Qantas debacle helps explain why Future Fund is staying bearish

As Arndt explained on Wednesday, the Future Fund’s house view is favourable investment conditions of the past decade – rock bottom interest rates, abundant fiscal stimulus and globalisation – have reversed.

What the Future Fund sees now is a world where inflation remains stickier, interest rates remain higher and government and regulatory intervention is more prevalent. That intervention can take many forms – it might be the Inflation Reduction Act in the US pouring hundreds of billions of dollars into subsidies for clean energy, or it might be governments trying to protect households from higher energy bills.

But Arndt’s key message is that this is not a temporary shift.

“We’re going through a turning point in markets and actually in society at large,” he says. “We’re moving into a new regime where we’re moving away from monetary policy as the lever towards fiscal policy and market intervention by governments – and that is inflationary.”

That’s precisely what we’ve seen at Qantas, writ small. The government has tried to pick a winner – foolishly, as it turn out – in what is claimed to be in the national interest. But its decision will keep airfares higher than they should be, keeping inflation sticky in the process.

Arndt’s mission in the past two years has been to try to build a more diversified, more inflation-resistant portfolio.

In the 2023 financial year, some of those bets didn’t immediately pay off, and the Future Fund’s 6 per cent return for the 2023 financial year was below both its 10.1 per cent return target and the median balanced superannuation fund return of 9.1 per cent. However, tax and liquidity differences between the Future Fund and super funds means that a direct comparison needs to be treated with some caution.

Weathering the economic storm

But Arndt is confident he’s got the settings right for the long term.

For example, he is happy to continue to hold inflation-linked exposures such as infrastructure, which don’t do as well when real yields are rising like they are now, but should outperform if inflation remains sticky.

Similarly, he’s happy for his portfolio to remain moderately below neutral risk settings at present, in the belief that markets are underpricing many of the big risks facing markets, including the eventual arrival of the lagged effects of interest rate rises and the potential for a sharp slowdown in China.

This is particularly the case in equity markets, where Arndt questions the confidence in the faintly illogical Goldilocks scenario markets have bought into, where earnings rise due to economic resilience, but also interest rates come down, despite the same economic resilience.

“What we saw over 2023 was that most asset markets repriced. We saw some pressure on real estate, which has been widely spoken, private equity, certainly credit, bonds and rates repriced, But equities actually got more expensive. So how do you explain that?”

With a narrative Arndt is clearly pretty sceptical about.

He says a third of the US market’s gains have been driven by just three stocks – Nvidia, Microsoft and Apple – with the remainder of the so-called Magnificent Seven (Tesla, Alphabet, Amazon and Meta Platforms) accounting for another 40 per cent of this year’s rally. “We’re just cautious about piling into that story,” Arndt says.

AI narrative powering stocks

To be clear, that’s not because the Future Fund doesn’t believe in the artificial intelligence narrative that has powered these stocks higher; Arndt says it has between $2 billion and $3 billion worth of investments in AI-related start-ups that give it plenty of exposure. But rather, he sees little incentive to buy stocks in the US that are trading on 22 times earnings when he can get a return from institutional grade credit of upwards of 7 per cent – with a heck of a lot less risk.

Arndt’s scepticism extends to the Australian market, where he says share prices have been supported by a China recovery story that has not played out.

Costello warned that while Chinese demand for Australian commodities had produced the best terms of trade since the gold rush in the 1800s, the potential for a deep Chinese slowdown to hit Australia is real. “If China is facing significant structural problems, as we think it is, that will rebound back, we think, on Australian companies and the Australian economy.”

Unsurprisingly then, Arndt has reduced his portfolio’s exposure to China markedly, and that looks unlikely to reverse any time soon. “It just looks like there’s a lot of risk there. And the returns don’t look all that attractive when you weigh it up,” he says.

None of this to say that the Future Fund is fleeing equities. Indeed, its allocation to Australian equities ticked up 0.5 per cent to 8.6 per cent, and its allocation to developed market global equities rose 0.9 per cent to 15.9 per cent.

But Arndt’s message is one of diversification and risk management. “We haven’t bailed out of equities, but we certainly don’t feel like betting the house.”

The Future Fund’s declaration on Wednesday that its “holdings and returns will look increasingly different from those of other asset owners” is a clear message that the paths of the Future Fund and the super funds may well diverge even further.

The 6 per cent return Costello and Arndt produced in 2023 is a good example of that; this was a deliberate decision to leave risk on the table in a tricky environment, and Arndt is happy to weather any short-term underperformance.

And in an environment where fund managers are being assessed not just on quarterly but month;y returns, and where Arndt sees super funds facing similar short-term performance pressures, he believes the Future Fund can take a different view.

“We’ve really got a much more long-term lens on how we’re building the portfolio and how we expect that to pay off, and we very clearly think it continues to be the right settings for this investment environment,” he says.