The Point

Michael Blayney: How to allocate assets as interest rates near their peak

Interest rates may be nearing their peak, but investors will need to manage the impact in their portfolios for the next few years, says our head of multi-asset Michael Blayney.

“Increases in interest rates usually flow through to the real economy and corporate earnings with a one-to-two-year lag,” says Michael.

“As such there may still be more negative “surprises” to come – and at least an elevated risk of recession in the second half of 2023.”

What does that mean for portfolio construction and asset allocation?

“We are slightly bearish on equities, neutral on government bonds, slightly negative on credit, but selectively positive on listed real assets.

“Global equity market valuations are broadly reasonable, and risks to financial stability appear to be contained for now.”

Economic outlook: what a weakening services sector means for investors

The first half of 2023 surprised markets with better-than-expected economic conditions.

But a key model used by Pendal’s multi-asset team is now signalling that rate rises are starting to bite the services side of the economy.

“Our economic cycle model has pretty much got it right up to this point,” says Pendal multi-asset PM Alan Polley. “Now it’s turning negative.

“That makes us more cautious on the second half of this year, so we’re slightly underweight equities in response.”

Pendal’s economic cycle model analyses the level and rate of change of economic indicators such as consumer and business surveys, while also examining how economic data surprises either positively or negatively.

The model is one of three key indicators that inform the team’s active asset allocation process – alongside a valuation model and a model that analyses market trends – and has a long-term track record of picking turning points in the economic cycle.

Michael Blayney: How to take a multi-asset approach to sustainable investing

Michael Blayney: Take care with stretched US valuations

The strength of global equities continues to surprise as we near the halfway mark of 2023 – but some markets make more sense than others.

Pendal’s head of multi-asset Michael Blayney is cautious on the mega-tech-driven Wall Street rally.

“The US remains one of our less-preferred markets given stretched valuations and the heightened risk of recession,” he says.

“AI is clearly an important thematic for the next decade, but markets have a habit of getting overly exuberant in the short term when a new theme emerges – and this appears to be one of those occasions.”

Michael prefers Japan, which is up some 20 per cent this year, compared to 1 per cent for the S&P/ASX200.

“We’ve liked and been overweight Japan for some time. Japanese companies have been more profitable recently and are relatively under-leveraged, putting them in a better position as rates rise.”

Overall Pendal’s multi-asset team is “marginally underweight equities and close to neutral on bonds, while holding a little more cash and liquid alternatives, which also gives some exposure to inflation hedging assets”.

Alan Polley: What is r* and how it helps investors analyse rates

We’d all like a better idea of where cash rates are going and what returns we can expect from our investments in the future.

One of the tools our multi-asset team uses to get a better view is r*.

Pronounced “r-star”, it’s a term economists use for the real level of interest rates at which the economy neither expands nor contracts.

“Looking forward, we see the r* around the 1 per cent level – providing a reasonable compensation for the opportunity cost of supplying capital,” says Alan Polley, a PM with our multi-asset team.

“A higher r* means the forward-looking return environment is higher than it has been since the GFC.

“Another nice aspect is valuations – with r* trending down before the pandemic we had valuations going up. High valuations mean more risk looking forward.

“Now that we have r* at more normal levels, valuations are back to more normal levels as well.

“These two things suggest the return outlook is more attractive than it was before the pandemic.”

Why our multi-asset team is increasing its exposure to bonds

As inflation begins to fall investors can have more confidence investing in government bonds, argues Michael Blayney, Pendal’s head of multi-asset.

“Inflation in the US has come off a long way,” says Michael. “It peaked above 9 per cent last year and most recently it’s come in just below 5 per cent on a headline basis.

“This has important portfolio considerations. It means you can have a bit more confidence in your bond allocation, because the biggest risk to bonds, ultimately, is inflation.

“We have moved to slightly over-weight bonds and that’s a big change because we were underweight bonds for a long time.”

While global bond yields are broadly in line with Michael’s estimate of fair value, he cautions that elevated services price inflation and a very tight labour market remain key risks for bonds.

Offsetting this is the risk of recession, when bonds should provide their traditional “risk off” portfolio benefits.

Economists have been forecasting a US recession for months and while the timing continues to get pushed out, it’s still on the cards, says Michael.

Michael Blayney: Why it’s better to stay the course on sustainable strategies, even when energy prices are high

The nerves of ESG investors were tested last year when oil and gas prices soared, causing underperformance in some sustainable funds.

But research by our multi-asset team shows long-term ESG investors should stay the course through bumpy times.

Analyst Rita Bodrina recently examined MSCI ESG data going back to 2000.

She found companies in the top 20 per cent of ESG-rated stocks were more efficient that those in the middle segment, and sharply better than the bottom 20 per cent.

Rita also found that ESG companies were better valued by the market over time. And based on cumulative returns over 22 years, low-rated ESG companies generally underperformed.

“Paying attention to ESG factors alongside traditional financial factors leads to better returns and better management of risk,” says our multi-asset chief Michael Blayney.

“Investors certainly don’t have to give up returns if they choose a sustainable strategy.”