Economic market review

Last month, we shared the details of a webinar Graeme Quinlan, Principal and head of the First Financial Investment Committee, hosted on Thursday 20 May. The first part of the webinar looked at the Federal Budget and the second portion was an economic market review from Tim Farrelly, our external asset allocation consultant.

In his review, he discusses five key themes that are currently impacting the way in which portfolios are put together. You can watch the full video or read the summary below.

COVID recession unlikely to have long-term impact on returns

COVID recession unlikely to have long-term impact on returns

We all know that the global pandemic has had a significant impact on society. The way we live our lives, the way we work and study… it has all changed.

And there are certainly strong economic impacts, but they don’t necessarily translate through to investment returns. Tim explains:

“The big impact is that governments around the world are far more comfortable with running huge budget deficits during a crisis or downturn.

Up until now, the job of lifting an economy that is in recession or slowing down an economy that is running too fast has belonged to the relevant country’s central bank – the Reserve Bank of Australia (RBA) or the Federal Reserve in the US. They lift interest rates to slow the economy or lower interest rates to encourage investment and inject money into the economy.

Prior to COVID, most governments were reluctant to use spending as a tool to help regulate the economy. But that’s changed now. There is the concern that this could lead to higher inflation, but we think the impact will be modest. In terms of what we’ve seen so far, we don’t anticipate much of an impact on long-term returns.”

Interest rates will remain low for years

Interest rates will remain low for years

When we look at interest rates, it is worthwhile distinguishing between cash rates and bond rates. In the accompanying chart the orange line indicates the cash rate that is set by the RBA and is a tool to control the economy. The blue line reflects the bond rates, and these are based on what the bond market is expecting to happen with cash rates on average for the next ten years. Tim continues:

“What the market is saying here is it expects cash rates to pick up over the next 10 years. Up to 1.5%, even up to 3%, which is quite a substantial increase… but still much lower than what we’ve seen in the past.

Our longer-term expectations are that cash is likely to sit somewhere between a little less than 1% and a little more than 2%. It’s higher than the almost zero we are experiencing now but still much lower than in the past. We have no expectation of going back to 4%, 5%, 6% or 7% of the past.

The main reason is there is so much Government debt and household debt. If home loan borrowing rates go up too much it will put the economy into a recession very quickly. The RBA doesn’t want that so it’s unlikely they will go beyond 2%.”

Growth returns should be higher than term deposits

Growth returns should be higher than term deposits

With term deposits sitting at record lows, it’s not difficult for growth returns to be higher… but as part of our asset allocation process we prepare detailed ten year forecasts so we can examine every separate asset class. Tim explains how we use these forecasts:

“When we look through the forecasts for different classes, if they appear too low compared to what we are getting from term deposits, then we start to reduce weights. We have done very little of this over the last ten years because the expected returns out of equity and property have been more than what we expect from term deposits and bonds, so it’s the right thing to be fully invested. But we are continually monitoring this, and the margins are getting a bit smaller.”

To prepare our forecast we look at income and growth – income is dividends or yield on property, and growth relates to how much the market is prepared to pay. Sentiment is an important factor here as is the speed at which a company can grow its earnings. Tim highlights how this works in the equities market:

“For Australian equities, at the moment, income is about 4.8%, including franking credits. And we think companies will have about 2.5% growth per year; all things being equal that should result in 2.5% growth in share prices per year.

But right now, the market is paying $22 for every $1 earnings and that is historically high… when we consider where interest rates are, a more reasonable multiple is around $17.

If we find we are paying $17 instead of $22, that implies prices grow 25% slower than they otherwise would. Spread out over ten years, that takes 2.4% per annum off our share price growth and we end up with a 5% total return. Now, 5% from equities is not that flash… but it’s still reasonable compared to term deposits.

The faster equities go up, the lower we should expect our future returns. We do this assessment across all markets and everywhere we look, returns are sitting around the same: 4%, 5%, 6%. They are lower than what we’ve got in the past, but compared to term deposits or government bonds, it’s still better. As long as we are expecting better returns out of equity and property, we don’t want to be shuffling money away from growth assets into very secure assets like bonds.”

The exception is the US market

The exception is the US market

“This table shows the current equity markets, and the red triangles highlight where they are each sitting at the moment. Australian Equities are at around 5% return and are described as fair value; however, if the All Ordinaries went up to 9000 our forecast return would be down to 2%… yield would be lower… instead of paying 22 times earnings you’d be paying closer to 30 times. When prices are too high it means future returns would be low.

The colour coding shows that red would be lower than that of government bonds and yellow around the same returns as bonds.

Typically, equity and property give us about 5% more than bonds and if we are achieving better returns then we would be in the green area and classified as cheap.

The US market is currently overpriced. And we are starting to reduce here. You may ask why we have any money there at all and typically when a market is pushed into the red zone it stays there for a number of years. Pulling out all money straight away tends not to be a great strategy. Instead, we reduce slowly over time. It could take one to three years to sell down assets, so there won’t be dramatic moves in portfolios, just a slow move away from the US.”

Credit is good value

Credit is good value

“When we refer to credit, we mean fixed interest type investments that are not government guaranteed. Examples are hybrid accounts or bonds from organisations such as BHP. The credit spectrum spans all the way to riskier companies that have returns that are reasonably attractive… about the same as you might receive for equities, but we think they are lower risk than growth assets – equity and property. That’s what makes it an interesting investment right now.

We know that cash and term deposits are funding day to day spending in Bucket 1. And growth assets are in Bucket 3. This means Bucket 2 is everything else and fixed interest type securities that have more risk are part of this group.

Hybrids have some volatility but have produced good returns and we think they have an extremely low chance of not getting your money back. Then there are BBB Bonds, also known as investment grade. The rating agencies have a high degree of confidence that they will be repaid on time, and they tend to pay around 1% more than government bonds. Occasionally they fail. Failure rates are around 0.2% per annum… so you are being paid 1% to get on average a loss of 0.2%, which makes them good value, but they are volatile.

Then we move down a step to High Yield debt… normally called sub-investment grade or junk bonds; they tend to pay 3-4% better than government bonds. They have higher failure rates than BBB and more volatility, but they are very interesting right now.

We also have very long-term government bonds that offer much better returns than cash and are more volatile, but we call it good volatility. They tend to go up when equity markets are weak and fall in price when equity price is strong, so they smooth out your portfolio.

In isolation, you would never touch one, but in a portfolio they work quite well. We weren’t interested in them a year ago, but today we are starting to consider them as an option.

Looking at the expected returns over a five year period – term deposits and cash sit at 1% per annum if interest rates lift a little. Government bonds are around 1.3%, BBB Bonds at 2%, High Yield at 4.5% or 30 year government bonds at 2.6%. All in all, while there is some risk involved in credit it is still an interesting place to consider.”

Speak to your adviser

We understand that some of these themes are highly detailed and investment strategies can be complex. If you have any questions about your portfolio or you’d like to discuss your personal situation in more detail, please contact us today.

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