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Risk appetite unwavering, beware of the PIE

Peter Warnes  |  13 Apr 2017Text size  Decrease  Increase  |  

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Investors should be aware of the presence of a rapidly growing cult within the global financial community, Morningstar's Peter Warnes says.

 

As global risk levels rise after the US missile attacks on Syria's Al-Shayrat air base and the diversion of US warships of the Third Fleet to Korean waters, investors' appetite for risk assets has not been affected.

Initially, bonds and gold saw safe-haven buying and the oil price pushed to a one-month high. The initial movement in these geopolitically sensitive commodities hardly reflected a meaningful change in the level of overall concern.

Subsequently, gold has surged to a five-month high, pushing to US$1,285 per ounce, and bond yields dipped to near 2017 lows. Perhaps the penny is starting to drop in recognition of elevated geopolitical concerns.

Global equities markets were basically unmoved. Expectations remain high, supporting markets. The possibility of disappointment hardly recognised.

Upbeat purchasing manager indices (PMIs) from the US, the Eurozone, and China are helping support growth expectations but not unnerving bond markets.

Last week, the German PMI reached a 71-month high at 58.3 and the Eurozone's services activity index reached a six-year high. German bund yields fell. The disconnect between equities and bonds remains puzzling.

Despite the Eurozone's improving economic outlook, yields on German 2-, 10- and 30-year bunds have fallen from -0.67 per cent, 0.48 per cent, and 1.22 per cent respectively in late January to -0.86 per cent, 0.19 per cent, and 0.93 per cent, respectively.

The DAX is taking its lead from the improving economic data and equities valuations are supported by economic data and lower bond yields. The bond market is ignoring growth with benign inflation having no impact on yields.

Similarly, despite the Trump-inspired, fiscally-driven pro-growth initiatives, positive consumer confidence and sentiment readings, expanding PMIs, widespread deregulation and the Fed's inflation benchmark the PCE indicator touching 2.1, US bond yields have also eased--the 10- and 30-year yields down from 2.50 per cent and 3.09 per cent respectively to 2.24 per cent and 2.89 per cent, respectively.

While the bond market continues to ignore the expectation of increased economic growth and higher inflation, the US Federal Reserve may get its attention later in the year.

President of the Federal Reserve Bank of St Louis and a dovish member of the Federal Open Market Committee, James Bullard, has suggested just one more rate hike in 2017 could be enough in terms of tightening monetary policy, while favouring the unwinding of the Fed's bulging US$4.5-trillion balance sheet.

Shrinking the balance sheet by selling bonds should result in rising bond yields and have a similar economic impact of rate increases.

The balance sheet needs to normalise as economic conditions improve to provide a buffer in future if and when circumstances dictate. Rising bond yields will eventually weigh on equities valuations.

Passive Investment Evangelism

While most Australians love a pie, investors should be aware of the presence of a rapidly growing cult within the global financial community. The members of the cult may also be pie eaters but are the pies they eat filled with rich, juicy tender cuts or lips and gristle?

Passive Investment Evangelism (PIE) is growing so fast and attracting so many converts it has the potential to be a meaningful disrupter within financial markets.

One of the most fervent branches of PIE is aligned to exchange-traded funds (ETFs). The majority of passive index-based ETFs are agnostic with regards to the underlying value of the asset class, whether bonds, equities or commodities.

Their main attraction is the low cost. Introduced in 1993, index ETFs were slow to attract disciples, but in the aftermath of the GFC people have converted at a surprising rate. PIE evangelists abandoned their stock-picking faith for an index-hugging or benchmark-related belief.

Should excommunication from the traditional investing church follow?

But behind the surge in ASX-listed ETFs are financial advisers. The compliance costs increased significantly after the introduction of the Future of Financial Advice (FOFA) legislation in 2012-13.

FOFA required advisers to document the reasons behind the recommendation of specific financial products. ETFs are cost-effective and require little administration. Are financial advisers taking the easy way out?

Stock-picking requires diligence and care. The blanket ETFs provide conveniently sidesteps these onerous requirements. A recent Investment Trends-BetaShares report reveals over 90 per cent of advisers point to cost-effectiveness and almost 80 per cent to minimal administration when recommending ETFs to clients.

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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