Interview Transcript: Michael Pascoe & Kumar Phalgat

Kumar Palghat: If you look at the past five years or so, fixed interest as outperformed equities, especially on a global basis. Why has this happened? It’s happened because interest rates have come down from high levels to pretty low levels and equity markets ran through the spectacular collapse in 2001 in the US; but in the long run, equities should outperform fixed interest because people believe that in general we’re productive and that we’ll invest in capital goods and in companies that will do well over a period of time. So long term, most superannuation funds have more money in equities than fixed interest. But what fixed interest provides you is a stable income level so if you’re an elderly person and you have money in a superannuation fund, you don’t want it all in equity markets. Fixed interest gives you stable income and can give you good capital gains and consistent returns over long periods of time.

Michael Pascoe: Well PIMCO’s forecasting lower real interest rates. That means lower returns?

KP: Actually, when you have lower interest rates you have higher capital gains. As rates come lower, you not only clip the coupon that you’re getting on a monthly basis but you also get capital gains. So if you look at bonds, or global bonds over the past five years, they return about 11 or 12 percent for Australian investors. The reason we’re forecasting lower interest rates in the US is that there are large structural issues that the US faces today that they haven’t faced before. Oil prices have gone from $30 to $70 a barrel. That, at some point, is a tax on consumption. One could argue that consumers would spend less, but to offset that in the US over the past year or so people have taken money out of housing as home equity loans. So housing increases are [adding to] debt and now we have higher oil prices. If, as is highly likely, the US housing market doesn’t go up in the next 12 or 18 months, or even just stabilises, and oil prices [stay] around $65 or $70, that automatically says the US economy should slow down '” even if you ignore all the other factors.

MP: But you see that as being an international phenomenon? You see that happening in Australia as well?

KP: I don’t really see it happening as much in Australia because I think Australia has done a fantastic job compared to the US. The Reserve Bank of Australia found the cruising altitude on short-term rates somewhere around 5%. They have been one of the few central banks that hasn’t raised or cut rates a lot.

MP: Just on the individual investment scale, it’s becoming harder and harder to find things people can be confident about?

KP: That’s right. I think on an individual scale it gets harder and harder to do because you’ve gone through the equity market volatility of the past four or five years and you’re used to returns that were a lot higher in the 1990s. Now you have to pare down expectation levels on people’s returns. If they get high single-digit returns with low volatility, especially with an ageing population, people should be quite happy.

MP: You do come from the most conservative sector of the market, but does it worry you to see people chasing the more exotic investment forms, after that double-digit return?

KP: Absolutely. It worries me to see that, on average, superannuation funds in Australia now have 10% into the space called alternative asset classes. Alternative asset classes are good hedge funds, private equity infrastructure projects, etc. and hedge funds alone. There are 8000 hedge funds in the US and a hedge fund basically takes exposure to leverage, so obviously the amount of risk they take is a lot larger so the potential for a blowup is quite high. So the last 1 or 2 percent that you’re trying to reach to get to that double-digit return probably is not the best thing to do. You should be happy getting your 8 or 9 percent returns without that excess volatility.

MP: There’s a whole industry out there saying investment in a portfolio of hedge funds is a reasonable risk.

KP: Most people would say that because you’re looking at what your neighbour has done. People said that about the NASDAQ as well, and people were selling it 3000 and 4000 and it ultimately went to 5000 and completely collapsed. People are arguing now whether housing markets could be in a bubble as well. We just don’t know when it’s going to end. We know there are excesses that exist and, similarly, in alternative space when you come to hedge funds I think you’re in a situation where everybody is looking for yield and everybody is trying to reach for yield it probably is the wrong time to do it. On average hedge back into Australian dollars global bonds, Government debt, which is 70% triple-A rated bonds, are yielding somewhere around 6 or 7 percent so we think that’s not a bad bet to have, especially if you believe that the economies are going to slow down. If the central banks start cutting interest rates then you can get capital gains pretty quickly and those rates can go to 10 or 11 percent pretty soon and the volatility of this type of investment is quite low: somewhere around 2 or 3 percent.

MP: Now you’re not talking your own book here?

KP: No, not my own book.

MP: A very big picture: the absorption of the new workforces is the biggest economic driver. Does that pretty much guarantee low inflation unless we have particularly stupid government policies?

KP: One would say that it should because all of a sudden you’ve got a billion people joining the global economy, labour is cheap, [and] pricing power doesn’t exist in the US. The US was a manufacturing economy not so long ago. Then we went from manufacturing to a finance-based economy. Then we went from a finance-based economy to a service-oriented economy. Now all of that has gone. Pricing power does not exist for goods and services in the US because cheap labour is available in India and China. As long as we leave the markets open, you’re not going to have goods price inflation. The inflation that you’re going to get is going to be inflation either through commodity markets '” whether it’s higher oil prices because of demand from China '” or through asset price inflation. And asset price inflation is through higher housing costs, etc. The risk that the central banks run now is that you’re going to get higher inflation with lower growth. That’s what they have to worry about: that at some point the demand for some of these commodities remains high yet the economic growth doesn’t grow as fast because we’re all levered up to an extent and we haven’t really made investments into the economy. Instead, we’ve invested through the consumer sector, which is housing. So as the housing market goes, so goes the economy.

MP: Do you think the role of deflation '” the importance of deflation of manufactured goods '” is generally understood?

KP: It’s a great question because two-and-a-half years ago the world was really worried about the US going into a deflationary spiral and just two years later, with short-term rates going up from 1 to 3 percent, we think that that threat is gone. I don’t think it’s completely gone. I think there’s still a slight possibility that the world could end up like Japan. I don’t know how much [of a chance] it is, but I wouldn’t say it’s anything less than maybe 10 or 15 percent, and it’s still likely that with an ageing population and the structural problems we have, especially in the US and other countries, that you could have a threat of deflation again because pricing power doesn’t exist.

END