Strange paradoxes

For Melburnians, things feel a little grim. Last Sunday’s Victorian Roadmap seemed more like a roadblock as we head into Lockdown Version 2.1 (the first extension of the second lockdown!). Other Australian states maintain hard Victorian and international borders to avoid descending into similar lockdowns. There are still a lot of uncertainties.

  • We don’t know if the extensions to the JobKeeper and JobSeeker programs will be enough to prevent a huge number of small business failures in the country.
  • We don’t know what the permanent effects of the pandemic will be on consumer spending patterns worldwide.
  • We don’t know if the other states will be able to avoid secondary flare ups and shut-downs.
  • Outside Australia, the virus continues to accelerate in most countries. We don’t know if and when, and indeed how, the rate of new infections might come under control.
  • Although there are some promising signs, we still don’t know if and when an effective vaccine or vaccines will be available. The first adverse reaction in phase 3 trials of the Oxford vaccine reminded us that vaccine development is far from a quick and simple process.

And the virus is just one of our concerns! What about…

  • Rising geopolitical tensions – particularly with China
  • Looming US election
  • Unprecedented global stimulus – surely the flow of money can’t continue?

We have a strange environment where the economic outlook appears to be weakening, but, despite that, share markets have been going up.

Many have commented that this seems paradoxical.

So, are we set for another market fall? Or is it the case that markets seriously over-reacted in the first place and are now coming slowly to a more accurate assessment of the long-term risks involved in COVID-19?

Here we reassess our previous assumptions, look at the forecasts and consider the implications for pragmatic and sensible portfolio decisions today.

So, if the risk of a fall in markets is somewhat elevated, why don’t we move to the sidelines and wait until we are comfortable to invest again?

The answer is that we have seen, time and time again, that this is a recipe for achieving poor returns. It is not unusual for the market to defy the news, the most recent case in point being the last few months while infections have soared. Time and time again we see investors and commentators try to second guess the market, particularly in times of stress, only to result in selling at the low point and then having the difficult decision to buy back at much higher prices.

Furthermore, we may not see a correction at all. We may see an earlier than expected vaccine or cure for COVID-19 and all the volatility will be on the upside, with prices rising rapidly, leaving those on the sidelines lamenting.

So, at times like this, and, in fact, at all times, our philosophy is to preserve cash flow (to avoid forced selling), while keeping our eyes on the long-term impact of any developments. If we do tilt our asset exposures, it’s based around the very simple question: “Will investors be sufficiently better off in growth assets than term deposits in the longer term?”

Long-term forecasting

Long-term forecasting

In April, we produced a special update which outlined two economic scenarios, one at either end of the spectrum of possible outcomes – a milder, Short, Sharp Shock scenario and a very severe Doomsday scenario – the idea being that, if we could forecast returns under either scenario, it would help with decision making during a time characterised by extreme uncertainty. The decision to hold or even add to growth assets was straightforward (illustrated by risk premia – expected return above term deposits), if not necessarily easy. So far, and at the risk of counting our chickens, this analysis would appear to have helped guide us to make some sound decisions during the crisis.

But that was March and April.

Today, prices are higher, expected returns are lower and the timing of a full re-opening of the Australian economy seems more distant than envisaged in April. Given this deterioration, we need to address whether our base case is too benign.

Short Sharp Shock (that is not quite as short as before) assumptions

Still the base case – probability about 50%

Company profits and dividends in aggregate drop some 40% and don’t recover until 2022 – this decline is a little longer than previously assumed and is now very similar to the GFC.

Worst case or Doomsday

Probability now about 20%

Company profits and dividends in aggregate drop some 90% and recover more slowly. They don’t fully recover until after 2030 – this is similar to the Great Depression.

The remaining 30% probability allows for variations in between the two modelled scenarios. The table below shows how the forecasts look, given revised assumptions and changes in prices.

Financial 10 year return forecast

Conclusion - Remain fully invested for now

Conclusion - Remain fully invested for now

For growth assets, on average we need a risk premia of around 4-5% p.a. to be fairly compensated for the additional risk. This price is called its ‘fair value’.

The key point to note is that while the forecasts (and risk premia) in the table above have fallen since March, they still remain comfortably ahead of the expected returns from term deposits in the Short, Sharp Shock scenario, with still a reasonable buffer in the event we fall towards the Doomsday scenario.

If you were of the view that the Doomsday Scenario was the most likely, then most markets would be in the Fully Priced territory (risk premia less than 2.5% p.a.) and it would make sense to reduce exposure to growth assets somewhat – say, by 30% over a period of 18 months to two years.

However, Doomsday is most definitely not our base case scenario, and accordingly, we recommend that investors remain fully invested… for now.

Our philosophy is not to try to trade markets based on the short term – we manage risk through sensible research and portfolio construction techniques. Cashflow and asset allocation (‘the buckets’) are key to handle what is likely to be a volatile 12 months.

Importantly, our long-term forecasts provide a limit to what we should pay for growth assets, but we are not at this limit yet. Your adviser knows how to interpret and apply this to your portfolio and the First Financial investment committee will carefully monitor valuations moving forward.

If you have any questions or concerns, please contact our team today.

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