Investor Insight

August 2019

Ian Gillies talks to Will Hamilton how it is all about interest rates at the moment. Official rates have gone down in Australia, were lowered last night in the United States and are flagged to be decreased by the European Central Bank. The result is a rush into risk based assets.

We also discuss the growth in demand for ESG filters in investment mandates.

Transcript

Ian Gillies  0:09
Hello, and welcome. I am Ian Gillies and welcome to the Hamilton Wealth Management podcast No. 30 for August 2019. I’m joined today by Will Hamilton. Will, you attended the world’s largest global industry conference Fund Forum International, which was held this year in Copenhagen, Denmark. Can you give us some information or some thoughts that came out of that conference?

Will Hamilton  0:34
Thank you Ian. The 2019 conference was dominated by two things. So, the first of all was the ESG, which I’ll talk about later, and that’s become very much mainstream in Europe, and interest rates. So we’ve mentioned in these pages on quite a number of times that investment markets depend on the direction of interest rates. So in that context negative yield in government bonds are going to be a troubling feature for the investment horizon one day in the future. Mario Draghi, who’s the governor of the European Central Bank, or the ECB as it’s known, has opened the door to lower interest rates in Europe, and quantitative easing to be reintroduced in Europe. And at the same time, German and French government bonds are trading, at negative yields. It was recently reported that the quantum of negative yielding debt globally is now more than 12.5 trillion US dollars. So it’s also interesting to note that QE, when it was first introduced, was referred to as non-conventional monetary policy, yet it’s now considered conventional monetary policy, hence the recent announcement by the ECB. So there were predictions at the Copenhagen conference of anywhere between 50 basis points or half a percent to 1% for the fed fund rate cuts. Market and our analysis are not expecting cuts of this magnitude by the Fed over the next 12 months. And that was quite interesting, because last night we saw the first cut of 25 basis points to 2.25% but also signaling that this just might be a one off. The US Q2 earnings season has been mixed, you couple this with ongoing concerns over the China US trade dispute, the Fed’s showing a willingness to get ahead of further slowing in growth. The result has been further strength in equity markets, as people rush to risk based assets in trying to get a yield. And what this is doing is extending what will soon be the longest post World War Two rally with the S&P 500 now about 2,900. Our concern is that the US economy could not handle 2.5% interest rates, which is incredibly low. Look, a lot of people at the conference were referring to this as the “Japanisation” as I call it, countries that have very low growth and low interest rates such as the  European and the US economies, falling interest rates and slowing growth. These premature interest rate cuts are the first since 1995. The last time when the Fed cut interest rates while there was still positive growth. Note the Fed has never cut interest rates by 1% without there being a recession also. And I’d say given the signaling last night that that that is not a fear that we need to worry about. One area disagreement in discussions at the conference was over inflation. So, there are those that feared continued disinflation and hence held concerns around this Japinisation of economies as central banks continue to cut interest rates. While there are others that are seeing inflation starting to come in, but yes, at a very tepid degree and higher than central banks are targeting. So, they’re looking at cyclical tightening in US labor markets. So, what they have in their system surpass the previous peaks and tight immigration policies. You’ve seen industrial strikes in the US now they’re highest since the 80s. And so the pricing power is now aligning with the employee. And then you got the structural side, the US is importing higher prices through the tariff war as they increase consumer prices by their own policy actions and the consumer has to pay for this. So, cutting interest rates especially in the US is creating and I believe will continue to create a rush towards equities. Investors are chasing positive yields. The result might be a melt up in global equity markets, we’re definitely seeing the start of that. And as equity markets in the US are at or near record highs, the boost for demand on the back of bond yields, it’s going to further distort valuations which are already high. So let’s be clear, and I think this is what has to be remembered by everybody, equity markets are risk based asset classes. Investing in equities is about investing for capital returns balanced with income not for income alone. Investing in equities for dividends alone risks capital shock at some stage, when the cycle does turn. We are late cycle. And Copenhagen conference goers kept reminding themselves this as well as the fact that we’re in the longest bull market ever. There’s the added concern to the unpredictability of trade wars at the moment. It’s also worth remembering that the best returns are always late in the cycle, melt ups can occur. And for now, central banks are hoping this by their accommodative monetary policies.

Ian Gillies  5:15
Thanks, Will. Another theme at Copenhagen this year was ESG, or Environment, Social and Governnance issues. And this seems to be becoming more mainstream in Europe. Would you comment on how you see this developing?

Will Hamilton  5:31
Over the last four years ESG has been a topic their and I’ve seen it go from being a niche issue to one that now tracks very high levels of interest, it’s essentially become mainstream. So, ESG takes two forms; there is the negative angle about filtering to exclude what are referred to as harm stocks. So those are in industries such as tobacco, gambling, weapons, alcohol, and things like coal. Then there’s the positive angle; biasing towards companies that positively promote their credentials in the areas of the environment, social practices and corporate governance, Mark Carney, Governor of the Bank of England, has actually been talking about ESG a lot lately. In fact, he gave a talk last night at Coutts as well, in the UK, the private bank and what he’s saying is that ESG is crucial, crucial to the pressing need to manage between risk, reporting, and returns. So, we’ve noticed in active funds management in the UK and Europe, the allocation of capital by funds management industry is taken on a societal view. So, what we agree is that ESG is a crucial component of an investment process, we believe that it’s struggling between what I refer to as hopeful ambition and real action. So, what people often argue here, especially in Australia is there is no clear consensus. So, what’s the definition of ESG? Look, there’s been more than 2000 studies completed on ESG, not one of them agrees on what is the definition. So, they can’t compare apples with apples. This has led us to give this a lot of thought and I think that’s because ESG is values based, the values based. There’s impact investing which is positive. And then there are ESG qualities some what our social objective some are financial objective and there’s no agreement whether it’s a constraint versus an objective. But the thing is its values based and what is a value for one person is not a value for another. So, I believe this will never be resolved and will not see a practical one size fits all style definition or approach with ESG. As I just mentioned, that the values for one doesn’t necessarily mean it is for another. We’ve been watching trends globally and notice the time lag in many mainstream UK/EU investment issues coming to Australia. Four years ago, the hot topic in the Northern Hemisphere was funds management fees or any MERs as they called. We would say that issue took three years really to take hold here in and of some magnitude. We have no doubt that ESG will become a big issue in Australia but just not yet. There is definitely without a doubt increased demand from clients to invest here in Australia with do no harm mandates as is the case in Europe. We can only see this trend growing. Interestingly wealth managers we spoke to in Europe said the number one age bracket where the demand is being initiated from is in the 60 to 75 year olds, not the baby boomers. Now that raises questions, why not millennials? But you also have to take into account that that cohort millennials is only growing as an age bracket for investing. So, where we believe many critics lose focus on ESG and sustainable investing is that understanding it is about responsible investing with increased risk criteria. It is not and should never be treated as a donation. It’s about investing that does good. It is still firmly in the market.

Ian Gillies  8:50
Thank you Will. Thanks to Will for today’s podcast. As always, if you have any questions or would like a copy of our Insight, please call us on 039275 8888. I am Ian Gillies and thank you for listening