Last Friday I attended a panel discussion with Chamath De Silva, Head of Fixed Income at BetaShares, Chris Joye, Chief Investment Officer at Coolabah Capital and Anthony Kirkham, Portfolio Manager at Western Asset Management, part of the Franklin Templeton Group. Rather than transcribe the session, here are my key takeaways.
Anthony Kirkham (AK)
- Seeing deflation across the globe, central banks have done their job, as to whether they have tightened enough, there will be differing views
- Growth has been relatively resilient across most markets
- ECB getting close to cutting rates, LeGarde has said they don’t need to follow the US Fed
- Wages growth high in Australia and we haven’t seen numbers to indicate service inflation is coming down yet
- Stronger than anticipated retail sales in the US have changed the outlook, there’s too much heat in that economy. At the beginning of the year, the forecast was for six interest rate cuts, now the market is predicting 40 bps.
Chris Joye (CJ)
- On the RBA cash rate, a key question is whether it is right? Coolabah and Jonathan Kearns, Head of Economics at Challenger have both run modelling and analysis shows the cash rate should be at 5%
- Developed market rates are much higher. Historically the RBA cash rate has run at 150bps higher than the Fed fund’s rate
- We do have evidence of summary reacceleration of core inflation, firm services inflation, and at the same time goods prices are falling. With very strong immigration, which is a supply shock, evidence suggests the RBA isn’t going to be doing much with rates this year. The risk is that they have to increase rates further
- Late last year the Fed implied there would be rate cuts this year. At the time the 10-year US government bond rate was 5%, it fell to 3.8% and is now back up to 4.7%. that decline in the rate saw a huge equity market rally, house prices are very firm and that was a defacto easing of monetary policy
- Sticky services inflation globally which implies rates are going to be higher this year and that’s going to trigger stress against cyclically sensitive sectors
- Australian credit has benefitted from those very high interest rates and yields are very attractive. Senior ranking major bank bonds, which are basically riskless and AA- rated, you can get interest rates of 5-5.5%. On subordinated Tier 2 bonds you can get interest rates as high as 6-6.5%. CBA’s equity which is 15 times levered is only paying you about 5.5%, even with the benefit of franking credits
- We have a problem with asset allocation, because commercial property, A grade office is only paying 4.5%, Aussie equities paying about 5%, bank stocks 5.5%. you get better interest rates up the capital stack on Tier 2
Also read: Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch
- BetaShares HRBD ETF was 100% invested in hybrids a few years ago, but we’ve now cut that allocation to 35%, 50% is in Tier 2 bonds, 10% into senior to capitalize on the much better interest rates. Current yield on HRBD is about 6.7%. Hybrid spreads are unattractive to us right now
- Hybrid spreads are sitting at about 215bps over bank bills, normally they are 325- 350 over bank bills, so very expensive. Senior bonds 88bps, normally 80bps, so are attractive and subordinated bonds 181bps over bank bills, usually 180bps over, so quite attractive
- APRA has launched a review of the hybrid market, Coolabah believes there will be new types of hybrids that are riskier but pay better yields next year. We think that will mean brokers will churn out of existing hybrids for the new ones, so we can see the old type of hybrid spreads pushing wider as we get new supply
- Battle between yield chasers and spread traders. People that are focused on spreads compared to less sophisticated investors who focus on yields
- Our central case is for stagflation, deteriorating economic growth, sticky inflation and expecting to see more stress
- Explosion of private credit in Australia is pretty interesting because insolvencies in Australia last month hit their highest levels ever recorded. ASIC has reported more than 1,100 businesses went bust since they began recording data in 1991
- In the year to February, global corporate defaults according to S&P were the worst since 2009. US bankruptcies were the worst since 2010 and this is going to get a lot worse because everyone who was long risk was banking on deep rate cuts this year, which are not going to materialize
- US equities have started to drop as Israel dropped bombs on Iran. They are still 22% up on where they were last October
- Also, the looming possibility of a Trump ascendancy. He’s campaigning on cutting immigration, which will boost labour costs, tariffs on Chinese imports which will be inflationary, so it’s a very difficult market
- We recommend investors go up the capital structure and stay in liquid assets, until assets reprice. Also to avoid illiquidity and cyclical sectors such as high yield.
Chamath De Silva (CD)
- We now have forward rates of return on high quality liquid assets. Beyond that, you can earn 4.5% on cash and 5% on state government bonds and between 5.5 – 6.5% on high quality investment grade credit
- No matter what your target is, you can go a long way toward it with traditional defensive assets
- The ETF industry, of all the cashflows we’ve seen over the last few years, fixed income has only accounted for 20%. But 2023 was a really banner year for defensive ETFs with 50% going to fixed income of net inflows
- Investors took the opportunity to derisk and liquefy their portfolios
- While the soft landing scenario has been embraced by equity investors, we are still seeing good flows into floating rate ETFs
- Just over the last week as US 10-year Treasuries hit 4.7%, we’ve seen funds heading back into duration and core Australian duration funds such as BNDS ETF and flows into our US TIPS ETF
- The Australian Bloomberg AusBond Composite Index is a liability-weighted index, not what all investors want and creating opportunities for index-aware fund managers.
Podcast Listen: Diversity & Liquidity with Anthony Kirkham from Western Asset Management
Questions
How many interest rate cuts this year?
AK – It’s pretty line ball at the moment, whether it’s zero or one. There’s a reasonable amount of risk around the globe impacting economies and growth moving forward and it’s only April. We’ve moved so far so quickly. Volatility is incredibly high.
Our yield curve is relatively benign, compared to the US where it broke the record with the 2-year/10-year curve inversion record set back in 1978. This is the one that is meant to tell us if there’s going to be a recession. That fact it’s been inverted for 660 days tells us something isn’t quite working.
CJ – We expect the Fed to continue cutting after the election. We do think the level of rates is probably about right. We have a slightly different expectation to Anthony, where we do think the US will have a recession. We don’t see any way to break services inflation without pushing wage growth down and unemployment up. The US budget deficit is incredibly stimulative at 67% of GDP. The cycle for the equity junkies is not over and will be elongated. The reason being enormous cash buffers accumulated during COVID-19. Importantly we haven’t spent all that cash in Australia.
CD – We expect one cut this year. Not what they should do. Comments made by the Fed mean it’s more likely they cut and these so-called insurance cuts do have a precedence doing one or two cuts when they probably didn’t need to.
The Private Credit market really grew when interest rates were low, as rates have risen, where do some of those more risky, less liquid securities sit within a portfolio now?
CJ – Aussie private credit didn’t exist before the GFC. After the GFC, which was a banking crisis, the regulator said to the banks you have to stop lending to people who can’t repay their loans. Commercial banks and residential developers are the most common bank killers, which almost claimed the scalps of ANZ and Westpac in the last serious recession we had in 1991.
All the sub prime lending shifted out of banks into the non bank credit funds. Insolvencies are the highest in 25 years yet the Aussie economy is ostensibly fine. Right now we are seeing a huge increase in non bank defaults, but not the same increase on bank loans. These guys are completely unregulated, they have no obligation to report on anything about defaults or risk. They are telling investors there is no arrears but refinancing the loans and capitalizing the interest.
I think you are going to see these problems escalate as rates remain higher for longer. The issue is that all of these portfolios are illiquid. Clients are now withdrawing as the borrowers are not repaying money.
