News & Updates

Disclaimer: (00:01)
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.

Scott Tully: (00:26)
Hi, welcome to another edition of Investor Digest brought to you by Colonial First State. Today is our quarterly market update. I'm Scott Tully. I'm the general manager of investments at Colonial First State, and I'm joined once again by George Lin, senior investment manager at Colonial First State.

Scott Tully: (00:43)
George, how are you?

George Lin: (00:44)
Very well, Scott, thank you.

Scott Tully: (00:45)
Now, the last time we spoke, we were in the period just after the Russian invasion of Ukraine. At the time, we talked a lot about the impacts and expectations of what we thought would happen to markets.

Scott Tully: (01:01)
So let's start there. What has been the experience of the last month and a little bit, in terms of markets?

George Lin: (01:09)
Sure, Scott. Look, the biggest markets reactions have been seen in several commodity markets. Not only oil and natural gas, which the media focuses on a lot, but also among certain metal commodities, which Russia is a major, major producer. Aluminium is one which comes to mind. Nickel is another one.

George Lin: (01:36)
Also, agriculture commodities should not really be left out of the equations, because not only Russia, but Russia and Ukraine combined together, is a major wheat producers and exporters to the world. So the first thing which happened is, commodity prices or certain commodity prices increased very sharply. In the week or two after the invasions, continue to be volatile, but very much reacted to whatever the news events of the day were.

George Lin: (02:13)
If it's good news, IE, some progress in peace negotiation, energy prices drop. If it's the US releasing their strategic petroleum reserve, oil prices drop. If it is a threat by Russia to escalate, energy prices, especially oil prices sky rocket. But if you look through the March quarter, we have seen some pretty significant increases in the key energy prices.

George Lin: (02:42)
So for example, oil prices start at about 75, $76 at the end of December. At one point in middle of late March, just a few days after the invasion, it peaked about US dollar, 127 per barrel. Trade, very volatile at that, 110, $120 US dollars per barrel, finished the quarter at about 112 US dollars per barrel. Since then, it has come down a little bit more, but it's very difficult to predict daily price movement, simply because it's going to be very news dictated.

George Lin: (03:26)
We also have seen a massive increase in wheat price. It has gone up from about slightly below US dollars, $6 per bushel, to about $10 current, as at the end of March. So we are seeing definitely very significant price jump in selected commodities with a lot of volatility.

Scott Tully: (03:46)
And I think it'd be fair to say that pre the events in Ukraine, commodity prices are the numbers you're talking about there, particularly oil, were elevated anyway, in terms of the last few years.

George Lin: (03:59)
Yeah, precisely. Precisely. Because ever since the end of the first phase of the pandemic, and the availability of vaccine and economy start opening up, we have several or so factors driving together to drive the key energy prices, especially energy prices, up. One is that people started going back to work. People start traveling, so there's more demand for petrol.

George Lin: (04:25)
Same thing about our factories, we opened. And the third thing is the Chinese energy crisis in June quarter of last year, which was really due to administrative measures of China, trying to aggressively deal of fossil fuel consumptions. So energy prices already went up quite a bit, but if you look at the past quarter, oil prices went up by another of 30, 40%, above some very elevated price level. So we have seen a pretty strong energy price jump globally.

Scott Tully: (05:04)
So, that's interesting, in terms of what's happened to markets and obviously, supply and demand is a big factor in there. That then goes into broader prices in the economy.

George Lin: (05:15)
Mm-hmm (affirmative).

Scott Tully: (05:16)
If you filled up your car, if you have a internal combustion engine, then the there's a real sticker shock of filling up your car.

George Lin: (05:27)
Yeah. Yes, definitely. I guess it is not only about inflation, but the way we look at it is because of Russia and Ukraine, to a less extent, position as major commodity producers. This is basically a pretty significant negative supply shock to the global economy.

George Lin: (05:49)
So when you get a negative supply shock, you get two things. You get high price, IE, high inflation. You also get somewhat lower level of output. So it's against this context, that some people start talking about stagflation. I think it's probably a little bit too premature, to talk about stagflation at this point in time, but definitely somewhat lower economic growth and higher price inflation, is a possible outcome.

George Lin: (06:20)
Now, having said that, it's also important to note that because of the different economic structure of different economies, they all will have somewhat different outcome, all of this, price shock. So at one extreme, you think about Germany, very heavily dependent on Russian energy imports. So the German consumers have to pay a lot more for natural gas. Their factories have to pay more for oil. So they are having a bit of a double whammy, because they have no domestic supply, so they pay more. They don't get more... But they don't get high price in some way, from the end product, right?

Scott Tully: (07:08)
Yes.

George Lin: (07:08)
Now-

Scott Tully: (07:09)
So let's just go back. You used the word stagflation.

George Lin: (07:12)
Yep.

Scott Tully: (07:13)
So let's have a quick definition of that. That is where there's inflationary pressures in the economy, but you're not getting the growth, as you say, for say those producers to pass on or to have higher sales.

George Lin: (07:25)
Yeah. Yep. I think stagflation is to some extent, difficult and a little bit dangerous word to use, but there's going to people use stagflation in different contexts.

Scott Tully: (07:35)
Sure.

George Lin: (07:36)
When a lot of people talk about stagflation, they're really referring to the 1970s. So late 1970s, early 1980s experience in the Western countries, where you get very high inflation, IE, 10% or above, combined with very high unemployment, somewhere around 10%. So are we going back to that state of the world?

George Lin: (07:58)
I am somewhat sceptical, but having said that, I think we're definitely in a transition phase from low inflation, to somewhat high inflation. And therefore, I suppose, what the central bankers will say, from a monetary easing, to a monetary tightening type of cycle.

Scott Tully: (08:21)
So let's go there. We've seen high single digit inflation figures reported in the US.

George Lin: (08:27)
Yep.

Scott Tully: (08:29)
I think the last time we spoke, the Federal Reserve was expected to increase rates six or so times, this calendar year, in 2022. Things have changed a little bit now perhaps, or what's your thoughts on interest rates? Let's start with the US and then maybe bring it to Australia.

George Lin: (08:46)
Okay. I think a big shift is in US monetary policy, not necessarily in just what the Fed have done, but also in what they have told everyone. Now, if you dial back to end of last year, everyone was saying three to four interest rate increase. So could 1%, or somewhere around 1% cash rate by the end of this year.

George Lin: (09:09)
Now, as you said, we have some pretty shocking high single digit inflation number. So that moved the market expectations, as well as the Federal Reserve communications to more like six to seven interest rate increase, and roughly about quarter 1.7, 1.8 type of percent, type of cash rate by the end of this year.

George Lin: (09:36)
So what has changed is that in March, the Federal Reserve increased the target funds rate by 25 basis points. Now that was totally priced in by the market, so that was no surprise there.

Scott Tully: (09:51)
In fact, I think it was lower than what the marketer priced in-

George Lin: (09:54)
Precisely.

Scott Tully: (09:55)
At one stage.

George Lin: (09:56)
Because in early February, mid February, a lot of people in the market were expecting 150 basis points increase. Now, at the last minute, Russia invaded Ukraine, and the minutes of that FOMC meeting was actually published just three days ago. And it became very clear that the FOMC decided not to go with the 50 basis points increase, and go for a more modest 25 basis points increase, which they're not quite sure what the Russian invasion [inaudible 00:10:29].

Scott Tully: (10:28)
Yeah. So we're already seeing some change in behaviour for the Federal Reserve, as a consequence.

George Lin: (10:35)
Yeah, and the other thing is, the thing is called dot plots, which is the FOMC members expectations about where interest rate, where inflation rate will go. They published that, and it is a very clear case of the FOMC member trying to catch up with the market expectations of where interest rate and where inflation rate will go.

George Lin: (11:01)
Now, the big thing is they have now sort of catch up with what market expectation were at the end of March. But since then, they have published more information or they have communicated with markets informally, that they are prepared to tighten monetary policy, if inflation stayed persistently high. And there's so far no evidence that US inflation is slowing down.

George Lin: (11:29)
So what happened is that the markets are now expecting at least 2% cash rate, and possibly more by the end of this year. And there is also the expectations that the Federal Reserve will try to front-load the rate increase, IE, start de-rating at the next meeting. The current expectation is they will do one 50 basis points wise.

Scott Tully: (11:55)
Yeah.

George Lin: (11:56)
Possibly followed by another 50 basis points wise. So the logic is that, okay, if we really, really increase interest rate hot and sharp early in the cycle, we will get inflation down quickly. That will prevent us from moving too aggressively on policy rates, so more pain now, less pain in 12 months’ time.

Scott Tully: (12:18)
And we probably don't have time to give it the full service that we could, but the Federal Reserve is also contracting its balance sheet, which-

George Lin: (12:26)
Yeah, that is the other big news, because after the FOMC March meeting, they didn't really tell anyone anything. Now again, when the minute was released two or three days ago, they told the world that every month they are going to let our $95 billion of US treasury and mortgage backed securities mature, without reinvesting the principles.

George Lin: (12:51)
Now, what is the big deal about it? The big deal about this is, the last time they did the same exercise after the GFC, they actually start off with not reinvesting the coupons... Sorry, not but reinvesting with the principle. So last time, it was a very long and drawn out exercise, which takes them two or three years. This time, it's not going to take two or three years. It's more like 12 to 18 months exercise.

Scott Tully: (13:21)
So that basically means that there's less liquidity or less support for the economy.

George Lin: (13:26)
Yes.

Scott Tully: (13:26)
At the same time, interest rates are being raised to some level.

George Lin: (13:30)
Precisely. So that means that there will be less demand for bonds. So bond yields will be higher, tighter financial conditions. And we have seen a lot of reactions in the U-curve in the US. So for instance, US two years bond yield, start 2022, about 72 basis points. Lao is about 2.5%, US 10 years bond yield start here about 1.05. I think the last reading I have, was about 2.6%.

Scott Tully: (14:00)
Okay. That's about right. Yes. Yes.

George Lin: (14:03)
So the other thing is that the two years versus the 10 years bond yield, you are seeing a... Well, for a day or two, you'll see a small negative number. Now, that usually is a pretty accurate predictor that you are going to get lower economic growth, and probably at some point in time, maybe a recession in the US.

Scott Tully: (14:23)
Yeah, so to be clear on that. So the cost of borrowing money for two years is actually higher, than the cost of borrowing for 10 years.

George Lin: (14:29)
Yeah.

Scott Tully: (14:29)
But I think the significant change of that over the last month or so, at least over the quarter, was how much rates have gone up across the board.

George Lin: (14:39)
Yeah. Yes.

Scott Tully: (14:39)
So that's critical. So let's quickly turn to Australia, seems to be the current prediction is for a rate increase by the RBA in June. Your thoughts on that?

George Lin: (14:48)
Okay. I can't read the mind of the RBA governance.

Scott Tully: (14:52)
That's fair.

George Lin: (14:53)
I think that besides timing of interest rate increases, it's a little bit difficult to make, but I'm pretty sure, like most of markets, that we are going to see some rate increase sometimes in the second half of this year. We have seen inflation pretty comfortably sitting in the middle of the RBA's target range, which is where they wanted it to be.

George Lin: (15:16)
The RBA governance has said repeatedly that they probably still want a little bit more evidence of wage increase hitting that 3% level, before they want to increase rate. Now, having that, the latest labor market indicators are all pretty good. So we really should be getting close to it, if not actually achieving that 3% wage increased targets, sometimes over the next six months.

George Lin: (15:45)
Now, we have a federal election coming up. Now, like any good central bank governance, the best advice is don't do anything during an election campaign, unless it's totally necessary.

Scott Tully: (15:58)
Yes. So we'll have to wait til after the election.

George Lin: (16:00)
Yeah, but I think we can pretty comfortably pencil in, say two inches rate increase this year. If the economy turns out to be strong and inflation turns out to be a little bit higher, three is a definite possibility.

Scott Tully: (16:18)
Yes. Okay. So it sounds like a lot of bad news there.

George Lin: (16:21)
Yeah.

Scott Tully: (16:21)
We've had invasions, we've had higher interest rates and all that sort of thing. Yet, markets in the month of March, equity markets, Australian market at least, was up quite substantially.

George Lin: (16:31)
Yep. Look, the equity markets behaviour is quite interesting, because with all the concerns about US inflation, the [inaudible 00:16:41], January and February was pretty lacklustre months for most markets.

Scott Tully: (16:45)
It was quite negative. Yes.

George Lin: (16:46)
Quite negative. Now, when Ukraine happened, bad market dive [inaudible 00:16:51] five to 10%, probably even the bit more for selected market, especially European. But in the last two weeks of March, they actually re bounced quite strongly. Now, what is causing that, is a little bit of debate.

George Lin: (17:06)
I suppose, the most convincing rationale for that is, okay, when Russia invade Ukraine, everyone, supplies in end of the world type scenario, IE, direct mandatory confrontations between NATO and Russia. Now that didn't really happen. If anything, you could argue that Russia may have a little bit stronger incentive to negotiate, because their military operation has not gone as smoothly as they wish.

George Lin: (17:37)
So as that end of the world scenario sort of got fade away, the possibility of that, markets have a bit of a [inaudible 00:17:49], despite I should say, still rising bond yields.

Scott Tully: (17:54)
Yeah. I think we do have to be clear here that the Australian market has done well.

George Lin: (17:59)
Oh.

Scott Tully: (17:59)
The American market has done okay through that period, but [crosstalk 00:18:03] there have been a number of markets that had falls. So it wasn't always consistently...

George Lin: (18:08)
Look, if you look at March quarter overall, it's still pretty bad.

Scott Tully: (18:12)
Yes.

George Lin: (18:12)
For most equity markets, for example, the S&P did about minus 4.9%, Nasdaq did about minus 9.1. The European stocks index did about minus 9%.

Scott Tully: (18:25)
Yeah.

George Lin: (18:26)
Now, Australia is actually the outstanding performer. We get a positive 4.1%. Okay, not something to write home about.

Scott Tully: (18:33)
A big bit.

George Lin: (18:34)
No, but it's still pretty damned good. Now, what is happening here is that, the mining and resources stocks and the energy stocks, they are just having a hell of a good run, doing something like 16% in March quarter. Think about LPG prices, and you sort of get the picture because for example, I think Woodside Petroleum, their prices went up by something like 50 to 60% in the past three months.

Scott Tully: (19:04)
Yeah.

George Lin: (19:04)
That's probably an extreme, but you can look at it because their output is basically 60% more expensive now.

Scott Tully: (19:12)
Yeah.

George Lin: (19:13)
Now the miners also did quite well, because already we have seen a bit of a metal prices boom, which has been exacerbated by the Ukraine situation as well.

Scott Tully: (19:24)
Yes. Yes. So it has been an interesting month. There's all sorts of things we talk about in terms of China as well, in terms of ongoing lockdowns there. I don't think we're going to cover that much there, but just a quick word on what's happened in Asian markets and Chinese markets?

George Lin: (19:38)
Okay. One of the things which happened in Asia is that most of the Asian countries, which have done very well in the first wave of the COVID-19 pandemic, is having some difficulties to contain Omicron. You've seen that in South Korea. You've seen that in Hong Kong. You've seen that to a less extent, in Taiwan, but China is the worst affected, because it's still clinging to a very severe lockdown type of policy.

George Lin: (20:09)
So the biggest news in China is that Shanghai, which is the major, most important Chinese city, from a commercial perspective, has been in total lockdown for now more than seven days. There is no clear guidance as to when it will be reopened. Now, in terms of the economic impact, it's difficult to estimate. I have a suspicion that if things don't go well, the economic impact may be worse than that of March 2020 lockdown in Wuhan.

Scott Tully: (20:46)
Yeah. So that's a really quick recap, George, on the quarter. So thank you everyone for joining us on our quarterly market digest. I'm Scott Tully, I've been joined by George Lin. We thank you for listening, and tune in next time when we'll bring you more updates on markets. Thank you.

George Lin: (21:08)
Yeah, thank you, everyone.

Disclaimer: (21:14)
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 as 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. The opinions expressed in this podcast are the personal views of the speakers and do not represent Colonial First State's views.

Scott Tully:
Welcome to another addition of Investor Digest, the podcast from Colonial First State that talks about investment issues. I'm Scott Tully. I'm the General Manager, Investments at Colonial First State, and I'm joined today by George Lin, Senior Investment Manager. Welcome George.

George Lin:
Thank you, Scott. Good to be here.

Scott Tully:
So we have seen a very interesting time in markets recently. 2021 was an extraordinary year where equity markets went up by over 20%, supported by low interest rates and government support. Towards the end of the year, things started to get a little bit shaky. The expectation that Reserve Bank and the Federal Reserve and other central banks were going to increase interest rates, was a common discussion in markets. We didn't really see it coming through in returns.

Scott Tully:
2022, different situation with markets being off, quite a bit, that expectation of high interest rates started to become a reality. So today we're here to talk about markets and interest rates and inflation, but of course, we've had a fairly sizable event in Europe with Russia invading Ukraine. Now we're recording this podcast, not too long after the tanks rolled in. So any comments we make today may become outdated quickly, but let's touch on Ukraine because it's an important thing.

Scott Tully:
So George, we've seen some volatility markets, but what's your thoughts on the impact of the geopolitical situation in Europe?

George Lin:
Thank you, Scott. The first thing to note is that this is very, very early days, so we don't know what exactly will be the extent of the Russian military intervention and to what extent the Western democracies are going to respond. We know for pretty sure that the Western democracies are going to impose some type of sanctions on Russia, overnight. The U.S. have come out and imposed several sanctions on Russia, but those sanctions are mainly on the financial side and also on the export of technologies. Now, it hasn't touched on anything, on the most sensitive sector and which is also the most important sector, which is energy.

George Lin:
Now, Russia by itself is not a large enough economy to derail the global economic recovery. But it is a very significant energy exporters and if it wants to, it can really disrupt energy supply in the global marketplace, especially to Western Europe, which is highly dependent on the export of Russian energy, particularly natural gas. So a lot depends on how the Western European countries are going to respond and how Russia's, in turn, going to respond to that. Now at this point in time, the base case scenario is that energy exports from Russia will not be too severely disrupted.

George Lin:
Nonetheless, we think that the mere fact that Russia has the power to disrupt energy exports in a very significant way, means that the likely impact in the medium term is probably going to be inflationary, in the sense that there is going to be some type of [inaudible 00:04:02] being built into global enterprises, especially natural gas supplies. Now depends on how things go. If things go really, really pear-shaped or Russia start saying that we are going to restrict our natural gas supply to Western Europe, then the Western European economies will be pretty severely disrupt. There have even been suggestion that in a worse case scenario, Germany may have to rush in energy supplies and gas supply. Now that would be very, very serious situation. And in that case, you may even have a Stagflationary outcome in some of the Western European economies. But at this stage, we really don't know the answer.

Scott Tully:
So we're thinking that, that's probably unlikely for the Europeans to do something that's not in their economic interest. And so the energy will be more expensive but still flowing.

George Lin:
Well, I think that is the base case. And funny enough, that is probably [inaudible 00:05:10] calculus. And if history is any guidance, there is actually some credibility to this scenario because the last time Russia invaded Eastern Ukraine, the European did not put their hands up and say, "Look, we're not going to buy any more Russian natural gas." In fact, of year or two after that invasion, Germany decided to proceed with the construction of the [Nord 00:05:40] Stream 2 pipeline, under the Baltic Sea, which funny enough has the great benefits of bypassing Ukraine and most of Eastern Europe and piping Russian natural gas directly under the Baltic Sea to Germany. So in some sense, Germany responded to last Russian invasion of Ukraine by voluntarily increasing its gas dependence on Russia.

Scott Tully:
Okay, so let's explore the base case then. Inflation's higher... Let's go to the U.S., U.S. consumers are spending more to fill up their car. How do you think the Federal Reserve will respond?

George Lin:
Okay, this is the $10 billion question, because-

Scott Tully:
Only $10 billion?

George Lin:
Well, maybe $1 trillion question because, up to this point, markets have aggressively repriced the possibility of interest rate increases by the Federal Reserve. At the end of the year, markets were saying, "Okay, maybe the Fed would take 3 to 4 interest rate increase of 25 basis points this year." Just before the invasion, market's pricing is, "Okay. The Fed is probably going to hike interest rate by seven times or possibly even eight times under the most aggressive scenario." Now this is all before the Russian invasion. So now we have to ask ourself, "Okay. Has anything really changes?" Now the one big change is the [inaudible 00:07:15] for energy prices. It's probably going to be hard. By how much? We are not quite sure.

George Lin:
So that seems to say that at least on the margin, the Fed may have a little bit more incentive to wait a little bit longer. But having said that, that's probably not my expectations at this point in time. And the reason is, if you look back at the January U.S. CPI data, they are getting [inaudible 00:07:43] CPI of roughly 7% and Core CPI running around 6%. That is very strong. And perhaps even more than that, if you think under the underlying data, there seems to be a shift of inflation weight pressures in the supplies of goods, which is mainly caused by logistic disruption, which everyone expected to sort themselves out maybe gradually, but definitely sorting those things out throughout 2022.

George Lin:
But the big change is that there seems to be a lot of inflation going on in the services sector in the U.S., that seems to be getting entrenched. And I guess the honest assessment of that is, the U.S. has put in too much fiscal and monetary stimuli in the economy in 2021. And now they are getting to the point of overheating demand, which is being compounded by issue in the labor market supply, because a lot of Americans have just decided not to go back to workforce. Now that hasn't really changed. So from that perspective, I think the Federal Reserve will stay on the course to increase our interest rate reasonably, aggressively over the next 12 months, unless you really, really have a very, very big economic shock coming from the Western European economies.

Scott Tully:
Okay. So the perverse thing there is, inflation might be higher due to higher oil prices, but those other inflationary items are still going to be there. Higher oil prices could mitigate some of the rate increases, but you're saying that the trend and the intention of the Federal Reserve would be to increase interest rates.

George Lin:
Yes. I think that is the base case at this point in time. Basically the Federal Reserve has some need to reduce a domestic demand in the U.S. Now higher oil price may help them to do this job, i.e. they may need to do a little bit less than they want. But this need to reduce domestic demand is probably still going to be at the top of their mind. So from that perspective, I think the trajectory remains roughly the same. The pace may change a bit, depending on what happened. Now, interestingly, overnight, several Federal Reserve senior officials have made comments about economic outlook, interest rate outlook, and various things. And they haven't really made too many comments on Ukraine, probably because it's just really too early to conclude what the likely impact is going to be.

Scott Tully:
It'll have some impact, but we're not saying it's going to change the overall trajectory.

George Lin:
Yeah. I think at this point, that is pretty fair. Now, obviously things can change very rapidly. For example, in the worst case scenario of some type of direct military confrontations between [inaudible 00:11:08] Russia, everything will be off the table. But that is a very unlikely scenario at this point in time.

Scott Tully:
Okay. Now bringing a bit closer to home, we saw the New Zealand Central Bank being more aggressive in raising rates than the Australian Reserve Bank has done. Any observations on... What do you think the Reserve Bank of Australia will do this year?

George Lin:
Look, the Reserve Bank of Australia has actually been very consistent in terms of communicating their outlook on monetary policy or as they would call it, their reaction functions. Now, the consistent message is, things have got a lot better, but things have not got so good to the extent that we want to increase interest rate immediately. The two conditions they have laid down for interest rate increases, they want Core CPI inflations to be comfortably and sustainably back in the 2 to 3% range. Now they even naturally tell everyone what they mean by that. That means like it has to be in the higher part of that 2 to 3% range. And it has to be in that 2 to 3%, say 2.5 to 3% range for several quarters. Now, several quarters obviously open up to a little bit of interpretation, but let us say that means three to four quarters.

George Lin:
Now the latest Australian CPI data from December have Core CPI right in the middle of that 2 to 3% range. I think it's 2.6%. This is the second quarter of the Core CPI inflation, being at that upper end of the 2 to 3% range. So, what that means? That means is, they probably need another minimum one quarter, and I will argue probably more than one quarter, say two quarters of CPI hitting that targets, before they decide that box has been tick. So we still have the March quarter, June quarter, and CPI coming out. So the June quarter CPI will be coming out in early July. So we will just say that, "Okay, by that point, that box will be ticked." Now the-

Scott Tully:
So once that box is ticked, then the question is about the magnitude.

George Lin:
Yeah. Now there's still a second box, which actually is a little bit more problematic, which is wage. They want wage to be higher. Period.

Scott Tully:
So this is wage rises across the economy.

George Lin:
Yeah. Wage rise across the economy. So they want it to be somewhere close to 3. Now the latest Wage Price Index data came out earlier this week. It's in the high tools, not quite to 3, but it's getting there. So again, I think they have to wait for at least another quarter or two before they feel comfortable that Wage Price Index is now rising comfortably, say 2.5, 2.6, 2.7%, before they decide to move. So again, that seems to point to more of a second half of this year, weight tightening than in the first half. Now the [inaudible 00:14:33] material is another question. We are seeing increasing CPR here. But we are not, so far, at least, seeing the type of very high CPR increase as we've seen in the U.S.

George Lin:
Now, the Reserve Bank of Australia has signaled very clearly that... And in fact, the governor has deliberately contrast the situation between Australia and the U.S., pointing out that the U.S. has a lot more supply side disruption in the labor market than in Australia. In Australia, the labor market has actually gone back to the pre COVID state, in terms of the level of employment, in terms of level of participation rate. So, that again, seems to suggest that the RBA has a little bit more time than the U.S. And they can be a little bit less aggressive in terms of the pace of increase in the Australian policy rates.

George Lin:
So to me, we probably should expect one to two weight tightening in the second half of this year. And then Reserve Bank will probably wait and see a little bit. And look, the bias will still be... Don't get me wrong, the bias will still be towards higher interest rates. And the target is probably going to get interest rates somewhere back to say 2% or maybe higher. But it seems to me that they can be a little bit more relaxed in terms of the pace of the interest rate increase than the Federal Reserve.

Scott Tully:
Okay. So a more patient approach in Australia because of that situation.

George Lin:
Yeah. Relative, at least to the U.S.

Scott Tully:
Mm-hmm (affirmative). Okay.

George Lin:
Now having said that, all central banks are facing a bit of an inflation outbreak and they all have to catch up basically. So the Reserve Bank is no exception, but the pace of catch up just maybe a little bit slower than the U.S.

Scott Tully:
So the expectation then for economic growth in Australia and around the world-

George Lin:
Look, the outlook is not too bad. We're not going to get a 5, 6, 7% growth in 2021. No one can realistically expect that to happen because 2021 benefits enormously from the reopening of the economies due to vaccinations. Now this year, we're not going to get that. We are going to have, especially in the U.S., somewhat tighter monetary policies. Fiscal policies also not going to be as supportive as in 2021. So-

Scott Tully:
Oh, sorry, George. Just to be clear there, we're talking, so 2021 growth looks good because it's compared to 2020?

George Lin:
Yes.

Scott Tully:
2022, probably mathematically can't look as good because you're comparing it against a higher base.

George Lin:
Precisely. Mathematically is a totally different base. Well, everyone is counting on somewhat slower economic growth now. But the good thing is, there are still enough fiscal and monetary support out there. Now, even if you say that Reserve Banks increase... Sorry, not Reserve Bank, the Federal Reserve increase interest rate by seven times, you're talking about a cash rate somewhere about 1.5%.

Scott Tully:
Yeah. So still very low [crosstalk 00:18:14] historic.

George Lin:
It's still low by historical measure. So we don't believe in an imminent economic recession of some type, either in U.S. or Australia or for that matter in any of the developed economies where we feel things are actually more vulnerable in the investment markets, because a lot of asset class basically have been inflated, in terms of valuation, by the provision of liquidity by the central banks. Now that central banks are going to start with joining some of those liquidity, that is a pretty negative factors for most asset classes in 2022.

Scott Tully:
Yeah. But without making bold predictions, broadly speaking, equity markets, bond markets, are supported by economic activity through 2022. We'll see all sorts of dynamics going on, but that would be a reasonable position.

George Lin:
I think it's a reasonably position because for example, the Australian equity market just went through its reporting system, which is generally reasonably positive. The U.S. is a little bit mixed, but generally it's not too bad. There are some stocks, specific stocks, which disappointed the U.S. Like the Netflix is one which comes prominently to mind. Meta, the form of Facebook is another one. But those stocks seems to be suffering from very stock specific or sector specific hits. So overall we are still seeing earning growth, again, not as good as in 2021, but nonetheless is still earning growth. Recession is probably another 12, 24 months away in the U.S., depending on how tight and how fast the Fed [inaudible 00:20:23] are. So I think this still seems to us to be more of a mid-cycle collections than an end of cycle collection.

George Lin:
Now, having said that, because we start off with such high variation in some of the sectors, U.S. tech is probably the most permanent one. The magnitude of the collection will probably be greater than some of the minor collections we get in 2021. You may recall that over 2021 where the equity markets have done very well. Every time there's a bad news on the pandemics, there are a bit of collection 5 to 10%. So this time I think most of the equity industries have collected by roughly 9 to 10% from the previous peak in, say October, November, even before the Russian invasion. Now, there may be more volatility on those funds.

Scott Tully:
And volatility is a common feature of markets. Of course, we've all lived through it many times over. An investor who's got a long term view should be able to see through that. Take the volatility, not in his stride, but be aware of it. Recognize that it's going to happen, but you need to have the right risk. Your risk has got to be matched to your investment portfolios. And that's always the key message.

Scott Tully:
So look, I think on that note, George, great to have a chat around the quite extraordinary circumstances of the last, not only the last couple of days, but over the last year, with markets and interest rates alike. We will continue to keep informed through Investor Digest. Thank you for joining us today, from myself, Scott Tully and my co-host George Lin. Thank you very much. And we'll talk to you next time.

George Lin:
Thank you.

Disclaimer:
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. The opinions expressed in this podcast are the personal views of the speakers and do not represent Colonial First State's views.

Scott Tully:
Welcome to Colonial First State's latest edition of Investor Digest. I'm Scott Tully. I'm the General Manager of Investments at Colonial First State. And today, I'm talking to George Lin, our Senior Investment Manager, who's going to go through a recap of our recent experiences with investment markets, what it means, and perhaps give you a little bit of an outlook on what's likely to happen in the near term. George, welcome.

George Lin:
Thank you, Scott.

Scott Tully:
We've come up for a remarkable period – markets have been extremely strong since the pandemic-induced sell-downs in March 2020. We've seen a lot of recovery in markets. But I think that the last three months or so has been a little bit different. What are you saying, George?

George Lin:
Yes, the past three months have been pretty interesting. We definitely have seen a lot of negative headlines from China. But not only limited to China, there are also news headlines about the Federal Reserve and the tapering, so-called. Our financial markets performance are still reasonably good. As you said, not as good as in, perhaps, the first half of this year. But when you look at the equity markets, they have all delivered pretty solid results over the September quarter, despite a lot of volatility. So, for instance, if you look at the Australian equities market, it delivered about 1.79% in September quarter. The MSCI, which is a good measure of global equity markets, delivered 2.84%.

Now having said that, that headline MSCI number does hide a lot of different performance from different equities markets. Now the one to really call out is the Hang Seng, which is the Hong Kong stock indexes. It has actually fallen 14.8% over September quarter deals to development in China. But when you look at the other developed markets, their performance is okay. Not great, but definitely, okay. So, for instance, S&P 500 went up by about 0.2%, EURO STOXX went up by about 0.4%. Now the Australian dollars or the Australian investor's return from global equities, have really, really been helped over the past three months by the fall in Australian dollars.

The AUD start the quarter at about, quote $0.75 US. By the end of the quarter, it has fallen to around $0.72. So there's a 3.78% fall in the US dollars, which have been very useful in terms of buffering us from some of the weakness and volatility in overseas share markets. Perhaps we start with the good news, which is the pandemic. The pandemic has actually had very, very little impact on the markets, apart from introducing quite a bit of volatility along the way through the quarter.

Now the Australian equity market is probably best example, as everyone knows. We have the Eastern stakes in lockdown during most of that period. So obviously that translates into some pretty weak economic data. But even in Australia, investors largely adopt a look-through approach saying that okay, for the time being, we are going to have a lockdown, but vaccination is progressing very well. So we are going to have a reopening and once the reopening happens, economic growth will go back to, I suppose, normal in a very short time frame. Now that has largely been the case in all the overseas countries since the beginning of this year. So hopefully we are going to see that repeat in Australia over the next few months. Now, globally one of the driving themes is that we are seeing somewhat weaker than expected economic data from a number of major economies.

Part of this is because in the early part of this year, as vaccination went up and reopenings happened. We did see very, very strong GDP growth from a number of countries in the June quarter. Just to give you one example, year on year, the US economy growth by 12.3% in June quarter, which is pretty much unprecedented. So, because of that, I think there were had little bit of excess optimism built into the forecast of a lot of people. And over the quarter, a few things happened which makes things a little bit slower than expected. So there was a bit of economic surprise from the few countries which are sort of holding down the growth in equity prices somewhat. One very, very strong theme through the quarter is what we call central banks tapering.

As some of our audience may recall back in early 2020, as the pandemic hit a lot of central banks went out and engaged in pretty aggressive asset purchase programs.

So what that means is they go out in the open markets, they buy a lot of government bonds, and in some cases, more than government bonds. To basically support bond prices and push bond use, keep interest rates low in order to stimulate economies. Now, what we have seen is a few central banks basically assess the situation and say that the pandemic is over we are normalizing your phase. We don't need to put as much monetary stimulus into the economy.

So we saw the ECB announcing what they call a moderate reduction in their bond purchase program. At home, the RBA decided that it would reduce its bond at set purchase program by $1 billion per week, starting in November... and some central banks have actually moved even further than that and started increasing interest rates. For example, the Reserve Bank of New Zealand increased the policy rate by 25 basis points in early October.

So this collective move by central banks to either taper or to actually increase interest rates is one of the key variables which are limiting the rise in equity markets. Now obviously, the most important central bank in the world is the Federal Reserve. Now, what the Federal Reserve is telling everyone is that in terms of the inflation target, they feel that they have achieved the target. In fact, inflation, if anything is probably running a little bit too hot for comfort in the US.

So what the Federal Reserve is telling every investor is that they will likely start their tapering program in early November. And the expectation is that they will finish their tapering and i.e., they will stop buying any additional bonds in the open market by say, July or August next year. So then that will open up a window of opportunity for the Federal Reserve to possibly start increasing their policy rates towards the...some time before the end of 2022. So that is a major consideration which weighted on equity markets quite a bit over the past quarter, Scott.

Scott Tully:
Yeah. Good observation, George. And we've also seen the impact in bond markets over that period of time. Do you want to elaborate on how that view on inflation and tapering in the work is impacting bond markets?

George Lin:
Sure. Bond markets is an interesting market because since the start of 2021, in the March quarter, they have a strong rise in bond yields. Then starting in about mid-June maybe a little bit earlier than that as some of the economic state are disappointed. And also because of some of the concerns about your Chinese economic growth surface. Bond use actually fell in some case quite significantly. Now what we have seen over the September quarter, especially in the past four or five weeks caught since the start of September is bond yields in the developed market have gone back up quite a bit because currently US bond yields and US 10 years bond yields and, and Australian 10 years bond yields are roughly in that 1.6-1.7% range, still a little bit lower than the peak in back in the start of March and April of this year, but quite a sharp rise in bond yield.

So that is another factor which is affecting the returns from equity markets and the other influence on equity markets from this increasing bond yields is the...is that we have seen a bit of rotation back from the growth stocks to the value stocks over the past few weeks. Now, broadly speaking, it seems that a rise in bond yields is relatively better for various stocks than those stocks. So this fairly growth performance gap seems to be very, very much different by default and rise in bond yields over the past six months. Now, of course, the other thing which is very important to financial markets and especially to Australia is what is happening in China. I think what happened in China is almost a perfect storm and you have several negative factors coming together to really, really drive pessimism to some extent on the Chinese economics outlook.

Now, the first thing to note is that China was sort of the first one into the COVID-19 crisis and the first one to get out. So because of that, and because of concerns about high level of indebtedness in the Chinese economy, the Chinese fiscal and monetary authorities, took their feet off the pedals, gas pedal a bit aggressively, more aggressively than the other economies. So we are seeing a bit of a slowdown in Chinese economic growth going into the September quarter. Then in the September quarter two things happened which, actually three things happened which basically exacerbate this strength. The first one is the bankruptcy of Evergrande which is a very large property developer in China. Now that is important because of property sector in China is a very, very large contributor to GDP growth, and is also the main saving vehicles for most Chinese household.

So any further slowdown into Chinese popular market is going to be a pretty big negative for economic growth. Now the second thing which happened is the energy crunch in China. Now for a whole number of complex reasons which we can't really...which we don't have time to go into in this podcast. There is an acute energy shortage in China, especially concentrating in the most economically important provinces along the coast. So that is going to hit manufacturing productions over the next few months. And we are also entering the winter period in China. So if you have an unexpectedly or colder than usual winter in China, that may cause further disruptions in terms of energy supply. Now the third thing which happens in China, which is frankly more long term in nature, and is a topic which is very hotly debated both within our investment team and the investment community it is the regulatory crackdown.

Now, what is regulatory crackdown? Is there a lot of additional regulation imposed firstly on the big internet companies in China, Alibaba and Tencent are probably the two which comes to mind, but is not only the internet sector. It also hits other sectors such as private education in China, the media and entertainments of complex in China and even stock, which are normal or usually not listed in China, but are still impacted by China's political developments, namely the Hong Kong property developers, as well as the Macau casino and gaming stocks. Now the extent of this crackdown is pretty difficult to know at this point in time, but we do know that it's happening. It is actually impacting on a lot of Chinese stocks. Now some of those Chinese stocks in terms of share lives have come back a little bit over the past few weeks. But the long term impact is stills to be, I guess, fully absorbed by financial markets as we get more information about the extent and the duration of this crackdown. So that's sort of what happened over the past few months.

Scott Tully:
Yeah. Thanks, George. That is pretty comprehensive. It was definitely one of those quarters where there was plenty of things to keep an eye on. Outlook for the next few months, always difficult and dangerous to do that. But do you have anything particular that people should keep an eye on?

George Lin:
Yes. I think two things. Okay. Before I mention the two things, I should say that we are not too pessimistic about market outlook. We feel that the economic... while economic growth has been a little bit disappointing globally, we don't think it's too alarming. We just feel that it's a normalization of economic growth. The world economy is still recovering. We don't expect any short term recessions or anything. Now having said that, there are two major terrorists to market. One is Chinese economics development over the next, say three to six months. We know that the energy crisis has continue in China since the end of the quarter. Now, as with all things in China, it's a little bit long, transparent, and sometimes difficult to know the exact magnitude, but it's still happening. It's still impacting on Chinese economy. There is the possibility that Chinese economic growth in December quarters turn out to be lower than expected and that is a key list.

Now that also has some pretty significant full on effects on Australia because China is one of our major export markets. And you have already seen the influence of China on oil prices, which have gone done pretty significantly over the past six months.

Now happily for us Australia is also a very, very big LNG exporter. So gas prices have gone through the roof, compensating somewhat for the slowdown and the collections in our oil price.

Nonetheless, China is a major risk. Now the other terrorist is basically what the Federal Reserve is going to do. As I mentioned before, 2022 could end up being the year when the Federal Reserve starts increasing interest rate. So that is something which we need to keep a close eye on. And especially on this spot, how US inflations is going to behave because there is a risk that if we get stubbornly high US inflation, say still about 3% by the middle of next year, the Federal Reserve may tighten policy more aggressively and faster than anyone expected. So in terms of things to look out for over the next few months, that's probably the two major things to look out for.

Scott Tully:
Excellent. Thanks, George. And I think we'll call it a day at that point. Thank you all for joining us on this edition of Investor Digest. My name's Scott Tully. I've been joined by George Lin. Thank you for your time. And we look forward to having you join us next time.

Disclaimer:
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 PDS available on our website, assess whether the information is appropriate for you and consider speaking to a financial adviser 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. 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. Thanks for tuning into Investor Digest, a Colonial First State podcast. It's Tamikah here, investment writer. I hope everyone's been keeping well and locked down. I know I'm going a bit stir crazy. I can't remember the last time I was in the office, at the movies, a coffee shop, anywhere really. But our guests today can probably shed a little bit of light on this. Joining me for this episode are Ben, Dan and Leroy from the investments team. Thanks for being here, guys. How's everyone going?

Ben:
Good. Thanks, Tamikah.

Dan:
We're doing well. Thanks, Tamikah, for the invite.

Leroy:
As well as can be, Tamikah.

Tamikah:
That's good. I might kick off with a little bit of info on each of you, if that's okay? Leroy, you've probably been with Colonial First State the longest, is that right? Eight or nine years?

Leroy:
Coming up to 10 years next year, yes.

Tamikah:
Wow. Tell us a bit about yourself, your career, your experience.

Leroy:
Yeah. Thanks, Tamikah. I joined Colonial First State as a graduate almost 10 years ago now, and now I'm responsible for our list of property and infrastructure funds. And in my own time I'm also an avid property investor myself. Back over to you, Tamikah.

Tamikah:
Interesting. And you worked fairly closely with Ben in the past. Ben's been with the team for about five years I think. Ben, what's been the focus of your career both within and outside of Colonial First State?

Ben:
Yeah, so just over five years with Colonial and previously was actually a consultant to the team in a previous role for about eight years. And in that previous role I also covered property research and property advisory services to institutional investors. So a bit of a background in property. Currently, my primary responsibility is Australian shares but I also work closely with Leroy on property and infrastructure.

Tamikah:
And Dan joined the team about a year ago but from the sounds of things has had a pretty extensive career both in Australia and overseas. Dan, I'm really keen to hear about your time in the investment space and your role now in the investments team.

Dan:
Thanks, Tamikah. Yeah, I've probably been working in financial services for over 20 years now. I joined CFS just under a year ago and my focus is looking at all of our direct or unlisted assets, such as direct property and direct infrastructure and potentially other asset classes we might consider like private equity or private credit.

Tamikah:
And I'm sure all of you have seen some pretty interesting changes occur within the property sector during your careers, perhaps more so over the last two years, as a result of Corona virus. I know there have emerged some trends in certain sectors as a result of the way that people live and consume products, that's normal. But some of them seem to have been fast tracked or exacerbated because of the pandemic. Ben and Leroy, from the perspective of listed property, can you talk about some of those longer-term, perhaps, pre-existing trends?

Ben:
Thanks, Tamikah. Yeah, I think the key trend that has accelerated through the pandemic has been the transition to online shopping. So this impacts two of the key sectors within the property market. So both retail, which is your shopping centres and also your industrial and logistics area. So as more and more purchases are made online, the need for physical stores changes. And so that's probably been the key dynamic. So many people are trying online shopping for the first time and it's, I guess, opened their eyes to a lot of possibilities of accessing new products and services that they may not have been able to access previously. And also, I guess, one of the key benefits is that most people are at home. So you don't have your issues with waiting for parcels or getting a flyer out of Australia post and waiting in line to pick up those parcels.

Tamikah:
What about you, Leroy?

Leroy:
Yeah, so I can comment more on global property and that is certainly also the case for the trends that Ben talked about in terms of the disruption to retail shopping centres and the tailwind for logistics, that's also the case globally. And as Ben mentioned, that's been a trend that we have seen even prior to COVID and particularly in the US, which is the largest listed global property market in the world. We've saw a lot of retail store and mall closures even prior to COVID.

And on the other hand, some of the other trends we are seeing globally is that with people staying at home and shopping online, as well as needing to work from home, there's been a tailwind for property and infrastructure asset types, such as telecommunication towers, as well as data centres. And the telecommunication tower sector also benefited from an ongoing rollout of 5G, which will be a longer-term trend, even when COVID ends. And one of the other things I'll pick up on is that we're increasingly seeing what are called non-traditional or alternative property sectors. That's becoming a larger part of the global list of property markets. Some of these sectors such as healthcare, single family residential, overseas particularly, as well as self-storage.

Ben:
And I guess another trend that has emerged as a result of the pandemic that, unlike the retail and industrial move to online shopping, is the changing dynamic of what an office might look like in the future. As we all work from home, there is flexible working and that changing dynamic on what actually are requirements for offices in the future. So will we all move back to five days a week? Is there more flexible working and what that actually means for office markets. That is something that is still playing out and will be something to watch.

Tamikah:
Yeah, absolutely. Dan, what's your experience? How have any of those longer-term trends differed or applied to direct and unlisted assets?

Dan:
Yeah, I think the underlying trends were also taking place in direct assets. For example, retail was deteriorating pre-COVID but still generating revenue. Shopping centres were trying to increase the appeal of their shopping centres by introducing different types of usages. They were trying to bring in more dining and services and entertainment things, rather than just relying on retail shopping. But COVID has definitely accelerated the trend to online shopping so retail at the moment is quite challenging. But shopping centres that cater to the daily essentials, that are anchored by supermarkets, they're trading a lot better than those that are relying on discretionary shops, such as fashion or hairdressers and things like that.

In fact, during the first lockdown, supermarkets experienced a 30% increase in footfall compared to their historical averages and we would expect that to be similar each time lockdowns are imposed. But yeah, in general, direct assets, the trends are very similar. Logistics and industrial centres have seen a real tailwind behind them with COVID because of the demand from online shopping and deliveries. So some of the shopping centres that have been struggling have actually partly converted to be last-mile logistic fulfillment, where they help with the logistics chain and being able to deliver parcels from retail centres. And some of the bigger department stores are using some of their shops in shopping centres to deliver goods to customers online.

Tamikah:
Obviously Australia is not alone in its experience of Coronavirus-driven lockdowns and business closures and stuff, but it is a smaller market. I'm sure there's some key differences when compared to global property. This is a question for all of you, but what similarities or differences have you observed over the last year or two with Australia versus the rest of the world?

Ben:
That's a great question, Tamikah. Property's one of those interesting ones because whilst you can look at it from a global and different market perspective, it is a very local asset class. So each location and area with in which a property is located does make a difference. And a lot of the trends that were highlighted have been fairly consistent so it's almost a movement of the trends around the world. The online shopping phase was much more prevalent and started much earlier in the likes of the UK and the US, and Australia is almost in a bit of a catch up phase. So there are very similar trends on that front. The demand for industrial logistics has also been increasing globally. We see a lot of demand in Australia, but we're also seeing plenty of demand globally.

Industrial is one of those interesting ones, because if you look back through history, it was probably a bit of an ugly duckling within the property asset classes; very generic sheds located on the outskirts of major cities. But what we're seeing now with the emergence of online shopping is sophistication falling into these industrial warehouses where retailers are putting in aspects such as automation, cold storage, and actually really spending money. So the sheds actually have a lot of valuable technology within them. So they're actually much more valuable. And I see other dynamic within industrial, there was always this higher and better use for the asset. So industrial often wasn't the optimal usage for that piece of land. Whereas, now, logistics has definitely moved up the curve and is definitely a critical asset class.

Leroy:
Yeah, I'll add to Ben's point. The way I like to think about it is for both a short-term and a long-term basis in terms of the similarities and difference between domestic and global property. So in the short term, my view is the differences and how many are primarily driven by developments on COVID. Whereas in the long term, as Ben pointed out, we are seeing similar trends playing out in both domestic and global property.

So starting with the short term, my view is Australia right now lags the rest of the world in terms of our reopening from COVID, which is quite a large reversal from this time last year when the rest of world lagged Australia in terms of Australia being able to keep COVID out and keeping the economy reopen. So a clear example or implication of how this has played out in property is that now in the US, which going through a very sharp reopening phase, we are seeing more and more people returning to the coastal cities and pushing up residential rents for apartments. And with those rents now back about the pre COVID levels.

If you compare that to what's happening in Australia, where demand and rent for apartments, particularly in the inner cities of Sydney and Melbourne are still remaining weak. This, of course, is in part driven by the shift to more spacious homes, as Ben pointed out, as people are looking for a larger space to work from home. But it's also due to the fact that our borders remain shut. And there's a lack of international students and migrants coming to Australia.

Another example where there are differences between domestic and global property is the reopening and return to offices in financial hubs, such as New York. Whereas, of course, last year when New York was badly hit by COVID, these inner city offices were essentially deserted. Whereas, now, Sydney has gone the other direction with most of us in Sydney working from home. However, these trends overseas should be encouraging for us from a property perspective, because they point to where we can be locally when vaccination rates increase. So that's the short term where they are differences driven by COVID.

However, in the long term, as Ben and Dan pointed out in the examples of the various property types, such as logistics, built-to-rent apartments, et cetera, the growth of these alternative property types is similar between here and overseas. Now in Australia, we've already seen growth in Lester self-storage, childcare and manufactured home property trusts in Australia. And these have all existed in global property markets previously. So in the future, I expect a greater role for these alternative property types, both locally and overseas as a long-term trend.

Tamikah:
Anything from your perspective, Dan?

Ben:
Yeah, I think that point about residential property and building to rent is that's a developing sector here in Australia. We're starting to see more opportunities come to market about home developers, instead of just selling the homes that they built, they're looking to rent those out and have an ongoing relationship with those assets.

Dan:
It's interesting that we bring up build-to-rent because that has been traditionally a very successful asset class in global markets. In the US it's often called multifamily where there isn't necessarily this fascination with home ownership and there is a lifetime rental norm that exists in those markets and some of the interesting things that you can get from a build-to-rent is longer lease terms, because, I guess, rents in Australia are typically, in the residential space, six to 12 months, but you can sign longer term leases with build-to-rent. It includes a lot of maintenance, activities and some of the developments in Australia, you're seeing co-working spaces. So for people who are working from home, if they want a bit of a different environment, they can actually rent or book in an office, cinemas and the likes, which is quite a fascinating area that is, as I mentioned, very new to Australia.

We saw one of the first major examples of that in the Gold Coast with the Commonwealth Games Village a few years back, and definitely an evolving sector and one to watch, particularly with where house prices are going. They've been rising very fast and the challenge for a lot of people is getting that foothold in the housing market, whereas build to rent might offer a different solution for people.

Tamikah:
Okay. And if we sort of hold those back legal perspective, just a little, little longer and look to the future, what is some of the more structural shifts occurring within property and how might other developments say, you know, and need for climate risk mitigation impact those markets over the next six to 12 months? Do you think?

Ben:
I think a lot of those trends are probably longer term. They're probably not going to impact markets in the next six to 12 months, but probably longer term than that. I think that will really come into play particularly on the climate change side of things. I know that a lot of the bigger property funds are looking at climate risk and have adopted net zero targets or their properties. So that's something that's continuing to evolve and managers are responding to, I guess, society's expectations. And, and also as the evidence for, I guess, climate change becomes more and more compelling than I think people are taking greater action to, to kind of address those sorts of things.

Dan:
Yeah. I think what we will need to watch for some of these kind of key asset classes within property is when you reach an equilibrium. So there is often the sensationalist headlines that retail, physical retailing is dead. But that is unlikely. The case that people still would like to go to the shops, touch and feel products before buying, but it's just historically physical retail had a lot of tailwinds, particularly in Australia. So in a shopping centre, you'd have a development every few years expand the size of the mall. And also with many retailers, a focus was always on store roll-outs. Whereas I think going forward store roll-outs will still happen for many retailers, but they'll also be conscious of how many stores they have, ensuring that each store is profitable and serves a meaningful purpose because we are seeing whilst there has been the increase in online shopping, click and collect is still heavily taken up by many buyers. So whilst they're doing the shopping online, they're actually still going into the stores to pick up goods.

And then also the other equilibrium that we'll need to see in the market is what actually does happen with offices. So as employers and landlords work out what is the actual space requirement, because yes, we're going to have more flexible working, but it's just what that might actually look like, because you might want more space for each employee and flexibility in how that space is used. So maybe more either offices or shared spaces, what that looks like is still to be determined and something to definitely look out for.

Yeah. I definitely agree with that on offices as well. I think pre-COVID, we saw a trend for offices to try to maximize the usage of the space by hot-desking and using those sorts of techniques. With the social distancing requirements now, after COVID, I think there's been a reversal in that trend where there might be greater demand for flexible working spaces that incorporate more meeting rooms or collaboration areas that will actually, potentially in some offices, increase the demand for space. But as Ben mentioned, it's still a trend that's in transition and people are still working out what works the best and what's the most effective in terms of productivity.

Leroy:
Yeah, I'm very bullish on property over the next six months. So, in terms of property, what COVID means is that any properties which needs people to come together has been the most adversely affected. So as both Ben and Daniel pointed out, that's the case for retail property where you need people to shop together and offices where you need people to work together on a physical premise.

Now, to make it to your question on whether that's structural or not, that will depend on how COVID and our responses play out. So with vaccination rates ever rising here in Australia, and assuming the vaccine remains effective, I expect economic reopening to get apace here and overseas over the next six months. And one other thing that's been missing over the last year, which may come into play over the next six months, is the prospect of international travel resuming, which should bode very well for the recovery, particularly for hotels, which as you appreciate a more leveraged to international travel.

And taking another perspective, a policy perspective. Policy makers have shown a willingness to maintain very highly accommodative policies in terms of both low interest rates, as well as massive government spending, both of which are very beneficial for property. By keeping business ordering costs low, as well as sustaining tenant demand for property and in an environment where low interest rates and potentially rising inflation, I think property assets, which are able to sustain recurring income and rising income should continue to appeal to investors seeking dividends.

Tamikah:
Okay. Ben, I've got one last question for you. Have you noticed any flow-on effects of developments in property that other asset classes like shares... I'm just asking you to draw from your dual experience in both property and equities. Has there been any correlation between any of the sectors of those markets?

Ben:
Yeah, I think one of the interesting ones is probably going back to the online and shopping centre retail experience because covering Australian shares you're hearing the perspective from the tenant. Whereas when we're looking at property it's from the perspective of the landlord and their rent collection and how they're growing their income stream. Whereas when you look at the tenants, they want to, I guess, minimize the amount of rent they're paying because that impacts their earnings and profits and margins. And so we've seen shrinking footprints for quite a number of listed Australian shares with the likes of Flight Centre, Big W, Meyer, all shrinking their footprints during the pandemic.

But at the same time, we've also seen the benefits. But I guess what is somewhat interesting, hearing some discussions around retail, is the actual margin difference between selling online and selling in a store is not necessarily a material difference. Retailers are really just focusing on adapting to customer demands and desires. So offering choice to shoppers in terms of how they actually want to access products is probably the key thing for retailers. And whether that is online, whether that is in shopping centres, they will ensure that they meet the demands of the customer.
So that's definitely probably the key draw out for broader equities, just in terms of companies and how that influences their dynamic or interactions with landlords. And as you mentioned before, offices are also one of those ones that may be less impactful from a tenant perspective because rent's probably a smaller component for major white collar employees, but still a significant cost. Not to the same extent as for a retailer but it is definitely that kind of trend that I think tenants would definitely be watching out for, in terms of how much office space they require going forward. Because if they don't need to spend that money, they definitely won't.

Tamikah:
Anything from you guys, Dan, Leroy, on any of the other trends you've noticed?

Dan:
Yeah, looking forward I think the trends have been in play in direct property will continue to hold and I think industrial and logistics sector will continue to see really strong demand with demand outstripping the amount of supply that's available in industrial properties. So that will have a really strong tailwind behind it for, I think, the next few years at least as a lot of the other diversified property funds have been, I would say, overexposed to retail and office going into this pandemic and they're really trying to refocus and get an exposure to the industrial sector. I think retail is going to be very nuanced. I think some parts of it will be quite challenged for the next few years, but I think the non-discretionary segments will continue to show a lot of appeal to investors as well. And I think offices are kind of in transition and people are still waiting to see how that model goes and develops going forward.

Leroy:
Yeah. One other thing I might add is, when it comes to property, a lot of time at the end of the day it's about supply and demand. And what we saw during COVID is a slowdown in construction or supply of new properties, which should serve as a bottleneck in the years ahead. And with limited supply and, presumably, with the economy reopening that will push demand up relative supply and that bodes well for property. And also, what we've seen over the last half year in the US particularly is that the rising costs of construction material, in terms of both lumber steel and other raw material used to build property, and that all contributes to a rising cost of building new buildings, which, again, should support property evaluations going forward.

Tamikah:
Yeah, well it sounds like it's going to be an interesting space to watch, particularly as vaccines continued to be rolled out. We'll have to get you guys in again. Thanks for being here and thanks to everyone who tuned in to this episode of Investor Digest. If you haven't already, please be sure to subscribe and take a look at our website. The team produces timely updates, topical articles, and other helpful resources on investing to help keep people up to date on the latest developments. But for now, we'll catch you later. Thanks again. Bye.

Disclaimer:
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 PDS available on our website, assess whether the information is appropriate for you and consider speaking to a financial advisor for 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. The opinions expressed in this podcast are the personal views of the speakers and do not represent Colonial First State's views.

Tamikah Bretzke: Hi, everyone. How's it going? Welcome back to Investor Digest, the podcast on the latest investment tips, economic insights, market developments, and more. I'm Tamikah, investment writer, and I've got two of the team joining me today, returning. We have senior investment manager, George Lin. George, how are you?

George Lin: That's good. We also have a very special guest GM of investments, the OG, Scott Tully, thanks for joining us.

Scott Tully: Thanks, Tamikah. Hi, George. How are you going?

George Lin: Oh, good. It is quite a long time.

Tamikah Bretzke: Yeah. So apologies ahead of time for our tardiness. So for the audio quality, we are attempting to record in lock down. But by way of introduction, Scott is one of the original members, one of the key backbones of the Colonial First State Investments team. Nearly 20 years, you've seen the business and financial markets evolve a few times, haven't you?

Scott Tully: I have, there's been a few cycles Tamikah, over that time, and we're going through a very interesting one at the moment, that's for sure.

Tamikah Bretzke: Well yeah, I guess that's what we're here to talk about today.

Scott Tully: Absolutely.

Tamikah Bretzke: We're doing a June quarter catch-up, let's kick it off, I guess. So every month, George, who is our token economist gives the team a pretty detailed account of economic developments and how they feed into financial markets. But Scott, I'm really keen to hear your perspective on the quarter. Looking back at the last three months, what was some of your key observations in terms of, main events and market changes? And do feel free to jump in too, George.

Scott Tully: Yeah, look, I mean, just from a market perspective, I think there was a, it was another very strong quarter and so we'd seen that recovery to the end of March in markets, so posts lock downs of now 15 months ago. We have seen this really strong recovery, but the June quarter actually continued that period. So as markets responded to the strengthened economies, they generated some very strong returns for investors. The Australian market did return about 8% for investors, so that was on top of the very strong returns from the previous 12 months. Drivers of that and we'll get into that Tamikah, but yeah, there was the reopening of economies and some pretty strong technical data in terms of unemployment rates and the like, so quite an interesting quarter and we'll explore that definitely over the next little while.

Tamikah Bretzke: And in Australia, George, which you briefly covered off in your quarterly market wrap some of the potential risks of this Delta variant of Coronavirus, do you want to explain that to everybody?

George Lin: Sure. I guess the first thing to note about the Delta variant is that it's a pretty new variant and there are still a lot of unknowns about it. And like everything else with the pandemic's forecast stability or predictability is actually quite low. But having said that we can summarize the scientific consensus on the Delta variant as follows, number one, it's very highly contagious.

Secondly, it is a little bit more resistant to the existing vaccines. However, it is important to place this in perspective, most of the approved vaccines are still pretty effective against the Delta variant and is especially effective in reducing the risk of serious symptoms. Now, the third thing about the Delta variant, which is a little bit unsettled from a medical perspective, is does it cause more serious sickness than the other variant?

Now this is still a little bit inconclusive. But if you put all those three things together, then the key point is immunization and vaccination, a population, which is highly vaccinated in terms of the proportion of the population is a lot more protected against the Delta variant. And we have seen that happening in overseas countries. So our expectation is yes, we are going to be in a bit of a difficult time over the next, say two or three months as the various Australian states struggle with the Delta variant. We have already seen the stock working communities and the investment community, starting to revise up their GDP forecast over the September quarter. It's still early day, but it is quite a possibility that we will see quarter on quarter negative GDP for the September quarter.

The type of numbers which I have seen floating a lot is probably about minus 0.5 to minus 0.7. So that would be a little bit of a shock or that negative shock to investment markets. Now it's worthwhile to point out that at this point in time, the Australian equity market have really taken the shutdown news quite well. We saw a little bit of corrections towards the end of last week and on Monday of this week, when the local indices went down quite a bit, but over the past two or three days, they have come back quite strongly and recovered most of that losses. So when you put these two things together it seems to suggest to us that there will be quite a lot of volatility in the local equity markets.

A bit of a collection is quite possible given that some of the bad news may not have been fully priced in, it is going to be very, very contingent on the developments in the pandemic. Obviously, the longer the lockdown, the more severe the lockdown, the more serious damage to the economic growth there will be and with assets such as equities, will be under challenges somewhat over the next three months, that's a base fail. But if you look past for those three months and say, looking forward to say, end of this year, or early 2022, then the picture really gets somewhat better. Again, overseas experience tell us that after a period of lockdown, the virus can be suppressed and then controlled and there will be a reopening, and things will get back to normal.

So over the medium term, we see this as a little bit more of a short-term challenge rather than a medium term conclusion of the inflation already which we have seen since probably end of last year.

Tamikah Bretzke: And one of the other things you touched on in the quarterly wrap is inflation, which has been topical over some time and there are a couple of moving parts there. For example, world economies recovering faster than the supply of goods and services. Pick up in wages growth, and employers, at least in the US struggling to fill jobs. These are some of the elements driving price increases, and over the last few months, we have seen a couple of economic indicators flash Amber. The producer price index, for example, of more notably the consumer price index. So in June headline CPI, was above 5%, which is the highest it's been in about 30 years. And even when some of the variables say like food or fuel, for example, was stripped from that basket of goods and services, inflation was still high at about 2.9 to 3% over the same period of time.

But despite the data, financial markets have been kind of optimistic about inflation, at least recently, anyway, the consensus seems to be that, inflation will come into control with help from the Fed and perhaps go even lower than before the pandemic. For example, the bond market, which has tended to reflect investors predictions about inflation, seems to have relaxed over the last three months. It was a little bit volatile earlier in the year and the direction of the yields curve for 10 year bonds is also an indicator of investors view on the direction of inflation, fell below 1%. Guys first of all, what are your thoughts on some of these flushing signals, which suggests a period of higher inflation versus the market consensus of lower inflation? And what are some of the other key indicators that suggest what direction we're going in?

George Lin: Yep. Tamika, I think thanks you for very good summary of every things which have happened in the inflation front over the last few months. I guess, for inflation, let us focus first on the US, which is most important because the Federal Reserve is the most important central bank in the world. And clearly US inflation will have some influence on how the Federal Reserve will react. Now, the way we look at it is that when you look at inflation, you really have to differentiate between a cyclical element and a structural element. And for the sake of argument, let us say the cyclical element is what is going to happen over the next say 12 to 18 months. And the structural element is what is going to happen over the longer term, say three to five years.

So I think what is happening in the US is there's a very strong uptake in cyclical inflation, but you are spot on when you said that the markets have been quite comfortable with that. And I think part of the reasons for that is that the Federal Reserve has been very, very successful in selling to the financial markets the message that most of the inflationary pressures in the US are transitory. Now, what do I mean by that? When you look at the breakdown in US inflation and what is really driving inflation upward over the past few months are really two things. Number one, reopening of services sector in the US economy. As a result of that you are seeing a very sharp increase in things like air tickets, hotel accommodation prices and so off.

Now those increases should normalize somewhat over the next 12 months because we are, because they are basically driven off by one off factors. For instance, when hotels now reopen, they may not be able to rehire all the staff or they have to rehire the staff at high wages, so they have to pass on those high wages to the customers. Now, the second drivers of high US inflation over the past three months or what we call broadly speaking logistic supply chain driven. So those are sectors where there's a shortage of key components, which hinders the producer from responding to the recovery in demand, as quickly as they would like.

Now, one very good example is semiconductors in motor vehicle manufacturing's, there's a worldwide shortage in semiconductor and that is impacting and slowing down the productions of motor vehicles globally. And as a result of that, we have seen a very, very sharp increase in used car sales price in the US, now used car sales price in the US have jumped up by roughly 7 to 8% per month for three months consecutively, and that is driving part of the inflation story. So if you put those two things together, I think the Federal Reserve is probably correct in saying that we may be at the peak or near the peak of the cyclical uptake in inflation. Now, having said that the big problem and where there are doubts within the financial investment community is whether inflation will normalize and go down towards the 2 to 5% target range of the Federal Reserve targets as quickly as the Federal Reserve, like everyone to believe.

Now, some of the leading indicators are definitely showing some pretty serious signs of underlying inflation. So producer supplies inflation in the US is one component of that. That is clearly showing that there are some severe dislocation in the supply chain of the US economy. Again, over the longer term, those things should disappear, but are they going to disappear as quickly as market expected? At this point in time, we have some doubt. The other point about US economy is they are suffering from some pretty serious dislocation in the labor markets. And effectively what happened is because the US Federal government put in some very generous unemployment benefits to fight the lockdown effect from the pandemics, it becomes quite economically attractive for some part, and this is some of the states in the US, for the lower wage workers, not to return to the labor force and basically sit at home and collect the enhanced unemployment benefits.

So that is creating quite a lot of labor shortages in the US and they have a lot of job openings, which are currently unfilled despite the unemployment rate still being stubbornly high. So there's a bit of a mismatch in that labor market dynamics in the US again, that should smooth out eventually over the next say, 12 months. But again, the question mark is that, is this going to disappear as quickly as the more optimistic investors believe? So we have some question marks on this. And our belief is that over the next 12 to 18 months, we may see further upside supplies on the US inflation front. Now, that's the first part of the answer to your questions. The second part of the answer to your questions is really okay. If inflation supplies are on the upside, how's that going to impact investment markets? Now, that actually depends very critically on how the Federal Reserve respond, right?

Because the Federal Reserve in the US has basically two investment objectives or policy objective, I should say. Firstly, they want to get inflation back to the 2 to 3% range. Now you can look at all the underlying data and say, tick, that policy objective has been achieved. The second policy objective is they want to get US unemployment rate back to his neutral level. Now, what do we mean by neutral, is a little bit open to discussions, but broadly speaking, we're talking about so 4%. Now that clearly, clearly has not been achieved yet. And the Federal Reserve has been very, very consistent in saying that they're happy to allow inflation to overshoot somewhat until they get the unemployment rate back to that roughly 4% level.

Now, the markets are pretty convinced by that, but a June FOMC actually shook up the market confidence on this a little bit. Essentially a number of policy makers within the Federal Reserve have come out and indicated that they may be prepared to move a little bit earlier than expected if inflation-

Tamikah Bretzke: And that was kind of a big deal, wasn't it? Because it seems like the Fed was sort of dragging their heels a little bit, a little bit resistant to change. So that was quite a bit of a surprise for markets.

George Lin: Yep, and that was a big surprise on the markets and you have seen financial markets reacted pretty significantly to that, but again, after two or three days, markets came back to the convictions that the Fed Reserve will still be patient. And we are still not going to see a much faster than anticipated increase in policy rates or tapering. Now, the current consensus is that the Federal Reserve probably will announce some type of tapering say either in September or by the end of this year, the actual tapering is not going to happen until say early 2021.

There is a reasonable chance of an interest rate increase in 2023, that's probably a little bit of a borderline decisions. A lot of the peoples in the market still believe that 2024 is the earliest day for an increase in interest rates. That's sort of the consensus, the main danger is if we get very, very high inflation over the next 12 months, that schedule could be pushed a little bit forward. So instead of having interest rate increase in 2024, we'll have that in say mid to late 2023 and so on.

Tamikah Bretzke: Okay. So Scott, what do you think the implications of interest rate rises at least in the US could mean for asset classes, market sectors. Obviously, the US being one of the world's biggest economies, having significant influence, what are your views on an interest rate rise?

Scott Tully: Yeah, I mean, I think George has highlighted the timeframes that we're talking about here, and what we have seen is it's not so much necessarily the rate rises themselves, but the perception of rate rises in the future, has already had impacts on markets over the last 12 months. But yeah, let's assume that rates do eventually rise, which they will, the impact will probably dependent on the timing of the rise, the size of the rise and the reasons for the rise. So if it's a consequence of high inflation, that's a bit like the Coronavirus, suddenly sprung out of control, and the Fed and other central banks are trying to catch up.

Then that implies that there are certain things happening in the economy that will influence the prices of things like infrastructure assets, and property assets, but also some of those growth stocks that we saw come off relatively over the last, early this year. If it's a more deliberate strategy of increasing rates, indicating that the economy is improving and it's a major than a gradual approach, then that should provide some support to assets because it does imply the economy is traveling okay. So there isn't very much a path dependency on the outcomes and the implications for markets. I think markets have obviously done exceptionally well, as I said before, because the cost of funding is so low.

So for an investor or a company looking to do something with cash, there's almost no option, but to invest it in growth assets. So if you have a higher level of interest rates, then maybe the investment choices that people have, give them more opportunities and maybe the FOMO and the necessity to invest in growth assets will be somewhat lessened, so that would probably mitigate a bit on some of the asset price rises we've seen. George, you've got any thoughts on that?

George Lin: Yep. I just want to add one or two points. One point is that earning growth for the equity sides also matters enormously. So basically as global economies, reopen and economic growth accelerators, expectations for earning growth over the next 6 to 12 months is still pretty strong. And unless we really have another significant deterioration in the COVID-19 situation, that aspect seems to be still pretty positive over the next 12 months. So I think from an earnings growth perspective, we are still pretty okay.

Now the second point I will like to add is that if we do get a very rapid rise in interest rate earlier than expected, which is by the way, not a hundred percent certain, there's just a risk of that. Some of the asset classes, which may be impacted most, are the yield sensitive asset classes. So that may be things like properties, securities, infrastructures, as well as corporate bonds, high yield bonds and so on. So it's something which we keep our eyes on, but it's not a hundred percent certainty of this happening in the period.

Scott Tully: I suppose the interaction there is between earnings growth and discount rates on those sorts of assets.

George Lin: Yep.

Scott Tully: So if your top line earnings are growing strongly, that are at a higher discount rate, potentially let's say neutral, but if your top line earnings are not growing, yet your discount rates are going up, then in theory the price of those assets should come down. So it is very path dependent.

George Lin: Yeah. Precisely, Scott. And one further point to elaborate is the relationship between growth stocks and value stocks and bond yields, because what we've seen over the past, well, actually since the start of the pandemic is that there's very strong coalitions between the outperformance of growth stock over value stock with the bond yields. I.e when bond yields goes down, growth stock tends to outperform value stocks. So obviously, there are a lot of factors playing into this, but one of the factors is that the growth stocks tends to have a lot of expected headline growth in the future. So when bond yields goes down, the discount rate goes down, those expected future earnings become more valuable to investors. So one of the key things to watch out for is bond yields and how they will impact on the value versus growth stories in the equity markets.

Scott Tully: Although, what has been interesting on that... Sorry, Tamikah. Is over the last couple of months, we have seen that happen, yields have come off and growth has done well, but I'm not sure whether that it's been quite as correlated in that period. So the retracement and the falling bond yields and the rise in bond prices yeah, I don't think it was being quite as impactful on growth value relativities. Would you agree George, or have you got a different view?

George Lin: To some extent, yes. I mean, obviously there are quite a lot of other things going on. For example, one of the things which we have not touched on is the Chinese mega-cap technology stocks have gone through quite a difficult times over the past few months. And that a lot of that is driven by I suppose, politics and policies. For instance, basically the Chinese government force, one of the Chinese, big Chinese technology stocks, which did an IPO in the US three or four weeks ago. Instead, they basically adopt sanctions against that company, because the Chinese government was trying to discourage Chinese technology stocks to list in the US of due to geopolitical reasons, frankly.

And this particular stocks defying the central authority, so they have to be taught your lessons. And that triggered a lot of reassessment about the growth prospect of the Alibaba, Baidu and Tencent of this world, because they seems to be facing a pretty hostile type of regulatory environment from China. So things like that obviously do have an impact on the valuation of technology stocks. Bond yields is one important factors, but it's not everything, in terms of the performance of growth stocks.

Scott Tully: Yeah. Apologies. I think I was being a little bit Western centric there. Yeah, I was talking about your Amazon, your Apple's, Microsoft's, Alphabet's and the like. But yeah, there's definitely a country by country and geopolitical risk still is a factor, isn't it?

George Lin: Yep. And interestingly, all those US stocks are themselves under a little bit of regulatory cloud because the Biden administration seems to be signalling a tougher anti-trust regulatory approach to the mega-cap US technology stocks. And there seems to be a bit of bipartisan support for that in fact, because some of the Republicans in Congress are upset about the Facebook of this world, about censoring Trump and freedom of speech. So the technology stocks are frankly, not very popular among the politicians in the US at this point in time.

Tamikah Bretzke: I think what's happening country by country, is another time, probably another conversation. But before we do wrap up... Sorry, Scott. Are there any helpful considerations for investors or any resources or sign posts that people could potentially look to as this uncertain environment continues unfolding?

Scott Tully: Look, I always take the view that it's really difficult to be making calls on short-term market movements. Invariably, if you're an investor in and you are trying to figure out what's going to happen in the next three months, broadly speaking, you're not going to have any more information than the rest of the markets. So my view is always, make sure you've got the right settings on your investment portfolio for the long term and be prepared to take on some short-term volatility, always euphemism for loss of value. But yeah, don't try and respond to the short-term in that. I know that completely doesn't answer your question Tamikah, so George, might have some very specific insights that he has.

George Lin: Okay. I guess first thing is, remember your long term SAA, what you're trying to achieve. Markets always are volatile and markets always tends to overshoot, so don't chase short-term returns. I think that's the first thing I'd like to say. In terms of-

Scott Tully: That's what I was saying, George. That's what I was saying.

George Lin: In terms of things to read or look out for, several things. On the COVID-19 developments, the one country to really watch as a pointer to how the world will respond to Delta is the United Kingdom. Why is that case? Because they have a very high immunization, vaccination rate, I think roughly about 55 or 60% of their population has been fully vaccinated. Now they have basically lifted all social restriction from four days ago. And that's the reason why, for example, last week or the week before, if you watched soccer on TV, you saw all those soccer fans at the Wembley Stadium.

And the third thing is because they are actually going through a pretty severe wave of new COVID-19 cases, driven by Delta. So you put everything together, the prime minister of Great Britain essentially has taken a calculated gamble on how to live with COVID-19. He's saying that, "Okay, because I've high vaccination rate, the most vulnerable segment of the population is, are well protected. Vaccinations probably will help me to control the number of hospitalization case, I'm just going to give freedom to the population." Now how this works out, I think will be, quite an interesting and relevant pointer to other countries as their vaccination rates goes up.

So one country I have in mind is Australia obviously, because we have pretty ramped up in vaccinations over the past two weeks as to lockdown stopped fears about the virus. So potentially the UK, whether they are successful or not may offer some pretty good pointer to how Australia will react over the next six months to, on the COVID-19 front. I guess, on the economic data front, the one to watch out for is always the Federal Reserve and what they're going to do with tapering of how that affects, because that clearly focus a lot of market attention is on.

Tamikah Bretzke: Yeah, absolutely.

Scott Tully: I'll add there. I mean, I think the 10 year bond rate seems to be the one that's been maybe not a predictor of outcomes, but it's definitely been a reason why certain things have happened in markets. So the 10 year, US 10 year rate and the Australian 10 year rate went up quite strongly through the end of last year and into the beginning of this year, that drove that value growth split, but markets in themselves continued to go up.

We've seen that retrace quite substantially. There's been a bit of a reversion in stocks that performed at that period of time. I still think that's probably an indicator that will give you some sense of what's actually happening in terms of the markets, expectations of economies, but it's just that one.

George Lin: Yep.

Tamikah Bretzke: Yeah. Definitely.

Scott Tully: And if you can't find the 10 year bond rate, I think the Aussie US dollar is not a bad indicator as well. A relationship between a higher Australian dollar and the strength of equity markets has again demonstrated itself.

Tamikah Bretzke: Yeah. I think we'll wrap it up there. Thank you so much guys, for your insights. It was really good to get into this, we've covered a lot for the quarter, and thanks to everybody who tuned in. Now, our team shares regular market updates, topical articles on our website. You can see more from George Lin and his monthly and quarterly wraps, so check those out. And if you haven't already be sure to subscribe, you can tune in to Investor Digest in just about every platform, but for now, we'll catch you later.

Disclaimer: 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 PDS 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.

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 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 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 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 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.