Quarterly Market Review October 2019

• In this quarterly report we have reviewed aspects in financial markets that are, in our opinion, unique to the cycle and those that are the same as historical patterns.
• Economic growth is expected to remain sluggish for the time being but we are of the view a widespread recession is unlikely. The household sector is in reasonably good shape and while some of the corporate sector is clouded by uncertainty, there are sectors where the impact is relatively immaterial.
•  Monetary policy settings continue to be unusual. Central banks are again debating various forms of easing, while there is also pressure on the fiscal side to contribute. A notable difference to past cycles has been the absence of inflation, which has had a widespread influence on financial markets.
• Aggregate equity earnings growth has all but dried up. While cyclical factors have played a role, the combination of slowing demand and increasing cost pressures are likely to remain as the primary challenges for the corporate sector.
•  Nonetheless, we remain confident that active managers can select those companies with differentiated growth options or are able to withstand a mild downturn. A key question is whether the longstanding bias towards high growth companies continues or whether value stocks come back into vogue. We recommend a diversified approach to manager styles to avoid unforeseen shifts in the biases within the equity market.
•  Fixed income presents unusual challenges given low interest rates. Bond portfolios have provided outsized returns as yields tumbled. Barring another downward movement in economic activity or an unexpected event, it is hard to make a case that large allocations to developed market bonds will be productive.
• The middle ground remains in corporate credit. At this juncture, neither high yield nor investment grade credit pricing is overly compelling, but for the defensive purposes of fixed income, we are skewed towards higher investment grade and securitised debt.
•  A widespread rise in allocations to alternative investments is based on the two main factors. Illiquid assets that are infrequently priced act as a stabilising component in a portfolio and private equity and debt has increased in scale in preference to listed equity and traditional bank lending. We believe these changes are structural while the review process to assess the options remains, as always, core to the decisions.

We have retained our tactical allocations set in our July 2019 Asset Allocation report.

Returns are expected to be measurably lower in the coming few years, with the potential for periods of negative outcomes. However, these should be met with renewed buying as we do not observe a major dislocation in financial markets, albeit the dependence on central banks is a concern.

Asset Allocation

Expected index return (excluding alpha and franking)

Expected return (including alpha and franking)

In this asset allocation quarterly report, we discuss where economic and financial conditions are the same as in the past or, alternatively, distinctive to current circumstances. Similarities are considered in the misquote of Twain, “history does not repeat itself but often rhymes”, as each cycle has its own nuance.  The new patterns are problematic for investment markets as the consequences are open to conjecture.

Trade tensions and geopolitical instability are undermining corporate confidence, notwithstanding the periods of apparent truce. Business investment spending has therefore stepped back with risk that employment growth also comes under pressure. A modest revival in industrial activity can be expected in forthcoming months as we cycle the impact of inventory building due to tariffs and the changes to auto emissions that impacted on this sector 12 months ago. However, unless there is renewed policy that encourages further investment, it is probable that an upturn will not be sustained.

The US small business (National Federation of Independent Business) sector has significantly reduced its planned capital programmes, notwithstanding the underlying strengths and (arguably) policies that have been skewed in their favour.

The trade dispute between the US and China looms large and has an undue influence on short term market behaviour. Resolutions have been followed by another setback. Business is likely to respond cautiously to any settlement and it is still unknown if the attention of the US administration turns to Europe, where the auto sector is under the spotlight, but inevitably other categories will most likely be dragged in.

To date, the household sector has been relatively unaffected by this instability, yet in most countries is exercising self-control on spending and debt levels. This is supporting the services sector, where demand is notably higher than the goods sector.

Household balance sheets are generally in reasonably good shape. The combination of stellar returns from financial markets over the past decade and house price rises have rebuilt household wealth, though the disparity between cohorts has also widened. In some countries (and Australia is a standout) the resulting rise in debt is a less welcome feature, but this has not been a universal trend.

China is stimulating its economy, but within limitations to avoid excess credit expansion and in the face of uncertainty on its trading relationships. Recent data suggests a modest upturn in activity.

Locally, GDP growth may be plateauing at a below par level with some risk of a deterioration in employment conditions, alongside the persistence of low wage growth. However, the stabilisation of the housing market and improved cash flow due to lower mortgage rates and tax cuts are helpful developments.

• At this level, ignoring monetary settings, the pattern of the economic cycle is relatively similar to history.  Tightening labour markets typically result in rising inflation which leads to higher interest rates and cost of capital followed by slowing economic growth. Usually there is a political or geopolitical influence that is unhelpful, though in the current phase it is notably problematic. Some of these features, inflation being the obvious, are not evident today. The influence of technology, global trade and demographics is attenuated in this cycle.

It is the monetary policy of the past decade that is a step change from what is considered normal cyclical patterns. The longer-term consequences of central bank balance sheet expansion and such active participation in bond markets is unknown. What is clear is that financial markets are of the view that central banks are key to supporting asset prices.

Central bank rate cuts have become less effective in encouraging credit growth and investment spending. Instead, the primary motivations appear to now be exchange rate management and influencing the shape of the yield curve.

There is a heightened expectation that fiscal policy may be a substitute for monetary activity to induce growth. However, the combination of a limited appetite to expand fiscal budgets and the one-off benefits of potential tax

cuts are likely to restrict the impact. Fiscal spending is a tried and tested policy to buffer household income. Today, the household sector has limited pockets of distress. It is the low share of wages in the national economies compared to income that accrues to capital that is restraining consumption spending.

A bout of fiscal spending is relatively normal when governments feel the political pressure. A change would be the widespread implementation via Modern Monetary Theory (MMT), a government-led expansion of the monetary base. So far this has only been the purview of discussion amongst economists with a few political adherents. It is unlikely to receive widespread adoption.

Higher inflation is no longer viewed as likely in this cycle, though there is some concern that the disruption to supply chains from trade could result in an unexpected rise in inflation, even if growth slows. If there is a combination of costs from trade, interest rates that result in another rise in asset values, and fiscal policy designed to create even more demand, it is possible that inflation may return to the 2-3% range.

In summary, global economic growth continues to slow, yet there is no indicator that a significant deterioration is inevitable. A resolution to trade disputes and improvement in business sentiment is necessary to stabilise growth.

• The financial economy has overridden the industrial demand economy of the past 40 years. Similarly, services and capital light models dominate the corporate sector. Then, by adding in the demographic pattern of the larger GDP countries and the end of trade as a primary source of growth, the determinants of financial asset pricing have taken on a different flavour.

The question whether cheap debt financing distorts investment markets and its consequences are the subject of ongoing debate. Bear commentators view the value of assets that are based on current interest rates as extreme, while the opposite case is that markets are not expensive as low rates are here to stay.

To date, equity markets have taken a relatively benign view on the current potential risks. Valuations have increased in the absence of earnings growth, but dividend yields are supportive and at low risk of a cut, even if there is a modest easing in the earnings base.

The key debate is how to value equities in the light of low bond yields and the impact on methodology based on the risk-free rate. There is no uniform path to valuing equities and the table below illustrates the interplay between a web of determinants and the participants.

Source: Stern Business School, Aswath Damodaran

The argument for a change in equity valuations are based on:

•  The length of the cycle. This is the ‘it’s time’ that relies on cycles regardless of evidence. It ignores changes in earnings, cash flow or structural shifts that have major impacts on corporate outcomes. We are of the view that this is a weak argument, even though history illustrates equity cycles, but the cause is not based on a time horizon.
• The CAPE ratio (which measures cyclically adjusted earnings) and assumes that over a roughly 10-year time frame, excess profit is cannibalised by industry change bringing the return on capital back to a long-term base line. There is merit in this argument, but it is a weak predictor and describes a pattern rather than an emerging phenomenon.
• Equity values relative to other asset classes are attractive. This is a tenuous case, as it is based on game theory. Investors are assumed be committed to financial assets, and as others are overvalued, therefore equities have merit. History shows that this is rarely a foundation as asset values converge in distress.
•  The rise of new companies, expressed in the US as an acronym, FAANG (Facebook, Apple, Amazon, Netflix, Google), that are achieving high earnings warranting high valuations. Every region has their own mix. Their weight is large enough to reflect through to overall pricing for equities given their returns, which achieve high outcomes on new capital light balance sheets. Every cycle has its new winners and the overall market cannot rely on a few stocks that can drag up an index in isolation to other issues.
• Central bank rates provide the foundation via the risk-free rate. This is an iterative argument on low rates while ignoring an additional overlay of low growth. Too many assume low rates for ever but have not dialled down the inevitable low real profit growth that is an implicit assumption. Nor has the low inflationary challenge been factored into corporate profits. External to the measured CPI, corporations face higher cost in regulation, compliance, marketing and, in many cases, a skills shortage.

The constant is the change in interest rates and the implication for valuations and growth. The significance should not be lost on investors. All asset returns will struggle to match history barring unusual circumstances.

The long-held concepts that underpin equities have not changed. What is different is the nature and behaviour of the participants and the sources of information.

ETF inflows have been US$4.1tr in the past ten years, compared to the US$1.5tr of outflows in active strategies. We do believe that ETFs result in a higher momentum flavour, as these structurally chase recent gains, thus compounding the flow to the ETF category. In some sectors or ETF styles, the proportion of the stock that is represented in ETFs can frustrate active managers as the performance will be predominantly determined by the size of ETF participation. For example, in the first half of this year, just 6% of the stocks in the MSCI World Index accounted for 53% of the returns.

The average holding period for any stock in the S&P 500 is now well below a year (depending on the statistical methodology it is anywhere between four to eight months). Since mutual funds overtook individuals as the primary holder of stocks in the 1970s, the average holding period had hovered between 2-3 years.

• The short-term behaviour bias does cause reactive share price performance and low tolerance for management taking a long term view. In turn, this has resulted in more buybacks, which rewards management even if unwarranted and a low appetite to undertake capital investment. For long term funds, such as MFS Global Equities, the consequences can mean that the performance will take time to reflect the merits of their judgements.

Another theme is falling equity share count. This is a combination of buybacks, mostly a US phenomenon but increasingly across the world, and the lack of IPOs. Very low interest rates are the primary culprit. Stocks with longer term buybacks in place will likely be less volatile than those left to their own devices.

The weak IPO market is a function of the longer holding periods in private equity. A large amount of spare capital has been raised in private equity that is acquiring companies which may have come to the equity market. Finally, poorly structured IPOs with the most recent notable example of WeWork, possibly the pinnacle of what not to do in such a process.

• Fund managers have a cautious to outright negative view on buybacks where they are clearly aimed at short term rewards for management. Yet, for capital light business models, they are a way of enhancing EPS without committing to a higher dividend that possibly is unsustainable.

Information sources on industries and companies is very different to past decades. Direct access to senior management can be a challenge and, if so, the commentary tends to be pre-prepared rather than a point of engagement. Further, investment banking equity teams have been hollowed out due to the payment for research costs in Europe, the growth in ETFs and general cost pressure in the industry.

Fund managers therefore do more of their own research and look to external sources.

• Most fund managers do use broker reports, notwithstanding claims of the opposite. However, gaining a unique insight is becoming harder and artificial intelligence is proclaimed as the new potential path to sensing the nuances for a company’s outlook. State Street Global Equities’ approach is to delve into data to assess expected returns. This is the recommended manager closest to the purely quantitative style.

We expect that a much more thorough approach to ESG (environmental, social and governance) to become the norm. Governance has had the sway, but the concepts on sustainable business models that ‘do no/less harm’ is evident in the presentation from the corporate sector. Similarly, there is increasing attention on the culture of the organisation with many investors hurt by executives that lose sight of their customers and shareholders.

• Companies with high ESG ratings are increasingly given a notional valuation uplift to their peers. WCM (Escala Partners’ recommended SMA) has a long-standing view that culture is a key driver of corporate and ultimately investment success.  We have also recently initiated an ESG portfolio across all asset classes.

US domination of equity returns has continued due to the type of company rather than the local economy. The S&P 500 has a large number of high growth companies that are considered to have defensive, low volatility earnings. This theme has been persistent for much of the past decade leading to the ongoing ‘growth versus value’ debate. Growth stocks are now considered vulnerable in a pullback given their valuation, while also without much in the way of dividends. Very recently, value stocks, with lower P/Es and reasonable yields, have matched the growth performers.

Value fund managers have been frustrated and inevitably lost FUM in the past decade. Were the pattern to change (as the long-term historical chart shows), the selloff in widely held growth stocks could be quite severe.

While too early to be confident that this rotation in favoured stocks will persist, there is a rationale that the divide in valuation and performance will narrow.  The outlook for growth companies is not as clear as it was with regulation, populist sentiment, privacy concerns for social media and the spotlight on IPOs that have underwhelmed. The implication is that there has been too little credence paid to risks in growth companies which should be factored into the price.

Nonetheless, it is unlikely that value stocks will become entrenched, as the category is littered with economically sensitive, energy and financial companies. However, we do believe there is a greater focus on the sometimes-stretched valuation of growth companies and the assumption that their past profit growth rates can be repeated now that their business model is more mature.

Sector selection may become the key to a portfolio. It is therefore likely that the US outperformance is less entrenched than before given that some preferred sectors such as consumer staples, healthcare and utilities have a reasonable weight in Europe, while there is also a large list of companies trading at very low valuations and reasonable yields.

• Fund managers with a value orientation have struggled to match the index in recent years. We recommend an allocation to offset the growth bias that would otherwise dominate. Platinum Unhedged and Antipodes Global Equities are two funds with a notable value discipline. As at September 2019, Platinum Unhedged’s portfolio had a weighted average P/E of 11X.

Emerging markets (EM) hold promise given the growth in their economies, the emergence of consumers and the low level of equity participation. The trade dispute has clearly had a negative impact, but there are other reasons the regional category has underwhelmed. Lack of coherent policies (in South America in particular), unstable currencies (such as the Turkish lira) due to deficits and weak governance (South Korea) are examples.

Active management in emerging markets is at times caught on the wrong end of the rapidly changing attitude towards the region. In time, a separate allocation to China is likely to become the norm. While it today seems improbable that the US will lose dominance, we point to the period when Japan was the largest country weight in the MSCI. The most likely area to gain share in global markets is within EM.

• We recommend Somerset Dividend Growth and RWC Emerging Markets as active managers across EM. They are focused on specific locally dominant companies and have low to no weight in those EM companies which are common in global equity mandates.

The domestic reporting season was among the softest in recent years. Reported earnings were slightly worse than expectations, with aggregate earnings supported by continued growth in the resources sector, offset by a contraction in profits from industrials and financials. At a sector level, weakness was evident in stocks exposed to residential construction, cost inflation emerged across a range of industrials, while financials also disappointed. Retail was a somewhat surprising source of positive news, with stocks rallying ahead the realisation of an improvement in conditions from monetary and fiscal stimulus. Dividends again surprised to the upside, an extension of a well-established trend.

The most notable takeaway from the month (and arguably more important for the year ahead) was the broad-based revisions in forward earnings estimates. This reflects a rebasing of expectations of forecasts that were overly optimistic, along with cautious corporate outlook for FY20. Outside of the resources sector, earnings trends have been negative over the last 18 months.

ASX 200 Sectors: Change in Forward EPS since January 2018

Escala Partners, Bloomberg

Growth vs. Value 

As with international markets, the growth versus value debate has attracted attention in Australian equities. The primary argument used to justify the premium attached to growth is relevant to the Australian market is the persistent decline in interest rates. Growth stocks receive a greater valuation uplift when interest rates fall, given their longer duration cash flows. Additionally, if the growth is viewed as structural and not significantly influenced by economic growth, they should be less impacted when investors fear an economic slowdown.

In the Australian market, there is also the scarcity factor of higher growth stocks (particularly in the large cap end), which has also been a contributor to the premium. The following chart illustrates the standard deviation of sector P/Es in the Australian market to give an indication of the dispersion between high growth/high P/E sectors and the rest of the market. A significant driver of this dispersion is the expansion of P/Es in IT (now on 40x) and health care (31x).

Standard deviation of Sector P/Es

Escala Partners, Bloomberg

While predicting a turnaround is difficult, some have taken the view that the valuation gap has become so wide that mean reversion could occur at any time. A more probable catalyst would be a sustained rise in interest rates combined with an improving economic environment, both of which are not on the immediate horizon. A mini-selloff in growth/defensive equities occurred in early September, however this proved to be short-lived.

• If sustained, the low rates/low growth environment continues to favour growth-focused strategies such as the Selector High Conviction SMA and most small cap funds.

Yield Differential

ASX 200 Forward Yield – Australian 10 Year Bond Yield

Escala Partners, Bloomberg

Yield is the most compelling reason for owning domestic equities. The forward yield on the ASX 200 has been higher than the benchmark 10 year bond yield since 2011 which averaged around 1-1.5% over the past decade, and has now has expanded to 3.4%. Yields on equities are generally much less volatile than bond yields, though that ignores the capital volatility in equity capital values.

• The Martin Currie SMA remains attractive from a yield point of view. The gross forward yield on the portfolio is 6.2%, a gap of more than 5% ahead of the domestic cash rate.

Small Caps vs Large Caps

Small Industrials P/E Premium to Large Industrials

Escala Partners, Bloomberg

Small cap industrials currently trade on a ~10% premium to large caps, slightly below the average of the last two years, but above the longer term relationship. Given the lack of earnings growth among many large cap stocks, the valuation differential looks reasonable for investors seeking capital growth. Small caps tend to be domestic-focused and the risk lies with the trajectory of the Australian economy.

Outlook

Resources: The key risks are from an escalation of the US-China trade war and further deterioration in manufacturing data. The temporary boost to earnings and cash flows from the spike in the iron ore price should play out over the following 12 months, although the miners remain well placed to continue to deliver above-average dividends to shareholders in FY20 (BHP and RIO trade on a forward yield of more than 6%) and valuations are not stretched like other parts of the market.

Banks: A few hurdles are still to be cleared before a positive view can be reached. These include NZ regulatory capital requirements, margin contraction from falling interest rates and ongoing remediation charges. On a more positive note, better data has emerged in the housing market, which could help to revive anaemic credit growth. Valuations look reasonable compared to history, although need to be viewed in the context of a large structural decline in return on equity.

Industrials: Earnings for the broad industrials group declined slightly in FY19, although optimistically are forecast to rebound in the next 12 months and are thus likely to be subject to negative revisions. Earnings trends have been markedly negative through this year.

As we have previously noted, the conditions are in place for a cyclical pick up based on monetary stimulus and cuts to tax rates. However, this is yet to be fully reflected in recent trading updates and guidance statements and therefore the upcoming AGM season will be particularly important for evidence of a positive tone. There are more optimistic outcomes priced into certain sectors of the market (such as retailers), while others (such as companies exposed to home building) remain under pressure.

Defensive industrials have a more predictable low-growth outlook, although are priced at a premium. Two examples are worth highlighting; Woolworths and Coles both now trade on mid-20s P/Es, while Telstra is on 18x. In these cases, the outlook has improved at the margin, although not nearly to the extent warranted by the re-rate. Bond proxy stocks could be linked in with this group, although are more warranted based on a relative yield basis and with predominantly growing distributions.

Developed market government bonds

Bond portfolios have provided outsized returns as yields tumbled. It is hard to see how this can continue, as developed market (DM) government bonds appear expensive. It is only the relative argument that favours the US; which is not difficult given two thirds of Europe’s bonds are offering negative yields, while Australian yields are at all-time lows. Relevant USD and AUD government bond indices have returned 7.7% (10.4% annualised) and 9.3% (12.65% annualised) since the start of 2019.

We understand that global central banks are responding to a deterioration in global economic conditions and yields are subsequently pushed lower, but when assessing a bond’s ‘fair value’ (a function of real growth, inflation and a term premium) they all fall short. Notwithstanding stretched bond valuations, market pricing seeks more rate cuts and other stimulatory measures (QE), notwithstanding the Fed’s dot plots (the forecast from each member of the Fed) showing a shallower pathway for further easing. The ECB is running out of monetary options, and the RBA is teetering on a below zero cash rate.

Several reasons can be cited for the breakdown in what one normally uses to assess the fair value of a bond. Central bank intervention (particularly the use of balance sheet expansion through QE), trade wars and structural global shifts in demographics, digitalisation and globalisation suggest that inflation and rates will be permanently lower. Commentary often states this as ‘the new normal’ and ‘lower for longer’. If this is the case, there is no value in term premia and historic trends on rates are all but irrelevant.

If inflation fails to emerge, and growth remains subdued, bond yields can fall further, notwithstanding current pricing. However, our base case is that rates will be broadly range bound. Fiscal spending in the US and Europe (funded through treasury issuances and a subsequent increase in supply), together with some pull back in rate cut expectations may see yields drift a higher, but any significant rise is likely to be capped by the structural changes.

Investors buy government bonds for three reasons:

Income – regular and known distributions. Current low coupon rates make the income argument a difficult one and potential returns now hinge on capital appreciation, which is no certainty.

Capital preservation – high quality credit of governments and mean reversion of bond price upon maturity. Bonds held to maturity reprice at par ($100) and the credit quality of developed market governments is not in question. However, we note the risk to capital over the term of the bond if sold prior to maturity, and the real return is likely to be negative once inflation is considered.

Diversification to equity – Diversification rests on the argument that the negative correlation between equity and bonds remains intact. This we consider below.

The relationship between equity and bond pricing is unstable. It is true that there has been a negative correlation between the two for much of the 21st century and this is the case when analysing the past 15 years as well.

However, in a shorter time frame other trends have emerged:

• In the four decades prior to the 1990s, equity and bonds had a positive correlation, and more recently, the five year correlation figures are positive.

• Since 1976, stocks and bonds have both gained in the same calendar year in 32 out of 43 years.

• 44% of quarterly periods since 1988 have seen both global bond and equity markets rally.

As it stands, the negative correlation between equities and bonds is intact over most longer-term cycles and is therefore the best hedge available to offset equity risk, noting it is not perfect. We have our reservations, given the low level of rates and the ability of bonds to offer enough capital appreciation and coupon income to offset any equity drawdowns. The trade war, political uncertainty and central bank intervention could also be influencing the correlation between the two markets. However, the real value of being diversified between stocks and bonds is often realised during a bear market.

• Our outlook for the global economy is a continuation of the low growth and inflation story, which will keep rates supressed. The returns from bonds are therefore likely to be lacklustre and reflective of the low yield environment. However, while not our base case, we acknowledge that recessionary risks are rising and recommend an underweight exposure to developed market bonds as a hedge to a downturn in equity markets. US treasuries are our preferred region and our recommended exposure is through the Pimco Global Bond Fund.

Credit

The traditional metrics used to measure the value of credit need to be interpreted in context. US investment grade (IG) credit spreads are tracking close to their average over the last five years but are below if viewed over a ten year timeframe. Driving these reasonably tight valuations are record low interest rates, supporting corporate profitability, and very low default rates for US IG credit over the last two years. However, the change in the investment grade universe is riskier given that 50% of the index is made up of BBB rated bonds (the lowest rating for investment grade), which as a weighting, has more than doubled in ten years. Corporate leverage is also higher than over the decade.

Default rates in high yield (below investment grade corporate bonds) are also tracking below the five and ten year average, with the sector similarly benefitting from low interest rates. Despite this, credit spreads are higher when compared to five and ten year average data.

On this metric, high yield (HY) appears cheap. Yet there is a distortion in spread pricing within the high yield sector. The margin between the lowest rated credit, ‘CCC’ and highest rated ‘BB’ has widened to its largest in three years (since the energy crisis). BBs have tightened while CCCs have remained relatively stable. The average yield on BB corporates has fallen from 6% to under 4% in the last few months.

Investors that previously bought investment grade bonds have taken on more risk and moved into the highest quality bonds available within the high yield sector – a ‘search for yield’.  Not surprisingly, the spread differential between BBs and BBB rated securities has narrowed to a 12-year low.

Source: Federal Reserve Economic Data

We opportunistically recommend small exposures to the high yield market when pricing is favourable, but always evaluate the metrics of this market as a bellwether for overall credit conditions.

• The middle ground remains investment grade corporate credit. Funds and research houses are divided on the outlook for credit markets. At this juncture, neither high yield nor investment grade credit pricing is overly compelling. However, acknowledging low interest rates and default rates, we continue to support the segment as it offers income above bonds and greater diversity. The Kapstream Absolute Return Income Plus Fund and Aquasia are our preferred credit managers.

Our recommended funds have significant exposure to securitised bonds.  We like this asset class given limited supply, high spreads, strong fundamentals, and more conservative lending standards. These bonds also offer diversification to other investments. Domestically, the Kapstream Absolute Return Income Plus Fund and Aquasia Credit Fund invest, as do the JP Morgan Strategic Bond Fund and Pimco Global Bond Fund in offshore markets.

We maintain our view that hybrids are expensive for the risk. The spread on a 5-year major bank hybrid has fallen 1% in a year, notwithstanding the lower total return given the reduction in the cash rate against which these securities are priced. The discretionary nature of coupons, position on capital structure and potential for conversion to equity is not being rewarded. We suggest investors wait for a better entry point, while existing hybrid holders trim exposure and remain tactically underweight.

In light of low rates, investors have sought other investment classes and structures. Flows into private equity and debt, unlisted real assets and other less well-known strategies have been high.

As we have referenced in the past, alternative assets are mostly equity or debt like but are in a different part of the capital structure or in a different entity to listed equities and traded bonds.

Private equity and debt have grown substantially in scale and diversity. Private equity’s advantage is in its capacity to take a longer term view without the quarterly focus on reporting. Private debt is a function of the tighter regulation placed on the banking sector.

What has not changed is the rigour required to judge the investment merits. Given the illiquidity in these holdings, the emphasis on this process is critical.

Other alternative investments in unlisted property have not changed over the decades and we recommend these as a core component of the alternative allocation.