Financial Market

Future Fund is dodging expensive equities in these three ways

Raphael Arndt, chief executive of the Future Fund, was a beneficiary of last year’s equity market rip; a strong December quarter helped the fund finish 2023 with an annual return of 8 per cent, just below its target of 8.4 per cent (inflation plus 4 per cent to 5 per cent).

The appeal of floating credit

But Arndt, whose long-held view is that the world is heading for a prolonged period of elevated inflation and higher interest rates than we’ve come to expect since the GFC, isn’t getting carried away with what he believes are expensive equity markets, where price-to-earnings valuations have pushed up to 22 times for the S&P 500, and about 16 times for the ASX 200.

“They’re not cheap, and they’re pricing in quite a bit of growth. And it’s hard to see a world where that growth will come through, especially if interest rates stay higher than the market’s expecting,” he says, adding that while he does expect rate cuts in the US, he questions whether those cuts will arrive as early as expected given the resilience of the US economy.

And like our “heck if we know” analyst friend, Arndt is cautious on the outlook for AI. “These changes tend to take years to play out, and it’s very unclear who the winners are going to be.”

The market might have latched onto the Magnificent Seven – Amazon, Alphabet, Apple, Meta Platforms, Microsoft, Netflix and Tesla – but the Future Fund’s exposure to those giants is limited, Arndt says. “We think there are better ways to take risk than ‘growthy’ equities at the moment.”

Part of that, he says, is about hunting in other parts of equity markets. Small caps, which have been left behind amid the focus on large companies in Australia and the US, are one target, while Arndt also likes Japanese stocks, which have had a stonking run, with the Nikkei Index up 35 per cent in 12 months and also hitting record highs.

“Although it’s a little more expensive than it used to be, it remains attractive,” Arndt says of a Japanese market trading on a P/E multiple of 16 times.

But the biggest shift in the Future Fund portfolio is towards floating rate credit, which is now more than 10 per cent of the fund.

There are two attractions for Arndt. The first is that returns are attractive, especially compared with the last decade or so when bonds of any type offered investors very little. The second is that this asset class reflects the Future Fund’s higher-for-longer view on rates.

“If interest rates stay high, or indeed have to go higher, which is unlikely but possible, that would flow through to the returns compared to long-duration equities, which are very highly poised for interest rate cuts,” he says.

The Future Fund’s retiring chairman, former federal treasurer Peter Costello, suggests the neutral rate (at which monetary policy is neither adding to nor limiting economic growth) is likely “a little lower than the current cash rate, but not a lot lower than the current cash rate”.

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