Tuesday 10 October 2017 by Guest Contributor Opinion

Back to the future…

FIIG founder Jim Stening is back managing the company but did you know he was the original editor of The WIRE? Here he recounts his early days, the impact of the GFC and his thoughts on the future of the market  

jimstening

It’s been a long time since I wrote an article for the WIRE. In fact, I don’t think I have done so since I handed over the editorial duties to the very capable Liz Moran around nine years ago. 

Prior to that, every Wednesday, for approximately 10 years I used to pen the WIRE and I have to say the evolution of this document, as an insightful source of information about the fixed income asset class, has dramatically improved and expanded under Liz’s stewardship, which is testament to her continued commitment to quality and her work ethic. 

I am pretty sure that many of my old WIRE articles would have ended up in Liz’s round file today and I am also confident that what the WIRE has become would not have been achieved if the editorial responsibilities had been left in my or anyone else’s remit.  Coincidentally, this is something I had the pleasure of reflecting upon with Liz when I recently attended a dinner to celebrate her 10 year anniversary at FIIG.

Having said that, I have to admit, it is not without a touch of nostalgia that I revisit the ritual of writing a WIRE article (not to mention a sense of trepidation that it might not live up to expectations given its nine year gestation!!......Hopefully Liz sees fit to publish).

Whilst I don’t propose that this article manifest a summary of what has happened during my nine year absence, I have to say that it’s been an incredibly interesting period of time where a broad range of key drivers have fundamentally changed in the wake of a once in a lifetime financial sector meltdown and accelerated technological change. So perhaps in order to consider the future appropriately, this period does require at least some reflection.

If someone had told me the day after I wrote my last wire article in 2008, that in 2017 we would have, record low domestic and global interest rate levels out to 15 years for close to a decade, Australian  share market indices would still be 20% below their relevant historical (hysterical) highs, seen property prices in Sydney and Melbourne more than double, experienced extended levels of low inflation and limited wage growth, the UK vote to leave the European Union, a US share market that has doubled and continually hit record highs prior to and after the election of a “mentally deranged dotard” (who communicates through Twitter) as that country’s President, who was in turn being harangued by a nutcase “rocket man” from North Korea as the Federal reserve was raising rates and withdrawing the stimulus of three unprecedented episodes of quantitative easing totalling USD4.5 trillion dollars, I think I’d be politely excusing myself from the room before running away very quickly.

Putting all of that to one side, and with the benefit of hindsight, I think that the GFC was such an enormous shake of the tree that an extended cycle is to be expected. We are still seeing it play out - as the market seems unable to correct, growth and employment are improving but inflation lags. 

Yet, people have short memories of the carnage over our recent history that is categorised as the GFC. The urban myth that Australian banks stood resolute, in the face of the inexorable tide of the GFC is evidence, of this failure to remember. The reality is that if they hadn’t been rescued by Kevin Rudd vis a vis the Australian tax payers, it would have been game over. 

This memory loss coupled with the propensity through any cycle of new participants to continue to front up for their kick in the nether regions citing new paradigms, despite proven doctrines and sage advice from experienced campaigners should also be a reason for introspection and caution.  

Evidence of this and the wounds having healed are perhaps a sign of complacency. There is momentum behind a belief that entrenched economic laws have been undermined if not debunked. I refer to the recent spate of online conversations and press articles relating to the potential moth balling of the Philips Curve and an emerging disregard for laws of supply and demand. 

The added layer of confusion is that normally not many people are calling the turn of a cycle, but the commentary around markets is as full of doomsayers and bears as it is of those with blind faith and new paradigms. This mix of extremes seems to create a strange balance which is more supportive of a healthy market than one that is teetering on a cyclical cliff. 

On balance, this probably means we have a few more years of more of the same left in this cycle and in my opinion I don’t think a downturn or shock correction (if it occurs in this time frame) will be anywhere near as bad as the GFC and will most likely represent a great chance to take on risk at cheaper prices. I’d expect a more regulation “V” shaped recovery (in line with pre GFC cycles). And I wouldn’t be at all surprised if risk/equity markets move sideways and correct over time rather than trade lower in price for a prolonged period.

As far as interest rates go, it just isn’t sensible to ignore the Fed. Official US rates are moving higher as surplus funds are being withdrawn, reversing quantitative easing. This will impact all global sovereign yield curves to varying degrees but it makes shortening duration a compelling strategy (that is if you still believe in the forces of supply and demand). 

The market has become materially desensitised - where once just the suggested removal of stimulus resulted in a taper tantrum, so far this time round, it has had very little impact. In light of this, you would have to have extremely high conviction to be long duration. 

As far as a credit strategy goes – if investing in the investment grade space I would look to migrate up the capital stack of issuers given the balance of risks in the market place. This could translate into moving out of subordinated into senior debt positions and favouring floating rate compared to fixed. Residential mortgage backed securities remain stand out value in this category.

In the high yield space, we cannot ignore that longer dated high yield bonds are likely to be impacted by rising US interest rates.  However, we can take comfort in historical high yield performance that has shown a remarkable resilience to rising interest rates due to the low correlation of this asset class to underlying movements in risk free government bonds and investment grade bonds.  This is because performance more closely tracks underlying equities. That is, it is strongly linked to the financial performance and fundamentals of the underlying corporate issuer and in turn, the relevant sector. Every other consideration is in the back seat. 

It is therefore not uncommon for high yield to outperform other bond classes during interest rate increase cycles and in the current environment the argument for medium to short dated high yield issues which will benefit from a continued upturn in the US economy is still valid in my view. 

As always, it is essential for any investor to adhere to the proven principles of a well diversified portfolio, particularly when allocating to high yield.


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