As we kick-off the new financial year, it’s timely to look back at market conditions over the first half of 2019 and consider how best to adjust portfolios for the remainder of the year.
2019 so far
At the start of 2019, after a few months of significant market volatility and growing concerns that the trade dispute between the US and China could last a lot longer than originally expected, we believe that continued uncertainty would remain and would weigh on market sentiment, even if there did not appear to be any immediate risk of a major correction. Markets to date have lived up to this, as further commented on in our lead article this week.
The global outlook has gradually weakened over the first-half of 2019, causing monetary policy expectations to backflip from tightening to easing. The Reserve Bank of Australia (RBA) led the charge with back-to-back rate cuts, something not done since the European bank crisis in 2012. Expectation is high that the US Federal Reserve will follow suit in late July while the European Central Bank (ECB) explores alternatives given how low rates in the Eurozone already are.
Investors have been reallocating to bonds and equities, as investors try to maintain returns they’re accustomed to in the new ‘normal’ world of low interest rates, where earning 4% or more on relatively stronger bonds (typically investment grade) is a thing of the past. This has resulted in unprecedented market conditions where equity prices and bond yields are both rallying, which we don’t view as sustainable in the longer term.
How will my portfolio react in a correction?
With the weak economic outlook, and no catalyst for growth in sight, we expect the current positive correlation between bond yields and equity prices to break-down. Where equities usually perform well in times of growth and inflation, weaker conditions would suggest demand for safe-haven assets will prevail.
In a risk-off environment, higher rated bonds rally in price (as yields move lower) on safe haven demand, however lower rated bonds will experience a pull-back in price, as too will equities and hybrids. A diversified portfolio is crucial to cushion the impact of weaker performance across asset classes.
Corporate credit spreads reflect the credit worthiness of the bond issuer, and lower rated bonds have higher credit spreads than their higher rated counterparts. Credit spreads on lower rated bonds will widen during risk-off market conditions, as investors exit these holdings in response, pushing prices lower (and moving yields higher).
However, the price action is only relevant for investors wishing to actively trade their lower rated positions and can provide attractive entry points (as the yield has improved). It is a worthy reminder that as long as the issuer remains solvent investors know the exact amount of capital they will receive back at maturity, which is not the case for equities or hybrids.
For investors holding lower rated bonds as a strategy to supplement income in their diversified portfolios, the price volatility will only be relevant from a valuation perspective, and the yield and margin locked in on entry is more important. If investors are comfortable with the yield they’re receiving, then it pays to not react to negative price movements unless liquidity is required.
With ongoing uncertainty expected for the remainder of 2019, it’s important investors have appropriately constructed their portfolio to weather weaker performance across some asset classes. FIIG holds regular Portfolio Construction seminars nationally, where investors can attend to gain a better understanding on how to best build a balanced portfolio to withstand different economic cycles.
Click here to access our How to Build a Balanced Bond Portfolio seminars.
Portfolio construction considerations
While it’s hard to predict when, if and what the catalyst for a market correction will be, there remains ample uncertainties to come to the forefront, including ongoing trade tensions, continued weak growth outlook, stalled Brexit, high household debt (and subdued consumer spending), and further slack in the labour market.
There are also further conditions and fundamentals emerging, that we suspect will become bigger considerations for the remainder of 2019. These include the recent strength in the iron ore price, and the updated Tier 2 capital proposal from Australian Prudential Regulation Authority (APRA).
Iron ore sentiment
The recent highs in the iron ore price have gained much attention, mostly from market participants questioning if it’s sustainable at these higher levels. The price has surged 70% this year, and in less than two months has jumped from USD98 dmt (dry metric tonnes) to USD118 dmt, levels not seen since February 2014 as shown in the chart below.
Iron ore has skyrocketed on volatile output due to bad weather in Australia and the Vale SA dam disaster in Brazil, during a time of strong Chinese demand. However, the strength in the price seems beyond fundamental drivers. Trade tensions and slowing growth will impact continued demand out of China. The country’s recent Q2 GDP data release at 6.20%, a 27-year low, points to slowing growth.
The current spike in the iron ore price will generate higher than expected royalties for government, and may artificially inflate economic data for Australia. This is despite all other economic indicators pointing to a slowdown, similar to the ‘two-speed economy Australia experienced during the resources boom.
The strength in iron ore prices, along with USD credit markets rallying has seen BHP 2020, 2025 and FMG 2022, 2024 USD bond prices move higher as a result. This has allowed bondholders to take profits while levels remain elevated and switch into other investment options. We believe these opportunistic investment options will appear in the short term, as bonds, and credit remain strong, however may not be sustained.
Tier 2 bank capital requirements
Following APRA’s proposal last November to increase Loss Absorbing Capital, it has since released an update with Tier 2 remaining the preferred option. The major banks will be required to raise ~AUD50bn of additional Tier 2 capital by 2024, down from ~AUD70bn-AUD80bn in the original proposal.
It remains to be seen the extent to which the additional supply will impact Tier 2 margins, with ~AUD35bn currently outstanding in the market. Some widening in margins is expected, as more attractive returns will entice investors and ensure new supply is absorbed. However, considering the longer-time frame APRA has allowed for issuance, and appetite for attractive investment options in a lower interest rate environment, we expect demand to remain strong.
In the week following APRA’s updated proposal, ANZ and Westpac respectively issued new Tier 2 notes. Westpac’s USD2.25bn dual tranche USD transaction was six times oversubscribed, with margins tightened 30 basis points (bp) and 50bp from initial price guidance as a result.
Likewise ANZ’s AUD Tier 2 issue was well bid for in primary, attracting orders in excess of AUD3.6bn and initial price guidance set at 3month BBSW +2.10%, was tightened to +2.00%. This remains relatively in-line with existing Tier 2 issue margins, launched prior to the recent APRA update. Two months ago NAB issued a similar structure Tier 2 note, with the same rating at 3month BBSW+2.15%.
If these recent Tier 2 issues are any indication of what to expect going forward, then additional new Tier 2 issuance will result in limited margin widening, subject to market conditions. The margins on Tier 2 notes have generally tightened in secondary markets, making recent Tier 2 issues look attractive to add positions to portfolios.
Conclusion
Despite the recent low volatility, uncertainty is expected to return to markets in the second half of 2019. This will test the performance of certain asset classes, and also the resilience of portfolios. Set against a weak global outlook, we don’t view the current rally in both bond yields and equity prices as sustainable. With this backdrop, we maintain our recommendation that clients should consider diversification and capital preservation across asset classes. While high yield bond allocations play a role in portfolios to generate excess returns, the core holding should be made up of higher conviction positions that are lower risk. This includes investment grade exposures in defensive sectors.
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