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    Economic update with Justin Tyler | recorded webinar

    Transcript

    Jodi Pettersen: Hi, everyone. Thanks for your patience today. Well, we have our lovely Justin Tyler. So my name is Jodi Pettersen. A lot of you know me already. And Justin, of course, is the portfolio manager of the eInvest Core Income Fund and the Data Hybrids Opportunities Fund under the ECOR and and DHOF. And what we’re going to be talking about today is, I guess, understanding and navigating what on earth is going on with markets right now. Justin manages over $1.5 billion in fixed income and spends his head in interest rates every single day.

     

    Justin Tyler: Someone’s got to do it.

     

    Jodi Pettersen: And so he knows a lot more about this than me and most others. In fact, he’s now managing some really sizable portfolios for some big institutional managers. So, look, Justin knows all about this, and I wanted to. Cut through the noise and he’s prepared five only five slides for us to talk about today. And he’s going to really give us an insight as to what is actually going on in markets, particularly with interest rates and what we can expect going forward. Before I hand over the reins to Justin, I’ve got a couple of housekeeping. One, we have a Q&A function. And so in the toolbar, you’ll find that there’s a little Q&A section. You can type in your questions there. So please, as we’re going through, type them in and you can as we when we can get the right time to stop and answer them, I’ll make sure I do so. Also, this webinar is being recorded because we will be sharing it to others who couldn’t attend themselves right now. Lastly, very importantly, we have let me get the slides going. Disclaimer So this disclaimer is really important. What it basically discusses is how the information we’re speaking about today is only in a general nature, only it isn’t financial advice. So we don’t know your circumstances, we don’t know where you’re at. So please always seek your own personal financial advice and read the PDF and TMD and invest accommodate you. So all the great housekeeping’s out of the way. Justin Should we dive in?

     

    Justin Tyler: That’s what’s.

     

    Jodi Pettersen: Happening. What is happening?

     

    Justin Tyler: It’s the best place to start, I think is, is Treasury bonds. And for those of you who aren’t looking at markets all day, you might go like y you know, everyone looks very closely at equity markets. Even if you don’t really want to, you can’t help it because, you know, every morning on the radio, you get to hear what the the market’s done overnight, etc., etc.. And so why don’t I start with bonds? Because bonds at the moment are driving all markets, equity markets, you know, commodity markets, what have you, arguably commodity markets, certainly some currency markets as well. And what you can see here is a chart of the US ten year bond, which is probably the most important interest rate at the moment to observe. And you can see how much it’s risen. So government bonds have had a terrible time because as interest rates rise or as government bond yields rise, I should say their prices fall. And so what I’ve done is put together a slide taking the history of this bond yield all the way back. You can see that to the early nineties. And I’ve so-called two instances where you can see also government bond yields have risen. And it’s interesting to look at history because, you know, the old saying history doesn’t repeat, but it does rhyme.

     

    Justin Tyler: And you can see here to sell off. So the similar what can we take from those. Well if we ask ourselves firstly about the 1998, 99 time period, what was happening? Well, that was the time when there were crises, currency crises in Asia and Russia as well. And in fact, Latin America, the LTCM hedge fund, failed. For those of you who are around, you may remember that. And the Fed, the US Federal Reserve at that point looked at what was going on and decided, look, there’s going to be probably a contagion effect from this, you know, the US is going to suffer as a result of these events, I’m sure. But what actually happened was nothing of the sort because the Fed actually didn’t really take into account just how strongly the US was was growing. So they cut rates and that actually was a policy error. Fed staff in after the event have admitted that they shouldn’t have cut rates at that point. They ended up behind the curve and the sell off that you can see is the market reacting to the fact that the Fed was behind the curve. Arguably today the Fed is also behind the curve.

     

    Justin Tyler: If you look at 1994, you had a similar selloff, but actually this was the Fed trying to stay ahead of the curve and they were concerned about their credibility should inflation end up going up. They got ahead of the curve and raised rates quite sharply. And these two themes of credibility versus, you know, being behind the curve are really important for what’s going on today, because arguably today the Fed is behind the curve, as I said, and their credibility is suffering as a result. And so I think it’s really interesting to look at history and figure out what can we take from it. Now, looking at the next slide, you can see just how behind the curve the Federal Reserve is. You know, US, CPI, you only really need to rewind the clock a year or so and you can see just how differently things have turned out versus where they were No. One, and that this includes the staff at the major central banks extent expected inflation to be where it is. But again, history shows that when inflation. It does surprise. And what’s more, when it comes, it tends to be persistent or at least more persistent than expected. And so we’re seeing that now.

     

    Jodi Pettersen: Can you explain briefly what you mean by behind the curve? Ahead of the curve?

     

    Justin Tyler: Yeah, sure. So the. Yeah, yeah. So central banks typically wants, you know, if that if they think that inflation is going to be an issue, they want to get ahead of that and start raising rates before it actually does become an issue. And it’s hard, hard to sort of prove the counterfactual, but I’d say that 1994 is probably a reasonable example of that, you know, these aggressive hikes. And when you look at the inflation data, well, there wasn’t any inflation to speak of. Who knows whether they would have been if they had if the Fed hadn’t taken that action, arguably, they would have been. It’s just a matter of how how high it would have been. So, you know, getting behind the curve is the opposite. You know, the Fed is now raising rates more quickly than they otherwise would have because inflation is higher than than they would like. If they had started hiking rates more early and perhaps more aggressively than perhaps inflation wouldn’t be as high as it is now, it would probably still be higher, but certainly not at levels that it that we’re seeing.

     

    Jodi Pettersen: So I guess the difference is being more reactionary versus product.

     

    Justin Tyler: Exactly. Yeah, exactly. Yeah. And so you can see that you’ve got this this persistence and on on the right hand side, what I’ve done is taken that ten year yield that we saw in the previous slide. And I split it into two components. The green the light green line is the inflation expectations component. The dark green line is the real component. So basically, you know, real plus inflation equals nominal. And what I wanted to draw out of this is that the light green line tells you that inflation hasn’t been a surprise to the bond market. It has perhaps been a surprise to central banks that bond markets have been expecting this. And indeed, it’s this inflation fear, if you like, that that’s driven yields so sharply higher. But the dark green line is interesting, too, because just more recently, real yields have also risen. And why is that? That’s because this time around, the US Federal Reserve is not just worrying about cash rate. They’ve also got quite a bloated balance sheet courtesy of QE. And now we’re moving to a cute sort of phase that is, instead of buying bonds in the market, they’ve stopped doing that. And that means that as those bonds roll off, the easing that they achieve by buying them is also rolling off. So you’re getting a tightening of financial conditions, which is what you see here on the right hand side of this slide.

     

    Justin Tyler: What I tend to like to do this is this is a Goldman Sachs indicator or others. Bloomberg run one. But it’s good to look at these because when you think about what monetary policy actually does, you know, when when interest rates are put higher, it sort of flows through all the cracks in markets. And markets are across, you know, currencies, commodities, bonds, equities all tend to react. This tries to sort of meld all of those reactions into one index. And you can see what’s happened. You know, clearly we’ve had a tightening of broader financial conditions. And you can see in the writing on the chart there what that means. It means that treasury yields have risen, means that credit spreads have widened. That means that credit has underperformed the rest of the bond market slightly, which you would expect in a period like this. The S&P 500 has fallen and the US dollar has has risen in value. So all of those things tend to happen together, you know, and that sort of constitutes a tightening of financial conditions. And you typically see that when interest rates are put up higher. And the reason I put this chart into the pack is that when you have inflation in the US running with an eight handle, I would argue that getting financial conditions back to an average level is not going to be sufficient to fix the problem.

     

    Justin Tyler: Right. So when I look at this, I immediately ask, okay, well, how much tighter are they going to get? Because clearly we’re only at sort of average levels despite the sell off that we’ve seen. I’d argue that all of these trends that we’ve seen in the last couple of months have some way to go yet. And when you look at the left hand chart, that’s interesting because if I believe that, that probably implies that I believe that the Federal Reserve will be raising rates into 2023 as well as 2022, or are they going to be doing faster rate hikes in 2022? I’m not sure which will get. But you can see in the left hand chart here that on average the market isn’t expecting them to do much at all past 2022. In fact, there’s there’s cuts priced in 2024 and further out. So what the. You’re saying here is that the Fed is going to do a lot and in fact, they’re going to do so much that perhaps they slow the economy to a recession and then they’re going to have to start cutting rates again. That’s the way that markets are saying things at the moment.

     

    Justin Tyler: I don’t disagree with that view. I think that a recession in 2023, 2024 is is probably more likely than not. And why? Because the Federal Reserve and other central banks have never achieved a soft landing from the sort of starting points that we’re seeing now in inflation just so elevated. They have to do so much to fix the problem. And bearing in mind that when you see inflation, you’ve got to think that where it’s coming from is it coming from supply side factors, that is to say, higher commodity prices and this sort of well-publicized supply chain issues that we’re seeing in markets? Well, yeah, we’re certainly seeing that. But in the US particularly, we’re seeing a demand side pulse as well. So we’re seeing higher wages. Right. And we’re seeing people reacting to the cost of goods and going, well, actually, I’m starting to be pulled behind here. I want higher wages. That’s the beginnings of a wage price spiral. We saw what happened in the seventies when when that happened, it took Paul Volcker to come along to the US Federal Reserve in the eighties and raise interest rates to nosebleed levels, really to fix the problem. So I would argue, given those historical precedents, that rates need to go very high.

     

    Jodi Pettersen: Yet and so should we move to the next slide? Yeah, yeah. What we got next.

     

    Justin Tyler: This is an interesting one because if you think that interest rates are going to continue to move higher, as I do, because inflation is is a problem is likely to remain a problem for a little while yet. That has implications beyond the bond market. Clearly, I’ve talked a little bit about it, but let’s cut to the chase. When you’re talking about portfolio construction, if you look at how most portfolios are constructed, multi sector portfolios, you tend to find a 60% equity allocation or 40% bond allocation. Know that is a standard that’s been with us for four decades now. Now, on this chart where you can see on the x axis is CPI inflation in the US, on the Y axis, you can see the correlation between equity and bonds. It’s a noisy chart, so I’m not going to try and b be sort of too cute here. I’m just going to point out the broad relationship, which is that as inflation rises, that correlation tends to increase.

     

    Jodi Pettersen: Which is where is in traditional portfolio construction theory. There should be.

     

    Justin Tyler: Precisely the opposite. Right. And and and that that rise in correlation is a worry because if inflation remains where it is, then you might expect bond yields to continue to rise and the correlation being positive, that means bond prices are falling at the same time as equity prices. Now, we’ve seen that sort of price action this year so far. You know, in the first part of the year, we saw equities suffering at the same time as bonds. Just over the last few days, week or so, we’ve seen the opposite where equities have fallen sorry, equities have risen while bond yields have fallen. And that means bond prices have gone up at the same time as equities. So this positive correlation is something people really need to think about because if you have defensive assets in your portfolio, you would typically want them to to either have a negative correlation with your equities or at the very least, just to have a zero correlation with your equities. A positive correlation is probably not what you’re are, not what you’re after. So that’s one thing to be to be really aware of. Now, the other thing to be aware of in the outlook is, you know, clearly inflation is elevated, but now people are starting to think about when it might have peaked. You know, and I think part of the price action that we’ve seen in markets over the last week or so, the relief rally we’ve seen in equities, is that people are allowing themselves to hope that inflation is paid.

     

    Justin Tyler: Now, it may have. Right, but I would say that if it has and where we’re in a world where we’re moving slowly from sort of 8% inflation in the US to 7%, and we stick around there for a while and maybe down to 6%. And you know, two or three years later, we still find ourselves with 4 to 5% inflation. That’s very different to inflation, peaking where it is and falling quickly back to the Fed’s target. And I would argue that the longer that inflation remains elevated, the more problematic that is for markets. And what I’ve done here, and if you look at the blue line, is I’ve looked at the spread and I’ve moved to Australia now and I’ve looked at the spread between the Australian ten year government bond and cash, and since the early nineties when Australia sort of retained some credibility as an inflation targeting jurisdiction. You can see that that blue line has broadly range traded. It’s a wide range, yes, but it’s range traded. If you go back further and you look at the period where inflation was actually problematic in the seventies and eighties, you can see two things. Firstly, the ten year yield peaked at around 5.4% above cash. The the peak in the more recent decades has been below 3%. So if inflation is problematic, that says bond yields have a fair bit further to sell off potentially. And secondly, you can see just from inspection just how much more volatile those lines were in the seventies and eighties.

     

    Justin Tyler: Now, that’s not all likely to repeat because markets were very different back then. But it’s entirely reasonable to expect that that bond volatility, in fact, volatility across all markets ends up being higher if inflation remains more elevated. So again, an important read through to people when they’re thinking about their portfolio construction. So with this outlook in mind, you know, we have a question to to answer and that is, is fixed income of buying more particularly? I’ve split it into two components. Firstly, government bonds, sort of long duration assets, and then secondly, credit. Now, if you take government bonds first, you’ve got to think about, well, if I’m going to hold government bonds in the portfolio, why am I doing it? Right. There’s typically two reasons. One, because you expect them to be sort of that equity hedge, that diversifier. The chart that I just showed I think illustrates the doubt we have as to whether that’s going to continue to be the case. Secondly, you might say, well, hang on. Interest rates have risen and government bond yields are now much higher. Maybe we can get a decent income out of these assets. And I’d say, well, yeah, that that’s true. But at the cost of what? Volatility. Right. If if you end up with an inflation issue that remains, then you’re going to have a fair bit of volatility in those assets.

     

    Justin Tyler: Which brings me to credit. If you if you want to look at fixed income from a credit perspective, I’d say a couple of things. Firstly, the volatility is certainly at the moment higher than what we’ve we’ve had in the past, but it’s been nothing compared to what we’ve seen in government bonds. If you look at a core income trust as an exemplar and the reason there is we don’t run the same degree of risk of some of those those benchmarks because we just don’t think it’s right to do so, particularly not in the current environment. And if we look at credit just as an asset class, the main risk that we’re concerned with in credit is default risk, because at the end of the day, if you hold a bond and there’s no default, then yes, sure, you can get some capital price volatility, but eventually you’ll get your money back. And I’ll show you a chart of how that title is, how that works in a second. So we feel that as long as default risk is not a problem, the main risk where we’re running in the fund is, okay, how volatile are things going to be and can we do things to mitigate volatility? Certainly when we’re doing that, we’re not going to be able to shield the fund from from every drawdown we’ve had drawdowns over the last couple of months and that that might continue for a while yet. But what we’re doing is shielding the fund from from the sort of worst drawdowns that it would otherwise experience if we weren’t doing those sorts of things.

     

    Justin Tyler: And in doing so, that’s that’s allowing us to just, I guess, be reasonably constructive, that credit’s being reasonably well behaved from a fundamental viewpoint at this stage. If we do have the recession that I’m talking about in 2023, 2024, that might not be the case. You might start to see some problems creeping into various credits. But remembering that we invest in the shallow end of the pool, if you like, we’re in the quite highly rated issues. We don’t think defaults are ever going to be an issue in the portfolios rerun. It’s more a matter of again, can we sort of do what we can to to dampen the volatility. And certainly we believe that some credit at this point, I wouldn’t be buying it tomorrow, but at the same time I’d be saying that, can I pick the top? Well, no. You know, at the end of the day, I’m a professional investor. I have no idea when these things are going to top out. And so the sensible thing to do then is to average in as long as you don’t see a fundamental sort of problem with the asset class, which we don’t. So that’s that’s certainly what we’re planning on, on when we look at our own portfolio construction and we look at how we’re managing the fund.

     

    Jodi Pettersen: So to interpret this slide then and what you’ve just discovered or just discussed, I’m reading that credit as in corporate bonds are relatively more attractive than government bonds right now. So you.

     

    Justin Tyler: Indeed. So if we move on to the next slide, as I promised, I think this is the last one actually just to check out as an outlook that I’ll come back to. But I made the point earlier that if there’s volatility in a bond price, that’s perfectly fine, as long as the bond doesn’t default. What does that mean? Well, what it means and just taking a step back, the thing to realize about bonds is that they mature right. At the end of the day, you’re loaning money to a company for a certain period, whether it be to two years, three years, whatever it is. And then at the end of that period, you get your money back, right? That seems like such a simple thing to say and such an obvious thing to say, but it has really quite much ramifications for how bond prices behave. And what it means is that you can see here, I’ve modeled out what happens if if yields rise by 100 basis points just after the issue of five year bond, you can see the bond price drops from 100 to 96.34, but you’re still getting your coupons and you can see what happens to bond prices in in the ensuing years. You know, you started with a bond with a yield of 3% for you know, for the second, third, fourth year, you’re getting a yield that’s above or just below 4%.

     

    Justin Tyler: Right. You end up, in other words, with a higher expected return in the future just because you’ve had this loss early on in in the bonds life. So what that means to an investor is if you’ve got a 2 to 3 year time horizon, this is a great time to be involved in bonds as long as you can stomach the volatility, as long as you realize that there will be drawdowns along the way, we certainly expect that there’ll be drawdowns in the in the coming months. But as I said, we can’t pick the top. So we think the sensible thing to do is to average in. And the other question I get is, okay, well, if you think there’s going to be a rough period that perhaps continues for a few months yet, why not invest in cash? And again, the answer there is because it’s really difficult to then make the decision to jump out of cash and into bonds at the right time. And in fact, most people, if they decide to go to cash, they’ll just leave the money there. And you’ve got to remember that with inflation at such elevated levels, when you do that, you just lock in a negative real return. And so averaging into bonds at this point, we think is a much smarter option for those who have a sufficiently long time horizon to do.

     

    Jodi Pettersen: So, which let’s be real for the E core and D portfolios. The guidance is that they’re there. You hold them for at least three years.

     

    Justin Tyler: Yeah. And for how much longer? Longer. And you know, there are plenty of people who, you know, have a need to do that, you know, who want to have a defensive allocation in their portfolio just as part of their general portfolio construction. It doesn’t change very much. It sits there as a volatility sort of dampener, you know, investing in a in a bond fund at this stage, particularly one that doesn’t have a whole lot of interest rate risk in it, you know, like it or lack like half that would tend to be a good idea in our view, as long as you’ve got the time horizon to justify doing it.

     

    Jodi Pettersen: Yeah. And I want to also point out when you say bonds could be highly volatile. That’s in in your bonds being turned. Right. Compared to equity markets, nothing.

     

    Justin Tyler: I mean, we you know, if you look at the track record of equal drawdowns are few and far between. Other than this last sort of period that we’ve entered, because credit has started to underperform a little bit, and this will happen from time to time. But for us, a drawdown is, you know, like maybe in a month, we we lose half a percent, maybe even up to a percent. Whereas your equity is in any month, can can be down, you know, 5% easily or more. Of course.

     

    Jodi Pettersen: So March 2020 was.

     

    Justin Tyler: Yeah, yeah, that’s right. So it’s a very it’s a very different sort of volatility than that, for sure.

     

    Jodi Pettersen: Yes. So I did want to insert that because this is relative relative to everything that we’re talking about before we go into the next slide. Justin, I had a quick question. I wanted to take us back from this to the very beginning of the deck. Why is it that that the ten year Treasuries are so important in in determining or at least reflecting what’s actually going on in the world right now?

     

    Justin Tyler: Sure. So if you if you let’s just think about the equity market and think about if you have a share, how do you value that? How do you figure out how much it’s worth? Well, without going into the weeds, there’s, as usual, you know, lots of ways. But one way is to think about, okay, what dividends am I going to get in the future? And when you look at a cash flow in the future, what you’ve got to realize is that a cash flow in the future is worth less to you than a cash flow. Now, if you if you have the choice of receiving cash right now and it just sort of lands in front of you versus someone promising to give you something in a year’s time, you clearly take the money now. So in finance, what we do is we discount cash flows that are that are likely to arrive in the future. And so the usual discount rate that equity managers use to discount future cash flows is the ten year government bond yield. And, you know, whether that’s right or wrong, you know, that’s tends to be what happens. And so what happens is as that as that bond yield increases, the value of those future cash flows goes down. And why? Well, with a higher bond yield, you can you can just invest in bonds. So, you know, the higher the bond yield goes versus equities, the more attractive bonds become. And so, therefore, in relative terms, the less those future cash flows from an equity should be worth. That’s one way of looking at it as many others. But because of those sorts of linkages, you know, when when bond yields move in the way they have, every other market sits up and takes notice. And so if you’re looking for a reason as to why equities have suffered more recently, well, you know, that’s why it’s because bond yields have risen, which, you know, when you look at why, the reason is because inflation is a problem.

     

    Jodi Pettersen: And so that number is so important because it actually forms the basis of a lot of stock market valuations that we’re saying. So that all links right now. I’ve got someone coming through on the chat in your fund. How do you change that, your duration for you and how long does that take?

     

    Justin Tyler: Sure. So just to be clear, what does that mean? When when the question says how do you change your duration view, it means, you know, there’s lots of levers we can pull in the fund to add value. We can decide how much sensitivity we want to have to interest rates, you know, so if interest rates rise and we have a whole lot of interest rate risk in our portfolio, we’ll lose a lot of money. So we don’t we actually have very little sensitivity to interest rates in the portfolio, which means we’ve been shielded from that. Conversely, if we think that interest rates are going to fall, we can increase the sensitivity of the portfolio to that and potentially add value. And so the questioner is saying, how do we do that? You know, when we decide to make those sorts of decisions, how do we go about it? How long does it take? And the answer is we do take our time. You know, we don’t swing the risk of the fund around a lot. And why? Because it’s meant to be a defensive asset. So it’s not a vehicle for us to to, you know, go and trade wildly. You know, we tend to be quite conservative in in terms of the amount of risks that we assume and sort of push out of the out of the fund.

     

    Justin Tyler: And in fact, you know, when you look at what we’re doing now, whereas defensive in the fund as we’ve ever been since the fund started, we’re holding around 30% cash. We have all sorts of hedging instruments in place, you know, to, to try and shield the funds from, from volatility. We’re holding, you know, the sort of higher rated assets in the fund compared to what we’d usually hold, some of the lower rated assets we sold out of in around December. So there’s lots of defensiveness in the fund at the moment. But, you know, the time will come when we want to start increasing risk. And, you know, to the questioner, we’ll say, yeah, we’ll certainly be. That. But we’ll do it slowly and we’ll do it carefully because we feel that in a fund like this, we’ve got to always worry about what happens if you’re wrong. You know, we have a strong view. That’s fine, we’ll put it into the funds. But you won’t see the duration of these funds moving, you know, from sort of plus or minus to it will move in much smaller increments.

     

    Jodi Pettersen: Slow and steady. Edit Now we’re moving onto the final slide that looks like so this is a good opportunity for anyone who’s got additional questions. Please drop them in the Q&A box.

     

    Justin Tyler: Oh, there’s one, then.

     

    Jodi Pettersen: Oh, there’s another one that’s come through. Should we look at it? Here we go. Can you please talk about whether the funds invests in or are seeking to seeking out green type bonds to enable support for climate change and other socially responsible activities?

     

    Justin Tyler: Yeah, that’s a that’s a great question. We certainly do. And actually, we feel that that that element of what we do sets us apart a little bit from from competitive funds. There are certainly green bond funds out there, but unfortunately, most of them tend to come with a whole lot of interest rate risk attached. And I’ve just been through why we we don’t think that’s a great thing to hold in your in your bond fund at the moment. So we do look at ESG quite carefully. In fact, it’s one of the reasons that we we chose the name Daintree. And, you know, what do we do? Well, there’s a few things. Firstly, we have a screening sort of program and a negative screen is what you call it. So there are certain business activities that we just don’t want to be associated with, you know, whether it be whaling and whether it be nuclear weapons, etc.. There’s a list of screens that we have in in the fund and we think that that’s the bare minimum. If you’re going to call yourself an ESG aware fund manager, you need to be doing those things. So so we do. That’s quite easy, though, because at the end of the day, you know, in a government bond or in a global bond portfolio, I should say, you’ve got tens of thousands of assets to choose from, from around the world. You know, the fact that we’re screening out of various things doesn’t reduce our investable universe that much proportionally. You know, maybe we have 10,000 to start with and then we have 7000 to finish with.

     

    Justin Tyler: It’s still a lot when you’re when you’re choosing 100 names. So that’s, I guess, the easy bit, the more difficult part of ESG is, right. Okay. We have a whole list of things that we look at when we look at our bonds. And to be honest, if we see a bond that might have concerns from an environmental perspective, a governance perspective, or due to those they’re their social sort of activities or lack thereof, we will just typically exclude it. It’s just easier to not go there and move on. The question is what happens if there’s a bond that offers really good value? There are some risks that the company has addressed those and always addressing them. What do you do then? What do you do on in that sort of line board call? So that’s where engagement comes in. You know, you engage with the company and with for a bond fund manager, that’s often quite difficult to do. The reality of the matter is that when you’re looking at what companies tend to do, they spend a lot more time with their equity investors than with their debt investors. But that’s where we are, where our association with Perennial is really valuable because, you know, we’re we’re sharing the floor with seven other equity boutiques. And so when we need to engage, we have a lot more chance of doing so successfully, given that we can sort of, you know, join hands, if you like, with the equity holders who are also involved in whatever stock it might be.

     

    Jodi Pettersen: And you also hold a couple of the specifically green bonds, too, right?

     

    Justin Tyler: Yeah. Yeah. Sorry, answer that part of the question. Yes, we do. We do hold green bonds. They’re not a massive part of the portfolio. And the reason for that is they’re often very expensive. And so we need to to marry up, you know, investing in a green bond versus are we actually doing the job and achieving the return for our investors. Sometimes it’s better value to invest in the bond that is not green. But then again, we’ve already done the work with the issuer and made sure that we’re we’re happy with their their business profile, you know, with the ESG risk factors that we can see and all of those sorts of things.

     

    Jodi Pettersen: Thanks for that question. I really liked that one. So let’s go to your last slide, Justin. I remember drop in your question.

     

    Justin Tyler: Sure. Yeah. And the last slide is a summary of the outlook that I’ve said really, you know, just to to leave you with a few points. The first one being that central banks are going to have to take policy not just back to normal, where they’re going to have to take the into restrictive territory. And that’s particularly the case for the big central banks and particularly even more so the US Federal Reserve. But I would say that in Australia, in New Zealand, we may be an exception to that. And the reason is that we have such sensitivity to the RBA’s cash rate here. It’s much, much more powerful as a policy lever than it is in the US because most homeowners have floating rate mortgages and those who have fixed rate mortgages will see those rolling off during the course of 2023, 2024. So if the if the RBA continues to raise rates, as we expect that they will, you’ll start to see very quickly the impact that that has excuse me on the local economy. So that says that I don’t think the RBA’s going to have to take rates as high as what markets expect. And the other reason is, well, is that as time goes on, banks are going to have to pay more for their funding. You’ve got to remember that the bank funding was subsidised by the RBA. The banks were able to access extraordinarily cheap funding and what that meant is they were able to to offer those extraordinary fixed rate mortgages.

     

    Justin Tyler: So if people were able to take advantage of those mortgage rates that were below 2% while they’re on offer, you’ve got the RBA ultimately to thank for that because the RBA, you know, enabled that funding and therefore enabled the banks to to offer mortgages at those sorts of levels. Well what’s going to happen going forward is that that sort of special deal is rolling off. We’ve already seen fixed rates move to much higher levels. Variable rates have already started to move, of course. So if banks start to to raise rates away from what the RBA is doing, we’ve seen that in the past. Sometimes they’ll add, you know, ten or 15 basis points to a rate hike because their funding costs have gone up independently of of what the RBA is is doing with their interest rate lever. Well the RBA will take that into account and the banks will in effect do some of the RBA’s work for it if they decide to raise rates away from mum, you know the sort of official rate hikes that that the RBA delivers. So for those reasons I think Australia and New Zealand as well, for the same reasons might be exceptions and we might see cash rates rise, perhaps not as far as what what markets expect, but nonetheless I think what we’re in now and it’s increasingly likely that that this remains with us for a while, is what’s called a stagflation backdrop, that sort of economic speak for a backdrop where you have high inflation and low growth together won’t last forever, you know.

     

    Justin Tyler: But as central banks raise rates, the risk is that they do it, that inflation doesn’t move as quickly as what they would like. Because you’ve got to remember that inflation is being driven by supply side factors that they can’t directly control. You know, the war in the Ukraine is an obvious one. The recent shutdown in China, central banks had no impact on, you know, on on those things happening. They have no impact on when they stop. And so ultimately, I think the willingness of the Fed and other central banks to act decisively and the fact that in the face of what’s going to be some some weaker risk asset values later on in the year, I think is going to be key. You know, we’ve already had some weakness in equities. If that continues, will the Federal Reserve continue to raise rates? Over the last week or so, markets have come to the view that perhaps they won’t. But I would say that unless inflation turns, that view is going to be proven incorrect and we’ll start to see rates rising once again. And the selloff has in bonds has much further to go if inflation expectations end up dislodged. That’s not the case now, but the longer inflation remains elevated and the more people start to to ask for wage rises to, you know, to compensate, which in that feeds back into the inflation issue that that caused them to watch that wage rise in the first place.

     

    Justin Tyler: First place, you know, the longer that sort of dynamic goes on, the more people go actually. Is inflation really going to stick around? Two and a half per cent in Australia it’s been three or 4 to 5% for so long, maybe 5% to more sensible number. And when that thought process starts to kick in, that’s when central banks have a problem. I don’t think we’re there in Australia, but it’s a risk that we’re aware of and ultimately we think the circuit breaker here is going to be. A combination of central banks raising rates and the economy, particularly in the US, hitting a recession in 2023, 2024. When that happens, that’ll take the the air out of out of bond markets and inflation will start to fall. Unfortunately, that’s not a pleasant process, you know, because at the moment, what makes me think that and what makes me sort of confident in this view, well, central banks have not managed the so-called soft landing from the sort of starting point that we’re seeing today. They’ve never done it. And, you know, given that we’re seeing commodity price shocks from from the war giving, we’ve already seen an inversion in the yield curve. And for those of you that read a little bit around the financial literature, you know what that means.

     

    Jodi Pettersen: We’ve got to what we’ve got to blog on on our website.

     

    Justin Tyler: Yeah, that’s.

     

    Jodi Pettersen: Right. I’ll send it around.

     

    Justin Tyler: That’s right. So, you know, when you when you have that starting point, it just makes me more worried about a recession in in that period than I would be otherwise. And so, yeah, I think it’s going to be a bumpy ride for all asset markets over the over the coming months. But that’s why we’re here as portfolio managers. As I say, we can’t give you a term deposit like sort of payout if that’s what you’re after, you should go and buy a term deposit. But if you have the time frame that allows you just to stomach some volatility, what this is doing is setting up something like the equal product for an expected future return with a five handle. And it’s been a lot of years since I’ve been able to sit here and say to current and potential investors that that a product like or is able to offer a 5% yield. But when we start to remove all of our hedges and move the portfolio back to towards fully response stance, that’s the sort of return profile that we’re looking at.

     

    Jodi Pettersen: Yeah. So I think it’s important to emphasise that the point on the top left the sell off in bonds that you’re talking about is. I mean, obviously the portfolio is like a core and Dov are designed to be able to navigate this. You’ve got a lot of flexibility in the portfolio. So don’t just because the market is having a selloff in bonds does not necessarily mean that the core DOV portfolios will have the same level of impact because of all these, I guess, defensive elements that you can add to the portfolio, which again we often get compared to compared to like index products in bonds. And I think that this is an area that is this type of volatility and this type of level of risk that’s going on right now where the additional work that all you do can really make the differences in outcome stand out between products like Aeco and the typical bond indices.

     

    Justin Tyler: Yeah, that’s right. And there’s a couple of questions here, actually. So someone has asked what would be the total return in dollars if you theoretically invest $100,000 in a in a five year bond with a coupon of 3%? So like the slide that was up before. So the return in percentage terms is best estimated by the yield. It’s going to be around 3%, but it’s going to be 3% per annum over five years. So you get 3% of 100 of $100,000, so $3,000 in the first year. And then you get 3% of $103,000 in the second year and so on. Right. So you end up with I haven’t got a calculator in front of me, but it’s going to be sort of 15, 16, $17,000 as you as you try to return over, over five years. And so that’s the magic of compound interest. So the longer that goes on, the the better the return is. And the other question here is, you know, would TD rates be expected to increase? Yes. But are the days of 5% TDs coming back? I’d say no. You know, and this is the this is the kicker. If if you want to move to TDS because you need access to your money in the short term and or you don’t like the volatility or both TD rates will rise. You know that they have started to to rise, but that will be at the expense of return. And indeed with inflation elevated, as I said, you will realize a slightly negative, I would say, real return. But again, that’s always been the cost of sitting in cash, you know, if to where in a positive, real return, you typically do have to move into the bond market.

     

    Jodi Pettersen: Let’s see, I haven’t got any more I’ve got one more question here and then that will sign that off. Just Justin, my question is, please, if you’ve got additional questions, this is your last chance to drop them in. Justin, what is of all the things that we’ve talked about and I guess the things that are going on is what what is what changes would you have to see in the market to really like to really change your view? Like what elements would it would you have to really shift for you to make have this this outlook changed dramatically?

     

    Justin Tyler: Yeah. Know, that’s a great question. I think the the main one is that you need to see inflation, particularly in the US actually peak. You need to see inflation on a on a steady downward trajectory. So it’s not going to be immediately obvious that things have peaked because I think you really do need to just sort of say that. But for a shorter term horizon and what we’re sort of more looking at from from an investment perspective is probably two things. Firstly, there was a slide early on where I showed the ten year yield and I split it into its two components, the real yield and the inflation sort of compensation. And when you look at at the bonds, bond markets, pricing of inflation, you know, it’s clearly still elevated and elevated over a long period of time. So a three year sort of average sorry, a ten year average inflation rate in the US that’s more elevated now than it’s been since about sort of 2013, 2014. I would want to see that starting to fall, but the market’s view of long term inflation starting to fall and I’d want to see it at the same time falling or falling along with the market’s expectations for short term rate hikes. Because if you think about it, what’s the market saying at the moment? It’s saying the Fed’s going to have to raise rates, you know, eight, nine, ten times or whatever the number is in a pretty short space of time. And in doing so, they’re not going to be able to really bring inflation back down on average over the next ten years. So it’s not a great sort of vote of confidence in the central bank. But the opposite is is a vote of confidence, you know, when people believe, okay, the Fed is going to have to do it. Much because inflation is coming down, i.e. they’ve started to solve the problem. That’s when markets will start to behave in a sort of better, more friendly fashion. But I just don’t think we’re back yet.

     

    Jodi Pettersen: All right. Well, we wait and see. Let me just check for any additional questions. That’s everything for now. Look, if you think of something overnight or in bed tonight and go, oh, I wish I asked Justin that, please just send me an email and I’ll be sure to help you out. Justin, thank you for joining us today and everyone on the call. Thank you again for joining us. If you’ve got additional questions, you know where to find me on our website and. Oh, oh, here we go. I’ve got one more question from Rebecca, because she kept me busy. Rebecca, I love it. Where is the best place to see what these funds are actually invested in?

     

    Justin Tyler: Sure. On the website, if you if you look at the M’s website, you will see there’s a fact sheet that shows you the sort of broad risks that we’re taking. You know, how much we have in bonds, in particular credit ratings, and what our largest holdings are and all of that sort of thing. And there’s a list of holdings there as well. I tend to find for bond funds. It’s better just to look at what those averages are. You get sort of more information from that rather than getting lost in the weeds. But it’s all there on the website.

     

    Jodi Pettersen: Yeah. I mean, the reality is, is that a whole portfolio and such holds over 100 holdings. So it’s a lot. It’s very diversified. Rebecca A lot of that information can also be found on our website in the reports page. So if you go along the top insights and then reports every month through a report on the positioning of the funds, and that gives you a really good summary as well. But Rebecca, if you’ve got if there’s a special things you need, just hit me up. I’m happy to help. I know that you’ve got lots of questions about ESG, which I love. So bring it on and let’s call that for now. Thank you again, everybody. And I’ll be putting the recording up of this shortly.

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