Australia will look more and more like other developed countries, not less, over the next few years. Compression of spreads to inflation is now the order of the day - and will remain the order of the day. Here, the relentless compression of spread will begin to impact matching assets to liabilities as that is much easier to do when real rates are high, compared to when yields are low.
Opportunities for protection against inflation come and go and recent opportunities in the Australian inflation market are fast going. Low cash rates for longer will mean that the Australian market follows the trend toward lower yield that is now entrenched in other developed markets.
Quantitative easing (QE) has elevated bond prices and depressed yields, yet the influence on equities is bigger, stronger, and potentially much more dangerous. Hence the question for investors is not whether there is a “bubble” in bonds, but which “bubble” provides the best risk-and-return trade off.
While recent European data is crumbling as you read this, and China is fast slowing, we all hope that the US will carry the global economy. Such a hope is sustained by QE in most developed markets, but a warning: QE has created “bubbles” in all markets. While QE is forcing rates lower, it is forcing market participants into any equity that vaguely resembles a bond (via “known” dividend yields), to the degree that equity markets can now be seen to be very much in “bubble” territory.
Here, this “bubble” has divorced equity pricing from the fundamentals of very meagre economic developed world growth on the hope that QE will save everyone. Equity-market volatility is now beginning to rise as the withdrawal of QE highlights risks that were not present before. A better portfolio design typically means, in the case of Australia, more bonds and less equities, since Australians are typically overweight equities relative to other developed markets, and underweight bonds.
In this heady environment, which is fast evaporating, it is important to stand away from the declining euphoria and look at what investors are trying to achieve with superannuation savings. Here, one can argue that the basic problem for investors is to avoid inflation between the point of saving while working on the one hand, and spending in retirement on the other hand.
Saving is deferring spending, and the value of that deferment is best gauged by the CPI. If you think about your retirement in terms of an inflation-linked liability, then the value of inflation-linked bonds, or “ILBs”, as an asset, become manifest. Specifically, in contrast to building your savings - which actuaries and others refer to as “accumulation” - retirement is all about spending, or what the actuaries call “de-cumulation”. Spending, during retirement, is all about having adequate investments to achieve adequate purchasing power.
If the time between saving and spending is long, which it typically is, then the influence of inflation on spending power is not only very large, it can effectively “make” or “break” your investment strategy.
Global pension-fund managers take the idea of a pension cash flow as an inflation-linked liability very seriously. The procedure is called “liability driven investing”, or “LDI”. Here, the “asset”, or the pension-asset cash flow, is selected relative to the underlying “liability” - or series of expenditures - which typically remain linked to the CPI.
Given the recent equity market outperformance, and subsequent decline, one would suggest that around now would be a good time to rebalance your portfolio using the LDI approach. Several steps are involved in implementing the “LDI” strategy:
- Estimate liabilities: Estimate the spending required each year of the forthcoming retirement period, after assumptions regarding social security payments. This stream of spending, or expenditure, can be thought of as a stream of “liabilities”, which typically rises with inflation,
- Select assets to match liabilities: Given that the liability stream is now known, assets should be purchased to match that stream of inflation-linked liabilities. This would typically mean purchasing a series of ILBs and shorter dated bonds.
- Invest balance of funds in “growth”: If there is a surplus, then these funds should be carefully invested in so-called “growth” assets, like equities, commodities, gold, and housing.
This is a very important part of institutional investing worldwide and should not be ignored. It makes a lot of common sense. In the UK, companies now have to advise of the funding position in their pension funds as part of the company balance sheet. It is similar in the US.
If major corporations need to report funding shortfalls, where liabilities are greater than assets on the balance sheet, then one wonders why more Australians do not think about the strategy of their investments in a similar way. The need to report shortfalls brings problems out of the dark.
Instead of buying “growth” assets and simply “hoping” that everything goes well, as seems to be the complacent attitude of most Australian super funds, this approach is much more measured and conservative. Equities are typically marketed as inflation “hedges”, yet there is little or no evidence to support this claim. Specifically, before you buy anything you need to know your liability stream, and that can be estimated from monthly expenditure levels. It is not that hard to define. Longevity is also important, so plan for a longer life; not shorter.
Yes, there is room for "growth”, yet the room is measurable and the risks are known. The risk of underfunding your own retirement quickly becomes apparent.
While other asset classes masquerade as inflation hedges, the facts do not support this charade; the rouse is well and truly up. Choosing which market, or which “bubble”, is the best for your portfolio is more crucial today that it has been in many years, as the riskier the asset the larger the “bubble”. Using LDI as the framework for portfolio allocation provides a sensible framework for retirement planning, even in the current optimistic investment environment.
Dr. Stephen Nash is an author and Cambridge Ph.D. graduate with extensive experience in fixed income markets.
