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Insights

A message from MLC Asset Management's Chief Investment Officer

May 2020
 

Dear Advisers and Investors,

As I was preparing to write this note to you, my mind went back to a June 2009 letter to the Queen — “The Global Financial Crisis – Why Didn’t Anybody Notice?”1 — from a group of eminent British economists attempting to explain the causes, timing and severity of what occurred.

Blame was summarised as being due to “a failure of the collective imagination of many bright people.”2

A crisis in the US sub-prime mortgage market sparked the GFC. The packaging of those high-risk mortgages with lower-risk debt securities made them popular with many global financial institutions. It created an illusion of low risk investments, when the truth was that those packages were a house of cards.

Incidentally, sub-prime mortgages, post the GFC, became known as NINJA loans (as in, loans made to people with no income and no jobs). Given all this, why did so many investors and ratings agencies miss the warning signs?

The unfortunate fact is that “many bright people” massively underestimated risks or failed to imagine what could go wrong.

Failing to imagine what can go wrong, especially when markets seem calm, as was the case in the lead-up to the COVID-19 crisis, is something all investors have to constantly guard against.

There is a natural human inclination to want to predict the future, but behavioural biases are a barrier to understanding how the future could unfold. These biases tend to ground us in what’s currently happening, making it difficult to imagine a future that’s different from today.

It’s common practice in many investment organisations to try and land on a scenario of what the future might look like and then position portfolios accordingly. However, a single base case scenario, or even instances where an upside case and downside case are also developed, runs up against the world’s complexity.

Arguably, the coronavirus and the severe societal and economic disruptions caused by it, is an example of another failure of imagination.  This might seem harsh, but the truth is that while the pandemic is a shock, it should not be a surprise.

There have already been other diseases that have crossed borders and threatened countries, in the past two decades. Severe Acute Respiratory Syndrome (SARS 2002-2004), Swine Flu (2009), Middle East Respiratory Syndrome (MERS 2012), Zika Virus (2015-16), and Ebola 2018 have already inflicted suffering.

Of course, none of those menaces were truly global like COVID-19, but we can’t say we weren’t warned. This is the backdrop for a ‘global pandemic’ scenario always featuring in our Investment Futures Framework, which is the architecture for our investment approach.

The Investment Futures Framework recognises a vast number of possibilities, including remote possibilities (maybe not so unlikely, after all) like global pandemics. It imagines what can happen, rather than narrow down by trying to guess what will happen. It accepts the complexity of the world rather than trying to boil things down to just one or two future outcomes.

In this context, focusing on the pandemic specifically as a flash point for risk is perhaps misleading – for the mayhem across societies and economies need not necessarily have come by way of COVID-19.

Other triggers could have been a major war, a major cyber-attack, a global catastrophe (perhaps a natural disaster), or a sudden rise in inflation, for instance. Instead, the learnings ought to be that risk can ignite from the non-obvious, and that low probability, high impact events should at least be considered when setting investment strategy.

How investors react to shocks is equally important. The world is not short of disease modelling expertise. Yet, investors caught out by the pandemic too often scramble to build expertise in an area that requires years of education and training.

This expertise ordinarily resides in academic institutes, think tanks and consultancies, not amongst investment teams.  At times like this, true investors, true managers of risk, need to focus on identifying uncertainty and hammering out solutions to deal with the unknown, all the while preserving as much client wealth as possible.
 

How the pandemic could play out 


In managing MLC’s multi-asset portfolios using our Investment Futures Framework, the following are the short-term scenarios that we have assessed as currently providing the highest potential future risks and opportunities.

While at most points in time the outlook relies on multiple sources of uncertainty, the next 12 to 18 months pivot around COVID-19. Consequently, our thoughts on short-term scenarios are all sub-versions of the main global pandemic scenario:

  • Short disruption: No second wave

    o The northern hemisphere summer helps rid the community of COVID-19. No substantial second wave of infections arises and seasonality does not emerge.
    o Lockdowns end with only mild earnings implications for this year and next.

  • Drawn-out lockdown with mild second wave of infections

    o A mild second wave of infections arises across the globe. Partial lockdowns are re-established.
    o Earnings suffer in both FY20 and FY21.
    o Hospitality and other impacted sectors are severely disrupted.

  • Drawn-out lockdown with severe second wave

    o A severe second wave of COVID-19 emerges. Full lockdowns are re-established.
    o Fiscal and monetary stimulus near the point of exhaustion.
    o Populism gains more strength.
    o High risk of global depression.

Balancing intensive risk-management with careful opportunity seeking


The Investment Futures Framework lens we are looking though underscores the high degree of uncertainty we see across markets and economies. It’s for this reason that we continue to remain cautious and were not drawn in by the ‘bear market rallies’ of April.

Such rallies are common during market corrections and prematurely create the impression that things are heading back towards normal. Usually, bear market rallies unwind as investors process uncomfortable realities.

Currently, those realities include company and economic data that continues to point in a pessimistic direction, at least for this year. With many industries in lockdown, a wide range of companies have stopped offering earnings guidance. Many companies are also scaling back their dividends, as their earnings have been hit hard.

There are also many competing views on when economic recovery will eventuate, and the speed of recovery. All of this leads us to believe that this is not time for ‘swinging for the fences’ portfolio positioning.

Instead, an intensive risk-management focus must be maintained and balanced with carefully selected additions to portfolios.

Our derivative strategies — which are a form of investment insurance against falling markets —  have succeeded in providing some cushioning from the full impact of market volatility on client investments in MLC’s multi-asset portfolios.  We’ve continued to retain much of this investment insurance against the risk of further falls.

We’ve also taken profit from our foreign currency holdings and slightly increased our Australian dollar exposure as the local currency recovered from previous lows.

In terms of opportunity seeking; we’ve slightly increased our allocations of both global and Australian defensive shares.

Not all companies are the same. Some will perform better in volatile markets than others, and those are the shares we’ve been carefully leaning into.

A number of our active investment managers have commented that they are seeing ‘once in a lifetime’ opportunities because of the market sell-off. However, even in those instances, they are only buying assets after intensive analysis of the risk-reward trade-offs.

MLC has been a careful steward of our clients’ savings since 1985, and we know how privileged we are to be responsible for the financial wellbeing of so many Australians.

We are applying all our knowledge, experience and skill to both preserve the value of our clients’ investments, and to also position them for the recovery that will eventuate. Of course, nobody knows when economies will recover so we recognise the need for patience and being prepared for more fluctuations in the foreseeable future.

Warm regards,

Jonathan Armitage
Chief Investment Officer, MLC Asset Management

1 The Global Financial Crisis – Why Didn’t Anybody Notice? British Academy Forum, 17 June 2009. https://wwwf.imperial.ac.uk/~bin06/M3A22/queen-lse.pdf. Accessed 30 April 2020
2 Ibid.

Important information

This information is provided by MLC Investments Limited, ABN 30 002 641 661 AFSL 230705, as responsible entity of a series of managed investment schemes collectively known as the “MLC Investment Trusts” including but not limited to: MLC Wholesale Inflation Plus – Conservative Portfolio, MLC Wholesale Inflation Plus – Moderate Portfolio, MLC Wholesale Inflation Plus – Assertive Portfolio, MLC Wholesale Index Plus Conservative Growth Portfolio, MLC Wholesale Index Plus Balanced Portfolio, MLC Index Plus Growth Balanced Portfolio, MLC Wholesale Horizon 1 Bond Portfolio, MLC Wholesale Horizon 2 Income Portfolio, MLC Wholesale Horizon 3 Conservative Growth Portfolio, MLC Wholesale Horizon 4 Balanced Portfolio, MLC Wholesale Horizon 5 Growth Portfolio, MLC Wholesale Horizon 6 Share Portfolio, MLC Wholesale Horizon 7 Accelerated Growth Portfolio (“MLC” or “we”). MLC is a member of the group of companies comprised National Australia Bank Limited , its related companies, associated entities and any officer, employee, agent, adviser or contractor (“NAB Group”). An investment in any product or service offered by a member company of the NAB Group does not represent a deposit with or a liability of the NAB or any NAB Group member. NAB does not guarantee or otherwise accept any liability in respect of any financial product referred to in this communication.

This information included in this communication is general in nature. It has been prepared without taking account of an investor’s objectives, financial situation or needs and because of that an investor should, before acting on the advice, consider the appropriateness of the advice having regard to their personal objectives, financial situation and needs.

Investors should obtain the relevant Product Disclosure Statement or other disclosure document relating to any financial product which is issued by MLC, and consider it before making any decision about whether to acquire or continue to hold the product. A copy of the Product Disclosure Statement or other disclosure document is available on mlcam.com.au.

Any opinions expressed in this presentation constitute our judgement at the time of issue and are subject to change. We believe that the information contained in this presentation is correct and that any estimates, opinions, conclusions or recommendations are reasonably held or made at the time of compilation. However, no warranty is made as to their accuracy or reliability (which may change without notice) or other information contained in this presentation.

Any projection or forward-looking statement (‘Projection’) in this communication is provided for information purpose only. Whilst reasonably formed, no representation is made as to the accuracy of any such Projection or that it will be met. Actual events may vary materially.