Sinead Rafferty, Portfolio Specialist, NAB Asset Management speaks with Dr Susan Gosling, Head of Investments, MLC, about a challenging investment environment for 2019.
Sinead Rafferty: Hi I'm Sinead Rafferty Portfolio Specialist at NAB Asset Management and I'm joined by Dr Susan Gosling, Head of Investments at MLC. Welcome Susan.
Dr Susan Gosling: Thank you Sinead.
Sinead Rafferty: Susan, 2018 saw the worst share market falls we've seen since 2008. What happened?
Dr Susan Gosling: The fragilities underlying the prolonged strong returns of the past few years became more apparent in the final quarter of 2018. Prior to that, real returns had for 6-7 years been well in excess of long term averages. These returns rested on the foundation of ultra-low interest rates and quantitative easing. Low rates and easy money pushed investors up the risk spectrum making all assets expensive at the same time. During the March quarter last year we saw the first challenge to the perception that the strong return environment can persist. Stronger than expected US wages data resulted in a sharp interruption to the US share market’s relentless rise. Investor behaviour has to some extent shifted towards ‘selling the rally’. This is in contrast to what has been a persistent ‘buy the dip’ mentality over the past decade. However, a sustained shift in investor expectations requires repeated confirmations that the future is not as rosy as previously presumed. In the December quarter a combination of monetary policy concerns, global trade worries and related concerns about global growth, plus the US budget impasse more clearly shift investor expectations.
Sinead Rafferty: Were the market impacts in 2018 similar to what we saw in 2008?
Dr Susan Gosling: In 2008 when equity markets declined, government bonds yields fell sharply and returns surged providing a great risk offset. But last year bond yields were not an effective source of diversification. While bond yields did decline in the December quarter, for the year as a whole they rose. This confirms what we already suspected that the only reliable way to limit downside risk has been to accept lower returns. Our understanding of this reality is the reason our real-return funds, the inflation-plus portfolios have been positioned so defensively.
Sinead Rafferty: What was the most important change?
Dr Susan Gosling: The pivotal change has been that the progressive tightening of monetary conditions is starting to have an impact. The US has raised interest rates nine times over the past three years, and is stepping up quantitative tightening. Additionally, the ECB is running down quantitative easing; and the Bank of Japan has now reduced asset purchases. Tighter liquidity will be particularly challenging given that, not only is US Treasury bond issuance rising, but there is also a very significant jump in volume of US investment grade debt maturing in 2019.
Sinead Rafferty: In the light of all this, what does the future hold?
Dr Susan Gosling: While it can take a long time, the fundamentals will ultimately drive market outcomes. Asset prices that are high suggest low future return potential. While there are some exceptions (emerging market equities), our assessment is that asset prices are mostly not cheap and in some cases (US equities, nominal bonds) clearly expensive. We suspect that many investors remain over-optimistic and vulnerable to misperception about the risks that lie just beneath the surface. But the path of returns that unfolds will depend on how investor expectations change. A trade deal between the US and China that is favourable for economic growth is still possible. The argument over the Mexico border wall will be resolved one way or another. We also know that the US Fed is ‘data dependent’ and that US economic growth is still robust.
So a positive mindset could persist across global financial markets, and we have seen some of that during January in response to soothing words from the Fed and hopes for a trade deal.
However, the reality is that liquidity is tightening. The rise in equity market volatility is a reminder of vulnerabilities that have accumulated in the financial system. And we also know that the Fed understands the imperative to build policy options for the next economic downturn. Indeed the Fed under the leadership of Jerome Powell has partly removed the “lower for longer” bias that has distorted the outlook for US interest rates. This is a very important change for all risk asset markets. The presumption of “lower for longer” interest rates has been a core driver of stretched valuations across asset classes. Even a small movement in long term discount interest rates can have a pronounced effect on the valuation of all assets.
Sinead Rafferty: Have you made any changes to the portfolios in light of this?
Dr Susan Gosling: Following the equity market decline, we have cautiously added to our equity allocation for Inflation Plus, but we continue to believe that it will be difficult for the strong returns of past years to resume and that significant vulnerabilities and downside risks remain. As we have said before, we are at the beginning of the end of an era. The tailwind of abundant liquidity has turned into more of a headwind.We expect this to continue to challenge asset prices, inflated by the presumption of low rates and easy money.
Sinead Rafferty: Thanks for your time Susan.
Dr Susan Gosling: Thanks Sinead.