What Happens Next as Interest Rates Rise?

Interest rates are going up across the world and it will impact all asset classes. While we are currently seeing stock markets reacting negatively, higher rates are going to flow through to the real economy and impact everyone from businesses to consumers, as well as asset values for bonds and property. This isn’t simply market movement that comes and goes. We are witnessing the end of a 15-year period of historically low interest rates, never seen before and unlikely to be seen again. With that comes an entire generation of investors, advisers and fund managers who have not experienced a rising inflation and rising interest rate environment and certainly not a high inflation, high interest rate environment.

Looking back over the long term, the RBA reduced rates over the last 15 years from 5% to virtually 0%. But in the 15 years prior to that (1992-2007) rates were consistently between 5%-7%. Go further back to the 70’s and 80’s and the RBA rate ranged between 6% and 17% for the entire period. Since the GFC, the absence of inflation allowed rates to continue at ridiculously low levels. That changes if inflation starts to dig in for the long term. If inflation gets away from governments, interest rate rises become the primary weapon to fight it and rates will rise to whatever level is needed to curb it. From such a low base a return to ‘normal’ rates in historical terms would be a major problem. I don’t expect that but the move to higher interest rates is a permanent change.

While stocks have fallen significantly over the last month or so there is probably still further to fall before markets settle. But the asset bubbles that emerged globally over the last several years are not limited to stock markets, they include property and bonds too. My view is that the value of fixed rate bonds and property will fall significantly over the next couple of years as interest rates increase. A fall in the price of property seems fairly straight forward. Higher interest rates are going to put pressure on property owners. Banks started lifting their rates last year and tightening their lending criteria.

Residential property is especially vulnerable to a serious downturn. Sky high prices and many property owners are already overextended even with record low interest rates. Borrowers tend to ask the bank ‘how much can we borrow?’ as the starting point for their property purchase and upsell themselves from there as they progress through the process. I expect that residential property will see a similar re-rating to that of the share market, and I wouldn’t be surprised by a fall of 10%-20% or more over the next year or 2. This has significant implications for the entire economy.

I am also cautious of REITs and property trusts across the board, but especially those that use high leverage to generate higher yields. These all look great on the spread sheets and in the prospectus forecasts but that great yield starts to look quite different in an environment that combines soft rents and rising interest rates. Factor in structural issues such as working from home for office property and online shopping for retail centres and it’s going to be more important than ever to be selective with your exposure to REITs and property. 

Fixed interest bond values will be under pressure too. In simple terms, if you bought a 10-year bond for $100 last year and it pays 2% pa no one is going to want to buy it from you at that price if the new bonds issued in a year at $100 are paying 4% pa. So, investors are going to be stuck with either 10 years of much lower income if held until maturity or a significantly lower value on the bond if they sell. I prefer bonds and notes with a floating interest rate so that as rates increase so do the rates on the security. This provides investors with an inflation hedge and a welcome pay rise as rates increase.

Be careful with unlisted investments. Investors are often attracted to these investments because their values are more stable. This is one of the dumbest investment misconceptions I have ever heard, and it’s perpetuated by those with a vested interest in the assets. Asset managers from small asset managers to the large industry funds like unlisted assets as they appear more stable. But the reality is that it’s just not valued every day the same way assets listed on the share market are. If interest rates rise and asset prices fall then those unlisted assets won’t be worth as much if you sell them. It’s as simple as that. There is a lag time here to be mindful of.

As interest rates rise, share markets will continue to be volatile. But share market investors do expect volatility and do expect markets to fall from time to time and occasionally crash. It has happened repeatedly over the decades. It is not abnormal. Markets run too far in the good times and then retreat, usually too far, in the down times. It presents opportunities and I look forward to buying at more reasonable levels.

What I am more concerned with right now are the other asset classes where bubbles have evolved and will also come to an end as rates now rise. Property, bonds, and unlisted markets and their investors are far more complacent than the share market in this regard because these markets do not usually experience the level of volatility that is ahead. It means there is likely to be systemic risks within those markets that have developed over many years. The fallout from rising interest rates may well be more harshly felt than many investors and stakeholders in these areas expect going forward.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

10 Themes for 2022

For all the uncertainty over the last 2 years with the pandemic, investment markets across the world had performed very well. However, 2022 is already shaping up as a more difficult year for investors with the All-Ordinaries index down over 6%, the S&P500 down over 8% and the NASDAQ down 13% all in the last few weeks. Markets are going to continue to be challenging as we move from an environment of low interest rates, low inflation, and significant government stimulus to one of rising inflation, higher interest rates and a wind back of government stimulus.

From an investor’s perspective, I think the pandemic will largely be over by June as the omicron variant continues to spread throughout the world like wildfire over the next couple of months and we move to the endemic phase. Obviously, a more serious variant could emerge, but for investors, I expect we are through the worst. If that’s the case, then all of these issues slowly start to rectify themselves. The disruption to supply chains will work themselves out over the next 12 months and with that inflation will ease too. Interest rates will then stabilise.

To me the most important theme is the continued rise in all facets of technology, not only for 2022, but for the next decade and beyond. It underpins everything. It determines the areas we invest in and those we bypass; it determines the companies we buy and those we avoid. It is central to our investment thesis and generating returns over the long term. Outside of the big tech giants there has already been very significant falls in the prices of pure tech stocks. This is not unreasonable given their high prices and adjusting for rising interest rates. However, as markets retreat exceptional long-term buying opportunities are emerging in this area. Patience is key.

Perhaps the biggest threat to the Australian economy is the slowdown in China on the back of their property and debt issues. China appears to be dealing with this situation so as to protect the country from any major financial catastrophe however, as always, their methods are opaque and do not provide the outside world with great confidence in the overall system. Importantly China’s president, Xi Jinping, needs to ensure the nation’s stability as he locks in his next term later in the year. What is most clear though is that the Chinese economy is slowing, and that Australia’s economy will be directly impacted by this.

While there are always geopolitical concerns and the risk of conflict it appears to me that the USA and the west will have a more challenging time than usual in 2022. Russian troops at the Ukraine border are the latest to add to ongoing threat of China invading Taiwan. I expect China and Russia to coordinate the timing of their provocations as to apply pressure on the USA and its allies, forcing them to either prioritise one potential conflict over the other or spread themselves thin. Either way, rising geopolitical instability is an emerging concern to note.

Energy as a theme is similar to technology in that it encompasses several important sub-themes. Captured here is everything from oil and gas to uranium and renewables. Importantly ESG may be the most influential sub-theme here as energy use, production and sustainable business practices are increasingly prioritised by investors, consumers, and leaders across the world. On the flip side under-investment in traditional energy will create distortions in markets and potentially create opportunities. Demand for energy globally will continue to rise and will likely require a pragmatic approach to avoid dislocation in energy markets in the short term. Big opportunity in multiple areas.

Overall, the inflationary pressures driving interest rate rises are a short-term game changer, even if it’s just for the next 12 months. Higher interest rates not only mark the end of easy money but the end of easy investing across all asset classes. Add to this a slowdown in China, rising geopolitical risks across the world and the now familiar backdrop of pandemic and there is more uncertainty than ever. Looking ahead the investing environment for 2022 appears more challenging than it has in recent years. The key variables that were previously so conducive to growth have turned and a tougher outlook will be the result. Returns on most asset classes will be lower than we have come to expect. As always though there will opportunities that present themselves despite the challenges.

10 themes for 2022

1. Continued rise of technology

2. Rising interest rates

3. Inflation risk

4. Covid variants and vaccine

5. Supply chain disruption and economic impact

6. China economic issues

7. Geopolitical risks

8. Energy

9. Govt debt and spending

10. Bond market concerns

Everything on Demand

My major takeaway from 2021 is a simple one, and as basic as it may initially sound, it is a foundational pillar of my investment thesis about the future.

People today, of all ages, have come to expect life to be easy.

It may sound like the start of a ‘get off my lawn’ style rant from an old man, but it is not. It’s an observation of the way society and the consumer has evolved over many years. It is especially important to understand because the overriding psychological mindset of the population drives all consumer behaviour and ultimately the businesses and stocks, we invest in.

Almost all of the technological trends evolving today are driven by removing friction from existing processes and creating faster, more efficient ways of doing business and consuming goods and services. The rise of the entire buy now, pay later sector is a case in point. We expect life to be easy. We want everything now and we don’t want to wait. We want tv and movies streamed on demand. We want our food delivered on demand.

On the downside, we have come to expect governments to bail us out on demand. We have come to expect employers to fix our problems. We don’t expect to deal with any of the pain. We talk about accountability but rarely with respect to our ourselves. As a society we seem unable to deal with a situation if isn’t easy. Presumably giving every kid a trophy for the past 35 years hasn’t helped this.

Today, the relationship between government and the people has developed into a similar dynamic to that of the parent and the spoiled brat child we all know from somewhere. Parent says no, spoiled brat cries, parent gives in. It is a recipe for disaster for both the future of the child and the economy.

What has been lacking is for government to ignore the cries of the people and let them endure a degree of genuine hardship, for their own good in the long run. For the last 15 years, pandering governments have offered continuous accommodations, money printing and economic stimulus at the hint of every problem.

Thankfully, this will soon stop.

The fact that there is now higher inflation, regardless of the causes, will necessitate governments increasing interest rates and pulling back from their excessively accommodative stances going forward. It will be interesting to see if governments hold their nerve. In the past they have not followed through, but it is now overdue.

Of course, this goes in cycles.

Hard times develop resilience and patience in the population. Whether through The Great Depression or WW1 and WW2, the generations that lived through genuinely tough times had their work ethic and perspective on life shaped by those experiences. It also shaped the consumer behaviours of the day and the companies that grew to meet their needs. It’s no different today as companies meet new needs. 

Conversely, success leads to complacency and then to failure and ultimately change. It applies to nations as much as it does to technological disruption or your favourite sporting team.

From a societal perspective, those that experience relatively easy times become complacent and entitled. In the absence of any unexpected and genuine hardships, the rise of technology will continue to enable easier and easier lives, facilitating everything ‘on demand’ and the expectation of more to come.

In my opinion, the continued rise of technology is the most important and impactful investment theme in the world today. But the most important factor driving the consumer behaviours, that build the businesses we invest in for the future, is overwhelmingly that people have come to expect their lives to be easy. 

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Old Dogs, New Tricks.

These days there is a lot of focus on companies being disrupted and the new companies challenging the status quo with cutting edge technology and ideas. The warning to the old companies is ‘adapt or die’. There are many examples of companies that haven’t from Kodak to Blockbuster. It’s easy for investors to see the shiny new technology companies and look down their nose at large companies to see who is going to be disrupted next. But not all the incumbents are slow moving laggards.

In fact, there are many outstanding businesses that have been around for 50-100 years that continue to reinvent themselves decade after decade. They may not have the appeal of the new tech companies, but they have an enviable track record of delivering results and tremendous brand loyalty and pricing power (important inflation hedge). These are companies that are easy to ignore and label as boring companies. But the way they continue to embrace change they are clearly leveraging the most exciting technological trends emerging in the world today. Here are a few standouts:

McDonalds (founded 1942) In 10 years I don’t think McDonalds will employ nearly as many young workers as they do today. Stores will be fully automated. We are already starting to see this in stores as they move to automate customer ordering. This is a business that will be able to automate every aspect of its business. From ordering to preparation and cooking to delivery of orders. Incredible brand loyalty is evidenced by McDonalds recently raising prices in the US by 6% due to inflationary pressures and have reported that these increases have been implemented without issue across the business. They have pricing power and will be able to protect their margins as they can pass on increased costs.

Caterpillar (founded 1925) Caterpillar is fast transitioning from an old school machinery company to a robotics and automation company. They have a reputation for making extremely high-quality products and have built very strong customer loyalty over time. From a branding perspective whenever you see a company that can sell their own branded clothing and boots at a premium price you know they have a market leading brand and customer loyalty. They also have hundreds of autonomous trucks operating on mines around the world. Many of these machines each cost millions of dollars. This is not an operation that is easily replicated due to their scale, quality, and brand loyalty.

Walt Disney (founded 1923) In an era where content is king there probably isn’t a company with a better suite of entertainment brands than Disney. Beyond the Disney banner, over the years they have acquired a stunning collection of the world’s most popular franchises, from Star Wars to Pixar to Marvel. To leverage this content and monetise it 2 years ago Disney started Disney+ their own version of Netflix but built on the back of the Disney catalogue and content library. In just 2 years since the launch Disney+ have reached over 118m subscribers and created a new recurring revenue stream worth billions of dollars out of nowhere. For comparison Netflix has 200m subscribers. Both are forecast to hit over 300m subscribers in the next 5 years or so which is extraordinary.

Walmart (founded 1962) Their size and scale provide them with access to an unprecedented ability to leverage the revolution in automation and robotics across almost every aspect of the business. Walmart may not have the pricing power of the others on this list but almost every aspect of the supply chain for supply markets is being reinvented by automation and tech. From the way the products are made and grown, to the way they are sourced and delivered to the store, the way the shelves are stacked to the way their products are bought, paid for, and even delivered to the customer. There are just so many costs and inefficiencies being removed from the supply chain. It’s going to equate to lower prices and higher profits. They have been using autonomous trucks in the USA for the past few months.

The demise of companies often isn’t really that difficult to predict. They have a product or service that was popular but fail to change as new products or services emerge. In many ways, it’s the same with the rising companies riding the wave of new technological trends. Relatively easy to spot as they provide a better product or service using the latest technology. But for long term investors that is only a part of the equation because both are on the same product or business cycle, just at different stages. The great companies are those that are able to sustain success over a very long period of time and have a proven track record of navigating change and technology over the course of decades, not just years. 

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Jumping at Shadows

It’s been my experience over the years as an observer of markets and human behaviour that our fear in response to possible outcomes is usually disproportionately (and incorrectly) weighed against its probability of becoming a reality.

For all the concerns about an issue they usually don’t come to pass. On the occasions where there is a bad outcome we fear an even worse outcome, which usually do not materialise. We are very good at being fearful, but we are not very good at allocating a level of rational probability to that fear.

In other words, things are never as bad as they seem, and investors spend far too much time worrying about unlikely events becoming reality. The opposite is also true. Rarely are things as good as we think. The reality is far more boring, somewhere in the middle.

With this new covid variant it is no different. Listen to the media and it sounds bad, but we don’t actually know anything useful at this point. The number of “what if” articles I am seeing in the media is ridiculous and just a waste of time and energy. We will deal with it if it is an issue.

A big part of the current reaction to the emergence of the new variant is that everyone is tired of it. Everyone has had enough of the pandemic and just wants to go back to living a normal life. So, we are more sensitive than ever to the prospects of going backwards. The media love it and are pushing those buttons hard. This is probably the biggest risk going forward, pandemic fatigue.

There are going to be new variants. We know that. We also know the drill about how to manage them. Until we have answers on a couple of key questions, I just don’t think it is worth worrying about. From an investment perspective there are two questions I need answered in relation to the new variant and that’s pretty much it.

1. Is it resistant to the vaccine?

2. Is it more deadly?

If the answer to these questions is “no” then it’s not a big deal and in a few weeks, everyone will have moved on and the rest is just noise.

If it is resistant to the current vaccines, then we go back to the original drill. It will take time for new vaccines to be developed and then distributed. But this time we know how it works and have the foundations in place to manage the next steps. It might set the recovery back 3-6 months (that’s a guess).

I hope to add to our positions in December if markets fall further and if the new variant is vaccine resistant, I expect to buy again in January if the market overreacts.

There are going to be new variants. There will be more of them next year too. At this stage we should know the drill well enough that we can wait and see if it’s a problem. Then make rational decisions to deal with the actual situation. Life will go on. We need to stop jumping at shadows.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Dividend Dance

In Australia, investors and companies have become twisted in a little knot around dividends that needs to be undone. Dividends in Australia are just too high. I know no one wants to hear that but it has to be said and it needs to be discussed. More importantly, if our companies are going to remain competitive on the global stage it needs to be addressed because times have changed. The way businesses grow has changed and unless we review some of the practices that have evolved, our company’s risk being left behind their global competitors.

Over the last 30 years investors, especially self-funded retirees and SMSF investors, learned the benefits of having a portfolio of stocks paying generous fully franked dividends. It started in the 1990s as the level of share ownership in Australia started to explode. The old adage at the time relating to banks stocks was why invest money on term deposit at say 5% (remember those days!) when you could buy the same banks shares and get 6% fully franked dividends and participate in the growth in shares too. Made sense.

From there people started to understand that a diversified portfolio of blue-chip companies paying fully franked dividends was a great way to generate a retirement income. It wasn’t too difficult to construct a portfolio focused on income that could generate say 5% per annum with some growth too. For someone with say $5m in capital to generate retirement income of say $250,000 pa. It was also cleaner and neater than property, better diversification, without the headaches of tenants. This approach has been very successful and become very much mainstream. It does make sense.

But today, investors in Australia have become too focused on the dividend return instead of the overall return. The rationale is sound, but in this era of continuous innovation, it’s worth reconsidering this strategy and whether it is still as appropriate today. I am not saying company profits or cash flow are not important, in many respects they are more important. I am talking about whether investors and companies, by focusing on higher dividends is causing them to make decisions to their long-term detriment.

In many cases in the past, it has resulted in the dividend payout ratio creeping up over time. This isn’t a great sign, and it has happened more and more over the last 10 years as companies face pressure to continue paying high dividends. But it’s really important to understand that a dividend yield of 3% from a company that pays out 50% of its profits is not worse than a 4% dividend yield from a companying paying out 100% of its profits. In fact, it’s probably a better managed company. This is often overlooked by investors.

In this new era of continuous innovation, it is more important than ever for companies to reinvent themselves. That means reinvesting in their business to lead the next phase of change. ‘Blue chip’ companies in mature or maturing businesses need to recognise this and prioritise reinvesting profits back into the business to innovate or they are going to be disrupted by those who do.

That means not paying out dividends or at least paying out much less in dividends. But because these dividends are the foundations of retirement incomes, a large part of the investment market is dependent on them. The companies that pay the dividends know this. Major companies face significant backlash from self-funded retirees and large superfunds if they were to reduce their dividends.

The irony is that the shareholders will complain about companies adopting this strategy because they receive lower income, but its ultimately for the long-term benefit of those exact shareholders. The reality is that in a business environment changing at the pace that it is, paying out dividends that are too high simply doesn’t leave enough in the company to reinvest in its future. So, while in the past high dividends were a sign of good profit and stability it is increasingly becoming a sign of underinvestment and future challenges ahead.

The most innovative companies in the world are in the US and they do not pay high dividends. The average dividend of the USA Dow Jones industrial average (30 stocks) is 2.4% and for the S&P500 is 2.0% and for the NASDAQ is 1.0%. In Australia, the ASX200 payout collectively dividends that equate to well over 4% grossed up for franking credits. Though this number is somewhat skewed by higher than usual dividends from big miners, the point still stands.

If this philosophy doesn’t change soon then Australia’s leading companies, beloved by investors for their high fully franked dividends, will soon fall behind their global counterparts. As our market and investors in Australia become more sophisticated it will be important that we focus more on total returns over the long term.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Welcome to the Metaverse

With Facebook recently changing its parent company name to “Meta” rest assured you’re going to be hearing a lot more about the metaverse from now on.

What is the metaverse?

I think the easiest way to visualise it is if you think of the current internet experience as 2D and screen based. Then, the metaverse as the next iteration of the internet, which will be 3D and fully immersive.

If you think people today spend too much time staring into their mobile phones, then you’re in for a shock. Soon enough we will be effectively living in them. Virtual reality (VR) and augmented reality (AR) headsets will be to the metaverse what the iPhone was to the web.

I see it as being at a similar stage to the internet, domains and websites in the early 90’s. It’s starting to take shape but it’s a long way away from being functional for mainstream use. A lot is going to happen in the next 5-10 years that will take it mainstream. All the major tech companies are already heavily investing in building the metaverse. Once it starts to scale, the network effect will do the rest.

Why does it matter?

Because it is the future of the world. It doesn’t just change it. The metaverse brings together many of the technological trends emerging today including machine learning, AI, cryptocurrency, NTFs and virtual and augmented reality to create completely new worlds and experiences. The most obvious area to start is computer games but it will encompass all aspect of our lives before long, from music and fitness to the future of work and education.

Today’s most popular gaming companies understand the potential of the metaverse and are already providing the early platforms for these immersive experiences. The companies that run Minecraft, Fortnite and Roblox are at the cutting edge. Kids don’t just play these games they spend their time there socialising and creating. They experience these worlds with their friends, both from school and those they meet in the metaverse.

But gaming is just the start. The virtual economy will be massive and paying for virtual goods and services will be standard. The music industry is already starting down this path with an exclusive concert on Fortnite by Travis Scott attracting 27 million participants last year. The fitness industry through the gamification of workouts and exercise is next.

In the metaverse you will be able to travel to anywhere in the world and experience travel adventures from the safety and convenience of our own home. You’ll be able to put on a VR headset and spend a Thursday evening in a gondola sightseeing in Venice or meeting up with friends on a Friday night to attend the live Rolling Stones concert.

In the US the National Basketball Association (NBA) partnering with Facebook already provides fans the ability to watch selected games in fully immersive virtual reality from a range of vantage points at the game, including courtside seats. Imagine being able to attend any event in the world at any time from your own home and it all feels like you are there in person. This is no longer science fiction.

How to invest in it?

It wasn’t that long ago companies repositioned themselves from web based to be ‘mobile first’. Well over the next 5-10 years companies are going to be moving to ‘metaverse first’. Right now, there are several companies at the cutting edge of creating the foundations of the metaverse. No doubt there are going to be many more in the years ahead. Many are going to lose so it’s important to be strategic here.

Facebook through their Reality Labs business are very well placed to lead the way in the hardware and software of the future. They plan to spend at least US$10b this year alone in this division. However, Microsoft is equally well placed and is taking a more pragmatic, if less visionary, path to providing the tools for the metaverse through their existing suite of products such as Microsoft Mesh and Teams.

I see Facebook and Microsoft as market leaders here. To me, they are the lowest risk way to gain exposure to one of the most exciting areas of growth we will ever see. They are both great businesses, very profitable, yet are still both growing rapidly each year and have excellent long term growth potential too. I see these stocks providing a free hit to the future upside of the metaverse.

But perhaps my favourite company in this field is Roblox. Roblox reports that their 47.3 million average daily active users spend approx. 2-3 hours per day on Roblox. Talk to anyone with kids under 14 and chances are they are already very familiar with their kids spending real money to buy Roblox digital currency, Robux. The engagement metrics and revenues are amazing. This is a company consistently growing at over 30% pa and in my opinion is poised to be one of the next tech giants in the era of the metaverse.

Facebook, Microsoft and Roblox are all outstanding companies that we own in many of our growth-oriented client portfolios, and I own personally. Subject to price, I will continue to add to these holdings over time.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

The First Domino to Fall

Wednesday last week, Domino’s was the first major company here in Australia to flag seeing inflationary pressures such as rising food prices and labour shortages. The market reacted poorly to this news with the stock down 18% for the day. Domino’s is a great business, and while and a drop like that was probably an overreaction, it is the sort of re-rating we can expect if inflation takes hold.

Higher inflation has certainly arrived. The only question is how long it is here for. I’ve previously outlined my view that this bout of inflation is primarily a result of supply chain issues and that it will ease in due course. Overlay the slowdown from China and I believe inflation is most likely a 6-to-18-month issue. Ultimately, 1 of 3 scenarios will play out. I’ve listed these below with my view on their likely probability:

1. 20% likely inflation subsides within 6 months and markets continue bull run.

2. 60% likely inflation is a consistent theme for 6-18 months and causes a significant correction before inflation eases and markets continue their bull run.

3. 20% likely inflation stays and causes a fall a permanent re-rating of all asset prices of 20% or more. The bull run is over, and we have an inflation problem.

If you look at the breakdown of the scenarios more deeply, you see the conundrum investors are faced with. When combining scenarios 1 and 2 my view is that it is 80% likely inflation is dealt with within 18 months. At the same time, if you combine scenarios 2 and 3, I also think there is an 80% chance that markets will see a significant correction due to markets re-rating on inflation concerns.

The reason this is my view is that unless there are signs that inflation will ease within the next 6 months, investors are going to start getting nervous. The prevailing view in equity markets seems to be that the inflationary pressures are going to be transitory. But 18 months is a long time. Once we enter the next phase at some point within that 6–18-month time frame, markets are going to lose their nerve on inflation, and we’ll see a correction.

I am also mindful that central banks and Governments around the world are typically not great at managing these situations and can make them worse. They are almost always reactionary and rarely brave enough to be proactive. They act too slowly, then too quickly. This is why interest rates are still at zero when they should be higher and why a massive stimulus package has been approved in the US when the global economic recovery is already well underway. It only adds fuel to the inflationary fire now.

The data in the year ahead is going to provide very mixed messages on both growth and inflation. Labour shortages and increasing wages are next and that just adds another layer of inflationary pressure. While equity markets are currently expecting inflation to be transitory, I think this sentiment will change over time as doubts creep in. We will see over the next 12 months more knee jerk reactions like that seen by Domino’s as concerns around inflation persist and are flagged more and more frequently by companies. This will be a buying opportunity in my view.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

China Consolidation

While the prospect of inflation and the debate over whether it is just passing through or permanent will dominate markets in coming months, I think Australia should be more concerned with the impact of the economic slowdown in China. Everyone seems so focused on the reopening of the Australian economy they are not looking at the other headwinds emerging.

China has dramatically changed course in the past 12-18 months. They are battening down the hatches from both an economic and political perspective. Their ‘Common Prosperity’ mantra is the overriding political philosophy ushering in a new period of consolidating the government’s power and control.

Unlike the West, China thinks long term. They will forgo higher growth now if consolidating makes their nation stronger and better prepared for the battles ahead. I believe this consolidation is in line with their longer-term ambitions around Taiwan and the South China Sea.

There are many examples where the Chinese government has deliberately destroyed businesses and industries and actively limited their potential profit. Combine this with the government crackdown on property debt and developers, the world now faces the prospects of a China with materially lower growth prospects.

The level of sovereign risk in the communist nation makes investment there untenable. In the past 12 months, they have torpedoed their own internet giants Tencent, Baidu and Alibaba to the point that their share prices halved. They banned all education and tutoring companies from making a profit. In September, they banned children from playing video games for more than 3 hours a week.

The philosophical differences between China and the west make investing there a nightmare. The Chinese government is not concerned about that though. This is about consolidation of power first and the economy second. But it is certainly consolidation of both.

The property and construction debt problem in China appears to be an issue that China will manage over time. While there will be serious fall out, it may not be the economic disaster that was initially feared. It is likely China still grows and we will continue to see the emergence of the middle class.

But in the short to medium term, exposure to China growth is best found via the Chinese consumer. That doesn’t really help Australia as we are highly leveraged to the building of China. But with around 65% of the Chinese population now living in cities we are starting to move to the next stage.

Ironically, a phase of manageable consolidation for the Chinese government is likely the worst outcome for Australia.

When China is building and booming, demand for our resources is high and obviously Australia does well. If China does poorly, for example a major economic disaster, then we are likely to see China launch a massive stimulus package and focus on new infrastructure. Again, great news for Australia and the iron ore price.

But if China goes through a period of consolidation, Australia has a problem. In a consolidation phase, we’re going to see sustained lower iron ore prices and lower volumes. It will impact our entire economy, starting with the mining sector and flowing through to property and the banks. I think it is likely the Australian economy is going to struggle in 2022 as it finds itself hit harder by the Chinese slowdown than almost any other country.

From an investment perspective, I think there are still great opportunities in some sectors here in Australia, but I have reduced our client’s exposure to Australian shares. I am avoiding direct stocks in Chinese companies as the sovereign risk is simply too high. Most importantly, I prefer international equities over Australian shares at the moment. I am slowly increasing our portfolio holdings in blue chip international stocks, especially in the US.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Is Rising Inflation Here to Stay?

Inflation is rising. In the US, it now sits at 5.4% pa and just last week New Zealand confirmed a rate of 4.9% pa. These are the highest levels of inflation in over a decade. The main concern evolving in financial markets right now is whether the inflation genie is out of the bottle permanently.

Complicating the issue is that many investors have long been worried that governments around the world are creating serious inflationary pressure with quantitative easing, asset purchases and money printing over the past 10-15 years.

Over the course of the pandemic, the price of many goods and commodities have skyrocketed. The biggest question now facing financial markets is whether these increased prices, combined with supply shortages, will lead to a permanent jump in inflation. If inflation does increase significantly and leads to interest rate rises, it will be a problem for everyone.

If interest rates go up, and go higher, it is a real concern and with serious implications. It would result in a one-off re-rating of asset prices across the world. Almost all assets would fall in value as markets adjust. Bonds would fall, as would most stocks, especially high growth stocks. High inflation is a big deal.

In relation to the money printing impact, my view is that we are still years away from seeing the inflationary impact of this. The reason being is that the quantitative easing money wasn’t pushed into the consumption economy. Instead, been captured within assets for now and while its forced asset prices up around the world it is going to take many more years to flow through into the economy and create price inflation.

So, in my opinion, that’s a separate issue from the current inflation spike. It’s a problem, but not today, and it isn’t the source of the inflation we are dealing with now.

I think the current bout of inflation brewing is really just due to supply chain disruption caused by repeatedly closing and opening parts of the global economy as the world went into lock down. Combine that with the unusual buying patterns that followed from consumers and businesses in the past 18 months, and you’ll obviously have supply chain bottlenecks as a result, forcing prices higher.

However, everyone brought forward a lot of spending on goods while stuck at home. They don’t need more. But no one was spending on services. That’s going to change in 2022. I expect spending on goods and commodities to fall in 2022, while spending on services increases as the global economy reopens.

If so, we will see the current supply chain bottle necks and the congestion at ports around the world start to ease. This will all work itself out in my view. It will just take time. That’s good news for inflation. In fact, there are four main reasons I am not overly concerned with the inflation we are seeing now.

The first is as I mentioned, supply chains will rectify themselves and we will likely see less demand for goods than normal in the coming 12 months. Prices are more likely to come down as supply and demand normalise.

Second, as people realise that the demand for goods is falling, a major component is removed from the inflation equation, expectations of higher prices. This removes the need for people to rush to buy before prices go up which perpetuates inflationary pressures. If prices start coming down, they will wait.

Third, ongoing impact of technology is deflationary. Shortages in any area whether its labour or energy or commodities accelerates technology trends and creates permanent additional capacity.

Fourth, the slowdown in China is real and it’s going to impact global growth. It will especially impact the Australian economy, subject to the degree to which the property sector there slows.

Regardless of how it plays out, the spectre of inflation will make for a relatively difficult 12 months with the market coming to grips with the real story as it unfolds. In my view, inflation pressures will likely subside in due course. For Australia, I am far more concerned about the impact of the slowdown in China in 2022. I think that is the emerging headwind for the Australian economy next year.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Converging Technology: Driverless Vehicles

Bill Gates once said, “people overestimate what can be achieved in one year, but underestimate what can be achieved in ten years”. This is especially true of the disruptive nature of technology. It seems so far away until suddenly its right in front of you. That is exponential growth at work. 

Consider driverless vehicles. This one technological subset will probably be the most visible example of hundreds that demonstrate the convergence between automation, robotics, and artificial intelligence. Not just cars but trucks and every other mode of transport that currently requires a human to drive it. They will not only be autonomous robots they will be connected learning machines aggregating data from all users across the globe to create massive efficiency.

Soon enough families will no longer own a car. They will subscribe to Transport-as-a-service. It will save them thousands of dollars a year and be incredibly efficient. Not to mention hundreds of hours a year of time freed up for each person. By 2030 this will likely be a reality. By then many industries will have changed significantly and the companies that are the winners and losers already defined. 

Imagine the not-too-distant future where you have an appointment. You won’t need to order the car; it will know your routine and schedule. The driverless Tesla connected with Uber and integrated seamlessly to your calendar will send you a notification upon approach. The car will arrive at your front door exactly at the time required to ensure you are at your destination on time. It will consider the traffic and weather conditions and know if you will be out the front waiting or dawdle out 5 minutes later. 

Their integration though will not be without challenges or controversy along the way. They will eliminate millions of jobs, most obviously it means no more truck drivers, bus, taxi, or train drivers. Yet as we have seen throughout history, it is likely that many millions more will be created in industries that are only just emerging or not yet invented. Upskilling, education, and entrepreneurship will boom.

With over 90% of road accidents resulting from human error they will prove to be significantly safer than human drivers. But they won’t be perfect and no doubt the media will spark fear with every mishap or accident until they become mainstream. But once driverless vehicles are adopted across the board, they will virtually eliminate road deaths and road accidents. Insurance companies and road safety authorities will all be on board and in the end, statistics will win out and lives will be saved.

It has massive implications for not just the economy but society. Frees up first responders, police, paramedics, emergency wards, massively reduced insurance premiums, no one will own a car, no need for car parks as cars will operate 24/7 stopping only for maintenance, no more smash repair businesses because there are no crashes. No more car theft. Massive reductions in pollution. As with all computing devices they will become cheaper and more powerful over time. It will ultimately reduce the costs of logistics and the price of goods. 

Agriculture, mining, manufacturing, and logistics are all industries that will see once in a lifetime reduction in costs and increases in productivity. This will translate into significant increases in profits, equating to increased returns for shareholders both from dividends and higher stock prices. We are talking about trillions of dollars globally. 

This is not an incremental change; it’s going to completely change the world. All this from just driverless vehicles. So, consider the dozens of similar changes that will occur in other industries from retail and hospitality to health and finance as automation, robotics, and artificial intelligence become standard.

It is my view that investors are too focused on the short term and medium term and drastically underestimate the real pace of change. As these changes occur at an ever-accelerating rate it is more important than ever to position your portfolio for the long term (10 years plus). Investors need to consider more deeply what the future will look like, the companies that will transform it, those that will be out of business because of it and those that can adapt and will benefit from it.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Technological change is just getting started

Regardless of the uncertainty around markets in the short term, there is one reason I will always be extremely confident in the long-term prospects for investors and excited about the future.

Technology.

But before I talk about what’s ahead, just think about the way the world has changed in the past 20 years. There are a whole range of technologies and platforms we use every day that didn’t even exist back then. Go back to 2001 and we were using dial up internet, the iPhone wasn’t invented yet, there was no social media, and Amazon was only selling books. Fax machines, The Yellow Pages, calendars, diaries, rolodex were standard in the office and DVDs, CDs at home. It is incredible.

The list of companies that did not even exist back then but today are household names is staggering. Facebook, Instagram, YouTube, Uber, Tesla, Twitter, Zoom, Spotify. Companies such as Google, Amazon and Netflix were only a few years old and not nearly as advanced.

A lot has changed in just 20 years.

In my opinion, the change is only just starting. The advancements we are going to see in the next 10-20 years will change the world even more than we have seen in the last 20 years. There is a ground swell of innovation and technological advancement coming. These trends will further accelerate the pace of change and disruption and their convergence will make it exponential.

Automation, robotics, energy storage, artificial intelligence, blockchain, the evolution of the metaverse, genomics and DNA sequencing are some of the most important advancements that we will see in our lifetime. They are no longer the domain of science fiction, they are very real, and will change the world forever. It will all be mainstream much sooner than you expect.

For investors, every company you hold will be impacted by these trends in the years ahead. Every investment. It’s also not just about the opportunities emerging in the companies directly involved in these technologies. These are opportunities for existing companies that will change the way business is done, reducing costs significantly and increasing productivity massively.

I genuinely believe that we are on the cusp of one of the most exciting periods of technological advancement in history. As investors its critical to keep your eye on the long-term prize. The great companies of the future will realise their potential despite any economic head winds; and in my opinion many of the companies that are emerging as the leaders of tomorrow are hiding in plain sight.

In the coming weeks I will write more on these technological trends and some of the industries that will benefit most. I will also outline my thoughts on companies I think are best positioned to profit from these trends in the years ahead.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Busy Being Patient

A month ago, I wrote that it was a good time to take some profit. While markets have dropped a little since then (around 5%) by almost any measure, share markets globally remain fully valued. We took some profit, not because I have any great prediction to make about what is going to happen next in markets. Rather, it is simple risk management to allocate capital in a prudent way.

But what next? 

Markets have performed very well over the past 12-18 months. To the point where we find stock markets well above their pre-pandemic levels. That alone tells me that either markets have run too far or that governments have over done the stimulus. In reality it is probably a little bit of both.  

As such we hold more cash in our portfolio’s than we would like. But at the moment I think that is sensible. Ordinarily we might allocate more to bonds but with interest rates as low as they have been for as long as they have been govt bonds are even more fully valued than shares. 

As far as an investment goes, cash is currently terrible. Basically, no return and in real terms, taking into account inflation, you are going backwards. However, from a portfolio perspective I am comfortable holding cash where there is increasing volatility and uncertainly, which is what we are starting to see.

There’s a lot going on in the world at the moment that reflects the increasing strain globally stemming from both recent (Covid) and past events (GFC). In addition to the full valuations on stocks, we are also now seeing an increasing range of risks emerging. 

Domestically, we are adjusting to slower growth from China, lower demand for iron ore, and now regulators & banks targeting property.

Globally, we are seeing skyrocketing energy prices and emerging energy crises in various parts of the world, supply chain issues, semiconductor shortage, China property and debt concerns, US debt ceiling, China / US tensions and concerns around rising bond yields & inflation.

Each taken individually appear manageable but as a collective the story emerging is that the world is a little out of whack (more than usual). Coming out the other side of a once in a generation pandemic, this is not unreasonable. Many of these issues are symptoms of the same problems, other are not.

So, we have fully valued markets and a global economy trying to digest almost 2 years’ worth of disruption, stimulus and stops & starts. It’s just common sense to have a little extra allocated to cash. Good performance gave us the opportunity to take some profits.

Obviously, I’d like to deploy that additional cash into investments, but there’s no rush. Opportunities will arise. Regardless of what markets do next there will always be individual investments or sectors that are underpriced or present an opportunity. This is especially true when uncertainty his higher.

While we have increased our allocation to cash, I remain bullish on the long-term prospects of the global economy and share market. Our allocation to both domestic and global equity markets reflect this.

But for now, we are busy being patient.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Is the Size of US Debt a Problem?

In the coming days, we will read about the annual Mexican standoff in the US as the Republicans and Democrats jostle over raising the US debt ceiling. It’s a ridiculous game of political brinksmanship that will resolve itself out of necessity. I expect an agreement of some kind at the very last minute.

The issue is that the US has once again run out of money and need to borrow more to fund the basic functions of government such as pay wages and social security payments. Both sides need to agree to lift the previously agreed debt limit or by mid-October they run the risk of defaulting and causing a serious problem.

The debt ceiling has been increased almost 100 times since it was put in place after the war, and not once have the US defaulted. On each occasion, Republicans and Democrats have reached an agreement and raised the debt limit, usually at the last minute, and everything continues on.

But it raises a far bigger question long-term. Just how long can the US continue to fund huge budget deficits and borrow trillions of dollars before it becomes a problem?

At the start of the GFC in 2007, the US National debt was about $9 trillion. The US then embarked on massive spending, funded by debt, to deal with the once in a generation financial calamity. By 2009, the US annual budget deficit was up to $1.5 trillion on the back of only $2 trillion in revenue but spending of $3.5 trillion.

The idea of using deficits in a time of crisis is ok. Why take the full hit in one year when you can borrow now and spread the pain over 10 or 20 years. At the time of the GFC it made sense and likely averted a global depression. Even in times of recession and economic downturns it makes sense.

Unfortunately, we all know that’s never how it works in practice. Once a government starts spending, they rarely know how to reign it back in. Well intended budget deficits, designed to smooth out a serious downturn, become structurally entrenched in the system. People across the world expect their governments to borrow rather than have to go through tough economic times.

Fast forward to 2021 and US Federal Govt has revenue of $4 trillion and spends $7 trillion annually. US national debt is now approaching $30 trillion. The debt will be much higher in the years ahead.

This is not sustainable.

We are not even close to the US bringing their budget deficits under control let alone balancing their budget, and light years away from repaying it. Modern money theory says the US can borrow and print more money to inflate their economy to the point that debt becomes comparatively smaller and more manageable. Great in theory but there are always unintended consequences.

The main reason the US can take on so much debt is because interest rates are basically 0%. If interest rates go up it’s a different story. But even then, debt in the form of govt bonds is typically 10 years to maturity so it will still take time to impact the costs of borrowing for much of their debt.

It might not matter for many years, but it will one day. It is a path whereby the US loses optionality. If anything goes wrong, they are not in a position of strength to choose their path for growth. They are reactive and need to enact measures to get through. That is not prosperity. It is policy failure.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

What’s Next In The Evergrande Debt Crisis?

There’s a lot going on in and around China right now, with concerns around their intentions with Taiwan, the South China Sea and escalating tensions with the US and its allies. But perhaps the biggest issue impacting markets right now is the imminent default and potential collapse of property giant Evergrande with over $300 billion in debts. There are many potential implications from this.

The default to bond holders, people who bought property, suppliers, the loss of equity, the impact on property and construction, will all make their way through to their domestic economy and ultimately result in slower growth and have an impact on global commodities. But it’s the fear of the unknown that is causing financial markets to become fearful.

The bigger concerns at the moment relate to the uncertainty around how it all unfolds, the potential contagion and impact on China’s financial system (including debt markets and liquidity). It is one thing for a company to go broke, that is a part of the risk inherent in doing business. But the calculus changes when the organisation at risk is a systemically important one.

My observations in relation to these types of events:

• They take time to evolve

• There will likely be contagion

• The issue is usually bigger than we first think

• There are probably other organisations in similar positions

• Government can bail out the organisations involved if needed

We’ve seen this type of issue over the course of history including the US subprime issues resulting in the Federal takeover of institutions Fannie Mae and Freddie Mac. The indebtedness of this organisation occurred with China’s knowledge, and the factors leading to the current issue at Evergrande are as a result of the Chinese regulators demands to repay debt.

The next question will be, what do the financial positions of the other major property developers look like? Moreover, how are the other large corporations with huge debts positioned. I suspect that China ultimately wants to make an example of Evergrande and will force the organisation to resolve the matter. But this is equally a warning shot across the bow to all the corporations in China, not only Evergrande.

However, we should not assume that China wants to fix the problem in the same way a western nation would. That would be a mistake. China is a communist nation, and they operate accordingly. Their focus is not the wealth of investors or institutions. We have seen repeatedly now that China is prepared to destroy companies and damage industries if it serves their political objectives.

Perhaps one of the most counter intuitive lessons for investors from democratic capitalist nations to learn is that China isn’t ruled by money. We all assume they will act commercially because that is what business is all about, being pragmatic and obtaining the best commercial outcome. But we assume they believe the best outcome is what we think it is. It is not.

While China can potentially bail out Evergrande, it will be seen as a bad example. In my opinion, a bail out is only likely if there is an existential threat to the economy, financial system, or the political regime due to the fall out. Nonetheless its worth keeping in mind that, if the need arises, the backstop is a bailout. It will occur if it is essential.

The Western World is going to find out what an economic crisis in a communist state looks like and how it will be dealt with. Some sectors and nations will feel the pain more than others with iron ore and the big miners, here in Australia, the most obvious examples in the short term.

Overall, though, it is perhaps most important to remember that the long-term growth of China and their rising middle class is a theme that will continue for decades into the future. 

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Ignore the noise

These days everyone understands the amount of time people can waste when they aren’t focused. The internet, social media, Netflix, and countless other apps will consume your time with endless notifications and activity unless you consciously ignore it and turn them off. 

While modern technology and media has made accessing information massively better, it’s also created such a huge volume of news and data that people have forgotten how to focus on what actually matters. They’ve become overwhelmed and distracted.

Well, it’s the same in the investment world, where a lot of time and energy is spent by investors, advisers and institutions talking about and watching the latest news, event, or announcement.

Monthly and quarterly economic data, daily share market and company movements and ongoing geopolitical issues. Everyone is too focused on the short-term news cycle.

What actually matters is really quite boring and generally uneventful. So, it often gets ignored because the new sensationalist headline, exciting development, or breaking news has caught our attention.

Very little of the noise that is produced each day in the financial world will be significant enough to matter in the very long term. Yet so many people spend far too much time trying to know everything that’s going on, when a lot of it is noise. In fact, I would say, most of it is noise.

Now, to be clear, I am not saying these things don’t matter at all. I am saying they don’t matter as much as everyone thinks they do. I am saying that too many people spend a disproportionate amount of their time concerned with variables that are less important than the ones they should be paying attention to.

Of course, how we see short term movements in markets or the economy unfolding will impact whether we add to or reduce our portfolio positions. And, while it does happen, it is relatively rare that issues that appear in the daily news cycle actually change our long-term view and the companies we hold. 

Overall, though, it is far more productive and profitable to spend your time on what really matters and ignore all the noise. That is the key. Understand what really matters as an investor. Then by default the rest is noise. That is where you need to be spending the vast majority of your time and focus.

Great companies, in the right areas, will deliver great returns over the long term regardless of whether markets are up or down next week, or whether inflation and GDP are higher or lower next quarter.

What really matters are the macro themes and technological trends that will play out over the next decade or two. What really matters is how the 20-40 global companies we hold in our portfolios are positioned, not for the next quarter, but for the next 10 to 15 years.

What really matters is having a high degree of understanding and conviction in those companies and trends. Then it is easy to focus on what matters and ignore the noise.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Should You Participate in Share Buy Backs?

If you hold shares in major companies such as Commonwealth Bank (CBA) and Woolworths (WOW), you will have received an offer from the company to participate in share buy backs. The offer document and process look quite complex and confusing but it’s worth understanding how it works and why.

Whether it is worth participating and selling some of your shares back to the company depends very much on the entity that you own them in. Depending on how the buy back is structured, the simplest answer is often that buy backs are great for low tax rate entities. If the shares are owned in a higher taxed entity, then it may be a terrible deal.

I’ll use CBA as an example to explain how it works.

At first the offer looks confusing because CBA are offering to buy back your shares at a discount. Where the buyback offer is that CBA will buy some of your shares at a 14% discount it appears to be a bad deal. At face value it results in you receiving $86 a share when you could sell them on the share market at $100.

Why would you do this? 

The key is in the make up of that $86. CBA are proposing $21.66 is capital and $64.34 is a fully franked dividend. If it was an offer of $86 all capital, it doesn’t make sense. It’s the use of the franking credits in the structure of the offer that makes it work. 

The fully franked dividend component is for tax purposes a large dividend. Like any fully franked dividend, the tax credit is added back on as a credit for tax previously paid. It is real money. So, the price becomes $21.66 plus $64.34 plus the franking credit of $27.57 for a total of $113.57 per share.

Let’s assume you own Commonwealth Bank shares in your self-managed super fund which is in pension phase where the tax rate on income and capital gains is 0%. Let’s also assume the current price on the stock market for CBA is $100 a share. 

So, for a SMSF in pension phase participating in the buy back, the effective sale price of your CBA shares is actually $113.57 which is a significantly higher price than you could achieve by selling the shares on market.

It’s a great deal for SMSF’s in pension phase. However, these numbers change as the tax rate goes up.

For a SMSF in accumulation phase where the tax rate is 15% those franking credits are only partially refunded because the fund pays 15% tax in super accumulation phase and so you only receive a refund for what’s left after you pay tax. There is also an element of CGT to consider although significantly discounted. For a SMSF in super accumulation phase the effect price is around about $101.21 which is slightly better than selling on market. 

If the shares are held in a company paying 30% it simply doesn’t make any sense. The franking credit component is fully absorbed. You’d be selling the shares at $86 in the buyback when you could sell them for $100 a share on market. 

For high income earners with CBA shares in their own name the figures would be even worse. Not only would the franking credit be absorbed but you may need to pay additional tax on the difference between your tax rate and the franked dividend component. 

For the companies themselves it is an excellent deal. In the case of CBA, the way its structured uses their excess franking credits, they get to buy back their own shares for $86 a share.

You to need to crunch the numbers for your specific situation to consider your tax rate, potential CGT and check the details of how the buy back is structured in each case. But generally speaking, the way they typically work makes these style of share buybacks excellent for SMSF pensions, closer to break even for SMSFs in accumulation phase and terrible for anyone with higher tax rate such as companies and high-income earners.

General advice warning. This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

This Is a Good Time to Take Some Profit

With reporting season basically complete it looks like corporate Australia is in pretty good shape. While I’m mindful of the fact that those results are all in the past and largely pre-lockdown, it is clear that the financial positions of our biggest companies are as strong as ever. BHP, Rio Tinto, the big banks, Wesfarmers and Woolworths all had great results. Many are seeing record profits and paying out increased dividends. With excess capital, low levels of debt, their balance sheets are in such good shape that many are returning that capital to shareholders via special dividends and share buybacks. 

This is a positive as not only do investors get a bonus return it’s generally a sign of sound corporate management. If the companies are flush with cash and they can’t find ways to use those funds, either by reinvesting them within the business or using them to fund a new acquisition, then it is most prudent that management return the capital to the shareholders. In any case, with low levels of debt and the cost of borrowing being so cheap any takeover is more likely to be funded by debt or a share swap.

While corporate Australia is in good shape the stock market has already priced this good news in. The consensus is that lockdown has only delayed the recovery. In fact, for the past 12 months, the ASX has priced this in and at current levels doesn’t seem to put any weight on any downside risks or consider the potential that a recovery may not be a foregone conclusion. There is a chance that we go into recession. It is possible that the economy, even as it likely rebounds in the December quarter, doesn’t recover as quickly as everyone expects.

So, in my view, this is a good time to take a bit of profit. While I also think the economic story for Australia is still positive and that the economic recovery has only been delayed by recent lockdowns, I don’t think the stock market is really factoring in the potential risks emerging, including possible new covid variants and increasing geopolitical risk. Overall, I think there is more downside risk than upside at the moment. Company valuations are high on almost any measure. In the coming weeks, it won’t take much for markets to start to worry about some of these risks and for the ASX to pull back 5-10%. 

I think it’s a good time to make some minor adjustments and take a small amount of profit off the table. Recently, we’ve started reducing our exposure to financials including Commonwealth Bank, retailers like Wesfarmers and Woolworths, tech such as Xero and Afterpay. These are great companies that have performed really well, and we continue to hold them. However, in my opinion, at such good prices it is prudent to lock in a little profit and reallocate capital to better value stocks or cash for future opportunities.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Small Business Failure Is the Biggest Risk Emerging in the Economy

It has been about a month since my last update on Covid19 and the emergence of the delta variant. Without a doubt the NSW State government have made a mess of this in the last few months, somehow creating a worse outcome for both the health of the people and the economy. 

It is clear that the only way out of long-term lockdowns is by getting the population as close to fully vaccinated as possible. In a perfect world, it would be 95% plus but it’s going to take too long to get to that figure before we end up with mass civil unrest and small businesses collapsing. I expect both NSW and VIC to end their lockdowns in November once over 70% of the population are fully vaccinated.

From an economic perspective, the prospect of the lockdowns ending is obviously good news. People can go back to work and companies can get on with doing business. If this all goes ahead, then we will likely see pent up demand for goods and services and a great Christmas period to boost the economy back into gear.

From an investment portfolio perspective, at the moment, the share market remains largely unaffected regardless of whether we are in lockdowns or not. In many cases, the large companies listed on the stock market are somewhat insulated and have diversified income streams from across the world. They have access to capital and the ability to negotiate favourable terms with suppliers due to their size and scale.

That is not the case for all businesses.

The area I am increasingly concerned about is small and medium sized business, the real engine room of the Australian economy. In my opinion, there is a growing risk to the entire economy emerging as small business continue to be neglected by all sides of politics while bearing the brunt of the impact from lockdowns. They have neither the voice of unions like workers nor the deep pockets of the corporates.

Extended lockdowns for any reason, be it lower vaccination rates, materially higher ICU and death rates, or a new variant, will be a problem for many businesses already on the edge.

These businesses depend on local customers and have neither the size nor scale to access capital or negotiate favourably with suppliers when in trouble. They are increasingly finding themselves at the mercy of their banks and their landlords, both of whom are effectively accumulating unpaid interest and rent as debts. Small businesses have no leverage in this situation as it plays out.

It doesn’t show up as a problem at the moment because the banks are capitalising the interest and using it to increase their loan book. Landlords in many cases are accepting whatever the small business can pay as rent and accruing the unpaid rent as a debt. It all looks good on paper. At some point, the reality is that these amounts need to be paid.

When this side of the equation starts to play out it will be a problem. If small businesses are left with nowhere to turn then many will go broke. It’s that simple, it becomes their only option.

If there is a material spike in small businesses collapsing in the months ahead then there is the very real possibility that this leads to flow on effects for almost everyone; for the economy, unemployment, the property market, the banks and ultimately the big corporates listed on the stock market.

Significant economic problems always seem obvious in hindsight. Usually, they seem to come out of left field because everyone is too distracted or complacent to spot the real problem emerging. For years governments across the world have bailed out the biggest institutions because they are too big to fail. However, if we are not careful, it will be our disregard for small businesses that will be our economic downfall.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Death by a Thousand Cuts – How Fintech Is Disrupting the Banks

The big banks here in Australia have just released very strong results, which is great news for investors. Increasing dividends and share buybacks during a global pandemic show just how strong a position they are in.

However, there is an undercurrent of change brewing that can’t be ignored. In my view, the banks are in the early stages of being disrupted and this process will play out over the next 10 years or so. It’s not going to happen quickly, but the seeds have been planted and new competitors will ultimately change the way bank’s function. Structural change will eventually compress their margins and reduce their market share, starting with their most profitable products.  

Yes, I know they currently make billions of dollars and record profits year after year. That doesn’t matter when it comes to technological change. They are not impervious to disruption and their success over the past 30 years doesn’t make any difference going forward. In fact, their position as high paying dividend stocks that the market seems to love perhaps makes investors all the more complacent.

So here I want to outline my thoughts on how this is starting to happen, specifically to the banks, and to flag it as a very real issue to be aware of in the years ahead. You need to understand the issue early because once it happens it’s too late.  

Fintech (Financial Technology) continues to grow as a sector with thousands of companies emerging across the world. Unlike Amazon in retail, it appears to me that no individual fintech company will singlehandedly disrupt the banks, rather the reality is that collectively they all will. Not the banks themselves, but their individual products. Because of this the disruption to the big banks will play out a little differently.

But we have seen this type of disruption before.

Back in the early 1990’s newspapers were exceptional businesses. Very profitable. The businesses that disrupted them did not create better newspapers. But one by one the newspapers lost their most important revenue streams and core products, their cash cows.

It was death by a thousand cuts.

Back in the 1990’s there was no Seek, no Realestate.com.au, and no Carsales.com. There were only newspapers. As the internet evolved it allowed a new generation of companies to emerge and cherry pick the most profitable parts of the newspaper business. New online marketplaces developed and led to exciting new platforms that would become the leading companies of the next 30 years.

This is how the banks are being disrupted. One by one their most profitable products are being picked off. Afterpay and the buy now pay later sector is just one example. New payment companies such as Square, Stripe and PayPal are another. But there are dozens emerging across all their product lines. They are leaner, nimbler and provide cheaper, more efficient alternatives. 

Technology and the internet especially have been the catalyst for disintermediating markets. Wherever there is an intermediary the internet has created extremely efficient ways to cut the middleman out.

Banks are ultimately intermediaries.

They have done a great job in presenting both sides of the market as separate products ranging from term deposits, cash accounts, credit cards, home loans to personal loans. But really, they are just the middleman between depositors and borrowers. They take a cut from both. It’s a great deal for them.

It can be difficult to be bold on issues that are not obvious right now. This is especially true when the companies concerned appear to be at the peak of their powers and profitability. It is far easier to talk about tech disruption when a company or industry is in the middle of it. At that point though it’s too late for investors and the company share price will reflect the structural problems.

That said we still hold the big banks in our client portfolios, and they are still great businesses. But don’t just blindly follow the crowd. As an investor its far more important to consider disruption before it is obvious to everyone else, and the market factors it in. That process has already started. Although it may take many years to play out you cannot allow yourself to be caught off-guard by the threat nor miss out on the new opportunities that emerge. 

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.