January 2015
For professional investors only
Real Matters
‘Breaking Bad’1: Outlook and strategy 2015
Simon Doyle, Head of Fixed Income and Multi-Asset
Overview
The last few years have been good for investors. Asset prices have risen across the risk spectrum aided in large part
by the actions of desperate central bankers. Investors have reaped the rewards and in doing so have been able to
pay little attention to the risk they are taking to achieve these returns. But as markets rise and the policy dynamics that
supported this broad based rise in asset prices come into question, valuations become more important and risk
matters more.
In this article we:
‒
review the performance of markets in 2014, highlighting the increase in volatility and the divergence of
performance across markets (in contrast to the previous year);
‒
discuss the outlook for key markets, examining in particular valuation and cyclical drivers of asset returns.
In particular we highlight that for many assets, current valuations imply low returns over the medium term
and heightened risk of loss. From a cyclical perspective we argue that while the outlook for key global
economies is mixed, that deflation risk is being overstated and the Fed will start edging towards a more
“normal” policy environment this year; and
‒
finally, while the return outlook may have compressed, volatility is likely to increase. This is expected to
provide us with the opportunity to capture opportunities at more appropriate prices. This has important
implications for investors and is an important part of our strategy to achieve decent real returns over the
medium term (especially in the context of our Real Return strategy).
While risk has not mattered much as central banks have looked to suppress volatility it will matter more in
future as the ability of central banks to continue to suppress volatility is tested. Pushing the envelope to keep
returns up, yields high etc may well back-fire. While I can only admit to watching an episode or two of
“Breaking Bad” on a recent return flight from the UK, the parallels in my mind were clear. Investors will push
the envelope to generate returns. This can work for a time but at the end of the day it could prove very costly.
2014 in review
2014 was a positive year for local investors. That said, there was plenty of grist for both the “bulls” and the
“bears” to mill. Whereas in 2013 developed market equities were universally strong and credit spreads
narrowed markedly, 2014 saw more divergent performance. Of the major developed markets only the US
posted double digit price gains (in local currency terms) with major non-US markets posting returns ranging
from low single digit positive price performance to losses in the UK and Korea (refer Figure 1). The
appreciation in the USD has compounded the challenges of 2014 dragging down returns to non-US equity
markets when measured in USD terms. While Australian dollar based investors have fared better, the
contribution from the currency has been significant.
1
Breaking Bad is an American crime drama television series. The title of the show has been adopted from an American
colloquial expression meaning ‘to raise hell’. The intended parallel is to the desperate lengths some will go to generate
returns even if it is a really bad idea.
Schroder Investment Management Australia Limited ABN 22 000 443 274
Australian Financial Services Licence 226473
Level 20 Angel Place, 123 Pitt Street, Sydney NSW 2000
For professional clients only. Not suitable for retail clients
Figure 1: Equity market price returns in calendar 2014
15.0%
25.0%
Local currency
USD's
20.0%
10.0%
AUD's
15.0%
10.0%
5.0%
5.0%
0.0%
0.0%
-5.0%
-5.0%
-10.0%
-10.0%
-15.0%
Korea (KOSPI)
UK (FTSE 100)
France (CAC 40)
Aust (All Ords)
Euro (DJ Euro Stoxx 50)
HK (Hang Seng)
Germany (DAX)
Japan (Topix)
Switzerland (SMI)
US (S&P 500)
Korea (KOSPI)
UK (FTSE 100)
France (CAC 40)
Aust (All Ords)
Euro (DJ Euro Stoxx 50)
HK (Hang Seng)
Germany (DAX)
Japan (Topix)
Switzerland (SMI)
US (S&P 500)
Source: Datastream / Schroders
Against this, volatility in equity markets picked up, credit spreads widened, commodity prices declined sharply
(especially iron-ore and oil) and sovereign bond yields again collapsed as deflation fears permeated investor
thinking (refer Figure 2). To put this last point into context, Australian bonds2 returned 9.8% in 2014,
significantly above the 5.6% return (including dividends) from Australian equities. So much for the “death of
bonds”!
Figure 2: Gross 12 month returns from major asset classes in calendar 2014
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
-15.0%
26.8%
10.3%
5.6%
5.8%
5.6%
8.1%
2.7%
-0.1%
-1.8%
-8.5%
AUD/USD
Credit ⁹
Government ⁸
Cash ⁷
Global High
Yield ⁶
Aust High Yielding Credit ⁵
Property Trusts ⁴
Emerging Market Equities ³
International Equities ²
Australian Equities ¹
Source: Schroders/Datastream. 1. S&P/ASX 200 Acc; 2. MSCI World ex Aus TR (USD); 3. MSCI EM TR (USD) 4. S&P ASX300 A-REIT
Acc; 5. Schroder Higher Yielding Credit Pool; 6. Merrill Lynch Global High Yield Index (USD); 7. Bloomberg Bank Bill Index; 8. Bloomberg
Treasury Index; 9. Bloomberg Credit Index. * Past Performance is not a reliable indicator for future performance.
2
UBS Composite Bond Index / Bloomberg AusBond Composite 0+Yr Index
Schroder Investment Management Australia Limited
2
For professional clients only. Not suitable for retail clients
Valuations
Updating our return forecasts continues to highlight the risk emanating from stretched asset valuations. Figure
3 shows our return forecasts and for comparison, actual performance for key US asset classes: equities, high
yield debt and treasury bonds. These forecasts are in turn derived from our valuation framework and primarily
reflect reversion to our estimate of “fair-value” over a three year horizon.
Figure 3: Schroders 3 year return forecasts through time
3 Yr Returns:
US High Yield Bonds
Forecast v Actual
Forecast
0%
2%
-5%
0%
-10%
-2%
Actual
Forecast
Actual
Forecast
2014
4%
2010
5%
2006
6%
2002
10%
1998
8%
1994
15%
2014
2014
2010
2006
2002
1998
1994
1990
-20%
10%
2010
-10%
20%
2006
0%
12%
2002
10%
25%
1998
20%
14%
1994
30%
30%
1990
40%
3 Yr Returns:
US 10 Yr Bonds
Forecast v Actual
1990
3 Yr Returns:
US Equities
Forecast v Actual
Actual
Source : Schroders
What is clear from this analysis is that current valuations imply low, perhaps even negligible prospective
returns across key US markets. In terms of historical comparisons it’s worth noting that while for equities and
high yield debt prospective returns are similar to those prevailing immediately prior to the GFC, prospective
returns from US treasuries are significantly lower (close to zero in fact) assuming a modest normalisation in 10
year yields over the next 3 years. Clearly, if these forecasts are close to being right, then in terms of broad
asset class exposure there is nowhere really to hide. So while central bank policy has supported returns to
investors over recent years, from current levels the outlook looks increasingly difficult.
A second important point relates to risk. Low prospective returns mean a heightened probability of negative
returns from major asset classes over this period. This is evident in Figure 4 which shows the implied
probability of a negative return from the respective asset class over the coming year3. While the probability of
loss from US equities remains high at just under 40%, the more notable is the nearly 50% probability implied in
the US treasury market. As yields continue to decline, this risk grows. While still high, the risk of loss in the
high yield debt market has moderated due to the oil induced widening in physical credit spreads. That said, on
this basis, high yield credit remains far from good value.
3
This is estimated based on the expected distribution of returns around our return forecast. It highlights the probability of
a negative return overa 12 month period but not the likely magnitude of this return.
Schroder Investment Management Australia Limited
3
For professional clients only. Not suitable for retail clients
Figure 4: Heightened downside risk
0%
0%
2013
0%
2010
10%
2007
10%
2004
10%
2001
20%
1998
20%
2013
20%
2010
30%
2007
30%
2004
30%
2001
40%
1998
40%
1995
40%
1992
50%
2013
50%
2010
50%
2007
60%
2004
60%
2001
60%
1998
70%
1995
70%
1992
70%
1995
Probability of loss:
US 10Yr Bonds
Probability of loss:
US High Yield Bonds
1992
Probability of loss:
US Equities
Source: Schroders
This analysis focuses on US asset prices, and while this is clearly important it does not represent the
investible universe. Figure 5 shows prospective 3 year returns against the probability of loss across the major
asset classes within our universe compared to realised returns and volatility over the last 3 years.
Figure 5: Expected 3 year return & risk assumptions
To generalise, the overall return outlook across the universe looks tough and consistent with the rationale laid
out for the US above. A number of issues impacting key asset classes though are worth drawing out:
Schroder Investment Management Australia Limited
4
For professional clients only. Not suitable for retail clients
‒
Australian equities look to be the “best” prospects for reasonable returns over this horizon. There are two
main reasons. Firstly, valuations simply look better. Australia has underperformed the US over the
recent years as the drag from declining commodity prices has impacted resources directly and more
cyclically exposed sectors. In large part a softer economic prognosis has been priced in – particularly into
the major commodity plays. While the local market would be dragged lower by any material weakness
emanating from the US, the starting point is better and on a medium term perspective this matters.
Secondly, yields on the Australian market (especially on a tax adjusted basis) are still attractive - both in
absolute terms and relative to both other equity markets and to other yield based assets.
‒
In contrast Australian REITs offer minimal future expected aggregate return as we believe their
vulnerability to a capital repricing will offset the benefits of their steady yield. In a recent paper4 we laid
out these views in more detail but it comes down to three factors. Firstly, adjusted funds from operations
(AFFO) are being flattered by unsustainably low financing cost and by paying out the benefits of these
low rates today future distributions are likely to be clipped by higher funding costs. Consistent with this, AREITs are starting to gear up to take advantage of low financing costs. Secondly, the growth
assumptions embedded in the sector (and implicit in recent price performance) are too optimistic. Finally,
that the risk premium required by REIT investors is currently too narrow given these risks – put more
simply we believe valuations are expensive and we’d prefer broader domestic equities to REITs.
‒
In Emerging Markets (EM), while valuations in the sector do not look demanding (and are probably now
back to around “fair-value”), factors such as the dramatic falls in commodity prices and the appreciation in
the USD are likely to lead to further outflows from EM assets (both debt and equity) – implying that these
markets are still high risk and require a significantly higher risk premium than is currently implied in
pricing. This has been our argument for some time and has not changed despite of recent EM
underperformance.
‒
While fixed income investors have reaped the benefits of collapsing yields, it is becoming increasingly
difficult to see how anything other than very low returns are in prospect from fixed income assets over a
three year investment horizon. This is especially the case given that key markets like Germany and
Japan where yields on bonds out to say three years in Japan and five years in Germany are offering
investors negative nominal starting point yields. While the maxim “never say never” in forecasting market
returns remains valid, the mathematics implies the risks are heavily skewed to this being a disappointing
investment over time. Furthermore relatively narrow credit spreads mean credit enhancement will not be
sufficient to make a material difference to returns.
Figure 6: Yield curve comparisons
3.0 %
2.5 %
2.0 %
1.5 %
1.0 %
0.5 %
0.0 %
- 0.5 %
3mth
1yr
Ger
3yr
Japan
5yr
US
7yr
Aust
10yr
Source: Schroders / Bloomberg (19/1/2015)
–
4
We also expect volatility across markets to pick-up as central banks find it more and more difficult to
supress volatility in markets. A clear example of this is the Swiss National Banks’ surprise departure from
its currency peg to the Euro. This followed a significant and sustained defence of the peg which
accompanied a significant expansion of the SNB’s balance sheet. The subsequent appreciation of the
“A wolf in REIT’s clothing”; David Wanis, Schroder Investment Management Australia Ltd, November 2014
Schroder Investment Management Australia Limited
5
For professional clients only. Not suitable for retail clients
CHF and the ramifications of this for banks, hedge funds and currency trading houses is a potent reminder
of the damage that can be unleashed once distortions are corrected. Iron ore prices, and the Russian
Rouble also highlight this point.
Cyclical and other considerations
While valuations matter (and are ultimately in our view the key driver of medium term returns) cyclical factors
play a key role in the timing and realisation of valuation anomalies and in the associated policy responses. On
this front the outlook is particularly murky.
Since the GFC interpreting the macro economy has been complicated by the unusual nature of the recession
and subsequent recovery (ie. as a financial crisis with a deep trough and a modest recovery) and the unusual
and experimental nature of the policy measures employed to foster recovery. Many of these measures have
been pivotal in supporting asset prices and as described earlier, supressing risk. While a return to recession
has been avoided in major economies, what’s less clear is just how much underlying improvement has
occurred. Clearly both the European and Japanese economies remain weak while the US economy appears
to be on a more self-sustaining recovery path albeit question marks remain around the ability of the US
economy to withstand a move towards a more “normal” policy environment.
In framing our thinking around the cyclical influence on markets in 2015 and beyond the following factors are
most relevant:
‒
Despite a hiccup or two lately, our base case is that the US recovery continues to unfold, the labour
market continues to tighten and wage pressures slowly build. While the collapse in the oil price is
negative for energy related investment, it is a clear positive for consumers and this will help support
consumer demand and offset some of the negative effects on investment and of the strengthening US
dollar. If we are right on this front the Fed should start to move rates up sometime this year. Low
headline inflation probably means that they won’t be in a hurry but core inflation and wages will ultimately
be more important. The US treasury market is rapidly and prematurely in our view pricing out this
prospect.
‒
We think the market is a notch or two too negative on Europe (reflected in the significant
underperformance of European equities and the significant rally in European bonds). While we do not
expect Europe to match the US’s growth trajectory we do think European recession will be avoided in the
near term. With the completion of the Comprehensive Assessment5 by the ECB, it appears the European
banking system is no longer an obstacle to recovery. On a more short term basis the decline in the Euro
will provide a significant boost given the export intensive nature of the European economy, and the fall in
oil prices will release real disposable spending power and add to activity. Also, QE will support broad
money growth, which is a strong leading indicator of economic growth in Europe. While headline
deflation now seems a reality in the short run, this would also seem to be priced in with the 0 – 5 year
German bunds now offering negative nominal yields to investors. The surprise in Europe could well be
that things aren’t as bad as current pricing would imply.
‒
In Japan, the weaker Yen has failed to significantly shift inflation expectations as demand has remained
patchy post the tax changes. Structural reform remains the missing ingredient and while we don’t doubt
the commitment, Japanese growth is unlikely to be a game changer for the global economy.
‒
China has seen a significant slowing of growth and a housing market under stress. However, this has
seen a response by authorities to underpin activity. While we believe significant imbalances have built in
the Chinese economy, while inflation remains low, policy makers have flexibility to push out the day of
reckoning - it is when inflation is rising and authorities have no options but to slow growth when
imbalances turn to crises. What has been different this time is that the policy response has been more
measured, and the focus has been more on employment than on growth. However, structural growth will
continue to decline as the benefits of urbanisation are seen relative to a larger base, seeing lower
potential growth.
5
The Comprehensive Assessment was a financial heath check of 130banks in the Euro area (including Lithuania) covering approximately
82% of total bank assets.
Schroder Investment Management Australia Limited
6
For professional clients only. Not suitable for retail clients
‒
In Australia, the cross-currents are strong. The big negative is of course the declining terms of trade
(down 18% since their peak in 2011), but this has been mitigated by a weaker exchange rate (down 18%
in trade weighted terms), lower interest rates (both official and market rates) and more recently the
declining oil price which will provide significant support to the consumer. In fact lower oil prices and a
weaker exchange rate would be a much more palatable combination to the RBA than another rate cut to
support mixed demand. On balance, we think the Australian economy is at or around trend and that it
would require a further leg down in growth, or a shock (such as a sharp collapse in asset prices) for the
RBA to make any major changes to monetary policy. In any case further modest easing is already priced
into local rates.
Portfolio construction implications
Through 2014 we advocated increased caution with respect to asset pricing and risk levels and reflected this
across our multi-asset portfolios by reductions in exposure to riskier assets, predominately high yield debt and
equities6. Our rationale reflected deteriorating valuations as asset prices climbed (particularly US equities and
bonds – but also yield based assets such as A-REIT’s) and the increasing disconnect between “risk” – defined
as losing money, and “volatility”. This was reflected in our key Real Return strategy by holding both low
exposure to equities (<30%) and a high exposure to cash (>35%) for much of this period.
Consistent with this, and despite poor valuations across fixed income assets, we advocated maintaining a
material duration position to protect against the material risk of either deflation or at a minimum the emergence
of concern about the possibility of deflation emerging. If this were to happen, bonds would be a clear
beneficiary despite of their starting point yields as perhaps the only asset to see prices rise in this
environment. We also advocated that currency realignment would play an important role in driving returns –
with our preferred play being Australian dollar depreciation supplemented by further Euro weakness. These
strategies worked well to support returns in 2014.
Figure 7: Estimated contributions to Real Return strategy returns in 2014.
8.0%
3.17%
7.46%
Other
Total
Contribution to Return
7.0%
6.0%
5.0%
1.26%
4.0%
1.79%
3.0%
2.0%
1.24%
1.0%
0.0%
Cash
Duration
FX
Source: Schroders
6
“2014: The Year of the “Boiling Frog”, Simon Doyle, Schroder Investment Management June 2014
Schroder Investment Management Australia Limited
7
For professional clients only. Not suitable for retail clients
Our starting point for 2015 from a portfolio construction standpoint is very similar.
Figure 8: Asset allocation of the Real Return strategy, 31 December 2014
At a broad level our overall risk allocation remains moderate. Expected portfolio volatility remains just shy of
4% and towards the lower end of the volatility bands (ex poste volatility has been closer to 2%). While the
biggest contributions remain from equities (Australia in particular) this has to be seen against the overall
moderate total risk contribution.
As discussed above we remain cautious on equities – particularly the US where valuations remain the most
stretched of the major markets. While we have less concern from a valuation perspective on European and
Australian equities, the US market will likely set the tone for the year ahead. While the “core” of our global
equity exposure is in our QEP7 Dynamic Blend Strategy, we have a short US S&P futures position in place to
effectively reduce our aggregate exposure to US equities to less than 3%, leaving us overweight in a
traditional sense Europe and Australia.
7
Quantitative Equity Products
Schroder Investment Management Australia Limited
8
For professional clients only. Not suitable for retail clients
Figure 9: Composition of the Schroder Real Return CPI Plus 5% Fund equity exposure
Equities Allocation by Region
1.87%
Australia
2.69%
United States
UK
0.64%
Europe ex UK
0.77%
Japan
1.36%
Other Developed
14.87%
Emerging Markets
2.68%
Source: Schroders. As at 31 December 2014
Regional Allocation - Real Return vs MSCI World
70.0%
60%
Regional Allocation
60.0%
58%
50.0%
40.0%
30.0%
17%
20.0%
11%
10.0%
3%
8%
5%
11%
8%
3%
3%
0%
0.0%
Australia
United States
UK
MSCI World Benchmark Exposure
Europe ex
UK
Japan
8%
6%
Other
Developed
Emerging
Markets
Real Return CPI+5% Exposure
Source: Schroders. As at 31 December 2014
While credit spreads have widened recently (mainly on the back of the implications for the US energy sector
given the collapse in the oil price) we have only added modestly to our position (in global high yield).
Compositional differences between the physical high yield market and the CDX index has meant that the
physical market has widened significantly more than the CDX market on oil concerns and this has created a
short term opportunity. That said, with overall yields and spreads low and volatility rising, we would need to
see a more material widening in spreads before credit becomes attractive again.
Schroder Investment Management Australia Limited
9
For professional clients only. Not suitable for retail clients
Figure 10: Physical vs CDX high yield spreads
2,000
1,800
1,600
HY Spread (bps)
1,400
1,200
1,000
800
600
400
200
0
2006
2007
2008
2009
2010
Markit CDX NA HY Spread
2011
2012
2013
2014
2015
Merrill Lynch US HY Option Adjusted Spread
Source: Schroders / Datastream
Bond valuations remain extreme and unappealing on a medium term view, but we are retaining duration for
the same reasons we have done so over the last year or so – namely as our predominant deflation hedge.
Given already low yields and the fact that this risk is significantly priced already, it is likely that this position will
get wound back as the year progresses.
We view our cash exposure independently to that of bonds. Should equity volatility continue to pick up and
key equities deliver poor “absolute” returns cash returns will look good (in a relative context anyway). As we
have argued for some time, holding cash in a period of rising volatility is attractive as it provides the optionality
to take advantage of the changing market valuations and prospective returns.
Achieving Real 5% against this backdrop
The outlook and its implications presented above clearly suggest that achieving a 5% pa real rate of return
over the next 3 years looks challenging. Figure 5 shows that on our numbers there are few assets with the
potential based on current valuations with the potential to achieve solid returns.
That said, we believe that the Real Return strategy’s objective is achievable from here. As we have pointed
out in the past8 our objective has several facets: a target return of 5% pa above Australian inflation over rolling
3 year periods, minimising path and drawdown risk, and maintaining a high level of liquidity. In balancing these
at times competing targets, implicit in our thinking is asymmetry in the risk equation as we believe the
preservation of capital is critical in its own right but also that the portfolio is well positioned to exploit
opportunities that the market presents after periods of volatility and disruption. This asymmetry is particularly
important in the shorter run. Likewise, we believe the 3 year timeframe is important as it is a sufficient enough
interval to allow significant mis-pricings to play out. Equally, risk premia are dynamic and this can and will
drive changes to strategy, sometimes significantly over this timeframe.
8
“Achieving a real return of +5% in the current environment” Simon Doyle, Schroder Investment Management, June 2013
Schroder Investment Management Australia Limited
10
For professional clients only. Not suitable for retail clients
On the basis of our assumptions an asset mix that notionally matched our target return would require a much
more risky portfolio than we are currently comfortable with. The current portfolio provides us with sufficient
risk to get close to target without exposing the portfolio to substantial drawdown risk. While we have argued
for some time that we will deploy cash on weakness we have not yet seen sufficient weakness (certainly not
enough to alter our medium term return outlook) to warrant deploying this cash. It should be also noted here
that while medium term return expectations have compressed (see Figure 5) we do expect volatility to pick-up,
creating the opportunities for us to buy appropriately priced risk.
We also expect positive contributions to returns to come from continued $A weakness (and more broadly US
dollar strength), a positive contribution from security selection (this has been a drag over the last year). We
expect that the positive contribution from duration has largely played out but in the absence of alternative
deflation hedges, we are likely to retain some (albeit reduced) duration.
In achieving our objectives we believe patience will be important and rewarded. Holding overpriced high risk
assets while notionally may look more consistent with our objectives the reality is likely to be the opposite.
High risk activity is unlikely in our view to be rewarded. Maybe I should watch some more episodes of
“Breaking Bad” to see where it goes….
Important Information:
For professional investors only. Not suitable for retail clients.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this
article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000
443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without
notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and
completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not
give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except
insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any
company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise)
for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or
otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be
relied on as containing any investment, accounting, legal or tax advice. For security reasons telephone calls may be taped.
Schroder Investment Management Australia Limited
11