|Summary: The strong gains in the sharemarket have revived investor confidence in equities, but there are a series of global risks that markets are not pricing into valuations. These include ongoing economic risks in Europe and the US, and the potential for a sharper slowdown in China.|
|Key take-out: Recognising the current under-pricing of risk, some fund managers are now shifting into defensive assets.|
Key beneficiaries: General investors. Category: Portfolio construction.
Today I want to talk about a subject rarely discussed, risk and the pricing of risk. I think there is a very good case for suggesting that many markets at the moment are not pricing for risk. One of those markets is the Australian dollar.
I was led to this subject via a unique experience (for me) on Anzac Day. I was good naturedly booed at the Essendon vs Collingwood football game! I attended with the Essendonians, where I am a member. With a grin, a number of Essendonians came up to me and said, “you cost us 15%”, referring to the recent proposed superannuation changes. There was no offence meant by those remarks and there was certainly none taken. It was all in good fun. But there was a message that I had played a bigger part in the superannuation decision than is normal for an investment commentator.
And so today I first want to go back to that superannuation decision, because it is a perfect illustration of risk. It is now clear that when Cabinet was making the superannuation decision it was a chaotic time, so there was a risk of a horrendous outcome.
Prime Minister Julia Gillard was looking for money for disability insurance, and the Gonski education proposals and the budget deficit had blown out dramatically. Treasury, using false sums, was advocating that the knife be placed into superannuation. So I make no apologies in steering the Cabinet towards a tax-free $100,000 superannuation income threshold and then a 15% tax because the alternative could have been a great deal worse.
In a strange way I was pricing risk.
Diverting, I would add that it showed just how nervous the total community has become given the chaos now existing in Canberra.
As I move around the community, the despair with the current government is almost without precedent. I think it is likely that if Tony Abbott wins handsomely, the relief in the community will be so great that we’ll see an upsurge in consumer spending and business investment.
To some extent the sharemarket, with its recent rises, is anticipating the surge of confidence that will come with the change in government. That leads us to the questions of markets and risk.
During the week I was yarning to Danish national Jeppe Ladekarl, who is director of research at First Quadrant, a firm with $18 billion under management.
Ladekarl concentrates on risk pricing. Right now he can see a series of global risks that markets are not pricing into valuations. Those risks include a serious blow-up in Europe, US consumers failing to come to the stimulation party, and an extension of the China slowdown into demand for commodities. The massive injection of liquidity into the US, Japan and parts of Europe has seen substantial rises in sharemarkets. But those sharemarket rises have not triggered consumers to begin spending again, which would trigger a new wave of investment to justify the rises.
Of course, we are seeing some companies substantially lower their cost base by changing the way they act (not just slashing staff). Ladekarl illustrates this with the example of Swiss manufacturers, who have prospered via big rises in real productivity. I suggested an Australian example – the improvements in ANZ’s computer costs to become more of an Asian bank helped boost profits, despite stagnant income in Australia.
The bottom line for Ladekarl is that most global sharemarkets have risen to the point where they are under-pricing risk, so he is directing First Quadrant into defensive assets with a concentration on the US dollar. And because he believes that the markets are under-pricing the risk of continued low growth, he is particularly bearish on commodity currencies like the Australian dollar, which, he believes, is not priced for the risks ahead.
First Quadrant from time to time shorts the Australian dollar and would have done well in recent days. If we look a couple of years down the track, the Australian dollar looks set for big falls as the major LNG projects in WA and Queensland are completed. The completion of those projects compounds the difficult task ahead of Tony Abbott, assuming he becomes Prime Minister.
Abbott and his people are going to have to slash government expenditure, and that will involve a large number of public servants losing their jobs and a feeling of depression in many areas of Canberra.
It is likely that around 2014-15 China’s movement towards a service economy would have gathered momentum and the demand for our minerals could be less than we originally anticipated, so prices will tend to be lower.
If this scenario is right, then by about 2015 (probably earlier) we will start to see the Australian dollar fall. If it falls sharply interest rates will tend to rise – almost the total reverse of what we are experiencing at the moment. I would expect that the weakness in the Australian dollar would be compounded by the strength of both the Chinese currency and the US dollar. From an investment point of view none of these scenarios are priced into the market. It does not mean they will happen, but they are a risk.
Meanwhile this could be a difficult time for Tony Abbott because unemployment will be rising as he approaches the next election and he will be given a hard time by whoever is leading the ALP.
And so this is a period that will require some careful thinking in terms of investment strategy. Bank shares seem to be rising higher and higher. There is nothing to stop them continuing to advance in this particular point in time, but they are way out of line with other global banks. I think down the track the very high margins they are enjoying will be trimmed.
The real problem is that there is a shortage of income-producing stocks, but I think within two years we’ll start to see an avalanche of better-quality infrastructure assets coming onto the market that provide high yields, often with some government backing.
If we start to see interest rates edge up a little bit, because the lower dollar is likely to boost inflation, then bank hybrids will be particularly attractive. I think that miners will have to be managed much better and operate on lower cost structures.
Our miners will be helped by a lower dollar, but to prosper they will have to do what Swiss manufacturers are now doing. Dramatic management changes are required in corporates like BHP to make them more productive. But Rio Tinto management also requires work. I think this new scenario is now recognised by the mining company boards and we are seeing new managers being brought into place.
It is going to be a period when you will be looking for companies to become a lot more efficient at what they do The new technologies enable them to do that, but is management is up to the mark? I fear that while there will be exceptions, Australian management won’t be.