Quarterly Market Review January 2018

In this edition of our Asset Allocation we will focus on investment markets, product and security positioning after a brief summary of the current economic background.

The pattern of global economic growth that emerged through 2017 is consolidating into a robust cycle, supported by both manufacturing and services. Australia is belatedly participating as the labour market improves and infrastructure spending takes over from the housing sector. The risk of inflation accompanied by tightening monetary policy is the primary concern.

Upward earnings revisions off the US tax reform compensate for elevated valuations for the S&P 500. Other regions have yet to show operating leverage, valuations are either at or below historic levels and out of favour sectors such as financials and energy are buoyed by a change in outlook.

Within our neutral to overweight allocation to global equities, the blend of active management in currency exposure, regional weight, investment style and exchange traded fund composition are important considerations at this point in the investment cycle.

The ASX 200 is constrained by the weight of lower growth sectors and stocks, while dividend yields look sustainable. Resource sector upgrades are the most likely source of higher capital gains yet introduce features such cyclicality and potentially unreliable income.

We recommend increasing the weight towards long short and market neutral funds. These should buffer the portfolio in the event of a sell off in equity markets.

Fixed Income investing is challenged by the transition in interest rates off decade lows and tight spreads on credit securities. Low duration and unconstrained funds should prove the best option. Aiming for high returns may change the role of this asset class in a portfolio and should be accompanied by reducing risk in other asset segments.

Cash is a low return option for the portfolio to await a change in the investment environment.

After above average equity returns in 2017, investors should expect a reversion to mean in the coming two to three years. Rising rates reduce the equity P/E via the rise in the risk-free rate. Capturing additional sources of return via Australian franking credits and global above index potential is likely to be key features within a portfolio.

Fixed income is maintained as an underweight allocation relative to its strategic weight. Its role to preserve capital is constrained, while it does still meet sufficient of its income generation.

The addition of alternative investment processes such as long short, market neutral, global macro and unlisted assets can, in our view, reduce risk via uncorrelated processes and structures compared to long only equity and credit.

Asset Allocation

 

Expected index return (excluding alpha and franking)

Investors have entered 2018 embracing the sustained economic growth as viewed through Purchasing Managers Index PMIs, sweetened by the US tax cuts and Eurozone friendly German collation government. Suggestion of a slowdown in China has yet to occur and Latin America, as well as countries such as Russia, are rebounding on the combination of better government policies and commodity prices.

The much-heralded synchronised growth of 2017 looks even more entrenched. A pickup in business spending could extend the cycle further. The expectation is that US companies will bring forward capital programs to take advantage of accelerated depreciation in the next five years. European companies have, for some time, indicated that they expect to lift investment due to shortages in selected sectors.

Major developed economies: output    Major emerging markets: output

 

After lagging in 2017, the Australian economy looks set to participate with the rest of the world. The key sectors are state-based infrastructure spending and exports. The household sector will, however, be restrained by low wage growth and debt levels. If consumers reach in to their savings to fund consumption, the RBA is more likely to raise rates. The problematic aspects lie firstly, with the housing market, not in the sense that mortgage defaults will necessarily rise, but that the dependence on housing for wealth and income for investors is high. A second source of risk is commodity prices, which can be expected to react to any perception of slowing investment spending in China.

In the search for a spoiler, the key global issue that is raised is the risk of overheating. This would drag inflation into the headlight, along with likely tightening of monetary policy. Reports that the US Fed will ease its inflationary target to a notional price level or a range may not be enough to curtail a reaction through an unexpected rise in rates. Similarly, after ten years of adding liquidity to the financial system, it is not clear how the recent withdrawal of this support will impact on markets.

Politically, any restraint on trade could turn into a meaningful headwind, particularly in terms of sentiment.

Investor sentiment is at elevated levels, as are other measures of economic ‘surprise’. The rosy outlook is supported by a meaningful lift in forecast profit growth for 2018.

The US is the primary source of favourable sentiment, with 2018 earnings growth upgraded from 11% to over 14% due to the tax cuts, oil prices and a generally upbeat tone. Upward revisions are likely as the full effect of the tax changes are incorporated into models.

The charts show the rise in earnings estimates this year and the sector contributions based on the average and median, indicative of the depth of the profit growth across an industry.

S&P 500 earnings estimates for respective calendar year, Jan 1^st = 100

 

S&P 500 Sectors EPS Growth (%)

 

While the P/E is well above its comfort zone, it’s hard to make a case that the S&P 500 index will retrace given the earnings lift, in the absence of another influence.

European earnings growth for 2018 is pitched a touch under 10%, somewhat held back by the higher Euro. While the P/E has moved to approximately 15X after a rally in 2017, the dividend yield is also solid at 3.5%, particularly given the low-income yield from other asset classes.

Emerging markets are still trading at around the historic average of 12X, EPS growth is in the low teens and dividend yields are just under 3%.

Bar the US, other markets are mostly trading within their 10-year valuation range.

Valuation Range (last 10 years)

 

It is unsurprising that this positive scenario is holding investors to their equity allocations. We generally support the direction with a few provisos.

To some extent, the current conditions were paid for in 2017 and as the attention turns to forecasts for 2019, the outlook is somewhat unclear given the tightening financial conditions.

Another feature is the potential change in sector leadership within the equity market. For much of the past decade, growth stocks, particularly under the disruption theme, ran ahead of the rest of the market. Recently, the financial sector, a beneficiary of early rate rises, has come to the fore and energy has rallied alongside the oil price movement. We have noted reticence by fund managers to pay up for the high-profile, instead seeking less commonly held stocks. Specific risk may lie with the dominant internet names as regulators become concerned regarding their dominance.

Each of our selected fund managers has a distinctive style, time horizon, bias towards a region, market capitalisation or investment process. As previously noted, we don’t take outperformance against the index as evidence that will endure, nor do we judge underperformance necessarily as a misstep. There are many examples of funds that perform counter to the index yet experience a reversal of that outcome within a relatively short time.

The information technology (IT) sector in the All Country World Index was up 31% in 2017, well ahead of the second best, materials at 20%. Any fund positioned underweight to the IT sector or the large market cap performers would struggle to beat the index, even if stock selection in other sectors outperformed. Yet, on a five-year time horizon, all of our core global managers have outperformed the index even if they had consistently had low exposure to the IT sector due to their holdings in other sectors.

In considering the 2018 construct of a global equity allocation for 2018 we have focused on:

Currency hedging.

The weak USD is paring back reported returns from unhedged holdings in the US, while Euro and Yen assets at this stage translate into a currency gain versus the AUD on an annualised basis. The outlook for the US dollar is somewhat bearish given the rise in the deficit (both current account and fiscal), lower capital inflows and the general appetite for risk. We recommend some hedging against the USD, but not necessarily fully hedged as the currency is still likely be a buffer in an equity pullback.

– This can be achieved through MFS Global Equity Hedged trust and State Street Global Equity Fund, the latter of which has 40% hedging against its USD weight of circa 60%. Antipodes Global Fund, which is a long/short manager, has a 25% weighting to the USD as at the end of 2017. The Platinum funds take a currency position separate to their regional equity weights. Generally, the deviation is not meaningful. Platinum Unhedged Fund (as its name implies) does not hedge but has traditionally had a low allocation to US equities, currently at 20% and 25% exposure to the USD. Obviously, regional funds such as the emerging markets (Somerset Emerging Market Dividend Growth, RWC Emerging Market Fund, Macquarie Asia New Stars) have direct exposure to the USD, though recognising that some stocks are listed in the US and in Hong Kong, where the HKD is pegged to the USD. Platinum Europe and Platinum Japan allow investors to take regional and implicitly mostly unhedged currency positions outside the US.

Regional allocations.

With the passing of the US tax reform bill, the US corporate sector has been given a lease of life, notwithstanding the high valuations. Merger and Acquisition (M&A) activity may come through as buyers can write-off capital investment in the first year. The positive tone to the large US tech companies has also reappeared after a short-lived period of caution. The key sector in the US may be the financials. The lending banks benefit from lower taxes and are lifting their lending rates in line with the movement in yields. In designing our current blends of funds, we have a modestly underweight US bias.

Many global funds have explored the opportunities in Europe, but few have gone substantially overweight. Scepticism on the health of the banking sector has kept some investors cautious, notwithstanding their valuations. The financial sector is 21% of the MSCI Europe index. A proportion of the consumer staples and healthcare companies are global (Nestlé, Novartis, Roche and British American Tobacco) and are not related to the economic recovery in Europe. Implicitly, funds therefore struggle to find enough suitable stocks to participate in the local macro theme that result in a regional overweight allocation.

Japan has only recently become a focus and most global funds are underweight emerging markets, notwithstanding the top tier performance last year. We expect this gap to close given the research effort into opportunities in the region.

– The regional allocations of our preferred managers are shown in the chart as at end 2017. The highest US weight is in Magellan, followed by WCM. MFS has a large European allocation relative to the index, albeit the companies in the portfolio are mostly global. Platinum Europe naturally provides a specific European skew. State Street Global Equity and Platinum give a Japan tilt. Emerging market managers, Somerset and Macquarie Asia are dedicated to their index, in the case of Macquarie it is the Asian ex Japan/Australia small cap index. Platinum and Antipodes currently also have a bias to Asia.

Preferred Funds’ Regional Exposure

 

Style and process.

There has been an explosion in number of factor-based funds, particularly exchange traded funds (ETFs). In turn, any active fund can now be analysed to assess the type of factor to which they adhere. The four predominant factors are growth, quality, momentum and value. 2017 was defined by growth and momentum. Conversely, value and high dividend yield were not in favour. Factors can rotate from year to year, exacerbated by the ETFs which tend to follow whatever is performing at that time.

– As noted each fund has a distinctive approach and philosophy in creating their portfolios. WCM tends to follow a momentum driven growth stock bias holding positions for around two years. MFS takes a much longer-term view, shying away from momentum while still focused on growth. State Street has one-year timeframe, with a value orientation. Magellan manages to a beta, which aims to reduce drawdowns and volatility. Both Platinum and Antipodes have a contrarian view where it may take time for the consensus to come to their view. They can therefore both lag the momentum in markets. Somerset looks at capital allocation cycles where it expects free cash flow to improve, while Macquarie Asia selects stocks on consumption trends. RARE’s infrastructure mandate defines its stock selection, though it does emphasis the expected internal rate of return (IRR) from the assets within the company.

In blending our recommended manager universe, we account for the input above, and layer on top of the judgement of the organisation, the fees and communication. The intent is to avoid an index-like representation and allow the outcome to express the requirements of the investor akin to our asset allocation approach.

In summary, we retain our tactical allocation to equities, on the proviso that the portfolio is not excessively concentrated in one fund style or region.  2017 saw investment returns well above our expectations, yet even equity bulls concede that the high starting base – valuations, profit margin, low interest rates – imply a lower than historic return over the coming three to five years. A spike in inflation and rates may signal a more dramatic shift to and within equity markets.

The growth in demand for ETFs has made it easier for investors to gain access to specific asset classes. There are over 170 ETFs listed on the ASX based on over 130 benchmarks. These index benchmarks can vary even within a market category.

An example of this is the three emerging markets ETFs that are offered to Australian investors, each of which replicate a nominated index. The top ten holdings and weight for each are:

 

When it comes to countries, sectors and holdings, the three indices have some fundamental dissimilarities. The FSTE and S&P indexes exclude South Korea as it is classified as a developed market, whereas, the MSCI index has over a 15% allocation. Naturally, this is going to lead to a dispersion in performance among the ETFs. As the above table shows, the Vanguard fund is less concentrated in comparison to the other two.

 

The emerging market technology sector has powered ahead, contributing to nearly half of the index’s returns in 2017. Vanguard’s ETF has therefore lagged. The concentration risk of the narrowly defined ETFs is exacerbated by the high valuations attributed to the likes of Alibaba, Tencent and Baidu which are also represented in active fund manager portfolios.

– We therefore prefer the Vanguard Emerging Markets ETF, as it offers a broader exposure to emerging market equities with less of a bias towards large cap stocks and has a lower managed expense ratio (MER) compared to its peers.

Ultimately, it is important that investors consider how the underlying composition of an ETF is constructed when looking to gain exposure to an asset class.

The Australian equity market generated a solid total return of 11.8% in 2017. Notably, however, returns fell short compared to other developed markets, with major benchmarks rising more than 20% as synchronised global economic growth, robust earnings and well-behaved interest rates combined to lift equities. On a positive note, the advances made by the ASX 200 were due to growth in earnings as opposed to an expansion in the earnings multiple.

For the second year, it was the resources sector which underpinned the gains of the Australian market. The initial recovery came after an extended multi-year cycle of oversupply and overinvestment. Prices rose from a low base two years ago and stimulus in China helped to lift demand once more. More recently, returns have been buoyed by a combination of capital discipline, policy direction in China (restricting lower-quality domestic supply) and a pick-up in global demand.

The oil price has joined in the commodities rally, giving a boost to the listed sector. The price has been driven by a supply rebalancing following OPEC’s agreed production cuts, which have now been in place for over a year. Given financial and operational leverage within the energy sector, the earnings and share price gains have been quite significant.

The environment of an improving global economy and rising commodity prices is typically one that results in outperformance of the Australian equity market. However, it has not been the case in this instance. Resources companies have been less inclined to increase their hiring and capital expenditure plans in the current cycle. It has also reflected the structure of the domestic market and softer economic conditions. The structural issues include a low weighting in higher growth sectors of the market (such as information technology) and a high proportion of sectors that are relatively mature, or face regulatory hurdles (such as consumer staples, telecoms and the banks). While there have been individual winners across consumer-focused stocks, many companies have struggled given the combination of prevailing high household debt levels and benign growth in income.

Change in Forward EPS Growth Estimates

 

The chart illustrates the evolution of forward earnings across the sectors of the market over 2017, with the bulk of sectors huddled around a modest 5% growth. Energy and materials lead the way with 15-20%, while the relatively small utilities sector has been boosted by upgrades to AGL. On the negative side, downgrades to Telstra’s earnings forecast dragged down the whole sector.

The key risk for Australian equities remains the prospect of rising interest rates. We have noted that the RBA is expected to remain on hold for much of the year, however longer-term yields could follow international pattern. As detailed previously, the Australian market has a higher proportion of sectors that are negatively affected by rising interest rates. Notably, many of these companies have lagged the index over the last month, including REITs, utilities and infrastructure.

The interest rate and economic cycle has implications for the relative performance of ‘growth’ (or high earnings growth/high P/E) compared to ‘value’. This has a significant influence on the performance of investment managers that have a bias towards a particular style. Some may recall the large sell-off in growth stocks in the second half of 2016, highly visible in the small cap sector of the market. The trend, however, was short lived and growth stocks returned to the market’s leadership throughout 2017.

Respectable earnings growth has remained within a narrow range of companies and the premium attached to growth has again returned to the Australian market, with the valuation dispersion increasing through the year. The valuation gap that has now arisen suggests a level of caution is warranted towards high growth names and any earnings disappointment could result in a sharp selloff.

Small caps came back into favour as 2017 progressed, but outperformance largely driven by a small number of themes (for example, China related food stocks and commodities linked to the electric vehicle). Managers that have been able to identify these themes early have profited handsomely. While some highly speculative behaviour has arisen in some sectors (such as technology companies with limited revenue, or any company that associates itself with blockchain activities), these parts of the market are quite small. Nonetheless, there is still evidence of elevated valuations across stocks that are well-owned among managers and contributed significantly to attribution. Evidence of earnings to support the momentum is now required.

At a broad sector level, the following observations can be made:

– The banks have lagged the market, reflective of the soft credit growth environment (partially driven by housing lending restrictions imposed by APRA). Capital positions are sound (ANZ has already announced a buyback) and bad debts are well contained. However, margins are stable and earnings (therefore dividend) growth is limited. Restructuring looks to be an opportunity, with potential asset management sales by NAB and CBA. Banks currently trade on a relatively large discount to the broader market, although with a benign outlook, this is arguably warranted. This also reflects the decline in return on equity over the last few years, with a corresponding drop in price/book value, as illustrated in the following chart.

Australian Banks: Change in ROE and Price to Book

 

– Resources stocks currently have strong earnings and price momentum. Commodity prices are expected to moderate through the year, yet spot pricing implies significant potential upgrades to earnings. Broad global growth and the ‘risk on’ sentiment has provided a solid environment for the sector, offsetting a potentially slowing in demand from China.

– Industrials are quite mixed. Companies with overseas earnings have a better economic backdrop, currently challenged by a rising AUD/USD. The housing construction cycle has peaked, and the consumption growth is patchy. Certain sectors, such as the supermarkets, have elevated levels of competition. Higher growth is generally more company specific in nature (such as Aristocrat with market share gains), while positive themes (infrastructure spending and tourism) have limited investable options.

Interest rate sensitive areas of the market were spared a bond sell-off in 2017 thanks to benign inflationary figures around the world. The risk here remains to the downside.

The ASX 200 remains on the expensive side and it is worth reflecting on how investment managers are currently positioning their portfolios. Generally, the last year has been favourable for our small cap managers relative to our large caps.

The SMA manager, Investors Mutual (IML), runs a value-orientated portfolio, with a focus on quality and recurring earnings streams. As a result, the portfolios provide capital protection when markets are weak, but typically when high-beta resources and momentum factors are driving the index it does lags. The SMAs have trailed the index over the last 12 months, while the portfolios have remained true to style. IML has a cautious outlook and we would expect the SMAs to do relatively well in the event of a market correction.

SMA manager, Martin Currie (MC), currently expects ‘normal’ equity returns for 2018. The dividend sustainability filter leaves the MC SMA with a low allocation to resources stocks, which has hindered relative performance. Fundamental analysis will be critical in the event of a market correction led by lower earnings, as companies which can maintain their dividends are at a lower risk of capital erosion. Given the yield focus of the MC portfolio, it is reasonable to assume that rising interest rates may provide a headwind, although historically the portfolio has shown little correlation with interest rate moves.  We note that of these key sectors, only the utilities sector is overweight in the portfolio, while popular infrastructure stocks such as Transurban (TCL) and Sydney Airport (SYD) represent a low exposure.

Wavestone has more of a growth flavour than these SMAs, although the beta of the portfolio is kept in check by its short positions (typically index shorts), which reduce the overall exposure to the market to around 80%. While this growth bias leaves it susceptible to a correction given P/E expansion, the downside is limited by its short book. Despite a reduced exposure to market movements, the fund has outperformed over the last 12 months and it remains a good option to blend with the core SMA positions.

Many small cap managers are leaning towards the view that stocks are relatively expensive and have adopted more defensive portfolios. Nonetheless, following the market’s recent rally, investors may consider reducing their weight in high growth managers, such as Regal Australia Small Cap Fund and Ophir High Conviction Fund. Small cap funds with a value bias, such as Ironbark Karara Australian Small Companies Fund, JC Small Cap Long Short Fund and Spheria Australia Smaller Companies Fund, are less likely to underperform in the event of a market correction.

Funds within ‘alternatives equity’ should be less affected by a change in market conditions. To date, low volatility and sector dispersion have been unhelpful for funds such as Ellerston Market Neutral and ARCO Absolute Return Funs, which rely on these factors to generate returns. With a low correlation to the ASX 200, a correction may instead create opportunities, given their approach to identifying value (quantitative and fundamental). We note that ARCO has observed that “there are almost as many short opportunities as there are long” in the current market.

Style is more relevant to the Bennelong Market Neutral Fund, which is typically long higher quality/growth stocks and short a lower-rated counterpart. After a disappointing 2016, the fund had a strong turnaround in 2017, reflecting the growth style that has driven the market’s returns. With additional leverage employed in this fund, a market rotation back into value would likely see this fund lag.

Outside the equity component of alternatives, we recommend our unlisted property funds (when open for new raisings) and global macro (Standard Life GARS). We anticipate adding to the options over this year

Our underweight allocation to fixed income is reinforced by the unease towards bond yields in the US and ultra-tight credit spreads. Local low duration managed funds (Kapstream Absolute Return Income and Macquarie Income Opportunities) should generate higher returns than term deposits, subject to credit spreads. Globally, PIMCO Global Bond Fund represents a solid strategy and some portfolio insurance to navigate the changing emphasis within a longer duration style. Unconstrained global funds (Legg Mason Brandywine Global Opportunity Fixed Income (GOFI) and JP Morgan Global Strategic Bond Fund) will ride with the higher risk fixed income segments that continue to pay off within the positive tone to investment markets.

Two big themes for fixed income in 2018 are:

1) The flattening of the yield curves (short term rates rise relative to longer term rates) in countries that are raising rates compared to Europe (as shown through German Bunds).

 

 2) Credit spreads have tightened across sectors to the lowest levels in 10 years as investors sought income within the asset class.

In 2018, the consensus view is for the US rates curve to steepen slightly but, more importantly, for yields to lift across the curve. While a flat yield curve leading to an inversion (where long term rates are lower than short term rates) has preceeded the last seven recessions, this is judged to be a low probability this year. Instead fund managers are aiming to protect portfolios from higher yields (which erode prices on long dated fixed rate bonds).

The US forward curve, indicating two rate hikes for this year, is still tracking below most fixed income participants who are of the view that three to four increases are the mostly likely outcome. Wage increases, above trend growth, expansionary fiscal policies, rising commodity prices and the new tax reform are predicted to lift inflation this year. There has been some comment that the new members of the Fed may tolerate higher inflation by assuming a band or through the cycle approach. It is not yet clear, however, how the fixed income market will react if rates do not follow a trend in inflation.

– Global bond funds (for example PIMCO) have been adding inflation-linked bonds to their portfolios (known as TIPS in the US). This will help protect the portfolio should there be an unexpected lift in inflation

Adding to yield pressure is the reduction of the Federal Reserve’s balance sheet and the tapering of asset purchases by other central banks. In terms of the Fed, this has been communicated as gradual, but it raises the question as to who will soak up this supply of Treasuries, which is to increase as the US government increases issuance to fund fiscal spending and tax cuts. Historically Japan and China, flushed with excess reserves, bought up -dated Treasuries. Reduced buying by these countries and the four largest central banks, leaves the market exposed to reliance on pension funds and mutual funds to fill this gap. Talks of an end to the ECB’s bond buying and Japan’s tapering has already lifted yields in recent weeks, which may mark a significant turning point in pricing.

Projected demand from central banks for US Treasuries is expected to turn negative by the end of 2018

 

The focus on global bond yields, particularly those of the US, is the impact these have on the direction of interest rates in other countries, including Australia. While our short rates are anchored by the RBA, the long end takes the lead from the US and responds to movements in other developed regions. Many global funds have significant holdings of USD denominated bonds and credit products, where coupons are reset against US Treasuries.

– Given our view on rates in the US, we remain underweight traditional long duration global bond funds and favour unconstrained bond funds and short duration style funds.  As a buffer to risk we recommend the PIMCO Global Bond Fund, albeit on a reduced allocation, as this fund is dynamic in its approach to managing duration. This is expressed through its positioning in curve steepening, underweight benchmark duration, inflation protected securities (TIPS) and higher income generating products, such as agency mortgages

Domestically, the RBA is expected to raise rates in the latter half of 2018 responding to the improving economic data. High household debt and low inflation will curtail any significant moves. Regardless, offshore rate movements can be expected to drag yields higher. Capital appreciation, previously enjoyed by Australian long duration funds, is therefore unlikely, with the coupon from the bond being the main source of income. Reliance shifts to the fund managers to carve out some trading profits as markets overshoot (as they typically do). Returns of circa 3% from these funds in 2018 would be our best case are therefore best viewed as portfolio insurance rather than a source of real gains.

From a fundamental perspective, credit spreads are tight given a global search for yield (referenced in the chart below), below trend default rates and solid corporate profitability. However, from a technical perspective, the tightening of spreads on credit products across all sectors has pushed levels to 10-year lows, raising concerns that they are not compensating investors for the risks.

Fund managers differ in their views on where value lies, some noting that investment grade credit margins are too thin to warrant investment, preferring the wider spreads in high yield (HY) and emerging market (EM) debt. Others expect any correction in spread levels to come from the ‘riskier’ sectors such as these, and therefore hold defensive floating rate investment grade opportunities. Either way, we are not seeing many high conviction calls when it comes to credit, with most wanting to remain ‘flexible’ and diversify across sectors.

Given the challenges to effectively forecast spreads as we move into ‘late cycle’ pricing, we are comfortable with the diversification across credit that our recommended fixed income funds offer. Our exposure to local credit is through Kapstream, Macquarie Income Opportunities (all high-grade credit), Aquasia Enhanced Credit Fund and internal listed hybrid and subordinated debt models. Globally, the primary source is JP Morgan Strategic Bond Fund (for investment and non-investment grade credit, RMBS, hybrid and subordinated bonds, global high yield and emerging markets)

Australian Credit Spreads (iTraxx)

 

Continuing limited supply is expected to support valuations on the domestic listed debt and hybrid market, but tight spreads also make them vulnerable to a correction. Within our models we prefer maturities of three years and under, as we are of the view that there is too much repricing risk if spreads widen on the long-dated hybrids. We also seek relative value trades, looking for mispricing across securities with similar credit and maturity characteristics.

In summary our views for fixed income are:

– We remain underweight fixed income in our asset allocation.

– Global yields are expected to rise, with a potential steepening in the yield curve led by movements in the US and Europe. We prefer short duration funds and those with flexible mandates to manage interest rate exposure.

– Australian interest rates potentially rise later in the year. Income yield and security trading should allow for positive low returns.

– Diversification across credit products, as valuations look stretched and relative value trades become more important.

– Listed debt and hybrid security purchases to be opportunistic and within three years to the expected maturity.