How these Aussie stock and bond fundies are invested amid macro confusion

The local market is still puzzling out the meaning of the RBA’s latest move on interest rates – the “pause” announced yesterday by outgoing RBA Governor Philip Lowe. The cash rate is perhaps the nation’s most important macro signal but it’s just one of a raft of things investors consider in their decision-making, as we’ve been discussing in this two-part editorial series.

In part one, we heard about the signals watched by our stock and bond fund manager contributors, Aaron Binsted of Lazard Asset Management and Stuart Dear of Schroders Australia.

The concluding wire below delves further into how their respective funds are positioned in line with their big-picture views.

How is the Lazard Australian Equity fund positioned?

The outlook for Asian economies is the big swing factor here, explains Lazard’s Binsted. We’ve all seen lithium prices peak and trough on the back of China’s policy changes, with oil and gas equally exposed to fickle bureaucrats.

“Our energy position is mostly predicated on the structural growth in Asian gas demand for the next 30 years. A large component of this supply will come from LNG and both Woodside (ASX: WDS) and Santos (ASX: STO) have attractive projects that can meet this demand,” says Binsted.

Lazard uses a conservative long-term commodity price in its financial modelling. And Binsted suggests there is evidence long-term structural pricing will be higher (as opposed to the cyclical price swing we saw last year, for example).

“Crucially, the equities are only assuming modest commodity prices, which makes them attractive investments,” Binsted says.

Which sectors are you expecting to struggle the most?

Discretionary Retail and some REITs are the sectors he names as likely to underperform – which is probably unsurprising, given they’re some of the most susceptible to elevated interest rates and inflation.

“But we’ve been flagging them as areas of risk for more than 12 months. It takes time for rate hikes to work their way through the economy and we have seen the start of the impact, with much more of the effect coming down the pipe,” Binsted says.

And in listed property, despite the large discounts to net asset values, Lazard remains particularly wary of office A-REITs.

“Cap rate pressures, and rental pressures via vacancy rates, combined with higher financing cost, are all headwinds,” says Binsted.

“Even if these get worked through via conversion, or something else, it looks a long road ahead.”

(The Capitalisation Rate (Cap Rate) is a crucial metric used in real estate to assess the potential return on investment for a property. It is the net operating income divided by the property's value. Decreasing rental income, increasing property expenses, or changes in market conditions are all factors that can put downward pressure on cap rates.)

How else is Lazard positioned?

The Australian equities fund holds an underweight exposure to banks and healthcare, Binsted singling these out as his fund’s largest difference versus the market.

Healthcare

“Our positioning here is entirely related to valuations. Forward multiples for the sector have come down by about one-third but they are still about the same proportion higher than the longer-run levels,” Binsted says.

“The healthcare index is made up of well-established, good companies. We would be happy to buy them again closer to the long-run premium, as we have historically.”

Financials

Though much has been made of banks being potentially overvalued given the local property market weakness and broader economic malaise, Binsted says they aren’t drastically overvalued.

But he says there are two dynamics in play:

“Firstly, industry returns have been in structural decline since 2015 and we are yet to get firm evidence this has stabilised,” Binsted says.

“Market pricing of equities can lag these long-run fundamental changes, so we have been paying attention to the industry trends and market pricing offshore to get a read on where this dynamic may be up to in Australia.”

“And secondly, one of the main bull points for banks would be ‘higher for longer’ rates. Insurers also benefit on this front from higher running yield in their bond portfolios, so we have this upside risk covered in a sector that we think has much better fundamentals.”

Binsted believes the potential upside in bank shares is too low to compensate for the higher-than-normal chance of a recession – while emphasising his team doesn’t hold a view on the likelihood of a hard landing.

For that reason, Binsted prefers to participate in the financial sector via insurance stocks, with some of the Lazard Australian equity fund’s biggest holdings including:

• Suncorp Group (ASX: SUN)
• IAG (ASX: IAG)  and 
• QBE Insurance (ASX: QBE)

Equities

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What about credit investors?

Schroders’ Stuart Dear says his team is “moderately constructive” in its view on interest rates and the credit space more broadly.

“We think you can earn good income here at the moment and that eventually, the cycle will turn down and bonds will do relatively well. We’ve given ourselves room to add…particularly if we do see signs of the downturn accelerating.”

High-quality bonds are a clear preference because Dear believes the risk versus reward trade-off for lower quality simply doesn’t stack up currently. That’s why the Schroder Fixed Income Fund holds more than 70% of the portfolio in A, AA, or AAA-rated bonds.

And in corporate debt – around 26% of the fund is in Australian credit – Dear also prefers investment grade over high-yield.

Why Australia?

“Spreads here are quite wide relative to other markets, and that’s in spite of the Aussie market, generally speaking, being higher quality and shorter tenor. You’d expect that Aussie spreads would be tighter than other markets, but they’re not – they’re wider,” Dear says.

“If we do get recession, the current spreads are compensating us for the risk of the spread-widening associated with downgrades and defaults – which in Australia, because it’s high quality, are very unlikely.”

On a country basis, Dear says the fund has recently been getting some more exposure to US inflation: “US TIPS are looking quite attractive because the market’s assuming the Fed’s going to get inflation under control, so the price of that protection is quite cheap.”

Though Australia comprises the bulk of the portfolio – almost 90% as of the end of June – it now holds 9% exposure to North America.

What are you avoiding?

The UK is one developed nation the fund is avoiding almost entirely. And it is holding short interest in Japanese sovereign debt.

“Our preferred short in interest rates currently is Japan, where the central bank hasn’t hiked like every other central bank has. Inflation there is not as high, but it is elevated by Japanese standards,” Dear says.

“We think Japanese bonds can underperform when the central bank there does tighten policy, with a yield curve control program that could change.”

What are Schroders’ preferred industries and sectors?

On a more granular basis, Dear notes that the paper issued by Australian companies in the utilities and transport industries has been particularly appealing for a while now. And that’s despite some of them being rated at the lower end of the investment-grade spectrum.

“They do borrow quite a bit - they’re BBB - but are very sound BBBs. We like the business structures – often they’ve got CPI-linked income streams and are regulated,” Dear says.

“Improving inflation protection is a general theme we’re looking to apply in the portfolios, particularly if we’re right about our medium-term view on inflation.”