Marked Up November 3rd

A balanced portfolio in unbalanced times

Recent nervousness in markets has been driven by concerns over monetary policy and geo political risk.

The traditional view of portfolio construction has been that a balanced portfolio will provide a counter balance to volatile markets.

In today’s interest rate settings there are possibly two problems with that strategy.

1.   All asset classes have rallied as rates have plummeted so too have the returns from most traditional asset classes.

2.   In a scenario where rising interest rates will likely impact all asset classes how will investors respond?

If there is a possibility that markets are irrational in response to market news, then investors need to decide on how they will react to irrational markets.

Will you as an investor be able to remember what drove the decision making when the portfolio was first constructed? Then decide if there have been any changes in your assumptions.

It isn’t the avoidance of rebalance that is at stake it is the avoidance of panic which is at risk.

When a market lacks direction, the void is filled by commentary and that risks becoming strategy.

Investors need to be careful about regurgitating theories as facts and acting on theories without question.

Investors who follow the herd and don’t build portfolios to meet their needs tend to be the same people who complain they are the last to know when the market moves on.

If the institutional market doesn’t bid, should you?                                                                                        

Recently Charter Hall Long WALE REIT was brought to market.

The Real Estate Investment Trust (REIT) was a franchise of 66 properties that had very little gearing and a lease duration of 12.5 years.

The distributed return was 5.30%, which would grow with mandated rental increases.

After gearing the returns would be 6.40%

Early indications were good; there was support from institutional investors and retail investors.

While the issue was being marketed to investors global bond yields were rising and some segments of the global REIT market were being sold.

The end result was that when the issue came to market the institutional market didn’t provide the company with enough confidence that the REIT would launch with appropriate investor support.

The market was swamped with opinions and the concern amongst retail investors was did institutions know something that retail didn’t?

Institutions may not have known anything; they may just march to a different beat.

When I spoke with institutions, they focused on the fact that the issue didn’t have enough gearing, at issuance.

Professional managers are judged on the performance of the investment at a point in time. The fact that the company had advised they would in time be adding gearing, didn’t help institutions.

If institutions were worried about distribution returns when the REIT listed they were also cognisant of the possibility that the listing would be poor without institutional support.

That may have resulted in institutions underperforming the index, and nothing focuses the mind than underperforming if you are a fund manager.

Gearing and post market pricing didn’t detract from the underlying properties and the company’s capabilities.

Many retail investors responded to the institutional feedback by saying that retail focuses on the underlying companies and the long term cash flows generated by contracted rental increases.

Retail and institutions, have two different masters, one is a real time master the other is a real return master, and both should be equally respected.

Has the risk free rate changed?

The risk free rate is the rate an investor achieves when they invest in Government securities; the assumption is that these assets are “risk free” as the issuer can print money to repay debts.

This is a standard building block approach to investing that has been challenged by the GFC.

As an example investors recently became concerned about Greece and worried that the Greeks could not repay their debts. If the risk free rate moves up the butterfly effect means that all asset classes need to provide enhanced returns. All returns are relatable even in the uncorrelated.

It is not just the return on an investment; it is the return relative to the return of competing investable products.

If 10 year Australian bonds return 2.347% what return do investors require when investing in other assets?

The following chart is the spread difference between the yield on Telstra equity and Australian 10 year Bonds over the past year.

The equity market has been describing Telstra (full disclosure I own Telstra equity) and other infrastructure equities as “bond like” equities, now they are no longer bond like. They are now equities that reflect the expectations for movement in the “risk free” rate. The following example is Transurban.

I do not know if Telstra or Transurban or any other equity will rally relative to the Government bond curve.

What I am interested in is how far the equity market has sold the “bond like” equities and if bond like equities yield almost 9.00% what are the expectations for bond yields?

Bond yields might go significantly higher but if they do it will come as a surprise to the majority of central bankers in the world

I am not suggesting investors buy “bond like” equities. In the famous words of John Maynard Keynes “The market can stay irrational longer than you can stay solvent”

Investors merely need to ask the question, “What assumptions are driving the pricing on the risk free rate”

What does this mean for Australian Investors?

Investors are reluctant bulls; it is hard not be anything else when bear market assets have returns of under 3% or in the case of physical gold do not provide cash flow.

The following chart is the gold price as it responds to the reassessment of global rates.

Since late September the Gold Spot price has struggled to recover.

Unless they invest exclusively in cash Australian investors will be in volatile assets, regardless of what they invest in.

The market will be full of advice, and readers of any advice have to be sure in their minds that the advice is relevant to them and not just opinions written by commentators that are based on hard wired bias.

Readers might be better served deciding on some macro themes before they react to the latest insights,

Such as:-

1.   What is the expectation for global growth over the next few years?

2.   Where is that growth, Asia, Europe, Nth America or emerging markets?

3.   What is the sustainable risk free rate?

4.   What is the acceptable margin above the risk rate for any investment?

5.   How much volatility is acceptable?

If investors have a sense of where they are going they have a better answer for why the market occasionally goes in a different direction.

Rumble in the jungle

The latest incendiary moment in the American election has been the announcement that Mrs Clinton’s email enquiry has been reopened as part of the investigation into former congressman Anthony Weiner’s behaviour on the internet.

Mr Trump has tapped into a rich vein of vernacular that he has used to describe Mrs Clinton. Mrs Clinton has characterised herself as a fighter, while her supporters have challenged the intentions of the FBI.

So Mr Trump uses language not heard before in polite political hustings and Mrs Clinton’s supporters denounce one of the most iconic institutions in American society.

Welcome to Presidential USA.

The investment narrative is that Mrs Clinton will be better for markets, and I assume that is true to an extent. The reason Mr Trump would be viewed as bad is that investors don’t know how to “price” a Trump Presidency.

How isolationist will America become, what does the Fed do, what is the balance in the congress, who fills the Supreme Court and Fed vacancies?

Mrs Clinton is seen as more of the same.

My question is after such an incendiary election who or what is immune from the fire?

It will be interesting to see how whoever wins unites or attempts to unite the country.

I imagine it will require a gracious loser.

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.

Please read the NAB disclaimer.

Have a good one.

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