It’s hard to recall, but it was only last year that we were talking about the prospect of increased cash rates, the slow down or ending of quantitative easing programs, historically low unemployment and strong economic tailwinds in the U.S. economy with the potential to drive global growth forward. While there were risks and issues on the horizon, a la Brexit, the disastrous Italian economy, and some emerging tensions on trade, prospects for markets seemed fairly positive.
A few offending tweets later, a package of tariffs and tit for tat trade retaliations accompanied by a market sell-off and rebound, and the world has flipped 180 degrees to increasing concerns on growth, rising unemployment and the prospect of a recession sometime in the next 12-18 months. 10 out of 12 of the last business cycles ended in recession and, as we all know, they’re not particularly favourable investment climates for equity holders.
While the rest of the world may be familiar with zero rates on cash, with the RBA reducing its cash rate to 1% in July of this year and forecast to drop another 0.50% by next year, the prospect of earning no interest on term deposits and other cash products is now very much front of mind for Australian investors.
Of more concern is the fact that 0% nominal interest, assuming 2% inflation, is actually - 2% interest in real terms. For investors with cash holdings, their principal is actually going backwards in terms of purchasing power. Investors should be thinking that the opportunity cost of sitting in cash as opposed to being invested in other assets is now higher than it has ever been.
So – what are investors to do? Unfortunately, we’ve been seeing for a number of years investors moving up the risk spectrum. When interest rates on cash moved lower, in order to maintain the level of return on their portfolios, investors moved funds into higher returning asset classes, such as fixed income, high-yield securities or equities. They have looked at other types of assets, such as core infrastructure or property assets to try and get exposure to ‘safe’, but higher yielding assets. In the stock market, we’ve seen movements of funds into bank hybrid securities or the bank head stock, in order to access very attractive, fully franked dividend income streams.
This ‘reach for yield’ has helped investors maintain income streams, however it may have also materially increased the risk in investors’ portfolios. As Warren Buffet said, “Only when the tide goes out do you discover who’s been swimming naked”. In other words, it’s only when markets correct will some investors become acutely aware of the actual risks that they’ve been carrying in their portfolios.
When we build investment portfolios at Perpetual, we are always aware of the potential investment risk – we’re obliged to be aware as we construct plans for both a target level of return, as well as a given level of risk which is intended to reach a particular goal. One of the key planks of our “Protect and Grow” philosophy is researching and finding diversifying assets and sources of income that are aimed at making portfolios more resilient, particularly in times of market stress.
As opposed to just dialling up the credit risk or equity risk in investment portfolios, we actively seek out alternative assets, in illiquid or inefficient markets which are intended to generate returns with a higher probability of meeting their objectives. The managers we choose to manage the assets in our pooled funds invest in lesser known markets where demand for capital, typically, outstrips supply; such as private credit, tradeable loans and alternative income. Also, we can appoint managers that we consider have the ability to make stronger “skill-based” returns compared to managers in broader, more liquid but ultimately more efficient markets.
Perpetual has a long track record of investing in alternative sources of income where the economy has slowed and cash rates have started going backwards in real terms. There’s no question that the outlook is currently for a period of ‘lower returns for longer’. If there are opportunities to take on alternative sources of risk that don’t concentrate investors’ exposure to equity or credit markets, this additional ability to eke out potential returns in alternative assets will become all the more valuable in terms of continuing to target the return objectives of investors in the coming years.
Kyle Lidbury is Head of Investment Research for Perpetual Private. His team manages the Perpetual Income Opportunities Fund, the 2018 Best Multi-asset Fund as well as Perpetual being named 2018 Alternative Asset Manager of the Year in the Australian Alternative Investment Management awards.
This article has been prepared by Perpetual Investment Management Limited ABN 18 000 866 535 AFSL 234426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The information is believed to be accurate at the time of compilation and is provided in good faith. This document may contain information contributed by third parties. PIML does not warrant the accuracy or completeness of any information contributed by a third party. Any views expressed in this document are opinions of the author at the time of writing and do not constitute a recommendation to act. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital. Past performance is not indicative of future performance.
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