TOL - 20th Jun, 2023
This investor says the "goldilocks" period is yet to come for bonds
The RBA may send Australia into a recession, but it's not all bad news. Pete Robinson of Challenger Investment Management explains.
The RBA's June rate hike didn't just surprise the economic consensus. It also shocked the life out of the bond market.
The 3-year government bond yield increased by 32 basis points in a week and no less than seven research houses increased their terminal rate bets. Those higher for longer bets are all Capital Economics needed to make this next call:
"That aggressive monetary tightening will push the Australian economy into a mild recession in the second half of the year," Marcel Thieliant, head of Asia-Pacific at Capital Economics wrote to clients recently.
In fact, a recession caused by excessive interest rate hikes is the single biggest thing that keeps Pete Robinson of Challenger Investment Management up at night.
"I'm relatively bearish in terms of the overall outlook," he said.
"I think the cumulative impact of all those rate hikes are going to start to weigh on the household sector. I think there's simply some sectors that cannot sustain a cash rate in the five's."
However, just because the outlook is bearish, it does not mean that your portfolio has to go down with it. As part of Livewire's fifth annual Income Series, Robinson sits down for an interview to discuss the opportunities in fixed income and real estate.
Edited Transcript
LW: What is your terminal rate forecast and how does it inform your investing strategy?
Robinson: It's a really tough call. I think I'm relatively bearish in terms of the overall outlook. I think the cumulative impact of all the rate hikes that we've had are going to start to weigh on the household sector, but it's going to take time, and this is the quandary that the RBA is facing. We've built up cumulatively on bank balance sheets.
You can see around $250 billion worth of excess deposits, above trend deposits, sitting with the banks, so households have a lot of money and that's a big buffer as interest rates rise. So in an aggregate sense, it's going to take a while for that pressure to be felt.
In the interim, what we've got is high levels of inflation and starting to see that inflation pass through to the wages side above the RBA's target. And so I think you're going to have to see them go again and potentially multiple times.
If we look at the US, which is ahead of Australia, and I think a good leading indicator in terms of their hiking cycle, they still have excess deposits residing in their system. So the Federal Reserve of San Francisco put out a piece of work in May talking about another US$500 billion of excess savings still within the US and that's from a peak of $2.1 trillion dollars. So they're still there, even though they're ahead of us, still lots of excess savings. I think for them, there's a way to go maybe six to 12 months and Australia's lagged even behind that. So it's still a way to go before we see that excess liquidity flow out of the system.
LW: Are you factoring in the possibility of excessive rate hikes into your portfolio construction?
Robinson: Absolutely. That's one big factor that we're thinking about at the moment. I think there are simply some sectors that cannot sustain a cash rate in the fives. There's just so much leverage that's been built up during the period of low interest rates that they can't cover their interest repayments when the cash rate goes to 5%.
And that's not even factoring in, as default risk rises in the system, the fact that lenders will charge more for each dollar that they lend, so they're loading on extra credit spread on top of that higher interest rate. So think about the office sector where rents have barely moved. In the US, that's a sector under acute levels of focus. I think some of that focus is going to come here because if the cash rate hits 5%, I think we're going to see interest coverage ratios below 1x.
So that means that the actual rents coming off the assets themselves aren't enough to pay the interest. And so the question is how do banks and non-bank lenders respond to that environment?
LW: How long do you expect this "goldilocks" period for fixed income to last?
Robinson: I don't actually think it's a Goldilocks period right now because inflation's so high. So inflation's eating into all of those returns. We have got CPI at 7%, and a cash rate at 4%, so actually, you're not having a very solid real return for your cash at the moment. So I think that the search for yield that we had during 2021 and 2022 is still on, but it's a search for inflation-adjusted yield. So we're still searching for that yield after inflation.
I think that the opportunities in fixed income are going to get better, particularly in that front end of the curve as we see inflation normalised. The reality is inflation has happened, it's already baked into the numbers and that's backward-looking.
I think on a forward-looking basis, if you are starting to get yields on cash at around 5%, you're getting mid to high single-digit yields on credit and more if you extend yourself into the high yield part of the market, that nets your positive real return after inflation, even factoring in some elevated level of credit risk and market risk into your portfolio.
LW: What is the biggest opportunity in today's market and what is today's most over-hyped opportunity?
Robinson: I think the thing that I'm looking at really closely that I talked about before is the real estate sector. So we're currently quite underweight in real estate and have been for some time. It was very aggressively priced and in some respects, still remains quite aggressively priced. And really, I think that opportunity is going to emerge in the next six to 12 months as we start to see lenders having to recycle positions and they face those questions that I mentioned earlier of how do I deal with something where the interest coverage ratio is less than 1.5x where typically, the banks are setting their covenants, how do I address that issue?
And what we're going to see is, I think, a transition of lending out of the banking system into non-bank lenders. So those non-bank lenders who have the capacity to undertake that lending are going to see some really attractive investment opportunities.
The flip side of that is the over-hyped idea. I think there are still parts of the private markets where valuations don't reflect reality. I think there are some venture capital-backed FinTech NBFIs (i.e. Non Bank Financial Institutions) valuations I struggle to reconcile with. They don't have a long-term sustainable path to profitability. Add to that a lot of them put leverage on their holding company which was predicated on a much bigger balance sheet, which looks unlikely to occur. So I think there are parts of that market where some of these businesses that aren't worth a whole lot are still being carried at very elevated valuations.
LW: Distinguish the opportunities available in corporate credit and government-issued bonds.
Robinson: For government debt, what we're really talking about here is a fixed rate of return without credit risk. So we're lending to a government, governments can raise taxes in order to repay their debts. We had an interesting period last month with the Fed dealing with its debt ceiling issues, but ultimately, you're backed by the full faith and credit of a government entity, which in the case of Australia or the United States, is a pretty solid credit risk.
So what you're really being compensated for is an outlook on where yields are heading. So you can lock in a return, which historically has been above the cash rate. If I lend you money, if I lent the government money for 10 years, historically, I would get a return above where cash is today. The yield curve would be upward sloping, and that was a return for me lending out money for longer.
Now as it stands today, that return is actually below the cash rate. So we've got an inverted yield curve. I'm getting less by lending money for longer than I am for just sitting in cash today. That's because what typically happens when we have a shock or a recession is long long-term interest rates decline on an expectation of lower growth. And so, you have a capital appreciation in the government bonds.
That's distinct from credit. And really, when I look at credit, I like to separate out the fixed rate component to it and think about the credit spread. That credit spread is compensation for the risk of that borrower defaulting so you'll get a spread on investment grade of around 100 basis points. Historically, default rates in investment grade credits are significantly below that. So you're getting an excess return for lending money to a company that may or may not pay you back.
Right now, let's say, in the high yield market, it's around 4% excess return over cash that you're getting paid. Expectations for defaults in that 4% to 6% range, I think, picking up from very low levels. With recoveries of 50%, I'm getting some excess return for credit risk.
So I think credit is fairly valued - it's not super cheap but it's not super expensive. I think the inverted yield curve makes it pretty difficult for me to get my head around investing in long-dated government debt at the moment.
LW: Are investors really prepared for the impact of the fixed rate roll-off on the economy?
Robinson: I think the psychology of markets is a fascinating thing. So when we see the same headline for six months, the first time we read that headline, we have a reaction to it. But after six months, that reaction really falls away. I think that's really instructive for the way that the market is thinking about this fixed rate mortgage cliff. We've been reading about it for a long time and anticipating it for a long time, but actually, the impact of it hasn't hit yet.
So as we discussed recently, most of the resetting and most of the most impactful resetting, and by that I mean, those mortgages that were fixed when rates were at their lowest, is yet to come, and it's actually starting right now.
And the cumulative impact of that as we see a contraction in consumer spending, a reduction in household savings rates, which we saw from the GDP data, that happens cumulatively over time. So it's not just that first month that the rate resets where you see the impact, it actually takes time. So I do think that markets have become, I guess, dulled to the news around the fixed rate mortgage cliff and are perhaps underestimating what the impact of that will be.
LW: How long do you think the residential rental crisis will continue?
Robinson: I think the housing market is really at the centre of the quandary that's facing the RBA right now because we have a two-speed market. We've got people that are on big mortgages, owner-occupiers who are earning an income but have high levels of mortgage debt really struggling with these higher interest rate repayments that they have to make. And then we've got another part of the economy that has very low levels of debt that is not bothered.
In fact, if you think about a retiree, higher interest rates are actually benefiting them. So they're relatively insensitive to the level of interest rates. We've got the baby boomer generation transitioning into the latest stages of retirement as well. And so some of those transactions that we've seen that's really fuelled that housing market recovery has been predicated on downsizing, where you're effectively a price-insensitive buyer.
I think that's what's driving, at least in part, the housing market and driving that quandary. It's facing the RBA right now because that cohort, while they're driving asset price inflation, they're not really sensitive to where interest rates are.
LW: Are interest rates not having the impact they once had on the housing market?
Robinson: I think that's certainly the case. And I think this is the thing, we've been preaching patience for a long time to our investors. Our word of the year for 2023 is patience. And I think it's just going to take time because if you think about the overall mortgage market, we've got a third of people renting, a third of people with a mortgage, and a third of people without.
Let's call it round numbers. And so there are a third of people who are starting to feel the impact of those rate hikes, but there's a third who isn't. And so it's just that balance between the two. Over time, I think the impact and the pressure on the people with mortgages are going to start to weigh on the overall housing market, but clearly, that hasn't been the case today.
Access to income and capital stability
Pete's Fund aims to provide clients with capital stability and income on a regular basis accompanied by lower levels of volatility than traditional fixed income strategies.
Managed Fund
Challenger IM Credit Income Fund
Australian Fixed Income
View
Never miss an update
Enjoy this wire? Hit the ‘like’ button to let us know.
Stay up to date with my current content by
following me below and you’ll be notified every time I post a wire
Hans is one of Livewire's senior editors, specialising in global markets and economics. He is the creator and presenter of Livewire's "Signal or Noise".
........
Livewire gives readers access to information and educational content provided by financial services professionals and companies (“Livewire Contributors”). Livewire does not operate under an Australian financial services licence and relies on the exemption available under section 911A(2)(eb) of the Corporations Act 2001 (Cth) in respect of any advice given. Any advice on this site is general in nature and does not take into consideration your objectives, financial situation or needs. Before making a decision please consider these and any relevant Product Disclosure Statement. Livewire has commercial relationships with some Livewire Contributors.
2 topics
1 fund mentioned
1 contributor mentioned
Hans is one of Livewire's senior editors, specialising in global markets and economics. He is the creator and presenter of Livewire's "Signal or Noise".
Expertise
Hans is one of Livewire's senior editors, specialising in global markets and economics. He is the creator and presenter of Livewire's "Signal or Noise".
Expertise
Comments
Comments
Sign In or Join Free to comment