Summary: Interest rates are unusually low, some companies are paying an unusually high share of profits as dividends, it has been an unusually long time since a recession and house prices are unusually high. By focusing on what’s unusual about the market, opportunities and risks become clearer.
Key take-out: Cap your exposure to banks and mining stocks, ensure you are exposed to international shares, take profits in highly appreciated equities and consider reducing your residential property exposure. Remember to be cautious in case what’s unusual now becomes usual again.
Key beneficiaries: General investors. Category: Investment portfolio construction.
We really do live in unusual times and there are aspects of Australia’s investment markets that are unusual. By using an “unusuality filter” we can shine the spotlight on the investment equivalent of elephants in the room which perhaps you can profit from or use to protect yourself from the risks that are ahead. I’ve identified twelve investor implications for you to consider.
1. Plan for lower portfolio returns and worry if stretched asset prices stretch further
The share market has enjoyed an unusually strong tailwind of falling interest rates which one day will turn into a headwind. At the moment share prices overall are not tremendously overvalued as high prices are justifiable while interest rates are low. But further increases in share valuations beyond the current 60% rise in market price/earnings since the middle of 2012 (when we worried about Greece collapsing) can’t be expected. As Yale economics professor Robert Shiller has pointed out, the higher the starting price/earnings of your equity investment, the lower your future expected return.
In the other part of your portfolio, it is more certain that debt investments will underperform long-term averages. This is simply because deposit rates and bond yields are unusually low. Defensive and debt investors have been asked by central banks to subsidise the recovery from the GFC. Like the 1950s when interest rates were last this low, it may take a decade for fair value to be returned. Rising rates will create a capital loss, headwind superimposed on lean bond yields. While the recent rally in bond prices (further yield fall) surprised many, it just means the rubber band on bond valuations has been stretched further and future pain will be greater.
2. Don’t panic and sell out of equities but plan to take advantage of those who will
The GFC was unusually severe and not surprisingly it traumatised investors. Many individual and institutional investors have made a promise to not go through that again. Indeed many new investment products brought to the market in recent years include mechanisms to shield investors from falling markets including automatic selling. While there is little cause to panic sell yourself out of the share market now, don’t be surprised if investors overreact when an event occurs that justifies a correction. You either need to have a trigger finger to exit the market before them or you need to have some cash on hand and be brave to invest when better value emerges.
3. Take profits in highly appreciated equities and especially high-yield stocks
After a couple years of double-digit returns in equity prices, it wouldn’t be surprising if investor portfolios have become overweight equities and especially high-yield shares and other bond substitutes like property and infrastructure which have rallied further. For instance, it is unusual to see boring global utility and infrastructure stocks returning 15% annualised returns over the last five years. I’m certain the underlying assets haven’t grown profits that fast. This has just been price action which we’ve seen in many high-yield sectors.
Locally, companies are also paying out an unusually high share of profits as dividends, which makes high-yield stocks more prone to future underperformance through lack of reinvestment. The share market recovery in the US is getting unusually long in the tooth and it would be normal about now to start worrying about when the next recession might emerge.
4. If parking profits, relatively generous bank deposits beat Australian fixed-interest bonds and hybrid income securities
Australian government and corporate fixed rate bonds as measured by the UBS Composite Bond Index are yielding a little over 3%. The higher yielding Australian investment grade, corporate bond component (half of which are loans to Australian banks) is yielding only about 3.8%. This is an unusually low reward for lending your money at this rate, fixed for five years on average.
Australian depositors can earn about 3.5% on high yield at-call and three- to six-month term deposits, guaranteed by the AAA-rated Commonwealth Government. While it might not feel like it, this is an unusually generous 1% premium over the cash rate. It reflects demands to local banks by the Australian Prudential Regulation Authority to raise more “sticky” deposit funding for its gigantic lending activities.
Comparing rates we see Australian fixed-rate bond investors unusually receive no premium for lending their money to less credit-worthy entities and no premium for the duration difference. Fixed-rate investors can only beat deposit yields by taking on substantially more credit or term risk and the incremental return (or spread) for doing so is the lowest it’s been in a while. The lower yield of the most recent (even lower credit quality) hybrid securities reinforces this.
So my conclusion is to invest in unusually relatively generous cash deposits and not in Australian fixed rate bonds, funds and hybrid securities. With comparative real yields of about 1.5% (plus CPI), I’m more comfortable investing in Australian inflation-linked bonds.
5. Reconsider medium-term international bonds which pick up half their return from Australia’s relatively high cash rate
Americans don’t get much joy investing in their local bonds either, as these yield about 2%. However, that is at least a justifiable premium compared to local cash rates there of less than 0.5%. You might find it unusual that when an Australian invests in US and other developed country bonds through a hedged bond fund they pick up extra hedging income equal to the difference in the cash rate between Australia and those countries – or about 2.5%. This means Australians investing through this arrangement in US bonds yielding 2% earn about 4.5% counting hedging income. For this reason you should consider investing in a high credit quality global bond fund, not the local Australian version.
6. Cap your debt and equity exposure to too-dominant Australian bank stocks at some sensible metric – say one third?
While our banking system has proved itself unusually resilient through the GFC, it has many unusual characteristics. One is the banks’ size and another is their overdependence on often highly indebted householders. The big four banks make up four out of Australia’s largest five stocks and alone represent 30% of our share market valuation. They can make up 40-50% of some high-yield equity funds and a higher proportion of some investors’ equity mix.
In March 2014 our big four banks were ranked as the 10th, 13th, 18thand 22nd largest banks in the world based on market valuation, though none appear in a top 20 ranking of underlying assets. Counting equity and debt investments plus deposits, Australians have nearly $1.5 trillion of their financial assets and hence future tied to the banks (that’s the size of the entire superannuation system!). The banks have the majority of their future tied to residential mortgages, which worries me too – more on that later.
I would suggest capping your investment and lending exposure to banks (excluding guaranteed deposits) at about a third of your portfolio to lessen the dependency of your future on theirs. I don’t mind if you choose a different number, but just choose one.
7. Do the same for resource shares though perhaps to a lesser amount – say one quarter?
Another unusual feature of our local share market is the large presence of mining, material and resource companies. This is all to do with our geography and not our ingenuity. It is good to celebrate but when doing so in your portfolio I would suggest similarly limiting your exposure, say to about a quarter of your portfolio. There is a strong case to have these stocks in your portfolio for inflation protection purposes but realise that prices fluctuate with those of the commodities more than with the talents of management and staff. It takes a while for commodity prices to fall and recent declines might not be over.
8. Allocate to other Australian oligopolies and monopolies
Another unusual characteristic of Australia is our many high pricing-power oligopolies and monopolies. While this is bad news for the consumer and raises a question mark over the effectiveness of competition policy, this is good news for investors. Coles and Safeway enjoy unusually high margins, it underpins the share prices of Wesfarmers and Woolworths. Telstra and Foxtel also seem quite gifted at passing on above-CPI price increases in segments with less competition. So if you have to lighten your load to oligopolistic banks, simply allocate to another oligopolistic industry. Now that I think about it, perhaps the poor performance of the Small Ordinaries Index probably doesn’t just relate to the woeful economics of small miners. It could equally be due to the extraordinary performance of a few big companies that are more shielded from competition.
9. Ensure you have a meaningful exposure to international shares, including possibly cash and unhedged bonds
The Australian dollar is unusually strong and it’s been an unusually long and complacent 23 years since Australia has had a recession. History suggests when we have a recession it will be more painful than in countries that have already cleaned up their low profitability businesses, reset anomalous prices and improved business conditions. Having funds invested offshore might thus help mitigate this impact on your lifestyle. The Australian dollar is unusually high owing to the greater flexibility the US Federal Reserve has to lower interest rates and avoid fuelling a property bubble that we worry about here. Of course, given the yield differential you need the Australian dollar to fall about 3% a year to justify investing in non-Australian dollar deposits and bonds. If you choose to hedge your equity exposure your share income yield isn’t penalised.
10. Wait and only reluctantly buy into Australian residential property. Reduce your exposure if you think are overweight
By pretty much any measure Australian residential house prices are unusually high. We can of course justify this on multiple compounding effects including the shift to dual incomes, relaxed credit standards, negative gearing, demographics, behavioural price reinforcement, record low interest rates and overseas demand. Rising interest rates one day will create a headwind to slow price growth, though that may be some years off. Many factors that propelled growth could slow it.
While the most likely scenario is below average price growth for many years, a correction and a severe one is entirely plausible. The key trigger for a correction would be recession-driven unemployment. Having unusually not had a recession for many years Australian house prices (and perhaps bank shares) would be particularly vulnerable to a severe recession. Recessions are the bushfires of asset prices and have a tendency to reset unusual pricing.
My gut says to postpone adding to your portfolio until there is a sale on. If I’m wrong then it is hard to believe prices will run away even more to increase regret. If you are overweight property, this is probably an unusually good time to take some profits. Yield-hungry investors could enjoy eating some capital gain for a change.
11. Increase your portfolio’s inflation resiliency
It has been an unusually long time since anyone worried about inflation, including our policy makers and central bankers. Fears that money printing would stoke it so far haven’t eventuated. All we got was price inflation. Inflation is the number one enemy of the self-funded retiree investor so it is important to be vigilant. Rather than wait around for signs of inflation to occur, increase your portfolio’s inflation protection while it’s not expensive.
12. Plan for higher taxes and to rely on lower government spending
While perhaps I’m naïve, it does feel like we are suffering through an unusual period of poor government both in Australia and in other parts of the developed world. Australia’s budget deficit is problematic and if unmanaged for much longer our debt will accumulate enough to put in us in the precarious position of others we can’t afford to imitate.
Despite current events being manipulated otherwise, this should mean higher interest rates to benefit bond holders. But higher rates, continual short-termism and a “politics first” mentality are not conducive to corporate profit and share price growth. The longer Australia takes to live within its means, the larger the rise in future taxes and the more severe the cut in spending. Inevitably your after-tax returns will suffer as the budget for incentivising investors shrinks (read: no refunds of imputation credits, tax on pensions, end of negative gearing and less CGT exemptions). In the meantime, don’t miss your opportunities to shelter funds in superannuation, start pensions, minimise future estate taxes, share your tax burden among the family and so on.
At a recent conference an overseas pension fund manager remarked that “finding high returns in today’s market is like putting a blind man in a dark room and asking him to find a black cat which isn’t there”. We need not be so morose. Australia is still the lucky country where investors earn above inflation returns on share dividends, cash deposits and foreign investments hedged back into Australian dollars. If the Australian dollar does revert, then at least we can look forward to earning a double-digit return for another year in International equities. However the take-out from this unusual exercise is to be cautious in case what’s unusual becomes usual again.
Dr Doug Turek is principal advisor of family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au