Don’t dismiss market risks

There’s one key way to diversify your portfolio in the face of ongoing dangers.

Summary: Investors face more geopolitical tension now than at any time since the Cold War. Meanwhile, the risk of inflation looms, the iron ore price is falling and safe haven money is flowing into the US. Local bank shares are sliding but the market does not consider banking risks, and this boom-time thinking makes me a little jittery.

Key take-out: Despite a fall in the Australian dollar, there are enough warning signs to warrant increasing your portfolio’s international exposure as part of your risk diversification.

Key beneficiaries: General investors. Category: Economics and investment strategy.

Over the past week we have been bombarded with major events and so today I want try to make sense of what they all mean.

I can’t recall so much geopolitical tension since the Cold War. As I write, American and Arab planes are bombing the Muslim extremists in Syria. We not only have the Middle East in turmoil but Ukraine could break out into another war any time; China is pressing its claims in areas around Asia; Russia is looking to expand its influence to the south and we have independence movements in Spain, Belgium and other areas that could easily slip into violence.

This is taking place at a time when there is considerable liquidity in the world and as a result I don’t believe the markets are focussing on the military risks. We are pricing stocks on the basis that we will be able to contain terrorism and that the military response in the Middle East will be manageable.

At the same time governments are trying to restrain their budgetary expenditures. If the military/terror situation deteriorates then in this sort of climate there is a greater risk of inflation. Most bullish equity investment strategies have higher than expected inflation as a major risk which they discount. It is impossible to make predictions in this area but just be aware that it is an area of risk not being taken seriously by the market at this point.

Then we have the fall in iron ore price, which is spooking the outlook for Australia because of its impact in export and tax revenues. This week I was fortunate enough to have some time with the chief executive of Fortescue Nev Power. I reached the conclusion that the iron ore price is not going to recover sustainably in the short or medium term, leaving aside the normal day to day fluctuations.

In simple terms looming higher output means we will be awash with iron ore and the Chinese demand is simply not rising fast enough to absorb the output in the short or medium term.

The iron ore industry expects China will shut down about 100,000 tonnes of its higher cost output which will bring the market to rough equilibrium on the current supply and demand levels. But we have high tonnage increases in the pipeline. It is possible some of these tonnages will be held back but that is certainly not the message we are currently getting from the major players. My guess is that the avalanche of extra output may push the iron ore price below $US70 a tonne but around that point the majors will begin to actually cut back their output to stabilise the price.

Nev Power did not get into discussing that sort of detail and these kinds of forecasts are very hazardous. The biggest game in town is to force out the high-cost producers, first in China and then in other parts of the world. But if we start pushing out iron ore producers that have costs at around $US60 and $US70 a tonne (and that includes Fortescue) then we are going to see great long-term harm in the industry. Stability presumes an almost OPEC-type response where the iron ore industry, in common with the oil industry once upon a time, acts in a uniform and predictable manner.

The looming fall in the iron ore price will cast a pall over the Australian dollar. Australian self-managed super funds are not highly exposed to overseas investment and this is an important weakness in many Australian investment strategies.

I realise the Australian dollar has fallen sharply but it is capable of falling a lot further so you do need greater overseas exposure. Don’t forget that the mining investment flood, which played such a big role in boosting the Australian dollar, is rapidly reaching its end and there are simply no new projects to replace the completed installations. On the export front, not only is iron ore likely to fall in price but coal is also struggling.

We will get a good surge from gas in the next two or three years but in the end the gas price will be linked to oil and the extra US oil output is weakening the price although a big blow-up in the Middle East would reverse the trend.

We are seeing a lot of safe haven money going to the US due to the prospect of slightly higher interest rates. That means that the great yield game, which saw investors borrow offshore and buy into Australian bonds or bank shares, is going to be curbed. Banks have delivered rewards for individual Australian investors like no other set of stocks. In the face of lower yields on term deposits Australians have bought bank shares that continue to deliver high yields.

But although there was a recovery on Tuesday, September 23 bank shares have been falling, partly because the overseas borrowing yield game has become more dangerous given the rise in the US rates and the fall in the Australian dollar. In addition, Australian bank shares are priced on the basis that nothing must go wrong. They are currently valued at around twice the level of their assets whereas US banks are around their asset backing. But of course Australian banks are far more profitable so deserve the higher ranking. Nonetheless, high prices and high levels of profitability create considerable risk. Australian banks are going to have to counter various attacks on their market including high technology companies and those looking to take a higher slice of the mortgage market.

Like the military risk, the Australian share market does not consider these banking risks because there is nowhere else they can get those sorts of yields and many investors also face capital gains tax liabilities on the sale of any shares.

What makes me just a little jittery is that such logic is boom-time thinking. My message is that despite the dollar fall there are enough warning signs out there to increase your overseas exposure as part of your risk diversification.