Finding value deep within asset classes

13 Mar 2024

Our panellists

Jo Masters

Jo Masters

Chief Economist, Barrenjoey Capital Partners

Jo is the Chief Economist of Barrenjoey Capital Partners. She focuses on analysing trends across the Australian and global economies and financial markets, delivering those insights to investors, and senior members and executives of government and business.

Belinda Boa

Belinda Boa

Portfolio Manager, BlackRock

Belinda is the Head of Active Investments for Asia Pacific and Chief Investment Officer of Emerging Markets, Fundamental Active Equity, where she is responsible for delivering investment excellence and investment success in the region.

Rony Ma

Rony Ma

Managing Director, KKR

Rony joined KKR in 2011 and is a Managing Director on the Credit team. He serves as a portfolio manager for the firm’s private credit funds and portfolios.

Crispin Murray

Crispin Murray

Head of Equities, Pendal Group

Crispin is Head of Equities at Pendal Group, an ASX-listed fund manager with AUD 90 billion funds under management. He is responsible for managing a number of the firm’s flagship Australian equity funds.

Rob Mead

Rob Mead

Managing Director, PIMCO

Rob is a managing director in the Sydney office, head of Australia, and Co-Head of Asia-Pacific Portfolio Management. Previously, he was an executive vice president of the PIMCO Group, based between Munich and London.

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 leads LGT Crestone's portfolio construction. With more than 16 years' experience in financial markets and managed investments research across multiple asset classes, Stan has a wealth of experience in constructing portfolios and strategies for clients.

While global economic growth has continued to moderate, recent sticky inflation prints highlight that the mission of central banks has yet to be fully accomplished. Fixed income markets have relinquished much of their prior hoped-for aggressive central bank easing cycle for this year, while renewed excitement over the ’blue-sky’ potential of generative artificial intelligence (AI) has propelled equity markets to fresh record highs across the US, Europe, and Japan. The domestic equity market has also hit new highs. Elevated valuations and a year of elections are likely to sustain heightened market volatility.

At LGT Crestone’s most recent investment forum, we asked panellists to discuss the merits of the evolving ‘soft-landing’ consensus, together with the risks that central bank policy easing might be delayed as a result. This fostered a discussion that broadly supported adding to duration in fixed income, while risks in US equities led to a discussion on the opportunities in emerging markets and Japan, as well Australia, where the recent reporting season was viewed favourably. Panellists debated the attributes of alternatives, particularly their lack of correlation versus the need to maintain portfolio liquidity.

Themes emerging from the forum

•    The peak in rates is in, and growth has further to moderate—Despite the risk of a ‘no-landing’ scenario, panellists broadly aligned around a ‘softer’ growth landing in 2024, with the next move in interest rates likely to be down, as growth and inflation slow in the year ahead. Whether this will underpin a new cycle or renewed inflation risks through 2025 is less clear, while a Trump Presidency was flagged as a potential factor pushing inflation unexpectedly higher.

•    The cost of de-risking portfolios is at its lowest in 15 years—Interest rates are likely to fall in the year ahead. For investors who have been underweight duration and enjoyed a sustained ‘risk-on’ period in equity markets, moving duration towards a neutral position may be a sensible idea. Australia was viewed favourably in terms of the potential for adding to duration. High quality credit was also viewed constructively in the absence of a sharp growth slowdown.

•    Regional dispersion will likely foster equity opportunities—Concentration risk in markets is challenging active management and demanding a more nimble investor approach. Despite a favourable reporting season, domestic equity opportunities were debated through the lens of further potential consumer slowing. Emerging market opportunities are seen as somewhat captive to US policy easing, while Japan’s differing policy direction is also a key focus.

•    Alternatives benefit from being uncorrelated, but tactical liquidity remains key—The correlation between bonds and equities has not always been negative, and a more positive correlation is persisting post-pandemic. While this favours uncorrelated assets, a low correlation between bonds and equities still adds to portfolio diversification. They also provide much needed liquidity for tactical positioning. The absence of low-cost financing also challenges some areas of alternatives.

What's the next move for rates?

Growth appears to be slowing, inflation coming down, and there is an expectation that central banks will lower rates either later this year or in 2025. However, at the same time, the International Monetary Fund has upgraded its outlook for the global economy, forecasting growth of 3.1% in 2024—an uplift of 0.2% on its previous prediction. Is there a chance that markets could be wrong? Could the economy be gaining strength? Has inflation already troughed? Scott Haslem, Chief Investment Officer at LGT Crestone, posed the question to the panel as to whether the next move for interest rates could be up.

Will economic growth slow further in the US?

Jo Masters, Chief Economist at Barrenjoey Capital Partners, explained that most economies are performing better than expected, and in the US, the economy could very well be re-accelerating.

Rob Mead, Managing Director at PIMCO, agreed that the underlying economy in the US has been resilient. Housing, labour, and profits have performed well. However, PIMCO believes that the effects of monetary policy will eventually trickle through the economy and ‘do their job’, and he highlighted that household savings are depleting very quickly.

“If a slowdown happens as a result of policy tightening, there is still a degree of freedom or flexibility to ease if there is an unexpected aggressive slowdown. It’s not all ‘goldilocks’. There is a lot that needs to play out for a soft landing to eventuate.”

Belinda Boa, Managing Director at BlackRock, commented on how unusual this business cycle has been. Not only have we experienced a global health crisis, which was followed by massive monetary and fiscal stimulus, we are now experiencing monetary tightening and fiscal looseness.

Boa explained that it is likely that both US administrations will keep fiscal policy loose, and she questioned whether the soft-landing scenario represents an equilibrium for the economy. She believes the geo-political landscape plays a role in this. Any hostile reactions by the US could impact US Treasuries, so this needs to be considered when assuming that a soft landing is the base-case scenario.

“You have to assume a number of things are working well if we’re to engineer a soft landing without any issues.”

Rony Ma, Managing Director at KKR, explained that markets appear to have reached a consensus that the factors that would lead to a hard landing have disappeared.

“As credit investors, we are trained to assume a recession will take place the year after you make a new investment. But looking at history in the US, for economic weakness, either unemployment needs to be a problem or house prices need to be a problem. Neither of these factors appear to be an issue at present.”

What would another Trump presidency mean for the US economy?

Mead feels the outcome of the US elections may have a marginal impact on US growth and inflation, but the greater impact will likely be felt on the rest of the world. This is largely a reflection of the different geo-political policies the Democrats and Republicans have.

Masters feels that any geo-political retaliation by the US would likely fuel inflation.

“We’ve already seen this with the tariffs. It’s the US consumer who is largely paying for them. This adds more weight to the notion that inflation will be higher in the next 10 years than it has been in the last 10 years.”

On the subject of inflation, Crispin Murray, Head of Equities at Pendal Group, believes that while inflation will remain elevated, there are some counter-forces at play, including artificial intelligence and what is happening in China, which could keep a lid on inflation.

Expect to see more softness in Australian growth

Masters explained that growth in Australia has largely been driven by strong population growth—but, on a per capita basis, we are already in a deep recession, as is New Zealand. Going forward, she expects to see some softening in Australian growth, as well as in other regions, such as the UK, Europe and China.

Murray explained that the Australian consumer does not appear to have run down their accumulated savings as much as in other regions, and this has created a buffer for the economy.

The picture in Japan has changed

Stan Shamu, Senior Portfolio Manager at LGT Crestone, noted that Japan has lived through a different policy regime to counter deflation with no growth. There now seems to be a number of tailwinds (for the economy and subsequently markets) that are encouraging investors.

In terms of Japan’s macro and fundamental picture, Boa explained that a slowdown in growth for Japan’s trade partners could be a potential headwind for exports, but there are positive tailwinds, such as stronger wage inflation and a tax-exempt investment scheme. As there is always scope for policy error, she commented on the importance of not “betting everything on the macro”.

While acknowledging that Japanese companies have one of the highest cash balances on record, Boa also pointed to the challenges of market volatility, driven by actions from the Bank of Japan and the local currency.

Could the next move for rates be up?

Masters believes that across the major economies policy has achieved what it set out to do. She explained that the US is benefitting from an uplift in productivity, a trend not seen elsewhere. This is likely to lead to a situation where rate cuts are delayed, rather than triggering more hikes.

“The US has experienced a structural and cyclical uplift in productivity, which has lifted potential growth. This makes the economy look like it has ‘immaculate disinflation’, where supply-side inflation and transitory inflation are falling. It means that the US economy is now able to run a bit hotter than it has previously been able to.”

Haslem commented on how the market has been pricing in rate cuts, but the underlying economies have been stronger. He also noted that the pace at which inflation had been moderating had also pulled back and some rate cuts had subsequently been removed from forecasts. If the start of the rate-cutting cycle keeps getting later, potentially to Q3 2024, the overall thesis would appear unchanged—i.e., rate cuts are coming, but just a bit later. He also questioned whether there is a chance that the market has misread the next move in interest rates.

“Is there a chance that we are completely on the wrong page, that growth isn’t slowing and inflation has already troughed and the next move in interest rates is up?”

Although the market is painting a picture of positive sentiment, Mead feels the consumer is feeling more pain than the numbers suggest. He explained that investors should be aware that central banks tend to hesitate before cutting rates.

“They’d rather be too late to the party and let economies slow a bit more than they need to, rather than prematurely cut. Borrowers and lenders need to realise that rapid rate cuts may not materialise.”

In terms of the timing of rate cuts, Masters feels the European Central Bank (ECB) could move before the Federal Reserve (Fed). For now, Barrenjoey Capital sees the Fed and ECB both cutting around June this year.

“The ECB is operating in a very different economic backdrop, both cyclically and structurally. There are also geo-political concerns it needs to deal with.“

Volatility will likely remain elevated

Masters commented that supply-side shocks make forecasting challenging. Not only are they difficult to model, they are also difficult to understand. She sees the trend of supply-side shocks continuing, driven by a variety of factors, including geo-politics and climate change.

“While we believe in the concept of economies always reverting to their equilibrium, we are likely to see a lot more volatility going forward—in the business cycle, inflation, and activity. We need to get better at dealing with that.”

The LGT Crestone view: We expect most central bank policy easing to start in H2 2024, as inflation moves closer towards central bank targets. Overall, the backdrop for financial markets is constructive, and the likelihood of a ‘hard’ economic landing globally has decreased.

"[Central banks would] rather be too late to the party and let economies slow a bit more than they need to, rather than prematurely cut. Borrowers and lenders need to realise that rapid rate cuts may not materialise."

Rob Mead, Managing Director, PIMCO

Is it time to add duration?

Last year was characterised by global central banks fighting inflation, and outright yields in investment grade bonds rising to be at or close to 20 year-highs. With yields compressing in other asset classes, fixed income returns have once again become competitive. As markets adjust to the reality of higher long-term interest rates and persistent inflationary pressures, bonds have once again regained their relevance, underscoring the important role this asset class plays in investment portfolios. The panel discussed whether now is the time to add duration in portfolios, as well as some of the areas where they are seeing opportunities in fixed income markets.

Is it time to add duration?

Haslem feels that 2024 will be a tale of two halves, characterised by higher rates in the first half of the year, with the second half paving the way for moderately lower rates. While this scenario would have been ideal for bonds and equities, markets have pre-empted these potential rate cuts, and equities have already rallied. Given the expectation that interest rates will fall, he feels it is still worth remaining modestly overweight duration in fixed income portfolios, as yields will likely rally further when the first round of central bank rate cuts is delivered.

Mead explained that PIMCO has been adding duration. Previously, PIMCO had been underweight the front end of the yield curve as it believed the market was pricing in too many rate cuts. Now, it feels yields are closer to fair value. For investors who have been underweight duration and who have ridden a very aggressive ‘risk-on’ period in equity markets, moving duration towards a neutral position may be a sensible idea.

Mead feels the cost of de-risking portfolios is currently much lower than it has been over the past 15 years.

“You’re not de-risking from an asset class that gives you double digits to one that gives you zero. Instead, you’re derisking from an asset class that may deliver double-digit growth to one that may deliver high single digits. This is an easier decision.”

Shamu added that fixed income is a broad spectrum and not just a duration call. He commented on the importance of investors structuring within the asset class and making their portfolios more efficient.

In which regions should investors increase duration?

When it comes to being overweight duration, PIMCO has a bias towards Australia versus the US. Mead explained that in jurisdictions that are less exposed to the transmission of monetary policy (such as the US where fixed-rate borrowers enjoy a higher level of protection) central banks may hold rates higher for longer—or may be very slow to cut. However, markets like Australia and New Zealand (where policy traction is occurring more rapidly, particularly as fixed-rate mortgages expire) will likely rally first.

Where are the opportunities in credit?

Ma sees compelling opportunities in both public and private credit, and supports the notion of some high quality duration. Within private credit, he thinks there are attractive opportunities to invest in larger borrowers in non-cyclical industries like software, business services and insurance, as well as in asset-based finance.

Mead added that quality US corporates were protected during the pandemic and were able to raise very long-dated funding. He sees these as a great proxy to add duration in some of these high quality areas.

“These are incredibly well protected borrowers with strong robust underlying cashflow strength.”

The LGT Crestone view: If markets experience volatility, we expect fixed income (particularly government bonds and investment grade credit) to be relatively defensive, particularly if the growth outlook deteriorates. At a sub-asset class level, we are positioned in favour of both investment grade and high-yield credit, though expect investment grade to outperform high-yield credit.

What are the key messages from reporting season?

With positive signs emerging from reporting season, equity markets have continued to rally, reaching new highs. We asked our panellists what the key messages were from the recent reporting season, whether there is room for any upside from Japan, as well as the outlook for emerging markets.

What are the key messages from reporting season?

For Murray, the key message from reporting season is that there are no real challenges with underlying demand. While the positive story in Australia could be explained by population growth, he believes that the overall message remains a positive one. Banks are interesting because the ‘mortgage cliff’ (i.e., where a large proportion of borrowers on fixed-rate mortgages have needed to refinance with higher variable mortgages) was largely uneventful, and consumers appear to have been adapting to the new regime. In the US, there have been material earnings upgrades this reporting season. However, corporates are acutely aware of the dangers of media and/or government backlash if they broadcast how well they are doing. In the US, there have been material earnings upgrades this reporting season.

Masters agreed that the market underestimated the extent to which consumers could readjust to the new regime by working longer hours to boost household income. However, the labour market is now slowing, with average hourly earnings contracting faster than during the GFC. As a consequence, we should expect to see some slowdown.

Murray added that a rise in merger and acquisition (M&A) activity has been a positive for Australia, with Boral, CSR and Altium all recently targets.

“This corporate activity is a good signal of how companies see prospects for their businesses.”

Murray explained that one of the macro signals Pendal Group follows is how different sectors perform at different points in the market. As an example, in the US, discretionary companies have outperformed staples, which suggests that people are reasonably comfortable with the economic outlook. It is for this reason that he feels the technology sector has been the best performing sector recently.

Room for further upside in Japan

There have been significant international cross-border flows into Japan recently, and Boa feels that we are only at the start of that trade. Approximately 50% of the TOPIX index still trades below book-to-value, so there is room for further upside.

For global asset portfolios and multi-asset managers, Japan is likely to represent a larger allocation of portfolios going forward, or be an individual allocation or line item, given it is likely to have a different policy direction from the rest of the world.

What’s the outlook for emerging markets?

While emerging markets have been unloved more recently, Boa feels the fundamentals are beginning to look more appealing.

“We are expecting earnings growth just shy of 20%, which is significantly better than developed markets. Valuations are also looking more attractive and central bank balance sheets are probably the best we’ve seen.”

Emerging market equities have been in a ‘holding pattern’, waiting for action from the Fed. Boa explained that if the Fed cuts interest rates and US dollar dominance subsides, this could be very positive for emerging markets. On the flip side, if rates remain higher for longer and global growth slows, this would be negative. Importantly, dispersion within country allocations across emerging markets remains large, so it is important to remain active and not passively allocate.

How should investors deal with greater index concentration?

Murray explained that higher concentration makes it harder for investors, particularly active managers. However, it’s important that investors still think about active management, particularly when it comes to drawdown risks, as this is where being active and nimble really does add value. Murray commented on how an increase in passive investing, as well as diversification away from listed equities, have led to opportunities in valuation arbitrage. Quite often, private equity and corporate M&A can capture these arbitrages.

The LGT Crestone view: We are neutral equities overall, reflecting the ongoing resilience of the US economy and corporate earnings. We are overweight domestic equities due to attractive relative valuations and potential tailwinds from economic outperformance. We are underweight Europe due to its weaker macro and earnings outlook.

What does this mean for multi-asset portfolios?

With correlations between equities and bonds in positive territory, this has presented challenges for portfolio construction. Investors have increasingly been broadening the opportunity set, and questioning whether there is still a place for the traditional 60/40 (equities/bonds) asset allocation split. We discussed the future of the 60/40 rule, and if alternatives are likely to become a permanent fixture in portfolios.

Will positive correlations between equities and bonds persist?

Shamu highlighted that there has been a misconception that the correlation between equities and bonds has always been negative. The reality is that there have been many regime shifts historically. As an example, in the early 1990s, when inflation was high, there was a positive correlation between the two asset classes, while in the early 2000s, there was a negative correlation.

According to Boa, the correlation between fixed income and equities has changed structurally, and this raises the question about whether there is still a place for the traditional 60/40 (equities/bonds) asset allocation split.

“Previously fixed income has been used as a hedge [against equities], but that has changed. Now, alternatives will likely become a permanent fixture in portfolios. The underlying reason for this is structural and has long-term implications for asset allocation.”

What does this mean for portfolio construction?

Mead warned against abandoning the 60/40 rule entirely. He highlighted that the rule can work even when there is low correlation—it does not necessarily have to be negative correlation. He also cautioned that investors need to be cognisant of less regular mark-to-markets in private markets. This may give the impression of less volatility, but it is not necessarily the case.

Boa emphasised that in this environment of increased volatility, it is important to be active and tactical, and not take large directional views. Passive investors need to understand what they are buying and their exposures. Looking deeper within asset classes for opportunities will be key, and it will be important to rebalance more frequently.

What are the compelling opportunities in alternatives?

According to Ma, private credit has become very popular with investors, as has infrastructure. Private credit can mean many different things, but much of the interest among investors has been in direct lending, which is a core allocation in many investor portfolios. This is because it generates current income with an illiquidity premium and is generally not volatile from a mark-to-market perspective.

Ma explained that there are also opportunities in subordinated debt (floating and fixed-rate) and asset-based financing. He sees asset-based financing as a particularly interesting segment of credit which is growing rapidly and increasingly seen as complementary to direct lending in investor portfolios. This is, in part, because the investment opportunity set for asset-based finance is expanding with attractive portfolios of loans coming to market as regional banks continue to divest non-core assets following the US banking crisis last year.

Ma believes investor strategies in private equity will need to adapt to a different regime over the next 15 years, and there needs to be a greater emphasis on value creation. This is in contrast to the last 15 years, where a low-rate, high-growth environment allowed for lower cost of debt financings and a more benign equity valuation market opportunity.

“Corporate carve-outs are great for this and present a big opportunity. The focus will be on true operational value creation. Japan and Korea have been great for this.”

The LGT Crestone view: Within alternatives we favour private debt and credit-oriented strategies. Low double-digit yields for US private debt make for an attractive entry point to an asset class that has historically offered equity-like returns with far lower risk. However, being active, flexible, and opportunistic will be key.

Where would you invest your incremental dollar?

Jo Masters

Jo Masters

Chief Economist, Barrenjoey Capital Partners

“Small-cap equities and Japan.”

Belinda Boa

Belinda Boa

Portfolio Manager, BlackRock

“Japan (and the next round of transformations).”

Rony Ma

Rony Ma

Managing Director, KKR

“Asset-based finance within credit.”

Crispin Murray

Crispin Murray

Head of Equities, Pendal Group

“Companies with great intrinsic value, low risks, and high yield.”

Rob Mead

Rob Mead

Managing Director, PIMCO

“Core bonds supplemented by asset-based finance, aviation finance, and life insurance receivables.”

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