In this roundtable discussion, Nick Maroutsos, Dan Siluk and Jason England, portfolio managers on the Absolute Return Income strategy, talk candidly about matters affecting markets and how these are influencing their investment decisions. The video discusses three topics:
Asset allocation in light of more accommodative monetary policy
How to deal with a more politically driven economy
How to generate income in a negative rate environment
(Nick Maroutsos) So given the last ECB meeting where Draghi called for some pretty momentous fiscal stimulus and monetary stimulus, how should we be thinking about our portfolio allocation in the region?
(Dan Siluk) I don’t think a lot has changed in terms of structurally how we view Europe. We have not been allocated to Europe for a good six or seven years and I don’t think that this significantly changes our allocation. I simply don’t think that we’re getting paid to take the risk of owning negatively yielding assets in Europe. However, tactically, from time to time, I think we’ll see some opportunities. So I’d be happy to own a zero-yielding European asset because when the cross currency basis between euro and dollars blows out and I can pick up 300 basis points or so hedging that back, then I’m happy to make that trade. But, structurally, to be long Europe, I think that’s not a trade I’m too keen on.
(Jason England) Yes, I agree with Dan. I think we want to continue to avoid the region as far as owning assets there that are negative yielding. Besides those opportunities that you’ve brought up with the cross currency basis going into our favour, that’s when maybe, tactically, we take a position. But right now, I think there’s just you know, not only the negative yields, but the volatility in that region of the globe, whether it’s Brexit or whether it’s the European Central Bank (ECB) and their funding issues, I think we want to continue to avoid it.
(Dan) Yes, agree. I mean for the same name in another currency, you can probably pick up a better spread. So for example, a European bank or a UK bank, by virtue of ECB quantitative easing (QE) that has just driven the central bank to buy that paper, it has compressed the spreads. I would rather own those European banks or those UK banks in Australian dollars, in Canadian dollars, or in US dollars where you can get a little bit of spread pick-up.
(Nick) Right, and I think that’s where the global component of our portfolio comes into play, because we have the ability to really go anywhere and seek out where we see the most opportunistic value for the least amount of risk. And it may not be replicating it exactly in terms of all of our portfolios across the board, but looking at things more broadly based and finding those opportunities like you suggest.
(Dan) Yes, absolutely. We’re not changing the default risk. If I find a Lloyds Bank [bond], whether it’s in euro, or in sterling, in US dollars or Australian dollars, it’s not a question of default risk. It’s really a question of the cross currency basis and also the spread pick-up, based on liquidity or issuance size. So Lloyds, for example, are not going to issue as much paper in Australian dollars as they would in sterling. So that illiquidity premium provides some attractive opportunity for us.
(Dan) So guys, I guess the last few years have been characterised by some pretty significant political upheaval or political volatility around the globe. When we go back to 2016, it was the Brexit vote, a few months later, Trump was elected despite the polls, bookmakers, markets, all predicting a Clinton win. And then more recently, we’ve seen the trade rhetoric between the US and China really escalate and that has led to uncertainty in markets. It has led to a slowdown in Europe, it’s led to a slowdown through Asia. Is there an end to all of this? I mean, do we become political analysts rather than the traditional financial analysts, economists that we’ve grown up being?
(Nick) I think the political side of things has really become a focal point in all of our portfolio management ideas and strategies. And I think we have to take more of a longer term approach when looking at markets. When focusing more on the political side, it certainly is important. So you have, like you said, the overhang of Brexit which has reverberated through the markets time in and time out, adding undue volatility. Then you have, probably more topically, the trade tensions which are really wreaking havoc across let’s say China and the US and spilling over into the rest of the globe. So, I think in addition to central bank expectations, the political side of things is also driving market expectations because, we’re sort of at the whim of a tweet from a President or any sort of expectation that there may be a resolution to trade deals or less progress being made. And that ultimately affects markets and our positions.
(Jason) Yes unfortunately, I just think that’s the world we live in today. I think the hard part about it is, you know, take Brexit for example. They just keep kicking the can down the road and you can never escape. Every time you think you’re reaching some kind of conclusion and you can form your investment thesis on that, then all of a sudden, it changes or the date changes and it gets moved down the road. And I think we are seeing that with the trade talks as well. All of a sudden, they’re going to come to some kind of agreement and then the markets rally off that. And then all of a sudden, no, it’s not, and then the markets go in the other direction. So I think the key thing from a risk management standpoint when you’re looking at the political side of things is, you can’t be knee-jerk, where you’re going to move your portfolio here and there because of this. But you also want to make sure that you do put proper hedging in place when you want to ride out this volatility. And I think that’s the key thing, yes, we don’t want to be political experts, but we do have to be cognisant of what is out there and what is going to affect it and what kind of shock that could have on our portfolio.
(Nick) Focusing on exclusively our European investors, how do we reconcile the fact that we’re facing an investment universe that is littered with negative interest rates but also our mandate of trying to deliver consistent positive returns? What exactly do we need to be looking at in order to achieve that but also maintain the risk and return profile that we have for the past decade plus?
(Dan) Look, I think the negative yielding asset base in Europe is really not a source of return for us in this environment. I think we need to look at positive real yielding jurisdictions such as the US, such as places like Asia ex-Japan, such as Australia and New Zealand. I think there are certainly some opportunities there where we can still deliver a low but positive return profile for our investors. And the other thing to note is the yield of the portfolio is only one component of the potential return. Structurally, we’ve increased duration to the US over the last 9 to 12 months and our view there was we saw the risk-off shock in Q4 of 2018 and rates started dropping, the 10-year Treasury yield got to 3.25% and since then, it’s been pretty much in freefall. So while we were running zero US duration throughout 2016, 2017 and a large part of 2018 as the Fed was hiking rates and on auto pilot as Jerome Powell suggested, that certainly has shifted. And so taking that interest rate risk and taking a little bit of duration in the portfolio has aided returns this year. And one other factor is credit. I mean, despite there being inverted yield curves around the world and all this talk about whether it’s the 3-month/10-year or the 2-year/10-year being inverted, being a predictor of recession, the important thing to note is that the credit yield curve remains positively sloped. Credit curves are sloped, so we can still get some roll-down by investing in the front end of credit curves. So there are a number of ways that we can still achieve some positive return for our European investors.
(Jason) Yes, and I think that’s what differentiates our product from the rest of the peer group is we are so global by nature, so being benchmark agnostic and being able to go and find the best risk-adjusted returns across the globe. We don’t have to own European assets that are negatively yielding and as you said, we can go and find jurisdictions that have positive yields and we can invest in those. And even after hedging costs, we can still produce a positive yield. Although low, it’s still generating that income and that total return when you factor in the carry and roll-down as you spoke to. So there are still opportunities in asset classes and sectors out there across the globe that we can put in our portfolios that kind of differentiate us from the rest of the peer group and help get a positive return.
Notes Cross-currency hedging effect: Differences between interest rates between two currencies and the relative demand for currencies at a particular point in time mean the currency hedging cost can be a cost or a profit depending on which direction an investor is buying a foreign asset. Currently, for example, it is possible after hedging for a US dollar-based investor to earn additional yield on a euro-denominated bond.
Roll down. If you buy a longer-term bond and the yield curve has a normal upward slope, the market price of a bond increases as the bond rolls down the yield curve. For example, imagine buying a 2-year bond, paying a 3% coupon with a 3% yield – the bond is priced at face value of 100. After a year, you effectively own a 1-year bond. If rates have not changed, the market yield on a 1-year bond should be lower because it is a shorter-term bond. Your bond still pays 3% but the market yield for a 1-year bond is say 2%. An investor would be prepared to pay 101 for your bond. The bond has gained value as it rolled down the yield curve.
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