With more than $US5.6 trillion of assets under management State Street is one of the world’s largest investment firms. Sydney-based Senior Strategist Clive Maguchu talks to Stewart Hawkins about the changing nature of what constitutes “acceptable” risk in an increasingly volatile world, how inflation is causing him one of his biggest concerns and why he actually sleeps quite well at night.
This story features on the cover of Issue 22 – out now. Tap here to secure your copy or become a Forbes member here.
Let’s start by looking at the past decade before examining today’s paradigms. Money was essentially free for some time around the Global Financial Crisis – did that shift the way you advised investors, and what did that mean for risk profiles?
We had a period of about 30 years where interest rates were falling consistently and that got exacerbated when we had the credit crunch and the GFC where central banks had to reduce rates in some cases to below zero. That was the key catalyst where investors globally, particularly in the Western hemisphere, started considering that there was this idea of free money and that you could invest anywhere and you could reach for yield in ever more risky parts of the economy.
It was chase for yield because you couldn’t get yield in fixed income assets, you couldn’t get yield in government bonds so you had to go up the risk curve to get more returns, and equity markets were booming so the risk profiles of a lot of investors’ portfolios were a lot higher than they might have been.
If you look at volatility over the short term, it hasn’t actually been as pronounced in the equities market as you would expect. Why?
There’s probably been a behavioural change with markets, and I think it started post the GFC when you had all these extraordinary measures from not just central banks but governments more broadly stepping in to prevent major catastrophes in terms of economic collapse.
Investors learned a little bit from that and fast-forward to COVID-19 when we had that massive shock and the shutdowns and governments stepping in to prevent economic collapse, central banks stepping in, I think investors have learned every time there’s a crisis or potential crisis that there will be massive policy support, whether that’s central bank support or government support so you do get this buy the dip mentality that’s coming to into vogue, particularly post COVID-19, where you see sell ups recover much, much quicker than they have in previous cycles.
Does that de-risk portfolios to a certain extent?
We don’t think that’s the case. We do think that that is a feature of the markets currently, but we always run the risk that at some point governments do not step in adequately or they just don’t have the capability or resources to be able to step in and prevent collapse or prevent a recession in particular situations. An example would be if we have a prolonged energy shock. There is a longer-term risk that some of these interventions are not sustainable.
How is the world different now than it was, say, five or 10 years ago?
We’ve seen over the last 10 years or so a shift from this global rules-based order that we were used to for the last three or four decades… a persistent weakening of this rules-based order, an increase in terms of domestic policy intervention from governments. We don’t quite know where the end state is yet and whether that’s definable now or not, but a few of the features are pretty clear in this new world. We’re definitely going to see a few more geopolitical blocs forming; the return of things like proxy wars and great power competition, particularly between the US and China. With that, you also see the effectiveness of international organisations and treaties such as the WTO, NATO and so on being consistently weakened. Because of that, you have to rethink some of the long-term fundamentals that a lot of asset allocation and portfolio construction has been based off for decades now.
Talk me through that rethink.
One of the features is that you’ll see the dependencies that were created as a result of this rules-based order become vulnerabilities that get exploited. A very clear example of that is in terms of oil supply through the Strait of Hormuz. That has clearly been exploited to impact the global economy, particularly the US and its allies. We’ve seen that with Russia and gas supplies to Europe, the US and China, [and] sort of mutual sanctions on rare earths and semiconductors. That’s going to be a feature for economies now, and because of this, there’s more fiscal intervention, which means there’ll be structurally larger deficits and higher government debt burdens.
Dangerous Debt?
During COVID, US debt to GDP pushed through 120%, double the 2005 figure. Australian debt has quadrupled in the past 20 years.
That need to be paid for…
And that’s government borrowing through the bond markets, and that means bond yields will be structurally higher. That also means that the correlation, the negative correlation that we’ve come to rely on for balanced portfolios, 60/40 portfolios [60% equities 40% fixed income], becomes unstable. That correlation between bonds and equities stays positive, or it becomes an unstable relationship, so in terms of an investment implication, the biggest victim, I guess, would be the 60/40 portfolio. We think portfolios need to be constructed with a little bit more inflation sensitivity – that’s commodities, gold, real assets, and possibly even more equities than you currently have in your portfolio.
But if you can get meaningful yield from sovereigns [government bonds], would you not then start pushing your portfolio more towards sovereigns rather than away from them?
Not necessarily because the yields are increasing in response to an excess of supply, and they’re also responding to an increase in the risk that governments won’t be able to pay back these high levels of debt without having higher inflation. In terms of the difference between the bond yield and the inflation rate, that real yield will actually probably compress as yields are going up and inflation is increasing as well.
In a broad sense, you are shifting away from fixed income?
Broadly. Yeah, to a point. [Toward] gold, commodities and real assets, buying infrastructure equities or unlisted infrastructure would be our preference – power grids and so on that have more inflation sensitivity because some of the contracts have inflation clauses in them for income generation.
In terms of commodities, what are we looking at?
Energy would be a good one, industrial metals and obviously rare earths is a big topic as well, and we think that will benefit, but it’s a niche part of the global commodity complex.
How dangerous is inflation? We’ve had a whole generation that didn’t experience it?
Growing up in Zimbabwe, I got an early taste of hyperinflation. Not that I’m saying that we are headed towards a hyperinflation environment, but I think we are heading to a higher level of structural inflation in economies in the developed world. Some of these factors in terms of what’s happening geopolitically, are forcing governments to spend a lot more money to become internally resilient. That’s things like spending more on energy infrastructure, so that there’s less reliance on global energy supplies, and rebuilding trade relationships with friendly blocs. That means you’ll have maybe less efficient global trade happening because you’re trading with friends first, rather than the most convenient or most economically viable trade partnerships.
That results in structurally higher government spending and structurally higher inflation, because the economies are not operating as efficiently as they could.
What are the major dangers you see emerging? Let’s investigate the medium and the longer term. What are the risks out there?
I think for decades, markets treated geopolitics as something that had a temporary impact. You’d have a temporary shock, and the market would sell off for a little while, and things would recover pretty quickly, and you’d move on to refocus on fundamentals. What markets may be missing in the last year or two is that some of these geopolitical events are going to impact investment markets for a long time. That means we’ll need to adjust our portfolios accordingly to deal with that world rather than go back to that old playbook of it’s only a couple of weeks, only a couple of months, and then things will be back to normal. The big change in the paradigm is that a lot of this government intervention has limits, and we could get major recessions, in which case governments won’t have the resources or the capability to soften the blow. What if the US gets into another Middle East quagmire, and it just goes on and on? Then what we’ll see is that the energy supply shock will persist, and you’ll have oil trading above $100 for an extended period, which obviously will feed through to inflation.
What happens if it blows up?
Then that’s the danger zone for both economies and markets, because if there’s a blockade of the Strait of Hormuz. Energy supply shock will impact most of the world for several months. And that means we’ll have not just an inflation spike but also get a growth shock as well, and with that, you will get a major market sell-off, both bond market and equity market sell-offs as well, which is not great news for investors, where it would be hard to find places to be shielded.
Where are the havens in that scenario?
You’d probably look to commodities, but then there’s a danger with commodities that industrial metals sell-off in a lower growth environment. You’re probably looking just at energy allocations, whether that’s oil or natural gas exposures. Gold might do very well, but not necessarily have a positive impact or have less of a negative impact from this scenario. Your private assets might be shielded more so because repricing might not happen as quickly, but some of these infrastructure assets and private equity assets will have to be marked down if there is a broad economic slowdown. In terms of the bulk of most investor portfolios, there are very few places to seek protection against in a scenario like that.
Let’s talk about your US dollar position.
In the short term, we actually have a bullish US dollar position. We think what we’ve seen over the last few weeks is that the US dollar still has a role to play as a safe-haven asset in terms of stress. And we see some of the effects of this event persisting for a couple of months. Medium term and longer term, our view on the US dollar is more bearish. The medium-term views are based on the change in interest rate differentials that we anticipate, obviously with the Fed, in line with our core view for them to be looking to cut rates more than other central banks.
The medium-term view is that the US dollar will weaken and will continue to weaken. And the longer-term views are also bearish. We do think the US dollar is overvalued against the Aussie dollar by at least 15%.
What does that mean for domestic investors in Australia in real terms?
We’ve seen Australian investors actually quite overweight US-denominated assets, and a large proportion of that is unhedged. The first thing is that Australian investors need to start thinking about increasing the hedge ratios of their portfolios to deal with the potential for the US dollar to fall meaningfully over the next few years.
Why are Australian investors heavy in US-denominated assets?
There are a number of reasons.
The first one is that it is pretty much most global investors are overweight US assets, and that’s because the US is obviously the deepest, the most liquid market.
It’s got very strong investor protections. And for the last five to 10 years has had most of the most exciting companies as well that investors want access to. We’ve recognised that there’s a large home bias in a lot of Australian equity portfolios, and for several years now, we’ve been encouraging Australian investors to diversify not just to the US but more globally as well. Emerging markets, even Japan and Europe as well, are selective, because they offer more diverse sector exposures and better growth opportunities compared to the local index.
Which emerging markets?
Particularly, Emerging Asia is a very exciting region for a number of reasons. You have countries in that index that are growing very quickly. You have companies that are plugged into the global economy that benefit from some of these tailwinds, like AI and the technology revolution that we’re going through at the moment.
[A weaker USD] opens up the opportunity set globally for [Australian] investors to start thinking about other parts of the world to invest in. Emerging markets have a negative correlation to the US dollar. Japan’s also another area we think is presenting probably the most attractive investment opportunity it has had for a long time.
Why?
You’ve got a confluence of things… the potential appreciation for the yen, also, we have a new government that’s just come into power in Japan with a pretty strong mandate under PM Takaichi. Her agenda is a pro-growth agenda, and it’s about spending more money in impactful ways that can improve the growth outlook for Japan, particularly in areas like AI, where they definitely are lacking the investment that’s gone into China and the US
What keeps you awake at night?
I generally sleep quite well at night. As I said, I try to think of markets in a more long-term perspective. I’ve lived through a number of market cycles, a few big market sellers, and I’m sure I’ll live through several more market sell-offs. Having a focus on what the long-term investment objective is and sticking to the plan that’s consistent with that objective helps me not worry too much about individual trading days.
Let me rephrase the question. What’s your worst-case scenario for the next 12 to 24 months?
A broader geopolitical conflict that draws in the major powers. Having a more direct conflict would impact the global economy quite significantly, and that would lead to, I guess, a big recession and a big market sell-off.
What is your best piece of advice?
The only better time to invest than today is yesterday. Don’t get too bogged down in the news of today. It’s always a risky time to invest.
Data correct at time of interview.
This article represents the views only of the subject and should not be regarded as the provision of advice of any nature from Forbes Australia. The article is intended to provide general information only and does not take into account your individual objectives, financial situation or needs. Past performance is not necessarily indicative of future performance. You should seek independent financial and tax advice before making any decision based on this information, the views or information expressed in this article.
Want to see more Forbes articles on your feed? Tap here to make Forbes Australia a preferred source on Google.
Look back on the week that was with hand-picked articles from Australia and around the world. Sign up to the Forbes Australia newsletter here or become a member here.