Market Watch

https://w.soundcloud.com/player/?url=https%3A//api.soundcloud.com/tracks/724800409%3Fsecret_token%3Ds-wsdpL&color=%23ff5500&auto_play=false&hide_related=true&show_comments=false&show_user=true&show_reposts=false&show_teaser=true&visual=true%22%3E

With interest rates at historic lows and concerns regarding valuations of equity markets, retirees often wonder what is the right strategy to generate sustainable income for the longer term? In this podcast episode, we speak with Dermot Ryan, Co-Portfolio Manager at AMP Capital, to discuss this timely topic.

Author: Tim Keegan, Global Head of Marketing Digital & Innovation & Direct, Sydney, Australia

Source: AMP Capital 9 Dec 2019

Important notes: AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity and the issuer of units in the AMP Capital Equity Income Generator (Fund). To invest in any the Fund, investors will need to obtain the current PDS from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232 497) (AMP Capital). The PDS contains important information about investing in the Fund and it is important that investors read the PDS before making a decision about whether to acquire or continue to hold or dispose of units in the Fund. Neither AMP Capital, AMPCFM, nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this podcast. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this podcast, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This podcast has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of the information in this podcast, and seek professional advice, having regard to their objectives, financial situation and needs. This podcast is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. For more information on the fund, please click here.

There are several global events and themes on our radar for the remainder of 2019 and moving into 2020. Those who recognise the utility of bonds in a broader investment portfolio should take note of these broader conditions.

There have been strong gains for bonds in recent months, after a period of declines. An example from the Australian market is pictured below. Part of the reason for this could be that bond markets are responding to an anticipated global economic recovery.  

Source: Bloomberg, as at 30/9/2019

Here, we take a look at some key events on the global stage that impact fixed income markets.

Financial conditions

Policy easing has contributed to more supportive financial conditions worldwide, which is one to watch moving into 2020.

In fact, the monetary easing put into effect this year is one of the reasons our chief economist, Shane Oliver, holds some optimism about the global economy for the year to come.

That said, central banks are expected to remain dovish for a period, and in some cases, constrained in their ability to offer further support. The Reserve Bank in Australia, for example, has called on the federal government to introduce fiscal stimulus into the economy.

Growth on the global stage

Economic growth internationally is, as ever, one to watch. Broadly speaking, although monetary policy is set to have an impact, conditions are still soft and the risk of recession lingers.

Further, there are ongoing weak spots of note. For example, there is an increasing risk that trade-induced weaknesses in both Europe and Asia are becoming entrenched. Given time, this may begin to spill over into the United States.

In addition, core inflation has been suppressed, but looks set to be moving slowly higher if growth can rebound globally.

Trade tensions

The fixed income market is also not immune to the knock-on impacts of an event which has had a far-reaching impact on international economies since it began: the US-China trade war.

The political climate in the US, as it heads towards the federal election in 2020, could prompt a short-term breakthrough. US President Donald Trump will be under pressure to keep the economy stable, and progress on trade talks with China would be favourable for his campaign.

Nevertheless, the conflict remains a key risk to watch and monitor for impact.

In focus: the Australian market

No doubt, in a lower-for-longer environment, investors in the Australian market would be questioning the utility of a bond portfolio.

Source: AMP Capital Global Fixed Income team, 30/09/2019.

Granted, Australian bonds will not be able to provide the same defensive attributes that they have historically, given the multi decade falls in yield, but in a world of ever increasing negative yielding debt, Australian bonds continue to offer defensive characteristics. Australian bonds whilst offering a low yield, remain a triple AAA rated, liquid, defensive asset, that is attractive to many of its peers.

Author: Ilan Dekell, Head of Macro Sydney, Australia

Source: AMP Capital 5 Dec 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

At its meeting today, the Board decided to leave the cash rate unchanged at 0.75 per cent.

The outlook for the global economy remains reasonable. While the risks are still tilted to the downside, some of these risks have lessened recently. The US–China trade and technology disputes continue to affect international trade flows and investment as businesses scale back spending plans because of the uncertainty. At the same time, in most advanced economies unemployment rates are low and wages growth has picked up, although inflation remains low. In China, the authorities have taken steps to support the economy while continuing to address risks in the financial system.

Interest rates are very low around the world and a number of central banks have eased monetary policy over recent months in response to the downside risks and subdued inflation. Expectations of further monetary easing have generally been scaled back. Financial market sentiment has continued to improve and long-term government bond yields are around record lows in many countries, including Australia. Borrowing rates for both businesses and households are at historically low levels. The Australian dollar is at the lower end of its range over recent times.

After a soft patch in the second half of last year, the Australian economy appears to have reached a gentle turning point. The central scenario is for growth to pick up gradually to around 3 per cent in 2021. The low level of interest rates, recent tax cuts, ongoing spending on infrastructure, the upswing in housing prices and a brighter outlook for the resources sector should all support growth. The main domestic uncertainty continues to be the outlook for consumption, with the sustained period of only modest increases in household disposable income continuing to weigh on consumer spending. Other sources of uncertainty include the effects of the drought and the evolution of the housing construction cycle.

The unemployment rate has been steady at around 5¼ per cent over recent months. It is expected to remain around this level for some time, before gradually declining to a little below 5 per cent in 2021. Wages growth is subdued and is expected to remain at around its current rate for some time yet. A further gradual lift in wages growth would be a welcome development and is needed for inflation to be sustainably within the 2–3 per cent target range. Taken together, recent outcomes suggest that the Australian economy can sustain lower rates of unemployment and underemployment.

Inflation is expected to pick up, but to do so only gradually. In both headline and underlying terms, inflation is expected to be close to 2 per cent in 2020 and 2021.

There are further signs of a turnaround in established housing markets. This is especially so in Sydney and Melbourne, but prices in some other markets have also increased recently. In contrast, new dwelling activity is still declining and growth in housing credit remains low. Demand for credit by investors is subdued and credit conditions, especially for small and medium-sized businesses, remain tight. Mortgage rates are at record lows and there is strong competition for borrowers of high credit quality.

The easing of monetary policy this year is supporting employment and income growth in Australia and a return of inflation to the medium-term target range. The lower cash rate has put downward pressure on the exchange rate, which is supporting activity across a range of industries. It has also boosted asset prices, which in time should lead to increased spending, including on residential construction. Lower mortgage rates are also boosting aggregate household disposable income, which, in time, will boost household spending.

Given these effects of lower interest rates and the long and variable lags in the transmission of monetary policy, the Board decided to hold the cash rate steady at this meeting while it continues to monitor developments, including in the labour market. The Board also agreed that due to both global and domestic factors, it was reasonable to expect that an extended period of low interest rates will be required in Australia to reach full employment and achieve the inflation target. The Board is prepared to ease monetary policy further if needed to support sustainable growth in the economy, full employment and the achievement of the inflation target over time.

Source: Reserve Bank of Australia, December 3rd, 2019

Enquiries

Media and Communications
Secretary’s Department
Reserve Bank of Australia
SYDNEY

Phone: +61 2 9551 9720
Fax: +61 2 9551 8033

Email: rbainfo@rba.gov.au

In today’s environment of low interest rates, many investors are chasing income by moving into lower-quality high-yield bonds, but are they ignoring the downside risks?

While an overweight to high-yield credit may be an efficient way to boost a portfolio’s yield, investors need to be mindful of the additional risks they are taking on and how those risks will interact with other parts of their investment portfolio.

For example, for retirees seeking a stable income-generating portfolio, the addition of less-liquid bonds that have an increased risk of capital volatility might not be the right investment option, despite the income they produce.

Here, we explore the different types of fixed income securities and their associated risks.

Types of fixed income securities 

The types of fixed income securities investors can choose from include both publicly-traded debt securities (such as corporate bonds, sovereign and non-sovereign government bonds, supranational bonds, and commercial paper) and privately-traded instruments (such as loans and privately placed securities). The credit market also includes structured financial instruments, such as mortgage-backed securities, asset-backed securities, and collateralized debt obligations, which tend to exhibit higher yields (and lower liquidity) as the complexity increases.

Within corporate bonds, there are several classes of debt, ranging from senior bonds to preferred securities. Senior bonds have greater security in the issuer’s capital structure than subordinated debt and preferred securities. In the event the issuer goes bankrupt, senior debt must be repaid before other creditors receive any payment. Senior debt is often secured by collateral on which the lender has put in place a ‘first lien’ or legal right to secure the payment of debt. The further down the capital structure a security is, the higher the risk of ultimate loss.

The importance of quality bonds

A bond issuer’s ability to pay its debts (i.e. to make all interest and principal payments in full and on schedule) is a critical concern for investors. Most corporate bonds are evaluated for credit quality by credit rating agencies, such as Standard & Poor’s, Fitch Ratings and Moody’s Investors Service, and result in a rating on a standard scale that can be compared across issuers. These ratings scales are broadly split into two categories to reflect safer securities – referred to as “investment-grade” – and riskier securities – referred to as either “speculative-grade” or “high-yield”.

The financial health of the company or government entity issuing a bond affects the bond’s yield and subsequently the price investors are willing to pay. If the issuer is financially strong and investors are confident that the issuer will be capable of paying the interest on the bond and pay off the bond at maturity, then the yield will be lower as the perceived risks are lower.

High-yield corporate bonds on the other hand have lower, speculative-grade credit ratings than their investment-grade brethren. The greater risk of loss implied by these lower ratings, leads to higher yields compared with those seen within investment-grade corporate bonds. This is because there is a higher probability that a borrower defaults or fails to meet its obligation to make full and timely payments of principal and interest. Historically, speculative-grade companies experience higher default rates throughout economic cycles – and particularly so during recessions – resulting in potentially significant losses to investors when these occur.

Liquidity and volatility

High-yield bond funds tend to invest in loans, corporate bonds and structured credit which are at the riskier end of the investment universe. These types of securities can be difficult to buy or sell as they do not trade frequently, making them less liquid than investment-grade bonds. Bond funds where the underlying investments are investment-grade rated typically provide investors with daily liquidity as the market for these assets is larger, better-known and therefore more liquid. This is most prevalent when markets are volatile and investors are searching for “safer” assets, and when market pricing tends to be very reactive to liquidity and volatility risks.

High-yield bond funds can often have returns that behave similarly to equity markets; in other words, their returns often move in the same direction as equity markets. This is due to the capital price impacts of movements wider in credit spreads; namely the size of the bond yield margin above a risk-free asset yield which compensates investors for the associated credit risk. Typically, a credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity.¹

When credit spreads widen, this is a reflection that the market for those securities is requiring higher compensation for the underlying risk of holding those securities – for instance, for a higher risk of default, or more compensation for liquidity risk.

In times of heightened volatility, these dynamics can become self-reinforcing, given the right conditions. For instance, investors observing the capital value of their investment falling (as risks are increasing) may attempt to sell their exposure. If enough investors attempt to sell the same assets into a liquidity-constrained environment, this can exacerbate the issue, causing further losses – and in extreme circumstances, can cause a fund to “lock-up”, or result in capital being unable to be returned to investors in a timely fashion.

All investors have a different risk-return appetite; however, investors need to be mindful that economic growth has been reasonably solid for much of the past decade, and an environment where yields have been pushing progressively lower creates an environment where liquidity and volatility risks may not be appropriately priced in some markets. Funds with larger exposures to credit investments of lower-quality or greater complexity are likely to exhibit a higher likelihood of drawdowns on capital, and the potential for negative returns.

The final word

The ‘lower-for-longer’ interest rate theme continues to dominate markets, and low yields are likely to see low returns from bonds for a period of time. Investors moving into lower-quality high-yield bonds, should consider whether the additional yields on such bonds adequately offset the higher capital volatility and liquidity risks that come with them.

A retiree, or someone heading into retirement typically needs an investment strategy designed to provide a predictable and reliable income stream throughout their retirement years so if you’re not comfortable with capital volatility, lack of liquidity and you require a regular reliable monthly income stream, then a high-yield bond fund may not be the best choice for you.

There are many options along the risk curve when it comes to fixed income, with cash at the least risky end and instruments such as hybrids that also have equity characteristics at the other end. In other words, there is a wide spectrum of fixed income investments and it pays to understand what these are, the risks they have and how they can help meet set goals when building the fixed income component of a portfolio.

¹ https://www.investopedia.com/terms/c/creditspread.asp

Author:  Nathan Boon, Sydney, Australia

Source: AMP Capital 12th Nov 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

There are mechanisms to maximise returns in this lower-for-longer environment, and a green alpha strategy in real estate investment is one option on the table.

Against a global backdrop of lower interest rates, falling government bond yields and bank term deposit returns at or below 2 per cent, achieving higher, low risk returns is becoming more challenging for investors.

With the lower for longer trend seemingly entrenched as global economic uncertainty rises, investors are turning to green alpha strategies as one way to maximise returns, whilst improving the sustainability performance of Australia’s built environment at the same time.

How does this apply to real estate?

From a real estate perspective, maximising the returns you can generate in a portfolio is primarily linked to boosting the rental income and keeping operational costs down. Reducing the outgoings of an asset by cutting energy costs is an important, and relatively simple method to boost income yields and according to market evidence and international studies into green buildings, can make significant differences to the return an asset delivers over its life.

Asset valuations and returns are already starting to reflect a growing divergence between high-standard green buildings and their less green peers that can add as much as 50bps per annum to a total return.

For example, according to the MSCI Green Property Investment Digest, over the past three years, Prime CBD Office buildings with a NABERS star rating higher than four stars (the maximum is six) have delivered a total return to their investors of 13.4%, versus 12.9% for all other assets in this category.

Source: NABERS.gov.au

Looking at a cities level, investors chasing green returns might do well to focus on the Melbourne market, which had the highest total returns for prime office buildings with a 4-6 star NABERS rating at 15% in the year to June 2019.

After Melbourne, investors in Canberra benefitted from the highest ‘green alpha’ with a 200 basis point boost in total returns, versus the average for the prime office market there. Government tenants in this market place a high priority on green credentials when leasing space, driving better income return outcomes for landlords who can offer 5 star plus opportunities in that market.

Source: MSCI/IPD, AMPCI RE Research

Thinking long term, and looking beyond cost savings, sustainability initiatives such as integrated solar in commercial assets can provide long term downside protection against spikes in electricity costs. These sort of initiatives could reduce the outgoings of an asset, a competitive advantage at a time where electricity prices have risen by over 20% in the past two years.¹

Green alpha and the boost it provides to total returns has become a bigger part of an asset manager’s toolkit in maximising returns. Greener buildings, apart from delivering superior returns, tend to offer investors lower systemic risk with a more stable income profile, lower incentives and enhanced tenant “stickiness” which can reduce the vacancy of a portfolio.

The bottom line is, environmentally sustainable buildings offer both financial and environmental benefits to investors for the long term. In an increasingly challenging lower for longer returns environment, green alpha is a pathway to get ahead of the pack.

¹ https://www.nabers.gov.au/publications/annual-report

Author: Luke Dixon, Head of Real Estate Research – Real Estate Sydney, Australia

Source: AMP Capital 28th Oct 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

Investors may be surprised to learn about the patterns which have formed in the small caps market since the Global Financial Crisis. Here, we take a closer look at recent data, and what is driving earnings and valuations.

Overview

Australian small cap stocks have failed to live up to their potential in recent times. By definition, small cap companies are generally at an earlier stage of their life cycle with good growth opportunities ahead, and in an environment of record low interest rates and freely available money for companies to expand their operations, it would be expected that they are growing strongly and generating good returns. Some are doing just that, however it may surprise investors that the aggregate level of earnings generated by companies in the ASX Small Ordinaries Index has consistently declined since 2008 when the Global Financial Crisis (GFC) hit.

Source: AMP Capital, FactSet (2001-2019)

Earnings under pressure

There have been a few different factors driving the underperformance of earnings:

• The end of the resources capex boom in 2012-13 resulted in large earnings downgrades in mining and mining services related stocks, which were significant components of the index at the time.

• The domestic environment has been challenging for large parts of the economy with cyclical and structural factors affecting the earnings base of both consumer (subdued consumer confidence, e-commerce) and housing (new start declines, rising power prices) related companies.

• A number of technology and other high growth stocks have gone through a significant cost investment program – investing heavily in sales, marketing, product development and offshore growth to capitalise on new market opportunities. This has the potential to raise the earnings profile in outer years but has resulted in downgraded earnings forecasts in the near term.

The overall market has delivered muted growth since 2014, which has reflected a stronger period of earnings growth in mining companies (notably gold stocks), while earnings for industrial companies have flat lined and are virtually unchanged since post-GFC lows 10 years ago.

Small caps versus large caps

The factors highlighted above go a long way to explaining the underperformance of small caps stocks compared to their large cap counterparts over this time period. In fact, since small cap earnings bottomed after the GFC in September 2009, the Small Ordinaries Accumulation Index has underperformed the ASX 200 Accumulation Index by 70% in aggregate. It’s interesting that an index dominated by banks and diversified miners has substantially outperformed an index which has contained material exposure to stocks which have captured investor’s attention over the past few years including technology, Chinese consumer consumption (e.g. infant formula and vitamins), electric vehicles and gold.

Source: AMP Capital, FactSet (2009-2019)

Follow the earnings

The research we have undertaken into small cap returns and our experience in the market shows that earnings drive share prices. Valuation is an important consideration, however it is mean reverting and hard to predict, so we focus on our core strength – forecasting earnings. An earnings-based approach to valuing a stock is resilient to valuation changes and its serially correlated nature makes it more predictable.

Since 2001, the ability to pick a portfolio of stocks that has actually delivered the highest level of earnings growth in the small caps market would have delivered a compound 14% annual return, or a cumulative return of 828% over this period. This compares to an index return of 1% per annum. Obviously forecasting earnings with perfect foresight is impossible, but this illustrates the potential opportunity for active managers in the space who can spend time undertaking detailed fundamental research on a company and get an edge on the market.

Source: AMP Capital, FactSet

The above chart also shows that sell side analysts have added very little value when picking earnings over this period and investing by following consensus earnings leads to underperformance. In fact, since 2001 a portfolio of small cap stocks with the highest growth forecast by consensus has provided a return of -2% per annum, or -29% in aggregate. This isn’t a huge surprise given sell-side analyst forecasts are typically a lagging indicator. This is further exacerbated by the number and quality of earnings estimates in the Australian small cap market falling dramatically over the past few years. 

Source: Goldman Sachs Global Investment Research, Factset

When analysing performance of the AMP Capital Australian Emerging Companies Fund since its inception in July 2014 to September 2019, the Small Ordinaries Index has been a solid performer despite the earnings headwinds, providing investors with a 8.9% per annum compound return (55.9% cumulative return). But when we dig into what has been driving this return, it’s clear this performance has been by dividends with muted earnings growth and a P/E multiple re-rate (or put simply, the stocks becoming more expensive). In a world of record low interest rates and rising asset values, the multiple re-rate is understandable and not out of sync with other asset classes, however it is unlikely to be sustainable unless investors start to see material earnings growth starting to come through in order to justify the higher valuations.

The AMP Capital Australian Emerging Companies Fund has returned 11.5% per annum (after-fees) over the same period (76.8% cumulative return), with earnings growth contributing the majority of returns, which is aligned to our investment philosophy and process. The ability to pick stocks which are growing earnings consistently has been the major driver of the Fund’s outperformance.

Past performance is not a reliable indicator of future performance Cumulative total returns from July 2014 to September 2019 are shown after fees and before tax

Bigger is better? Not necessarily…

Despite the relatively gloomy picture we have presented for small cap earnings, there is one major reason for optimism in small caps. The median small cap manager has significantly outperformed not only the ASX Small Ordinaries Index, but also the ASX 200 Index and the median large cap manager over a long time period. Investors who have trusted their money with even a middle of the pack small cap manager have seen excellent compound returns over this period. The Australian small caps market is inefficient and not well researched, providing good managers with the opportunity to find new information which gives them an edge in picking stocks.

Source: AMP Capital, Mercer, FactSet (2000-2019)

Key take-aways:

• An investment process which is focused on earnings can lead to significant outperformance.

• The need for investors to be benchmark unaware – why invest in a stock just because it is in an index? It’s much better to construct a high-quality portfolio of stocks from all the available options in the investable universe.

• The benefit of active management, especially in small caps, which have proven to generate excellent returns for investors over the long term.

Author: Matt Griffin, Co-portfolio Manager, Small Caps Sydney, Australia

Source: AMP Capital 8th Nov 2019

Important notes: AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity of the AMP Capital Australian Emerging Companies Fund (Fund) and the issuer of the units in the Fund. To invest in the Fund, investors will need to obtain the current Product Disclosure Statement (PDS) from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232 497) (AMP Capital). The PDS contains important information about investing in the Fund and it is important that investors read the PDS before making a decision about whether to acquire, or continue to hold or dispose of units in the Fund. Neither AMP Capital, AMPCFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this document, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to their objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.