Renewed optimism for a trade deal and a good earnings season so far has driven a rally in stocks and a sell-off in bonds. As I write this, the S&P/ASX 200 is up 1.39% over the past four weeks whilst the S&P 500 is up 4.3% in the same period, clawing back some of the underperformance in late September. Europe and Japan had another strong showing with the Euro Stoxx 50 up 4% and the Nikkei 225 up 6.1%. China was the big underperformer, shedding 1.2%.
Oil rose, recuperating some of the earlier losses in September. Iron ore continued to fall sharply to around U.S. $80 whilst industrial metals like copper were steady. Gold and other precious metals fell as risk sentiment rose.
Meanwhile, bond yields rose strongly as the U.S. 10-year yield hit 1.9% despite the U.S. Federal Reserve (Fed) cutting rates again. The Australian Dollar continues to trade around 68 U.S. cents.
A trade deal or ‘phase one’ is still yet to be signed and doubts are coming to the fore again and the tariff escalation on 15 December remains on the table.
Inflation in Australia remains below target with the latest reading at 1.7%. Overall economic data remains weak, though consumer sentiment and business confidence readings improved over the month. The latest employment figures were a big disappointment as jobs fell by 19,000 versus a forecast of 15,000 in gains as the unemployment rate rose to 5.3%.
In the U.S., employment figures were much better than expected but continue to slow and wages rose less than expected. Manufacturing and service indicators continue to point to slowing growth in the U.S. The Fed cut interest rates to 1.75% as expected but signalled that the economy would need to deteriorate further before considering more cuts.
Europe is showing some signs of bottoming out as manufacturing and service indicators were better expected, though manufacturing is expected to continue to contract.
China data remains mixed as trade fell less than expected but indicators for the service sector disappoint. Investment and industrial production figures also missed estimates, indicating that the authorities are having difficulties combating the slowdown. China is also facing difficulties in Hong Kong as protests continue and violence has escalated in recent weeks.
On the earnings front, the local banks results were broadly disappointing. U.S. and European companies have generally beat low expectations but forward guidance has generally been lacklustre, resulting in future estimates falling.
Reaching for income
With interest rates so low, investors are often disappointed with term deposit rates and bond yields. The cash rate of 0.75% and 12-month term deposits of 1.2% to 1.6% cannot keep up with inflation around 1.6%, so what other sources of income is there?
Defensive income investments generally stem from debt, though many consider property, infrastructure and even high dividend stocks to be income investments, a big proportion of returns from these are capital in nature and they do not have a fixed repayment date and are generally classified as growth assets.
Within defensive income, investors actually have a wide range of options to consider outside of cash and term deposits but below are some segments that look appealing relative to the rest of the market for yield seekers.
Domestic Investment Grade Credit
The Australian economy appears to be bottoming out and domestic companies generally continue to maintain robust balance sheets. Contagion from a global slowdown could push some companies with weaker balance sheets to default, so investment grade exposures provide higher yields without taking on excessive default risk. Unlike government bonds, many of these investments pay distributions as a spread over the floating rate, meaning that if the benchmark yields rise, the distribution received will also rise and vice versa. A diversified portfolio of domestic investment grade credit currently yields between 2.5% to 3.5% gross.
Domestic Senior Loans
Private credit or senior loans are similar to the corporate bonds or credit discussed above. The difference is that it is not an issued bond and does not have an established secondary market, meaning that it is illiquid. This asset is like a bank’s fixed term loan to a business. Senior loans are generally ranked at or near the top of the corporate structure and on floating rate terms. A diversified portfolio of high quality domestic senior loans currently yields about 4% to 5% gross. This sector of the market is generally hard to access for normal investors but there have been a plethora of recent launches of listed investment trusts (LITs) investing in this space which helps investors access exposure. A good manager, size and structure are key considerations for assessing these LITs as they carry a separate set of risks.
Domestic Asset Backed Securities
Asset backed securities are loans tied to an asset whereby a default on the loan results in the lender acquiring the asset. Mortgages are a popular segment of asset backed securities. Again, this is an illiquid asset and does not have an established secondary market but there have been a number of LITs that have been listed in recent years. Again, LITs need to be carefully assessed as manager, size and structure can heavily influence the end outcome. There is a wide range of quality and yields for asset backed securities. A diversified portfolio of high quality domestic mortgage backed securities yields about 6% to 8% gross but there are higher risk segments like mezzanine funding that would provide higher yields though at much higher risks and lower chances of recovering capital in the event of a default.
Remember to collect your free lunch
As the Nobel winning economist, Harry Markowitz, famously said, ‘diversification is the only free lunch’. Therefore, it is important to remember that higher yield generally means higher risk so diversification between the various segments is still necessary on the defensive income side of a total portfolio to spread out risk and achieve a better risk-adjusted return. Low yielding assets such as cash and government bonds still have their own roles to play in a portfolio. Investors should not reach for yield blindly, it is important to consider risk appetite, liquidity needs and investment objectives when constructing the portfolio.
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