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Investors have been faced with more historic events in the past three years than most people see in two decades. Charlie Jamieson and Mark Burgess share their views on what's ahead and how lessons from the GFC have prepared investors.

KEY TAKEAWAYS:

• Funds and high net worth individuals are keeping cash ready to buy distressed assets.
• In a rising rate environment, fund performance will be closely tied to the skill of fund managers in picking assets.
• It's unlikely there will be a V-shaped recovery from the current bear market.

Investors have been through a range of extreme events in the past three years. Those trials have included zero interest rates followed by the fastest rate hiking cycle in history, oil prices turning negative, two of the largest banking collapses in US history, several crypto crashes and - most obviously - a global pandemic.

Now, three years on from the start of the pandemic, Jamieson Coote Bonds (JCB) Chief Investment Officer, Charlie Jamieson and Mark Burgess, Chair of the Advisory Board, have shared their views on the path ahead for markets.

SKILL TO DRIVE FUND MANAGER RETURNS

In the years following the global financial crisis (GFC), falling cash rates drove better returns from bonds, according to Mr Burgess.

When central banks cut their cash rates following the GFC (and abruptly 'raced to zero' during the early stages of the pandemic), it helped fund managers deliver generally better results, he said. Typically, banks lower their borrowing costs as the cash rate trends downward. As a result, falling rates reduce the cost of capital for businesses and increase the expected return on investments*.  Lower borrowing costs also encourage businesses to invest more in new capital assets.  

But that situation has changed with significant lifts to cash rates worldwide in the past 12 months.

Mr Burgess said fund performance will come to lean more heavily on the skill of fund managers. Their ability to pick assets, the strategies they employ and the timing of their implementation will be vital to their success.

"So the choice of manager matters," Mr Burgess reiterated.

"Skill will be the biggest proportion of return, rather than falling rates which has been the biggest proportion of returns in my career. And if you have invested with a fund manager who's not that skilled, you're about to find out about it."

NO 'V-SHAPED' RECOVERY

Mr Burgess explained that while there's little doubt the global economy is in the throes of a bear market, there's some debate over whether this is a normal cyclical bear market, or a structural one. If it's a structural bear market, the correction will be "far deeper and longer" than if it were simply cyclical.

Mr Burgess, however, is not in the structural camp. "For that correction to happen, the structure of the system has to break," he said.

Mr Burgess went on to explain that while the environment remains fragile, lessons from 2008, interventions by authorities in any failing institutions and better capitalised core banking systems, should allow for less cyclical damage than markets such as 2008 or 1970s which saw severe structural corrections.

He noted however that the environment remains challenging, which will limit the ease of an immediate recovery.

"It's no longer about creating credit; it's about how we structure debt and refinance. With high levels of debt refinancing is the key and the recovery there will be challenging."

Although assessing the current bear market as cyclical, JCB does not expect to see a 'V-shaped' recovery in which asset prices enjoy a sharp rise back to previous highs after a similarly sharp decline.

"Barring a catastrophic and systemic shock we're not going to be cutting rates," Mr Jamieson said. "That's why it's such a different go-forward, because all of the things that got carried to that very high place pre-COVID are unlikely to get carried in that same way.  

"So, as we've had these adjustments through the bond market, through some credit markets and the like, we're not going to get that V-shaped recovery."

PLENTY OF CASH ON THE SIDELINES

Mr Burgess said one of the big surprises is how much money is currently "sitting underneath the market". This, he said, is likely driven by the lessons learned in 2008 during the GFC.

"One of the advantages of having had a global financial crisis in '08 is that when you get a financial crisis, you actually get some future benefit, and that future benefit is that you know how to handle a financial crisis," he said.

"The way people are preparing for it is that a lot of high-net-worth investors have a lot of cash ready to buy distressed assets."

Most institutional investors have already pre-allocated cash to purchase distressed or oversold assets, he said. However, in some cases Mr Burgess said the volume of cash sitting in some areas such as private equity and institutional and high net worth holding is notable. Other areas however will see cash constraints - such as speculative technology.

COMMERCIAL REAL ESTATE SECTOR SET TO DIP

Property markets have received significant attention as rising interest rates place the sector under mounting pressure. In the residential space the effects of these rate changes are already being felt, Mr Jamieson noted.

"Anecdotally, from talking to my friends, we're all in our 40s - we've got our own families, we've got a high cost base at this point in our family lives - everybody knows it's going to be hard," he said.

"I don't feel like anyone's really well set up for it yet. They just think that they'll make the adjustment if and when it comes."

In the commercial property sector, however, some interesting themes are starting to take root. Mr Burgess noted that between higher interest rates and the 'work-from-home' revolution that started in COVID-19 lockdowns, office spaces may not be generating the same returns.

The outlook for the sector remains negative, he added, and some investors are now looking at strategies to profit off this weakness. He cited Blackstone's newly launched US$30.4 billion distressed property fund as a prime example of this approach.

Mr Burgess cautioned that while he expects prices for commercial property in Australia to continue falling, he doesn't think the downturn will be as pronounced as in past cycles.

"There's not so much distress out there that people are going to have to give buildings away this time around."

BONDS STAGE A RETURN

Throughout the past cycle, Mr Burgess said, markets were plagued by "too much capital" chasing select stocks - with buy-now-pay-later businesses, speculative technology areas and video streaming giant Netflix both prime examples.

This excess capital pushed distorted valuations and ultimately hurt returns. Mr Burgess said much of this excess capital has already "been washed out" of the market but cautioned "there's other areas that have yet to play out".

With this in mind, Mr Burgess predicted a return to "good old-fashioned investing" where investors are wary of too much capital flowing into companies they're looking at.

At the same time, Mr Burgess said investors are starting to look to government bonds as another option for their portfolios.

"What I hear as a bond manager is that people are buying government bonds through gritted teeth, but bonds have gone back into some sort of normalised range," he said.

"Now institutions are gradually allocating to bonds because they're starting to think it actually makes sense. The sharp rise in interest rates have made bonds quickly attractive again".

The key to navigating the next 12 months, he said, would be to consider the current market with fresh thinking, weigh up which direction capital is flowing (and how much of it is moving), and using 'age-old' investing techniques to generate returns. True investment skill will finally be back in fashion he noted.

* Reserve Bank of Australia, 'The Transmission of Monetary Policy: How does it work?', September 2017, accessed 20 April 2023.

Author: Charlie Jamieson and Mark Burgess

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In UK, the bulk purchase annuity (BPA) market has seen around £150bn of value transferred from pension schemes to insurers over the last five years. ¹ Projections for the next decade suggest further transfers of over £500bn, fuelled in part by higher interest rates improving schemes' funding ratios.

Although the backdrop may seem irrelevant in APAC, the capability to efficiently construct cashflow-matching portfolios is of increasing importance to both insurers and pension schemes in the region.

In this article, we take a look at how novel portfolio construction techniques offered by asset managers can allow insurers and pension schemes to accurately match their liability cashflows whilst also ensuring their risk appetite and specific fund tolerances are fully considered.

Holistic

With a holistic cashflow match framework, it is possible to optimally construct portfolios which offer desirable levels of yield, whilst reflecting all possible specific client specifications and restrictions. This includes clients who want their matching portfolio to meet the requirements for Matching Adjustment (MA) compliance under Singapore RBC 2 currently and the upcoming Hong Kong RBC.

An investment manager can also offer pre-trade modelling and optimisation capability

As well as portfolio construction, efficient ongoing portfolio management ensures assets also continue to be rebalanced and optimised throughout mandate life cycle.

Later in this article we will examine the range of assets and different client specifications that can be embedded into a flexible portfolio construction and management framework. But first, what about risk appetites and tolerances?

Flexible

A cashflow matching framework is centred around maximising the correspondence between the asset cashflows and the client's liability cash flow. The latter can be on best estimate basis, or based on guaranteed cash flow, depending on the nature of the mandate requirements. The asset cashflows may also include haircuts reflecting the imperfect FX hedge, necessary for example in matching adjustment mandates.

It is through the additional constraints, however, that the portfolio can be tailored to meet client and regulatory requirements. For example, asset managers' tools can include:

• A minimum yield constraint to increase the return of the cashflow matching portfolio.
• Maximum issuer/sector constraints, e.g., no more than 3% of the market value of the portfolio within a specific issuer or no more than 20% of the market value of the portfolio in financials.
• Maximum rating constraints, e.g., no more than 25% of the market value of the portfolio can be held in BBB bonds, or constraints on the 'average rating' of the portfolio.
• Constraints around the accuracy of the cashflow match, even ensuring matching adjustment portfolios are able to meet Cash Flow Shortfall Test as specified by some RBC regimes. Such criteria are required to be met for on-going compliance with the matching adjustment requirement.

 

Such a framework is flexible enough to meet any requirements or risk appetites. It's also important that asset managers work collaboratively to ensure clients' views and demands are fully reflected in the portfolio construction and on-going fund management tools.

The full client life-cycle and all asset classes

Cashflow-matching managers are able to incorporate the full client life-cycle and a wide range of asset classes ensuring they are particularly well-placed to work with insurers and pension schemes. But what should these clients look out for in terms of manager skills, tools, capabilities and scale?

The best teams benefit from a suite of proprietary, on-desk cashflow matching tools and use these to manage sizable matching portfolios in accordance with regulations in different jurisdictions . These tools aid portfolio managers and clients throughout the full lifecycle of such funds:

*Initiation of mandates and fund restructuring e.g., a fund uprisking from government bond to credit or switching from credit to higher-rated supranational bonds whilst maintaining the match

*Pre-trade modelling to ensure proposed new purchases and switches are suitable from a cashflow matching or on-going matching adjustment compliance point of view.

*Portfolio rebalancing/liquidity management to meet cash requirements in and out of the fund.

With a fast growing MA market and a limited supply of eligible public securities in local currency, it's a key requirement for MA portfolios to widen the scope of asset classes in order to continue to offer attractive solutions within a competitive market place.

As such, in addition to local currency investment grade fixed income securities, best-in-class cashflow matching solutions can include overseas debt, e.g., USD corporate bonds, paired together with cross-currency swaps or repackaged up as a special purpose vehicle.

It's a key requirement for Muli-Asset portfolios to widen the scope of asset classes

The capability to model private placements, commercial real estate loans, and infrastructure bonds is also crucial. Naturally embedding such securities allows for efficient management of public credit alongside non-public debt within cashflow matched & matching adjustment mandates.

Quantitative portfolio design

In short, proprietary quantitative portfolio design can be applied on a wide and diverse investment universe. This design may be tailored to meet clients' needs and constraints. Such a flexible and transparent process also allows for informed discussion between key stakeholders, enabling comparison of the relative merits of a spectrum of matching portfolios with different 'risk-return' profiles.

To illustrate this point, we showcase such an 'efficient frontier' of matching adjustment compliant portfolios for a stylised liability profile and a public credit universe in Chart 1 and Chart 2 below.

Chart 1 Matching Adjustment 'efficient frontier' constructed from the public credit universe. Typical portfolio issuer/sector /rating constraints. Liabilities c. 12y duration. Close of Business (CoB) 30-Dec-2022.

A "Best cashflow match" portfolio with no yield constraint (meets various portfolio limits & MA CF-Match Tests).

B Better yielding MA Compliant Portfolio (still meeting all limits & CF-M tests)

C Pushing yield at the expense of cashflow match (portfolio only just matching adjustment compliant).

Source: abrdn. For illustrative purposes only.

Chart 2 Cashflow match plots for the three highlighted portfolios along the MA 'efficient frontier'. Stylised liabilities of c. £1bn PV (present value) and 12-year duration. All portfolios meet the required'Tests'. CoB 30-Dec-2022.

Source: abrdn. For illustrative purposes only.

The above portfolios also embed insurers' typical issuer, rating and sector limits and demonstrate the benefits of an optimisation exercise, potentially resulting in a 30bps gain in spread whilst retaining an acceptable quality of cashflow matching.

A huge opportunity for insurers and pension schemes

With Hong Kong insurers embracing the upcoming Hong Kong RBC and Singapore insurers moving from RBC adoption to RBC optimisation, we are witnessing a trend in APAC similar to what has been ongoing among their European peers. Asset managers with proprietary techniques and insurance asset management capabilities could be well placed to support this journeys that lie ahead.

Author: Mark Cathcart, Investment Director, Liability Aware

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Miserable IPO returns have been the story even though Kenvue got away with a 22% stag on day one of its US listing last week; a gap has opened between small and large stocks with the "jaws" notable in both price movements and valaution comparisons; in that context it is interesting to see how smaller stocks have outperformed historically coming out of market drawdowns; in Australia the industry survey looks negative but S&P/ASX EPS revisions haven't really been notable; insolvency is on the rise as is US consumer credit card debt; and finally for whoever is advising the state fo Victoria, credit ratings do matter.

Distribution of returns from US IPOs by issue date (2023 to date)

Source: Equitable Investors, StockAnalysis

Distribution of returns from ASX IPOs by issue date

Source: Equitable Investors

ASX small caps (SSO - orange) v large caps (STW - blue)

Source: Equitable Investors, TIKR

US micro caps (IWC - orange) v large caps (IVV - blue)

Source: Equitable Investors, TIKR

Past 20 Years World Small Cap P/E Ratios

Source: Pzena

Nasdaq 100 Price/Sales Ratio

Source: Charles Schwab & Co.

US small caps v large caps during & after the "dot-com bubble"

Source: abrdn

US small caps v large caps during & after the GFC

Source: abrdn

S&P/ASX small v large during & after the "dot-com bubble"

Source: Equitable Investors, Iress

S&P/ASX small v large during & after the GFC

Source: Equitable Investors, Iress

AIG Industry Index

Source: IFM, AIG

Consensus EPS expectations for S&P/ASX 200

Source: Cannacord

Large bankruptcies ($US50m+ liabilities) - Jan-Apr count for 2023

Source: Bloomberg, @jsblokland

Australian companies entering external administration for the first time (FY23 = black line)

Source: ABS

US Consumer Loans (Credit Cards & Other Revolving Plans, All Commercial Banks)

Source: @glightfinancial, FRED

Government Bond Yields and their S&P credit ratings

Source: Equitable Investors,

worldgovernmentbonds.com