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On several occasions Arminius has outlined the difficult competitive landscape which Australia's big four banks have had to face since the GFC. Just recently, the most successful bank CEO of the last two decades has given us an update on the main competitive threats to the industry.

Jamie Dimon has been running JP Morgan Chase (JPM:NYQ) since 2004. JPM is the largest bank in the US with a market capitalization of $600bn, or four times the size of CBA, which is Australia's largest bank. During Dimon's tenure, the JPM share price has increased four-fold, comfortably beating the S&P500 accumulation index as well as the US financial sector. In particular, Dimon guided JPM through the GFC without material damage, because he kept its capital ratios high and avoided risky derivative positions.

Every year Dimon writes a letter to shareholders. This year's letter is a record 66,000 words, available here at JP Morgan Chase. Dimon spends five pages on the challenges facing the banking sector, which we summarize as follows:

• Shadow banks provide more credit to the US economy than regulated banks - USD18.4tn versus USD10.5tn. Lack of regulation means that shadow banks enjoy important advantages, such as lower costs, lower capital requirements, and lighter "know your client" and anti-money-laundering obligations.
• The size and strength of unregulated competitors in the banking sector is increasing as the giant tech companies expand into banking functions. For example, Alphabet (Google), Amazon, Apple and Facebook all have cash reserves in the billions as well as market capitalizations in the trillions.
• Fintech start-ups funded by deep-pocketed venture capitalists are trying to build their competitive advantages and capture market share in specific areas of banking services - such as payments, data management, and mortgage origination and approval - by creating products which are faster, cheaper, or intuitively simpler to use.
• Most bank information technology (IT) is based on legacy systems which have been linked together by subsequent patches and fixes, with the result that processes are slow and data cannot easily be shared across platforms. By contrast, modern cloud-based IT systems are cheaper, faster, more efficient and more flexible.
• Over the last twenty years, the importance of US banks as credit providers has steadily diminished due to these competitive disadvantages. Unless there is regulatory change, the market share of US banks will keep on shrinking.

In conclusion, we point out one risk factor which Jamie Dimon did not mention. The world's central banks are planning to introduce their own digital currencies over the next five years. China's central bank is already trialling its digital renminbi with ordinary citizens. In order to encourage individuals to quickly spend any digital renminbi that may be distributed as part of a stimulus package, the Chinese central bank is considering placing a used by ("must be spent by") date on the digital currency. The government can control when it can stop being used in order to encourage immediate consumption increases in the Chinese economy, as opposed to the stimulus recipients "saving" the digital currency. The implications for commercial banks are not yet known, but they are unlikely to be favourable.

What does all this mean for shareholders in the big four Australian banks? When the Australian economy reaches a post-coronavirus "new normal" in late 2021 or early 2022, the banks will still face the type of hostile environment which has kept their share prices below their 2015 peaks. We recommend that bank shareholders stick with the sector for another six months. After that, they should sell down with a view to re-deploying the proceeds into sectors with better growth potential.

Q.E.D.

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In the month of March, global markets saw the rise in bond yields as investors worried about unmanageable inflation on the horizon. This has definitely shaken up global equity markets. And while inflation is a genuine concern that should be on the minds of investors, the market has overreacted. While we understand a cyclical economic upturn has just begun, we believe inflation will remain manageable in the short term.

In the video below, I explain why longer term, we have a high degree of confidence that the world will return to its low-growth, low-inflation, low-interest-rate environment.

On the basis that we believe interest rates will remain structurally low over the long-term, we are particularly excited about our holding in REA. There can be no dispute that Australian residential property markets are rebounding strongly, supported by very low interest rates in the context of an improving economy.

In the month of January, REA reported more than 128 million visits to realestate.com.au - and extraordinary feat, given a total Australian population of 25 million (including children).

                  

And the long-term low interest rate environment also stands to benefit our alternative asset managers, Blackstone, KKR and Carlyle Group, as institutional investors outsource their investments to these major global platforms as the need for yield becomes increasingly acute. The structural shift in assets to the world's leading alternative asset managers will drive very strong earnings growth for many years to come.

                  

Whilst inflation is a concern for investors, we believe that with the US still grappling with the COVID-19 pandemic, unemployment and low interest rates, inflation is a manageable concern. Therefore, we are selecting the companies that have a runway of structural growth ahead of them.

Edited transcript

What are your views on the recent surge in bond yields, which has caused some volatility in equity markets?

So, let me just take a step back and look at what's actually happening. We know that the global economy has just started to experience a meaningful cyclical economic rebound, and that will only continue throughout the course of this year and into next year as well as economies open up post-virus. We know that there's still plenty of stimulus about, both on the fiscal side and on the monetary side. So, that's created some degree of speculation that perhaps inflation will take hold and that's resulted in an uptick in bond yields. And so the chart that I've just shown here is a chart of the US 10-year government bond yield going back to about 2016.

                  

You can see that 2016 to 2018 example where yields went up from 1.5% to 3%, and then more recently, yields have gone up from about 0.5% up to 1.5% over the last six months or so. That uptick in bond yields more recently has caused a bit of a stir in equity markets. We've seen some equity prices wobble a little bit. And the question of course is, is this the beginning of a real fly up in bond yields as a result of inflation, which is taking hold, or not? We certainly remain in the camp that that won't be the case. And as a result, we think that the market is really overreacting. Now, we could, of course, be wrong here, but let me tell you why we hold that view, and what I'll do is I'll break it up into a short-term view versus a long-term view.

Short term, it's almost as simple as there are still 10 million Americans out there who are looking for work who can't find it. There are 44 million Americans out there today who are still on food stamps and really struggling to make ends meet. These are not typically the types of conditions that result in really aggressive wage inflation. This analysis is also, for what it's worth, consistent with all the analysis we're seeing out of the major central banks, that the overwhelming consensus view is that this recovery still has a long way to go. So, that's the short-term perspective.

Longer-term, we really just take it back to thinking about some of these big long-term structural drivers, and we think about things like ageing populations, advances in automation, but really the big one is the degree to which governments are indebted, really as a result of funding all of these major fiscal stimulus packages. And that's really important. In our view, that's really going to place a lid on interest rates and stop them from increasing materially.

I'll just give you a simple thought experiment to illustrate this point. So, today, as a result of the gigantic fiscal programmes that the US has undertaken, their federal debt is about US$28 trillion.  Let's say the US 10-year yield increases from 0.5%, a few months ago, all the way up to 3%, right? So, that's an extra 2.5% interest rate, which, of course, drives up the borrowing costs for the federal government. Well, that's an extra US$700 billion that the federal government has to pay to service their debt that is otherwise not being used for fiscal spending.

So, all else being equal, taxes would have to be raised or spending would have to be cut. Both of these things are disinflationary. That's more than a three percentage point GDP negative fiscal stimulus each year for the rest of time. That alone would be enough to push the US back into recession, and frankly, the whole world back into recession. So, our argument, long term, irrespective of what happens in the short term, our argument is, we really struggle to see a world in which interest rates can remain higher for a sustained period of time, given that feedback loop it would have on all of the indebted governments out there who would have to service debt at much higher costs.

Then the final point I'd add is that if we use Japan as an example, the country has seen its interest rates falling from 8% down to zero over a period of 25 years. And I'm just showing that on the chart on the screen, there have been numerous instances over short periods of times where you've seen bond yields tick up sharply, whether it's 50 basis points, whether it's 100 basis points. It's happened a lot, but you zoom back out and the long-term structural trend in Japan, for a lot of the reasons that we've described, around ageing populations and increased government indebtedness, is really kind of a low-growth, low-interest-rate environment. And so that's where we think we're ultimately heading, notwithstanding the cyclical upturn that we're experiencing over the next 12 to 18 months and all the stimulus to go with it.

                  

So, to summarise, interest rates aren't going to be a problem and will remain low for a very long time.

Yes, tht's certainly our long-term view, for sure. And so that's why we think it makes sense to own some of the long-term winners, some of the long-term, high-quality growers out there, like Microsoft,  Alphabet,  Spotify and  Tencent, for example.

But you do also own some names that are benefiting from this short-term cyclical economic rebound?

Yes, we do have some exposure in the portfolio as well. So, names like Visa and MasterCard, still have a wonderful long-term growth story. Obviously, there's still a lot of cash and check transactions that can and will be shifted to cards over time. There's US$18 trillion of that transformation still to happen. So, that's a great long-term growth story, but short-term, they're really going to benefit from the cyclical rebound and particularly the opening up of travel and international tourism, given the extent of the cross-border transactions that are tied to that.

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Disclosure: Montaka owns shares in REA, Blackstone, KKR and Carlyle Group.

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As long-term investors in Taiwan we prefer to look at the investment flows by Taiwanese companies into China as an indicator of the state of relations and not media speculation regarding the prospect for military hostilities. If China were going to invade Taiwan it would have happened years ago.  The financial relationship between China and Taiwan is strong and growing. It is that financial relationship which will ultimately guide China and Taiwan to a sensible compromise regarding political differences.As long-term investors in Taiwan we prefer to look at the investment flows by Taiwanese companies into China as an indicator of the state of relations and not media speculation regarding the prospect for military hostilities. If China were going to invade Taiwan it would have happened years ago.  The financial relationship between China and Taiwan is strong and growing. It is that financial relationship which will ultimately guide China and Taiwan to a sensible compromise regarding political differences.

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Taiwan has been in the news a lot recently, especially with media headlines highlighting the apparent threat of invasion by China.  In Australia we have seen this being used as a justification for increased military budgets in part to support the defence of Taiwan.  We have been investing in the market in Taiwan since it opened to international investors in the early 1990s.  Taiwan has some world class companies and was recently awarded four of the top one hundred places in the survey of global innovation published by Clarivate, not bad for a small island population of 23.5m people.  We expect to continue to invest in world class companies that are headquartered in Taiwan and prefer to focus on the flow of investment money that takes place between Taiwan and China rather than speculation about imminent invasion. 

April was a month of very mixed performance in the Asian region, by far the strongest market was Taiwan where the small to mid-sized stocks increased by 13.1% bringing the return over one year +75.8%.  The broader measure of market performance in Taiwan for large capitalisation stocks increased by 7.7% during the month of April and +82.3% over one year. This was despite "The Economist" announcing Taiwan as the most dangerous place on Earth.  "The Economist" was highlighting risks of military action by China to seize control of Taiwan.  While China has been increasing incursions into Taiwan's airspace, their way of testing responses, this is not anything new, China has a long history of this behaviour and we do not see this as the move towards an invasion of Taiwan.

In recent months we have seen China objecting to the United States Navy movements through the Taiwan Straits. In February there was tension between China and the United States when the destroyer USS Curtis Wilbur sailed through the Taiwan Strait, with China suggesting that the United States was undermining regional peace and stability.  The United States sends their Navy vessels through the Taiwan Strait on a regular basis in a show of support for Taiwan, this however is a token show of support. The official United States policy of formal defence of Taiwan ended in 1979 when it ceased with recognition of the Republic of China as "China" and started referring to it as "Taiwan". This change of status occurred when the United States recognised the People's Republic of China as "China" and all relations with Taiwan then became informal.  

Late in 2020 Beijing made an explicit warning that independence for Taiwan "means war".  China's Taiwan problem dates back to 1949 when the Communist Party seized control of the Mainland and the displaced Kuomintang (KMT) government relocated to Taiwan.  China has never renounced the use of force to take control of Taiwan, however, overt verbal threats of conflict are rare.  The current ruling party in Taiwan, the DPP previously talked about "independence", however, that word has been quietly removed from the narrative employed by the party. Relations with China tend to worsen when the DPP hold power and improve when the KMT hold power which is somewhat ironic given that the KMT were the original enemy of the Communist Party during the civil war that concluded in 1949.  We can expect better progress towards a form of political accommodation between China and Taiwan the next time the KMT hold office in Taiwan.

A good deal of the recent tension regarding Taiwan can be attributed to the former US Administration under Donald Trump due to increased military equipment sales and US Navy activity through the Taiwan Strait.  We expect the Biden Administration to adopt a lighter touch with respect to Taiwan. We have already seen Vice President Wang Qishan indicating to a delegation of US representatives that common interest outweighs differences with the United States.  A period of relative stability with respect to trade and an end to the arbitrary Trump imposed tariffs will be taken very positively by markets. 

Taiwan's President Tsai Ing-wen responded to "The Economist" headline assuring everyone that the government is fully capable of managing all potential risks and protecting Taiwan from danger. President Tsai went on the speak about responding prudently to regional developments and overcoming the challenges posed by authoritarian expansion in a reference to China without naming China. The equity market in Taiwan was much more interested in the news that the local economy grew by 8.16% in the first quarter, the fastest growth recorded in a decade and well above consensus expectations. The positive growth surprise was driven by stronger domestic manufacturing and demand for exports. Two of Taiwan's major semiconductor manufacturers have recently announced large investment programmes aimed at alleviating the worldwide shortage of semiconductors needed in the automotive industry and consumer products.  Taiwan is expected to achieve economic growth in excess of 5% for the full year of 2021.

The table shows officially sanctioned investment that have taken place by Taiwanese companies investing in China. From the start of 1991 to the end of 2020 there have been 44,400 investments from Taiwan into China totalling USD 192.4 billion.  By way of context, China received a total of USD 141 billion of foreign direct investment in 2019. Typically, "Hong Kong" appears as a major contributor to investment in China and this is usually money from Taiwan that has to be channelled via entities in Hong Kong.  China's official policy position is that Taiwan is a domestic province of China and therefore investment flows sourced from Taiwan should not be treated a foreign source of investment.

Source: Investment Commission, Ministry of Economic Affairs

While the annual flow of aggregate investment funds from Taiwan to China have slowed from the USD 14 billion annual peaks in 2010 and 2011, the figure in 2020 approached USD 6 billion and remains a substantial number.  It is also important to note that the 2020 level showed a substantial uplift from the 2019 number which was a response to the then President Trump's habit of surprise tariff restrictions being applied to China. For a while China was the predominant area of manufacturing investment by Taiwanese companies, the cost savings from manufacturing in China were too tempting to resist.  The rising cost of labour in China and then Trump's trade war prompted a sensible diversification of investments by the Taiwanese to ensure that China did not end up putting their supply chain at risk. The cost savings of manufacturing in China available a decade ago are much less pronounced in the current environment.

An example from our portfolio in Taiwan is Novatek Microelectronics, a leading fabless chip design company specializing in the design and development of a wide range of display driver integrated circuits required for sophisticated flat panel displays and audio/video applications for all digital devices.  We originally acquired our position in Novatek at an average price of TWD 102 in late 2018, those shares recently reached the TWD 600 level. We have taken profits along the journey and remain a happy shareholder in a business that is attractively valued especially versus global peers. We acquired the position on a p/e ratio of 11x, since then profits have expanded from TWD 6 billion in 2018 to more than TWD 20 billion in the current year, putting the company on 14x p/e and a net yield in excess of 4%.  Novatek has eight of their eleven global sales offices located in China, their relationship with China remains crucial to the prospects of the business.  Novatek opened their first office in China ten years ago.  Going forward, the company expects to achieve significant growth in Japan and South Korea in addition to ongoing development of sales in China.  Novatek typically invests the equivalent of 14% of revenues on R&D, a significant and ongoing commitment to the intellectual capital of the business. In the field of display driver integrated circuits, Novatek has global market share of 20%, second only to Samsung at 30%. 

In conclusion, as long-term investors in Taiwan we prefer to look at the investment flows by Taiwanese companies into China as an indicator of the state of relations and not media speculation regarding the prospect for military hostilities. If China were going to invade Taiwan it would have happened years ago.  The financial relationship between China and Taiwan is strong and growing. It is that financial relationship which will ultimately guide China and Taiwan to a sensible compromise regarding political differences.

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Insights by Australian Fund Monitors Pty Ltd (AFM) provides investors and advisors with commentary and articles originated and provided by fund managers and other contributors. The views and opinions contained within each Insights article are those of the contributor and do not necessarily reflect those of AFM. www.fundmonitors.com.

Disclaimer: Australian Fund Monitors Pty Ltd, holds AFS Licence number 324476. The information contained herein is general in its nature only and does not and cannot take into account an investor's financial position or requirements. Investors should therefore seek appropriate advice prior to making any decisions to invest in any product contained herein. Australian Fund Monitors Pty Ltd is not, and will not be held responsible for investment decisions made by investors, and is not responsible for the performance of any investment made by any investor, notwithstanding that it may be providing information and or monitoring services to that investor. This information is collated from a variety of sources and we cannot be held responsible for any errors or omissions. Australian Fund Monitors Pty Ltd, A.C.N. 122 226 724

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Back when coins were originally made out of an alloy of silver and gold it was uncommon but not impossible to debase one's currency. The death penalty as a consequence of currency debasement seemed to inhibit the practice. The Lydian Empire in 700 BC (before they fell to the Persians) lays claim to inventing "coinage". Once the use of coins as a medium of exchange became commonplace, the Greeks were known to debase their currency from time to time. The Romans of course (in order to fund large wars or for natural disasters - beginning to sound familiar?) perfected the art. Currency debasement goes by many names and methods, amongst which "sweating" and "clipping" were popular. These days, the world's central banks and Treasury Departments are performing this role and the eventual result is becoming clearer: inflation.

The chart above shows US consumer price index (CPI) inflation for the last sixty years. For those of us who can remember the 1960s and 1970s, history seems to be repeating itself.

In the 1960s, the US government steadily increased its annual budget deficit in order to pay for the Vietnam War and new social programs. Consumer price index (CPI) inflation rose modestly at first, then it took off in the 1970s as a result of three key events - Richard Nixon ended the gold convertibility of the US dollar, OPEC quadrupled oil prices, and global commodity prices rocketed up. Inflation continued to accelerate despite the efforts of three US Presidents, until Paul Volcker (Chair of the Federal Reserve 1979-1987) raised official interest rates to a record 20% per annum in 1981.

This time around, the Trump and Biden stimulus packages have injected an unprecedented amount of money into the US economy to combat the virus, at a time when the Federal budget deficit had already passed one Trillion dollars and US government debt was rapidly approaching 100% of GDP. These factors are inflationary in their own right, and they are reinforced by the imbalances which the COVID-19 pandemic has created in the US economy.

The chart above shows US inflation on a month-to-month basis. For the last three decades it has been pretty stable, with no big monthly moves up or down, producing an annual average inflation rate of about 2%. Then in early 2020 the onset of the coronavirus pandemic triggered lockdowns, which set off a sharp deflation, followed by a sudden rebound in consumer demand and in CPI inflation.

Is this inflationary surge just a temporary side-effect of COVID-19, or is it the beginning of a longer-term trend? We think that the US is about to see higher inflation - above 3% per annum by year end-2021.

Inflation will rise in the US because the Federal Government's support packages have created an estimated USD$1.6 Trillion of "excess savings" in the bank accounts of US consumers - money which they were unable to spend on their usual activities like restaurants and travel.

At the same time, the rapid recovery from the pandemic has caused supply bottlenecks in many sectors, from electronic goods to cars to housing. A shortage of cargo ships and containers has raised freight costs and delayed delivery dates. A shortage of builders and skilled labour has raised new house prices and slashed the number of houses for sale. The consumer goods giants Kimberley-Clark and Procter & Gamble have already announced across-the-board price rises, on the grounds of rising raw materials costs and higher transport expenses. Coca-Cola has recently announced price increases of the globally consumed beverage, citing identical reasons - higher commodity prices. Coke's CEO James Quincey this week stated, "We intend to manage those intelligently, thinking through the way we use package sizes and really optimize the price points for consumers". In true corporate-speak, by "optimize", he means "increase" the price points for consumers in order to offset Coke's increased production costs.

Most importantly to observe, is that it is the prices of many commodities - from copper to iron ore to corn - that have risen sharply in recent months. The chart above shows the Bloomberg Commodities Index (BCOM) for the last thirty years. The last resources boom is clearly visible, peaking in March 2008, followed by a 75% fall over the next twelve years.

The index has risen 47% from its bottom in April 2020, but it still has plenty more upside potential. It is now at the same level as it was in 2002 before the start of the last resources boom. Most commodity prices (except for iron ore) have been depressed for years because of over-supply, so they have considerable upside potential individually: the prices of strategic minerals and agricultural commodities could easily double from current levels. Commodity price rises feed very directly into inflation by raising manufacturers' raw material costs.

There is an additional inflationary driver which will also raise manufacturers' costs. Semiconductors - the tiny silicon wafer chips which are essential for phones, computers, cars and all other electronics - are in short supply worldwide. 

The shortage began when the Trump Administration prevented Chinese companies from buying critical US patented technologies, including semiconductors. Not surprisingly, many Chinese companies started stockpiling semi-conductors as a precaution, and other companies followed suit.

The semiconductor shortage worsened when the rapid US economic recovery in the last six months brought a surge in consumer demand, which encouraged retailers to rebuild their inventories and manufacturers to increase production. Very soon, the mostly Asian makers of semiconductors reached their capacity limits, so they increased prices, lengthened delivery times, and rationed new orders. Because new semiconductor capacity is expensive and takes at least two years to build, the semiconductor shortage will last until 2023.

Last but not least, China. Chinese manufacturers face the same commodity price rises and semi-conductor shortage as the rest of the world, but there is also a political twist. Any retailer can tell you that imports from China have had a deflationary effect of consumer goods prices ever since China was allowed to join the World Trade Organization in 2001. As "the world's factory", China had lower input costs and lower labour costs, not to mention national and provincial governments which actively encouraged the creation and expansion of export industries.

In recent years, however, the situation in China has changed. First, China's working-age population (those aged 16 to 59) has been falling since 2012, and average wages in China have been rising faster than GDP and inflation.

Second, new entrants to the labour force are no longer the country boys and girls of the 1990s, who hadn't finished high school and were willing to work long hours in poor conditions. The new generation born in the 1990s is better educated, has higher expectations, and knows how to exploit its bargaining power. No more cheap China!

Third, the 14^th Five Year Plan for 2021-2025 de-emphasizes manufacturing exports in favour of domestic consumer demand, and it prioritizes investing in high tech industries. These objectives reflect what is happening on the ground: labour-intensive industries (e.g. textiles) have been moving from China to cheap-labour countries like Vietnam, Indonesia, Malaysia and Bangladesh.

Fourth, Xi Jinping has committed China to peak carbon emissions by 2030 and carbon neutrality by 2060. Conclusion: China is no longer a deflationary force.

In June 2020, when we started predicting higher inflation in the US, we thought that it would only spread very slowly to other countries, because the US dollar would fall against currencies such as the Australian dollar. We still expect the US dollar to fall, but recent trends in global inflation drivers -commodity prices, shipping delays, semiconductor shortages, and China - imply that inflation will be a global phenomenon.

Source: Brandes Investment Partners

What sort of stocks do well in times of inflation? The chart above shows how rises in inflation (grey line) have been correlated with higher share prices for value stocks (green line) since 1936.

Value stocks are companies trading on lower price-earnings ratios (P/E) than the market average; they are often cyclicals, and usually in sectors such as banking, mining, energy, building materials, manufacturing and industrial supplies. As a class, value stocks underperformed the market from 2008 to 2020, but they have picked up dramatically since the vaccine good news of November 2020.

What should Australian investors do to prepare for inflation?

• Hang on to your banks for a while longer. Banks tend to do quite well in times of moderate inflation, because rising prices make it easier for them to raise lending rates and increase their interest margins. Also, the Aussie love affair with property means that rising property prices will stimulate the demand for loans.
• Look for companies with strong pricing power, because they can pass rising costs on to their customers in the form of higher prices.
• Cyclical stocks usually do well out of economic upturns - provided that, like building materials companies for example, they can easily raise their prices.
• The resources sector will benefit from higher commodity prices, but needs a targeted approach rather than a shotgun, because different commodities will rise and fall at different times. Lithium, for instance, has already had its ups and downs, and the great iron ore boom might be over by 2022. Oil, gas and coal stocks require a cautious approach because of the impact of the transition to renewable energy.
• Buying directly into so-called inflation hedges like gold and bitcoin is not recommended at present. The gold price soared in the 1970s because of the conjunction of several factors - e.g. CPI inflation above 10%, Arab petrodollar buying of gold, the US dollar no longer convertible into gold - which are not in place this time around.
• The rising Australian dollar (AUD) means that most overseas investments need foreign exchange hedging.

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Over February the Australian bond market1 was down approximately 3.5%, suffering its biggest negative monthly return since 1983. In combination with its negative return in January, this episode essentially wipes 80% of the bond market's 2020 returns. Meanwhile, the 10 Year Australian Government bond yield has almost tripled since the lows experienced in 2020.

While oonly the rates market has been affected so far, in our view this could extend into risk assets (such as equities, high yield and investment grade credit) if central banks don't intervene in a coordinated fashion to avoid a 'taper tantrum' style sell-off.

The ingredients for a bond market sell-off have been brewing for some time, and while hard to predict the turning point, as active managers we must be poised to re-position our portfolios and identify investment opportunities.

The three forces responsible 

1. Rising Inflation expectations: 

• There has been a meaningful lift in inflation expectations over the past quarter resulting from positivve sentiment around the post COVID-19 recovery and reflation.
• This has been largely driven by vaccination programs getting underway and central banks` and governments commitment to supporting economies back out of the crisis
• The rapid turnaround is depicted by the 10-year breakeven inflation rate shown in Chart 1 below. Inflation expectations are many times higher than the low point experienced in March 2020 and have now crept up into the Reserve Bank of Australia`s (RBA) inflation rate target 

Chart 1: Australian 10-year breakeven inflation rate (%)

Source: Bloomberg, ABS, Australian 10-year breakeven inflation rate to 4 March 2021.

2. Rising cash rate expectations:

• In Australia, cash rate expectations suggest an RBA cash rate of 3% by late 2028. As at 26 February, with three- and 10-year Australian Government bond yields at 0.127% and 1.91% respectively, there is an embedded expectation that cash rates will rise very quickly, surpassing pre-COVID monetary policy settings into 'tight' cash rates.
• To illustrate the shift in cash rate expectations, the chart below depicts the market's pricing of the future path of cash rates on 26 February 2021 (orange curve), which is nearly three times higher than the market pricing back in October 2020 (blue curve).

Chart 2: Australian implied OIS forward 1m cash rate (%)

Source: Janus Henderson Investors, Bloomberg, monthly to February 2021, spot 26 February 2021.

• Interest rate risk (or duration), which is the sensitivity of bond markets to movements in bond yields, is a key risk for fixed interest investors to manage. The pre-conditions for adverse outcomes from the bond market1 had been brewing for a while given it is featuring a potent combination of record high levels of duration and record low bond yields. In general terms, and for illustrative purposes only, the effect of six years of duration essentially means that, even a 1.0% rise in bond yields would result in a 6% decline in capital for index investors.

Chart 3: Yield to maturity and modified duration on the Bloomberg AusBond 0+ Yr Index

Source: Janus Henderson Investors, as at 31 December 2020. Index: Bloomberg Ausbond Composite 0+ Yr Index. Note: Past performance is not a reliable indicator of future performance.

3. Question marks over central bank commitment:

• Despite the asset purchase programs and dovish rhetoric from central banks, markets are pricing in an earlier return to the RBA tightening monetary policy than the 2024 conditional commitment they've made.
• Markets are now challenging the central banks on whether they will stay the course with forward guidance and yield curve control (YCC) measures over the next three years.

How we are navigating the turmoil

Effectively navigating the more volatile rising rate environment at the key turning points will be vital given the magnitude of interest rate risk (duration). Ultimately, as yields rise, we believe it is worth taking some duration risk to capture higher yields, especially if markets overshoot.

Higher bond yields when cash rates are anchored at close to zero present very steep yield curves and the opportunity for investors to participate in both the yield and roll-down effect that adds to performance.

Today a 10-year risk free government bond, if nothing happens in markets over the next year, can deliver a return that's at least twice that of a five-year major bank floating rate corporate bond2. These are exactly the type of opportunities active managers wait for even if some volatility in the near-term needs to be tolerated. One will only know after the fact whether the strategy went too early or too late.

The team have also been focusing on capital preservation strategies to protect against a breakout in inflation expectations.

Below is an overview of our investment strategy:

Rates:

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Duration:

• We have gradually bought into the weakening bond market, with the expectation of higher returns in the future.
• While a plausible case can be made for bond yields gradually lifting over the medium to long term, the recent sharp price action seems to have brought forward that theme too quickly.
• Buying duration early will necessarily bring some near-term drawdown in return, but one can rarely pick turning points and only in hindsight will it be obvious.
• Our focus is on having the largest active position at the turning point, as it will be too late to position after markets have turned.

Inflation protection:

• Our sizeable allocation to inflation linked bonds has largely served the purpose of protecting portfolios against the market's expectation of a sharp lift in inflation. However, the best time to own inflation protection is when others don't want it or are not thinking about it, and that time is now gradually passing.
• As such, we have taken some profit through the sale of some of our holdings of government inflation linked bonds, though we have retained some exposure in order to reduce the impact of inflation expectations rising even higher should they break out to the upside.

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Spread sectors3:

Having participated in the meaningful rally of spread sectors, we feel prudent to take some profit while valuations are at peak levels in the post-COVID market rally.

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Semi-government debt:

• We have more than halved our semi-government bond position amid dissipating relative value.

Credit protection:

• We have added some credit protection (through credit default swaps) as a means of more quickly reducing spread sensitivity to tail risk events.

Investment grade credit:

• We have reduced some investment grade credit in order to more selectively participate in key primary market debt issuance.

High yield:

• We have reduced holdings of high yield credit.

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We are intentionally still exposed to credit markets, but the above provides some room for risk taking should markets become unstable.

This year is shaping up to be one where active interest rate strategies, including taking advantage of higher yields, may overshadow excess returns from spread sectors. Accordingly, our strategies will emphasise this from time to time as prevailing market conditions offer investment opportunities. While we expect some volatility and drawdown, near-term volatility presents an opportunity for active managers. Ultimately, higher bond yields restore the defensive characteristics and create better value for the asset class.

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1. Australian Bond Market as measured by the Bloomberg AusBond Composite 0+ Yr Index.

2. Based on no change to the current bond yield of 1.91% for 10-year Australian Government bonds and the estimated yield of an Australian five-year major bank floating rate notes of 0.45% (as at 26 February 2020).

3. The above are the Portfolio Managers' views and should not be construed as advice. Sector holdings are subject to change without notice.

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This information is issued by Janus Henderson Investors (Australia) Institutional Funds Management Limited (AFSL 444266, ABN 16 165 119 531). The information herein shall not in any way constitute advice or an invitation to invest. It is solely for information purposes and subject to change without notice. This information does not purport to be a comprehensive statement or description of any markets or securities referred to within. Any references to individual securities do not constitute a securities recommendation. Past performance is not indicative of future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

Whilst Janus Henderson Investors (Australia) Institutional Funds Management Limited believe that the information is correct at the date of this document, no warranty or representation is given to this effect and no responsibility can be accepted by Janus Henderson Investors (Australia) Institutional Funds Management Limited to any end users for any action taken on the basis of this information. All opinions and estimates in this information are subject to change without notice and are the views of the author at the time of publication. Janus Henderson Investors (Australia) Institutional Funds Management Limited is not under any obligation to update this information to the extent that it is or becomes out of date or incorrect.