Investment update with John Pearce - July 2022

John Pearce: Hello. Welcome to this investment update, I'm John Pearce, Chief Investment Officer.

We've just closed off another financial year, and as many of you would know, it's been a tough one for superannuation returns. In this update, I'll be taking you through the economic and financial market cycle. I'll be talking about how we actually got to where we are, the impact on our returns, and finally, the outlook. I'll be explaining why I am a bit nervous in the short term, but why there are some key reasons why I remain positive in the medium term.

Moving now to the cycle, and I think it's important that we go back to when I first introduced this in January 2021. This is the slide I put up. By this stage, we we're about 9 to 12 months into the pandemic. Markets were being flooded with cheap or free money from central banks, the governments were playing their role—they were lining the pockets of businesses and individuals. The markets—anticipating a rise in corporate profits, strengthening economy, etc.—staged a pretty impressive rally. 

Chart 1: Chart showing the economic / financial cycle. Typically, recession and higher unemployment is followed by: policy stimulus and market rallies; a recovery in growth and a fall in unemployment; inflation and market falls; policy tightening. Then the cycle repeats. A highlight indicates that in January 2021, we were at the ‘policy stimulus’ and ‘market rallies’ stage of the cycle.

We move then on to June and the markets, indeed, were right. The economies have bounced back. Think about this statistic—in April 2020, US unemployment was hovering around 15%. Roll the clock forward about a year, and unemployment had dropped to below 6%. This is quite incredible. But then of course, you had question marks appearing. Will the tightness in the labour market lead to inflation? Is the market overheating? Will central banks panic in the response? And ultimately, will markets fall? 

Chart 2: Chart showing the economic / financial cycle. A highlight indicates that in June 2021, we were at the ‘growth recovers’ and ‘unemployment falls’ stage of the cycle. Question marks indicate uncertainty as to whether: the tightness in the labour market would lead to inflation; the market was overheating; central banks would panic in their response; markets would fall.

We move to October, and here we have an interesting situation. The question mark around inflation had gone—the US was printing inflation at three-decade highs. But still a couple of question marks, and why was that it? It was because central banks really weren't moving. As far as they were concerned, their narrative was ‘look, inflation is going to be transitory, nothing really to worry about here’.

Chart 3: Chart showing the economic / financial cycle. A highlight indicates that in October 2021, we were in the ‘inflation’ and ‘market falls’ stage of the cycle. However, a question mark signifies uncertainty because central banks thought inflation was transitory and nothing to worry about.

As a matter of fact, if you think about our own central bank, we had the governor saying that he didn't expect to see rate rises until 2024. Well, here we are halfway through 2022, and already three rate rises.

We skip forward a bit to April of this year, and question marks have pretty much disappeared. Central banks were tightening—and they were tightening aggressively by then. And the markets indeed were taking fright. 

Chart 4: Chart showing the economic / financial cycle. A highlight indicates that in April 2022, there was no doubt that we were in the ‘policy tightening’ stage of the cycle, which is usually a very volatile period. 

Where are we today? We are well and truly into the final leg of this cycle, and the real question now is whether we're going to see a hard landing or a soft landing. In the final leg of this cycle, it's always very volatile—but this time it's even more volatile than normal. And why is that? It's because of the speed at which this cycle has actually gone full-turn. Normally, from a recession to a full employment situation, it can take the better part of a decade. Yet we have gone full-cycle in about two and a half years.

Chart 5: Chart showing the economic / financial cycle. A highlight indicates that in April 2022 we were in the ‘policy tightening’ stage of the cycle, which is usually a very volatile period. A question mark signifies uncertainty as to the severity of the volatility we’re currently experiencing—it's more volatile than usual because we’ve moved through the economic / financial cycle so quickly.

The speed at which this has happened has really caught central banks napping, and now the narrative has changed to ‘we are going to do whatever it takes to bring inflation under control’. 

Let's now move on to the impact on financial markets and they've been quite dramatic, as many of you would know. A couple of statistics—if we look at the US share market, this has been the third-worst start to a calendar year in the history of the S&P 500. Only two years have recorded worst starts—during the Great Depression and World War Two. That puts it into context. Bonds—in terms of start to a calendar year—the US bond market, you have to go all the way back to 1788 to see a worse start to a calendar year. 

Of course, UniSuper—any superannuation—cannot escape the volatility we are seeing in these markets. If you look at the returns across all of our accumulation options, there's a lot of negative numbers there.

Chart 6: Table showing the investment returns for the financial year to 30 June 2022 for UniSuper’s accumulation investment options. International Shares: -16.7%. Sustainable High Growth: -10.8%. Global Environmental Opportunities: -9.8%. Australian Bond: -9.4%. Sustainable Balanced: -8.9%. Global Companies in Asia: -8.9%. High Growth: -8.4%. Growth: -7.8%. Listed Property: -7.8%. Balanced: -4.2%. Diversified Credit Income: -3.5%. Australian Shares: -2.1%. Cash: 0.3%. Conservative: 0.7%. Conservative Balanced: 1.2%. Australian Equity Income: 4.5%. Data is correct as at 30 June 2022.

Top of the list is International Shares. Now, -16% is a bad result, there's no two ways of getting around that—but you've got to put in a long-term context. Over a decade, this option has returned about 12% [per annum], and that's including last year. So, I guess it's one of those corrections that were inevitable, and it has happened this year. 

Underpinning that strong decade of performance has been a large position in technology. Technology has actually been the worst-performing sector this calendar year, and hence we've suffered accordingly. We aren't giving up on technology. We think that the trend remains intact and we will keep our overweight in technology. 

Typically, when you see a sell-off in equities, you have a flight to quality or a flight to safety in the bond market. That actually hasn't happened this time. If you look at the performance of our bond option, that's almost a double-digit negative. Why hasn't it happened this time? Because the crisis has really been built on inflation, and inflation is bad for bonds. 

Fortunately, we do have options that have proved to be a safe haven. If you look at our Cash and our Conservative options, they've eked out slightly positive returns. That's a fantastic result for members who have elected this option because their primary concern is wealth preservation, and that's exactly what these options have done. Of course, if you’re a member in our Defined Benefit option, you’ve got absolutely no reason to be concerned, it remains in a very healthy surplus. 

Our Balanced option returned -4.2% for the financial year. Once again, we don't like to see negative numbers, but let's think of that number in context. It was the first negative result since the GFC. It was only the fourth negative result since the inception of the Balanced option 33 years ago. So, once again, I think we have to look at the long-term context. -4.2%, not a great result, but generally speaking, our Balanced option members have been served very well by this option over the long term.

Chart 7: Chart showing that: in the Balanced investment option’s 33-year history, it has only yielded negative returns four times; the Balanced option’s negative return to 30 June 2022 is its first negative return since the global financial crisis.

Where to from here? The fundamental question is, will inflation subside naturally as supply chains start mending themselves, or will indeed we have a hard landing? The market appears to be evenly divided on this question. My own view? I am a bit nervous in the short term because of the central banks’ narrative now—‘whatever it takes to bring down inflation’. So, I expect at least the remainder of this calendar year to be quite volatile. 

However, I think there are really good reasons to be positive over the medium term. Firstly, for accumulation members, you're accumulating assets at a cheaper price, so corrections should be welcome—as strange as that might sound. Think about the property market. If you're on the market looking to buy a property, you actually want property prices to be falling. And the same applies to shares. 

What about other reasons to be positive? I think this correction—we are wiping out some of the excesses that have been built up in the system. Think of something like negative interest rates, negative yields. There was a time when there were $18 trillion of bonds outstanding that were yielding negative rates of return. That number is now down to around $3 trillion, which is a lot smaller, and a welcome development. I personally have never seen the merit in negative interest rates. 

What about other excesses? Think about these high-flying companies making no money with questionable business models—they’ve come back to Earth with a thud. We pricked the most obvious bubble in financial market history, and that's the crypto bubble. Once again, I believe that's a positive development. 

Economies have gone into recession and recovered throughout history, and even if we do go into recession, we will stage a recovery. And what's important—what's quite intriguing—is that share markets stage very impressive rallies before economies fully recover. The timing is impossible to predict, but this is the general pattern of share market behaviour.

What has UniSuper’s strategy been? We've built up enormous levels of cash, and we will be looking to deploy that cash. And we won't wait until the world turns to perfection before we deploy that cash because share markets will anticipate a bounce back. Now, that's our strategy, whether it's the right strategy for you as an individual— that's up to you. And if you need some help making that decision, please see one of our excellent financial advisors. 

Thank you very much for tuning in.