A permanent state of distorted reality

Glenn Freeman  |  30/06/2016Text size  Decrease  Increase  |  

Glenn Freeman: I'm Glenn Freeman for Morningstar. I'm here in Magellan's Sydney offices with CEO Hamish Douglass.

Hamish, thanks for joining us today.

Hamish Douglass: My pleasure, Glenn.

Freeman: Hamish, what's your view ahead of the Brexit vote in terms of global markets? If Britain exits, do you see a knock-on effect?

Douglass: I think in terms of a large macro event in the world, I think it's much more short-term noise than reality. And actually, leaving the EU is very different to leaving the Eurozone. The Eurozone, you're a member of the monetary union, but you're obviously part of the political and trade union as a part of the EU. The U.K. is only a part of the EU. They've got their separate currency and they've got the pound. So, I don't think it really sets a precedent, if it was to happen, for a pulling apart of the Eurozone.

I think that is far more complex, and re-domiciling currencies is far more complex than somebody leaving effectively a trade pact and somewhat of a political pact.

But I would expect in the short term there would be quite some market volatility. But do I expect major global ramifications from a Brexit? No, I don't. I think there's more noise than reality around it at the moment.

Freeman: Now, in global bond yields, we're seeing record lows across a number of countries at the moment. What's your view on this and how does it play into your investment approach?

Douglass: Well, first of all, I'd say we're in a very bizarre point in history.

We have three major nations in the world where we currently have their 10-year bond yields in negative territory, being Japan, Germany and Switzerland.

This is an extraordinary proposition. We've had central banks who have printed over $10 trillion worth of money, I think it's up around $11 trillion now, and we have, I think, total bonds in the world that are negative yielding across the full spectrum, we have US$10 trillion worth of bonds in negative territory.

And these actions by the banks around the world have absolutely bent the risk spectrum curve and it has had a dramatic effect on asset pricing. Bond markets are most obvious, but it's affected all asset prices around the world.

The question is, will this environment change? Are we in some sort of permanently new state of what I'd call distorted reality?

Or are we at a point where we will start unwinding some of the effects of these over the next few years and get, I think, lower bonds than we've had historically but not these negative bond yields that we're seeing in these countries. There is no economic justification for these negative bond yields.

If long-term bond rates rose, absolutely there will be an effect on asset prices around the world. We think it's more than likely that will happen over the next two to three years.

We are not talking about super high rates. But we are just talking about 10-year rates being negative just is not a sustainable reality of the world and even the U.S. rates, their economic situation does not dictate long-term rates at 1.5 per cent, even current inflation expectations of 1.7 per cent.

So, you have negative real rates of return in the United States for an economy with an unemployment rate of less than 5 per cent, with much of the inflationary or deflationary forces likely to be transitory over time. So, I think we're at an odd point in history, Glenn.

I think people need to understand, and I would strongly argue, that what the central banks are doing at the moment with their policies are not actually having any economic benefit.

Markets may like it, but they are not having any economic benefit any more. Rates have got to a level where it's not inducing anyone to borrow money. People will still borrow money if rates were 3 per cent or 4 per cent.

Being down at sort of zero doesn't actually change the desire to invest in the world. So, what you're doing is you are transferring a massive amount of wealth from savers to borrowers.

If borrowers aren't borrowing any more money, but you're stealing wealth from savers, but the borrowers aren't doing anything, is that positive for economic growth or is it actually negative to economic growth?

We would argue that this repression on savers is actually turning out to be counter-productive.

They need to find a solution, but more of this is actually doing more harm than good, in our view. At some point this will change.

Exactly what it changes into is a great unknown. But it has affected asset prices dramatically. Over the last seven years, asset prices are very inflated and eventually, when this changes in some form, asset prices will get affected.

Freeman: On currency movements, how do you factor currency trends into your approach and where do you sit in terms of hedged versus unhedged?

Douglass: Well, largely, we only run a fully hedged and a fully unhedged strategy, Glenn. So, we're not taking directional positions around the currency.

We may decide not to invest in certain stocks, because we may be nervous around a macroeconomic issue.

A number of years ago we were very cautious on the Brazilian real; we were cautious on the Canadian dollar. There have been times when we've been cautious on the Australian dollar and we may not have made investments because currencies may have been taken into effect. But we don't speculate on currencies.

In terms of using a fully hedged or a fully unhedged product, if I was thinking as an investor, maybe people would watch out what I've done personally over time, because I actually have to lodge any investments I made,

When the currency hit $0.68, I actually bought some of our fully-hedged product and when it was in the mid-70s, I was buying our unhedged global equity strategy.

At $0.68 even though the currency could well go lower at point, taking a medium to long-term view I would regard $0.68 to the US$1 as most likely to be neutral to beneficial to you over the long-term, and when the currency is sort of above $0.75, I would take the view that it's certainly going to be neutral to beneficial to be unhedged to the dollar.

So, I think about where long-term exchange rates are and if you're a long-term investor, think about that in terms of whether you would have part of your portfolio hedged or unhedged.

The other factor I would say to people is currency isn't the determinant in the long term of investment performance.

If stocks go up, if we could invest and our stocks go up at 10 per cent per annum compound, we are in a world where every seven years we're doubling the investment returns.

If the currency goes, over a period, from $0.70 to $0.85 over seven years, you may be talking of 3 per cent or 4 per cent per annum. It's important directionally getting that right, but actually the compounding effect of the stock returns is far more important than the currency aspect.

If the currency is well out of whack, like when it was over parity to the U.S. dollar, I used to almost preach to some people to say ‘just think about the reality of the situation, where Australian residents can travel overseas and feel like they are Swiss citizens’.

It just hasn't happened in history and it's very unlikely – this is a cycle – this is very unlikely to prevail.

So, I was urging people if they haven't thought about offshore investing when we were over parity to say, ‘well, maybe this is one time in your life, we should do it and do it unhedged because not only may be being offshore investments could be beneficial, you're probably going to get a tailwind from the currency at some point.

It’s very difficult to pick exactly when it happens, but it's not that difficult to understand when currencies can be dramatically out of whack with long-term averages.

Freeman: Hamish, thank you very much for your time.

Douglass: A pleasure, Glenn.

Freeman: I'm Glenn Freeman for Morningstar. Thanks for watching.

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