extent as they have for defensive assets. Our strategy of favouring quality companies with sustainable yields also plays a part, particularly given that dividend yields remain much closer to their longer-term averages than bond yields.
The table below compares current asset class yields (green line) relative to their long-term averages (blue line) for different asset classes along the risk spectrum. Generally speaking, asset class yields can be interpreted as the income earning component of an asset class' return. For growth assets, we also expect returns from capital appreciation.
Worth noting in the chart below is the sharp step-down in asset class yields for the most defensive asset classes, compared to a smaller fall in the dividend yield on Australian equities.
Could the recent market weakness change our thinking on expected growth option returns?
The short answer is no.
One of the more irrational traits we often see is the downgrading of future return expectations after prices have fallen.
During the depths of the GFC, after share markets around the world had plummeted by around 50%, it was quite common to hear of ‘experts’ downgrading their outlook for returns on risky assets. Of course, common sense would suggest that—all else being equal—expected future returns should increase as prices fall. In hindsight, expectations should have been downgraded just before the GFC, but of course this was a period when people were most optimistic.
The recent fall in the Australian share market has been driven by a spike in bond yields. The 10-year bond yield, for example, has shot up from 1.91% to 2.35% at time of writing. The sectors tending to be more interest rate-sensitive, such as property and infrastructure, have been particularly hard hit.
High quality listed property is now trading on dividend yields above 5%, which obviously compares extremely well to bond yields.
Importantly, the share price falls we’ve recently experienced in the majority of our key holdings belie the fact that the underlying operating performances of the businesses remain strong. In the past week, for example, both GPT and Vicinity provided quarterly trading updates which included small upside surprises. Yet, over the past three months, the share prices of GPT and Vicinity have fallen 18% and 20% respectively.
While the initial sell-off represented a somewhat inevitable correction from stretched valuations after five years of strong returns, current valuations are starting to look compelling, particularly in the context of our investment objectives.
A dividend yield of 5% equates to a return of about 2.5% over the RBA’s inflation target of 2-3% (which looks increasingly hard to achieve). On top of the dividend yield, we could expect the capital value of quality property to appreciate in line with economic growth over time.
Using some simple arithmetic, it’s clear to see why we’re favourably disposed to accumulate these assets in our investment options—even when target returns of these options are up to CPI + 3%.
The US election and global markets
Following the prolonged and intense media coverage of the US election—and now, its unexpected result—it’s natural that many members are concerned about adverse changes to the world economy. But how serious should these concerns be?
At this point, all we can do is speculate and look at similar historical events and their market impacts. While Donald Trump's victory may impact geopolitics, it's difficult to predict how and what those impacts will be. As far as market impacts go, there may well be short-term movement similar to the ‘panicked’ behaviour we saw post-Brexit. We saw this already in the immediate fall in markets across the world as the election result unfolded, and in the ensuing rally. At this stage, it’s difficult to anticipate medium to long term impacts of a Trump presidency on the US or global economy.
As always, we encourage all members to think long term when it comes to their investments, and to seek advice from a qualified financial adviser before making any changes to their investment strategy.
Return objectives are not promises or predictions of any particular rate of return. Negative returns may occur more or less regularly than expected. Returns specified relate to our Accumulation (not Pension) investment options and are published after fund taxes and investment expenses, other than account-based fees.
This is not intended to be an endorsement of any options, listed securities or fund managers named above for inclusion in personal portfolios. The above material reflects UniSuper’s view at a particular point in time having regard to factors specific to UniSuper and its overall investment objectives and strategies.
Past performance is not an indicator of future performance. This information is of a general nature only and may include general advice. It has been prepared without taking into account your individual objectives, financial situation or needs. UniSuper’s investment strategies will not necessarily be appropriate for other investors. 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. This information is current as at 7 November 2016.