23 Mar 2020
We are experiencing an environment without precedent in our lifetime, with people the world over gripped with fear for their physical as well as financial well-being.
Our Chief Investment Officer, John Pearce, provides an update on the current state of play—and how we are managing the investment challenge.
The confronting facts
The facts in this update relate to investment matters. The tragic human element to this crisis is, of course, incalculable.
At the time of writing, the American and Australian share markets are down about 35%. The speed at which the markets have capitulated is actually faster than the GFC, and comparable to the crashes of 1987 and 1929. There is now no doubt that the longest global economic expansion on record will end this quarter. The only debate is around the depth and duration of the 2020 recession.1
Any of our investment options with an allocation to riskier 'growth' assets are obviously being impacted—and in general, the higher the allocation to risky assets, the larger the loss. For the financial year to date, the Balanced option—which most of our members are invested in—was down about 13% at close of business on Friday 20 March. I don’t in any way want to diminish the concern this might be causing many members, but some perspective is warranted. In the nine financial years leading up to the current year, the Balanced option’s average return was 9.7% p.a. The current loss has therefore erased the equivalent of about one and a quarter years of returns.
Our Defined Benefit Division (DBD)
The assets in our DBD have taken a hit but the DBD remains in surplus. In monitoring the DBD’s financial health, we use two key measures—the Vested Benefits Index (VBI) and the Accrued Benefits Index (ABI). At the time of writing, we estimate the VBI and ABI to be around 107 and 116 respectively. We can’t rule out the VBI falling below 100. However, we should keep the following points in mind:
- A fall below 100 doesn’t trigger any automatic response in terms of benefits.
- The VBI has been below 100 on previous occasions and there has been no impact on members’ accrued benefits.
- The impact of further falls in the share market will be mitigated to a reasonable degree by portfolio protection strategies (‘put options’, for the technically-minded) that we put in place at cheap prices, when the market was trading at much higher levels.
A note on the traditional ‘safe haven’ options
When investors flee the share market, their flight to safety typically lands in government bonds or cash. The very unusual feature of this latest crash has been the sharp sell-off in government bonds, and there are a couple of key drivers at play. One explanation is that investors who want to raise cash are reluctant to sell shares at such depressed prices in an illiquid market—so they’re selling an asset (bonds) that they believe to be relatively less attractive than shares. There are other technical factors, but the bottom line is that bond prices have been falling, and this has resulted in negative returns for an asset class that should be outperforming in a crisis.
The central banks around the world have responded by slashing their cash rates (so bonds become more attractive than cash) and re-engaging their quantitative easing (QE) programs. On Thursday 19 March, our own central bank (the RBA) made history by announcing they would be stepping into the market and buying bonds. It was a powerful show of strength—the RBA is targeting a three-year bond rate of 0.25% without specifying a limit to how much they would buy. It was the RBA’s ‘we will do whatever it takes’ moment. The Australian bond market has since rallied (with yields falling) and, with the threat of recession and deflation, it would not surprise me to see the rally continue.
Unlike bonds, there have been no surprises with cash, and that particularly applies to our Cash option which is conservatively managed. In a world chasing yield, we’ve seen evidence of funds increasing the credit risk in their cash options to enhance returns. We have never been tempted. We work on the principle that the Cash option is there to preserve wealth, not grow it. As interest rates trend toward zero, we would expect returns on the Cash option to follow and they may even dip to slightly negative after fees and taxes. However, the only way our Cash option could incur a permanent loss of capital is in the event of a bank default, which we consider highly unlikely. The global banking system is in much better shape going into this crisis than the GFC, with substantial capital buffers. Most importantly, the RBA consistently reassures us that our domestic banks have unlimited access to liquidity.
Which brings me to the most important management lesson I’ve learned from the history of market crashes.
The importance of liquidity
Having been directly involved in financial markets since 1984, I’ve seen a few crashes in my time. Old timers like to say how their experience stands them in good stead to manage the next crash, which is an exaggeration because all crashes are different. However, one common feature is the primacy that liquidity plays in mitigating the loss during such times. Liquidity in this context means having enough cash, or assets that can be easily convertible to cash at fair prices, in order to avoid selling assets at distressed prices in an illiquid market. With hindsight, we often look back at crashes and wonder how prices got so cheap.
Broadly, there are two types of sellers in a crashing market—those who want to sell because the pain of further loss is too much to bear, and those who have to sell. The latter group includes investors who need to meet redemptions, pay margin calls, repay bank loans, etc. Even though they might believe that asset prices are ridiculously low, they are forced to sell because they haven’t got enough liquidity to meet their commitments until the crisis subsides.
We’ve framed our conservative approach to liquidity against this backdrop. For example, we have a relatively low exposure to unlisted assets in our diversified options (about 7% for the Balanced option). We think of property and infrastructure as ‘growth’ assets so they don’t qualify for inclusion in our defensive allocation. When we conduct our stress testing, we assume a scenario where the worst three months of the GFC happens in a single day!
To date, our conservative approach to liquidity has held us in good stead. Despite members having collectively switched $2 billion from growth to defensive assets (mainly the Cash option), we’ve been able to comfortably manage without selling shares at prices we believe are too cheap. Another way of looking at it—we’re effectively using our cash to buy the shares that members are selling. The strength of our liquidity position is such that we plan to continue the strategy for the foreseeable future.
What about the liquidity of our major investments?
Just as a fund needs to focus on liquidity, so does a company—and in general, corporate Australia has entered this crisis in much better shape than it did pre-GFC. Companies will undoubtedly take a big hit to profits over the next year, and dividends will be cut. This is bad news, but only becomes fatal if a company doesn’t have enough funds to avoid insolvency (going broke), before things get back to normal. Having experienced the GFC, our better managed companies have used favourable funding conditions to reduce the cost of their borrowing and lengthen their maturity dates.
DEBT MATURING IN NEXT SIX MONTHS ($)
% OF TOTAL DEBT
DEBT FACILITIES ALREADY AVAILABLE ($)
||$1.3b (cash + undrawn debt)
||$1.5b (cash + undrawn debt)
Source: Company reports, UniSuper estimates
When will the tide turn?
In my view, three things need to have happened before we see a genuine recovery (as distinct from a sharp rally that quickly reverses):
- Central banks reassuring the market that there’s ample liquidity so that credit can keep flowing to solvent companies
- Governments cushioning the collapse in demand by announcing massive fiscal programs
- Passing the point of peak infections in the US
The first two things have already happened, and if this was purely a financial crisis we could already have been on the road to recovery. However, the added fear for life itself makes this crisis so different—hence the third condition. While we desperately want to see peak infections behind us in Australia, developments in the US will ultimately determine the course of the global economy and financial markets.
Unfortunately, on this count, it looks like things will get worse before they get better.
Why not just sell now and buy back at lower prices?
If things are going to get worse before they get better, it may appear logical to join the selling—with a view to buying back at even cheaper prices. However, there are a few reasons we aren’t keen on such a strategy. Markets can turn very quickly and they’ll definitely turn before we see a turn in the economy. The rise in prices could be just as sharp as the fall, and picking the timing is very difficult. The economic consensus is currently a sharp recovery in the last quarter of this year.
Most importantly, we are a long-term investor and believe that current prices for most companies are too cheap. Take Transurban, our largest investment, as an example. At the time of writing, Transurban’s shares were trading at around $10 after recently trading as high as $16. For argument’s sake, let’s conservatively assume that (i) Transurban pays zero dividend for this half-year and (ii) traffic on its toll roads takes a full six months to get back to normal and then resumes the trajectory it was on pre-crisis. In this scenario, the average dividend yield we expect to earn over the next five years is 6.5% (and that’s taking into account a dividend of zero this half-year). Bear in mind that the RBA expects interest rates to be close to zero for years.
Any short-sellers hoping to pick up Transurban from UniSuper at $10 would have been disappointed. We’ve been buying.
We are all experiencing a sense of the surreal. At times, it feels as if the world has stopped. It hasn’t stopped, but it has certainly paused.
The actions that governments are taking—previously unthinkable in liberal democracies—will indeed inflict a lot of damage on the global economy. But we have to believe that the more severe the actions, the shorter the period of pain will be. If economic pain means saving lives, then so be it. And when we return to normality, as we surely will, the human condition will reassert itself.
Everyone wants a better tomorrow than yesterday. That’s why the human condition is innately programmed for growth, and history is not kind to those who want to bet against it. It’s why long-term graphs of asset prices start from the bottom left and finish at the top right.
1 Past performance is not an indicator of future performance.
This information is of a general nature only. It’s not a recommendation or endorsement of individual companies and doesn’t take into account your individual objectives, financial situation or needs.