Paul O'Connor:

Welcome to the Netwealth Portfolio Construction Podcast series. My name's Paul O'Connor and I'm the head of strategy and development for the investment options offered by Netwealth. Joining us for today's podcast is Brett Lewthwaite from Macquarie Asset Management, or Macquarie, who's the Chief Investment Officer and Global head of Fixed Income and based in Sydney. Good morning, Brett. Great to catch up, and thanks for joining us for today's podcast.

Brett Lewthwaite:

Yeah, good morning Paul, and great to be here. Looking forward to our discussion today,

Paul O'Connor:

Given how topical inflation and interest rates are at present, I think this podcast recording's quite timely, and looking forward to hearing your thoughts and insights into where markets and rates are headed. So, hopefully you've got the crystal ball with you today.

Brett Lewthwaite:

I'll do my best. There's definitely lots to talk about, that's for sure.

Paul O'Connor:

Brett oversees Macquarie's fixed incomes, broad range of investment capabilities globally, including global fixed income, multi-sector, credit and insurance, emerging markets, debt, and municipals. He's also been the lead portfolio manager of the highly regarded Macquarie Income Opportunity Strategy since 2004. Additionally, he serves on Macquarie's Public Investments executive committee. Brett has more than 25 years of experience in financial services, and previously led Macquarie's fixed income teams in Sydney and London and became a senior credit portfolio manager in 2004. Before joining the firm, he worked as a portfolio manager at BT Funds Management for nine years.

Brett holds a graduate degree in applied finance and investment from the Securities Institute of Australia, as well as a Bachelor of Agricultural Economics from the University of Sydney. Macquarie is a large Australian-headquartered investment manager with fixed interest personnel based in Sydney, London, New York, and Philadelphia, and is one of the operating divisions of the ASX-listed Macquarie Group. Macquarie is a multi-discipline asset manager, managing assets across fixed income, Australian equities, and property. As of 30 June, 2023, Macquarie managed 864 billion in funds under management, of which almost 300 billion was in fixed income and currency. Macquarie has been managing fixed income and cash assets since 1980.

The Netwealth Super and IDPS investment menus include 14 Macquarie funds, and an additional 12 Macquarie professional series funds, covering Australian and international equities, fixed income, global macro, currency, and property. The menu includes four fixed income funds that Brett works on, including the highly successful income opportunities fund. So after a decade of benign interest rates where the cash rate reached close to 0% in Australia and many developed countries, the last 18 months has seen surging inflation that's driven rising cash rates and bond yields as markets try to adjust to higher levels of inflation. Current conditions are unlike any other period I can recall, where not only are rates and yields rising whilst inflation remains persistently high, but unemployment is at record low levels.

This environment must be creating challenges for fixed income managers that many would've never experienced. We could postulate on what's been the driver and has caused inflation to rise, but I think issues such as the huge fiscal stimulus response to COVID, central banks' movement from quantitative easing to quantitative tightening, and low unemployment have all contributed. Inflation's typically caused by either demand pool, i.e., the consumer, cost push, i.e., the supplier, and rising prices and/or expectations. So I'll certainly be interested in Brett's view on the fundamental drivers, but also, his outlook over the medium term.

Brett, you're a long serving member of Macquarie, and I recall when the income opportunities fund was first launched back in the early 2000s. So how have you maintained your passion and your interest in navigating markets?

Brett Lewthwaite:

As you rightly point out there, Paul, it's incredible. The Income Opportunities Fund just had its 20th birthday, and you do wonder where the time went. Passion and interest I think in markets stems from... It's always a fascinating challenge. We can't exactly know what happens next, but how you try and collect as much evidence as you can with a group of people that you hope to work with for many, many years, creating that stable team environment, having a consistent approach that tries to navigate those things the best way you can, I guess it's the game that never really ends. So really enjoying it and being passionate about and enjoying all the ups and downs is a big part of that. And to this day, as I said, I can't believe the years have ticked by like they have, and here we're in I guess the latter part of 2023, and there's another exciting twist in markets and perhaps some of the most exciting opportunities, particularly in fixed income that we've seen for many years.

Paul O'Connor:

Yeah, you must be quite proud of the growth of the business over that two decade period. I'm not sure what Macquarie was managing in fixed income and cash 20 years ago, but it wouldn't be anywhere near 300 billion what you're managing today. So well done on the growth of the business.

Brett Lewthwaite:

Thank you. No, that's great. Appreciate it. It was probably about 30 billion back then, so it has really gone up. I mean a couple of acquisitions in there, but a lot of organic growth too, out of, I guess, a sense of incredible platform. So it's been an incredible journey. Thank you.

Paul O'Connor:

So, moving into the questions for the podcast today, clearly we've seen some very dramatic moves in bond markets of late, so perhaps the natural starting point, can you talk us through your current thoughts on the bond market and the drivers of the latest increases in rates?

Brett Lewthwaite:

Yeah, it's been quite interesting, isn't it? And it's probably some intertwining themes, and as we quite often like to say, it's choose your own narrative, but I think we can probably work through it and sort of drill it down and at least put some emphasis on what's probably been driving things. There's no doubt, I guess the resilience in the global economy, particularly the US economy, there's definitely been one of those themes in the face of what is the most aggressive monetary policy tightening cycle in 40 years. So far, I guess the long invariable [inaudible 00:07:22] of monetary policy hasn't had as big an impact as many thought, and some of the recent economic data has been a little bit more upbeat than people thought. So this sense that the economy is more resilient I think has been playing a role in that. You've heard that from central banks who are talking about concepts like hire for longer, and I guess that has leaked its way into market narrative as well and probably been playing a role.

But one of the more interesting aspects is the confluence of the debt dynamics in the United States. This year has been quite interesting in the US. The debt ceiling debate back in May was drawn out a little bit. There's still challenges going on with who's going to be the speaker of the house, but ultimately, as that's been resolving itself, the market's become aware that the deficit this year in the United States is much greater than previously advised. A lot more supply or the need to borrow from the US Treasury is playing a role. So lots of supply plays a role. And on the other side of it, interestingly, I'm sure we'll talk about this a little bit later in the podcast, is that quantitative tightening, whilst it's been a background feature, hasn't really played much of a role in 2023, but as we turned into September, central banks were again sort of entering that sort of quantitative tightening phase. And we don't think it's any coincidence that perhaps the volatility in all markets, but in particular at the bond market, is a function of some of that quantitative tightening.

Now, quantitative tightening is essentially the Fed letting its balance sheet roll off, so it's no longer buying US treasuries amongst things like mortgages as well. And so that supply dynamic where the treasury is needing to borrow more money than some of the biggest buyers, Fed themselves going from emergency QE around the banking crisis to now QT in the latter part of the year, is creating a bit of a supply-demand imbalance. And when there's a lot of supply of assets, generally the prices fall, or in the sense of bond markets, yields go higher. So our sense is that there are intertwining themes, but we shouldn't discount this sense that quantitative tightening, it plays a draining of liquidity role in markets, pushing yields higher and assets lower, at the same time as this deficit situation in the United States is lined up as well, creating a little bit of angst as to who's going to fund the US government and at what rate.

Paul O'Connor:

It almost sounds like some level of dysfunction between the Fed Reserve and the government on that on one case you've got the government still running, the US government running significant deficits, but you've got a bit of a liquidity drain coming from the Fed it QT. But we'll get into that a little later in the podcast. But so how do you reconcile the recent shift of higher bond yields with the current prevailing economic data?

Brett Lewthwaite:

It's quite difficult to do that. I mean, if you look at statistics coming through around the economic environment, it's not necessarily that growth has picked up and is it running at a much higher level, or there's a start of a new cycle. I guess the data's been better than expected, but it's still fairly low rates and I think people are still somewhat concerned about the growth outlook, particularly of the global economy, so it's hard to reconcile it from that point of view, and even from an inflation point of view. Yes, there's heightened geopolitical risks with the Middle East at the moment, perhaps supporting oil prices and the risk of a shift higher again in energy, and perhaps that plays at the inflation rate. But you're not really seeing that flow through to things like inflation yields and the like. So it's hard to believe that inflation is the driver as well.

And so as we work through these what could be driving the move, you're left back at that sense of the demand-supply imbalance around lots of issuance required at the same time as many buyers being absent. And it's not just the Fed that's absent as well. It's some of the previously larger buyers, people like China, for geopolitical reasons they're not buying anymore either. And other big buyers of treasuries in the past, like Japanese investors. They're also being somewhat encouraged with much more attractive yields back home in Japan to perhaps invest less than in treasuries and more in things like Japanese government bonds. So all these things are playing a role, but as you tick them off, it becomes increasingly clear that it's more likely that supply-demand imbalance that's driving the shift, even though there's other influences that seems to be a significant driver of the most recent shift higher anyway.

Paul O'Connor:

Historically, market cycles have had their unique characteristics. You never get two absolutely identical cycles. So in what ways might this cycle be different?

Brett Lewthwaite:

Yeah, it's interesting, isn't it? I think it's quite often something that is embraced by market commentators when you're experiencing monetary policy tightening cycles. And this one, keep in mind, is a very aggressive one. So everyone I guess congregates around all the reasons why this time will be different. The saying goes, "It's never different this time." So I think it's worth at least highlighting that. Of course, this time around, I guess the flow and effects from the pandemic are still with us. So whether it is the changing of work environment or employment habits, tight labour markets, all the fiscal policy that was utilised and how that is gradually drawing its way down, all of these things could perhaps be reasons why this time is different.

Even things like the onset of AI, which has really captured market attention, I think all these things do lead themselves to perhaps nuances in this cycle, but I think we need to keep our feet grounded and say there's always reasons why this time could be different, but the weight of evidence, particularly in the face of such aggressive monetary policy tightening, and you can see that work its way through things like credit tightening in the financial system. These patterns are very familiar to ones of the past, and they generally do indicate a recession of some form is coming regardless of hopes or beliefs that perhaps this time could be different.

Paul O'Connor:

In light of the narrative of the resilience in equity markets, do you foresee a possibility of a soft landing. You've just touched on the comment around a recession could be coming. So could you talk maybe a little bit more around your thoughts there and how deep that economic slowdown could be?

Brett Lewthwaite:

Well, I think it's probably a couple of components to that question that we could focus on. I think the first thing is that all market commentators seem to be looking at the economy as a key to the way forward. Look, that makes sense, but a soft landing in the economy doesn't necessarily mean a soft landing in financial markets. The economy in financial markets haven't necessarily been in complete sync since the financial crisis and the onset of the age of all that trillions of dollars of quantitative easing. There's been quite the disconnect there. So I think we've got to be careful that a soft landing in the economy then translate to a soft landing in markets. That may or may not be the case, but I think the risks to financial markets are much greater, given such a significant change in interest rates or the cost of capital, and also such a significant change in liquidity dynamics. We've gone from QE to QT.

So I think the first thing I'd say there is let's not get too focused that one equals the other, because quite possibly, you could have a soft landing in the economy, but I don't think that necessarily means a soft landing for financial markets. The second thing is around that resilience piece. There is a sense out there that this year's been a very strong year for equity markets. And on the surface that's what it looks like, but if you scratch a little bit closer, what's actually taking place is that the so-called magnificent seven, which I think everyone's become aware of now, so there's seven mega tech stocks, they are largely driving all of the equity market performance. So I think some of those north of 30 to even 60% up year-on-year, and I think Nvidia is even 180% up year-on-year.

But if you actually took those seven stocks out, the remaining almost all the equity markets are pretty much almost flat, slightly down. And so I guess what I'm saying is that it's very narrowly led, and that halo effect that we're getting is the sort of assisting the broader narrative or the sense that the equity market has put in impressive performance this year. Now look, that could continue, those narrow large mega tech stocks could continue to drive that sense forward, but equally, I guess they could be vulnerable to a setback. But I think that sense around resilience and equity markets is on closer inspection, it probably something to be a little bit more cautious about than perhaps read into. It's a sign that this time is different.

Paul O'Connor:

Yeah, it does amaze me how resilient the equity markets have been no matter what the news, really, over the last 15 or 20 years. It always seems to get back up there, but it will be interesting to see, and interesting your comments there too around the fact that such a small number of stocks have really been responsible for the total return on the S&P 500. The higher for longer narrative suggests if the economy has a no or a soft landing, then financial markets will weather the slowdown, and potentially equities, the impressive performance of equities may continue. Is this how you see it playing out, or is that a bit of a blue-sky view?

Brett Lewthwaite:

Yeah, it's interesting. I think higher for longer to some degree leans towards that. This time is different, and there's immaculate transition from zero rates and lots of QE to a world of a much higher cost of capital, and liquidity drain can somehow be seamless and we can now operate in a very indebted world with higher interest rates. And just saying it like that, it doesn't really make a lot of sense.

And so I think that concept that it proves to some degree that there is a soft landing, I'm not sure is the right way to think about it or is something to celebrate, so to speak. Perhaps the higher for longer is probably the more cautious we probably should become. And I'll touch on this a little bit more as we speak further, but I think financial markets, they're dealing with aggressive monetary policy tightening that has led to credit tightening.

And at the same time, central banks are trying their best to do liquidity drain, liquidity tightening, quantitative tightening. That is a significant amount of weight pushing against the forces that were previously supporting financial markets. And again, I point out that focusing on the economy is one thing, but it's really financial markets that benefited the most from zero rates and QE, and it's therefore financial markets that have to adjust the most from a much higher cost of capital and much higher interest rates, and without that liquidity impacts even liquidity draining. And that's a stark change in operating conditions. And so I think in terms of that higher for longer coming through and validating the soft landing is not necessarily congruent to what that means for financial markets. I think the higher for longer, the more cautious we should be here. And I think looking at history, I mean central banks quite often talk about being back at normal or at much higher levels for much longer, but history suggests that those periods aren't anywhere near as long as central banks hope or intend for that to be.

Paul O'Connor:

Moving to monetary policy, there's been such a significant rise in cash rates and yields over the past 18 months. So can you give us what the team's views are on monetary policy, and have central banks been sort of behind the eight ball or sort of do you believe in front of the eight ball, so to speak, in terms of inflation and tackling the issues there?

Brett Lewthwaite:

They were probably a little bit late to begin with, but once they appreciated that the inflation situation was more significant and perhaps more prolonged than they originally anticipated, they have undertaken the most aggressive monetary policy tightening cycle since the late '70s. And so we haven't seen anything like this in over 40 years. It's broad, it's fast, and it's very steep as well. So it's happened in a very short amount of time, and monetary policy does work with long and variable lag, so we don't fully appreciate some of those impacts yet. It takes a while to make its impact in the economy. So it's aggressive. We haven't seen anything like it for 40 years, and every other cycle in the past 40 years has been far more gradual and far more drawn out. Now, part of the reason for that is the buildup of debt in the financial system has been bigger and bigger and bigger each time, and this time's no exception. Between the last hiking cycle and now, there's even more debt in the system.

And as we all know, higher interest rates and high debt levels don't dance well, they don't go together. You either have one or the other. We are experiencing a very aggressive monetary policy tightening cycle into a very indebted system, and I think it's naive to think that rates don't matter. They absolutely matter. It just takes some time here. So our sense around monetary policy is that they've done a lot very quickly. You can see the effects of that moving through to credit tightening. You know that there's liquidity tightening coming through as well. And so they're most likely at the end of their hiking cycle. Now because of geopolitical risks and perhaps the sense that inflation's sticky, they might have to do a little bit more just to make sure that's okay. The reality is the bulk of that move is behind us, and we need to be thinking about what end of cycle looks like, and how to take advantage of that, particularly in our fixed income portfolios.

Paul O'Connor:

So why might we not yet be witnessing the full effects of this aggressive monetary tightening, despite its ongoing implementation?

Brett Lewthwaite:

The saying is monetary policy works with long and variable lags, and history suggests that the lag is somewhere between 12 and 18 months. And I think we ourselves would have to admit that we thought, given the debt levels, that the variable lags wouldn't be that long this time, but at the moment, we're sort of tracking a fairly average amount of time. So right here right now is where you would start to see some of the more aggressive hikes that we saw in 2022 start to really roll through the economy. And that's because not everybody refinances their loans on the same day. People turn out their funding, different borrowers at different levels, so it just takes time. But each and every day, somebody somewhere is obviously moving from a low rate to a much higher rate, and that each interest expense really starts to bite. But those longer variable lags are, on average, let's call it 15 to 18 months.

So if we take that back from here, we're sort of starting to get back to when the hiking cycle was just beginning. And so the bulk of that tightening and its impact on the economy is actually in front of us here at the end of 2023 and end of 2024. You can see that in the patterns as we've talked about a couple of times already, as the monetary tide goes out. At first, there's small things blowing up here and there, and I think this time around you could probably point at things like Bitcoin and NFTs and some of these things that seem to not make any sense at the height of the last cycle really started to get into trouble. But as time goes by, things break. A sign that the monetary policy tide is going out, bigger and bigger things break, and we saw that back in March with some of the very large regional banks get into significant trouble, and fail.

And so that is a sign of that monetary policy getting through. And as a result, the banking system and even the shadow financing system then responds by tightening lending conditions, which is the natural flow on from aggressive monetary policy tightening. It then leads to credit tightening, and we saw that in March. And then there's a lag of, say, six to nine months before that credit tightening starts to affect the real economy. So again, March plus six months is September through to December, and so you've got that monetary policy converging at the same time as the credit tightening converging. And on top of that, this time central banks are hoping to continue to draw down their balance sheets with liquidity tidying. And so most of that is sort of in front of us rather than behind us, and largely probably explains why, to this point, there's that sense of resilience. And so the real test if we're going to weather it is the coming six months, I'd say.

Paul O'Connor:

So moving from monetary policy to extraordinary monetary policy, which was quantitative easing and now moving to quantitative tightening and the potential liquidity drain, how do you assess the transition from a decade of QA to the current environment of liquidity, contraction and QT?

Brett Lewthwaite:

In a number of our presentations throughout that QE period, we would say things like, "I know, you know, we all know that QE is good for asset prices, providing ample liquidity, that's chases and tries to find a home." So there was a significant chase for yield. So interest rates were more or less zero, there was ample liquidity, and essentially permission to try and chase and get that yield. That's very, very different to what we're facing now. And I think we've seen a number of episodes where central banks have entered or tried to enter an environment without QE and then entering into QT, so, in other words, liquidity drain. 2022 was a year where central banks' net net were draining liquidity from the system, and it was a very difficult year for financial markets. The surprise this year is even though the intention was to continue on with it, things like whether it was the LDI crisis in the UK or the regional banking situation in the US, it required central banks to provide emergency liquidity, in other words, provide more QE and push more liquidity in.

So 2023 has actually been a year of net QE, and it's only really now in the latter parts we're transitioning to QT. And whilst very few people talk about it, it just so happens to coincide with the more recent volatility that we've seen picking up since the beginning of September. And so our sense is that QT situation is far more problematic for financial markets than anyone generally focused on and talks about, and I think if you think about 2022, it affected all markets. It was bond markets and equity markets. And once again, it feels like it's doing that again, albeit with some of those supply-demand imbalances that we focused on in the early part of this situation.

So I think that transition, particularly for financial markets, is very well worth understanding it and keeping an eye on. If indeed liquidity continues to drain, we think it's going to be a pretty challenging environment for asset prices, keeping in mind though that central banks can change their mind or if more things break, they can turn around pretty quickly. So keeping an eye on whether QT is continuing to occur or whether in fact central banks have become concerned about the volatility it's creating is something we definitely have to focus on in the coming three to six months.

Paul O'Connor:

So there's been so much discussion there about US government bond issuance, and also to your comments about the Fed seeking to implement QT. So what does that mean for the bond market from a technical perspective?

Brett Lewthwaite:

We've sort of seen that move over the past few months, and we think this is definitely playing a role and potentially a large role in that. And it really is a supply situation where there's a lot of borrowing required, at the same time as the Fed is trying to add to that supply by doing qt. In other words, it's letting its balance sheet roll off, adding to the need to borrow more or issue more bonds, and they aren't on the other side as one of the most significant buyers. At the same time as Russia, China, and obviously Japan, some of those incentives aren't there as well. So that, I think, is definitely playing a role. There's probably a limit to what can occur there. There is a lot of funding that's required. It's possible that because of the overall yield level now, which is very attractive, particularly compared to what we've seen over the past 10 to 15 years, that natural market buyers, whether they're insurers or real money managers like ourselves, continue to buy these attractive yields.

A risk off move in equities might see a flight to quality take place as well, and perhaps that would help that demand side of the imbalance start to pick up and perhaps market settle down. But if that isn't the case, you could start to see even more volatility there, and it would feed on itself. You'd see volatility in the treasury market then feeding the credit market, which likely feeds the equity market. And so at some point in time, we wouldn't be surprised if you saw the fed themselves come back, and they probably wouldn't use the words QE, but they'd start to talk about some operations to smooth market functioning or to aid liquidity and things like that to perhaps temper these things. Because the reality is, I've said, is that rates do matter. Rates at these levels do matter. Higher for longer will be very challenging, and whilst a gradual level of adjustment is perhaps something that might mean that we have high rates for a period, I think the higher we go from here, given those long and durable lags are still in front of us, the more challenge it's going to become. So it's quite the situation that central banks are monitoring at the moment.

Paul O'Connor:

So I'm guessing from your comments that we haven't seen the full effects of QT and how that eventually plays out. So will this drain liquidity from financial markets, and what will be the impact on bond prices ultimately?

Brett Lewthwaite:

Yeah, well I think central banks keep trying, and as they do when monetary [inaudible 00:29:28] goes out, more and more things break. And I think there's this narrative at the moment that says, well, obviously lost a few big banks in March and Credit Suisse was forced in the arms of UBS, and look, nothing else has broken. And I think in part that's because some of the conditions that the Fed put in place to sort of ringfence the situation that was causing those problems. And so there's almost this sense that perhaps the Fed can continue to do those more targeted operations. But the true story is that, ultimately, it required emergency levels of liquidity to be put in the system. In other words, emergency programmes of QE. When we think now what are conditions like versus March, well, interest rates are slightly higher again, and here we are, central banks are back trying to drain liquidity.

And so that tide probably was on pause for maybe six months, and it's now going out again. Now things were breaking before. Perhaps this time it isn't a US bank, maybe it's a foreign bank, or maybe it's an insurer, or maybe it's something in the commercial property space. But the reality is that that financial tide and the liquidity is draining, and as we've talked about before, that one of the primary beneficiaries with financial markets, so the risk that more things break continues to go up, and it's really only that shift back into QT that we've seen since mid-September. And so if that was to allow to go unabated, then perhaps we should be more prepared for more things breaking than is the common narrative out there in markets.

Paul O'Connor:

Maybe moving to credit, in what ways has credit tightening impacted on corporate bond issuance and yields and especially for companies with lower credit ratings?

Brett Lewthwaite:

Yeah, it's been interesting. I think when you look at leading indicators, you look at senior loan offices survey, the natural patterns that would normally lead to lower equity prices, wider credit spreads, things like that, that hadn't really occurred this year. So there's a significant difference between what those indicators are suggesting credit spreads should be and where they currently are. And again, we'll probably put back to things like that narrative around resilience in the economy, the concept of AI being a game changer, but most importantly, that 2023 was actually a year of QE, not QT. And so as that QT occurs, there's that real risk that credit spreads and things now start to play catch up to where the leading indicators around the economy are pointing. So what we're saying is tighter credit conditions are slowing economy concerns around the outlook, equity market volatility, even volatility in bond markets. It's all uncertainty, and credit markets ultimately are uncertainty parameters, and the more uncertainty, the wider the spreads, and so the vulnerability should be that we start to see that take place.

The counterbalance to that, though, is keep in mind that the overall interest right now in so many of these markets is very attractive. Investment grade bonds in 6 and 7% yields, fairly highly quality companies is pretty attractive returns. And as you move into things like high yield, you're getting closer to 9, 10, 11, and further out, the credit spectrum [inaudible 00:32:28] the low teens. So some of that level we is going to attract people who are willing to lend and take that risk, given those interest rates are pretty compelling. Provided it doesn't turn into a harder landing for the economy, you can see a little bit of two-way, but ultimately, our sense is that less issuance, less credit availability, perhaps a cheaper price, in other words a high yield, some of those moves are still in front of us, and we'd still warrant a bit of more of a cautious positioning, particularly as we wait to see that full impacts of monetary credit tightening take place. But keep in mind that some of these things are attractive, and you're not going to try and pick the bottom. So it is a good idea to start accumulating some of these yields as they present themselves in the coming months.

Paul O'Connor:

Yeah, I think it was yesterday I noted the judo hybrid yield, and that was a double digit yield at the moment. So yeah, the potential out there in the market for high yields compared to what we've experienced over the last decade is certainly creating some opportunity. To try and distil everything that we've been discussing and talking about or the challenges at the moment and potentially to put yourself on the spot, considering your cautious stance, how are you currently positioning your portfolio? I guess anticipation of the potential market shifts ahead of us.

Brett Lewthwaite:

Part of this is what we're seeing in market pricing already, which is embracing more of that no or soft landing. So perhaps that's helping us with that thinking. But ultimately, when you look at the situation of that aggressive monetary policy tightening leading to credit tightening, we know when you get those two things, every other time you've ended up with a recession, and this time we also got liquidity tightening. They're formidable forces that will weigh heavily on the economy and most likely even more so financial markets. So if that continues to play out, caution is the way forward. That means accumulating duration. And we talk to a lot of people saying, oh, shall I be buying bonds here? What if yields keep drifting higher? Well, they might, but ultimately they're at attractive levels, and you're never going to go from not having too much duration exposure to the right amount in one go. We would just sort of, I guess, encourage or at least doing in our portfolio is accumulating duration of these levels, which we think are very attractive and will form in the medium term.

On the more riskier side, we've taken down a lot of our credit exposures to lower levels. We're holding high levels of cash, anticipating that we'll get to use that at slightly better yield levels as this cycle continues to play out. Cash is pretty rewarding at the moment. You're getting paid for being patient. At the same time you've got that cash on hand to take advantage of opportunities. As we know, credit markets can be quite fickle. When there is difficulties, liquidity can dry out, and so you need that liquidity on hand beforehand. So when you combine longer levels of duration, higher cash levels, and lower level of credit risk, that all comes to a cautious stance and should set us up well to weather volatility and also take advantage of those opportunities.

I'll have to say that we are washing closely, because a number of these conditions we've talked about, if indeed things like quantitative tightening was turned off, or perhaps central banks were forced to jump back in and help out with other forms of emergency QE because of breakage, that would temper our thinking, and we'd have to acknowledge that the yield level that's already available in treasuries and in credit and even high yield is already [inaudible 00:35:50] attractive. And so we'd have to go back to a neutral balance fairly quickly if indeed you started to see that shift of tightening go back to more of a neutral even towards an easing side of things. Now, easing can come from many levels. I mean central banks might maintain interest levels at a higher level, but they might decide that QT can't be done. In fact that they might need to do levels of QE to smooth some of the treasury assurance.

Some of those things would factor into sort of a more prolonged or I guess drawn out cycle that's a bit more shallower, and therefore our sense around caution would change and evolve through that. So I guess what we're trying to say is that ultimately we have for quite some time lived in a world that has had lots of policy maker intervention. More recently it's felt like central banks have gradually been moving further and further away from that. And maybe there's something more in it, but our senses as things have broken, you've seen activity from them, and that has created these sort of counter-trend moves that are quite significant, and we have to be alert to that as well. So there's definitely plenty of good reasons too to be thinking about how do we take advantage of the opportunities and what are some of the triggers that perhaps make us a bit more constructive about the outlook for things like credit.

Paul O'Connor:

Yeah, well, I guess your comments around positioning just really do sound rational to me at the moment, where if we are getting later in the cycle, I guess history's taught us you do need to be cautious about more aggressive lower-rated credit. The return that we're getting on cash at the moment is so attractive compared to what we've faced over the last 15 or 20 years. And then in addition to that, you make the comment around duration, and when you look at the 10 year, both US and Aussie getting close to 5%, you're getting some pretty good returns that if you've got a medium- to longer-term view on investing, which is what most people should have. So yeah, there might be a little bit of volatility in the shorter term around a duration positioning, but yeah, just sort of rational common sense to me there, Brett, your comments there. So maybe just to finish there, what are you actually doing then for portfolio positioning? What are the securities that you're actually looking at and purchasing in the portfolio?

Brett Lewthwaite:

I think broadly I described that overall positioning in terms of accumulating duration. So we're mainly focused on, particularly in Australia, given the interest rate sensitivity of the variable-rate nature of our housing market here. So we feel like that's much closer to the end. We're also accumulating treasuries and also US agency mortgages, which are trading at historically very attractive levels, but most of that is concentrated more towards the front end. We feel like the central bank hiking cycle is very close to its end. There's a bit of volatility out in the long end. More recently, with the volatility, we've changed the curve a little bit, but ultimately there's so many different ways we can play that out. But at the moment it's fairly cautious, mainly short end, mainly in Australia and United States. In the credit markets, it's centred mainly in investment grade where our exposure is there, but again, sort of bringing it back to more shorter end exposure rather than being out there on the long end.

So it's pretty uninspiring in terms of the opportunities, but we're keeping an eye on particularly emerging markets and high yield as places that we can take very low positioning at the moment to much higher levels. In many ways, Paul, just thinking about our conversation is that we appreciate that higher rates matter, tight credit matters, and liquidity matters even more. And those three things in particular all at once are something that we have to really focus on. One of the titles of our most recent presentations was Everything, Everywhere, All at Once, and that's a take on recessions. They happen gradually and then suddenly, and all of the patterns that we can see look very similar this time, albeit there are some nuances in this cycle to do with the pandemic and fiscal policy we have to watch. But given what you said earlier in terms of being sensible around some of the things that we are seeing and taking that medium term approach, we are somewhat encouraged by the opportunity set that we're facing in fixed income. We're looking forward to taking advantage of some of those opportunities this cycle continues to play out.

Paul O'Connor:

Well, thank you very much, Brett, for joining us today on the podcast. You've touched on a number of different topics that I think we could talk to in depth for hours there, whether it's QE to QT and whether it continues monetary policy lag, the continuing emphasis you've made around rates today matter. And I think one of the key take outs from the discussion has been that there is great opportunity set out there in the market now, and a better opportunity set for fixed-income investors today than there has been in many years.

But like always, challenges lie ahead. Challenges lie ahead into the comments you've highlighted around monetary policy lag and the impact that will have on the economy, in addition to QT and the impact that will have, the liquidity drain it could potentially have on the economy. And then we've also got the geopolitical risks, but I think for as long as I can remember, there's always been risk in markets and that's why returns are there at the end of the day. So thanking you very much there, Brett, for joining us on today's podcast. It's been a really fun and interesting discussion.

Brett Lewthwaite:

Thanks, Paul.

Paul O'Connor:

And to the listener, thank you again for joining us on the Netwealth Portfolio Construction Podcast series. I hope you've enjoyed the discussion today as much as I have. I wish you all the best, and I'll look forward to joining you on the next instalment of the podcast series. Have a great day, everyone.