Implications for Everyday Australian Investors

Extraordinary monetary stimulus programs, implemented over a sustained period, create real problems for the global financial system. Cracks are starting to show in the form of reduced Defined Benefit pension payouts and an erosion of business and consumer confidence. Investors are essentially forced to take on more risk to generate meaningful income and higher expected returns. In so doing we believe this increased risk – and in particular equity volatility – needs to be effectively managed.
This is a large, complex and contentious topic to be covered in a single opinion piece. That being the case in the sections that follow, I’ll seek to draw out key concepts and ultimately illuminate a potential solution that can assist Australians investing for their retirement security.

A conundrum for investors

The challenging nature of the current market environment can be outlined as follows:

  • Rates are (incredibly) low;
  • Valuations are high;
  • Returns are likely subdued in the future;
  • Volatility is elevated, and;
  • Future liabilities loom large[1]

What this means for investors is that they face the conundrum of:

  • on the one hand, having to take on more risk to generate meaningful yield and deliver higher expected returns in the future;
  • while on the other, needing to preserve capital to meet future liabilities and avoid a damaging drawdown.

‘Modestly accommodative’ Fed Reserve monetary policy

Following the US Federal Reserve’s decision to leave rates unchanged this month, the associated press conference from the Chair Janet Yellen outlined a modestly accommodative view of US monetary policy.
“Since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future” (source: www.bloomberg.com, Janet Yellen press conference 21st September 2016)
I find this perspective extraordinary. After lowering the US Fed Funds rate to 0.25% in December 2008, maintaining this near-zero rate for seven years before increasing by just 0.25% to 0.50% in December 2015, I struggle to share the view of ‘only modestly accommodative’ monetary policy! Coupled with an estimated $4.5 trillion USD bond purchasing program, this perspective moves from being extraordinary to bordering on delusional.
The US Fed Reserve’s modestly accommodative monetary policy setting and influence of bond purchasing program may be seen visually in the charts below. Also shown is the resulting influence on Australian cash and bond yields.
US cash and bond yields
Figure 1. US cash and bond yields
Source: Datastream
 
AU cash and bond yields
Figure 2. AU cash and bond yields
Source: Datastream
Australia’s ‘resource driven resilience’ coming out of the Global Financial Crisis may be seen in figure 2. The recent collapse in Australian cash rates and bond yields is also clear to see. As has been the case across global financial markets, overly accommodative central bank monetary policies, sustained for too long, have markedly inflated asset prices. Australian yields have succumbed to this sustained stimulus effort and collapsed in the process. The cumulative effect has been to distort the efficient allocation of capital and bring a distinct ‘speculative tone’ to global financial markets.

Future liabilities looming large

Against this backdrop of collapsing cash rates and bond yields, consideration needs to be given to the influence on future liabilities. Following the Netherlands’ adoption of a new financial assessment framework (nFTK) in January 2015, ultralow long-term interest rates (used to discount future liabilities) have seen funding levels fall to a level where pension rights for members are now being cut. In February of this year the €300m Dutch pension scheme for midwives (SPV) announced its intention to cut member’s pension rights[2]. Unless long-term interest rates rise and/or equity markets move meaningfully higher, further cuts to much larger pension schemes payouts will have to be made. So spare a thought for the Dutchies!
While the migration of the Australian retirement savings system away from Defined Benefit to Defined Contribution has transferred this risk to the individual, the challenge to meet expected future liabilities doesn’t go away.

Early signs of policy restraint

I still clearly remember a fantastic statement by Mario Draghi during a speech early in to his Presidency of the European Central Bank: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.”[3]
Pleasingly, there seems to be some moderation in ECB policy more recently. Earlier this month, the ECB elected to leave rates unchanged and perhaps more importantly not to extend the current bond buying program beyond March 2017. It remains to be seen whether this is the start of a more moderate approach.
Another very recent and encouraging sign has come from the BoJ’s Haruhiko Kuroda, expressing concerns on the effect that driving down long-term bond yields has had on expected returns on insurance and pension products and the adverse effect this has had on people’s confidence. Kuroda also acknowledged ‘an excessive flattening of the yield curve could harm the economy’[4]. No doubt, Japanese banks would welcome this sentiment.
A key consideration in central banks easing what has been extraordinary and sustained monetary stimulus program is the effect on currency. John Abernethy has recently written on this topic of ‘Worldwide Currency War’[5]. As part of this monetary policy adjustment, more central bank capital may need to be directed to implementing a managed currency. It can be argued that a managed currency would be far less damaging to the broader financial system and business and consumer confidence than sustained negative interest rates in long-term bonds.

Market response and investing conditions

Following the ‘disappointment’ of the ECB’s decision not to continue its bond buying program, there was a contained sell-off across global equity and fixed interest markets. This change to the prevailing view of yields remaining ‘lower for longer’ (with sustained monetary policy stimulus) and corresponding ‘carefree risk mindset’ was a welcome contrast to what can best be described as central bank rhetoric aimed a carefully managing inflated asset prices deemed too big to fail.
The effect of the contained sell-off in financial markets is also apparent in the spike in market volatility. Chart 2 below shows the S&P 500 Price Index and the CBOE VIX since 31st August 2015.
US market volatility and drawdowns (S&P 500 Price Index and CBOE VIX)
Figure 3. US market volatility and drawdowns (S&P 500 Price Index and CBOE VIX)
Source: CBOE, S&P and Factset
What can also be observed in Figure 3 is the negative correlation between market uncertainty (the sharp increase in the VIX) and equities valuations. Over the past twelve months, there are multiple occasions where this relationship can be seen.

Capital preservation

Capital preservation is one of the foundations of long-term value investing. One familiar Benjamin Graham Principle is ‘first and foremost preserve capital, then try to make it grow’. During times of increased uncertainty there is a corresponding increase in the likelihood of capital loss from growth assets such as equities.
As was the case in Chart 2 over a shorter-time frame, this relationship between increasing uncertainty – measured by the S&P/ASX 200 VIX – and market drawdown in an Australian setting can be seen visually in Chart 3 below.
AU market volatility and drawdowns (ASX 200 Price Index and VIX)
Figure 4. AU market volatility and drawdowns (ASX 200 Price Index and VIX)
Source: S&P/ASX and Factset

Part of the solution to the investor conundrum

We believe that equity volatility can be managed and in so doing deliver a smoother return profile and improved outcome to investors. Unlike returns which are inherently difficult to predict, the tendency for volatility to cluster means it is less difficult.
In August 2016, Damen Kloeckner introduced ‘Portfolio Hedging with Exchange Traded Funds[6]’. Tools such as the Betashares Australian Equities Strong Bear Fund (BBOZ) provide an easily traded and transparent way to better manage Australian equity market volatility.
Within the Clime portfolios, we selectively incorporate a degree of portfolio protection. This is consistent with the foundational pillars of value investing and perhaps more importantly preserving our client’s capital. Consistent with our approach of using market selloffs to actively deploy capital, the negative market exposure and resulting positive payoff from portfolio protection provides additional capital to selectively invest in our most favoured positions. Incorporating portfolio protection in this way helps solve the investor conundrum of balancing the pursuit of meaningful yield and higher expected returns, with the need to preserve capital to meet looming future liabilities.

Summary

Extraordinary monetary stimulus programs, implemented over a sustained period create real problems for the global financial system. Aside from creating distortions in the efficient allocation of capital and bringing a speculative tone to financial markets, ultimately these measures actually detract from business and consumer confidence.
Cracks are starting to show in the form of reduced Dutch DB pension payouts to members. The Bank of Japan has also acknowledged the damaging effect of stimulus measures on insurance and pension products, and people’s confidence.
Australian investors effectively have two choices. Accept a lower living standard in the future or take on more risk to generate meaningful income and higher expected return. If choosing the later, we believe this increased risk – and in particular equity volatility – needs to be effectively managed.


[1] Having a background in equities, I will make the ‘glass-half-full’ forecast that Australia is not heading into a sustained period of deflation, where future liabilities would actually be lower
[2] CFA Institute member magazine, June 2016
[3] European Central Bank, Eurosystem Media, Speeches July 2012
[4]BOJ Shifts Policy Framework to Targeting Japan’s Yield Curve’, published 21 Sep 2016, by Toru Fujioka, Bloomberg, http://www.bloomberg.com/news/articles/2016-09-21/boj-shifts-policy-framework-to-targeting-japan-s-yield-curve
[5] ‘Outlook for 2016/17 Worldside Currency War’, John Abernethy, Clime Asset Management August 2016
[6] https://user.stocksinvalue.com.au/reports/content/201608/portfolio-hedging-exchange-traded-funds