Are rates barking or biting?

John Abernethy, Clime Asset Management

11th March 2021

In calendar year 2020, the US Treasury issued US$4.4 trillion of new debt to undertake and fund its "rescue and recovery" plan for the US economy. 

Of the bonds that were issued, only 5.2% (US $200 billion) were bought by traditional non-US (foreign) buyers. Meanwhile, the US Federal Reserve (the Fed) bought US$2.4 trillion (54%) or an average of US$197 billion per month as it reignited a new and sustained QE program.

For calendar 2021, the Fed has now indicated its intention to buy bonds at a rate of US$80 billion per month. However, pundits and market players are concerned because this rate of buying seems too low. This is particularly so given the anticipated passing through the US Congress/Senate of the US$1.9 trillion Biden "rescue" program and perhaps up to another US$3 trillion of "recovery" fiscal stimulation ("build back better" infrastructure investment) that is being proposed for later in the year.

The above may amount to the world's largest sustained fiscal stimulus of all time. Consequently it will also require the support of the largest QE of all time and this is what is weighing on the long dated US bond markets. Should the Fed not introduce a program of higher and more sustained QE along the yield curve (even past 10 year duration), then long bond yields will probably rise further.

Whilst inflation is flagged as a risk for bond yields, it is not that big an issue at present with an excess supply of both labour and energy dampening inflation. Rather, it is primarily the excessive supply of bonds to fund extraordinary fiscal expenditure that is driving long dated yields higher.

However, the massive fiscal plan has led to upgrades in the outlook for US growth in 2021. Recently some major US economists have forecast that gross (or pre-inflation) GDP growth will be 7% in the US. This forecast begs the question: How significant will inflation be in this gross GDP outcome? Our view is: not much - maybe 1.5% - but we also doubt that 7% growth can be achieved.  The complete COVID vaccine rollout will take at least 4-6 months to occur and the infrastructure investment is really a 2022 story and beyond. The US will recover but not as quick as many suggest.

The rolling US fiscal program seems based on Modern Monetary Theory (MMT). As discussed previously in these pages, MMT argues that governments create new money by using fiscal policy, and that the primary risk once the economy reaches full employment is inflation, which can be addressed by gathering taxes to reduce the spending capacity of the private sector. If unemployment is too high, then this is a signal that the Treasury or the Fed is overly restricting the supply of financial assets needed to pay taxes and satisfy the desire for savings. It would appear that the Biden Administration firmly believes that with unemployment still very high, there are few bounds to fiscal stimulation and that the Fed will maintain QE at a sustained rate.

This point is totally lost in the political debate across the world. Indeed, if for a moment we think about the current monetary and fiscal policy settings in Australia, we see a disconnection between the policy makers (Treasury and the RBA) and the politicians.

For example, in the last week we have had a Royal Commission declare that Australia's aged care system is broken. The response from the Government is that we must increase expenditure in this area and that it may be best to fund it with an income tax surcharge. That begs the obvious but uncomfortable question - Why not just increase Commonwealth borrowings and fund Aged Care investment inside the QE policy?

At some point, the politicians need to focus on this issue. Also the bureaucrats need to share their analyses of the logic and sustainability of QE or MMT. The average Australian may soon question why QE that funds "JobSeeker" or "JobKeeper" is fine, but a substantial investment in aged care, healthcare and general public infrastructure is not?

Moving back to the US, we see the surge in expenditure in the Biden program below as the new Administration revisits and resets the programs that were originally set in March 2020 as COVID commenced.

The explosion of the Fed balance sheet is shown below as it lifted from about US$3.5 trillion in assets to over US$7.5 trillion last week. Based on the projections above, it may well reach US $10 trillion by year's end (or about 40% of US GDP). At that point, the Fed would own about 35% of all US bonds on issue.

The effect of sustained QE is well observed. Bond yields are held down and the rates that would exist in a "free market" - where Central Bank interference does not occur - are absent. A free market would see bond yields affected or influenced by economic activity, inflation expectations and the credit quality of the issuing government as measured by its fiscal responsibility.

The graph below compares global manufacturing activity (Purchasing Managers Index or PMI) to US bonds, and shows that bond yields are particularly low on this measure. Since the GFC it has been a fairly good tracker, but during COVID the relationship has broken down with the massive US QE program artificially suppressing yields.

That is not to deny that bond yields have risen lately. However, across the world yields are rising back to where they were prior to the COVID crisis - and that is to be expected. It is not alarming; rather, it is logical.

The above chart shows that Australian 10 year bonds have moved above their pre-COVID levels despite the RBA introducing QE. The reason for this is because the RBA program is very focused on the short end. It originally (in March 2020) targeted 3 year bonds at 0.25%, until November 2020 when it reduced the target for 3 year bonds to the same as the official cash rate, namely 0.10%.

It is likely that the RBA will expand its QE program and move into the 10 year bond market at some point. It is truly perverse that Australian 10 year bonds yield 2% higher than German bonds - which are still trading with a negative yield!

The next chart takes a slightly longer look at Australian bond yields. In early 2018, three year bond yields were over 2% and therefore substantially higher than today's ten year bond yield. The compression of three year bond yields to slightly above the 0.1% target by the RBA is a major reason why investible cash will continue to flow towards the Australian listed yield market.

The next chart shows that US ten year bond yields have now moved above the S&P 500 dividend yield. So is this a problem for markets? Our view is "No" because the dividends that will flow from the US economic (and world) recovery will grow, and will be far superior to the static and controlled yields of the bond market. We regard the chart as interesting but not persuasive.

The sustained decline in bond yields driven by QE programs had an outsized effect on returns generated by all bond indices. The return for Australian asset classes is shown below and it is observable that Australian bonds delivered an extraordinary return compared to Australian shares. The return on so-called low risk assets (bonds) should not be the same as the return on risk assets (equities).

Based on historical data the chart above, in our view, suggests a relatively strong outlook for Australian equities compared to both Australian bonds and international equities.

Excess performance over a short term (say 3 years) is often reversed over a longer period. Markets typically "overshoot"; more so when the relative out-performance is generated by the use of QE in offshore economies.

Thus, as Australia has now joined the crowd and also embarked on QE, our view is that our market will benefit from this policy -- just as international markets have.

However, a sobering observation (our final one in this edition) is the forward looking benefit of having a balanced portfolio that has an allocation to bonds.The following chart shows the "defensive" benefit of bonds as a risk and return offset to the volatility in equities has and is declining.

The lift in long term bond yields is predictable. A consequence is that while the outlook for equities is positive, the ability to manage portfolio volatility has become harder. For self-directed pension funds, this suggests that an increased allocation to direct property, credit and yield assets should be sought as the usefulness and return on bonds declines.

Funds operated by this manager:

Clime Australian Value Fund - Retail, Clime Internation Fund - Wholesale

How Hybrids fit into 2021 Income Portfolios

Campbell Dawson, Director, Elstree Investment Management

24 March 2021

• Income investing in Australia was relatively simple between 1990 and 2015; lots of cash, a few higher yield equities and some property gave stable returns at well above the rate of inflation
• The collapse in cash and TD rates has made things much, much harder
• Just buying more equities doesn't work; volatility goes through the roof
• It is still possible to create income portfolios with acceptable volatility? Yes, you just have to be more diversified
• Hybrids are an essential part of an effective income portfolio. They offer a combination of return, muted volatility and good liquidity that can't be matched by other income and asset classes

"We have seen better days" (Shakespeare)

Australian income investors lives have changed, maybe permanently.

Between 1990 and 2015, Australia was the lucky country. High interest rates meant that it was relatively easy to create income portfolios with good returns and low(ish) volatility. After adjusting for inflation, Australian cash and bonds produced the highest 'real' returns in the world for most of the period since 1990.  After 2015, cash and bond rates started to fall, and income portfolios became a lot harder. In the chart below we've shown the income yield and rolling 12 month return of a typical capital stable/safe income portfolio (50% cash/TD, 30% equities, 20% property).

How good is Australia?

The past 15 years have been great; average income levels were 4%, the annual total return (income plus capital) of the 50%/30%/20% portfolio was around 5.25% p.a. including two pretty severe stress events (GFC and Covid-19). Ex Covid, the portfolio volatility was 5% p.a. which meant that capital changes were within the range of +/- 5% for 2 out of 3 years.

Of course, some years were more volatile than that. The portfolio got towelled during the GFC, but if you went to sleep often enough in the years after that, you probably didn't see the portfolio generate a negative return on a rolling 12-month basis until Covid-19, and even after that it's now back to a flat return for the year.

But the income has halved ... and investors can't cut their spending by 50%

The income yield on the previously impeccable income portfolio is now less than 2%, down from the previous decade of average of over 4%. The obvious dilemma is that investors can't cut their spending by 50%, so they either need to start eating into capital, or take more risk on in an attempt to generate previous income levels.

We've highlighted the dilemma by showing what happens to the previously effective TD/Equity/Property portfolio when you increase the equity component to generate higher income. To get to a 3% income return, you need to increase risk materially. It's a big jump for most investors to almost double their risk tolerance, so there has to be a better solution.

Uncomplicated portfolios don't work anymore

We don't think there are any magic solutions. Investors need to take on more risk, but they need to do it more sensibly than just buying more equities, because even 'defensive equities' lost 35% in the Covid-19 downturn. The solution is more difficult because investors need to buy more stuff. It's not going to be as familiar as the old portfolio and has different risks to watch out for.

Diversify and get the free lunch

It is one of the wonders of investment science that you can mix a bunch of higher return but risky assets but if they are not exactly correlated, you end up with a portfolio that's not as risky as you might think.

For example, combining non-AUD equities with AUD equities produces a portfolio with around 30% less volatility than each individual asset class.  Diversification is the biggest free lunch an investor will ever get.

We think investors should use this free lunch concept to combine a range of income type investments with a range of return and risk profiles and let the correlations work for you.

The table below shows a range of asset types with their return and expected volatility. What should be immediately apparent is that there are a range of assets that sit in the mid points between Term Deposits (which are risk free) and Equities (which are definitely not risk free).

A combination of these asset classes increases the return above a Term Deposit exposed portfolio, but the risk and the correlation benefits result in a less risky portfolio than jumping to a higher equity position.

So, how does it look in practice?

We created a portfolio with 10% cash holdings 20% Hybrids and the balance evenly split between the other 8 asset classes mentioned above. Only 35% was allocated to equity and property. We've detailed the return and volatility of the portfolio on the table below and compared them to the "capital stable" of last decade.

It's interesting to note (with the caveat that we have made assumptions about volatility and correlations) that if you diversify your income sources, you can create a c4% income portfolio while still having an acceptable amount of volatility. The previous optimal portfolios either produce less income with the same risk, or the same income with more risk. Neither are particularly palatable outcomes. 

The one trade-off is liquidity.  Most previous income portfolios were very liquid with up to 90% invested in cash and term deposits and with lots of that in TDs which are able to liquified at face value.

The more diversified portfolio has a greater proportion of assets in classes that are either less liquid or more volatile, so selling in crisis results in a discount.

The liquid, non-volatile component is around 30% of the portfolio (cash and hybrids) with a further 25% in listed equities and listed property, which are liquid but maybe not at close to face value.

Why are Hybrids so important?

Hybrids are really important in new age income portfolios for two main reasons:

• They are about the next asset out on the risk spectrum from cash/bonds, but still offer a c3% increase in income.
• Unlike most of the asset classes mentioned above, Hybrids have very little default risk because the issuers are investment grade and unlikely to get into trouble. Most of the other asset classes have sub investment grade exposures and they default far more frequently. It's not immaterial. If you owned 100 companies with the Hybrid markets credit rating, less than one would have defaulted after 5 years (on average). The comparative for a sub investment grade bond loan or fund is around 10 or 11 companies defaulting in over a 5-year period.
• Hybrids are liquid. Other income assets are either do not freely trade or are subject to price and liquidity problems under stress.

The liquidity benefit is particularly important in a portfolio which is trading off liquidity for return.

More about Elstree:

Elstree Investment Management Limited was formed in 2002 and is exclusively and equally owned by the three executives associated with the company. Since 2003 it has managed ASX listed hybrid portfolios and at the same time developed the Elstree Hybrid Index, which is the only index of post-1999 hybrid prices and returns. The data from the Elstree Hybrid Index extensively for security selection, risk management and benchmarking. 

Currently the firm manages approximately $150 million across a wholesale unlisted fund (Elstree Enhanced Income Fund, minimum investment $500,000) and a number of individually managed accounts.  The Elstree Enhance d Income Fund returned 8.8% (excl franking) for the 12 months to end- February 2021.

Elstree has recently launched the Elstree Hybrid Fund (EHF1), an Exchange Traded Product (ETP) version of the successful unlisted Elstree Enhanced Income Fund for retail investors.  EHF1 will shortly commence trading on Chi-X (Chi-X: EHF1).  For more information visit www.elstreehybridfund.com.au.

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Chris Gosselin, CEO of Australian Fund Monitors, speaks with Martin Pretty, Director at Equitable Investors.

The Equitable Investors Dragonfly Fund was started in September 2017 and has returned +3.06% p.a. since inception. Over the 12 months to February 2021, the Fund rose +59.82% against the ASX200 Accumulation Index's +6.48%.

Making up the numbers

Adam Chandler, Evans & Partners

26 March 2021

By the measure of whether companies "beat" estimates, the most recent U.S. reporting season was outstanding. At our last count, 79 per cent of S&P500 companies had exceeded consensus estimates.

With the S&P500 at record highs, easy monetary conditions, another fiscal stimulus package and reopening ahead, perhaps that's all equity investors need to know.

But, as we look more closely at earnings trends in the U.S. market, what becomes clear is that companies are increasingly making adjustments that boost official earnings numbers - and at times, mask the underlying business reality. So, exactly what earnings are beating estimates?

In this article we will look at how some companies are using adjustments to inflate earnings, the escalating use of adjustments, and lay out why all this matters for investors.

A brief historical context

In short, adjusted earnings are financial metrics that don't meet the relevant U.S. accounting standards for inclusion in financial statements. For those that don't spend their time digging through listed company financials, adjusted earnings are often provided in company's earnings press releases, and in investor presentations and calls, which are less heavily regulated than the standardised, Generally Accepted Accounting Principles (or GAAP) earnings found in financial statements[1]. We will refer to adjusted (or non-GAAP) earnings and GAAP earnings throughout this article.

Adjusted earnings should help improve the visibility of the core business' performance and sustainability. A one-off event involving a large legal settlement, may blur the picture of a company's underlying health. For example, when rating agencies Moody's Corporation and S&P Global added back settlements following the Financial Crisis and subsequent industry reform, it provided a clearer view of core businesses that remained incredibly profitable.

However, adjustments are nuanced and may be misleading. Unsurprisingly, some management teams have, at times, gamed the system, making questionable adjustments to earnings to give the appearance of higher profitability. A former Chief Accountant at the Securities and Exchange Commission, Lynn Turner, succinctly described non-GAAP earnings as reporting "everything but the bad stuff".

One of our favourite examples in recent years was the adjusted earnings manufactured by WeWork, the provider of shared office space. The company's 2018 offering document caught our attention with the very creatively titled "Community adjusted EBITDA". This inflated earnings by adding back almost every imaginable expense including stock compensation, rent adjustments, sales and marketing costs, growth and new market development expenses, as well as general and administrative expenses, magically transforming 2017's EBITDA loss of $769 million into a profit of $233 million.

Funds operated by this manager:

Evans & Partners International Fund

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