Transcript

Paul O'Connor (POC): Welcome to the Netwealth Investment Podcast series. My name is Paul O'Connor and I'm the Head of Investment Management and Research at Netwealth Investments. In my role at Netwealth, I manage and govern the investments that are made available to you through the Netwealth Investment platforms. Today we're fortunate to have Sebastian Mullins, Portfolio Manager of the multi-asset funds at Schroders. Welcome, Sebastian and thank you for joining us.

Sebastian Mullins (SM): Thanks Paul, pleasure to be here.

POC: Schroders have a number of funds available on the Netwealth platform across equities, Australian and international fixed interest and multi-asset or diversified funds. We're fortunate to have a portfolio manager of diversified strategies with us today. So, thought it opportune to understand your outlook for the global economy and what you and the team at Schroders are focusing on in the management of diversified portfolios today.

POC: COVID-19 is a human crisis and tragedy that has impacted on all of our lives and precipitated the financial crisis that we are now dealing with. When did you, Sebastian, and the Schroders team start to think that the virus would materially impact on markets?

SM: Well, we were quite lucky because we went into this pretty defensively positioned. Now, it's not that we predicted a virus or any kind of economic shock this year. But based on our process, we did believe that valuations in most asset classes were quite stretched. So, if you can think about back in January when the year started, you had credit spreads tightened significantly. So, bonds did very, very well. Equity markets started to rally quite significantly as well. So, we believed that valuations were stretched, markets were really optimistic. We had some sort of longer term or one to two year recession indicators that started to say recession risk was quite high. So, we kind of came into this thinking markets are stretched, people

SM: Now, stretched valuations don't mean there'll be a crisis. But it means you're more vulnerable to any unseen shock. So, when we did see the unseen shock, which in this case was a global pandemic, we used that as an opportunity to cut some risk. Now, the way it kind of unfolded is that first in January you had some information about it. And markets kind of did a bit of a wobble, but nothing much. Then in February, you sort of get more information out of the WHO, especially around things such as asymptomatic transmission. You started to see more out of the Hubei Province in China, things getting locked down, things getting quite scary, actually, on the news out of there. And the market only fell 5% at that time. And then, throughout February, it actually rebounded and retested new highs.

So, we took both the opportunity in January to cut risk, and also again in February to cut risk. By cutting risk, I mean we cut quite a substantial amount of equities, probably around 5-7% we reduced during that period before the real crisis hit in March. And we also reduced some of our credit exposure. So, we kind of went in with only 20% equities. We cut quite a lot of investment grade and high yield debts and favoured duration to sovereign bonds. So, we went into that quite well positioned.

When things really started to percolate in Europe, that's when we became quite concerned and thought, this is just not a market you can look though or buy the dip. This is something a bit more serious.

POC: Yeah, interesting there because when you think back over the last few months, I guess the original news of COVID-19, we started to hear about in November. And then it appears in early-mid January. China really started to open up and explain the issues and make it more transparent that they'd been having. And then, I guess it wasn't until late February that we really started to see financial markets impacted. So, I guess it's positive to hear that we've got active fund managers out there that have a defensive positioning in their products and they're monitoring these issues on a daily basis.

In terms of governments and central banks right around the world appeared quite slow to act when the early signs that the virus was actually spreading well beyond China. But I guess in recent weeks, both the monetary and fiscal policy actions announced have been nothing short of astonishing. Does Schroders have a view or thought on the damage to global GDP and the likely impact of the fiscal and monetary policy actions?

SM: Yeah, it's a real hard one to judge at this point, given first of all, most market participants aren't used to these kind of exogenous shocks. When you think about a usual recession through a market cycle, you have an overheating economy. The Fed steps in to try and squash that with higher rates, and then eventually something cracks. So, a bubble will pop, like IT or housing. And then, the recession lasts as long as it takes for that to be unwound. Now, in this case, hopefully so far we haven't seen any bubble popping and it hasn't been a Fed induced or a central bank induced potential recession. There has been a demand shock from this crisis.

Now, I think what's interesting, there's a very good article you can read online called The Hammer and Dance. And the idea basically behind that is eventually governments have to do something to stop the spread of the virus. And the longer you wait, the more expensive it becomes. So, if you think about places like South Korea, they just did lots of testing and that meant they didn't have to do the full shutdown. Whereas, the US dragged their feet and now they're approaching, at least in some states like New York and California, where they have to do a full shutdown and fiscal spend.

Now, I think overall in aggregate, there will be a very significant impact to global GDP. This will be worse than the GFC in terms of the depth of the impact. I mean, you think about the US, you could easily lose 10% of GDP from this, which is a huge amount. Unemployment could hit double digits. I mean, initial claims, I had a graph maybe two weeks ago showing initial jobless claims in the US spiked significantly to 280,000. Then the following week it was three million. And the week after that, it was six million. So, these are really substantial hits to growth and to unemployment.

But unlike the GFC and other recessions, it should be a short lived recessions. So, a very deep, but a very quick recession. But the numbers are looking scary. I mean, I think we are definitely in a recession globally now. Australia is not going to continue its 30-year expansion. I think this will hit everyone. But hopefully, it is a short and ... A sharp but short recession with some of that fiscal spend helping. If you think of some of the PMIs now globally below 40, which is typically indicative of a recession. Global, Australia's the same. China was the same. Europe is below 30 on the PMIs. US is still above 40, but services are below. And services are 70% of the US economy. And I think that's a real important part to this recession, unlike others, where typically you have a manufacturing recession, which hurts, but isn't really that important given it's less than say 20% of GDP.

Services is the normal bellwether in these kind of environments and that is what's being hit directly. So, you're not going out and consuming anymore. You're not going to restaurants, you're not going to concerts, etc. So, the services and goods section is really under pressure in this recession. And it's going to be quite, quite painful. In Australia, we have consumer confidence that's fallen below the level of the GFC. We're actually down to 1990 levels, which is pretty bad. And if you think about Australia in particular, consumption is a third of GDP. So, that's going to zero, unless you're buying toilet paper. And tourism and foreign education, that's actually our fourth largest export. So, if you think no one's coming anymore and foreign students can't really come to the country right now. They can, but it's a bit convoluted. So, that's going to be impacted as well.

And if you think about the tourism section, that's actually quite a large employer of casual staff. And they're already impacted quite strongly with the bush fires, and now this. So, there is a likelihood that Australia has a similar level of double digits unemployment rate at the end of this. But the good news is, is stimulus is unprecedented, right? So, you have Australia spending 12% of GDP, US spending 10% of GDP. So, this should be substantial to help cushion the blow, not to overcome the whole thing. I think we still do drop down into recession. But this definitely helps us bounce back, assuming that this only goes on for one quarter or so. If it lasts longer, you'd need more stimulus to help with the potential downside.

POC: It's interesting the comments you make about the service sector, and I have thought in my own mind that the service sector is such a large part of the economies of the developed Western countries. Trying to think through in my mind, is COVID-19 potentially going to impact more on the developed economies than the emerging economies? But I guess we won't know the answer to that question for some time yet.

SM: I was just going to say with emerging markets, it's one of those things where because lot of them have a sort of poor... Well, it's region by region, but even country by country, but a poor health system relatively speaking, they will be impacted probably worse. So somewhere like India is in a very bad situation where their health care system is quite poor, relative to say, Korea. There is this sort of regional and inter-regional impact this will have, so it really does require sort of a overlay country by country look at how this will actually impact each individual market.

POC: As company earnings underpin share prices, what do you believe will be the impact on earnings over the short term from what information you can gather that's out there now by the impact of COVID-19? I guess in terms of companies that are impacted, can you make some comments on the sectors, and are there any potential even winners out of this economic downturn?

SM: Well, that's a very good question because lots of market participants are talking about how far the market has fallen and how cheap stocks are now. We probably have a question mark around that, because yes, prices have fallen substantially. I mean, they bounced back quite a bit off the low, but peak to trough, most markets were down 35%, so you would say that those are cheap. However, that assumes your earnings multiple stays the same. Now, the big question is, what is the earnings impact? If earnings are down substantially, then maybe equity is arching. Maybe they're actually expensive after this fall. We think right now the market's pricing in around a 10% contraction in earnings globally. We think it will be quite a bit more significant than that.

We have our own earnings model. It looks at a number of things like credit spreads for corporates, global PMIs, the idea there being if you have to refinance at higher rates, then less money can go to your equity holders more as to repay interest margins, et cetera. Also PMIs are slowing, your growth trajectory is slowing. Based on our models, we're expecting around 30% its earnings and that is not priced currently. It was getting close to being priced.

We're down 35% but right now we've kind of given a lot of that back. I do think that earnings can fall quite a bit from here. We might actually see a further shock to the downside in equities.

But talking about individual sectors, there are obviously winners and losers. It's a bit harder to find outright winners. There's definitely a lot of relatively better positioned companies. You think about just even the supermarkets the past couple of weeks. They've had a huge demand surge that wouldn't otherwise have been there. So probably be more of your defensive sectors like consumer staples, they're doing well. Whereas the flip side is anything related to the epicentre of this. Discretionary spending, travel and leisure, et cetera is going to be hit really, really hard. I mean I don't know about you, but I'm not going on a cruise anytime soon. But I will keep buying my groceries, either online or going to the supermarket. There's a large demand for your standard staples areas which are actually typically very good during your session because of that safety trade.

Now talking about individual countries and companies, there were some interesting things where video game companies globally have done very well. More people are staying at home and working from home in quotation marks. So video game companies have been doing well, things like Zoom, so video conferencing software has done very well. Funny enough with Zoom, there are two tickers. In the US, the actual Zoom we all use is ZM. That was up 130% from the start of the year to its peak. But Zoom, Z-O-O-M on the stock exchange, which has nothing to do with the Zoom software we're talking about was up almost 2000% because people mistook it for that stock. So there are definitely winners.

POC: Is that the passive investors buying that stock?

SM: Well, you'd have to hope it was someone doing something incorrectly and hopefully size is minuscule, but it is definitely the wrong stock. It's also a tech company, but nothing to do with online conferencing. That was probably a few people jobs after that. That's actually now suspended because of that, because enough people were buying the wrong stock.

POC: No, interesting there. I guess the experience of the last month has certainly brought home the definition of a staple, a consumer staple, and the important role that the large supermarket chains actually do play in Australia. President Trump appeased a term and to try and get as much of the US workforce back working as soon as possible. I guess a key question that no one really knows the answer to is, what will be the durational length of disruption to the global economy? Does Schroder have any view on that or even accepting the difficult nature of the question? What is the longer term views or focus of the investment teams at Schroder? Are you trying to look out two years perhaps to understand what earnings would be? Interested in any thoughts or observations there, Sebastian?

SM: Sure. It's definitely a moving feast. Things keep changing every day and the US in particular talking about Trump. He first came out saying after Easter, and has then pushed it back to the end of April. I think a very important comment to make is everyone's following the Chinese experience as a roadmap. If you think about China, you've had a pretty substantial lockdown in certain areas for about two to three months and then coming out of that, people are saying they're almost back to full capacity. 90% of businesses are back operational while they're not operating at full capacity, there's a large improvement there. You've seen consumption energy spike up. You've seen even retail sales start to improve, property sales improve. So it looks like China is getting back to normal. If you look at the PMIs in China, it fell to I think below, let's say low thirties, and has since bounced back to above 50, 53. So the Chinese experience is thought to be lock down and then back to normal.

Unfortunately, I mean our view is that China could do that because it was the first. When it came out of lockdown, there was still pent up demand that they had to fill after being shut for a couple of months. That's why you're seeing this massive spike back up. With the rest of the world not going through this demand is falling globally, so that demand is probably not going to be sustained. So you might even see China start to unwind some of that good news that's been occurring the past couple of weeks. As well PMI is back about 50 does not mean they've recovered all their output. It just means it's now bottoming and starting to grow from a lower base. Things are still looking pretty questionable in China. I don't think we're just going to get back to normal at the end of this month.

I think in the US it might even be dangerous for Trump to actually let people go back to work sooner rather than later. Because as you can see from things like the Spanish flu, you actually tend to have two or three waves of this. If they go back to work too soon, the actual death count would increase because if you think how many people have the disease now, even though it stopped increasing, if you let them all back to work, you have a far more amount of people with the disease spreading it. They do need to have lockdown probably longer than the market is anticipating. Our view is this doesn't go away in a month, it's with us for a couple of months, maybe even two or three quarters. Understanding how long it takes is very important because that then determines how much earnings contracts, how many companies can survive. Because a lot of them will go insolvent if they don't have enough cash flow to survive unless you have fiscal stimulus exceeding what is currently there.

Understanding that roadmap is very, very interesting. We think in tool you have either a vaccine or maybe more promising is these new antibody tests. If you can do tests on people to show they actually have the antibody so they've had it and have now reasonably be healthy again, then you can have a certain part of the economy go back to work. That'll be a very important milestone when they start rolling that out nationally in the US and other places to see who can go back to Our nationally in the U.S. and other places to see who can go back to work. So I think this is over now. They've had a peak case counts. I think you still got a couple of months of this to go through. Not full lockdown. But definitely not back to full activity. And I guess you need to use a quote from Churchill. We think it's not the beginning of the end. But probably at the end of the beginning. So the worst part is over. But now we're kind of through the new normal for I think a couple of months now.

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POC: It will be interesting how the Australian economy and the global economy manages getting people back to work. It's quite interesting. I've seen such a spike in I guess hate sensors or temperature sensors that automatically test your temperature. And will highlight to you that you've potentially got some type of virus if the temperature of your body is elevated there. So we might say those types of actions taken even by companies screening staff when they come back to work. So, yeah.

SM: That's what they're doing in Singapore and Hong Kong.

POC: Yeah, it certainly makes sense because we do have to try and get the economy back out of this holding pattern that we're currently in. We've seen liquidity almost completely disappear in recent weeks. And even from some of the most liquid markets. But I guess post the actions of the central banks over the last couple of the weeks in announcement of the significant fiscal spend by governments. We've seen that improved somewhat. Have you got any comments or insights into the condition of financial markets at present?

SM: Sure. I mean it did get pretty ugly to be totally honest. So you had was eventually a health shock morphed into economic shock. Morphed very quickly into liquidity shock. And if that was left unchecked you could have a GFC style liquidity crisis. Now, luckily that didn't happen. But you were having problems even selling government bonds. So even Australian government bonds, you couldn't sell it because no one was buying it at that time. So having central bank servicing the feds, RBA, et cetera step in and buy these things. They have definitely helped put liquidity back into the market.

Now the difference is it doesn't mean we're back to where we were. Market liquidity is still very bad. But you have an Avenue to sell now. So you want to sell government bonds back to the fed, or back to the RBA. You can do that within their windows. And the pricing is pretty good.

However, things like investment grade bonds, they're still quite challenging. Now the fed in the U.S. they're actually buying those now. Now legally they can't. But they have to give money to the treasury who then go and buy the bonds. But they made a loophole. So they can actually go and support those companies. And narrow those bid ask spreads.

But things are still liquid. Now many people say, you know why? Why is the central bank cutting rates? Or doing QE that doesn't solve a health crisis? What it does is it keeps those markets open. So corporates that need a line of credit.... They can then go and issue a bond. Or they can go and do some equity raising. Because if that liquidity dries up completely, like it did in the GFC or almost happened now, you can't get that lifeline.

So now the central banks have stepped in. It has improved liquidity from the dire situation it was in. But it's still pretty bad. But companies can tap in. They're going to be paying more. Spreads have widened. Equity is a lot cheaper than it was. So if they actually want lower pricing than there was, so they don't sell equity. They get less money for that equity. So it's going to cost them, but at least they can do that. Whereas if I didn't have that central bank liquidity injection, you'll see a lot more corporates having to shut down because they can't get access to financing.

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POC: Yeah. I guess the bottom line is that we must keep the global economy functioning in some form. So that then when the health crisis starts to dissipate, people can actually go back in to a job. So extremely important. I think these actions that have been taken by central banks and governments over the last couple of weeks. We've seen the value of the Aussie dollar fall dramatically against the U.S. dollar over the last few weeks. Which I guess has acted as a cushion to the economy. I think it's down almost 15 percent relative to the U.S. dollar. Do you have a view on the Aussie dollar at the moment? And the direction that it may move against the U.S. dollar?

SM: Yeah, we've been short. The Aussie dollar versus the U.S. dollar since essentially a parody. So for a long time we thought that U.S. Dollar was very, very overvalued at the last couple of years. Now where'd the actual fair value is? That's keeps changing. But we have PPP models, which is price purchasing parenting models. Essentially if you can buy one good in one country and the same good in the other country. Kind of like a big Mac Index. It can normalise to where fair value is. We see the Aussie dollar around the low 60s but the U.S. dollar is between 60 and 65. That said usually expensive currencies don't just go to fair value when stock. They usually go beyond it and become cheaper. So we were actually taking some profits on our short Aussie dollar along the U.S. dollar when you hit around 55 cents. So we did think that was a good opportunity to actually start adding a bit more Aussie dollars. But it has since bounced back from there.

So we would say that if you think about the fundamentals now, rates here are low. And they're more aligned to global rates. Before we had higher rates than the rest of the world. The RBA is doing QE like the rest of the world. We're now likely to have big fiscal deficits in both high public type of debt. As well as household debt. So we still think there's pressure downwards for the Australian dollar. We're no longer a higher yielder. Or sort of a safer pair of hands, relatively speaking.

So we do think the Aussie dollar could get even below, or touch 50 cents before this crisis is over. But we do think around we are here. It's around fair value. So for a longer term investor, I wouldn't be discouraging you for going along Aussie dollar at this point. But for us we think there's probably still some more downside. And then in a portfolio context is a very good hedge to have that long U.S. dollar position. So we still have that in the fund right now.

POC: Thank you, Sebastian. The 2008 financial crisis started as a banking crisis before spreading into the wider economy. How was the health of the banks both in Australia and globally looking at present?

SM: From a solvency standpoint, they are in far better shape and they were in the GFC. You've had in Dodd-Frank, Basel III et cetera come through to make sure they really clean up their balance sheet. And have significant amounts of safe assets in their books. So from a solvency standpoint, you know outside maybe the Eurozone with place like Deutsche Bank, I don't see this morphing into a banking crisis, per se. But that as well has its own risks because banks have delevered. And they have de-risked. But even this recent March correction you saw with liquidity drying up. They were no longer stepping in to provide that liquidity because they didn't want to touch those assets. Because of these liquidity requirements they have on their sheet. There's a bit more of a systemic risk in the markets because of that improved safety. And at the same time just because they're safer than they were in the GFC, I wouldn't say we're bullish on banks.

If you think about Australian banks, and this is kind of a global experience. During the good times, they actually let their provisions for impaired loans drift quite a lot lower than they have been in the past. So you think of the big four here on average started the year. He has probably a loan provision loss of around 0.5 percent. So less than 1 percent of their book. Whereas during the GFC impaired loan, it's got 2 or 3 percent.

So if we think this kind of situation is going to continue to unravel, you're going to have more people lose their jobs. You're going to see growth fall over. Maybe even housing markets start to flat line, correct. They will have to raise their provisions to offset that. Which means from an equity standpoint or even a hybrid holder standpoints, they will likely cut their dividends. Cut their franking in order to regain that provision they require for what is potentially around the corner.

You've seen that overseas. HBC said no dividend for this year. Some of the U.S. banks, if they get bailed out, can't pay dividends while they're being bailed out. I don't think banks will have to be bailed out. But I definitely think there'll be a hit to their dividends.

And that will cause equity markets to probably revalue them lower than they are now. And from a credit standpoint, not a hybrid, but an actual bond standpoint. That's credit positive because it means they're improving their balance sheet. So it depends where you investing in banks. But I think equities are probably too high at this point.

I guess a lot of it gets back to the earlier discussion around duration of the crisis. And then what impact that will have on property values both in Australia and globally. To then consider the stresses that may put on the banking models around the world. You mentioned earlier, Sebastian, that your portfolio.

POC:You mentioned earlier, Sebastian, that your portfolios are basically defensively positioned, the diversified portfolios of Schroder. So given the volatility in markets and the falling values across most asset classes, what opportunities are you starting to see, or starting to look at, potentially to include in your portfolios going forward?

SM: So a caveat there I'd say is based on our job, we're asset allocators, we actually have to think probably a bit more tactically than your average investor. So we're probably looking for better entry points. So if our view was maybe 10 years, we'd be buying probably more substantially at this point, but we do think there is a potential for a lower low.

If you think about usual bear markets, you do have this reflexive bounce, or bear market rally, which I think we're currently experiencing. Now whether that retests the low we saw before, or it goes lower, history would say that will occur. But even then, it might not be a bad time to stop buying now. So I'd like to say we're not trying to pick the bottom, but we are looking for high quality investment opportunities at a reasonable price.

When we saw the market for 35%, we did start to add to equities, because we thought even if we get the entry point wrong on a longterm perspective, that is actually quite an attractive entry point. We highlight our experience during the GFC and we actually added to equities in August in 2008, the month before Lehman collapsed. So of course there was significantly more downside after that point. But in three years time it was irrelevant, because that was still a very good entry point for a longer term investor.

So we are looking for opportunities. If markets continue to fall, we'll probably be adding a lot more equities. During the credit sell-off, we did find some opportunities in credit. There was some forced sellers overseas who gave us bank to on capital debt for around 9% yield, which was very high. So there are some pockets of opportunity.

For example, only three weeks ago said the U.S. investment grade credit section was pricing in depression level defaults, which we thought was too extreme, so we could add some risk there. And even things like REITs. REITs is the epicentre of this, because no one's going to malls anymore, but at the time of the low, they're pricing at a 50% reduction in book value, whereas it's more likely to be around 20 to 30%. So, it's still getting hit hard, but valuation was starting to become attractive in some of these assets.

So unfortunately there's no guaranteed buy right now, given the rally. But they're definitely longer term opportunities to start looking at if prices give up a bit of their gains.

POC: Interesting, the potential of the current and potential impact on rates over time. And I smile at the decision of the Lowy family to divest of Westfield over the last few years. So was very good timing, I would have thought on their behalf.

What tips can you actually provide the listener on how to navigate the current financial crisis and the volatility we're seeing?

SM: Well, I would say that market timing is very hard. Everyone tries to think they can market time, but it is very, very hard. And even for professionals it is a very hard task. So when you have extreme volatility like we've seen, you can weaken even the strongest hands. So that's the exact time when you need a very, very robust investment process, or an investment plan, stick to that plan.

So if you don't sell into a panic, but then again, don't buy into euphoria. So we think don't try and pick the bottom, find good opportunities. If your investment horizon is longer than a couple of years, then definitely it's a good time to start thinking about where to add risk. But if you want to invest in a manager like us, who actually spend time trying to figure out the best ways to navigate those, we do think there are better opportunities to be had.

But the main thing is stick your investment process, if you keep averaging it now, you're going to get a better price than if you bought it a couple of months ago. But then again don't buy into the market euphoria. Try and make sure you stick to your investment process and investment plan. Don't let volatility throw you off course.

POC: Yeah. I think it's very important for all of us to not get too sidetracked by the volatility in markets at the moment and just to keep focused on our longterm investment strategy and objectives. So I tend to think in times of crisis, it can throw up brilliant opportunities. And the other salient point in my mind is that some of the largest returns we have seen out of markets and out of equity markets has been towards the end of any crisis period over time.

So investors fleeing to cash need to be sure that they're not going to miss out on those returns when volatility starts to settle. Finally, as investing is a combination of art and science and we as investment professionals continue to learn more every day, what's an important lesson or two you have learned that you can share with our listeners?

SM: Well, I think this crisis has really shown us that at the end of the day, valuations and fundamentals do matter. You've had a long period of central bank liquidity and positive sentiment driving markets probably higher than they should be in the short term, but ultimately excesses mean revert. So while it can be tough to maybe sit out of some large rallies towards the end of a cycle, it's very important that you have a longterm view and actually have a valuation anchor, or a fundamental anchor.

Because when the shocks do hit, and they often do hit, you can't predict what the shock will be. But you know if things are extended that there was pull back down to mean revert to value. So I'd say that's in the last couple of years, 2017, 2019 have given you a fantastic [inaudible 00:32:57] hit, and they were fantastic to ride. But at the same time, don't forget about fundamentals and valuations because ultimately that's what markets revert to.

POC: Thank you, Sebastian, and thank you very much for joining us today on the Netwealth Investment Podcast Series. You've made some really great, I think, insights and comments on the markets today, and given the listener a view on how a professional investment portfolio manager is... What your day-to-day focus is on the Schroder Diversified Funds.

To the listeners, I wish you all well, and I hope you're safe and happy at home with your families. And we've all got to keep our head down and keep in self- isolation until we get through this human crisis that we're currently experiencing. Thank you very much, all for joining the Netwealth Investment Podcast series

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Views expressed are of the interviewee and may not be the opinion of Netwealth or its related companies.