Today's Market Update - The Past, The Present and The Future
I hope this finds you well. Firstly, please allow me to apologize in advance for the length and complexity of this email, I will try my best to keep it as short, sweet and simple as I can but I suspect that even with that goal this is going to be a big one.
The Past Decade…
In order to provide you with a reasonable understanding on where we are today, why markets are behaving in such a volatile and correlated manner I need to talk about financial conditions since the Global Financial Crisis (GFC) of 2008-2009.
At it’s core the GFC was a mixture of a crisis built on lax lending standards, over leverage by financial institutions, lax underwriting of loans, increased financial complexity in the system via the use of innovative (and poorly understood) derivatives and fears over the credit worthiness of borrowers. During this time for it was incredibly difficult for any corporate to borrow money, even the biggest and most reliable borrowers in the world were finding it impossible to get credit, banks were petrified to lend to each other in case the other bank would collapse over night (a side note when banks fail it tends to happen almost instantaneously, rather than the more drawn out and often easier foreseen failure of other businesses).
The global economy is a lot like an engine, there are hundreds of moving parts and in order to work efficiently lubricant is required to grease the moving parts. In the global economy the lube that is used comes in the form of credit. When you run out of lube (or there just isn’t any available) the engine will eventually seize and break down.
Much like a seized engine, if this occurs to an economy it is catastrophic. The fall out can be immense and flows into all other aspects of life. I.e. it can cost jobs, houses, businesses fail and asset values will plummet. With out a steady stream of credit and investment coming into the economy it can grind to a rapid halt. Most of you may not remember the GFC in great technical details but what is important to remember is that compared to the rest of the world Australia came away relatively unharmed.
In order to restimulate the economy, save jobs and prevent the system from failing, governments and central banks globally were forced to take unpreceded actions. This involved a mixture of various bank bailouts, reducing the interest rates on bonds/cash to levels that we had never experienced before (remember there was a long period where large parts of the world had negative interest rates), immense programs to stimulate liquidity in the credit market (such as bond buying and quantitative easing), various tax policies and other incentives.
This was largely effective in saving the economy but it ended up having the affect that in order to generate decent returns in your portfolio, you had to take additional risk. Largely this meant investing more of your portfolio into shares and real estate.
In the post GFC world global growth was slow, inflation was near nonexistent, and investors became accustomed to paying ever higher prices for the rare assets that were growing quickly. Look at companies like Uber, Afterpay and the likes. None of these businesses have made profit since creation, cumulatively have burnt billions of dollars in their quest for growth and ultimately have questions about their ability to generate profits ever (yet the values of these companies have been astronomical as they continue to show rapid rates of top line growth).
A key to this was that interest rates remained incredibly low (relative to historical averages), the system was awash in easy money and while inflation remained below the target bands of central bankers, it was a great time to own financial assets. For example, if you required a 4% yield from your portfolio to meet your expenses in retirement you would have been able to get an 8% return from a term deposit, so in order to justify taking the extra risk of owning shares the price had to be a lot cheaper to compensate you for taking more risk.
As the returns that you could generate on a safe investment like a term deposit continued to fall, investors flocked to share and property markets to generate the returns they needed. This had the affects of increasing share/property prices, as these prices rose reducing the yields available and reinforcing the requirement to take more risk to achieve the required yields.
This resulted in a popular term called TINA or There Is No Alternative. In fairness it was mostly correct. Particularly as we see central bank interventions every time markets would wobble and the infamous “Fed Put” was termed.
So that’s the past covered (I hope I was able to explain it simply), so where are we today?
As you would have experienced (or seen the headlines or hopefully my past letters) inflation has returned. In a nutshell, this is resulted in interest rates rising and there now being appropriate alternatives to growth assets for investors. For example, Australian government bonds are now paying 3.41% for the 2-year bond and 3.92% for the 10-year.
Needless to say, now that investors have been able to find reasonable rates of return once again, on safer assets the relative appeal of riskier assets has fallen. We have no idea at what level the cash rate or inflation will peak in Australia, in my opinion even the best estimates are just guesses. At the moment it expected that rates will rise for the foreseeable future but peak in the next 12 months, but again this is just a guess.
Central banks and governments are starting to move from incredibly easy financial conditions to the total opposite in aiming to restrict financial conditions in an effort to fight inflation. As mentioned, many times previously, inflation is like fire in the sense that when properly controlled it is a life saver but when allowed to run rampant it is as dangerous as a bush fire.
One area that this starting to become of interest is the decision the RBA will have to make in appeasing homeowners (and borrowers) by slowing their continued hiking of interest rates vs defending the value of the Australian dollar. Trading currencies is an exceptionally difficult exercise, and we typically try to mitigate this by utilizing a mixture of hedged and unhedged currency exposure for your foreign investments. This is pure speculation here (so don’t bank the farm on it) but I am of the current opinion that should the Aussie dollar start to trade below the $0.60 mark vs the USD then the RBA will intervene to protect the dollar. However, speculating on the RBA’s movements and decision-making framework is ultimately a relatively useless exercise (we can’t control their actions and even if we are correct, we don’t know how the broader financial community will react in the event that we are right).
Broadly speaking, equity and property markets have fallen recently as a result of the increasing appeal of more defensive options. This is a natural feature of markets (why take the risk of owning a business or property when you can achieve reasonable/high levels of returns from safer assets?).
It might surprise to you to learn that the increases we have seen in bond yields and interest rates result in lower bond prices. In essence, bond prices move the opposite to the yield. If yields rise the bond price lower to compensate for the interest rate on the bond relative to the new market interest rate. Alternatively, when bonds are issued with a high interest rate and market rates fall, the bonds face price (the quoted price) increased to adjust the yield relative to interest rates. So, yields up = bond prices down, yields down = bond prices up. As you have noticed, yields are rising so pricing is decreasing.
In the equity space we remained concerned about certain sectors over the short to medium term. This is due to the relative risk to reward of owning companies in sectors like manufacturing, retail and even banking if the economy was to cool significantly. Additionally, in the case of retailers and manufacturing they will be not only feeling the pinch of rising input, labour and operational costs but also are likely to suffer from declining consumer behaviour. As you can imagine (and might be experiencing yourself) when the cost to pay your mortgage, fill your car, power bill and groceries increase exponentially the appeal of buying a new couch/TV or other large ticket items declines significantly.
The upside of what we have seen in markets recently is that several of the high-quality businesses that we are always looking for are starting to trade at prices that infer high levels of value will be had if held for the long term. The downside is that we don’t know if this market is close to bottoming, will continue to trade downwards for a while or will simply go nowhere for the foreseeable future. The underlying complexities on what drives asset prices has filled several books but if we are able to buy outstanding assets at a fair (or even cheap) price and are willing to hold for the long term we expect to be appropriately rewarded as the underlying business continues to go from strength to strength (despite whatever the broad market will do in the short term).
At the moment it appears that future volatile times are ahead (and I hope that this is one of the occasions that I am wrong) but the important thing to remember if these do come into fruition is to avoid panic and be willing to ride out the short-term pain. Investing is all about the long-term and as we have highlighted previously, the issues that are top of mind for market participants at the moment will be forgotten about in 5 years’ time.
If you were to think back over the last 30 years, we have experienced recessions, currency crisis’s, war, fear over Y2K, inflation, deflation, pandemics (thanks Covid), political uncertainty, commodity booms/busts and more huge events than I can remember. Even with all of this, investors that have stayed strong to their strategy and plan have done well. It’s almost amazing to write that but at the end of the day regardless of how dire the outlook is today the power of human ingenuity and spirit will shine through.
As always, we will continue to treat your capital as if it was our own, meaning we will look to avoid excessive risk and invest in a long term pragmatic fashion.
Until next time,
Tyson Jonas (B. Bus, DFP)
Chief Investment Officer and Senior Financial Adviser