Including tail hedging in a portfolio can have the following benefits:

1. Provide a cushion against very large losses;
2. Allow investors to increase risk in other parts of the portfolio;
3. Provide liquidity during times of market stress.

Point 3 may be of particular interest to Australian super funds where, for example, FX hedges can incur large mark-to-market losses during times of market stress. For example, the latest Quarterly Superannuation Statistics published by APRA (March 2022) show the industry currently has $322bn of FX hedges. During the financial crisis AUD dropped 37.6%, which would have led to FX hedge losses of -$121bn based on current exposures at a time the overall portfolio was down -26% (-$577bn in today's terms), and a COVID scenario would result in FX losses of around -$58bn at a time overall assets were down -$466bn.

Investors use a variety of approaches to try and mitigate losses in their portfolios, including diversification, market timing, and explicit hedging. While we agree all three approaches have a place in managing portfolios, hedging is by far the most reliable way to mitigate losses during times of market stress. It (almost) goes without saying that even investors who successfully add long-term alpha for their clients via market timing cannot always predict market drawdowns, and one only needs to look at recent market moves to see the pitfalls of relying too heavily on diversification (eg simultaneous sell-off in equities and fixed income with ACWI -18.9% and Global Agg -14.5% YTD on a total return basis).

Because it is reliable, hedging can be an important tool in building resilient long-term portfolios. However, that reliability comes at a cost, and because true market stress events are few and far between, we often find that the costs of hedging are more visible to investors than the benefits. Since most investors are not particularly concerned by small drawdowns, the cost of hedging can be reduced by focusing only on larger, less-frequent drawdowns. Specifically, tail hedging allows investors to hedge against only the most extreme outcomes that can inflict long-lasting damage on even the most diversified portfolios.

It's worth reiterating that because tail hedging, by design, is only expected to 'work' in the most extreme circumstances, investors can expect to see (modest) losses in tail hedges far more frequently than they will see gains. However, it is the timing and magnitude of the gains that is important. A robust tail hedging program will provide investors with large gains when other parts of the portfolio are experiencing very large drawdowns. And that knowledge may also allow investors to adopt a barbell approach and take higher risk, and earn higher returns, elsewhere in the portfolio. One final point: to be reliable, a tail hedge needs to be "always on" since the whole point of hedging is that we can't always predict a drawdown. In this regard, systematic option strategies can be particularly useful.

In addition to the FX exposures outlined previously, an additional liquidity drain may come in the form of capital calls on private equity commitments. The super industry currently has approximately $106bn exposure to private equity. Some basic assumptions (1) lead to a rough estimate of $11bn liquidity required in a crisis year. Further liquidity needs might reasonably be expected to arise from such things as capital raising (eg rights issues) from portfolio companies, investment opportunities in real estate, infrastructure etc arising from market and/or funding stress. The main point is that super funds can expect to have high liquidity obligations that are required (or desired) to be met during times of market turmoil, on our calculations as much as 6% of fund assets, and possibly much more.

A super fund could budget for this by setting aside some amount to be held in low risk, highly liquid instruments such as cash, ready to be deployed in times of stress. However, such an approach has an opportunity cost because the return on cash is much lower than the return on the rest of the portfolio. Using the past 15y years as a rough guide, a cash investment would have returned 2.6%p.a. vs approximately 5%p.a. for a typical balanced super portfolio. The last 10y would have been an even larger difference (1.5% vs 8%). The chart below shows the performance of a systematic tail hedge strategy(2) (light blue line) compared to the realised opportunity cost of holding an additional 6% of fund assets in cash (purple line) and the projected constant opportunity cost of holding cash (dark blue line).

The chart shows the long-term performance impact of running a tail hedge strategy can be substantially less than holding additional cash in the portfolio. The mark-to-market of the tail hedging program would need to be met over time, but the chart shows that the realised negative performance during "normal" periods is no more than the drag on performance from holding excess cash, and during stress periods the tail hedging realises large gains which can be used to meet any liquidity requirements. For the specific objective of providing liquidity during a crisis, we find an effective tail hedging program to be a more efficient approach despite the perceived "cost" of hedging.

1 10y fund life, 5y investment phase with capital called evenly, investment realisations of zero in a market crisis.

2 The example strategy is a SPX 3m 1×4 20d/5d put spread rolled monthly.

Antipodes has owned Meta (previously Facebook) since the end of 2018 and despite the recent volatility in which many sold out of the company, it remains one of our top 20 holdings. 

We think that even though competition for eyeballs is increasing, and will continue to increase, the digital advertising pie is growing, and Meta can continue to dominate advertising revenue over our investment horizon. Further we believe there are opportunities to increase the monetisation rate of core Facebook and Instagram.  

In this new podcast episode, Alison Savas is joined by Ben Legg, one of the world's leading authorities on the digital advertising industry. Ben is a former Google COO, and now helps global brands advertise on social networks.  

Some key points covered include:

• Overview of how online advertise works today (04:00)
• The digital advertising landscape and why digital advertising as a percentage of GDP is likely to grow (07:30)
• The rise of Tik Tok (10:50)
• Meta's advertising technology and why it's seen as being superior to competitors (12:00)
• How Meta is moving to maintain user engagement (21:10) 
• Can Instagram become the world's biggest fashion retailer? (28.30)

The change of policy in 2022 has set off a series of dominoes for asset markets. Government Bonds were first to fall in quarter one, with other assets also following aggressively into quarter two. Listed assets are marked to market instantly (which can often be unpleasant) whilst illiquid or private markets can hold previous asset valuation marks as there is no observable price where price discovery could occur. It is worth considering what those realisable values might be if higher quality or liquid public assets are already -10, -20, -30%?

Is a credit crisis about to erupt?

The dominoes of change are quickly bringing attention to credit default as it stands to reason that refinancing outstanding lowly rated corporate debt will become increasingly problematic. The Australian Government was borrowing 10-year money at 1.05% in August last year, these rates have now moved to over 4.05% today. If the Government has to pay over 4% when it used to pay a bit above 1%, then spare a thought for corporate borrowers who might have borrowed at super low rates and are now asked to refinance at Government Yield of 4% plus some large credit spread component. How long will the markets have confidence in these lowly rated corporates to refinance at such punitive interest rate levels? The danger here is that they cannot ROLL those existing borrowings forward. That means there is no further credit extended and they need to REPAY the initial borrowing amount as well. That is exactly how a credit crisis erupts. 

The markets essentially say "we will not re-lend to you and we'd like to be repaid as well." This usually requires the lender of last resort - the Central Bank - to step in and provide a safety net of support.

This is the policy pivot we have written about for some time and has marked a turning point in asset performance. But how does a Central Bank do that here with inflation globally between 5 and 8 %? Central Bankers are now rapidly raising rates as fighting inflation has taken absolute priority over saving corporate zombies from bankruptcy, generating material stress in the credit complex as many investors flee the asset class.

Credit risk has been spectacularly dormant as the broad decline in long term Government Bond yields since the 1980's, plus support from Central Banks, has fostered a "begin" environment for the assets class, slingshot by the massive support of flows and investor sponsorship in the ''search for yield'', under the financial repression of low interest rates. That sponsorship and flow looks likely to have ended with rates markets having a stunning sell off this year, leading most asset markets to weak performance. Many public credit assets have also underperformed - primarily from their inherent fixed income duration, rather than the material recalibration of credit (spread) risk. 

The US Federal Reserve (the US Fed) is quickly approaching levels that flawed the credit markets in the last hiking cycle of 2018. At that time, in a peaceful and stable world, the US Fed Funds rate climbed to 2.50% before credit markets locked in November 2018, causing significant market stress through December 2018 for risk assets.

The US Fed moved to 1.75% this week and suggested its next move is either 0.50% or 0.75% hike to 2.25 or 2.50% in July to continue the fight against inflation by killing demand in the economy.

The forces corporate credit markets are now facing

So, the next complex issue facing markets will likely revolve around credit default and the stunning rebirth of credit risk in the corporate credit fixed income space. Credit is a high specialised market which is little understood by most investors. Credit quality, as measured by ratings agencies, ranges from the highly converted (but low yielding) AAA rated issuers, all the way through to lower CCC rated issuers classified as having substantial risk of default (known in markets as 'junk'). Due to the inherent credit risk in these lower rated securities, yields are far higher to entice investors to take on the risk of default.

Spreads on CCC rated US corporate bonds are approaching 1,000 basis points for the first time since the Covid-19 crisis, when the US Fed magically halted default issues by flooding the market with unprecedented amounts of liquidity and buying corporate credit as part of the Covid-19 stabilisation programs.

Any such support for the market looks very difficult to achieve this time as Central Bankers are now rapidly raising rates to fight inflation.

Would you lend money to a buy now pay later platform or a growth company with no sustainable earnings to meet debt repayments in the current environment? Thankfully for Australian investors we have very few names like this, but our corporate credit does move its sympathy with global markets which are full of such names.

Rate hikes strike in an uncertain world

With materially higher rates now priced by Government Bond markets, the economy is expected to slow rapidly as rate hikes bite, hitting the public, lowering confidence and curtailing discretionary spending. Liquidity and asset quality will become important considerations for portfolios looking to benefit from steep discounts in many quality assets. We do not expect that rates will fall back to anything like the emergency levels we have seen post pandemic, so it feels like the re-birth of credit and default risk could be with us for some time yet as we move to a structurally higher rate environment than in recent years. It is important to acknowledge that the playbook in the last few episodes of a corporate credit seizure (Central Bank rate cuts and Quantitative Easing) will not work under a higher inflation and unstable geopolitical environment. That pivot of policy simply isn't available if inflation remains above Central Bank mandate levels as we would expect for the balance of 2022 due to the global energy shock.

Aggregated property values across the country on a monthly basis have slowed marginally, (-0.80%). The highest performer this month was Adelaide (+1.30%), followed closely by Perth (+0.40%).

Australia's property price increases experienced over the last 18 months are now well and truly past their peak rate of growth.

Interestingly however unit prices are holding their value better than houses across capital cities with regional property still remaining in positive growth.

The market is quickly becoming a buyers market with aggregate home sales nationally through the June quarter now 15.9% lower than a year ago.

However, with housing conditions cooling, the flow of new listings to the market is slowing which along with a strong labour market should help support prices

Rental markets around the country also remain extremely tight with rents and residential property yields now rising at a faster rate than housing values also providing a buffer for property investors. Ultimately however it will be interest rates which will have the largest impact on the path of housing markets.
 

Source: CoreLogic

The weighted average clearance rate across the country is lower than last year at 59.8% compared to 2021's 75.4% clearance rate (-15.60%)

Other cities across the board also achieved rates marginally lower than last year, with the exception of Brisbane. 

Brisbane increased by +5.90% compared to the previous year, with Canberra being dropping in comparison (-29.70%)

Source: CoreLogic

Source: CoreLogic

Quick Insights

Lowered Rates & Politicised Policy

A new study by the Melbourne Institute has revealed that government support programs contributed very little to the health of the housing market during the pandemic. Instead, it was the RBAs low cash rate that boosted the purchases. Buyers took advantage of relatively low servicing costs and interest rates. Housing programs typically assisted only the few who applied early.

The War Room

Tony Lombardo, CEO of Lendlease; Janice Lee, PwC Australia Partner; Susan Lloyd-Hurwitz, CEO of Mirvac; and Tarun Gupta, CEO of Stockland, some of the nation's most senior property leaders came together earlier this month to discuss the ongoing housing crisis. The conclusion drawn in the Channel Nine boardroom was that government policies stimulating demand can only do so much. Ultimately, it is the lack of investment in property infrastructure and overly tight zoning policies that continue to stoke unaffordability.

Sydney's Stamp Duties

The NSW Coalition Government announced this month its new revisions to the stamp duty. The system would allow home buyers to opt-out of paying stamp duty in favour of a $400 and 0.3% annual land tax. Some were quick to note how this might increase housing prices as the money usually spent on stamp duty would instead go into an auction bid. However, as lenders take the cost of annual tax into their loan serviceability criteria, the impact of this legislation may become negligible.
 
Source: Australian Financial Review 

Inflation driving higher rates and earnings risk (given recession fears), combined with tax-loss selling and flows out of equities, to deliver a horror month for the Small Ords. The benchmark fell -13.1% for June delivered the second worst monthly return since the GFC.

The Aussie 10-year bond rate started the month at 3.34% and finished it at 3.66% but not before touching a high of 4.25% intra-month. The US 10-year Treasury Bond interest rate showed a similar pattern, starting the month with a 2.83% yield and finishing it at 3.06% via a 3.48% high. The moves lower in global and domestic equities are starting to price these higher rates.

The new fear gripping markets is earnings risk. Depending on who you read, the average US recession sees -13% to -17% earnings cuts (the GFC was a lot worse). It is this earnings risk that is now being contemplated by markets. We have managed money in rising and falling rate environments and know which we prefer! In the past, rising rate environments have been gradual enough so that the earnings growth of our portfolio has compensated for multiple compression from higher rates.

The unique feature of this market is not the magnitude but the speed of the move in rates which has led to the fastest compression of valuations ever as shown here:

Valuations have never before compressed so quickly

Year-on-year change in trailing Price/Earnings multiple of the S&P 500

The chart above shows we have been sailing into the wind, but it won't always be this way. Given the next leg of this bear market is likely to be a focus on earnings not multiples, we have been positioning the portfolio towards companies we believe have greater earnings certainty. This ought to mitigate the impact on the portfolio of a recessionary or slowing growth environment should it occur.

There are 3 important criteria for identifying a once in a generation buying opportunity: 1) confidence that the business model will still be viable in a generation; 2) confidence that the stock has moved out of an earnings downgrade cycle into an earnings upgrade cycle; and 3) valuation support that signals a true buying opportunity, not an opportunity to catch a falling knife.

Global equity markets have pulled back sharply in 2022 and it may be tempting to view some previously high-flying stocks as once in a generation buying opportunities. However, caution is needed because many of the worst preforming stocks year to date do not meet the 3 criteria outlined above.

The following table shows stocks in the MSCI World Index that are down 65% or more in the last 12 months. Arguably, the vast majority of these do not meet the first criteria of a durable business model that will definitely be around for generations to come. In addition, most of these stocks are not in an earnings upgrade cycle, nor do they have strong valuation support even at these levels.

Caveat emptor for these types of stocks

Source: Bloomberg, 31 May 2022, Alphinity

Unlike the stocks in the table above, ASML is a high-quality stock that has corrected over 30% from its late 2021 high and meets the criteria of a durable business model, earnings upgrades and valuation support.

A Business Model with Staying Power

ASML is definitely going to be around in a generation as evidence by the fact that the stock listed in 1995 and has seen a few cycles already. ASML's enviable market share of around 70% provides confidence that there are deep moats around the business that can outlast periods of strong competition or disruption.

Looking forward, ASML management likes to talk about the 3 main drivers of their stock being structural (AI, Internet of Things, 5G, Electric Vehicles, etc), cyclical (semi shortages and ongoing semi supply chain disruptions) and geopolitical (reshoring of semi capacity to the US and potentially Europe to reduce the risks associated with China/Taiwan). The combination of these 3 drivers is very powerful and supports a strong long term business case for ASML.

Earnings Upgrade Cycle

ASML's 1Q22 result came out slightly ahead while guidance for the FY22 maintained top line growth of ~20% and strong gross margins of ~52%. The bigger earnings story from the recent Capital Markets Day was a substantial upgrade to capacity targets for FY25 based on very strong demand. The potential upgrades here are significant - in the order of +50% revenue potential over the medium term.

Valuation Support

ASML is currently trading on a PE of less than 30x versus almost 50x PE at the end of FY21. This valuation is now below its 5 year average PE and represents an attractive PEG ratio of just over 1x. Furthermore, ASML's net cash balance sheet, 65% ROE and strong Free-Cash-Flow yield provide confidence in downside support for the stock.

As shown in the table below, ASML's valuation support is in sharp contrast to many of the unprofitable or barely profitable tech stocks with no valuation support even at these levels. If markets continue to trend down, then many of the stocks that have been crushed in the last 12 months can continue to fall further.

Conclusion

Stick with high quality stocks with durable business models, earnings leadership and valuation support. In this context, ASML looks very attractive. Happy hunting for once in a generation buying opportunities!

This information is for adviser & wholesale investors only

The S&P 500 was flat in May but at the time of writing is down 5.8% in June and -22.9% ytd. Most financial assets are down negative double digits ytd: Nasdaq -31%, 10-year US Treasuries -15%, and Bitcoin -56%.

The growing volatility and uncertainty in the financial markets globally is being driven in large part by the overdue and somewhat chaotic reaction of Central Banks to persistent inflation. The US Fed hiked rates by 75 bps in June - the largest hike in 27 years. The 10-year US real yields soared 150 bps in 60 days and most other bond markets suffered - the Australian 10-year yield rose 57 bps in 2 days.

The persistent inflation, made worse by supply chain problems from lockdowns in China and war in the Ukraine, is starting to bite consumer spending and reduce economic growth around the world. In Europe, the 80% rise in the price of natural gas is one problem; the 50% reduction in deliveries by Russia is a worse problem. Europe may not be able to buy all the gas they need for next winter at any price.

Investors fearing more volatility may want to raise cash to be "safe". But if cash buys 8% fewer goods and services next year compared to this year, too much cash may not be safe. A well-managed Life Settlements strategy can contribute to investors' portfolios in these turbulent times: it will be non-correlated with the equity and bond market turmoil, and it offers a return that has a strong probability of keeping up with inflation.

PORTFOLIO CONSTRUCTION: THE ROLE OF LIFE SETTLEMENTS - The Role of the Laureola Fund in Portfolios of Private Clients and Family Offices

Last month we discussed the role of LS in institutional portfolios showing that, mathematically, a small allocation to LS could both reduce portfolio volatility (risk) and increase returns over most 5-year periods because of its diversification characteristics, even if single digits returns are assumed.

But there are other definitions of investment risk sometimes used by Private Clients and Family Offices. Some are simple and straightforward, but still very useful in analysis - maybe even more useful. Many strategies that promise diversification in bull markets fail to deliver the needed diversification in bear markets. But the Laureola Fund does.

The Fund has outperformed all asset classes (except for commodities) ytd in 2022 including hedge funds as measured by the Barclay HF index (-5.7% ytd). The Fund has delivered positive returns in 7 of the 10 worst months for the S&P since inception, and in 2 of the 3 months when both had negative returns the negative return of the Fund was insignificant. The Fund has helped investors keep up with inflation delivering 6.7% net over the past 3 years.

For once the theory and the practice align: The Laureola Fund can make a positive contribution to investors' portfolios in turbulent times no matter what analysis is used.

There are a number of unique characteristics that make the insurance sector attractive in the current environment, including some company-specific factors which have led to valuation-based investment opportunities.

Valuing the insurance sector

Valuing insurance companies remains difficult due to the potential mismatch of estimated claims verses actual claims paid which may take years to finalise. Large catastrophes can take several years to be resolved—such as the New Zealand earthquakes—and injury claims can be stuck in the legal process for a long time. As a result, errors in claim loss forecasts can impact a company over many years.

As investors, we look at a combined ratio calculation to measure the profitability of insurance companies, which is the sum of operating expenses and claim losses divided by premium revenue. A ratio below 100% indicates profitable insurance underwriting.
Chart 1. below illustrates the 22-year history of natural disasters in constant dollar terms. The frequency of catastrophes has been higher over the last 10 years than the prior 10 years, yet the subsequent constant currency losses have yet to eclipse the 1990 insured losses from the Newcastle Earthquake.

Chart 1. Insured losses by Financial Years (in constant $2017)

The chart is a reminder that disasters happen, and that risk is why people buy insurance to protect them from the impact of a disaster.

A well-run insurance company prices risk appropriately. Insurance companies have accepted that there is an impact on the size and frequency of claims as a result of climate change, and premiums have increased to reflect this.
Insurance companies that manage aggregate underwriting exposures through price, category limits and by selectively purchasing reinsurance (insurance for insurers) will do well over time.

What makes insurance companies attractive in the current market climate?

The current market environment is characterised by rising interest rates, energy price spikes and higher inflation. This has led to a softening in economic growth and growing fears of recession. Stagflation or recession will negatively impact profit margins and valuations for companies.

One of the things that makes the insurance sector unique is that premiums are billed and collected up-front, delivering in a premium float before claims are paid. The float is usually large and is invested to generate additional returns on top of an underwriting margin.

Typically, this large premium float is invested in a mixture of cash and bonds, and possibly a small proportion in shares and other assets. Insurance companies aim to make an insurance margin which includes a return on the float that is akin to a leveraged investment return, since the return is earned on the premium float.

The insurance sector is one of a handful that benefits from higher interest rates, with a 1% increase in rates equating to 10-20% earnings upside. The insurance Industry structure in Australia is attractive, operating as a functional oligopoly with the two major domestic insurers—QBE and IAG—taking approximately 70% market share.

What makes the structure of insurance companies different?

The business service provided by insurance companies is the pricing and pooling of risk. It does not require an inventory of raw materials or finished goods, freight costs, or energy consumption.

Premiums are typically a function of asset value and rise with the insured value. The rate of return on insurance floats improves as interest rates rise, which is the opposite outcome experienced by most companies. Inflation can flow into claims costs, though insurers do generally mitigate this by adjusting premium prices upwards. Furthermore, insurers would face similar pressure and typically be less likely to compete in an inflationary environment.

Why are the insurance stocks undervalued?

The recent increase in the frequency of disasters and associated claims has weighed on investor sentiment, with concerns that estimated losses and exposure protection limits would be exceeded. To date, the measures in place have provided adequate protection.

In addition to claim frequency, a series of operating missteps have dented investor confidence. Most notably, QBE, IAG, as to a lesser extent Suncorp, were forced to raise provisions for Business Interruption claims relating to COVID-19 and to manage costs associated with insurance policy documents incorrectly referencing the Quarantine Act 1908 (rather than Biosecurity Act 2015). IAG was disproportionately impacted by this and had to raise equity. Litigation has so far favoured the insurers, which may lead to the future release of surplus provisions for claims.

Investor confidence in IAG waned further after the company suffered humiliating make-goods as a result of failing to apply group policy discounts and payroll errors. Accusations that IAG retained risk to the Greensill financial collapse proved unfounded, with the company clarifying that the business division that had this exposure had been sold and the risk transferred to the purchaser.

What are the signs that things are improving?

Consistent with IAG and Suncorp's February results commentary concerning premium rate increases, QBE released a performance update in early May which confirmed a healthy 22% growth in constant currency gross insurance premium revenue.

QBE indicated that after the increase in risk rates and a 9% reallocation into riskier assets, the expected running yield on the investment portfolio has almost tripled to an exit rate of ~2%.

The operating missteps of IAG and QBE have rattled investor confidence. Suncorp has fared better following its focus on cost reductions and dividends, and this has been rewarded by the market through share price gains.

We expect a recovery in market valuation and dividend payments from both IAG and QBE as: (i) the cost impact of remediation fades; and (ii) the industry-wide improvements in premium pricing are earned and higher running yields on the premium float are delivered.

The valuation, dividend profile, and sensitivity to rates, inflation, and the risk of stagflation leave IAG, QBE, and Suncorp well placed to outperform. And with high dividend payouts expected to persist, the Tyndall Australian Share Income Fund remains happily overweight the sector.

Author: Michael Maughan, Portfolio Manager, Tyndall Australian Share Income Fund

Leaders indicators warn of global recession

Central banks state they are not seeing signs of a recession as they continue hiking rates to curb spiralling inflation. But with forward indicators flashing red across the board, low consumer confidence, declining forward sales, the US yield curve beginning to invert, and the continued drop in the global equities, markets are telling us they see slowing growth ahead.

Will the RBA pause in August, or will they continue to tighten at the fastest rate we have seen in 30 years and drive the country into a recession?

Speakers: 
Darren Langer, Co-Head of Australian Fixed Income &
Chris Rands, Senior Portfolio Manager