The Weekend Edition includes a market update plus Morningstar adds links to two additional articles.
Howard Marks is well known to most readers of our newsletter but to recap: he is the Co-Chairman of Oaktree Capital, an alternative asset manager with US$193 billion in assets, and his regular memos are widely read by professional investors and average punters alike.
In his latest memo, Marks discusses his visit with clients in Australia last month and presenting his ‘sea change’ idea – that interest rates won’t go back to the lows seen over the past decade and that portfolios will need to adjust accordingly.
Marks has been pushing this thesis for a while, so there’s nothing new there. However, his presentations led to broader discussions about asset allocation, and from that he had two epiphanies on the topic.
Rethinking the two major asset classes
Marks suggests that ‘asset allocation’ is a relatively new phenomenon. No-one used the term when he joined the finance industry 55 years ago, and portfolios then generally followed a standard 60% equities, 40% bonds split. For US investors, that meant simply allocating to US stocks and bonds.
Now, investors have far more choices. In the types of assets they can invest in - debt, real assets, venture capital, private assets and so forth. In the countries that they can put money into – developed markets versus emerging, home versus abroad etc. And in the ways that they can try to increase returns - including levered strategies and putting more into ‘high beta’ assets.
What struck Marks in Australia though was that despite all the choices, there are essentially only two asset classes: ownership and debt. By this he means that if you want to participate financially in a business, the choice is between a) owning part of it, or b) making a loan to it.
You may think that these two choices are just between stocks and bonds. They’re more than that. Ownership assets can include common stocks, whole companies, real estate, private equity, and real assets, while debt can include bonds, loans mortgage backed securities, and other streams of promised payments.
Marks says ownership and lending have fundamentally different characteristics.
Owners put their money at risk with no promise of a return. They buy a piece of a business or asset and are entitled to a proportional share of any profit or cashflow made. Ownership assets typically have a higher expected return, greater upside potential, and greater downside risk.
Lenders, on the other hand, provide funds to help owners purchase or operate businesses or other assets and, in exchange, are promised periodic interest and the repayment of principle at the end. It’s a contract between borrower and lender, and the resulting return for lenders is known in advance. It’s called fixed income because it’s a fixed outcome.
All else being equal, the expected returns from debt are lower than from ownership assets but likely fall within a tighter range. There’s generally no upside on debt as you buy an 8% bond to make an 8% return. Yet, there’s also minimal downside as you’ll get the 8% return if the borrower pays, and most do pay.
Marks says that when building portfolios, investors have a choice of ownership assets and debt, and how much to allocate to each:
“Which of the two is “better”, ownership or debt? We can’t say. In a market with any degree of efficiency – that is, rationality – it’s just a tradeoff. A higher expected return with further upside potential, at the cost of greater uncertainty, volatility, and downside risk? Or a more dependable but lower expected return, entailing less upside and less downside?”
The best framework for asset allocation
The second epiphany that Marks had in Australia was about the basic characteristics of a portfolio. He says one decision matters above all else in allocating assets: the desired mix between aggression and defence or between preserving capital and growing it. Aggression is usually best played through ownership assets, while defence is better played through debt.
Marks believes that you typically can’t play offence and defence at the same time; they’re mostly mutually exclusive. "This is the fundamental, inescapable truth in investing", he says. And the choice you make between offence and defence will determine the risk profile of your portfolio.
When thought of this way, the goal of investors shouldn’t be achieving the highest return for a portfolio, Marks thinks. Instead, it should be achieving the highest risk-adjusted return, with the right mix between offence and defence to suit your wants and needs:
“For an investment program to be successful, the level of risk in the portfolio must be well compensated and fall within the desired range … neither too much nor too little.”
Concluding this second epiphany, Marks says:
“Ownership assets and debt assets should be combined to get your portfolio to the position on the risk/return continuum that’s right for you. This is the most important decision in portfolio management or asset allocation.”
Talking his own book
Marks also uses the opportunity to talk up one of his company’s preferred sectors right now: non-investment grade credit. He suggests while the returns on offer were better a year or two ago, you can still get roughly 7% on public credit and 10% on private credit. Marks thinks these returns are competitive with the historical returns of equities, but without the risks associated with owning equities. And because of their contractual nature, the returns on credit should prove more dependable than those of ownership assets.
James Gruber
In this week's edition...
In recent years, financial scams have been rife. Last year alone, there were more than 600,000 reported scams in Australia, with combined losses of $2.74 billion. A recent ruling from the The Australian Financial Complaints Authority may help to bring these numbers down, John Abernethy writes. For the first time, a bank is being forced to reimburse a customer for the amount that they were scammed.
Most of us don't want to think about death. But there is a compelling reason why we do need to plan ahead, and that's because leaving our loved ones with a mess is not how we want them to remember us. Kaye Fallick looks at some of the things you can choose to do now, financial and otherwise, to ensure those you care about will have the easiest possible journey at the time of your passing.
This week, it's a pleasure to welcome eminent financial journalist, Alan Kohler. Alan has written a new book on the property market, called The Great Divide: Australia's housing mess and how to fix it. In an extract from the book, he tells of how a succession of inquiries and reports haven't fixed housing's problems, and why we need a national consensus to improve housing affordability to ensure any genuine plan or policy can work.
The 'energy transition' is all the rage in investing circles, with good reason. It's a long-term theme that will impact a swathe of different sectors. Fidelity's Oliver Hextall says taking a 'long-term view' on the subject is a bit simplistic though and investors need to keep on top of short-term issues, especially when it comes to the supply of commodities. He looks at recent trends in graphite and lithium to amplify this point.
The 2024 Nobel Prize in Economics has been awarded to three US-based economists for their work on why nations succeed and fail. The Nobel Prize committee cited the economists' research into the advantages of democracy and the rule of law, and why they're strong in some countries and not others. John Hawkins has more.
Over the past year, can you guess which commodity has performed best? I imagine many would suggest gold, and that would be wrong. Here's the scorecard in US dollar terms: cocoa is up 82%, coffee 57%, silver 44%, followed by gold 38%. As a larger asset class, gold rightly gets more attention and today, Orbis' Eric Marais, explains why it's prudent for investors to have some exposure to gold.
The US elections are less than two weeks away, and the winner will have a big say on what happens in a host of different sectors. John DiMarco and his colleagues at Igneo Infrastructure Partners, investigate the possible implications for the global energy infrastructure industry.
Two extra articles from Morningstar this weekend. Roy van Keulen looks at an ASX stock trading at half his fair value estimate, while Greggory Warren explains Morningstar's downgrade of Berkshire Hathaway's wide moat rating.
Lastly, in this week's whitepaper, Vanguard outlines what asset allocators are currently buying and selling.
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Weekend market update
An opening gap in US stocks on Friday was met with supply, as the S&P 500 floated back down to unchanged, snapping its six-week winning streak with a near 1% loss over the past five days, while the Nasdaq 100 managed a 0.6% advance. Treasury yields finished higher by four basis points nearly across the board, with the two-year note finishing at 4.11% and the long bond at 4.51%. WTI crude rebounded towards US$72 and gold edged higher to US$2,745 an ounce. Bitcoin ticked lower at $66,800 and the VIX climbed back above 20.
From AAP Netdesk:
On Friday, the Australian share market morning gains mostly faded in afternoon trading, with the bourse snapping its two-week weekly winning streak. The benchmark S&P/ASX200 index closed just five points higher at 8,211.3 on Friday - a gain of 0.06%. The index dropped 0.87% for the week and is down 0.71% so far in October.
Four of the ASX's 11 sectors finished higher on Friday and five closed lower, with energy and materials little changed.
Tech was the biggest mover, climbing 3.3% as Wisetech Global soared 12.7%, clawing back some of its losses from its week of turmoil.
Wisetech announced after Thursday's close that co-founder and chief executive Richard White would be stepping down effective immediately amid an investigation into his conduct while transitioning to a full-time consultant role set to give him wide influence within the company.
In the heavyweight mining sector, Newmont had plunged 13.6% to a two-and-a-half-month low of $70.74, a day after the goldminer reported higher production costs. Other goldminers were higher, with Northern Star up 5.1%, Evolution adding 1.4% and West Africa Resources advancing 4.9%. Elsewhere in the sector, BHP and Rio Tinto both added 0.3%, to $42.39 and $118.08, while Fortescue dipped 0.7% to $18.99.
In the energy sector, Whitehaven Coal rose 5% to a one-week high of $6.74 after reporting that all of its coalmines delivered as planned or better in the September quarter.
In health care, ResMed had advanced 5.9% to a three-year high of $37.73 after the CPAP maker announced its first-quarter revenue was up 11% to $US1.2 billion.
The big four banks had a mostly quiet day, with ANZ flat at $31.71, Westpac and NAB edging 0.1% higher at $32.14 and $38.95, respectively, and CBA adding 0.4% to $144.02.
From Shane Oliver, AMP:
Global share markets hit a rough patch over the last week on concerns about valuations amidst rising bond yields even though economic and earnings data was mostly okay. For the week US shares fell 1%, Eurozone shares fell 1.2% and Japanese shares fell 2.7%, but Chinese shares rose 0.8%. Reflecting the weak global lead Australian shares fell 0.9% for the week, with falls in IT, property, industrials and retail shares leading the falls. Oil prices rose but remain well down from recent highs. Metal and iron ore prices fell but gold made it to a record high on the back of falling interest rates lowering the opportunity cost of holding it. The $A fell as the $US rose.
Rising bond yields and share valuations. The past week has seen a further rise in long term bond yields as investors reduce expectations for how much central banks, notably the Fed, will cut rates and price in potentially higher US budget deficits if Trump wins the presidential election. This is potentially a threat to share markets because high price to earnings multiples mean that the risk premium shares offer over bonds (measured by the earnings yield less the 10-year bond yield) is already very narrow compared to what its been since the GFC.
Australia lagging in getting inflation down, but it’s not as bad as the IMF is portraying. Much has been made of the recent IMF World Economic Outlook forecasts for inflation that show Australia as an outlier in having relatively high inflation next year compared to other countries, consistent with the RBA’s relative hawkishness in getting interest rates down. This partly reflects Australia’s relatively strong jobs market and more cautious approach to raising the cash rate along with strong growth in public spending which is keeping demand stronger than expected. But its not as bad as it appears. Firstly, the rise in inflation from 3% this year to 3.6% next year that the IMF is forecasting is similar to the RBA’s forecasts and reflects the ending as currently legislated of “cost of living” measures which pull headline inflation down this year and see a bounce back next year. Abstracting from this and focusing on trimmed mean underlying inflation suggests a continuing fall next year.
Secondly, as evident in the next chart Australian inflation lagged global inflation on the way up in 2022 and so peaked a bit later so its lagging on the way down is not surprising and doesn’t suggest Australia has a chronic inflation problem compared to other countries. In fact, underlying inflation in Australia at 3.4%yoy in August is not that different to core inflation in the US at 3.3%yoy and the UK at 3.2%yoy. Finally, we expect September quarter inflation data to be released Wednesday to show a further fall in underlying inflation to 3.4%yoy from 3.9% in the June quarter and below RBA forecasts for 3.6%yoy, and to 3.2%yoy in the month of September. And price indicators in business surveys continue to point to falling inflation. Our base case remains for the RBA to start cutting in February next year, but a cut in December still can’t be ruled out if September quarter trimmed mean inflation comes in as forecast and October monthly underlying inflation shows a further leg down. Market expectations for just a 30% chance of a rate cut in December and 70% for February now look to have swung too pessimistic after being at 92% and more than 100% respectively in early September.
Curated by James Gruber and Leisa Bell
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