Resetting expectations for long-term rates

Funds Management

by Clive Tompkins

MLC Senior Portfolio Manager, Dr Ben McCaw, speaks to Cassandra Crowe, Research Manager, about the recent market volatility brought on by expectations of rising long-term rates and the MLC low correlation strategies.

Cassandra Crowe:
Hello. My name’s Cassandra Crowe and I’m the Research Manager for the MLC strategies. Today, I’m here with Portfolio Manager Ben McCaw.

Hi Ben. Thank you for joining us today.

Ben McCaw: Hi Cass. It’s good to be back.

Cassandra Crowe: So Ben, today I wanted to ask you about what we’re seeing in markets, and if we look over last year, interest rates are starting to rise. We’ve seen the Bank of England raise interest rates for the first time in ten years, I believe, and the Fed is doing a similar trend. Can you tell me a little bit about what that means for the debt allocation in your portfolios and also any thoughts on inflation expectations as well?

Ben McCaw: It’s right. I mean, the Fed and the BOE have both been raising rates recently. But it’s not the fact that central banks are raising rates that’s put the market off. I mean, changes to the cash rate in the US and also in the UK were pretty well anticipated by the market. The difference and the thing that the market perhaps hasn’t anticipated that well is the pricing of longer-term interest rates. So, the yield curves have been quite flat insofar as as the cash rate has moved up, longer term bonds haven’t sold off very much at all, so we’ve actually got a very flat yield curve, which has kept longer term borrowing costs down.

And the main driver of the repressed back end of the yield curve has predominately been a grounding in the current view on inflation, that is, that inflation is far less likely than it has been in the past. Well, that’s the view of the market anyway. But we disagree with that. I mean, we’ve always thought that there are different outcomes from inflation and we’re not guaranteed to get a continuation of the low inflation environment that’s been around, you know, for the last 10 years or so since the crisis.

And I think what happened in markets last week was not so much about the outlook for short-term rate, it’s more about the markets resetting its expectation of longer-term rates based on a realisation that inflation may in fact come around again.

Now, that’s been very important for us because, as you’re aware, the Horizon funds have had a reduced exposure to interest rates for the past three or four years now. We’ve been running what we call a short duration position, which means the funds don’t have as much sensitivity to a rise to longer-term interest rates as they ordinarily would, and in the Inflation Plus portfolios where we’ve got a lot more degrees of freedom, we have no direct exposure to longer-term interest rates.

Cassandra Crowe: So, looking at equities now, I know it’s been a very volatile time, you know, very recently for equity markets. Can you comment on how you’re protecting the portfolios in light of the recent dip in equity markets?

Ben McCaw: Equity markets recently have been very difficult for us. The reason is that exposure to equities for a diversified fund is very important for long-term performance, but, at the same time, when equities become expensive, which is partly because of what we talked about before on the interest rate side, the question becomes how do you maintain exposure to the benefit of owning equities, but control the downside risk at the same time.

In Horizon, we’ve been running with pretty much a neutral allocation. We’ve obviously been nervous to extend allocation beyond neutrality. But within Inflation Plus, again we’ve got more degrees of freedom. The equity allocation there has been specifically crafted to target exposure to businesses that we think will be much more resilient in the face of a rising cost of funds and rising inflation.

Cassandra Crowe: Absolutely. And so I guess we’ve spoken about interest rates and now we’ve spoken about equities. Does this mean... You know, are alternatives more important now with all of the volatility that we’re seeing in the market? What’s your view there?

Ben McCaw: I think alternatives always have a place in a portfolio, and that maps back to diversification always being important. The issues with diversification is that it’s easy to say we need to have diversification in portfolios, and sometimes it’s easy to achieve, but sometimes it’s not. And so if you think back to pre-crisis, for instance, diversification in those days was quite easy. All we really needed to do was to own equities and bonds together because if equities were expensive, bond yields were OK, and so there was room for bond yields to protect in the case of an equity sell-off. Now, since the crisis, that’s been very difficult because both equities and bonds have been expensive at the same time, and so we’ve been very active in foreign exchange markets, which is where we’ve seen most of the diversification potential in that environment. So people looking at our funds would have seen probably more foreign exchange exposure than we ordinarily would, and that’s not an indication that we’re particularly good, or we’ve got a predisposition to being active in FX markets, it’s just that diversification has been most easy to achieve -- from an Australian dollar point of view anyway -- in foreign exchange markets.

Alternatives complement that, but, you know, there’s liquidity issues obviously and fee issues, and with sensitivity to fees these days you’ve got to be very careful in how we allocate to alternatives and make sure that the alternatives that we allocate to are the best of breed. That’s why we hold LCS.

Cassandra Crowe: So Ben, you just mentioned LCS, and that’s MLC’s low correlation strategy, I believe? Is that right?

Ben McCaw: Yep, that’s correct.

Cassandra Crowe: Great, thank you. So Ben, wrapping up, finally, with just a topical question, looking at the US, we keep hearing about Trump’s tax cuts. What do you think that means for US markets, and does it have any impact here in Australia?

Ben McCaw: Well, first and foremost, Trump’s tax cuts will definitely be fiscally expansionary, right, and will stimulate growth in a simplistic sense. So, all else equal, you’d expect that the impact of economic growth on earnings will be positive, which will have a flow-on impact to equity markets, the long term being positive. But on the other side of that, we’ve going back to what we talked about early on. I mean, part of the market ‘s reaction last week was due to the outlook for inflation, and part of the outlook for inflation is again underpinned by the perception that Trump’s tax policy will cause fiscal expansion and put pressure on longer-term inflation and longer-term bond yields.

So there’s a push and pull impact of the tax cuts on equity markets. And focusing on Australia though, although Trump’s policies are primarily directed at the US, you’re right to think that there will be some impact on Australia. I mean, globalisation has linked up economies much more closely than they were in the past, and so just simplistically through the impact of economic growth in the US on Chinese exports and then back to Australia, means that there is some transmission mechanism for Trump’s policies to feed back onto Australia, but I wouldn’t expect a massive change.

Cassandra Crowe: Well, Ben, thank you very much for sharing your insights and thoughts today.

Ben McCaw: No problem, Cass. It was a pleasure to talk to you.