Last week the ASX-listed multi-affiliate firm, Pinnacle Investment Management, gathered a selection of fund managers at the top of their game for its annual Investment Summit – this year in online-only format – as this Partner Content summary reveals…
The all-day affair involved 10 of the Pinnacle managers – including several that operate in the NZ market – with topics ranging from the rise of China to the hunt for yield and the search for alpha.
And, of course, the big issue of the times: the threat of inflation.
Despite a lack of consensus on whether inflationary pressures will be transient or persistent, investors across all asset classes are starting to see the impact of rising prices in real portfolio decisions.
Antipodes looks through to the other side of growth
Jacob Mitchell, head of pragmatic value manager Antipodes Partners, notes inflation expectations are already spiking higher as economies gear up for a post-COVID world.
Mitchell told the Summit audience that recovery from the pandemic stupor is supported by a glut of household savings and a rapid increase in broad economic activity.
While some of the imminent inflation could well prove temporary as, for instance, COVID-hit supply chains readjust, he says other forces suggest price pressures could be more intransigent than transient.
“The pandemic related pressures will eventually subside, but two major deflationary trends are behind us,” Mitchell says.
Firstly, he says China is no longer exporting deflation to the rest of the world through “low-cost, cheap labour-based manufacturing”.
At the same time, the aging global population actually represents an inflationary factor rather than the deflation touted in some quarters.
Both ends of the age-scale – children and retirees – tend to consume more than they produce, Mitchell says, which “needs to be financed”.
“We think that will be funded by more government debt, which will be inflationary,” he says.
But in a major “anomaly”, Mitchell says the fixed income market has yet to reflect the changing circumstances with negative-yielding bonds still the norm while equities – especially in the US – are at record highs.
The disparity between bonds and shares, which are essentially signaling a respective crash or boom, will have to unwind.
“There will probably have to be an adjustment in both [bonds and shares] but real yields need to realign on the upside,” he says.
Whatever the trajectory for inflation, Antipodes is positioning for emergent value opportunities in divergent regions (putting Europe and Asia over the US), new investment cycles (such as the energy transition) and the end of ‘growth at any price’ mania.
“As real yields move higher that will be a headwind for irrationally priced growth stocks,” Mitchell says.
With the world economy in flux, the Antipodes portfolio is weighted to “resilient cyclical companies with pricing power”, cyclicals morphing to growth (like energy firms those set to benefit from decarbonisation) and selective “secular growth” tech-flavoured stocks that dominate a particular niche.
Antipodes, which offers portfolio investment entity (PIE) versions of its core strategies to NZ investors, also uses shorting and even gold exposures to protect against downside risks.
“The tail risk is stagflation – US equities are most vulnerable given elevated valuations,” Mitchell says, suggesting investors need to “own resilient businesses with pricing power and be disciplined around valuations” to maintain sustainable returns through what looks to be a period of fundamental change.
REITs hold on to pricing power
While Antipodes targets a wide universe of global stocks to execute its strategies, another Pinnacle manager, Resolution Capital, seeks out inflation-proof returns in a narrower listed markets sector.
Andrew Parsons, Resolution CIO and global portfolio manager, told the Pinnacle Summit audience that real estate investment trusts (REITs) have delivered above-inflation returns for the last 25 years – albeit that inflationary pressures have been moderate over that period.
However, Parsons says certain features of REITs combined with a reinvigorated financial health of listed property operators suggest the asset class is well-placed to withstand rising inflation.
He says REITs typically offer inflation-protection via underlying lease agreements that include provisions linking rent increases to the consumer price index (CPI) measures.
Furthermore, most leasing contracts also have “fixed rent escalators” that maintain above-inflation returns for landlords over the medium- to long-term.
In addition to structural lease factors, REITs hold an inflation-beating power if building replacement costs move higher as “you’ll need higher rent to justify new supply”.
“REITs also need to see rental demand is greater than new supply,” Parsons says, to give confidence building owners have the necessary ‘pricing power’.
“If there’s no pricing power then all other discussion is meaningless,” he says.
Currently, most global commercial property markets meet all those conditions with low-to-moderate vacancy rates, rising construction costs and tenant demand expected to increase by 5 per cent or more globally over the next two to three years.
The REIT market, too, has bolstered its capital strength after being caught short in the global financial crisis (GFC) with over-leverage and poorly structured debt.
Parsons says today the average REIT has a leverage ratio of about 35 per cent across diversified sources of borrowing and longer maturities than in the pre-GFC era.
REIT managers are more cautious as well with income distributions, covering dividends out of cash flow rather than debt.
Overall, Parsons says the post-COVID recovery will be patchy in a market still “drunk on stimulus” and prone to volatility or disruption as interest rates inevitably rise.
Amid the uncertain environment, he says global REITs pose “limited idiosyncratic risk” while offering an inflation hedge underpinned by a strong earnings recovery.
In fact, REIT investors should focus on “what matters” for listed property – pricing power and sound capital management – instead of inflation, Parsons says.
How loans measure up for stable income, capital protection
Like Resolution, fellow Pinnacle manager Metrics Credit Partners expect inflation and market volatility to hit investors harder in coming years.
Metrics, a specialist non-bank corporate lender and fund manager, has originated some A$14 billion of loans across more than 450 borrowers in Australia and NZ. The group, which opened an office in Auckland last year, currently boasts over A$9 billion in assets under management in its listed and unlisted funds.
Andrew Lockhart, Metrics managing partner, says corporate loans provide a stable, uncorrelated source of income to investors at a time when yields are mired to historical lows.
In his Pinnacle Summit presentation, Lockhart says loans also offer inflation-protection via short-dated lending terms.
“Most loans are set at floating rates so if interest rates rise with inflation then returns to loan investors will also increase,” he says.
Private debt has several unique features that – if the risks are well-managed – will provide higher yields and capital stability through the economic cycle, according to Lockhart.
He says private debt managers need to have deep understanding of the bespoke nature of corporate loan origination – where long-term relationships with borrowers are paramount – and technical risk management requirements (including covenants, controls and security).
Diversification is also critical, Lockhart says, as the recent collapse of the Australian firm Greensill, which left investors vulnerable to a huge concentration risk via small pool of borrowers.
“Loan diversification is important to limit the exposure to loss by a single counterparty,” he says.
Metrics launched in 2013 to fill a gap in the lending market that banks have largely stepped away from after the GFC, managing successfully through the last disruptive 18 months.
“There’s been a lot of volatility and noise in the markets [in the COVID era] but that needs to be worn by equity holders, not lenders,” Lockhart says. “We’ve focused on the credit quality and liquidity of the companies we lend to.”
Finding alpha in beta times
In yet another angle on the corporate debt theme, Coolabah Capital Investments, has developed a unique ‘alpha-generating’ fixed income strategy for investors in Australia and NZ.
Christopher Joye and Ying Yi Ann Cheng – Coolabah chief investment officer and portfolio management director, respectively – outlined the group’s data-driven, rapid-trading approach to the global credit asset class in their joint Pinnacle Summit show.
Cheng told the Summit audience that fixed income investors had two choices in the low-yield world: either “add value or add risk”.
Risk-chasers follow the relatively simple strategy of moving up the credit spectrum – from sovereign bonds to high-yield corporate fixed income to loans – in order to achieve higher returns.
“The alternative is to chase alpha by targeting capital gains in mis-priced bonds – that’s harder,” she says.
But not impossible, Cheng says, in a “highly inefficient market” dominated by opaque ‘over the counter’ trades and passive players.
She says the investment opportunity is “immense” with over A$2.3 trillion in Australian government and corporate bonds and about A$33 trillion of investment grade credit currently in play.
Together, Coolabah estimates the broader Australian fixed income and global investment grade credit secondary trading market amounts to about A$20 trillion.
According to Joye, the secondary trading market is rife with alpha opportunities if investors know where, or how, to find them.
“Most [credit] investors are not looking for mispricing risks,” he say.
As a frequent bond trader – probably the most active in the Australian market, Joye reckons – Coolabah exploits the pricing inefficiencies through its sophisticated quant-based modeling tools.
In spite of the high turnover rate (average security holding period is just 59 days), the manager incredibly has a long-term record of incurring negative execution costs by efficient implementation of buy-sell spreads.
“What the means is that on average we buy below the mid bid-offer price and sell above it,” Joye says, creating “execution alpha”.
Cheng says the Coolabah strategy hinges on using 30-40 proprietary quant bond valuation models to revalue every live global bond.
The firm “seeks to acquire cheap, mispriced bonds paying excess interest (credit spread) for their risk factors”, she says.
Since inception in 2012, Coolabah has traded more than 22,800 securities (with an average A+ credit rating) collectively valued at over A$25.7 billion, generating positive returns in almost all cases while claiming capital gains close to 90 per cent of the time.
For access to the full replays of Pinnacle Investment Summit 2021 please click here. Registration will be required if you have not already signed up for the event.