“You’re not an investor until you’ve navigated a crisis,” says Simon Doyle

By that measure, Schroders Australia's Simon Doyle is a battle-scarred veteran. The Asian crisis, the tech wreck and the GFC are just a few of the market downturns through which he's invested during his 20 years at the firm. 

Adding the COVID crash and now the current inflation crisis to this list, the slings and arrows Doyle’s weathered have taught him plenty.

In his latest role as CIO of Schroders Australia, Doyle surveys the broad financial landscape including his previous (exclusive) domain of Multi-Asset investing.

• What happens now that even “safe” assets like government bonds are cratering?
• How have markets navigated the landmines he alluded to back in 2020, and what are the hidden traps now?
• Have the Fed and the RBA got the timing and scale of their responses right?
• And where in Equity, Credit and Alternatives does he see the most value now?

These questions and more are answered in the following interview. 

What has been the toughest part of the Schroders Australia CIO role so far?

Fundamentally, my role hasn’t changed that much. My key task is helping navigate markets in terms of what we do in our portfolios, how we explain what we think and our actions that follow and to help our clients meet their objectives. In this regard, steering a safe course through what I think is one of the most fundamental shifts in investment dynamics since the GFC (and possibly the early 1980s) is clearly challenging.

Investors aren’t used to seeing broad-based weakness, including in supposedly “safe” assets like government bonds. And central banks aren’t as well-equipped currently to step in to provide a backstop.

Expectations are being reset. Absolute return strategies have had limited places to hide, meaning any exposure (outside cash and commodities) has been costly. Discipline and process are really important and ensuring that we’re continuing to adhere to our beliefs, that we’re making decisions based on the research not the rhetoric of central bankers (who don’t have a great track record) are vitally important to ensure we minimise the impact and maximise the opportunity.

Which market downturn stands out the most? What are some of the key comparisons and contrasts?

I started my career in November 1987, which technically rules out the ‘87 crash from the count, but I was certainly enmeshed in the following:

• 1994 bond market crash,
• Asian crisis in the late 1990s,
• The bursting of the tech bubble,
• Global Financial Crisis
• COVID crash, and
• The current inflation crisis.

The interesting thing about market crises is that these are the periods that you remember most and in which you learn the most. In many ways, you’re not an investor until you’ve navigated a market crisis. The GFC probably stands out the most given its impact on the financial sector but also because we were relatively well prepared for it, and this made a huge difference to our clients.

The current environment is many ways is a lot more classic in its nature. Unlike the GFC or the COVID market crises (where there were clear systemic issues in the case of the GFC or an exogenous shock in the case of COVID), economies face a relatively classic recession scenario. By this, I mean that pro-cyclical policy leads to inflation, which leads to policy tightening and eventually leads to recession.

Energy and supply chain disruptions are exacerbating the inflation prognosis but are not the root cause. The real problem from a market perspective today is that policy settings led to risk mispricing (valuations everywhere extended). That’s where much of the downside is coming from and in all likelihood, has further to play out.

Looking back on this September article, several of these points are eerily prescient:

In September 2021, the market cap of US equities relative to the economy was at a record high (it was 2.1 times GDP in September; 1.3 times in 2008; 1.7 times in the tech boom). Where does it currently sit?

By my calculations it’s still sitting at around 1.83 times, so down on September but still very high in historic terms. This is another reason why I still think this correction has further to run. Multiples have improved but are yet really discounted weaker earnings or the risk of a higher ongoing inflation environment where more protracted lower multiples would be the norm.

In the July 2020 wire, “the way forward is littered with landmines” you said, “equity markets were too optimistic." What happens next?

While I’d hold to what I said in 2020, markets ignored the “landmines” and focussed on the liquidity tsunami that central banks and governments provided. Ironically, this probably laid more landmines in the form of broader risk mispricing, the gains in the no-profit tech, cryptocurrencies etc. This all held together while the liquidity taps remained on, but as we are now seeing, would likely unravel when the taps got turned off. Sometimes it’s easy to see what will happen, but it’s very challenging to know when and what the catalyst will be.

We think there’s more to play out. Equities have clearly repriced over the last six months but earnings expectations remain reasonably positive. The realities of policy tightening and a probable recession on the near radar suggest a material contraction in profits that’s yet to be factored in. Plus, we’re only early in the tightening process.

You’ve previously noted that “all hell broke loose” in 2013. Can you elaborate on those comments and what’s played out recently?

2013 was early in the post-GFC recovery process. Inflation was low, there was plenty of excess capacity in the system, and while liquidity and policy settings were expansionary, settings were still relatively moderate compared to today. Valuations had shifted and there was little evidence of either economic or market overheating. Markets rioted at the Fed tapering its policy settings and out came the Fed put.

While an oversimplification, the Fed could get away with this because there really was no inflation. The excess capacity built up through the GFC had yet to be absorbed. Fast forward to today. COVID provided a circuit breaker to the global economy, but central banks and governments doubled down on stimulus and created an effective free money environment that encouraged (directly or indirectly) risk-taking. Excess capacity was absorbed and eventually, inflation emerged with supply chain disruptions and more recently the energy price shock emanating from the Russian invasion of Ukraine, adding fuel to the fire. 

From a market perspective, there was really only one way for yields to go (up) and from a risk asset perspective only one way for prices to go (down). Inflation, its breadth, its rate, and the uncertainty over its trajectory, take the Fed put off the table. They simply don’t have the flexibility they had in 2013.

What are the potential implications of the decisions made by the Fed and the RBA so far? Have they got it right?

I’m reluctant to be too critical of policymakers from the sidelines – the counterfactual could be much worse, so we need to be considered in our assessments. That said, it is relatively clear that there’s been a growing mismatch between policy settings and nominal economic outcomes and as a result, a growing mismatch between risk and the pricing of risk. Relatively free money will do that!

So, I think looking back from the cheap seats, the policy was probably way too easy for too long, hence its contribution to the challenges we’re facing in markets today.

From here though, central banks globally have no choice but to tighten policy to moderate demand and rein in inflation and inflation expectations. The complication is that while policy tightening will act to curb underlying demand – particularly indebted consumers, it may do little to impact the supply-side factors in the energy and supply-chain channels. Recognising too that monetary policy works with a lag (economics 101) there’s always the risk (indeed the likelihood) of overtightening and facilitating recession. The risk of course of doing too little or acting too slowly is that ultimately more will need to be done and the pain greater. We shouldn’t underestimate the challenge, nor should we overly rely on central bank forecasts and rhetoric as these have not been particularly accurate – especially ahead of key turning points.

Could we see an outbreak of corporate credit defaults? How do you respond to such risks?

Absolutely, and while we’ve seen a decent widening in spreads, credit markets aren’t really pricing a flurry of defaults and genuine corporate stress. Corporates have been operating in a very favourable environment, benefitting from ultra-low interest rates and very narrow spreads, meaning ultra-low borrowing costs and with demand, strong interest cover has been high, despite relatively high leverage. Corporates could face the perfect storm of significantly higher absolute borrowing costs (and refinancing existing debt at a much higher cost) at the same time as demand slows. This scenario isn’t currently priced into credit markets and history tells us that it could get ugly given the right circumstances.

We’ve been very cautious on credit, particularly global high yield / sub-investment grade for a while and have hedged out most of our exposure. Avoiding this risk is the most effective way, but clearly not always possible. The downside tail of credit return distributions can be big in these circumstances (especially high yield) and this needs to be factored into risk positioning.

We’re hearing a lot about the appeal of Alternatives in this environment, but what are some of the risks?

One of the biggest risks of private equity is its popularity and a resulting increase in capital flows. Schroders built a proprietary fundraising index which we have been monitoring for several years now that tracks flows of capital into private equity segments and the resulting returns, and this index has warned us that large buyouts and venture capital have been overbought for several years now. In fact, our index currently shows that the only two segments of the private equity universe currently tracking below their long-term trend – which means they’re undervalued – are China and India. 

We believe our data-led, specialised, global approach to PE has permitted us to build a portfolio of well-priced companies that we think will be able to deliver strong returns into the future.

Following on from the buoyancy that we have seen in the M&A/Private Equity market, the consequential risk for Private Debt is over-levered transactions and increasingly borrower-friendly terms and conditions similar to what we have seen in the US markets. We are cautious about such deals and are assessing opportunities with an even greater level of stress-testing and downside analysis than our already robust analysis. We are primarily looking for the resilience of cashflows in the face of current volatility around inflation and rising interest rates, and challenges around global logistics frameworks. We have heightened awareness in the construction sector, retail sector and buy-now-pay-later sectors, and prefer more resilient sectors such as infrastructure, stabilised real estate and healthcare. We are looking for structures where there is a substantial equity cushion, to ensure capital participants' interests are aligned and think now is really not the time for dividend recapitalisation.

How are you positioning the Multi-Asset portfolios now? Where are you finding compelling value and what are you avoiding?

We’ve been very defensive for a while now. To put our recent actions from an asset allocation level into context, since late 2021 both our equity and credit exposures have close to halved in our Real Return Fund, which has put the portfolio is a good position to mitigate the impact of the carnage across most asset classes, but insufficient to avoid some damage given the breadth of the weakness in June and so far this year.

Unfortunately, we expect more weakness in equities and credit (particularly the riskier parts of the credit universe), but the think risks around sovereign bonds are shifting. We are not making material changes to positioning on the risk side and are waiting for markets to start to better reflect recession risk on earnings. While the more speculative parts of markets have fallen sharply, the drawdown in key equity markets like Australia and the US are moderate compared to past recessions and we’re still early in the tightening cycle. That said, we are continuing to add moderately to our duration positioning.

Take advantage of opportunities wherever they exist

With the flexibility to invest across a broad range of asset classes, Simon and the team aim to help investors grow their wealth with a reduced risk of losing money when markets fall. To learn more, please visit the Schroders website.