Marked Up August 11th

Everyone watches the Fed but the Fed is watching everyone else

The non-farm payrolls on Saturday morning were stellar, +255k in employment and wages growth was at 0.3. Previous months were revised higher.

The equity market rallied and the bond market sold off which all makes sense.

The market should theoretically be pricing in a September rate hike and if not September then December should be a very high probability?

The problem for the Fed is the rest of the world.

The BOE cuts rates for the first time since 2009. The benchmark rate in the UK is .25% and the asset purchase target increased by ￡60 billion to ￡435 billion.

The Governor of the Bank of Japan has ordered a monetary policy review and the intention is to increase the amount of stimulus. The review findings will be presented on September 20-21 when the BOJ next meets.

The RBA announced a rate cut to 1.50% with a view that a lower rate will both boost inflation and sustain reasonable growth in the economy[i].

Though our economy isn’t the size of Japan or the UK the reality is whether the Fed moves in September, December or 2017, they won’t be able to move too far with the rest of the world moving in the other direction.

Investors need to be conscious of the topside of rates when they consider rate movements. No one knows for sure but there seems to be a limit on upward movements if the rest of the world continues in the same trajectory.

When Europe, China and emerging markets are factored into rates analysis it would be a defiant central bank that lifted rates in any meaningful manner.

The RBA moved cash to 1.50%; investors have been moving cash for a while

APRA publishes data on the volume of term deposits placed with institutions. The following chart shows the volume of deposits with the four major banks.

This data set poses many questions but two that stand out to me are:

1. Why?
2. When will it stop?

Term deposits are a crucial foundation of the banking infrastructure; by offering competitive rates banks can create stable funding platforms.

Traditionally the role of cash in a portfolio has been to provide a buffer to volatility or it can be set aside to take advantage of forced sales situations.

I am not negative on term deposits but…..

In a world that is offering consistently lower rates why would investors continue to invest? How will a move to 1.50% really impact these numbers?

Everyone is under the pump

Recently I wrote about pension funds not meeting their liability hurdle rates, with CalPERS (California Public Employees Retirement Scheme) being the most prominent.

CalPERS has $302 billion in assets and needs a return over 7.50% to meet liabilities. The fund returned 60 basis points for last year.

CalPERS is now below every funding metric it can be measured by. Over the 5, 10 and 20 years cycles its return on assets means it’s underfunded compared to the expected liabilities.

The fact is that compounding affects performance in the negative as well as the positive.

Each year CalPERS underfunds it needs to be funded from future years, therefore 7.50% will not compensate for the lost years.

CalPERS will have to make up for 20 years of underfunding.

The question of underfunding is not just for professional investors it matters to all investors.

Investors should be considering matching liabilities to assets and managing sequencing risk so that retirement experiences are aligned to expectations

How many investors focus on short term gains, or roll 90 day term deposits while costs are consistent over year’s even decades?

Health costs, lifestyle costs, family costs, food and travel costs, government charges arrive consistently, consecutively and cannot be ignored.

Investors need to think about early intervention and getting an investment performance that is better aligned to permanent costs.

Fixed Income allocation

The criticism of fixed income is that rates are too low and rates will be going higher eventually. It might be a reasonable argument but it was wrong last year and has been wrong for the last few years.

CalPERS had few assets perform and one of them was fixed income.

To quote the chief investment officer of CalPERS Mr Ted Eliopoulos, fixed income represented an “extraordinary result “and “it’s an important reminder of the value of diversification of your portfolio.”

CalPERS has 20% of its portfolio in fixed income, most self-directed wealth investors have around 1% in fixed income.

What is often lost in asset assessment is the role each asset may play in portfolio construction. It isn’t that yields might go up, it is do you have balance in your portfolio because you don’t know when rates go up or what investors might pay for assets.

The self-directed investor wants information not advice, which is why they are self-directed.

On that basis the self-directed investor is underinvested in fixed income compared to CalPERS.

The question the self-directed investor needs to answer is “do I have a balanced portfolio that reflects the fact that we live in volatile times, where returns on different asset classes continue to provide some surprising outcomes, some good some not so good?”

What does it mean for Australian Investors?

The broad consensus is that SMSF investors are too heavily invested in cash and Australian equities.

The difference between APRA regulated and SMSF in portfolio construction is stark.

The blue columns are APRA regulated and the red is SMSF investment.[ii]

The questions I receive on fixed income are that it could be the wrong time to invest in fixed income.

That might be true; I don’t know which asset class stands out at the best place to invest.

All assets are rallying on the basis of zero rate worlds. In order to assess whether fixed income works for any investor they should consider the following points:

1. Fixed income is not a one dimensional product, there are fixed rate, floating rate, various government and corporate issuers and inflation linked bonds. If rates are going up buy floating rate bonds and if rates go lower buy fixed rate bonds.

2. Rather that invest on a basis of the highest expected yield it could be better to invest on the basis of outcomes. What is the expected outcome of the balance portfolio if it has cash, fixed income, property, REITS and equities?

3. Are you invested in cash because of its performance or are you invested in cash to escape the equity performance? Is equity volatility driving you to the cash asset class and is that a good enough reason to invest in cash?

   So nothing to worry about here?

   Everyone knows the market has rallied and it “feels” like we are in a prolonged period of musical chairs, you don’t want to be caught long when the music stops.

   In an environment where cash is at 1.50% and possibly going lower it is important to be on top of all portfolio investments.

   It could be time to assess the chase for yield. Clients are chasing emerging markets; high yield markets, anything that can provide a compelling return.

   If the herd is moving in one direction, it is a good discipline to check you are happy to be part of the move.

   The black swan events of this year have been driven by geopolitical actions.

   Chinese Government stimulus, the unexpected Brexit vote, and the rise of isolationism through the Trump and Sanders voter bases are impacting markets.

   As a consequence the expectations for 2017 are for more central bank support and generally tepid economic performances.

   If investors are all positioned the same way the risk is that any political driven sell off will find people heading for the exit and it could be that there are more people than the exit can hold.

   A low rate environment requires a higher rate of involvement.

   The lemon doesn’t squeeze itself.

Please remember this article is not investment advice. No one but you or your advisor knows (or hopes to know) what is best for you. We want you to understand the risks. If you’re unsure then don’t act.

[i] Statement by Governor Stevens, Monetary Policy Decision 2nd August RBA Website.

[ii] Source ASFA, APRA Sept 2015 ATO Jun 2015