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Insights

A message from MLC Asset Management's Chief Investment Officer

July 2020
 

Dear Advisers and Investors,

The supposed ancient Chinese expression, “May you live in interesting times,” certainly describes the period we’re living in.

We had the “Coronavirus Crash” in March where share markets fell faster and deeper than at any time since the 1930s. Those events were set off by governments across the world putting economies and industries into hibernation, and communities into lockdowns to contain the dangerous pandemic.

Yet, share markets performed an about-face over the June quarter.

The US S&P 500 Index closed the June quarter about 20% higher than it began,1 its best quarter return since 1998. Over the same period, the global and Australian share markets, as measured by the MSCI ACWI Index and S&P/ASX 200 Accumulation Index, respectively, also recorded double-digit gains. An upshot is that these share markets are now not far off their mid-February highs.

All this took place despite the fight against COVID-19 being far from won or over. Economic uncertainty also remains high because we most likely can’t return to normal business life and social interactions until a globally distributable vaccine become available.

Many countries have succeeded in flattening and even bending the infection curve, but coronavirus is advancing in the US, Brazil, Russia and India, all countries with large populations. The UK too seems to be losing ground again.2

Central banks fire policy missiles

So, what explains share markets’ recent sunny tone?  A four-word explanation —  extraordinary central bank policies.

Ultra-low official interest rates and quantitative easing3 policies put in place by major central banks, such as the US Federal Reserve, Bank of Japan, and European Central Bank, helped to drive strong returns from share markets as well as other risk-asset returns over the post GFC decade.

Commentators described those policies as being akin to central banks’ firing a bazooka. Taking that analogy further, recent central banks’ policies can be likened to firing heavy artillery.

“Whatever it takes” seems to be the adage of central banks. The US Federal Reserve has been buying corporate bonds,4 something they previously shied away from. The Bank of Japan has been dialling up its equity-buying program.

The amount of support through global central bank stimulus (and government spending) has been estimated at a staggering $US18 trillion (A$A26 trillion), with interest rates slashed to 0% or below (after taking inflation rates into account) in most major economies.5

It has meant, amongst other things, that borrowing costs for high-grade US companies are now below January levels.

In a zero-interest rate world awash with liquidity, returns from term deposits and governments bonds are unappealing to investors. Consequently, vast amounts of money are going into share markets and driving them higher.

Disconnect between markets and economies

Despite all this, we remain cautious because there is a disconnect between share market performance and economic fragility.

Figures like the US unemployment rate falling to 11.1% as the economy added a record 4.8 million jobs in June,6 while encouraging, can’t be taken in isolation. The American economy is still down nearly 14.7 million jobs since February and the number of Americans filing for unemployment increased to 19.3 million.7

With the spread of the COVID-19 virus accelerating in the US, many economists expect the recovery to be bumpier and job gains more muted.

Small and medium-sized businesses account for around 50% of US employment.8 A second wave of disease would certainly spark another round of firings and insolvencies.

A recent New York Federal Reserve study found that only one in five small businesses can survive a two-month loss of income.9  Many such small businesses are even cutting back on rehiring even as they reopen.

For the hardest-hit sectors, things may never return to normal. Another recent survey found that 17% of US hotels and restaurants, which are big employers, believe their revenues will never return to pre-COVID-19 levels.10

Investing, not trend-following

Many competing forces at work and investment professionals must be nimble to steer their clients’ portfolios though this complicated situation.

Share markets could keep rising, lifted by the amount of money flowing through the financial system. Against that are uncertainties because the pandemic is unbeaten and economies can’t return to normal until it is.

Thankfully, the way we invest isn’t reliant on us successfully guessing what the future may look like. Many investment organisations set out to forecast the future and position portfolios accordingly. Typically, they’ll have a base case as well as an optimistic case and pessimistic case.

Rather than thinking of what’s ahead of as just a handful of possibilities, we develop 40 investment scenarios through our Investment Futures Framework.11 The range of return outcomes that run off the back of the Investment Futures Framework is vast and forces us to be intensively aware of risks in each situation.

It also means that we’re not trend followers, which is especially important now when uncertainty dominates.

Rather than going all-in, or avoiding risks at-all-costs, we’re choosing to increase our exposure to investment grade credits (corporate bonds issued by companies with strong finances), as they provide exposure to companies’ cash flows, but with lower risks than would be the case if we bought their shares.

We’re also choosing to participate in equity markets through derivatives such as swaps and options, rather than buying shares. Again, we’re doing this because of our risk focus. By using swaps and options, our clients’ portfolios can benefit when share markets rise, earn a return when they fall, or be cushioned from the full impact of market falls.

Derivatives enable us to invest humbly. Using derivatives is an open acknowledgment that we are uncertain about market direction and thus hedging against downside risks is important.

Recently, we used an option strategy to access a major emerging share market as an investment within our broadly diversified multi-asset portfolios. The option would have delivered an 11% return for that part of the portfolio at the time of purchase.

At the same time, we also put in place a “put option,”12 just-in-case that market went down. If the market had gone down, we would have lost some of the 11% return at the time of purchase, but the hedging strategy would still have allowed us to keep some of the upside, contributing to the portfolio’s overall return.

The flexibility we have through our in-house derivatives team is the most significant change that’s taken place in MLC’s asset management capability since the GFC. It has been integral to our management of client portfolios through the mayhem of March and will remain important in the months and years ahead.

Our derivatives capability is another component of our belief in the importance of diversification across many dimensions. It reflects our risk-management heritage and the care we exercise in managing clients’ funds.


Warm regards,
 

Jonathan Armitage

Chief Investment Officer, MLC Asset Management

 




1 'Financial fragilities': We have just been reminded about how vulnerable the global economy is. Stephen Bartholomeusz. The Sydney Morning Herald July 1, 2020. https://www.smh.com.au/business/markets/we-have-just-been-warned-about-just-how-fragile-the-global-economy-is-20200701-p557yv.html. Accessed 1 July 2020.
2 For detail see Johns Hopkins University & Medicine, Coronavirus Resource Centre. https://coronavirus.jhu.edu/data. Accessed 2 July 2020.
3 QE, as it’s generally referred to, is form of unconventional monetary policy in which a central bank, such as the US Federal Reserve, Bank of Japan, European Central Bank, buys assets such as government bonds from the open market to inject money into the economy.
4 A corporate bond is a type of debt security/asset that is issued by a company and sold to investors. The company gets the capital it needs and in return investors are paid a pre-established number of interest payments at either a fixed or variable interest rate.
5 'Fasten your seatbelts': Sharemarket mayhem set to continue. Marc Jones, Sydney Morning Herald,  30 June 2020. https://www.smh.com.au/business/markets/fasten-your-seatbelts-markets-have-had-a-wild-six-months-and-more-is-to-come-20200630-p557fb.html Accessed 30 June 2020.
6 The US economy created 4.8 million jobs in June. But that's not the whole story. Anneken Tappe, CNN Business, July 2, 2020. https://edition.cnn.com/2020/07/02/economy/june-2020-jobs-report-coronavirus/index.html. Accessed 4 July 2020.
7 Ibid.
8 Small business the canary in US economic coal mineRana Foroohar, Australian Financial Review, 29 June 2020. https://www.afr.com/policy/economy/small-business-the-canary-in-us-economic-coal-mine-20200629-p5575q. Accessed 30 June 2020.
9 Ibid
10 Ibid
11 The Investment Futures Framework is MLC’s unique scenario-based portfolio construction approach applied to manage the MLC multi-asset portfolios, also known as the “MLC Investment Trusts” —including MLC Wholesale Inflation Plus, Horizon and Index Plus portfolios.
12 A put option is a contract that gives an investor the right, but not the obligation, to sell shares of an underlying security at a set price at a certain time. A put option is typically a bearish bet on the market, meaning that it profits when the price of an underlying security goes down.

[1] The Investment Futures Framework is MLC’s unique scenario-based portfolio construction approach applied to manage the MLC multi-asset portfolios, also known as the “MLC Investment Trusts” —including MLC Wholesale Inflation Plus, Horizon and Index Plus portfolios.

[2] A put option is a contract that gives an investor the right, but not the obligation, to sell shares of an underlying security at a set price at a certain time. A put option is typically a bearish bet on the market, meaning that it profits when the price of an underlying security goes down.

 

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; and NULIS Nominees (Australia) Limited (ABN 80 008 515 633, AFSL 236465) as trustee of the MLC MasterKey Super and Pension Fundamentals and MLC MasterKey Business Super, which are part of the MLC Super Fund (ABN 70 732 426 024), together “MLC” or “we”.

We are members 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.

This information may constitute general advice. It has been prepared without taking account any investor’s objectives, financial situation or needs and because of that investors 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 a Product Disclosure Statement (PDS) or other disclosure document relating to any financial product mentioned in this communication issued by MLC, and consider it before making any decision about whether to acquire or continue to hold these products. A copy of the PDS or other disclosure document is available upon request by phoning the MLC call centre on 132 652 or on our websites at mlc.com.au and mlcam.com.au.

Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. The performance returns in this communication are reported before deducting management fees and taxes.

Any projection or other forward-looking statement (‘Projection’) in this document is provided for information purposes 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.

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 communication 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.