Jonathan Armitage, Chief Investment Officer, MLC
In a low growth, low return environment, investment managers need to be more prepared and more risk-aware than ever. Jonathan Armitage, MLC’s Chief Investment Officer, discusses the long game of investing when return opportunities are scarce.
We are in a low growth, low return, ultra-low interest rate environment that is close to being unprecedented and it’s a challenging environment for investors. The key priority is working out the best way to continue to manage clients’ portfolios while being very wary of the unique risks this environment poses.
One thing we are paying attention to is what is happening in the US. At the moment there is significant focus on whether the Federal Reserve will raise rates. Economic activity in the US continues to be quite robust – wage growth has picked up, and there is now quite a difference between what markets are saying forward interest rates might look like and some of the underlying data we are seeing from businesses about wage costs which are starting to increase. This all suggests the pressures around wages, one of the key contributors to inflation, are starting to pick up.
That is contrary to what we are seeing in Australia. Wage growth has been quite anaemic here.
We are seeing some differentiation with what’s happening in the US, where the Federal Reserve is moving towards normalisation of interest rates and in many other economies, where that appears to be some way off. Japan continues to ease monetary policy, for example.
The biggest risk is that as investors search for return, they move up the risk curve and end up investing in things they don’t understand and are tempted into investments that on the surface look okay but actually carry much greater risk.
Given where bond rates are, using that as a discount on future cash flows, may be the wrong answer. Valuations in a number of asset classes have moved because interest rates are so low.
We are wary that investments normally seen as very defensive, such as some government bonds, may not be as defensive given how low yields are. You have 45% of the stock of global government bonds now subject to negative or ultra-low interest rates, so these investments would no longer have the defensive characteristics investors would have counted on.
Another key risk continues to be that central banks and governments make policy mistakes. Whether the US Federal Reserve is behind the curve and inflationary pressures are building to a greater extent than people currently anticipate, or that continued monetary easing is just “pushing on a piece of string” and not working – the risk of mistakes is significant. If these policies are pursued we will see more cheap money coming into the market, which pushes asset prices further and valuations become stretched. This is a risk, because at some point valuations can get to a level where they aren’t sustainable.
Our Investment Futures Framework, which is a scenario-based modelling framework, looks to account for this kind of environment and any possible changes ahead. We haven’t changed any portfolios recently because we have been anticipating and modelling for this environment for some time and we made the adjustments we needed to in advance.
If monetary policy and growth remain tight and returns remain low, the Framework helps us accommodate this in our portfolios. If the US moves down the path of more protectionist and isolationist policies in response to the election, we’ve modelled for this scenario too.
The most interesting possibility is that the Australian dollar will end up weakening. The currency has always acted as a safety valve in Australia; you can see that coming in through economic data – tourism has picked up and exports are up. It is possible that the Australian dollar may end up much lower than it is now.
The key is having flexibility in terms of the way you think about asset allocation, and around the way you manage risk. That is one of the reasons we created the MLC Inflation Plus portfolios. We wanted to have that flexibility around asset allocation and a better way to manage risks.
Our asset allocation is quite conservative at the moment. Our cash weighting is relatively high, we have changed our exposure to fixed income – we have brought it down and have focused on shorter duration opportunities. We have also continued to hold our exposure to alternatives – including private equity and our low correlation strategy. Our low correlation strategy is a hedge fund-of funds investment that finds returns in components that look very different to shares and fixed income.
Within the MLC Inflation Plus–Assertive Portfolio we’ve made our first investment in commodities – in gold. That was driven by the desire to manage risk. We think gold offered an opportunity earlier this year to be uncorrelated to shares and fixed income. If markets do retrace, gold is likely to be relatively robust.
That is an important step for us, because it is a different asset class that historically we haven’t had any exposure to.
There are other investments where current prices are offering an opportunity over a medium-term view, particularly in uncorrelated asset classes.
History teaches us that it’s so important to be clear about your objectives and focus on how you manage risk. If something looks too good to be true, chances are it is. If you look back through history, you can see the build-up of mistakes prior to a crisis. The warning signs are usually there – and the watchout is not to be so entirely focused on return that you forget about risk.
For example, now we are again seeing the emergence of complex and opaque instruments that investors don’t really understand. Leverage has been increasing again – personal debt in the UK is now as high as it was in 2007, just prior to the GFC. Cheap money encourages people to take too much risk and makes them very vulnerable to changes in short-term interest rates.
Many investors have experienced a period of strong investment returns, so we need to do a better job in educating investors about having realistic expectations about the returns that are available in this environment and the importance of managing risk.
For investors in accumulation phase, we encourage them to stay the course. The lesson post-GFC is that people who were still a long way off retirement and held the course recovered, while those who cashed out too soon lost a lot. Not making short-term decisions is important in this environment.
For those closer to or in retirement, it is critical to make sure they understand the risks of what they’re investing in and have clear outcomes in mind rather than just short-term returns. We created the MLC Inflation Plus portfolios so we could give investors an outcome-focused investment option that was strongly focused on risk management.
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