In this blog we aim to touch on some of the factors driving investment markets today. It may explain some of the things you are hearing on the news or seeing with your own investments. We warn you it may be boring! 😀
In our every day conversations with people in WA we hear stories of large drops in rents on properties due to higher vacancies, redundancies and high jobless rates, business closures and state budget disrepair.
On the nightly news we hear of collapsing prices of our major exports, unprecedented economic stimulus in Europe due to the ongoing weakness in their economies etc
We also hear of the US sharemarket reaching record highs and the Australian sharemarket being at post GFC highs, and we know our super funds are looking healthy.
So why is it that investments are still performing strongly in the midst of global and local economic weakness.?
Part of the answer is due to certain mechanical linkages somewhat like laws of physics which influence asset prices or markets.
One of those is the relative rate of return between different investments. At the heart of this is what is called the risk-free rate of return which is typically the interest rate you can earn by lending to governments that have a high degree of ability to repay the debt. Traditionally the US government bond has been the benchmark for this risk-free rate of return. For most of us in Australia we tend to reference what we can earn in a Term Deposit with our banks because it’s something we are familiar with.
- Logic says that is not worth taking on more risk to earn a lower rate of return than we can earn on a Term Deposit.
- Following on from that, logic says that if the rate of return on a term deposit increases, then then there is less desire to take more risk by investing in shares and property to chase a higher rate of return. This strategy played out after the GFC where 8% interest on a term deposit lead many people to pull money out of the share and property markets because they were happy with that rate of return.
- Conversely when the rate of return on a term deposit decreases there is more desire or more demand for investments which may pay a higher return.
So how is that relevant today?
The main tool used by governments throughout the world to support and stimulate their economies since the GFC has been to lower interest rates, in some cases to Zero, and by releasing more money (through what they called Quantative Easing).
So as interest rates have dropped on bonds and term deposits (the so-called risk free earnings), investors have diverted more money to assets such as high-quality companies like Telstra which pay strong dividends, commercial property trusts such as the Bunnings Warehouse Trust, Westfield etc in order to earn more income on their investments.
The laws of supply and demand mean that with a greater demand for these assets, their prices generally have gone up.
Happening in parallel with this demand increase, the low interest rates and cheap borrowing has allowed many companies to grow their businesses and make more profits.
So the combination of strong demand for quality dividend companies or rent paying properties, along with the growing profits of these companies, it has resulted in strong price rises.
Ok so if that is what has boosted markets then what else do I need to know?
Some people believe we are in the midst of a yield bubble and by that they mean those investments that are paying a higher income are overpriced and it is only a matter of time before something will burst that bubble.
There is certainly a focus on and demand for, quality income producing assets especially those ones that have the ability to grow their earnings and grow that income stream over time. A great example is the share price of the Commonwealth Bank which lifted from below $30 post GFC to $96 recently. Interestingly CBA is still paying an dividend income stream of ~4.4% pa (compared to a CBA term deposit which is paying ~3.1% for 1 year) which means the company is still in demand by those seeking a higher income stream and the potential for a growing income stream. The impact of franking credits strengthens this argument too.
So the questions are:
- Are these type of investment overpriced?
- Are these types of investments likely to suffer falls in price at some point?
It would be fair to summarise that these type of investments are overpriced slightly on various long term measures.
It is also fair to say that if the interest rates throughout the world remain below their historical averages (and it is likely that they will for a considerable time), that the value of these quality investments may be sustainable for that period of time. But yes at some point, they may fall if interest rates rise.
There are two ways an overpriced investment becomes fairly priced.
Firstly the price can drop or secondly the profit of the investment can rise which justifies this valuation.
So it could be argued that if the interest rates throughout the world remain low for a 5 or 10 year period and if these quality investments can lift their earnings during that time, then the price would not have to drop.
This would be very nice outcome but we are always more comfortable where the investments we hold are undervalued because it can limit the potential drop in price that occurs when there is a shock or unexpected outcome. What we do know is that there are always shocks and unintended outcomes, its just a matter of when.
The expectation of the pessimists is that the high personal and government debt levels in most major economies, the normalisation from record low interest rates and the current high asset prices will lead to a sharp fall in investment markets when there is a crisis in confidence or economic shock.
The view of the optimists is that the US is on a strong sustainable growth path, the major economies of the world are likely to have low interest rates for a long time, oil prices and commodity prices will be lower for longer – all of which will be hugely stimulatory for economies.
They feel therefore that the current asset prices are reasonable when the above is factored in and there will be further growth as people adjust their perceptions to this new environment.
So what strategy is appropriate in the current environment?
Our core financial structuring and investment philosophies work well here and our ongoing review and optimisation process aims to ensure that each family’s unique situation is reflected in the investment decisions made.
- As one of our clients you may have sat in your review workshops during the last two years where we explained why we recommend you sell down part of your assets to reduce debt.
- Or you may have had recommendations to reduce your allocation to higher risk investments.
- Or you may have had recommendations to borrow to invest.
It is not due to an inconsistency in our view of the markets or how we felt on the day. It is due to the rigorously applied review of your investment strategy in the context of your stage of life and what’s important to you as well as the state of the current investment market and outlook.
Our aim at Bennett Wealth Group is to take away from you the monitoring and worrying involved in having a sound wealth generation strategy. This gives you the time and mental freedom to enjoy the other more rewarding things in life. However at the end of the day it is the two way partnership between us as the advice firm and you as the family with unique objectives and circumstances that must chart a robust course through the complexities of modern day life.
One of our clients said recently “It’s hugely comforting knowing you have our back on this” however if the comments in this article raise any questions or concerns, we look forward to discussing them with you at your earliest convenience. Simply call us on 08 9274 2888 or send us an email enquiry today.