Ongoing uncertainty over the duration and extent of the Covid-19 economic downturn has extended the discount rates on alternative assets, particularly those that have seen hard stops on activity, says Sunsuper CIO Ian Patrick.
Airports and other transport-related assets, along with commercial and retail property, are likely to become increasingly attractive investments as the world gets better at handling Covid-19, he says.
“Whilst those assets have appeared to be sub-par in terms of defensiveness through this period because of a hard stop on economic activity, if you look forward and we learn to live with and manage through Covid-19 and eventually perhaps have a vaccine, those assets look pretty attractive given where they are valued today particularly in relation to alternative defensive assets like sovereign bonds and perhaps even some parts of the credit market,” Patrick tells Investment Magazine.
Sunsuper lists Brisbane Airport and Bristol & Birmingham Airports in its top two infrastructure exposures along with exposure to retail property through AMP Capital and GPT Shopping Centre funds, the fund’s most recent (November 2019) alternative assets report shows.
Patrick also argues large funds may find opportunity in other unlisted assets like energy pipelines, utility grids or transport assets with strong relative market positioning and a “degree of complexity”.
“If there’s a degree of regulatory or operational or multi-jurisdictional complexity to it which requires a long-term horizon, those are attractive assets to own for entities like us, and probably aren’t as sought after by others looking for yield-based assets as a proxy for bonds where complexity and long-term duration is problematic.
But pricing needs to reflect the higher degree of unpredictability still present in global markets, Patrick says.
In a wide-ranging interview with Investment Magazine, Patrick says emerging evidence has helped funds refine their scenario planning to get a better feel for how investments will perform.
The expected timeframe for borders to re-open is longer than initially expected. Behavioural changes have had time to play out allowing investors to refine their expectations on the forward earnings of consumer-focussed technology companies. And the extent and implications of lockdowns are better understood as societies move in and out of cycles that may be regional or localised with more specific implications for consumer activity.
“As one goes through these scenarios at first they are very rough and ready, and then they pick up degrees of thoughtful refinement as we progress through time,” Patrick says. “Initially the anticipation was a period of downdraft, then a rebound, the question was only to what extent would the pace of rebound be – steep or slow. Whereas now scenarios are far more nuanced in light of that emerging experience.”
What is defensive today?
So what does it mean to create a balanced portfolio in this time and what can be called a defensive asset? Assets that normally prove defensive in recessions – such as retail property focussed on non-discretionary spending–have been up-ended this time around.
“There’s no doubt that sovereign bonds and cash were the only effective defensive assets during the March and April period, but what that has meant is today you have the majority of those assets trading at negative real rates or even negative nominal rates,” Patrick says.
Unless investors believe the economy is heading into a deflationary or protracted recession phase, they need to take a hard look at the cost of holding those assets, he says.
One medium-term strategy response from Sunsuper, after de-risking the portfolio earlier this year, has been to increase the extent of foreign currency exposure in portfolios due to the pro-cyclical nature of the Australian dollar.
“It used to cost you not to hedge [foreign currency exposure] in terms of interest rate differentials, but that’s no longer the case,” Patrick says. “With short term rates at or near zero, you’re not losing out on return by not hedging.”
Sunsuper’s valuation-based dynamic asset allocation strategy–which makes assumptions about future cash flows which are adjusted as deemed appropriate as the environment changes–has also led to ongoing tweaks in response to unfolding events.
“As equities became cheaper through March you buy equities, and as they become more expensive through the reflation of May and June you reduce your weighting of equity holdings,” Patrick says.
“The harder the US ran the less enthused we were about holding overweight US equities relative to others, and likewise with bonds, clearly as rates plough the depths we are less inclined to hold sovereign bonds.”
Patrick believes the extent of the dispersion evident in markets will lead to a reward for active management skill, including hedge funds and concentrated active portfolios. They’re not truly defensive, but somewhat less correlated with equity markets, he says.
Investors also need to be wary of letting their winners in equity markets run too hard, he says.
“In this environment where equity markets have re-flated quite markedly, being disciplined about rebalancing–in other words taking equity risk off the table and not letting your winners run too extensively–is part of a process of managing a balanced portfolio.”
More opportunity to come
The downturn is likely to throw up a range of opportunities for investors, Patrick says. Well-funded and operationally sound companies may be able to benefit from asset sales of distressed competitors or other participants in their value chains, and private equity players may also be in the game for roll-ups or targeted expansions of capability.
But currently the available transactions in industrial and commercial property aren’t indicating high levels of distress in pricing at the moment, Patrick says. “I’m not sure we’ve come to the point where loans are breaching covenants and the loan holders are interested in realising value in a reasonably timely manner and therefore likely to effect a sale, but I think some of those opportunities will arise.
He also believes there will be opportunities to arise in newer technologies like data centres, mobile communications towers, fibre optic networks and other new infrastructure.
“I think there will be opportunities to either secure good operators on long term contracts or build to purpose something like that,” Patrick says. “You will need capital to do that so the large asset owners are probably in a good position for that sort of thing.”
But other large asset owners around the world will be looking for these same opportunities so competition could be strong.
“Most Australian funds are probably at the sweet spot where they are big enough to play a part in a consortium but not so big that the number of opportunities is very limited because they have to deploy a billion or otherwise it’s meaningless at the portfolio level,” Patrick says.
Moderately sized funds may also benefit from exploiting specialist credit opportunities, building up an exposure to family owned property assets and possibly private equity in highly competitive industries that have come under pressure, he says.
Patrick says Sunsuper is interested in nation-building investments, recognising the fund’s ability to have a broader impact on markets and help create a stronger economic recovery. But lingering concerns about a third tranche of the early release scheme are currently dampening the fund’s appetite, he said.
“Right now we think we have a fairly good grip on what the early release scheme looks like but there is still enough chatter in the broader environment about the possibility of a third tranche of the early release scheme,” Patrick says. “We would have to be cognisant of that in deploying liquidity to illiquid opportunities. And many of these nation building projects would be somewhat if not totally illiquid in the medium term.
“If you think what would generate the possibility of a third tranche is continued economic weakness and a limited capacity to support that hardship or offset it in other ways through fiscal means or otherwise, then the challenges to the fund will be not only directly meeting the requirements of that third release but also depressed asset values in listed markets which increases the proportion of illiquid assets.”
Inflation not a short-term concern
On the topic of inflation, Patrick believes higher levels of inflation are likely in the future, but not for a few years.
With stimulatory monetary and fiscal support, “there will be a desire to inflate out of that increasing debt burden in a nominal way,” Patrick says. The US Federal Reserve’s Jackson Hole shift in its policy towards inflation also points to a willingness to see an upside breakout of inflation. And de-globalisation also points to inflation if it isn’t accompanied by the deployment of technology in a productivity-enhancing way.
But while these factors point to inflation mid-term, Patrick says he struggles to see inflation emerging anytime in the next three years before the existing surplus capacity in economies is mopped up.
“I think it will possibly require another supply side shock of some description and I’m not sure where that comes from in an inflationary way,” Patrick says. “But you could see it come up in longer-term interest rates as inflation expectations pick up over the medium to long term.”
