Investment update with John Pearce – October 2023

Hi, I'm John Pearce, Chief Investment Officer. Welcome to this investment update. Today I'd like to explain why we're off to a bit of a rocky start this financial year. I'd like to discuss the impact this has had on a variety of our options. And finally, I'd like to address possibly the oldest question in investments—what's a better investment, shares or bonds?

Back to this financial year and you will recall that in July, when I gave an update, we had just finished off a very strong financial year. Our Balanced option recorded double-digit returns. Our global shares options were doing pretty well—Global Companies in Asia over 20%—we were in the middle of AI euphoria. That euphoria has now been swamped by panic in the bond markets.

To put this in perspective, think about this stat. The fall in value of a long-dated US bond, a 30-year US bond, has been equivalent to the fall in value of the US stock market from peak to trough during the GFC—about 55%. And bear in mind, the US bond market is massive and it’s very important. We have to pay attention to what it does because US bond prices pretty much set the pricing of most financial assets in the world.

What's particularly interesting and even unique about this sell-off is the backdrop in which it has happened, a couple of aspects in particular. Firstly, the Federal Reserve—the US Central Bank—has signalled a pause in its rate-hike cycle. What's more, the governors of the Fed Reserve have said we're pretty much close to the end of this rate-hike cycle.

If we look through history, the last 50 years, take a look at this graph. Look what usually happens to bond markets when the Fed signals a pause. What happens? Yields fall, prices rise in every single circumstance since 1978. Look what's happening today—the opposite. Yields are rising, prices are crashing. Quite unique.

Chart 1: A graph showing bond prices rallying after Federal Reserve rate-hike cycle pauses in 1978, 1989, 1995, 2000, 2006, 2018. The graph shows that unlike previous pauses, the current rate-hike cycle pause has seen bonds being sold off.

It is a cautionary lesson for those who rely too much on history to guide their investment strategy. People talk about history not repeating, just rhyming—frankly, I don't see even any semblance of a rhyme there.

What's the second aspect that's really interesting? Inflation is actually declining. In fact, it is declining quite significantly. If we look at US headline inflation, it peaked at around 9%. It's down to around 4%, slightly under 4%. But therein lies the sting in the tail. 4% is still a long way from where the Fed and other central banks actually want to be. They're targeting an inflation rate of around 2%. So the bond market is saying, “Look, we're not really buying the story about a pause—what are we seeing? We're seeing rising energy prices, we're seeing rising house prices, we see rising wages, we see overheated economies. Inflation is very sticky and if anything, we see upward inflationary pressures. Therefore, no pause in our view.” And that's what’s happening in the bond markets, and of course from the bond markets, the share markets are taking the lead and they're also very jittery. And that's having an impact in various ways across our range of options.

If you take a look at this table, it shows a range of returns across various options. Pleasing to see, as we'd expect, Cash proving to be once again a safe harbour. Interestingly, right up the top is the Australian Income option. This is a revamped and simplified version of the old Diversified Credit Income option. For those of you who are seeking a reasonable return at the lower end of the risk spectrum—that’s the lower end, not zero risk—you should have a look. You might be interested in this option.

Chart 2: A table showing returns for various UniSuper investment options for the period 1 July to 13 October 2023: Australian Income (2.1%); Cash (1.2%); Balanced (-0.7%); Global Companies in Asia (-2.2%); Global Environmental Opportunities (-11.3%).

Our Balanced option—pretty flat, which is not a bad result, all things being considered. And right down the bottom there we have Global Companies in Asia. Once again, I did mention—very strong return last year, over 20%, so we're giving back some of that return. And right down the bottom—Global Environmental Opportunities. It’s been a really tough start to this financial year. Once again, I do urge people to take a long-term view. If we look at the last ten financial years, they've been really stellar returns. It wasn't that long ago when it actually recorded a return of nearly 50%. So the last year and a half, it's very much a case of giving back some of those excess returns.

Chart 3: A graph showing the annual returns of the Global Environmental Opportunities investment option over the last 10 years (2014 to October 2023). In 2021, the option recorded a return of nearly 50%. This financial year, it is currently recording -11%.

Where to from here? What about the bond market? Should we be really concerned with what's happening in the bond market? Well, whenever you see a sell-off at the magnitude and speed at which we've seen this bond market, it is a bit nerve-wracking I do admit it. But once again, let's take a long-term look at this. If we go back 150 years, despite what we're seeing in the bond market, despite the sharp sell-off—where we’re trading at the moment is about the median level at where ten-year US treasuries have been trading for the last 150 years.

Chart 4: A chart showing the US 10-year bond yield over the last 150 years from 1871. The long-term median is just under 4%.

So the way I interpret this is that the world is getting back to some semblance of normality. I'm not overly concerned.

And where does that leave shares? That age old question—what's a better investment, shares or bonds? Well, I'll be accused of sitting on the fence here, but let me just say, the decision is tougher today than I think it's been for pretty much the last decade, and I want to illustrate what I'm saying with reference to a couple of very simple valuation techniques. I want to compare today's bond yields with dividend yields.

Quickly, just a definition. A bond yield—pretty simple, it's effectively the interest rate you earn from owning a bond. Dividend yield is also pretty simple. If we think about the Commonwealth Bank, for example—Commonwealth Bank share prices say trade around $100—Commonwealth Bank pays a dividend of around $4.50 so we have a dividend yield of 4.5%. 4.5 divided by 100.

It gets a little bit more complex because we have to take into account franking credits, which is really important, particularly for retired members who have to pay zero tax. If we add franking credits onto that, that 4.5% becomes around 6.4%, so they are pretty important. So we look at all dividends and all companies and take averages—we can actually apply that to the market as a whole.

Cast your mind back to around December 2020. It wasn't that long ago—less than three years ago. Bond yields about 1%, dividend yields about 4.5%. That's a 3.5% difference. So not only were bond yields so low, those who were buying shares were actually being rewarded for taking the risk. The technical amongst you will say, “Well, that's the equity risk premium”, and that equity risk premium was pretty high. And I would argue during those times this was a pretty easy decision. It was all in favour of shares over bonds. Let's roll the clock forward to today, what's that dynamic? Well, here's the graph. Today we have bond yields at, say, around 4.5%, and that dividend yield—including franking and if we applied it to the whole market—is around 5.8% and we see that narrowing. So not only is it narrowing—not much of a premium therefore for taking share risk—the bond yield itself is at 4.5% and some people might consider, “Hey, that's a pretty good return—that's risk-free.” So why buy shares?

Well, it's all about future growth. Let's roll this graph forward 10 years, and what are we seeing? With bonds, it’s 4.5% the whole way. So that hundred dollars—you're getting $4.50 all the way up to year 10.

What about dividends? Let's assume that dividends grow by around 3.5%, which is a reasonably conservative assumption. Earnings and dividends should grow in line with nominal GDP growth, so 3.5% is a reasonable assumption.

Chart 5: A chart shows that the projected yield of Australian bonds vs. Australian shares—from the current bond yield of 4.5%—over the next 10 years remaining flat. The projected yield for Australian shares—from its current position at 5.8%—over the next 10 years grows to about 8.2% (assuming a 3.5% dividend growth).

You can see what's happening here—your dividends are growing over time and in year ten, that actually becomes around $8.20—and that is why, over the long term, shares outperform bonds. It’s all about growth.

But that's over the long term, and there's something that's missing from this picture. What's actually missing is that what we're seeing is a straight line. We know that dividends don't go up in a straight line. We know that shares can be very volatile and some years you can experience large losses, some large gains.

For an accumulation member, that sort of volatility shouldn't concern them. As a matter of fact, you should welcome volatility. For other members, such as retirees, they might not have such a long-term horizon, and volatility might actually concern them. Fortunately, for retirees, we've got options spanning across all risk and return profiles. There is something available and even today, we’ve got options at the lower end of the risk spectrum that are offering a reasonable return.

As I said, it is a difficult decision. It's a very personal decision based on individual circumstances, and frankly, there is no better time to get good financial advice.

Thank you very much for listening.

This video provides general information and may include general advice. It doesn’t take into account your financial situation, needs or objectives. Consider your situation before making financial decisions, because we haven’t, as well as the PDS and TMD relevant to you at unisuper.com.au/pds, and whether to consult a qualified financial adviser. Past performance isn’t an indicator of future performance. Information is current as at 18 October 2023. UniSuper’s portfolios have been designed to suit UniSuper, and may not be appropriate for others. Prepared by UniSuper Management Pty Ltd (ABN 91 006 961 799, AFSL No. 235907) on behalf of UniSuper Limited (ABN 54 006 027 121) the trustee of UniSuper (ABN 91 385 943 850, AFSL No.492806) the fund.