News & Updates

Tamikah: This podcast may contain general advice, but does not take into account your personal circumstances, needs or objectives. Any scenarios and stocks mentioned during this podcast are for illustrative purposes only and do not constitute a recommendation to buy, hold, or sell any financial products. The opinions expressed in this podcast are the personal views of the speakers and do not represent Colonial First State's views.

Tamikah: Hi everyone, welcome back to the latest episode of Investor Digest. I'm today's host, Tamikah, investment writer. And you're tuning in for an interesting episode. We're doing somewhat of a bull versus bear debate on Bitcoin, which is a look at some of the potential risks and opportunities of this particular asset. In one corner, we have our designated bear, Curtis, how are you?

Curtis: Very well, thanks for having me, Tamikah.

Tamikah: And in the other, we have Ketan, our designated bull. Thanks for joining us.

Ketan: Glad to be here.

Tamikah: So, Katan, let's start with you. You said you view Bitcoin not as an investment, but as a form of digital currency, which is quite interesting. Could you give us a bit of a background on how you view Bitcoin and how long you've held it?

Ketan: Yep. So I am currently invested in Bitcoin only. I found out about it in 2013. And then from there, I previously had ETFs, which majority of my wealth was in there. Well, the little that I had. And then I've moved on since then to now being full-time into Bitcoin and going down that rabbit hole. And it's been an incredible journey.

Tamikah: I'm sure it has. Curtis, what about your investment journey? Do you have any exposure to Bitcoin?

Curtis: Unfortunately for me, I have not held any Bitcoin, not since 2013 either. It's sort of been something I've been aware of, particularly probably over the last two years, become more and more mainstream and something people are paying more attention to. My investing has been more in the traditional sense through probably Ketan – previous investing life in ETFs and probably something people don't think about, the biggest investment you have is your own property. So that's probably where a lot of my exposure lies as well.

Tamikah: And I'm sure it's with investing or holding assets, you've experienced gains and losses and that's to be expected. These things can be speculative in nature, but in the current environment, which has been referred to by a number of people as a speculation boom or as a market of excess, it seems to be upping the stakes for some people, especially with regards to cryptocurrency, which keeps making headlines. Bitcoin in particular has had some pretty turbulent price swings. Of course, other coins like Ethereum, even Dogecoin, to ride the waves of volatility.

Tamikah: On the one hand, you've got some people saying they like Bitcoin for its versatility over other assets, like bonds or gold, and have declared that the increasing acceptance and uptick of Bitcoin suggests the formation of a whole new asset class. Others still consider Bitcoin as a form of currency. On the other hand, of course, you'll hear the concerns of governments, central banks, regulators as to the fragmented, decentralized nature of blockchain backed investments and trading platforms.

Tamikah: And you might also hear others declare that Bitcoin sensitivity to the news or to tweets, not only takes away from its legitimacy, but also calls into question whether it's actually ready to join the fold as an official asset class. But needless to say, there's a lot of noise, but it seems a couple of schools of thought here. And that's why we have Curtis and Ketan here to offer their respective perspectives on Bitcoin.

Tamikah: Now, before we kick off, this is just a reminder, this podcast isn't providing any recommendations to buy, sell or hold investments. Rather, the guys are here to address some of the potential risks and opportunities of this asset. So let's kick this off. Let's start round one by looking at the fundamentals, Katan, let's start with you. What do you think are some of the fundamentals supporting Bitcoin?

Ketan: I don't actually see Bitcoin as an investment. I see it as money. Now, what that means is... What needs to occur is, you need to ask yourself why was Bitcoin invented? And I think that's the fundamental reason as to why I think, or I believe in Bitcoin. What that would entail is something that can be limited in supply. I'll give you a couple of examples of where these sort of injustices keep playing out. So as the money supply keeps getting printed more and more, you start to see house prices increase, you see things like rent go up, utilities, healthcare childcare, transport, fuel, all of these things go up in price. And so the real injustice here is that wages are only rising by maybe, if you're lucky, 1 or 2%. So year on year, your salary is really not in line with the amount of money that's being printed.

Ketan: I find that to be a gross, gross injustice. So the other question that is now being asked from people is, why do we pay taxes if they can just print the money? And so all of these injustices start to now pile on. Bitcoin has a strict limited supply of 21 million coins. And for the first time in human history, we have been able to produce a digital good that cannot be copy and pasted. That is the key breakthrough in computing science. And so that is what I believe is the fundamental of Bitcoin. It's a brand new evolution of money.

Curtis: I think probably a point I want to pick up on there. You mentioned the expectation that you pay taxes when you own money and the injustices that you see from in the world in its hands of monetary policy and inflation, but I think the idea as a society you pay taxes. The idea is that you're minimizing those social injustices. So if taxes are eliminated in an instance, then there's going to be a gap between the rich and poor or those people who benefit most from tax outlay, whether that's creation of roads or provision of childcare subsidies, or retirement subsidies or looking after those people who are the most vulnerable in our society.

Curtis: But probably something that's sparked my interest when I've done a bit of research, being the designated bear for Bitcoin is probably looking at there's this idea that a lot of people are buying Bitcoin and perhaps aren't fully educated as to what they're buying in terms of the asset class. As someone who's an advocate for investments, probably one of my main passions is educating people about what they're buying into and understanding what they're buying into and being fully across the fundamentals of that. I think I was reading a survey done by Gemini Crypto Exchange, which is quite a big provider in the US and about 70% of owners through their platform indicated that they were crypto curious, despite already owning the currency, which to me would probably indicate that there seems to be a bit of a FOMO, or fear of missing out, element and people aren't educating themselves about cryptocurrency and its implications on the upside or downside and what it means for the world going forward. Did you have any views on what you see across investors and are people fully educated before they're buying these assets?

Ketan: Yeah, you're right there. You've spotted that straight away. Most people are FOMOing in. They're seeing a price going against the US dollar and that price is rising dramatically. And then one tweet just goes out and that has almost halved. And so-

Curtis: Does that worry you?

Ketan: No. Because I'm going back to the fundamentals. I see Bitcoin as money. I don't see it as something that I'm going to convert later on into US dollars or Australian dollars.

Curtis: Yeah. I think that's an interesting point when I think about... I've probably been guilty of this in the past. There's a lot of people may think about Bitcoin as a share price return. But its existence in society is probably different amongst people and their views. Some people I think classify it as property, some people is an NFX or currency slave in your portfolio or is it a share like return? So I think I'd be interested to get your views on that. I personally don't have a view that I think where it sits at the moment, just given its volatility and probably some uncertainty about its correlations with other asset classes.

Ketan: Yeah. So as I mentioned, or me, I don't see it as an investment. It's not an investment for me. It is money. It is what I'm going to use or maybe my children will use, or maybe my grandchildren will use, as their money of the future. That is the way that I see it. I don't see this as a way to make a quick dollar. That's just me, personally. The majority of people who are coming in and seeing this are looking to make a quick dollar. And unfortunately, I think, if you keep that mindset, you are going to be constantly at... You're on edge. Whereas if you think of the number of Bitcoins that you hold out of a possible 21 million, that number never changes.

Curtis: So do you think conflicting views of what the asset is de-legitimizes it in a sense that if 40% of the market are just trying to make a quick dollar off it and see it appreciating, do you think that will cause problems down the future, if not, everyone's buying into this idea of crypto as a currency in the future and an alternative monetary source to what we already have and what we've been used to for thousands of years?

Ketan: Yep. So 100%, I agree with that analysis, but what you will find is, over the history, at least since 2013 for me, you will see these huge bubbles. And then on the way down, there are a select minority who start to learn the fundamentals. Not everyone, because everyone's just going to be burnt out. And they're saying, "Okay, well it's crashed, it's over, forget this." Then it will pop up and it will go even further higher. And then it will crash again. And it typically happens every, I don't know, maybe couple of years, four years is generally the consensus on when that type of thing occurs. Although, we've only had a 12 year history.

Curtis: Is that in line with that coin splitting I believe they do?

Ketan: Yeah. So it's not a coin splitting. It's called the halving. So Bitcoin releases coins. When it first started, it was 50 Bitcoins per 10 minutes. Every four years, it halves. So it is then going into the 25 Bitcoins per 10 minutes. And so when there is this squeeze of literally cutting this, the inflation supply, in half, the demand just-

Curtis: So it's economics 101.

Ketan: Exactly.

Curtis: You've got to cut off supply when the Bitcoins halve on whatever periodic basis they do, obviously demand knows the same.

Ketan: That's right. And so price has to go up. So that's what's happened. And then it crashes again. But then those people who want to understand the fundamentals of Bitcoin will start to learn and then they slowly start to put more of their wealth in. And then they ride that wave. And it keeps going up, from what I have observed on the past 12 years, that's all.

Curtis: Okay. Now probably if I move to talk about regulation, it seems to be the biggest threat to cryptocurrency and its legitimacy in the market, I know Australia's consulting some legislation that they've put in place, and Canada and in Singapore recently, and that's being explored by the Senate. What, for me, when I look at cryptocurrency and its volatility and news on regulation or the appearance that regulation might become more strict, it seems to drop significantly in price. Although, on the other hand, I'll join the bull argument for a second, the coin base IPOs seem to legitimize that in a way as well, being listed through sort of a regulated market as well. But how do you say the impact of regulation given it's probably going to be a moving part and it's probably going to change significantly with the emerging technology that the blockchain and crypto is, that they might implement some policy and might get it wrong and it could change constantly? How do you say that threatening Bitcoin as an asset or as a currency in your eyes?

Ketan: So it depends on what type of regulation is coming out. At the core level, if I was to send you a Bitcoin transaction, that is uncensorable. No government-

Curtis: Be pretty nice if you would actually.

Ketan: Yeah. Well, if you want to be paid in Bitcoin, well then I'm happy to oblige. But what I'm saying here is, that transaction cannot be stopped by anyone. Whether you're a government, whether you're the police, whether you're the... This is a brand new form of uncensorable money. There is no amount of regulation that's going to stop that. And so we now need to question, how do we arrange society in a way where we have the free... We had the free flow of information on the internet. Now we have the free flow of money as well. This is a huge breakthrough. And so regulators can do whatever they want on the fringes. They can only do things on the fiat system of what they can control. But on the network, well, they can't do much.

Curtis: So there's this idea, I guess, the Fed in the US has been sort of some whispers about this idea of releasing their own cryptocurrency in an attempt, if you can't beat it, join it. How do you see the impact that that would have? My view is that governments may try to intervene to be able to suppress the run that they assume with Bitcoin and in a way probably de-legitimize-

Tamikah: Well, you're already seeing that in China, which obviously is one of the world's largest economies, and there's suppression there that could have some flow and effects. And this is actually probably a good segue in to the second round where we're looking at the risks and opportunities. We've covered some of the fundamentals and you've made some really excellent, interesting points. But if we shift gears a bit, what are some of the other risks or opportunities here, especially if you've got central banks who are proposing their own sort of digital coins or things like that?

Ketan: Yeah. So with the central bank digital coins and all these sorts of things that are coming out-

Curtis: Gov coin.

Ketan: Gov coin, whatever it is called, I welcome it. And the reason is, let the free market decide what is the best form of money for them? Let them decide. Bitcoin is a voluntary participation. No one's asking you to use it. No one's asking you to invest in it. It is there for people who need it, who want it. Now, if you think that a central bank digital currency serves your interests, so be it. But at some point, it will compete with the monetary policy of Bitcoin. And if Bitcoin actually wins on that, then I can see so many people... More of a Trojan horse. They're already used to a central bank digital currency. This is just one stone's throw away into Bitcoin.

Curtis: But I think the beauty is that the central banks are going to be working in an environment that they regulate. Well, are regulated very closely by the government. Whereas Bitcoin is an outside force working in something that's not regulated by them, which they have no influence over as well. So you can sort of see that central banks and governments may have two levers to pull in terms of that. Whereas Bitcoin could be sort of held hostage by what governments decide to do or central banks decide to do.

Ketan:

I actually see that the other way around. I see Bitcoin holding central banks as hostage. What I think is that central banks, if they want to compete with Bitcoin, they're going to have to do something really, really good. And I welcome that. Honestly, I want the best ideas to prevail. And so if I'm looking at that and I'm going, "Okay, here's Bitcoin, it's got these properties. What is the central bank offering me?" And this is where we get monetary competition, but generally speaking money tends to go to the one most saleable good. And that is, when you have a good that people want, that people want to work for, it generally tends to be that one, which was historically gold.

Ketan: Now with this influx of government issued money, which has been removed from the gold standard, we have this experiment really, that has lasted 150 years. And now Bitcoin has come in and they've said, "No, we don't agree with these experiments anymore. Here's what we think. And it's up to you if you want to decide."

Tamikah: Well, Bitcoin's now being dubbed digital gold and is proving quite versatile. Well, I guess perhaps too, perhaps offer a comment on the bear side, one thing that central banks or governments could perhaps offer investors in comparison to those invested in Bitcoin is legal recourse or problem solving, a couple of things there that perhaps are more difficult or less clear, just given the decentralized nature of blockchain platforms and investments like that.

Ketan: I see that as a feature, to be able to roll something back, for me, is not acceptable. If you make an uncensorable permanent transaction, it needs to stand the test of time. That is a transaction that you have made. It cannot be reversed. And that's one of the risks, but it's also one of the greatest features of Bitcoin. You make that transaction, it's done. You're not getting it back ever. And that provides me with certainty. That if my customers pay me, they're not going to put in a charge back, they're not going to try and swindle me. That provides assurance for the business. Sure, customers are probably at a loss here because if the business decides that they don't want to oblige, then yes.

Curtis: What if I'm not happy with a service I've paid you one Bitcoin to come and mow my grass.

Ketan: Yep. Fantastic.

Curtis: You haven't turned up and done it. My ability to recourse that money isn't there.

Ketan: Yep. So first of all, you wouldn't pay up front. I would do the work first and then you'd pay me. That's good. The other thing is, well, the fact is there are reviews, so like on eBay, would you go with a dodgy seller that's just come out yesterday or would you go with a seller that has a big reputation, a reputation to hold and has five star ratings? That's me as a business.

Curtis: Yeah. I think the emergence of the internet, anonymous element of the internet, combined with the ability to transact in a currency which provides some shade from either side of the party probably allows a few loopholes through that as well.

Ketan: There will always be loopholes. There's loopholes right now, but it's just about what is a fair up system. What is a better system of doing business? And I think Bitcoin can do that.

Curtis: Okay. So probably another point I want to touch on, probably more of the social side of Bitcoin. Particularly over the last year, we've seen the environmental impacts that it's having, Bitcoin mining and its production is producing more CO2 than we're seeing out of Argentina or some other countries that aren't small in their own right. But we're seeing significant amounts of pollution through that. The common argument is that the banking system produces X, Y, Z more. But I think you've got to look at this in terms of totality that only a very small percentage of the world own cryptocurrency, but it's got a significant footprint. 99% of the world are using banking systems or legitimized banking systems at this stage.

Ketan: Yeah. Look, the energy argument has been going around since at least I've been around, so 2013. They keep pushing this argument that it's unjustifiable. I think, to be honest, I take a little bit of offense. The reason is, is because I don't ask you to justify your use of electricity. I think for example, the NRL is a waste of electricity. I don't go around saying, "Oh, let's go ban the NRL." I don't go around saying, "Okay, I don't like this TV show being produced, but it costs a lot of electricity and production hours and environmental degradation to produce that television show." I don't go around saying that. I think we're going to go down a very, very strange rabbit hole if we start to ask people to justify their use of electricity. I think that that is a world that I don't really want to live in because, quite frankly, if you're paying for that electricity, you should be able to do whatever you want to.

Curtis: But you might not be able to enjoy your Bitcoin or spend it if the world doesn't exist because we've destroyed it through mining of Bitcoins or providing electricity through other means.

Tamikah: You can say it's only adding to the problem.

Ketan: So this is a competition though. So there is a competing argument here. At some point, as a Bitcoin bull, I believe that this fiat system will slowly start to die down, over the longer term. And what will pick up as a result, which will replace the legacy system, which is what I believe it is, this will be the only thing that I think is worth looking into and worth actually using as money. So we're at that crossroads at the moment. And so yes, there will be usage, but then this will taper off and we will climb on this front.

Curtis: But probably the other thing I want to talk about is, and concerns that have come up, is the ability for it to be a place where money's laundered or crimes are committed, pretty infamous case through the early 2010s, I think, around 2013, Robert Ulbricht or Dread Pirate Robert, he was known in the dark web which sort of facilitated sales of narcotics or murder for hire and preferred payment was only through Bitcoin as well. It sort of allows, because of the anonymous nature of the transaction, for things to be done and crimes potentially commit without any trace or any ability for law enforcement to catch up.

Ketan: Look, I would somewhat disagree that Bitcoin is anonymous. It is not anonymous. If you are going to put something on a permanent ledger on everybody's hard drive, which is what Bitcoin is, then you really don't want that permanently on there. If I was to commit a crime, I'd be using cash, straight up money, like cash paper notes.

Curtis: You talk about the hard drive. How would I trace that imprint on the hard drive to anyone in the world?

Ketan: It's not an imprint on the hard drive. So what Bitcoin is, is a distributed ledger and that ledger is on everybody's computer who's running the Bitcoin network. And so if there is a history there of something happening, I wouldn't want that trace there.

Curtis: Is the ledger you're developing identifiable to anyone at the other end?

Ketan: It can be.

Curtis: Can be.

Ketan: It can be. That's what I'm saying. It can be. You can use various techniques to be able to drill down, what wallet they're using, the time of day, what the business hours were during those times. You can create sort of stories with this information on there. Whereas cash is a lot less traceable.

Curtis: Let's talk about wallets. So probably one of the obvious downsides of Bitcoin, you hear horror stories of people who have $3 billion of Bitcoin and they've forgot their password. If you had it in a portfolio and you're CIO of a super fund, and the CIO forgot his password. Well, you've lost your member's money and you can't access it again. That's probably a major concern from my perspective on the security side. Also, there's stories emerging of people's cards being stolen through, I think, some magnetic devices as well. So probably the big concern for me there as well as security, which is probably the number one thing people care about these days.

Ketan: 100%. I completely agree with you. The fact of the matter is though, for the first time in human history, we have been able to now hold our money without the need of a bank or a central bank. That comes with self responsibility. Broadly speaking, custody of these coins is a big, big topic. There are so many avenues by which to lose, but there's also avenues to protect and defend yourself against loss.

Curtis: We already have this problem in the world with wealth inequality. The top 5% in the world are controlling what? 95% of the assets around the world or whatnot. If cryptocurrency or Bitcoin for namesake is to become legitimized and a standard form of currency, don't you sort of see this idea that that's only going to fuel that problem is those people that hold Bitcoin now are going to hold all the aces in their pocket. Whereas those who don't, aren't going to be able to survive. I'm sort of picturing a post-apocalyptic world in my mind-

Ketan: So you're saying you're a bull?

Curtis: ... where we're going round, and I'm trying to steal your Bitcoin wallet to try and get money or whatnot, where there's very few people. If you're going to legitimize a currency, and putting aside the problems we have with money in the world today, because a lot of your arguments have been based about, well, it's better than the alternative. But if we want to move to this nirvana state where wealth equality is equal across the globe, I might sound communist in that sense but everyone has equal access. How do you go about that with a blockchain technology-

Tamikah: And, just a side question, what's the interplay between Bitcoin and the other 6500 crypto currencies, Ethereum, Dogecoin, what place is there for those coins as well?

Ketan: Okay. So this is a loaded question, particularly around equality. Solving equality, I think governments have been trying to do that for many, many years now. I don't know if they've succeeded. I don't know what metrics they use to say, "Yes, we are now all equal." And so I think that that is a nirvana that probably shouldn't be achieved or probably can't be achieved. There will always be someone who is better than you at something. When you come in as a fresh person into this world, you come with nothing and therefore, you have to earn your money. So depending on your skill, depending on your labor, depending on your education, you are paid in Bitcoin. That's all that's changing. I think it's irrelevant to say, "Okay, well, this person's wealthy because he got in early." The monetary system of 21 million, everything being priced in there, I think is a fairer system. So it's an equality of opportunity, not an equality of outcome. And that's what I think should happen. Again, loaded question.

Ketan: Your second point was around Dogecoin, Ethereum and all these other alternative currencies.

Curtis: You shook your head at that.

Ketan: Yes I did. So what we need to really go back to is the fundamentals of Bitcoin, which is what I was trying to be spruiking the entire time. If you believe that the monetary policy of choice that has stood the test of time for at least 12 years and has not changed, if you think that that is the credible source, then you should probably go into there. For example, Ethereum does not have those levels of, I guess, stability in the sense of the monetary policy. So they have rolled back the chain, for instance. In Bitcoin, that has never happened. And there would be an uproar, whereas Ethereum, Dogecoin, all of these other ones have what's known as a premine.

Ketan: A premine is where you allocate a certain percentage of money or that coin to a certain individual, usually the creators. In Bitcoin that never happened. So that is why it is the purest chain that we have. That's what I believe. Now, most people will see on the crypto exchange that they're using, "Ah, Bitcoin is $50,000. It's so expensive." I want you to be aware of unit bias. There are other coins out there who might have names attributed to Bitcoin-

Curtis: Because yeah, they're buying one whole coin. I don't really have the cash sitting around so I could buy one.

Ketan: The thing is though, you can buy Bitcoin in decimal places. It actually divides itself into eight decimal places. So you can buy 0.01 of a Bitcoin, if that tickles your fancy. So you don't have to buy one whole Bitcoin. And so be aware of these unit biases that occur saying, "Oh, this one's cheaper. Might as well go into dabble into that." Now you are doing investment speculation. I am doing, "Okay. Here's my monetary policy for my children, might give grandchildren." Completely different thought.

Curtis: So you're not a believer in diversification across Bitcoin. That sort of goes against investment theory in all its existence. So you're not an advocate for spreading across different types of coins out there?

Ketan: No. They have generally got a premine, they've rolled back the chain, or they're not as secure as Bitcoin.

Curtis: If you indulge the bear in me, what do you see as the biggest risk to cryptocurrency, if I haven't said it already or to Bitcoin, and it's moving forward?

Ketan: To be honest, central banks actually competing, going back to the gold standard. If you actually compete with Bitcoin, I think you might win at this point. But I think, it's now growing to become an unstoppable force. And the more that that grows, the more people have confidence in it. I've got confidence in 12 years. I think I'll have another confidence in 20 years and 30 years and 40 years. I think I will.

Curtis: So I think that's probably something I want to touch on, you think. I think what the beauty is of like a vanilla asset class like Australian shares or global shares, you know in 30 or 40 years through the compounding effect that you are going to have wealth creation. And even from a so-called Bitcoin bull, we do have some uncertainty there in the future that does pose risk.

Ketan: Of course. That's like with life, I mean, tomorrow you could get hit by a bus. Of course there are risks. There are things in the code that might get missed. There are a competition that may come out. I don't think so, but let's see. I'm not saying that Bitcoin is done, it's baked, it is it. I'm just saying, from what I can see and what's coming out and what's competing with it, Bitcoin is surpassing everything.

Tamikah: Now we are going over time. So moving to round three, just wanted to clear up some of the common misconceptions about Bitcoin. So perhaps the one from the bulk perspective, one from a bear perspective.

Ketan: People need to understand why this was created. I think it really comes back down to the fundamentals and that's what's causing many not understanding those fundamentals and that's what's causing the speculative mania, all of these sorts of things. If you come back down to the fundamentals of why, what is Bitcoin a direct response to, then I think you'll serve yourself well with all forms of misconceptions.

Curtis: I just want to address that energy comment. I don't think that's a misconception. I think that's a view.

Ketan: It was in that sense. Yes, yes.

Curtis: Everyone has their own views and well entitled to, around environmental impacts as well.

Tamikah: Isn't that what one of the latest tweets was about?

Curtis: Yeah. I think his latest view crashed at 30% or something, but moving on from that, I think probably my most common misconception is where it lies. I think a lot of people, which is probably back to the speculative nature and particularly we've seen the rise of the retail trader in stock markets, Robinhood over the last year is. Is Bitcoin a share? Some people say it's property. Is it currency? So I think there's a lot of misconception in the market around its function and what it does in a portfolio. I think, at CFS, we construct multi-asset portfolios. We think about the role of it in a portfolio. I don't think there's enough empirical evidence yet to understand how it's correlated. Because a lot of things we look at is the correlations between different types of shares, property shares, global shares, Australian shares, bonds and cash.

Curtis: But I think Bitcoin has been very sentiment driven, particularly over the last, well in its whole existence, if you look at where it started to where it is now. So I don't think there's really comfort in the market from investment management perspective to where it gives you diversification exactly. Because it seems to go up one day, down the other, where shares will be up completely, bonds will be down. I know correlation theory between bonds and stocks has gone really out the window lately, but I think that's the biggest misconception and probably the biggest point of discovery for the industry as well.

Tamikah: Well, that's a really great conversation, guys. Some really insightful points there, some views that I personally hadn't considered. I'm sure the same with you, Curtis?

Curtis: No, I've definitely, being the assigned bear, I definitely learned a lot today from Katan.

Tamikah: Well, I think we'll leave it there. Is everybody still friends?

Ketan: We'll always be friends, of course. Of course we're still friends.

Tamikah: That's good. Now, Colonial First State regularly shares timely market updates and other thought leadership pieces on a range of topics. In the meantime, if you haven't already, please be sure to subscribe. We're on Apple, Spotify, Google, everywhere, but for now, thanks for tuning in. We'll catch you next time.

Tamikah: Just a reminder, the opinions expressed in this podcast are the personal views of the speakers and do not represent Colonial First State's views. You should read the PDFs available on our website, assess whether the information is appropriate for you, and consider speaking to a financial advisor before making an investment decision. Past performance is no indication of future performance.

Disclaimer: This podcast may contain general advice but does not take into account your personal circumstances, needs or objectives. Any scenarios and stocks mentioned during this podcast are for illustrative purposes only and do not constitute a recommendation to buy, hold or sell any financial products.

Curtis: Hi and welcome. Thanks for tuning in to Episode 2 of Colonial First State's Investor Digest, the podcast breaking down the latest investment tips, economic insights, market developments and more.

I'm Curtis Dwyer, Investment Specialist, and today I have two very special guests. I'm joined by Peter Dymond and Ernest Kwok from the Investments team. Welcome guys.

Before we get into today's topic, I just want to take some time so our audience can get to know you guys a little bit better. I'll go with the age before beauty. So Pete, I'll start with you. Pete's the head of Portfolio Management and is responsible for managing team who has assets under management totaling approximately $60 billion. Is that right, Pete?

Peter: Yes, it's just under $60 billion.

Curtis: And Pete, you've been working at CFS since 2002?

Peter: Yeah. So, it's certainly a long time.

Curtis: And funnily enough, that also aligns with our inception date for our FirstChoice Multi Manager portfolios. So if you think for namesake, that's FirstChoice Balanced or FirstChoice Growth. That's right?

Peter: Yes. Along with a couple of the members of the team, we've been here since the beginning.

Curtis: And Ernest, I'll just move over to you. You've been in the team since 2016. I think you were in the graduate program at the Commonwealth Bank just before that?

Ernest: Yeah, that's right. So I was under a graduate program from 2014 at the bank, did two years there, and then joined CFS in 2016.

Curtis: Pete, I just got a few questions for you. What was the first investment you ever made?

Peter: The first investment was actually CSR, as a share, when I was about 16, was about $300, bought through a stockbroker through a bank.

Curtis: Just quickly, does CSR still exist?

Peter: It still exists.

Curtis: Okay, that's good to know.

And I probably just want to touch on the other end of the spectrum. What was the worst investment you've ever made?

Peter: Probably not an individual investment, but if I think of the worst investment decision, it was during the crash in 1987. Basically, like a lot of people panicked and sold a lot of assets. There's definitely a lesson.

Curtis: Yeah. I think if I've learned anything in the past year, it's to be able to have cash available for opportunistic investments. But I will just reiterate our listeners, none of these tips or their first investment or worse investment is a recommendation from Colonial First State. We're not considering your individual circumstances.

Ernest, I'll move to the other end of the spectrum. Your investing career’s probably started a little later than Peter's. What was the first investment you ever made?

Ernest: For myself, it actually happened straight out of university. I invested into a healthcare exchange traded fund back then.

Curtis: Okay, so I imagine that's probably done quite well over the last couple of years.

Ernest: Yeah, it's been pretty good.

Curtis: And then, does your investing journey -- is that sort of it? Or have you got any investments that in hindsight, probably weren't a great investment either?

Ernest: I would probably say last year was a tough one, personally as well. Because when COVID first hit the US, I personally had the view that it would take a while before US markets would bounce back. So back then I made a small allocation to an inverse exchange traded fund and that didn't pan out pretty well.

Curtis: So you were a bear, you were saying, on the markets?

Ernest: Back then, yeah.

Curtis: Okay. Well it has been quite remarkable how quickly the markets have turned around.

I guess what I want to do now is sort of move over to our focus for the day. At CFS we've been constructing, well since the day Pete's been here, been constructing multi asset portfolios. Lasting sort of almost 20 years now.

There a few areas which are probably very topical at the moment -- the value versus growth debate has been roaring for quite some time, low interest rates, and probably also building a portfolio, when you're considering inflation and potential spikes in inflation in the near future.

Pete, I'm probably going to open things up with you. With over 30 years’ experience in the industry, I thought we'll kick things off with a question for you basically focusing on the evolution of asset allocation and what you've seen over time. Traditionally 60/40 portfolios were long heralded as the backbone of a multi asset portfolio. However, as you know, we've seen, particularly probably over the last 10 to 15 years, bond and stock returns have become a lot more correlated.

How have you seen the thinking around asset allocation changed throughout the industry over time?

Peter: Thanks Curtis. There's probably a couple of points in that. If I go back to the 60/40 portfolio, that was, if you'd like to think of it as, was the mainstay investment vehicle back 20 or 30 years ago. It was basically a period where, as one portfolio, a simple set of instruments that suited everyone, did the heavy lifting for the majority of people. And in fact, it still does a lot of the heavy lifting for a lot of people today. But it was an era where there is very little, if you like, transparency or education amongst investors.

If you fast forward to more recent times, what we have today is a lot more transparency around investors, a lot more understanding around investment time frames and individual risks, through the advice process.

So that, today, leads to – well, a 60/40 portfolio doesn't suit everyone. It could be something much more conservative or something actually, much more aggressive, but recognizing a much longer time frame.

That's sort of one area of evolution. The other part is around asset allocation. For many people, 60/40 was, as we said, the mainstay portfolio, but you went through periods where there is actually some spectacular blow ups in the industry, where people were trying to time asset allocations through various times of crisis, such as the 1987 stock market crash. So that might have worked well, it might not have.

But fast forward today, many portfolios are very strategic in nature, making sure that they're getting exposures to the right asset class, and trying to remove some of the human factors or biases of not being able to invest when they maybe should be invested, or vice versa, making the wrong decisions at the wrong point in time.

Curtis: Thanks Pete. Pretty good answer, considering I was just reflecting on how many questions there were in that one question I asked you. You covered off that quite well.

I'll move over. Ernest, probably, I just want to touch on multi asset investing. What do you see as the main benefits to investors, and what do you believe it provides them with long term?

Ernest: Sure. Thanks, Curtis. So, multi-asset portfolios, or asset allocation in its purest form, is the practice of dividing up your investment portfolio into different types of asset classes, such as equities, bonds and cash.

And in my opinion, one of the major benefits of asset allocation or having a multi-asset portfolio is that it helps investors reduce risk through diversification.

It also helps balance the risk and returns in a portfolio in accordance to the investor's goals, risk tolerance and investment horizon as well.

Curtis: That's a good point. You make on risk and return. Is there a particular way that you guys factor that in when you're creating these portfolios? I mean, we have portfolios that cover off 400% growth assets through to defensive portfolio, which is 10% growth and 90% defensive.

Ernest: Yeah. So exactly what you said. So at CFS, we provide a wide range of different risk profile funds, expanding from, like you mentioned, most conservative investment portfolios ranges from 10% in growth to the more riskier portfolios that have 100% in growth allocations.

Curtis: Now, Pete, pivot back to you. CFS, we utilize the strategic asset allocation process. Could you just give us a high level summary of what that is and the key considerations for investors? And then if we have time maybe touch on that versus some other types – there's dynamic asset allocation and tactical asset allocation out there as well.

Peter: Okay. At CFS, what our proposition entails with our asset allocation funds is that we actually offer a range of what we call risk profiles, or level of exposure to growth assets.

For example, it could be a 70/30 growth defensive fund, or it could be something more aggressive, like 80% growth assets, or something even much more conservative. So our proposition is to have a range of risk profiles available to advisors and investors that are suitable for clients at different stages in their life.

It's important in managing for those risk profiles that at any point in time that they are in fact true to label, such that any member coming in at a point in time, they know exactly what they're getting, because that's what the advice told or that might be what they're choosing. So in managing those, as I said, it's a strategic asset allocation, where we set the level, and on a daily basis, we are actually rebalancing back to that level within a tight tolerance of approximately 1%. We do that rebalancing in a way that uses cash flow predominantly as a predominant driver, but also, market movements have a big impact on that, and at times we do need to do transactions to rebalance it back.

But at the end of the day, what that means is at any point in time, they are true to label for an investor coming in or exiting.

Curtis: Probably want to pick up on that point a little bit – rebalancing on a daily basis.

What was your experience from February 24, 2020 to sort March 25? What was your experience around the portfolios and how they were able to rebalance? And was there any clear benefits that you saw about having this process in place?

Peter: Definitely. And this goes back to once again the tenure of the team. We basically experienced a similar scenario in the global financial crisis, or be it in the COVID-induced selloff last year, there is much faster in terms of the effect, where different asset classes declined very rapidly. We had moves in currency of 10% in any given day. That certainly provides challenges. But through that our process basically ensured that we were doing the transactions to bring it back to that strategic asset allocation. So in that environment we were actually redeeming from cash and bonds to actually reinvest in equities on the decline down.

A key benefit was once we hit the bottom of the markets, we were fully exposed at our strategic level and were able to enjoy the rebound in markets, exactly the same as what happened in the GFC.

It might mean that the returns can be quite volatile, but it means any investor coming in at any point in time, they know that they're getting a fund true to label. And it actually removes any sort of emotion from the process.

Curtis: One thing I've learnt speaking to some clients over the probably the last 6 to 7 months, particularly as performance has turned around is that they're thankful for having investment professionals in place, to be able to take the emotion out of investing.

Because, a lot of people probably, we saw volumes through our call centre switching money to cash and what not and trying to time the market, but it's quite tricky, especially considering we've had 40% returns on Aussie equities over the last year. I think close 48-50% on hedged global shares.

Now, we sort of dipped our toes into the world of asset allocation and the processes that CFS undertake in constructing their portfolios. I want to shift across and talk a bit more about the defensive side of the portfolio, considering the environment we're in.

So, Ernest, typically what we've seen as a defensive part of portfolios, a bit of fixed interest and a bit of cash to reduce the volatility that you might experience on the growth side in your equities. I'm sure there's a whole other realm of assets out there besides just fixed income and cash. Did you want to run us through some of the other asset classes? And alternative – pardon the pun – types of investments that CFS utilise?

Ernest: Sure. As you mentioned, normally when people hear the term defensive assets, the first thing that comes to mind might be the fixed interest assets such as sovereign bonds and cash. However, at CFS, when we talk about fixed interest assets, we also consider both Australian and global sovereign bonds, global corporate credit as well as securitised assets.

Now if I take a step back from fixed interest assets and consider the whole defensive bucket as a whole, we also have exposures to other defensive assets such as emerging market debt, high-yield bonds, gold, and even unlisted infrastructure and unlisted property as well.

Curtis: And there's a few securities you just mentioned there, and I might just get you to clarify on those ones. Might test your definition knowledge here. Credit – that's just a fancy word for corporate bonds?

Ernest: Correct. So, lending towards companies.

Curtis: And if you also just want to touch on securitised…

Ernest: Sure. These are basically securities that are backed by a pool of assets, and in most cases debt.

Curtis: Okay. So is that sort of a residential mortgage backed security?

Ernest: That's an example of one. That's right, yeah.

Curtis: Now, Pete. Alternatives. Probably one of the trickiest topics we get, not for us, but potentially for financial advisors or for investors as well, to try and understand. It's probably an asset class not many people know about, and in our industry, or in the platforms business as well, potentially some of the complexities around this asset class probably cause more confusion than clarity.

Can you explain what alternatives are and how they diversify the portfolio?

Peter: Okay. Alternatives is definitely a complex area. There's two broad brackets of alternatives. There are things such as direct property and direct infrastructure. But we don't typically have that in our multi-asset portfolios here. However, there are the more common types of what we call liquid alternatives, which are basically a set of complex strategies where it's very much dependent on the skill of the managers and strategies in exploiting opportunities in the markets.

There can be a whole range of those. They are very complex in nature using these complex instruments. And they will behave in different ways.

The ultimate benefit to the investor in our portfolios is that they offer, ultimately, an uncorrelated source of returns. So they typically aren't correlated with equities or correlated with bonds. So they give you this different path returns such that over time, it helps smooth out the overall portfolio's returns.

Curtis: I think we've seen a good example of that, our alternatives portfolio that CFS over the last year returned, I think, approximately 14%. If you look at the index government bond in Australia, I think it's slightly negative over the year. And then Aussie equities at the other end of the spectrum of 40%. So it does look like it sort of fit well in there.

Peter: That's correct. And within that portfolio there is a specific strategy that was designed to perform strongly in a market environment of a strong sell-off. And we saw that strategy come through delivering something like 29% in that one month period of the COVID sell-off.

Curtis: Well, hopefully we've been able to give our listeners a bit more insight into alternatives there.

I'll probably move on to our next section that we wanted to discuss about. And that's probably our portfolio construction process.

Ernest, since this is probably your bread and butter and something that you're working on all year round, sort of painting the Harbour Bridge, once you finish, you're starting again and it never ends.

So can you run me through what this process typically looks like? And I guess from a very high level, what are the key considerations you guys are thinking about when you're making a change to a portfolio or if you're not making a change to a portfolio?

Ernest: Yeah, sure. At a high level we review our strategic asset allocation on an annual basis, where we consider both qualitative and quantitative measures. In terms of the process, we would review our risk and investment objectives to ensure that these are consistent with our members' objectives.

We also engage closely with our asset consultant where we review their latest capital market assumptions as well as conduct scenario analysis, stress testing, and pure analysis, across our diversified funds.

Curtis: Sorry, Ernest, just run me through a capital market assumption. Is that an outlook that they have for an asset class return over a certain period of time?

Ernest: Yes, that's right. And the capital market assumptions that we use look at 20 years forward.

Curtis: Okay, well I mean, superannuation can be sort of, for some people may be close to the time at a five year, but also for those not so close to a time in a 40 year investment. So it is pretty important to look at returns in that lens.

Pete, I'll move things back to you. How much are we factoring in higher inflation and lower interest rates into our portfolio construction? It's a pretty topical part of global news and debate at the moment. Has CFS made any changes to their portfolios, given the mantra that central banks have – interest rates being lower for longer.

Peter: It certainly is a very topical issue within the industry, and when it comes to a higher inflation rates and interest rates.

The simple maths is that we will see higher inflation numbers come through in the near term, simply as the impact of the COVID sell off sort of washes through, or impact on inflation. You'll see this natural spike over a 12-month period.

Lower interest rates certainly has been trending down for many, many years. People regularly say it can't get much lower. It did go lower, and we're certainly at a point once again where people would question whether it can go lower.

And in fact in the last three months we had a lot of concerns around both inflation and interest rates, where we saw both spike up. That did have an impact on markets and portfolio returns. Where concerns on the higher interest rates flowed through to a negative return on our bond portfolios.

So how do we think about this in a portfolio construction sense? Certainly we're not trying to time those markets in terms of what we do. We have strategic asset allocation. So we're not looking to form a view – will the inflation spike in the next six months and adjusting portfolios? – we're not doing that. We're looking through over the long term in terms of market assumptions, and factoring that in. So very much we're relying on the diversification across the asset classes to do the heavy lifting for the returns.

Curtis: It probably touches back to Ernest's point, capital market assumptions, looking through those short term spikes in inflation and changes in the market, and keeping your eye on the prize over that sort of 10 to 20 year period.

Now, just to wrap things up. I'll probably want to sort of reflect on, while I have you two guys in the room, and all your investment knowledge.

Pete, on the last 12 months as a general theme, how have the multi asset portfolios performed? Did you see any parallels? Which you've already touched on a bit about the GFC and now, have you seen any parallels between the GFC and what we've been through in the last year as well?

Peter: Definitely. Probably 90% of what we experienced was the same, albeit slightly quicker. The GFC probably took 12 to 18 months to reach its bottom, and probably took several years after that before it recovered to its highs.

We basically saw that in the COVID, saw a similar level of sell off in the space of a month. And the recovery in many markets, basically occurring within 12 months. So we're pretty well back to square today on the ASX200, the US markets are well and truly above their pre-COVID high. So there's certainly been a lot of recovery there.

The simple numbers are, if you look at our balanced fund for the 12 months to the end of April, it's something like 22% after fees. That number obviously doesn't pick up the COVID selloff, so you look at a longer two year time frame that looks beyond that sell off, it's a healthy 7.5% after fees. So you need the longer term investment horizon to look through some of these events.

Curtis: And for our listeners, that's a 70/30 portfolio.

Now, Pete does have his infamous playbook that he does like to bring out internally, but that's probably going to be a separate podcast to get through that. It has been a wealth of knowledge for us, particularly over the last year.

Ernest, Pete's talked about the year in reflection, I'm probably going to give you the hard curly question. What do you think the biggest challenge is facing multi asset fund managers over the next five to 10 years?

Ernest: Well, I think one of the biggest challenges for fund managers and multi-asset portfolios is going to be the low interest rate environment that we are likely to continue operating it in in the future. Given the low rate environment, this is especially important for retirees or pre-retiree investors who may have a more defensive portfolio.

However, a defensive portfolio may not generate the same level of expected returns today if we were to compare that to five years ago when rates were a lot higher. So therefore investors and fund managers will need to further adapt to this low interest rate environment going forward.

Curtis: Yeah, that's a pretty good point to finish on there. Across the industry, we are seeing lower environment is making our defensive portfolios to be thought about a bit more. And probably some like yourself and Jujhar Toki and Peter are probably thinking about.

So I'll just recap some of our key points. Pete, at the beginning – not one-size-fits-all. We've moved on from the 60/40 portfolio. Although it does work for some, as you did point out.

And probably just highlight alternatives within the portfolio. It is a complex and probably pretty underestimated world, in terms of asset class, but it has provided, and behaved as we expected within our portfolio over the last year as well.

And then Ernest, as you touched on there, probably just thinking about asset allocation over the next five or 10 years, just given the constantly falling interest rate environment we've been in today.

Thanks, Pete and Ernest, those were some great insights today, and a big thank you to our listeners for tuning in. If you haven't already, be sure to subscribe and reach out. If you have any comments or queries, we'd love to hear from you. In the meantime, we'll catch you next time.

Disclaimer: You should read the PDS available on our website, assess whether the information is appropriate for you, and consider talking to a financial advisor before making an investment decision. Past performance is no indication of future performance.

Disclaimer: This podcast may contain general advice but does not take into account your personal circumstances, needs or objectives. Any scenarios and stocks mentioned during this podcast are for illustrative purposes only and do not constitute a recommendation to buy, hold or sell any financial products.

Tamikah: Hi and welcome. Thanks for tuning into Colonial First State's Investor Digests, the Podcast, breaking down the latest investment tips, economic insights, market developments and more.

I'm Tamikah Bretzke, investment writer.

Curtis: And I'm Curtis Dwyer, investment specialist for Colonial First State.

Tamikah: We're kicking things off with a quarterly market wrap, and it was a busy start to the year, from geopolitical challenges, again with China, to US riots, company reporting seasons, a short squeeze, some vaccine setbacks, the list goes on.

But perhaps the biggest driver of markets was the anticipation of higher inflation and the associated increase in bond yields.

We're joined by senior investment manager, George Lin, our fixed income guru and token macro economist. Welcome George. Can you give us a quick rundown on markets last quarter, and then tell us what the big deal is about inflation.

George: Sure. When you look back, I think March quarter is a pretty transformative quarter. What do I mean by this? For the past 12 months the market's focus has always been on the pandemics and what is going to happen to the pandemics.

Now that relative changed quite a bit in March quarter with the commencement of the vaccination programs in various countries. So pretty much, what market is now anticipating is the achievement of herd immunity, at least in the major developed economies by, say, towards the end of 2021. In fact, that herd immunity may be achieved a little bit earlier in places like the US and the United Kingdom where the vaccination program has progressed it the best.

So markets are shifting their focus from what is going to happen to the vaccines, to what is the world going to look like, and what the financial markets will look like after everything is normalized towards the end of this year.

And what they are doing is then saying, okay, the world is recovering very quickly. We are still having some pretty big fiscal stimulus coming through in the US. We are starting to worry about inflation, and therefore there is a pretty sharp rise in bond yields.

When you look back to the beginning of this year, US 10-year bond yields were just a little bit below 1%. By the end of March quarter, it was about 1.74% or a little bit higher than that. And likewise, Australian bond yields have really, really gone through this sharp rise, roughly the same magnitude during the March quarter. So we end up having a little bit of an inflation scare in March quarter, a lot of rise in bond yields.

So far, what is very interesting to note is that equity markers have really been quite resilient despite the rise in bond yields.

So, for example, over March quarter, the OO stayed about 2.4%. Ultimately, there was a bit of corrections in the OO towards the end of February, early March, when there was the big, sharp, blunt rise in bond yield.

But nonetheless, if you look, most equity markets have done pretty okay. S&P 500 did also quite well, 5.8%. And the European stock markets did about 8.9%. So those are still very, very, respectable numbers, from the perspective of equity markets investors.

Curtis: Now, George, you just mentioned equities have done quite well across the board. Was there certain parts of the market that did better than others? I'm sure people have probably read in the news that we saw tech stocks sell off quite sharply towards the back of February. Seemed to have regained a little bit there. So could you just sort of explain the relationship between bond yields rising and implications for some of those tech or growth stocks?

George: Generally bonds yields rise, if everything else stay equal, are not good things for equity markets. Why? Because if you think about equity prices, the intrinsic -- or think about the intrinsic values of equities. It's really a series of cash flows discounted by an interest rate, and that interest rate is bond yields. So if you have higher bond yields, your denominator gets bigger. Therefore, if your expected cash flows over time stay the same, it should be lower equity prices.

Now, having said that, we need to be very aware of why bond yields are rising at this point in time. Why are bond yields rising? They're rising because people are expecting somewhat higher inflation. And why are people expecting somewhat higher inflation? They're expecting higher inflation because of strong economic growth as the lockdowns in the developed world ends, as people start to travel again, and so on and so forth.

What this means is that stronger economic growth also means higher expected earnings for companies -- think about the hotels and the airlines of this world. Those probably are the best examples. So you have two opposite forces pulling in opposite directions.

And for the time being, I think the better economic expectations are really holding up equities, rather than letting equity markets pulled on by higher bond yields.

You mentioned the technology stocks. One of the most significant developments over the March quarter is that there's a rotation back from the high growth technology stocks, which we call growth stocks, back to value stocks.

The best example of value stocks are probably some of those cyclical stocks which have been most adversely impacted by the pandemics...

Curtis: Sorry, George. Cyclical stocks -- by that you mean, stocks that would generally move in line with the strength of the economy?

George: Yes, definitely. That is a very good definition of cyclical stocks. And in this case those cyclical stocks are probably exacerbated somewhat by the massive shutdowns in the global economy we have seen over the past 12 months.

Curtis: So just to summarize on equities, they've had a pretty good quarter across the board. We may continue to see certain parts of equities outperform others. Would you agree with that George?

George: I think that's a pretty reasonable summary. I think at this point in time, our view on equity is still that -- look, the world is still on the reflationary type of environment, we know that the economic data are getting better, both in the US and in Australia, the central banks are reluctant to increase policy rates -- so you still have a pretty supportive economic environment for equities.

Having said that, we should all be aware that equity valuation has recovered a lot. And we have seen a pretty good rally in the price of equities globally over the past three or four months.

So I think it's also fair to say that the juiciest part that applies to recovery in equity markets may be beyond us.

Curtis: George, you just touched on a word there -- reflation.

There's a lot of words we hear associated with this. Is there a difference in your eyes between the term inflation and reflation? If you could just sort of give us a quick summary as to the key differences?

George: Okay. In my view, reflation is the economy recovering from a recession and going back to normal, and during this process, inflation should go up as demand recovers.

This is quite different from the type of inflation which currently is really scaring the markets a bit. Because what the market is scared about is that inflation will go beyond what we see as the normal acceptable range, and there will be structurally higher inflation similar to the type of inflation the world economy experienced back in the late 1970s, early 1980s, which most of us really don't have to experience of. But you're talking about a time when inflation was running 7-8% and unemployment rate was also pretty high. So that is really more of a stagflation period.

I don't think the market is really expecting a return to stagflation, but I think what a lot of people are concerned about is inflation being persistently above the target range of the central banks, which really is about 2-3%.

So they worry about -- okay, what happens if you get, say, 4%, 5% inflation persistently for a period of time?

Curtis: Thanks George. I did notice you did let our viewers know that you weren't around in the '70s and '80s inflation period. So thanks for that.

George: I was still in high school.

Curtis: Thanks George.

Tamikah: Would you say inflation could also be -- or at least the anticipation of higher inflation could be attributed to, I guess, the need for governments to make back or recruit the sheer size and scale of stimulus that they've rolled out to support economies?

George: That's a very good question, Tamikah.

One of the triggers for this sharp rise and bond yields towards the end of January is the -- you may remember -- the Democrats took control of the US Senate because of unexpected wins in the two Georgian Senate elections. So that basically improved the possibility of the passage of a massive US fiscal stimulus bill, which was obviously subsequently passed over the past few weeks.

Now when you went back to what happened immediately after the November US election, at that point, Biden proposed a 1.9 trillion fiscal stimulus. Most market economists and strategists said -- look, there's no way he can pass 1.9 trillion through the US Senate.

Tamikah: And you had some people as well say that it was almost too late. There was no need for it at this point, and that it would just be an additional cost.

George: And that's precisely what happened. So 1.9 trillion did end up getting passed. And there were a few very influential commentators who came out and said this is too much too late, it's just going to stoke inflation.

And the most prominent critic is Lawrence Summers, who was the Secretary of Treasury under the Clinton administration. He was extremely influenced among that group of policymakers in the Democratic camps in the US. So Lawrence Summers basically came up and say -- given that the US economy has already shown a very solid recovery, we really don't need another big fiscal stimulus. Be careful about this because two or three years down the road, you may have high inflation. You're better off saving some of the ammunition, see how the economic recovery progress in the US, and then decide later on whether you want to spend money or not.

So that really struck the initial tech rise in US bond yields. And this is really a question which is going to linger on, because Biden has proposed another big bill to increase infrastructure spending in the US.

Admittedly, some of this infrastructure spending is going to be financed by an increase in corporate tax rate, and also a personal income tax rates. But it's not going to be 100% financed. In other words, you're going to have another pretty substantial US fiscal stimulus, most likely being passed by the US Congress sometime over the next three months. So that is going to add on to some of those concerns about a high inflation, and may drive bond yields higher.

Curtis: There's this idea as well, as the economy reflates or is going through inflation, is the idea of structural, as you just touched on, and temporary -- if I look at commodity prices in Australia over the last six months, we've seen quite a surge.

So off of the back of that, would you expect to see a bit of a spike in inflation as we see those numbers roll on into the market? I think the RBA seems to be pretty strong in its view of targeting 2-3%. So we might see it a bit above 3% one quarter, or tracking above, and then we might see it dip down as commodity prices even off.

George: I think everyone is really expecting a pretty strong inflation number over the next six months. Whether it is going to be transitory or permanent or structural is really the question which market participants don't really agree on, and where you get a diverse spectrum of opinion.

We know that inflation is going to be higher simply because this time last year, yes, everyone may remember, everything shut down, everyone stayed home, you don't spend your money. Guess what happened? Inflation went down pretty dramatically during this time of last year.

And simply because of the way that inflation is calculated, you take whatever the CPR is today versus what the CPR was 12 months ago, and that's your annual inflation. So mathematically, it has to be stronger over the next six months due to these transitory effects of what the economists call the base effect.

Whether it will be permanently higher is really a big question. And I think we should not be too pessimistic about high inflation for several reasons. Firstly, we need to remember that ever since the end of the global financial crisis back in 2011, 2012, central banks globally have struggled to generate inflation is consistent with their inflation targets, which generally are 2-3%. And the Reserve Bank of Australia is no exception.

There are structural reasons for low inflation, some of those reasons are still here. Some of those reasons are probably a little bit, we can compare to one year ago, compared to over 10 years ago. But overall, I think central banks are pretty comfortable with seeing a period of higher than target inflation, maybe in the low threes, or roughly somewhere around 3% and say -- look, this is really transitory, there's nothing to worry about.

And the other way of putting it is this. The Federal Reserve has actually changed their monetary policy target since the pandemic. And they are very explicit in saying that we're going to target average inflation. What average inflation means is that sometimes inflation is going to be higher than the target, sometimes it's going to be lower than the target. We're not going to be too worried about those temporary...

Curtis: I think about inflation and the calculations, if you look at -- shipping container rates up 190%, it's probably quite concerning, or a house price in probably anywhere in Australia at the moment -- if you look at those in isolation, you'd be a bit concerned.

But I will just pivot to something else. We spent the whole time talking about equities. But I am conscious that Colonial First State, we're servicing clients or our members from first day on the job through to their retirement.

So I do want to touch on fixed income now. A tricky one to explain George -- I didn't really give you any four warning on this one -- you said bond yields are up, but I'm looking at... Bond yields over the last quarter are up, but I'm looking at returns of the indexes for bonds, and they seem to be negative.

So can you just explain the relationship? I know there is an inverse relationship -- and how that affects bonds and potentially what your outlook is for them as well?

George: Similar to equities, the fundamental values in bonds are basically all the coupons you receive from the bonds, the repayment of the principal at the maturity date, and all those cash flows have to be discounted by the bond yields.

So when bond yields go up, the denominator goes up. So given that the coupons are fixed, principle is fixed, the values will go down. So this is what we mean by the inverse relationship between yields and the principle of bonds.

Curtis: Okay. To think about in Australia, our index is quite different to the US, it's quite heavy with tech and growth, in Australia that the big banks, really, the big guys in our index, how do bond yields affect those? Because for our retirees are members closer to retirement, income dividend growth and dividends they receive is a big part of their portfolio. My gut feeling, just looking at some of the returns over the past quarter, the ASX20, so the biggest 20 companies, is up about 6.5%. But we've seen the smaller cap side, the ASX Small ORDS only up 1.5%.

So is there a relationship between bond yields rising and how that impacts different companies?

George: Oh definitely. For example...

Again, think about growth stocks. Suppose you're buying a company and you expect the earnings to go up by -- pick a ridiculous number -- 100% every year...

Curtis: Seems pretty normal at the moment, George...

George: [laughs] Give me one stock which is going to have revenue of 100%.

So think about this. You're expanding this company revenue and earning by 100% over the next 10 years. So you have 10 cash flow, and they're very big cash flows to be discounted by the bond yields. So an increase in bond yields will have quite a significant impact on this company in theory.

Now think about another company. You're only going to get revenue growth of say 1% per year for the next 10 years. So for this company, the impact of higher bond yields will actually be a little bit less, because the expected revenue for year 2 to year 3 two, to year 10 for this company is actually going to be somewhat lower than the growth stocks.

Tamikah: Just one last question from me, George, before we wrap up. We previously talked about the opportunities and where they were, in a low yield environment, particularly given the volatility that fixed interest investments experienced last year. Back then you said that investors might need to take on a bit more risk to generate higher returns.

In a higher yield environment, do you think that's still true? That they'll still have to take on more risk? I mean, we saw that corporate outperformed government bonds last quarter.

George: I think it is still generally true. And it's probably worthwhile to sort of put things in perspective. Although views are higher than what they were one year ago, they are actually still quite low by historical standards, like 1.7%, 1.8% 10 year bond yields means that if you invest purely in very high quality, very defensive sovereign bonds, you're not really going to get a lot of return.

So for investors who need to have income and have high returns, they still need to take a little bit more risk in the fixed income space in terms of corporate bones, even higher yield.

Having said that, the one qualification is -- investors need to be very careful about the return profile of those higher risk bonds. Because, for example, emerging market bonds issued by say, the Brazils or the Mexico of this world, they don't behave in the same way as US Treasury or Australian Government bonds.

Tamikah: And we could probably talk at length about higher yields and higher inflation and the impacts of markets. But as we wrap up the March quarter and we go into the next quarter, what are some of the key themes that you expect to play out?

George: I think there are several key themes which we really should keep a very close eye on.

Number one is the bond yields and inflation side of things. I mean, just last week the US had a very, very strong March employment report. A lot of people are expecting pretty good or even, really, gangbuster type of economic data coming out from the US over the next few months. So we need to watch that, how strong the US data are. Are we starting to see some build up in inflation pressures and how the Federal Reserve is reacting to those data? And what is going to happen in the bond markets? That's probably the most number one thing to watch out for now.

The second thing to watch out for, and it's almost at the opposite end of the spectrum, is any development regarding COVID-19, because market is now pretty convinced that the major developed economies are going to be in herd immunity by the end of this year.

So if anything bad happens on the vaccination front. For example, if there is a new strain of the virus which is very infectious and very resistant to the vaccines -- and so far we have not seen that, thankfully -- and which destroyed or diminished markets confidence on herd immunity, that would be a pretty bad thing.

Those basically are the two main things to watch out for. But otherwise from there, we are still in a reasonably good macro-environment for risky assets. Although that is going to come under some challenges. And definitely I think we should expect more volatility as markets start to digest some of the economic news coming from the US and Australia as well.

Tamikah: Absolutely. Some interesting things to consider the next three months. Thanks so much for joining us, George.

George has regular monthly market wraps and you can check those out on our website. But in the meantime, be sure to subscribe and reach out if you have any comments or queries. We'd love to hear from you. Curtis...

Curtis: Thanks, Tamikah. Thanks, George.

George: Thanks, Curtis and Tamikah.

Curtis: That was very insightful. Good wrap up. And we look forward to getting you on the podcast more in the future.

Tamikah: And thanks to our listeners. We'll catch you soon, cheers.

Disclaimer: You should read the PDS available on our website, assess whether the information is appropriate for you and consider talking to a financial advisor before making an investment decision. Past performance is no indication of future performance.

Tamikah: Hi and welcome. Thanks for tuning into Colonial First State’s Investor Digest – the podcast breaking down the latest investment tips, economic insights, market developments and more. We’re excited to have you here. And by we, I mean me – Tamikah Bretzke, Investment Writer – and Curtis Dwyer, Investment Specialist for Colonial First State.

Curtis: Thanks, guys. Very happy to have you here. Super and pension investing is at the core of what Colonial First State does. But we are aware that the super environment can be both confusing and challenging. So in this podcast, we’ll aim to focus on the investments space and on providing listeners with insights from our Portfolio Management team, currently responsible for managing approximately $60 billion in assets, as well as special guest speakers including some of the world’s leading investment managers.

Tamikah: Each month, you’ll have the opportunity to tune into the conversation and a team with more than 300 years’ combined experience, which means you’ll hear everything from timely market updates and economic developments, to investment strategies and topical insights on what’s happening around the world and what that means for investors.

Curtis: This podcast is designed for all. And our agenda is to help you stay up to date and informed about what’s happening in investments in one’s super and retirement funds. Of course, we’d love to hear from you. Send us an email and let us know if you have any feedback or if there’s anything you’d like to hear more of in Investor Digest.

Tamikah: To find out more, be sure to subscribe on Spotify and iTunes, and in the meantime, check out the latest from our team – simply visit colonialfirststate.com.au. Thanks again – we’ll catch you next time.