24 Jun David’s End of Financial Year Thought Bubbles
Firstly, let me wish you a Happy New (Financial) Year in advance. Many of you will know Anne and I are taking a few weeks off, so the new financial year will be well commenced by the time we return.
At the start of 2014/15 we anticipated investment returns would be lower than the previous year. This has come to pass as Australian shares have by and large underperformed global equity markets, thus subduing overall portfolio returns. We also anticipated an increase in market volatility. This has also come to pass following the unusual level of calm in the previous period As we approach 2015/16 there remains a number of specific concerns for global markets – some obvious, others less so.
As I write Greece is again in the news as another deadline looms. This deadline is a serious deadline and could represent an end game after 3 years of ‘kicking the can’ down the road. The issue at the moment is not so much the Greek Governments willingness to negotiate – we believe they are now more willing to come to the party. The issue is whether the Greek Government can push whatever agreement it reaches with creditors through its own parliament. My guess is, the Government will reach an agreement, the parliament will revolt and the country will remain on life-support until new election re completed. A cleaner result would be a default, but this carries with it unknown consequences. Does Greece still matter? Not as much as it did in 2012, when European banks had EUR300 billion exposure to Greek debt. However, the geopolitical outcomes could presage further European economic instability. Contagion is also a concern, but less so than in 2012. Spain for one has made significant progress in economic reform and is thus less likely to regress in a Greek style rebellion.
There is always the risk of a left field event, Donald Rumsfeld’s unknown unknowns, if you like. If I was to pick a left field event this coming year it would be in regards to China (the left field pun is recognised but unintended). The Chinese Shanghai A stock index is up about 130% for the year as I write. While this follows years of moribund performance from Chinese stocks the pace of the rise is pretty outrageous. Stories of Chinese citizens pulling up sticks and moving to places where they can more easily trade stocks combines with record levels of margin loan growth draw a simple conclusion – bubble. Chinese stocks are not particularly widely held despite recent growth in ownership, so it is unclear whether the impact of a bursting of this bubble would have broader impacts. If anything I believe it would be more of a political problem than an economic problem for Beijing. Either way this could feed into increased global market volatility for a time. As an aside, those of you with emerging market exposures in your portfolios should be aware the managers we use in this space are relatively conservative and have a significant underweight to Chinese stocks.
Many of you will know we are setting portfolios for potential higher interest rates. This may be a gradual process but it is already obvious that U.S. interest rates will rise. The anticipation of Federal Reserve tightening, if gentle and well-articulated to markets, has already seen long term U.S. rates rise. Despite the idiosyncratic economic conditions in Australia, long term rates have also risen here. From a U.S. perspective, this should not necessarily be a bad thing. Markets may have a minor conniption as a result, but expectations are well priced in. Nevertheless any rise in official rates will be due to economic strength. The Federal Reserve has indicated rates increases will be slow and data dependant – that is they will only raise rates if the economy can handle it. There is no appetite at the moment to slow economic momentum. If rising rates are a result of strong growth this will be a net positive for investment markets in the medium term. September/October will be prime-time for Fed watching.
From an Australian perspective you can be excused for thinking things look grim. We are going through a period of adjustment and this is likely to continue for some time. Rising rates in the U.S. may assist in pushing the AUD lower as the yield gap narrows. This will provide a welcome boost to export oriented companies or those with strong offshore earnings. What is also becoming apparent, again as a precursor to a changing interest rate environment, is the outperformers of the past few years are less likely to be so in the near future. Many ‘yield centric’ sectors have already corrected from hitherto ‘full valuations’ – banks will be the obvious exhibit. From a broader perspective, Australian shares as a whole are probably more attractive from a relative valuation perspective. You just need to be a bit careful about specific companies – as you may have already noticed any companies with negative earnings surprises are receiving no tolerance from investors.
So what does this mean for 2015/16 in terms of return expectations? Returns from defensive sectors are likely to be muted as the interest rate structure adjusts to a rising rate environment. U.S. stocks can continue to perform well as developed economies pickup further growth momentum. Having said that, U.S. stocks have already come a long way – sector and stock selection will be important so as to avoid buying into momentum. Australian stocks may surprise on the upside, but perhaps being driven by different sectors i.e. energy, offshore exposures etc. It may be too early to expect an incipient recovery in mining generally, however a rise in oil prices stemming from increasing global economic activity cannot be discounted.
As always, our guess is as good as anybody’s – or as bad. While the thematics described represent our best guess, we approach these with due scepticism. Investment portfolios should be designed to weather whatever conditions arise notwithstanding any forecasts or predictions. The usual rules apply; know where your risks lie and ensure you are comfortable with them. Be sceptical of conventional wisdom. Stay well diversified. If it looks too good to be true…
As a business we continue to invest in knowledge. This is the only way we know of that we can reliably protect and grow your wealth over the long term.
Best wishes for 2015/16.
David Graham, MApp Fin CFP® SSA™