Jorden Brown: I'm Jorden Brown and this is Capital Ideas, your connection with the minds and insights helping shape the world of investments. Today we'll be discussing one of the hottest topics with investors right now, and that is, when is the right time to move out of cash and term deposits? I'm joined today by our fixed income investment director, Haran Karunakaran. Good to speak to you again, Haran.
Haran Karunakaran: Hey Jorden, nice to be here.
Jorden Brown: Okay, well, why don't we begin by reflecting on what we're hearing from advisers right now? What brought so many advisers to leave aside fixed income and invest in term deposits instead?
Haran Karunakaran: It's a good question. I think it's the right question to discuss today, Jordan. When I talk to financial advisers across the country, that's a definite theme that I see, is this move into term deposits over the last few months especially. If I look back, I think actually there are two big shifts in how Australian advisers allocate towards fixed income. The first is a longer term trend that's been in place for about the last 10 years, so largely since the financial crisis ended. In that period, what's defined markets is really central bank intervention, so the idea of zero interest rate policies or the central bank put, which has provided support to financial markets whenever there's been a wobble anywhere. The implication of this for investors has been that traditional fixed interest strategies were much less attractive. Firstly, they were not really paying much income. If you look at a high-quality corporate bond fund, for example, that would have been yielding just over 1% not that long ago, 18 months ago, versus about 5.5% today. You can see here, the previous regime we're in was really quite different and much less attractive. In addition to the income element, the second bit of it was that defensiveness wasn't really a big focus for most investors, and rightly so because central banks were playing that role. Whenever equity markets stumbled, central banks would step in with an injection of liquidity. Clients were encouraged to shift further and further out on the risk spectrum, try and make up that yield gap and not worry too much of defensiveness. What we saw was a decrease in traditional fixed income core bond type strategies in favour of punchier strategies like high yield credit, private loans, et cetera, so that was the big overarching longer-term trend that's been in place.
I think a second more recent one has been the growth of term deposits and other cash proxies. And what's driven this? I think there's a few things. There's firstly, a lot of uncertainty that investors are feeling about the future. We have elevated inflation still, risk of recession, geopolitical tensions with Russia, Ukraine, China, and so on. These concerns were all amplified in the minds of many advisers by what we saw in 2022, which was pretty much all asset classes across the board underperforming expectations. In the light of that uncertainty and the 2022 experience, I think the return on cash looks pretty attractive for many investors. If you look at RBA data, the average term deposit rate for a six-month term deposit is 3.1%. Many banks are offering short-term bonuses on top of that, so you can conceivably get around 4% just by being in cash, so sitting on the sidelines, while you wait out that uncertainty, can seem like an attractive option.
Jorden Brown: I guess that explains the past, but with an eye on the future, does the strategy of sitting on the sidelines still make sense?
Haran Karunakaran: I don't think it does. As I kind of covered, I think the last regime has been driven by central bank policy, and that continues today. I think where we are right now is a really interesting inflection point in monetary policy. The last 18 months, we've seen very aggressive central bank hiking from the RBA, the Federal Reserve, pretty much all central banks across the world. But we seem to be reaching the end of that cycle. Let's look at the US as an example. After last month's hike, the Fed Fund's rate is now at 5.5%, the highest it's been in a decade. Markets are now pricing in maybe one more rate hike later this year, but then beyond that, some pretty aggressive rate cutting over 2024, so 1% to 1.5% percent of rate cuts, and then that rate cutting continuing into 2025. This is a really important shift because I think assets that do well in a rising rate environment are not necessarily the same one that will do well in a falling rate environment.
We've actually done some interesting historical analysis on this. We've gone back in history, looked at the last 45 years of interest rate cycles and tried to understand which assets do well at which point. In rising rate environments, it's pretty clear, cash outperforms bonds most of the time. Being in term deposits would have led you to a much better result than being invested in bonds in 2022, for example. But in a rate cutting environment, the pattern reverses. What we found is that the return on cash tends to decay very quickly after the last rate hike, so again, using the US example, after the Fed's last hike in a cycle, on average, the return on cash falls by 2.2% over the next 18 months. The realized return, I guess, for a term deposit or a cash investor is likely to be much slower than what they expect at the outset.
On the bond side, it's the opposite. The return on bonds, and here we're particularly focused on fixed rate bonds that have a duration exposure, see strong gains when rate cutting cycles start. And this isn't really a surprise, it's a sort of direct mathematical relationship when yields fall, the bond prices go up and an investor benefits from capital gains. Historically, if you look at the point where you have the last Fed High and then project forward over the next three years, high quality corporate bonds have delivered double the return of cash investors, so 32% cumulatively over three years versus 16% on cash. History is pretty clear, I think, as rates peak. Investors should be shifting away from cash into high quality fixed income assets.
Jorden Brown: Okay, that is really interesting. It might surprise a few people. So, what's driving fixed income to outperform in this part of the cycle?
Haran Karunakaran: So, you know, I mentioned that there's a direct mathematical relationship that drives bond returns, but we can stay away from that and think a bit more intuitively. Ultimately, it comes down to central bank policy. When you go through a rate hiking cycle, what often happens, or typically happens, is you end up in a recession in the economy. That's happened in all but two of the last 50 years of rate hiking cycles. What we find most of the time is central banks go too hard and too fast in their rate hiking, so it does push an economy into recession and when they start to see that happening, they get worried about the recession and will pre-emptively cut rates to protect the economy. Historically, what we tend to see is that within 12 months of the last rate hike, you start to see central banks cutting rates. Importantly for an investor in fixed income, though, you don't even need to wait till the rate cuts happen to see the benefit, bond markets are forward looking, so markets start pricing in those rates cuts before the central banks even start cutting. As a result, you get those capital gains on your bond holdings even earlier. What this means though is investors have a very limited window to get invested into bonds and benefit from that turn in the cycle. It happens quite quickly after the last rate hike.
Jorden Brown: So Haran does this historical analysis apply to the environment we're in today?
Haran Karunakaran: I think history is always a useful guide. As the saying goes, history doesn't repeat, but it rhymes. We use the analysis of the last 50 years of cycles as a good indicator to how we think about the future. We also think about specific scenarios that are likely based on what we see in markets today. At the moment, I think there are a couple of different ways you can look at things.
First of all, you can look at what's priced into markets. And that can be described effectively as a soft landing. Inflation moderating, rates being cut a bit, continued growth. This is all an environment that's quite good for bonds. They'll earn an attractive starting yield, so if you look at global corporate bonds as an example, today those bonds are yielding about 5.5% in US dollar terms. That's your starting point, investing in fixed income. On top of that, you'll benefit from a few rate cuts.
Another scenario that we often think about is recession. In our view, that's a fairly high probability I'd come over the next year or so. In this scenario, we think bonds should also do really well. You still get that higher starting yield, but you'll likely get a bigger benefit from rate cuts. As the recession bites, central banks will cut more aggressively, leading to bigger capital gains on your bond investment. You'll get a strong boost on your fixed income, which is nice from a return perspective, but even nicer from an overall portfolio perspective because it's diversifying an equity portfolio that may be a bit challenged. If we try to put some numbers around this, I think for fixed income, typically the yield to maturity of a portfolio is the best predictor of future returns. For a global corporate bond portfolio today, that suggests a future return over the next five years of around 6% per annum, pretty attractive. If you invest in an actively managed fund that does well and meets its targets, you're typically getting another 1% of alpha on top of that, so all in about 7%. If you compare that to term deposits today, being generous, I think the rate you could add on a term deposit is around 4%. But markets are pricing in a fall of about 2% in rates over the next two years, so the average return you'll get on that term deposit over the next few years is likely closer to 2 than the 4%, so a much worse outcome than the 7% you get on the bonds.
There is, I should say, a scenario where bonds don't do as well, and that's one where inflation re-accelerates. This would cause central banks to hike more - effectively, a repeat of 2022. This in our mind is a lower probability outcome - that we see a fairly clear downward trend in inflation. We also see central banks reluctant to hike more aggressively, particularly in light of some of the banking issues that we saw in the US and Europe earlier this year. While there is this scenario that we should keep in mind as a risk, in the more likely outcomes we think fixed income will do much better than cash going forward.
Jorden Brown: So we've discussed the past and the current situation. What do you think our future portfolio might look in a normalised fixed income environment?
Haran Karunakaran: Well, from what I've said, I mean, I think it's pretty clear that we would see fixed income over cash being an important shift for investors to make today. When you look at specifically what type of fixed income, the sweet spot for us is in high quality global credit or investment grade corporate bonds. That's because they offer a couple of different things.
They offer very attractive yield and upside from rate cuts, if that does happen. But at the same time, they're very defensive in a portfolio. They're high quality. They have very little risk of default and losing capital. The duration embedded in global corporates also provides a good diversification against equities. I should emphasize here, though, as you think about fixed income, those two points of high quality and duration are really key. Not all fixed income strategies give you that, so you really need to focus on having the right sort of fixed income strategy. That's sort of what a future portfolio might look like. A question we often get is what's the timing, how do you get to that scenario? How do you migrate from a portfolio today that might look quite different to that, to something that's high quality focused going forward? For us, I think the key thing is getting into the market sooner, getting into this position of investing in high quality fixed income and out of your term deposits sooner rather than later. A sensible strategy could be to sort of average in, so if you are invested, for example, in three months term deposits at the moment, potentially at each roll point, shift a quarter of your allocation into a high-quality fixed income allocation. That way over a year, you go from being heavily skewed towards term deposits to having a more reasonable allocation to high quality fixed income.
Jorden Brown: So, Haran, you mentioned an averaging-in strategy. So why is the urgency to act now?
Haran Karunakaran: I think it goes back to this idea that I mentioned at the start of an inflection point. We're really at the precipice of a big change in financial markets. We had a call with our fixed income investment group a couple of weeks ago where Mike Gitlin, who's the head of our fixed income investment group, was speaking and one of the things he said really stuck with me, which is that for most of us in the room, the next two years will be the most exciting point in our careers as fixed income investors. Bond yields are at the highest we've seen in a decade. This presents a really great opportunity for investors to lock in strong long-term returns today. It will be a huge opportunity, but it'll be one that will be easy to miss. It's a narrow window for investors. They need to get in near the peak of rates, but before the subsequent rates start getting priced in. I think, as we all know, perfect timing in markets is difficult, if not impossible. What we'd suggest is get in early, start today, and stay invested. If you try to get your timing exactly right, you wait too long, you'll miss the opportunity. So now is the time to act.
Jorden Brown:Well, thank you again, Haran. Well, just to recap, we've seen rapid growth of cash and term deposit reserves, but history is clear, as rates peak and investor would have been better off in fixed income rather than cash or proxies like term deposits. But thinking about looking forward, we have current bond yields presenting an opportunity to lock in strong long-term returns. However, the opportunity won't be around forever.
We're always trying to get better, so if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capgroup.com
For Capital Ideas, this is Jordan Brown, reminding you that the most valuable asset is a long-term perspective.
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