Paul O'Connor:

Welcome. Thanks for joining us again for another instalment of the Netwealth Portfolio Construction Podcast series. I'm Paul O'Connor, and I'm Netwealth's Head of Investments, which includes responsibility for the funds available on our own investment menus and the products we issue as a responsible entity, namely being the GSS funds and managed accounts. Joining us on today's podcast is Tim Van Klaveren, who is UBS Asset Management Australia's Head of Fixed Income, and will discuss the macroeconomic outlook including inflation and where he believes interest rates and bond yields are heading over the next one to two years.

UBS is a publicly listed global financial services company headquartered in Basel and Zurich, Switzerland. It provides investment banking, asset management and wealth management services for private, corporate and institutional clients worldwide as well as retail clients in Switzerland. The asset management business offers investment products across all major traditional and alternative asset classes. UBS is one of the largest asset management firms in the world with invested assets totalling approximately US 1.7 trillion as of 30 June 2024. UBS Asset Management is located in 24 countries with the main offices being in Chicago, Hong Kong, London, New York, Shanghai, Singapore, Sydney, Tokyo and Zurich. UBS Australia also offers strategies across multiple asset classes and as of 31 March 2024, the business managed over AUD 60 billion in funds under management with circa 23 billion in the Australian Fixed Interest Fund.

Tim is the Head of Australian Fixed Income and leads the Australian strategy team. He is a member of the Global Fixed Income Investment Forum and also chairs the Fixed Income Investment Forum Investment Grade Subcommittee. Tim also worked in the UBS Asset Management London office for seven years as the Head of Investment Grade Credit Research for Pan Europe and Asia Pacific. Tim joined UBS Australia in 1994, and prior to his move to London in 2003, served nine years with the Australian Fixed Income Fund. Tim was a senior member of the strategy team and contributed on duration and sector related decisions. Tim holds a bachelor of business in honours from the University of Technology, he is a CPA and a CFA charter holder.

There are seven UBS Australia managed funds on the Netwealth Super and IDPS Investment menus covering Australian equity small cap and micro cap strategies, emerging market equities, global listed property, global listed infrastructure, and the diversified fixed income fund that Tim works on supporting the portfolio manager, Jeff Grow.

So after a decade of historic low interest rates and benign inflation, Australia's inflation rose strongly post COVID, partly driven by the excessive fiscal measures of the federal government plus accommodative monetary policy, but also due to supply chain shortages brought on by COVID. Inflation rose to almost 8% in late 2022, and the RBA followed with tightening monetary policy to address this rising inflation with the RBA cash rate increasing to 4.35% and the Australian 10-year bond yield peaking at almost 5% in 2023. The restrictive monetary policy and higher bond yields have worked with inflation now falling to below 4%, which has a lot of investors now questioning whether the next RBA move will be to lower the cash rate.

Inflation has historically been about two-thirds of the cash rate. So if history is any gauge, the RBA will be looking for a further reduction in inflation to maybe 3.5% or lower before we see any reduction in that cash rate. But I'll certainly be interested in Tim's views on this subject. The latest unemployment figures also don't support any immediate cut in the interest rates by the RBA, so I guess they're playing a bit of a waiting game before making monetary policy more accommodative. So Tim, I've always thought managing fixed interest portfolios is a more difficult job than managing equities portfolios as you need both a top-down macroeconomic understanding along with a bottom-up security analysis skill set. So can you provide a few comments for the listeners on why you decided to specialise your career in fixed interest markets?

Tim Van Klaveren:

Yeah, thanks Paul and really happy to join you on this podcast for today's session. Interesting question and I'm sure there'll be a few equity portfolio managers that may disagree with a statement, but-

Paul O'Connor:

I may have upset a couple, Tim.

Tim Van Klaveren:

But interestingly for myself, I actually started in equities, so that was my initial entry into financial markets. One of my earlier roles back in 1985 through to 1987 was as a equity option market maker on the back of the ASX trading floor down in 20 Bond Street before I decided to go off to university and do a number of years there getting my qualifications. And then when I came back into the market, it was back into equities. But in 1994 I was convinced I should move across to the bond market and join, which was back with the UBS, one of its former entities, SBC. That's where my days in fixed income started.

Now your question about the difference in managing the different asset classes, you're right, I find fixed income a lot more complex and it's more global in nature. As you know, fixed income trades on multiple markets around the world, and being part of a global firm gives you a broader global sense of different markets and different opportunity sets. It's interesting, when I started in equities through that '85, '87, that was the '87 share market crash. So I traded through that, stepped out of an equity market crash, and in 1994 was in the bond bubble. So that was up until 2022, it was the worst total returns experienced in the marketplace up until that point in time.

But definitely when I entered in '94, the bond market was in its infancy, so it was a growing market, but also when you talk about that bottom-up very much, yes, in terms of your government bonds, but even more so in terms of your credit securities. Back in '94, the credit market was basically non-existent in Australia. Definitely I had that opportunity to come in at the cutting edge and the start of the market, and I've been around for 30 years since then. So it's been a great evolution to see the market grow and develop through that time.

Paul O'Connor:

Would have been exciting times working on the old ASX floor back in the '80s and during the '87 crash. And then as you say, in '94 you experienced the volatility in the bond markets there, so a bit of a baptism of fire in both asset classes for you.

Tim Van Klaveren:

Correct.

Paul O'Connor:

Tim, you heard my opening remarks on monetary policy and inflation, but what's your macroeconomic outlook, and what are the implications for monetary policy globally?

Tim Van Klaveren:

Now look, it's interesting, Paul, when you step back and when you look through history and why central banks ease monetary policy or reduce cash rates, and usually it's because of one or two reasons. That the economy is moving into a recession or there's a fear of the economy moving into recession, so central banks cut rates to stimulate growth. Or the other usual reason is because we're in the middle of a asset price correction. So you're going from a bubble, and then risky assets have fallen quite substantially, and central banks are stepping into again support markets with easier cash rates and liquidity.

Where we sit at the moment, we have neither of these scenarios. You could ask the question, why would central banks be cutting? And the key reason is that growth globally has been slowing, it's sub-trend. Inflation is heading back to central bank targets, and under those scenarios, cash rates are just too restrictive for this scenario. The cash rates are heading back to more of a neutral level, and that's a debate what that neutral level means, I think for Australia we're talking three to 3.35. The US about 2.75 to 3%, that it is a moving feast and everyone has a view on that, especially central bankers. For us, we see the Goldilocks scenario playing out. We don't see a recession here or in the US, that's more a tail risk. So at the moment we're talking a moderate growth picture with easier policy.

Paul O'Connor:

Do you agree with my thoughts that the RBA will want to see inflation sub 3.5% before they'll consider cutting the cash rate? And when do you think the cash rate will be reduced?

Tim Van Klaveren:

Look, I think we go off what the RBA always states, so they want to have confidence that inflation, that is the true mean inflation, will get back in that band of two to 3% range, and when they have confidence that that will be achieved, they will look to start to ease monetary policy. If you look at the last CPI printouts for Q2 this year, it came in softer than what the market had expected. It came in around 0.8 when the market expected 1%. Market talk at the moment is that the Q3 number will come in around 0.7, so this is for the CPI trim mean. And often what you see is that people will take a couple of numbers and then look to annualise it. And I think if you take the 0.8 and the 0.7, you get 1.5, you annualise and you get around 3%.

So if the RBA started to think that that is going to be the ongoing trend, that Q4 comes out at 0.7 as well, they could see that we're going to get back at least to the top of the band, if not within it, and that would then give them the confidence to ease. Now in terms of the timing, we've always been of the view that's probably going to occur early 2025, let's say February. I think by then they'll have that Q3 print for the inflation trim mean. So they'll have three trim mean numbers, and if it does come out at 0.7, as I say, that could be the trigger as well as the number that's going to come out the 30th of October, which is the Q3 one, to ease policy.

Paul O'Connor:

And I would suspect also that the unemployment rate will not have any negative impact on that potential easing of the cash rate either given it's still at historically lower levels.

Tim Van Klaveren:

The unemployment rate is an interesting one because you're right, it's still low. We think it's going to head up, but when you do a breakdown of the unemployment rate or even employment, there's a big difference when you look at where the higher end has been going between public versus private. So that's something, when you look at growth here locally but also employment growth, it's been very much supported by the government sector. So more and more jobs now are going into the government sector, and more and more the growth here locally is being derived by government spending on top of the strong immigration. Consumers here, on a per capita basis, are effectively in recession, they've been hurting for a long time. It's the government sector that's been keeping nominal growth here to where it's been.

Paul O'Connor:

That's well understood in Victoria, I guess, particularly with the big build project and what have you there, the fiscal expenditure of the Victorian government.

Tim Van Klaveren:

Exactly.

Paul O'Connor:

We've all heard how the RBA was slow to raise the cash rate compared to other developed markets or developed market central banks when inflation was rising. So is this why the RBA also appears to be slow to cut rates compared to other developed market central banks?

Tim Van Klaveren:

An interesting question, and I think if you bring it back to basic fundamentals, we've always had the view that the Australian economy is about three to six months behind other major markets, in particular the US, so in terms of the growth cycle and inflation cycle. So that's part of the reason why the RBA has been slower. But again, it's a perception because when you look at when the RBA hiked versus when the Fed first hiked, the Fed hiked in March, the RBA hiked in May. So it's really a two-month difference, and let's call it three months for my argument's sake to put it in that three- and six-month window.

But yeah, when you look on the other side in terms of the easing cycle, the Fed, as we know, eased and eased by 50 points in September. And as I've mentioned, we think the RBA will act in February, March, so that gives you six months, but I think it's more the cycle. We also know the RBA hiked less than what the Fed did, but we also have a different monetary policy transmission component here in terms of we're floating, they're fixed, we've got a highly levered consumer, they have a less highly consumer levered, a heavily levered consumer. So there are some key differences. I think the RBA, rather than being slow, they're more acting based on the economic cycle.

Paul O'Connor:

If we're moving into a period of more accommodative monetary policy, what will be the implication for fixed income markets, and how do you start to position for such an outlook?

Tim Van Klaveren:

Another good question. So we're definitely well entrenched now in the global rate cutting cycle, and we expect this to continue through 2025 globally and potentially into 2026. We'll firmly be due at the end of 2022 into '23 that the central bank rate hiking cycle was coming to an end, and that at that point in time the best way to reflect strategy is to get long duration. And a long cycle has taken a bit longer than we thought to play out, but now that cash rates are moving lower and we expect bond yields will follow lower as well, though what you'll see is that the actual magnitude and pace of these falls will be different in different countries. And as we just spoke about here locally, the RBA will be slower in terms of easing rates, and the magnitude will be less than what you see in other markets.

So you definitely want to be long duration, and we have a bias at the moment to be along the front end of yield curves because usually shorter data bond yields rally into a rate cutting cycle more than what you get in the back end of curves. I think what is key because if central banks are going to move at different times and different paces, you want the flexibility to express that long duration position in different markets. So the flexibility to move between different markets and express different views, I think, is going to be key. Because if you're locked into a very narrow base of where you can take your risk and it is just purely on Aussie interest rates, that could be a more difficult task to deliver after because the market won't just go in one direction too, so you want to be able to move your risk around to where the best opportunity is.

Also, we think this Goldilocks scenario of a soft landing is the most likely scenario that will play out. And if that's the case, then credit, especially Australian credit, can continue to deliver reasonable excess returns. All-in yields here in Australia still look attractive. The expectations here is that credit can still be a good place to invest.

Paul O'Connor:

What toolkits are available to fixed income managers to navigate markets with more normalised rates, Tim? And do you take on more and more interest rate duration or interest rate risk in your portfolio and reduce the credit risk compared to the last five years say?

Tim Van Klaveren:

Again a good question. I think, again, the journey we're about to go on and the journey your manager may take you on, I think for those that can, I think you need to be tactical. You have to be very cautious of when you put your risk on and when you take it off. As the old saying goes, make hay when the sun shines, and when it's not shining, you want to take that risk off and lock in your profit. I don't think what we won't see this year is a straight line move. There will be volatility. There are a number of risk events that are coming up, being geopolitical or on the election front. I think having the ability to move across different markets will be an important place to be able to manage the cycle and place your bets in those opportunities that are going to give you the best risk adjuster payoff.

I think that's something that working for a group like UBS Asset Management, being global, having boots on the ground in numerous markets gives us that not only information advantage but the ability to take bets out of a bigger pool of choices. So we're not forced into a narrow group. We're always forced to put risk on and put risk on at not the right time. We have a bigger pool and a bigger market we can trade in, and it's very much around placing your bets for the best high conviction payoff trades.

I think where the rate cycle has just started, so we are on the journey for lower yields overall into '25. Credit, you have to be a bit more cautious. In the US you are now down or close to multi-decade lows with credit spreads there being an 81. Australia is not. So we have a bias towards the shorter duration, higher quality markets of which Australia is one of these markets. So we think the Australian credit market can still deliver pretty attractive excess returns, but you'd also need to be nimble. As I say to investors, it would be nice if Australia drove global economies or global markets. It's often the other way. So again, it's something where we're lucky having that insight and people on the ground globally that give us the heads-up on when we should be taking a risk off or moving our portfolio to better reflect of how the market may trade.

Paul O'Connor:

What are the key risks that you're paying attention on at present in relation to the portfolios?

Tim Van Klaveren:

Political and geographic risks seem to be the biggest risks at the moment, but I also get a sense, if I could use the expression, FOMO, fear of missing out, that I'm seeing and sensing with some investor groups that are just chasing returns and potentially not paying enough attention to what they're buying in terms of the embedded risks and returns that potentially can come from the investments that they're placing the money in. If you look through past cycles, increased risk, increased leverage and poor quality assets can often lead in disaster. So I think we're at that point in the cycle, especially in credit, where I think where you do have your money and who you have the money with, you need to be very careful. Just don't go for the highest promised return. Ask a lot of questions in terms of what you are buying.

Paul O'Connor:

So we've all seen the increasing, I guess, investor interest and fund flows into passive benchmark exposure in fixed interest. But is the current environment actually conducive to active fixed income now, and what should investors be considering?

Tim Van Klaveren:

Another very good question, and it's something we confront when we talk to a lot of advisors who a lot of their client base, I think from the experience that they've had through the period of 2020 and maybe even '22, they decided to move into more passive exposure than active. And look, I understand when cash rates were close to zero, government bond yields were close to 1% and credit spreads were tight, it was definitely harder for active bond managers to deliver a lot of active alpha. So the whole debate about net returns became front and centre in people's mind.

But I think once we got into 2022, that all changed when volatility came back. And if you look over the last two years, 2022 was very much about trying to preserve capital, so trying to lock down as much risk as you could and having the firepower in the armoury once valuations came back, which they did in early '23, to be able to step up and put risk in the portfolio. If you look, for example, in our funds, so we did a great job in '22, we locked down risk. And then in early '23 when valuations came back, bond yields are at multi-decade highs, credit spreads had moved out to quite attractive and extreme levels, we were able to step up and put a lot of risk on.

So we added a lot of credit risk, and we put on some reasonable duration risk as well, long duration. That has meant that this year our Australian bond fund has added 239 points of alpha. Now these are gross numbers. Our credit fund is up 542 basis points, and then our diversified fixed income fund is up 257. Now that's the one-year number. The two-year numbers and three are also attractive, so I think the key point to save, you are in a passive investment, you've left a lot of return on the table. And the difference between active fees and passive fees these days aren't as wide as they used to be, and for a bit of extra fee, you get a lot of extra return. And I think going forward, markets are definitely going to be more volatile. They're going to be potentially more liquid, so there will be ongoing opportunities for active managers. As long as they have an extensive toolkit to add alpha, those opportunities will be there to be had.

Paul O'Connor:

Fixed income's always been used as a defensive play in diversified portfolios, and I guess essentially due to the low correlation, duration particularly has had two equities. But what roles do you think fixed income can play in a diversified portfolio? Is there anything further than just really trying to play a defensive nature?

Tim Van Klaveren:

Look, I think and if you look at this year to date, you can make some good returns. So people think back to 2022, and I think the Australian AusBond Composite Index, at its worst, delivered a negative 12.5%. But if you look this year, I mentioned the alpha in our Australian bond fund, but the gross return year-to-date September is up 9.5%. So you've got potentially very attractive total returns from the running yield plus capital gains when spreads come in. But I think also just back to that defensive characteristics, yes, fixed income has always provided that negative correlation versus your risky assets, some capital protection and a predictable income stream.

So I think all those characteristics are still there and are important in a diversified fund. We've done a lot of work internally. What we found is that when inflation is high, as in greater than 3% that we saw through 2022, then correlations between fixed income and other risky asset classes becomes more positive. And we saw that in '22 as bond yields and credit spreads went wider and other risky assets came off. But as inflation gets down towards 3%, which we are moving down towards now, then that negative or less positively correlated benefit comes back into play. And that's where I think we're moving to. So I think going forwards, that's where the fixed income will really come back into being an important part of a diversified fund, as you say.

Paul O'Connor:

And I guess, too, I've noted over probably almost the last decade now, the increasing amount of more aggressive fixed income funds in the market and funds that have a large exposure to, example, tier one securities. So I guess in my mind most fixed income strategies still have that defensive role to play, but there are an increasing number of strategies that can be accretive to returns and not just pure defensive. But I guess that the investor needs to do their homework and understand each strategy before they actually allocate money into a certain fund.

Tim Van Klaveren:

Yeah, no, 100% agree on that one. And I think also, to your point, there are more aggressive strategies out there. Are they fixed income or would you classify them as more alternatives? So I think that's where the investors, like you say, have to do their homework in terms of understanding what they're buying and then what bucket do you put that exposure into.

Paul O'Connor:

It's probably caused more discussion and interaction with managers than any other issue in that our investment menu has defined investment categories. And a lot of these more aggressive fixed income strategies, you are correct, that we have to alternatives, but at times it can provoke some interesting debate and discussion with the managers that are offering those products.

Tim Van Klaveren:

I can imagine.

Paul O'Connor:

What impact do you think can the current geopolitical risks, and you touched on the coming US election, but also the increasing, I guess, view that China will unleash more stimulus? What impact can those types of issues have on fixed income markets, Tim?

Tim Van Klaveren:

Look, I think with geopolitical risks, it's always difficult to predict how the event will play out and also the timing of the event. But under most circumstances, geopolitical events usually lead to a risk-off event in markets which normally see bond yields fall and other risky assets selling off. So under most scenarios, especially short-dated fixed income should perform very well and this is why you need fixed income in your portfolio, as we say, as that diversifier.

In terms of the Chinese fiscal and monetary stimulus, the way we're looking at that at the moment is first off, it reduces the downside risk for the Chinese economy. Things were looking very weak there for some time, and there were broader concerns about how weak their economy could get and how that could actually impact the broader global economy. But now we've seen some fiscal and monetary stimulus. I think on the monetary stimulus side, we still need to wait to hear how far they go and to what extent. For the moment, I think what we're seeing is definitely putting a bit of a floor under the economy in terms of the potential weakness that could have come through. In terms of a big growth boost and a big impact on global markets, we wait to see a bit more detail, especially on that fiscal side to see if the stimulus, there's a few more rounds of stimulus that may come that would have that impact. Because at the moment I think globally it's more reducing the risk impact rather than adding to a lot of global stimulus.

Paul O'Connor:

And I guess if China does unleash a significant stimulus package, it'll be good news for Australia ultimately in our commodities.

Tim Van Klaveren:

Great for growth, great for federal and state budgets, maybe more challenging then for the RBA to ease rates. So maybe not good for the mortgage owner, but definitely good for other parts of the economy.

Paul O'Connor:

What specific segments of the bond market look the most favourable to you now?

Tim Van Klaveren:

As I touched on earlier, I think we like long duration short data Australian and New Zealand interest rate markets. The RBNZ, for example, took their cash rate way above where the RBA got to. The New Zealand economy is in recession. The RBNZ lose 50 points, we expect the next one to be another 50, potentially people talking 75 points there. Yes, there's still a long way to go in New Zealand in terms of how far cash rates can fall. So we like exposure in Australia and New Zealand, as I said. Also the political risk, especially in the US and if either party gets in, Harris or Trump, the Republicans or the Democrats, there's concern around fiscal stimulus. Again, we see the risk to that scenario is probably bond steepness. So we've got steepness in the US and Germany. That means we're along the front ends of those curves, so particularly in the five-year part of the curve, and we're short in the 30-year bond.

And as I said on a couple of occasions, we also think that Australian credit remains attractive compared to other global markets, but the cycle is longer in the tooth. So you just need to be very careful where you place your bets and put your risk. But when it comes to this now, this type of market, a lot of it, the credit beater may have less to go or to provide, but that's where very much your security selection and relative value trading then starts to kick in. And there have been a number of deals that have come to market, and our next question is around tier one, but in particular we saw an ANZ New Zealand branch tier one bond come to the local market in the wholesale space, and that was a great deal, and it's done exceptionally well. And even bonds like Centagroup did a sub-debt deal here, that's traded exceptionally well. So there are pockets of value there to be had.

Paul O'Connor:

Maybe to finish there, Tim, I couldn't let you go without having a chat about the recent APRA notification about the change in regulations on tier one securities. But with what appears to be hybrid or tier one securities disappearing from issuance, are there any alternatives for investors seeking higher yielding subordinated fixed income securities? And I know our platform, the Netwealth platform, we've got a significant holding across super and IDPS and hybrid. So are there other alternatives in the market?

Tim Van Klaveren:

Yeah, a very interesting decision by APRA, and a number of people have very strong views around that decision. Just for interest sake, our income solutions fund, which is our credit fund, back in 2002 before I went to London, that was the first hybrid fund that came to market and was very successful. Tier one securities or hybrid securities have been a great hunting ground for us in the past. The one thing I would say, though, I've never seen tier one as a core fixed income allocation. I think that's one thing where our market potentially has things a bit wrong, that something we are always pushing up against as a bond is a lot of money gets put into tier one securities and then maybe term deposits, and that's where clients see their fixed income allocation going to. But all the things we spoke about before about what traditional fixed income characteristics provide in a multi-sector portfolio are neither tier one or term deposits provide.

So look, it's sad to see them go, but what it could actually be is a great opportunity that could lead to a lot of investors taking a more broader view of fixed income, and it'll be a great opportunity for people to start to potentially rotate their money into traditional fixed income like a bond fund or even a credit fund, which will provide attractive returns. As I mentioned before, year to date the bond fund is up gross 9.5%. Our credit fund's up 9.75%.

So again, attractive returns versus, say, a hybrid security. But they also not only just offered them all the diversification, but they also offer some of the negative correlations that you wouldn't get with tier one. Look, this could be a blessing in disguise that maybe you see investors move, as we say, offshore into holding more diversified defensive fixed income and away from a large exposure to Aussie banks. Because if you step back and think of what a lot of mums and dads have as private investments, not only in a direct sense but through their super, they had the tier one, they had equity and then turned deposits. It's a very concentrated exposure to a very small subset of the market.

Paul O'Connor:

Very much a barbell exposure in their portfolios the way I see it, Tim. But I think you touched on what probably drove APRA's decision there in the fact that some people have chosen to use tier one securities as a defensive allocation in a portfolio. And I guess the fact that the main investor in tier one securities appears to have been the retail market. So it got APRA quite nervous, I think there, that forced their decision.

Tim Van Klaveren:

And as I say, unfortunately, I think a lot of people see tier one just as a potentially high yielding turn deposit, and it's not. It's loss absorbing, so it's one step away from equity. And not that I would say our major banks are in any place of a major negative event. They're well capitalised and very profitable, as we know. But yeah, those securities are there for a reason. So it's not as if they're bailable and investors can lose their shirt if things did go bad.

Paul O'Connor:

Tim, I think in the interest of time, we'll draw to a close the Netwealth Portfolio Construction Podcast for today. It's been an interesting discussion, one I could, I think, just wander on with you for another few hours. We won't subject the listeners to a three-hour podcast, but thank you very much for joining us today. I think you've made some really key points there, the main one around the central case of a soft landing in this economic slowdown. And let's hope that is correct and that hopefully we may see some cuts to the cash rate in early 2025 and a bit of relief for the Australians that are struggling under significant mortgages there as well. So thank you very much for your time this morning, Tim, and I've appreciated your discussion.

Tim Van Klaveren:

Thank you, Paul.

Paul O'Connor:

And to the listener, thank you again for joining us on the podcast series. I hope you've enjoyed today's discussion with Tim Van Klaveren from UBS. And I'll look forward to you joining us on the next instalment of our podcast series. Have a great day, everyone.