Opportunities emerge amid persistent volatility

14 Nov 2023

Our Panellists

Leonie Wilkinson

Leonie Wilkinson

Senior Vice President, Portfolio Management, Real Estate Brookfield

Leonie Wilkinson is a Senior Vice President in Brookfield’s Real Estate Group. She is responsible for working with Brookfield’s local and global teams, overseeing portfolio management for Brookfield’s Australian core and core-plus real estate investment strategies. 

David Pace

David Pace

Portfolio Manager, Greencape Capital

David has over 27 years’ experience in the funds management industry. David co-manages the Greencape High Conviction Fund with Jonathan Koh, managing over $5 billion in funds under management.

Jay Sivapalan

Jay Sivapalan

Head of Australian Fixed Interest, Janus Henderson Investors

Jay is Head of Australian Fixed Interest and a Portfolio Manager, managing the Australian fixed interest portfolios. His responsibilities include formulating interest rate and sector strategies employed within the portfolios and working closely with key fixed interest clients.

Simon Doyle

Simon Doyle

Chief Investment Officer and Chief Executive Officer, Schroders, Australia

Simon was appointed to the role of CEO in June 2023, alongside his role as CIO. Simon has served as the CIO since February 2022 alongside his role as Head of Multi-Asset, Australia. Simon is responsible for delivering an investment-led and insight-driven approach to engaging clients and working with local investment teams.

Scott Haslem

Scott Haslem

Chief Investment Officer, LGT Crestone

Scott leads the Chief Investment Office at LGT Crestone, covering strategic and tactical asset allocation, portfolio construction and manager selection across equities, fixed income and alternative assets. He has more than 25 years’ experience in global financial markets and investment banking. 

Stan Shamu

Stan Shamu

Senior Portfolio Manager, LGT Crestone

Stan manages LGT Crestone's model portfolios and works closely with LGT Crestone's investment advisers to understand individual client goals and to deliver suitable portfolios. With 15 years' experience in financial markets and managed investments research across multiple asset classes, Stan has a wealth of experience in constructing portfolios and developing strategies for clients.

Opportunities emerge amid persistent volatility

At LGT Crestone’s most recent investment forum, we asked panellists to discuss whether the peak in central bank policy tightening had finally been reached, as well as their perspectives on the now increasingly consensus view that interest rates are likely to be held relatively high by policy makers until at least mid-2024. We then discussed the implications of this across the different asset classes and their views on deploying additional risk into the current investment environment. 

Our panellists, overall, expect ongoing volatility across inflation, interest rates and geo-politics to persist over the coming couple of years. However, the increased sector, sub-asset class and regional dispersion resulting from this was largely viewed as an opportunity to generate active returns. Fixed income returns were, not surprisingly, viewed favourably. However, our panellists also identified opportunities to capture mis-pricing across selected equity sectors, unlisted private credit, and unlisted real estate.

Four key themes emerged from the forum:

The peak in interest rate policy tightening not yet confirmed—While the peak in rates is near, further modest central bank tightening, particularly in Australia and the US, is still possible over coming months. This reflects the resilience of global growth during 2023, aided by larger-than-expected ‘excess cash’ balances held by consumers post-pandemic. (This has been helping to mitigate the impact of higher borrowing costs.) It also reflected still above-target inflation rates.

Shifting structural forces are likely to continue to impact the outlook—These include the extent to which consumers transition some of their excess savings to permanent savings, how ‘sticky’ inflation pressures prove to be, the impact of deglobalisation of supply chains, and the potential escalation of geo-political events. Reflecting this, market volatility was viewed as likely to remain a feature of the investment outlook.

Fixed income is still favoured for deploying additional capital—Given the recent rise in interest rates, the environment was viewed favourably for deploying additional capital into fixed income and selectively adding to duration. Even within equities, while index levels were not seen as attractive, selected stocks with defensive earnings streams are now presenting opportunities. While the US market is viewed as relatively expensive, this is not true for Australia, Europe, and the UK.

Heightened volatility now presenting selective opportunities—A higher cost of capital is now allowing for comparison of relative returns, while the dislocation in capital markets is creating stock, sector, and regional opportunities. Selected mid-curve, fixed-rate fixed income investments, unlisted real estate assets where distress is emerging, and private credit, where liquidity is increasingly scarce, were all viewed as opportunities to support portfolio returns.

How high will policy rates go?

Central banks have been signalling recently that the peak in policy tightening may have been reached. Markets, however, are concerned that rates have further to go, with growth remaining resilient in the US and inflation still above target. We asked our panellists how likely it is that central banks have finished their rate-hiking cycles, and what the long-term implications are for markets going forward.

Have central banks finished their rate-hiking cycles?

The panel feels there could be another one or two rate hikes in most developed economies, but there are unlikely to be more than this. 

Jay Sivapalan, Head of Australian Fixed Interest at Janus Henderson Investors, highlighted that the key drivers for all asset classes begins with the long-term bond yield, the primary discount rate. Cash rates alone do not drive this and various factors, such as the term risk premia, need to be taken into account. At a high level, economies have been resilient. Labour markets are still at ultra-tight levels and rate rises have not yet had the full effect central banks would have expected. 

“It’s becoming clear that the excess savings that amassed during the pandemic are slowing the response that central banks had been expecting. That’s not to say the response won’t come—and certainly, we’re seeing evidence in the data, particularly in the cyclical consumer household sector.”

Scott Haslem, Chief Investment Officer at LGT Crestone, feels there is a very wide estimate of when consumers’ excess cash will run out.

“Initially, estimates were that excess cash savings would run out in Q3 2023, but now that’s being pushed out to Q1.” 

Sivapalan explained that, at an aggregate level, Janus Henderson Investors expect this to happen in Q4 2023 in the US and Q1 or Q2 2023 in Australia. If we take the GFC as an example, not all cash needs to be spent—some cash may move into more permanent savings.

Haslem feels that the degree to which central banks sit back and accept a slower impact from tightening will depend on whether inflation continues to moderate. 

Sivapalan explained that inflation has already fallen significantly in certain economies. In Australia, the next phase of getting inflation down is likely to be influenced by other factors, such as population growth and rising rental costs. Additionally, the energy transition and increasing energy costs are likely to keep inflation ‘sticky’ for some time. The Reserve Bank of Australia has reiterated its low tolerance for an upward surprise to its inflation forecast, where a return to target is slated for late 2025. 

Simon Doyle, Chief Investment Officer and Chief Executive Officer at Schroders, Australia, agreed that structural issues, such as higher energy prices and de-globalisation, make the next leg of the inflation reduction harder to achieve. “Inflation was always going to be the thing that killed the market cycle and changed the policy dynamic.”

What are the long-term implications for markets?

Doyle feels that central banks have to keep reinforcing that policy will likely remain tighter for longer. He expects another one to three rate hikes as we counter-balance structurally higher inflation and fiscal policy dynamics, which are counteracting monetary policy. This will ultimately depress growth and create volatility in markets.

David Pace, Portfolio Manager at Greencape Capital, highlighted that, in an historical context, we are still not yet in a high interest rate environment. Interest rates have hit the consumer earlier in Australia than in the US, as higher rates in the US generally only kick in when the consumer re-mortgages or moves property. In the US, property sales are down around 50% and the inventory of used homes for sale is low.

Haslem explained that nobody remembers Paul Volker (former Chair of the US Federal Reserve) for sending the economy into a multi-year recession during the 1980s. They only remember him as the person who managed to get inflation down. He suggested major central bankers could be in the same position. Ultimately, the issue will be whether two more rate hikes in the US and Australia will break the economy. If it does, then history suggests that central banks will need to move in the other direction. 

What do higher discount rates mean for asset prices?

Haslem highlighted that the higher cost of capital and valuation headwinds will likely impact asset prices.

In terms of discount rates, Pace is excited about the opportunity set, given the arbitrage opportunities between value and price. The first response to a rise in the 10-year bond yield is a sell-off in long-duration names, which are more vulnerable than short-duration names from a valuation perspective. The second phase is a general market sell-off, with investors moving to cash. Pace sees a lot of indiscriminate selling currently, which creates a good environment for stock-pickers. In terms of identifying opportunities, he feels that examining cash flows is a good way to assess a business. Australia’s discount rate is currently inflated, which is putting pressure on corporate cashflows.

“When you think about the discount rate that is applied to future cashflows, the discount rate is a function of the riskfree rate, which is a function of bond yields and equity risk premia. Equity risk premia is a function of many things, but it’s mainly affected by geo-political issues.”

Leonie Wilkinson, Senior Vice President Portfolio Management, Real Estate at Brookfield, highlighted that, in hindsight, central banks were initially a little slow to respond to rising inflation. Keeping rates low to stimulate demand is something that works well generally, until you have multiple, concurrent supply-side shocks. This ultimately resulted in inflation that was more than transitory, and a very sudden period of hiking.

At Brookfield, they are paying a lot of attention to whether these rate hikes will peak and overshoot, then need to fall again—or whether they will remain at a level that is sustainable for investors. Wilkinson agreed that there had been a dislocation in capital markets on the back of absorbing the sudden rise in interest rates, and that this throws out some interesting opportunities for investors. 

Compared to the period from 2013 to 2022, which was driven by quantitative easing, Doyle feels the current environment is much better for investors. This is because there is a cost of capital and a risk-free interest rate to compare things to. This works well for thoughtful deployment of capital, as opposed to lazy deployment of capital, where asset prices were just driven higher by liquidity. Investors need to work harder, but it is likely to be much more rewarding.

What role will geo-politics play?

Haslem explained that from a geo-political perspective, the world seemed to have missed Israel and Gaza as a potential threat.

Going forward, Sivapalan feels that US dominance in the global order will be challenged. Consequently, the investment landscape will likely look a bit different or may become more volatile. 

Doyle highlighted that geo-politics is always a challenging factor to consider from a portfolio construction perspective, as they are high-impact/low-probability events. “If you load your portfolio up to protect against any one of [these events], it’s challenging, as they generally don’t occur.”

Understanding the short-term consequences of geo-political events (from a market perspective) is key in determining the impact of such events and how they play into longer-term structural issues. However, Doyle acknowledged that it is not all negative, as these events can trigger changes in government behaviour, which present opportunities for investors.

Wilkinson explained that Brookfield is leaning into deglobalisation as an investment theme—specifically, referencing the evolution of supply chains that were interrupted during the COVID pandemic. She noted that the implications of de-globalisation include more advanced manufacturing in India, Europe and parts of Asia. The executable investment idea is more investment into logistics, which feeds back into population growth. 

Citing research conducted by CBRE, Wilkinson explained that there is projected demand for another 4.5 million square metres of warehousing and logistics space over the next three years in Australia to stay in front of online demand from new residents. This space is already at critically low levels compared to other global markets.

The LGT Crestone view: We believe central banks are at or near their peak on policy tightening. However, there is a likelihood that inflation will remain above target for some time and that a sharp slowing in global growth can be avoided. As such, interest rates are likely to remain elevated for some time, ahead of policy easing from mid-2024.

"Equity-risk premia is a function of many things, but it's mainly affected by geo-political issues."

David Pace, Portfolio Manager, Greencape Capital

Should investors be adding risk?

As inflation threats continue to linger, it is likely that rates will remain higher for longer. How does a high-yield and high-rate environment impact investment decisions, particularly when allocating to risk assets? We asked our panellists what the implications are of higher inflation and higher rates on risk assets, and whether equity investors are being adequately compensated for risk.

Do equities carry a valuation premium?

According to Doyle, shifts in pricing are beginning to emerge. Equities are repricing, but they do still carry a bit of a valuation premium, particularly in the US. With a cash rate of 4-5%, bond yields at similar levels, investment grade credit at 6-7%, and high yield close to 10%, parts of the market are certainly looking attractive. Equities, on the other hand, may see some further derating over the next six to 12 months. 

Sivapalan reflected that markets have priced at least one more hike in cash rates, and that from 2025 to 2033, forward cash rates in Australia are priced to be 5% plus. 

In 2022, it was mainly the “price” in price/earnings (P/E) ratios that adjusted as rates rose from very low levels. However, in 2023, it has been the “earnings” that have adjusted. Earnings are based off nominal revenues, and these have been very strong as companies have had pricing power for the most part. Heading into 2024, the question is whether earnings can remain resilient as inflation moderates and as the consumer pulls back responding to these higher rates. If central banks are successful at slowing the economy, this could cause the entire yield curve to shift lower. In this scenario, there should be pockets of growth assets that perform quite well, despite general caution on risk assets. 

Sivapalan added that dividend yields are roughly at the same levels as term deposit rates and bond yields. This means that investors are able to fill out the non-equity parts of their portfolios with some really good opportunities. 

What are the implications of higher rates and inflation on risk assets?

Pace feels that the sweet spot in equities is defensive earning streams with duration.

“They will provide you with structural growth and low beta earnings that are being overly penalised today through the discount rate.”

He believes that earnings adjustments are still likely to play out. Financial year 2024 consensus earnings are for revenue of 3%, EBITDA (earnings before interest, tax, depreciation and amortisation) of 4%, and earnings per share of 5%. Pace believes that the prospect of earnings leverage between the revenue line and the EBITDA line needs to be challenge, given we will be annualising a year of higher labour costs and debt is no longer "free".

Are equity investors being adequately compensated for risk?

At the market level, Pace feels investors are not being adequately compensated—but at a stock level they are. The discount rate adjustment has largely already occurred but we need to start seeing evidence of earnings downgrades. He expects to start seeing this from February onwards.

According to Wilkinson, high interest rates and high inflation work in the favour of real assets. This is because, during periods of inflation, real assets with pricing power can grow revenue while managing expenses. On the revenue side, income grows through fixed or CPI-linked escalators, and new sources of revenue can be created. On the expense side, increased operating costs are usually passed through to the occupier, preserving the value of income and yield to investors. That works well in terms of growing an asset’s value by increasing the asset’s income.

The LGT Crestone view: With inflation moderating and interest rates near their peak, we remain constructive on the outlook. We maintain a preference for more defensive assets with attractive yield.

Do we see fixed income as a continued opportunity?

Our panel discussed the risk of further policy tightening by central banks sparking a sell-off in long-term bonds, given that further rate hikes have already been priced into the forward curve. We discussed the factors that should be influencing an investor’s exposure to fixed income, how attractive domestic bonds are versus global, and where the opportunities are in credit.

Which factors should be influencing an investor’s exposure to fixed income?

According to Sivapalan, markets have priced in some prospect of a further tightening in cash rates. However, after that they are building in term risk premia at the long end of the yield curve. He feels that even if investors are too early and bond yields move higher by a percentage point, they would still receive a positive return on a 12-month basis. Additionally, the defensive role of long duration fixed income provides a ballast in a risk-off event and has the potential to deliver double-digit returns.

Doyle is considering adding duration again. He feels that it is better to have duration in his portfolio today than it was two years ago. He sees bonds as a good way to build robustness in a portfolio.

“However, if you’re just trying to time the market it’s a different proposition. While we are all talking about an inflationary shock, it could end up being a deflationary shock and bonds will perform well in that environment.” 

While bonds present a compelling opportunity, Sivapalan emphasised that duration management is important as this results in a better return outcome. 

Haslem highlighted that if rates increase 25-50bps, the long end of the curve will price in an eventual fall in rates, and this will lead to a bond rally. That scenario would deliver some meaningful returns. The panel feels that mid-2024 is likely the earliest time we will see rate cuts. 

How attractive are domestic bonds versus global?

Haslem commented that global yield curves are inverted, but they are positive in Australia. The domestic fiscal position is also better than in the US. Given Australia is only 1-2% of the global index, if they were running an unconstrained fixed income asset class, he asked the panel if it would be more beneficial to have a higher exposure to Australia fixed income than global.

According to Sivapalan, if the long end of the US curve is tested for term risk premia, supply, and other fiscal factors, then all the curves should become more synchronised. However, over time there will be some dispersion due to various macro-economic dynamics. He believes we could be in a situation where the spread between domestic and US yields widens sharply in Australia’s favour because that consumer is more sensitive to variable mortgage rates. 

He explained that the other wild card is China, where authorities are “right-sizing” certain industries, such as real estate and infrastructure. This has implications for Australia’s commodity story. 

Are there opportunities in credit?

Wilkinson is seeing interesting dynamics play out against the current macro backdrop. Private credit is becoming increasingly popular, providing a great opportunity set. With the broader dislocation of capital markets, banks are pulling back and being a lot more selective, particularly across less “in-favour” sectors, and will only lend to high quality assets and high quality sponsors. As a result, this has opened up an opportunity for private credit, particularly when secured against a real asset earnings stream. 

Sivapalan explained that Australian real estate investment trusts (AREITs) could be the sweet spot for senior debt. Currently, you can purchase a basket of high-quality AREITs with yields of around 6.5-7.0% for a seven to 10-year period. These baskets have 20-25% gearing. On a hold-tomaturity basis, with these kinds of yields, he explained that there is a remote chance of permanent capital loss. While market-to-market is part of the course, on a risk-adjusted basis, they represent a healthy alternative to equities.

The LGT Crestone view: With interest rates likely to stay higher for longer, we are overweight government bonds and investment grade credit, while comfortable adding to duration. We have a preference for increased exposure to fixed rate debt and are neutral high yield credit, where slowing growth could lead to rising defaults.

How important will active management be in the period ahead?

The higher cost of capital is adding pressure to valuations, particularly for riskier assets. Our panellists discussed the factors that equity investors should be considering going forward, how real assets are likely to be impacted, and whether now is the time for active or passive management.

What are the important things equity investors should consider going forward?

Pace explained that consensus estimates have not factored in equity holders bearing the brunt of inflation, nor do they have a good handle on interest rates and treasury functions. For investors who are looking for long-duration names with defensive earnings streams, healthcare is an attractive sector to consider. Equities is a difficult asset class for short-duration names. More broadly, Pace sees opportunities in equities on a three to five-year view. 

Haslem added that in terms of the market cycle, we are at a point where rates are higher and there is a prospect of them drifting lower over the next couple of years as economies stabilise. Between now and then, there is likely to be increased volatility, which will create dispersion. 

Is this the time for active or passive management?

When markets are indiscriminate, this is the time for stock pickers, according to Pace. He believes we have moved into that indiscriminate phase, so it is important to be selective going forward.

Doyle cautioned that the US is an outlier, as it is expensive and dominated by a handful of stocks that may not deliver on high expectations. There are also significant earnings risks in the US. Australia looks reasonable, as do Europe, the UK and emerging markets. However, when there is a cost of capital and a cycle, you have to work harder to find good opportunities and differentiate good businesses from bad. Consequently, volatility reinforces the need to be active. Given the yields on offer from fixed income, it is no longer necessary to be in the equity market. The opportunity cost of holding liquidity is low, and it provides the ability to take advantage of dislocations when they occur. 

How are rising rates and inflation impacting real assets?

Stan Shamu, Senior Portfolio Manager at LGT Crestone, explained how liquidity has been increasingly problematic, with some strategies going as far as gating redemptions. This has been beneficial for some of the larger players that do not have liquidity issues, but smaller players are struggling to raise capital. 

Wilkinson feels that liquidity is certainly the starting point. How valuations in real assets are impacted by rising rates and inflation, and how much further they have to go is a big talking point. Additionally, the disconnect between unlisted real estate valuations and where listed real estate is implying valuations are is interesting. Gating is an output of investors trying to redeem from unlisted assets at a time when fund managers cannot make liquidity available. Where transactions have slowed, valuations are uncertain. Managers need to consider the best interests of all investors and it might not be in the best interests of everyone to sell assets at that point in time. 

Typically, this approach has worked well. The structures designed to maintain stability for the vehicle, prevent a liquidity mis-match, and maximise long-term value for investors. Wilkinson added that the majority of investors have been focused on long-term performance, which is positive. However, it gets interesting and provides opportunity when certain managers need to provide liquidity to investors who have to redeem. As the market starts to stabilise and investors get a better feel for how to underwrite and value assets and transactions pick up, then some normalisation will occur. There may also be situations where some managers are overwhelmed by the cost of capital and look to sell into an opportunistic market. This potentially means an asset may come to market that is well located, but where the manager does not have the expertise nor capital to do the work required to generate occupier demand. Additionally, some owners may be forced, or choose to sell, when sufficient time has passed for reality to set in, and either their assessment of future returns out of an asset readjusts, or they succumb to the increased pressure of a much higher interest rate load. All these scenarios provide buying opportunities for asset accumulators.

Where would you invest your incremental dollar?

Leonie Wilkinson

"Well-located logistics"

David Pace

"Stocks, such as CSL Limited."

Jay Sivapalan

"Senior debt of AREITs."

Simon Doyle

"Direct assets that have been sold at distressed prices."


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