Bond markets were on the back foot in February, in a material way, as global positions were liquidated challenging Central Banks in a way we have rarely seen since the GFC.  The optimism surrounding the Biden fiscal stimulus (USD $1.9 trillion) and inflation expectations on short run base effects caused a liquidation of bond positions against the commentary of Central Bankers, who remain committed to low cash rates and easy financing conditions to stimulate demand in the Covid-19 ravaged economies.  The sell-off became self-fulfilling in Australia as the RBA did little to redress algorithmic and Commodity Trading Advisor (CTA) style funds continuously selling interest rates futures, causing longer term holders to liquidate as the relative value of Australian rates cheapened against other cross market nations such as the United States. Ironically, this relative value is an explicit objective of the RBA's own QE program combined with the suppression of the Australian dollar. The RBA has failed on both fronts since the inception of the QE program and leads us to believe that further QE will be required.

Whilst Australian interest rates were a surprise under performer over the month, movements across global rates markets also pushed to higher yields in unison with heightened volatility in risk free Government bond markets.  This has huge implications for all asset markets the world over. This volatility does not stay in a singular asset class for long, other similar episodes often sees volatility morph to other asset classes as interest rates are the virus that affect all things - they are our funding rates and discount rates. When risk free rates rise quickly in a heavily indebted world, that volatility can spread with dangerous implications.  The most recent example of this was Q4 2018 when bonds sold off aggressively late in the year, freezing corporate high yield debt markets (there was no debt capital market issuance of high yield bonds for around six weeks as confidence collapsed) and ultimately triggering -20% liquidation of equity markets (which in and of itself generates a flight to quality bid in Government bonds).

Fast forward to today and we now have corporate credit at more expensive valuations than pre Covid-19 which we believe is crazy, especially as risk free rates are rising which usually forces a recalibration of credit spread premiums.  As experienced from episodes like last March and April 2020, when credit reprices, it can be truly chaotic with a huge loss of liquidity - volatility in risk free rates often moves into credit before then skipping to risk assets as markets become concerned around low quality corporates, funding themselves at higher interest rates using debt capital markets or rolling existing debt obligations.  

DEFENSIVE LONGER-TERM PORTFOLIO RETURNS DELIVERED BY CARRY AND ROLL

With the sell-off in risk free markets has come a reestablishment of yield (carry) and importantly delivered a steep term structure of interest rates curve (roll).  Whilst duration often gets all the attention in bond markets for its short run movement of prices, it is actually a minor contributor to total return over time. This is critical to understand when building defensive longer-term portfolios as the major returns are delivered by carry and roll.

Looking at the last decade of bond returns, almost everyone would tell you that bonds performed because duration rallied, and that was helpful no doubt, but the vast majority of performance happens slowly in an accretive and continuously compounding manner of carry and roll (roll in very simple terms is as a 5 year bond becomes a 4 year bond in one years' time, it has a capital accretion down a steep term structure curve generating total return). This rebuilds the defensive characteristics materially for a future time and has been met with interest from many of our clients, most of whom have been underweight Government bonds within their own asset allocations and are excited to rebuild more material positions into higher yields and steeper curves.  Having just witnessed the tremendous power of the liquidity optionality available in Government bonds in March and April of 2020, many clients are now acknowledging that it was the ability to sell easily (at a premium) in times of stress that allowed them to invest in deeply discounted equities.  For many, this move made substantial portfolio returns over the later part of 2020, thanks to a clean asset allocation that is not co-mingled with corporate credit making the entire structure vulnerable (many corporate credit funds were semi-gated during this time by raising sell spreads significantly as corporate credit froze).

CARRY AND ROLL ARE FAR MORE IMPORTANT OVER TIME THAN DURATION IN PORTFOLIOS - AUSTRALIA

Source: JCB team analysis, based on data from Bloomberg.  Past performance is not indicative of future performance.

As bonds are a continuously compounding asset, they have historically done very well after periods of underperformance. The below chart is the historical performance of the bond index only, noting the strong performance that has been generated following drawdown periods.

Source: JCB team analysis, based on data from Bloomberg. Past performance is not indicative of future performance.

In viewing such historical data, it is easy to see why many clients are now considering the timing of moving up from a neutral allocation to defensive or going into an overweight allocation. We believe markets will remain volatile in the near term as we push into the middle of the year when transient short-run inflation will likely peak.

OVER THE INFLATION HILL

We have written previously about the mechanical pathway for higher US inflation (remember Q2 2020 the entire world was closed and we had negative oil prices) on data rotation alone, inflation should peak in May (base effects). We can work out a fairly tight lane way on this scenario pathway, but the one thing that is difficult to economically estimate is how long supply blockages take to clear. Once the base effect gives inflation velocity, it also takes it away just as quickly. We are preparing a white paper titled ''Over the inflation hill'' that we believe is hugely relevant as it will have impacts on so many asset classes as the journey evolves.

From a secular viewpoint, disinflationary forces of poor demographics, high debt levels (interest rate sensitivities and zombie corporate funding), technology, automation, robotics, lack of unionisation and globalisation have all been an overarching deflationary force. You can now add to that list massive economic slack and untapped labour pools the world over, so it's hard to get excited about medium to long run 'self-reinforcing' inflation.  However, short run inflation is transitory and will be much higher before base effects fall out and inflation will cool.

So the major questions now asked by many investors are; what are the triggers or the pathway towards a short run inflation peak, how chaotic can this movement become across portfolios that are broadly long risk assets, and what would be the reflexive feedback loops to other assets markets?  JCB cannot caution enough that this volatility will be very unlikely to remain in the risk free complex.  Modern day markets are actually quite fragile, and whilst prices are observable at great valuations in many things, the true test remains how deep that pricing tension really is.  If bullish risk allocations go for the door, we know that opening can become a keyhole very quickly where only the first few folks get through.

In a matter of months, we've experienced a remarkable turn-around when it comes to Australian equity income and right now it's safe to say dividends are back.

After a thorough analysis of the February reporting season, the Plato team has updated its Australian equity income outlook. We now forecast the ASX200 will return a 4.8% gross yield in the coming 12 months and think high-quality active management should be able to deliver an additional 2-3% on top of the index.

For self-funded retirees who ain't got a lot to spare, this is great news.

At every RBA cash rate cut over the past decade, self-funded retirees have been dealt a blow and earlier this year they would have heard the RBA Governor state any increase to the cash rate is unlikely until at least 2024.

Generating meaningful returns from cash in the bank or bond yields has been near impossible for a number of years now and when dividends were slashed at height of the COVID-19 crisis, many would have been wondering how they were going to make ends meet. Thankfully, the dividend recovery has been swift.

The dividend income ascent

The last article I penned for the Plato Academy in the days ahead of February reporting season, was titled Cash rate locked, dividends unshackled. I highlighted a number of reasons why we believed dividends had been 'unshackled', including APRA repealing restrictions imposed on bank dividends and Federal Labor confirming it would no longer pursue changes to franking credits for retirees. This 'unshackling' certainly eventuated and has now evolved into what can best be described as a dividend income ascent.

Below, we have illustrated the change in our ASX200 index income forecast over just 2 months - from 31 December 2020, to 2 March 2021.

When we look into this ascent, 59% of the increase (which equates to 30 basis points in yield) comes from Financials. Few predicted such a rapid COVID-19 recovery in bank dividends.

Of the Big 4, we think Commonwealth Bank looks to be a compelling opportunity for income investors today. It declared a $1.50 dividend which was 25% lower than its February 2020 dividend, but importantly it equates to only 67% of earnings. The bank has said its pay-out ratio is likely to be 70-80% this year, so we expect a stronger second-half dividend.

However, what's most enticing about CBA, is the possibility it will use excess franking credits on the balance sheet to undertake an off-market buyback in the coming year. We've previously detailed why buybacks are great for retirement income.

Dividend strength is also evident outside of the Big 4. Bendigo and Adelaide Bank's half-year result came in at almost 30% above expectations. Cash earnings of $220 million were up 2% from the prior corresponding period and a whopping 156% on the second half 2020 result. The 28-cent dividend announced equates to a prudent payout ratio of 68% and a gross yield of 4.2%.

The dividend ascent amongst the banks is not only supported by the removal of APRA restrictions on payouts, but also somewhat surprisingly strong profit announcements. This is due to fewer than expected COVID-19-related bad debts across the industry, resulting in the unwinding of provisions. In a show of confidence, even before Job-Keeper ends on March 31, both ANZ and Westpac felt confident enough to write back some of their COVID-related provisions and barring any further outbreaks or deterioration of the economy, we expect even more write-backs.

Other sectors to watch

Mining stocks are the other big contributor to the dividend ascent. 39% of the increase  illustrated above (20bps in yield) comes from mining stocks. 

Plato has been banging the drum on miners for a number of years now and mining dividends just keep on delivering. For income investors this is a space, you simply can't afford to ignore.

Of the top six dividend payers in Australia right now, three are mining stocks - Fortescue Metals, BHP Group and Rio Tinto. For dividend investors these are the 'new banks' and you can see here just how much cash they're delivering to investors.

Over the past 3 years, while many income-focussed investors have ignored these three mining stocks, they've delivered our investors 3.4% p.a. gross income and we believe the income will keep coming in the foreseeable future. The supply and demand fundamentals for iron ore prices remain in-tact and even if prices do come off $50-100 dollars per tonne, these companies still remain quite profitable. Furthermore, management at the big miners seem to have learned from past mistakes about over-investing in new mines.

Much like the banks, there is also significant strength outside the big players. Mineral Resources is a great example of a smaller miner, offering exceptional income. Last month it announced a $1.00 dividend (3.9% gross yield) on net profit up 111%.

The remanding major contributor to the dividend ascent of the ASX200 index is Consumer Discretionary stocks. In this space, many leading retailers have been thriving and we think investors will continue to reap the dividend rewards throughout the remainder of the year.

JB Hi-Fi is one of our holdings that has delivered a stellar half-year result for income investors. Its record $1.80 dividend equates to a gross yield of 5.1%. Its half-year NPAT was up 86%. What is significant for the outlook is January 2021 like-for-like sales were up 17%. This is something also seen across other leading ASX-listed retailers and we believe this demonstrates the COVID-19-fuelled retail sales momentum has further to run.

Making the most of the dividend ascent

While this analysis is broadly based on the ASX200, as mentioned we believe active portfolio management is key to maximising income for retirees. A large number of dividend traps are hidden within the ASX200 - avoiding these is just as important as identifying the dividend stars.

Over the past few years, we've also witnessed why a set-and-forget strategy is a sub-optimal income solution for self-funded retirees. Many Australian income investors have historically just sat on the Big 4 banks and Telstra, but if you look at our chart below, you can see how this set-and-forget strategy would have resulted in significant capital underperformance along with a reduction in dividend income over the past 5 years.

FY19 was the last time the Plato team labelled a period a 'dividend bonanza'. Dividends are certainly not back to that level yet, but yeah, they're getting bigger. We think the best way to ride the ascent is a highly diverse portfolio of dividend paying equities, actively managed to optimise after-tax returns.

The Plato Australian Shares Income Fund is targeting gross yield of around 8% in the coming 12 months - an additional 3% to the market delivered through our tired-and-test active investment process.

Questions about free speech on social media, internet companies' policies on user expression, and government intervention in the tech industry are becoming impossible for investors to ignore. In the aftermath of a particularly bad-tempered US presidential election campaign, it is important, in our view, for social media companies to have external boundaries on speech. In the meantime, social media firms have to set transparent, non-partisan rules for speech on their platforms with independent oversight boards to ensure fairness and consistency for the good of democratic discourse and their own long-term business viability.

Approaching free speech issues through digital ethics

Former US President Donald Trump's suspension and banning from various social media sites is a high-profile case of the debate between free and responsible speech online that has been rumbling on for some time. The problem for social media companies is where to draw the line between acceptable and unacceptable speech, and perhaps, should they even be the ones to judge that distinction?

Before addressing these difficult questions, it is worth reiterating the position that we approach this topic from. As technology fund managers, it is our responsibility to take a keen interest in these debates because they directly affect the sustainability and long-term returns of companies in our investment universe. More broadly, we subscribe to digital ethics, specifically around:

• Misinformation: the commitment to truthful and honest debate on platforms
• Online fraud: protecting users from online criminality
• Privacy: safeguarding users' privacy and control over their data
• Online welfare: combatting harmful content (e.g. racism, sexual discrimination, criminal incitement etc) and promoting user welfare in the broadest sense

On free speech, we believe that it is ethically incumbent upon the dominant social media platforms to facilitate a range of user views, with only specific limitations where necessary against toxic content. Independent oversight boards set up by social media networks can be an important tool to achieve this while more societally driven frameworks are established. We think this approach is consistent with the long-term business interests of social media companies.

Who draws the line between free speech and incitement?

At the moment social media enjoys the best of both worlds: in the US, Section 230 of the Communications Decency Act means they are able to claim indemnity from prosecution for opinions expressed on their platforms, while they simultaneously reserve the right to ban whoever they want for any reason. This gives social media companies immense power that they sometimes wield unevenly.

In 2017, web infrastructure company Cloudflare removed a neo-Nazi website from the internet after a violent far-right rally in Charlottesville, Virginia. While there are undeniably strong justifications for such a move, it was the conflicting stances of the company that caught our attention. Cloudflare executives previously defended hosting a number of unsavoury forums on grounds of free speech, but following the Charlottesville incident, the CEO commented, "Literally, I woke up in a bad mood and decided someone shouldn't be allowed on the Internet." He may have been flippant, but what this statement and other actions from social media companies show are the lack of clearly defined frameworks around moderating online speech.

It should not be the job of internet businesses alone to wrestle with philosophical issues around free speech that affect our whole society. In democratic countries, governments and independent regulators should play a central role in shaping the parameters of speech for internet publishing, with a strong sympathy towards promoting open debate.

Facebook has been vocal about this need. CEO Mark Zuckerberg recently commented: "it would be very helpful to us and the Internet sector overall for there to be clear rules and expectations on some of these social issues around how content should be handled, around how elections should be handled, around what privacy norms governments want to see in place, because these questions all have trade-offs."

"Bad ideas die in the sunlight and thrive in the shadows"

In the absence of clear external guidelines on speech, social media companies must take a lead on policing their networks. Setting unambiguous policies for what is permissible content and a thorough, transparent hierarchy of potential actions against rule breakers would solve much of the problem. Some content is obviously verboten: violence, pornography, racism, sexual discrimination and clearly false and/or dangerous claims as they create harm and inequality of opportunity. But there are more contentious areas.

YouTube recently banned UK TalkRadio on the grounds that it had "posted material that contradicted expert advice about the coronavirus pandemic", only to quickly rescind the decision following a public outcry. The problem is that expert advice on the pandemic has changed in some fundamental respects. Last spring, for example, health authorities in the US, UK and elsewhere argued that face masks do not reduce coronavirus transmission and they were unnecessary. Today they are obligatory in various public places. We are not condoning breaking government guidance, but we think it is fair and healthy to debate ideas freely without fear of reprisal with a view to reaching consensus in society. It is precisely this process that leads to robust decisions that benefit everyone.

There is also the function that social media plays in political outcomes. During the 2020 US election campaign, the New York Post published a report challenging the veracity of Joe Biden's son's tax returns. Social media networks suppressed the story. The quality of research behind the Post's article at the time is debateable, although post-election the US Justice Department confirmed an investigation into Hunter Biden's tax affairs. The broader question is around the internal processes that govern these decisions at social media firms, and how fairly and consistently they are applied to speech across the political spectrum. It's impossible for us to know what impact this event - or others such as the well-publicised second FBI probe into candidate Hillary Clinton's use of private servers for work emails announced shortly before the 2016 election - had on election results. But it does demonstrate the reverberating effects of coverage decisions by social media.

Another dimension to the online speech debate is the potential for monopoly or cartel-like behaviour. Parler, a conservative/right wing social media forum, had its app removed by Apple's and Google's app stores in the wake of violence in Washington during a congressional session to approve the election vote count. Parler was allegedly removed because of promoting violence and its use, in part, to co-ordinate the protest. Amazon Web Services subsequently refused to provide cloud hosting to Parler, effectively restricting access to users. Whether the tech giants were justified in removing Parler or not, the incident shows the vulnerability of third-party apps in reaching an audience and the power of big tech to control the agenda.

Tech giants dominate cloud computing
Global market share and annual revenues of largest cloud computing providers

Notes: 12 months to 30 June 2020. Source: Statista, August 2020.

We think, as a general rule, companies should be diligent in treating both sides of a debate equally and tolerate the maximum level of free speech without it reasonably spilling into direct harm. We subscribe to the view that "bad ideas die in the sunlight and thrive in the shadows." Objective truth has nothing to fear from open debate facilitated by social media. Banning social media users, suppressing stories or removing forums should be reserved for exceptional circumstances where explicit incitement or falsification can be demonstrated.

Oversight boards can form part of the solution, at least while more permanent frameworks are developed. These boards could be comprised of lawyers, academics, journalists and political experts, and function in a quasi-judicial role to review cases, monitor content and contribute to policies. Social media companies can set up these panels themselves, as Facebook recently did, but it's important that they are seen as independent and balanced so they have legitimacy with the public.

If the social media market was more fragmented, it could be argued that platforms should be free to promote certain political and speech agendas as competition would ensure a variety of voices were heard - this is generally the case in newspaper markets. But the current social media landscape is dominated by just two names, Facebook and Twitter. This market structure makes it ethically necessary for the leading firms to prioritise impartiality, truthfulness and a commitment to free speech.

If social media companies fail to do this, they could invite harsh controls on their publishing rights and other business practices from politicians and voters increasingly resentful of their perceived biases. In this scenario, the leading companies could become utility-like entities where they would preserve their monopolies, but at the cost of heavy regulation and supervision restraining their ability to innovate and grow.      

Regulation of big tech is likely
In the short term, a repeal of Section 230 looks possible. With enough Democrats and Republicans concerned about internet speech, albeit for different reasons (Democrats see it as a tool for tackling hate speech while Republicans abhor limitations on free speech), the numbers could be sufficient to win a vote to repeal. Aside from significantly increasing the costs of monitoring content for social media firms, overturning Section 230 could push these companies to adopt ultra-conservative approaches to supervising content, severely restricting the dissemination of information and online debate.

Regulation on economic grounds is another flashpoint. There is no serious alternative to Facebook and Twitter yet in social media terms. Facebook and its network reach nearly half the world's population each month, three times more than equivalent platforms such as WeChat. As a result, fair competition in the tech sector has become increasingly prominent over the past 12 months.

Facebook reaches 3.2 billion people each month
Monthly active users of Facebook social media/messaging platforms

Note: Data using last reported figures: Facebook (3Q20), WhatsApp (1Q20), Messenger (1Q17), Instagram (2Q18), Any (3Q20). Source: Statista, December 2020.

The US Federal Trade Commission and attorney generals from 46 states launched antitrust proceedings against Facebook in December 2020 over its acquisitions of Instagram and Snapchat. In Australia, the government is attempting to legislate on a 'New Bargaining Code' for internet firms, which would force the likes of Facebook and Google to negotiate payments to third party media companies for content they use. European regulators are preparing new laws that will make it easier to launch investigations, curb growth into new product areas and bar tech firms from giving their own products preferential treatment in their digital stores.

The stakes are high for big tech and society
In the short term, there will likely be no negative financial impact to Facebook and Twitter from recent dramatic and controversial steps such as banning Trump. Because of the former President's often polarising tone, his views, tweets and posts were hard to monetise as many brands shied away from associating with him. In the longer term, however, there are some significant issues for active investors to consider such as increasing costs of policing content and antitrust regulations.

Social media platforms also need to maintain the loyalty of active users. As investors, we want to see commitment from these companies to free speech, political impartiality, and robust and transparent moderation policies. Establishing independent oversight boards is a solid step towards this goal. This would help restore trust in their output, appeal to users from a broad range of political persuasions and support their businesses in the long run.     

There are other issues about how to draw up acceptable parameters for free speech online. Governments and regulators need to play a role in setting clear guidelines for social media platforms, so they understand their responsibilities. We take heart that some companies, such as Facebook, recognise this and are taking steps to reduce political polarisation and improve the quality of content oversight and review.

Social media businesses hold enormous influence and, as a society, we should consciously decide what the limits to that power should be. If we don't, we could reach a point where the boundaries become so blurred, views so polarised and the dominance of internet companies so embedded that it becomes too difficult to unwind.

DISCLAIMER: 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 ("Fidelity Australia").  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets.

This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements ("PDS") for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading it from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity's managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

© 2021 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited.