Geopolitical Risks are Rising

Any time you have serious tensions between nations in a time of war there is the potential for escalation. From an investor perspective, I am concerned with the recent developments in the Middle East as there is obviously the potential for even further escalation given the recent attacks on Israel by Iran. That said, at this stage, my view is that it is not in the interests of any country to escalate from here and all things being equal I am hopeful that this doesn’t go further – for now. Keep in mind that any of my comments here are only in relation to their impact on investors and investment markets.

It appears that Iran flagged their attacks ahead of time, giving the US and Israel sufficient room to ready their defences. When the attack came, the Israeli air defence, supported by the US military and other allies was able to fend of almost all of the 200 plus drones and missiles sent their way. I’ve also read reports suggesting that Iran indicated that these attacks are the full extent of their response.

If Iran wanted to maximise the impact and damage, I would have expected them to launch a surprise attack. You would not provide any communication as to the extent or timing of the attack unless it was for misinformation. While that remains to be seen, if that communication is truthful then it suggests the attack was less about aggression or even revenge and more about perception at this point.

It was widely expected that there would be a miliary response of some kind from Iran following the Israeli attack on the Iranian consulate in Syria. Perception matters for all sides, most importantly in the military sense because leaders of a nation cannot appear weak in the face of an attack. A tepid response from a leader in the eyes of their citizens would weaken their leadership and possibly expose them to challenges internally.

Considering that a response was inevitable, and expected, what matters then is the size and scale of a response. In this case, it appears to have been relatively well navigated by Israel and its allies. Iran has responded. Israel has successfully defended itself. Again, from an investor perspective, markets are on edge right now and, in my view, rightfully so given the likelihood of a further Israeli counterattack. What matters most for investment markets is the scale of their response.

A forceful but measured counter will mean It’s still very possible that the situation can settle from here. Certainly, the US and its allies do not want to be dragged in to a war. Of course, any of this can change in an instant. Further disproportionate attacks from either Iran or Israel from here would amount to a serious escalation in my view and I would be concerned about the conflict broadening and the subsequent flow on effects.

So, while there remains a serious risk of escalation simply because war is unpredictable, my read is that this situation can be contained and managed for now. Of course, in a situation as perilously positioned as with tensions in the Middle East, you can never be particularly confident. These are the most complex dynamics of geopolitics because turning the other cheek isn’t an option.

While the situation in the Middle East is extremely complicated, it is made even more so because there are serious implications for the global economy. In this case, Iran’s involvement, and the potential for disruption in the supply of oil would have wide-ranging implications. Lower supply would translate into much higher energy prices and once again put upward pressure on inflation.

As we head towards the USA presidential election in November, increased inflation would create a situation that would bring the cost-of-living crisis to the fore of the election debate and potentially threatens the Biden leadership. It’s possible that this impact the outcome of the election but it’s also possible that it impacts the Biden government response to the situation in the Middle East.

The US political environment is so polarised and divisive that the upcoming election will not only impact the US but also the structure of the world. Whoever wins the presidency will lead a future path that will be dramatically different from the one that would exist if their challenger were to win.

This will be a sliding doors moment for the power structure of the rest of the world. All the nations involved in conflict around the world, or potentially involved in conflict, are well aware of this. So perhaps it’s less about whether geopolitical tensions will rise, but more about where they will arise.

General 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.

Head in the Sand

There are dozens of different types of risks and biases that investors need to consider when making investment decisions. Some such as market risk, concentration risk, credit risk, liquidity risk and time horizon risk are easier to quantify and are well understood. Others such as recency bias, confirmation bias and herd mentality are more nuanced and require some self-reflection to mitigate or offset their impact.

Share markets have been kind to investors over the past several months, and our portfolios have enjoyed solid returns on the back of this. However, the recent buoyancy in share markets has not changed my underlying cautiousness regarding the risks that investors face. I still think the world is precariously placed, even though the share market doesn’t seem particularly concerned now. Wars can escalate, inflation may not be over, the list goes on.

Investors have become complacent and seem to ignore any potential for bad news. Rather than factor in risks more conservatively, the share market has taken an attitude that everything is great until it has been proven that it is not. This binary thinking isn’t very smart because it doesn’t account for the reality that there are indeed risks that exist with varying degrees of probability. These risks need to be factored in.

To make the math simple, let’s imagine there are 2 separate global events, event A and event B. Let’s further assume each event has a 50% probability of occurring in the next 12 months and would result in a 20% decline in the share market. Based on the probability of each of the 2 events happening, the following outlines the combination of possible outcomes and their probabilities of occurring:

1.      25% chance that neither event A nor event B occur.

2.      50% chance that either event A or event B occurs.

3.      25% chance that both event A and event B occur.

Unfortunately, investment markets often misprice event risk. Perhaps it is due to complacency or the intangible nature of assessing risk. Nevertheless, in the absence of an event occurring, the default assessment of these risks by investors in the current market seems to be to ignore it until it happens.

This might turn out to be ok in the 25% chance where neither of the 2 events occurred. But that results in a mispricing of risk until that point because there was a 75% chance of a negative outcome whereby at least one of the events occurs. If the events do occur markets need to adjust much more aggressively. In the basic scenario I outlined above, there is a 50% chance that one or the other event occurs, resulting in a 20% fall. While there is also a 25% chance that both events occur leading to a much larger fall in the share market.

In reality, there are many risks at play of varying probability and consequence. But in today’s complex geopolitical and global economic environment, where there are many more event risks than usual, the prudent assessment of risk is imperative. It’s critical to think differently and ensure you don’t get caught up in the herd mentality as markets throw caution to the wind. Consider the way various biases impact your thinking and assessment of risk.

So, while investment markets and many investors seem to have taken a head in the sand approach to considering these risks, I am happy to carefully consider them. It means that we continue to take profit from time to time as share markets go ever higher. We want to be prepared for the day when one or more of these events do occur because eventually, they will.


General 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.

Is the S&P500 in a Bubble?

The USA has never seen such a large percentage of its share market represented by so few stocks. The booming share prices of the ‘Magnificent 7’ as they are called (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Netflix) has driven the market higher. But their disproportionate gains compared to the rest of the market means they now make up roughly 29% of the S&P500 index. If you are invested in a fund or ETF that replicates the S&P500 Index that’s the ratio your investment has. Basically 30% to 7 big tech companies and 70% to the next 493.

But does that translate into ‘bubble territory’ for the S&P500?

In ordinary times, it would be easy to for investors to assume that it is because at face value, it looks like a bubble given the rapid rise in share prices. However, the real answer is more complex. There are several nuanced layers to the recent surge in these 7 key stocks so it’s more difficult to quantify bubble territory than usual.

I am usually the last person to say ‘this time it’s different’ because inevitably it is not. A healthy dose of scepticism is a good way to stop yourself from getting caught up in the hype. However, at this very moment, it might be different for several reasons.

It is an unprecedented imbalance that has many investors comparing this situation to previous bubbles such as the dom.com boom and bust and more recently the tech crash following the rise and fall of crypto and the metaverse. The biggest difference here is what underpins the rapid rise.

Perhaps most significantly, these companies are at the forefront of capitalising on the early stages of the AI mega trend. This is not a fad; the AI surge is very real, and it is in my view going to be the most significant technological advancement in history.

AI is going to create huge revenue opportunities and importantly massive productivity gains across the world. In fact, it already is for many companies. As long as the revenue and earnings growth continue to meet expectations, you can justify higher share prices. It is even possible that markets are underestimating just how much and how quickly the exponential growth of AI will change everything in the world in the years ahead.

Secondly, these stocks are mainly online platforms with global distribution and scale unlike anything the world has seen. This is not hyperbole. The nature of technological globalisation is one that allows for access to customers more cheaply and quickly than any businesses have ever been able to.

The third aspect driving share prices higher is simply the weight of money being allocated to these stocks. These global behemoths are the types of businesses that are able to survive almost any economic or political conditions. So, a key element of that flow of money is effectively a flight to safety as investors look to protect capital in uncertain times.

In the past investors bought shares in ‘recession proof’ businesses like Coles and Woolworths or their international equivalent because the theory was people still had to eat. In today’s digital world it’s the tech companies that are essential to our everyday lives. The volatile geopolitical environment has influenced investors too. Similarly, rising global tensions creates uncertainty so investors look at ways to invest their funds so that their capital is protected.

Then there is the allocation through the massive passive funds management industry. These funds allocate capital to replicate exposure to the index. While that is generally a good thing, offering easy investment options it is not without its quirks, biases, or pitfalls. The simple weight of money pouring in gives no consideration to valuations. At a time where a sector is disproportionately weighted these index funds simply pour fuel on the valuation fire and make the bubble worse.

All of this is important context to understand when looking at the market. The recent performance of the S&P500 has been skewed by the performance of a handful of companies. For investors who are older or who have less aggressive risk profiles, exposure to the S&P500 is no longer the diversified exposure to 500 industrial giants in the US market. Its composition has changed significantly and as such the risk investors take being invested there. Most investors have unwittingly increased their risk.

So, while we do have exposure to many of the magnificent 7 in our clients’ portfolios because they are great companies, we do not hold them at the same levels as they are represented in the index. When markets are doing well, investors become complacent and forget to manage their exposure to risk. While the recent surge in big tech may not be a bubble just yet, the distortion in the composition of the index makes it more important than ever for investors to be cautious and prudent in their allocation of capital; not only across asset classes but in considering the underlying assets you hold.

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.

The Bubble of Confusion

One of the more random books on my bookshelf at home is one I bought many years ago called “Self Defence in 30 Seconds”. The author, Robert Redenbach, is a specialist in teaching self-defence tactics. There are several passages that I think apply equally well to investing as they do to self-defence. He outlines the three phases of a pressure situation where you need to defend yourself as follows:

• Phase 1 The Error

• Phase 2 The Bubble of Confusion

• Phase 3 The Result

In his opening sentence he writes: “There are only two rules for self-defence: 1) avoidance and 2) survival”. Avoiding bad situations seems obvious but it’s possible you take a wrong turn and end up in a dark alley in the wrong end of town. This is an example of an error.

From an investment perspective, everyone is still underestimating the dark alley of high interest rates and debt. That’s the error. I would love for a soft landing to be a real outcome. For the economy and for share markets. But if history and my experience are anything to go by that is not how it usually plays out.

The bubble of confusion he refers to is a 30 second window you get where you’ve walked down the wrong street, and you realise you made an error. You’ve got 30 seconds to survive what happens next. Still on the first page he states:

“… It is a tactical error to believe that if you can’t defend yourself in the first 30 seconds, more time in the affray is going to help. It won’t. It’s like trying to save yourself from drowning: if you can’t do what needs to be done in the first 30 seconds, more time in the water is going to make the situation worse, not better.”

For investors, the best option is to avoid being caught in the error. But if you can’t avoid it be sure you are positioned to survive it. That means reduced exposure to downside risk assets and reducing or even eliminating debt. These situations evolve very slowly, they build up over years and they take longer to peak than anyone expects. Then it all happens very quickly.

For investment markets, as it becomes clear that inflation is coming down and the economy slows investors will enter their own bubble of confusion. They will celebrate a return to the good old days (2010–2021) as they anticipate a return to low inflation and low interest rates.

With US inflation at 3.2% and Australian inflation figures released yesterday down to 4.9%, prices are no longer increasing like they were a year ago. The reason for the confusion is that the set of economic conditions that occur as inflation falls look the same as the early stages of the economy entering a more severe slowdown including a recession.

I expect the next 6 months through to mid-2024 to see much of the world enter this bubble of confusion. Investors will latch on to the ‘good news’ of lower inflation before realising that its actually ‘bad news’ as the lower inflation becomes a lead indicator of a global economy starting to slow more significantly. Frankly, it’s better that this happens sooner. If inflation rears its head again later it only forces rates higher and defers the eventual ‘bubble of confusion’ phase, making the slowdown more brutal when it arrives.

Australia will be especially vulnerable with inflation that’s now ‘homegrown’ and a reliance on potentially economically hobbled China. It’s a question of whether the economy, once it slows, settles to a nice soft-landing phase (what the market expects) or if it falls off a cliff (not what the market expects). These events tend to drag on until a sudden tipping point where things decline rapidly as the bubble of confusion ends with a result.

The path to a hard economic landing often looks and sounds like a soft landing until it’s not. In fact, I recently read a headline in the Financial Review stating that investors are expecting a “soft landing recession” I don’t even know what that means. Investors, commentators, and governments will contort themselves in every way to sound optimistic.

Ahead of every crisis I’ve ever seen over the last 25 years, I cannot tell you the number of times that almost every expert or government agency provided commentary or opinions that the emerging event was not in fact a crisis or a problem. Once there is clearly a problem the message becomes ‘it won’t last long’.

To be fair, governments are tasked with maintaining order, so they are going to provide the advice that’s required to ensure the best overall outcome. Investment institutions are tasked with making money, so they are never keen to talk negatively about markets.

This is very often at odds with the best outcome for any individual investor. Those messages are designed to manage the masses. More often than not as a crisis emerges, those proactive first movers who act counterintuitively to the crowd, recognise the problem and act are better off than the person who sits on their hands and lets it happen to them.

It’s critical how you assess the data as it emerges, how prepared you are, and how quickly you act will determine your result. These basic principles apply equally to managing investments in an economic crisis as they do in self-defence.

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.

How Much Do You Need to Retire?

A typical client comes to us with a range of assets that they accumulated in an ad-hoc fashion over time rather than from the execution of a master plan. Not everyone who is wealthy is financially sophisticated. Often, they were just really good at what they did, whether that was running their construction or earthmoving business or being a great doctor or lawyer.

Most of our clients are not financial experts; if they were they wouldn’t need us. However, they are smart and recognise the importance of seeking the right advice to optimise their position. I’ve had people with tens of millions of dollars asking me if they had enough to retire. As much as it surprises me, it is a great reminder that everyone worries about the same types of things when it comes to retirement:

• How much do we need to retire?

• Do we have enough to retire?

• How long will my money last?

There is not one simple answer because everyone’s situation is different, but these are easy questions to address. In financial terms, the three questions above are all a variation of the same equation, the basic variables of which are income, expenses and capital.

But for the purpose of the general concept, simple numbers are the best place to start. If you require income of $250,000 p.a. to meet your expenses in retirement and a typical investment portfolio produces income of 5% p.a., then you’ll need $5,000,000 in capital.

If you have more capital than this then you’ll be fine. If you have less capital than this then you have a decision to make, and you can either reduce your expenses or you can deplete your capital. There is no right or wrong answer it is up to you. But you need to understand the numbers.

I can’t emphasise enough how important it is to understand the context here and the impact of even the most basic variables. If we change the assumption for the typical investment portfolio in the scenario above to, say, 2.5% p.a., then you’ll need $10,000,000 in capital to generate the income figure of $250,000 p.a.

With regards to dipping into capital in retirement, people tend to fall into two camps; those that are worried about spending any of their capital and those who are more concerned about trying to use it all before they die. My philosophy here takes into account real life, not just the financial side. When you’re 65 maybe you live for another 30 years, maybe you live for 2. But I’ll say this, life is short, and I have not yet seen anyone get healthier and more active as they got older.

The reality is that your first 10 years of retirement are going to be your best, so make the most of it. If you are 65 and have $3,000,000 in capital and you spent $50,000 from your capital to have an amazing holiday every year for 10 years does it matter that at 75 your capital has reduced to $2,500,000? Probably not. What if you don’t make it to age 75?

Obviously, the above scenarios are basic and don’t consider specific circumstances, tax, inflation, and whole range of other variables but the overriding concepts and philosophy still apply. For our clients we complete sophisticated financial models that include a range of assumptions around returns, inflation, tax structures and scenario planning to ensure they are prepared for the future and have peace of mind. Certainly, if the three questions at the start are keeping you up at night then it’s probably time to get that type of advice and start planning properly.

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.

The good, the bad and 2024.

With so much bad news out there in the world for investors to worry about there’s one key element that has been strangely missing so far. Sure, there is some good news which I’ve highlighted below, but there’s nothing in there that’s really driving share markets. What is missing, despite all the bad news, from geopolitical tensions escalating to deteriorating economic data, is the absence of the bad new turning into an ugly financial or economic crisis. That is what is really kept markets from falling. There have been a few times where issues have bubbled to the surface, such as the mini banking crisis in the US in March this year, and the UK bond & pension fund crisis in September 2022, but these incidents so far have been managed and curtailed before they escalate.  

Some of the good economic and investor news out there is that:  

1. Inflation rates across much of the world have fallen reasonably quickly from their peak.  

2. Unemployment has remained low signalling a robust economy. 

3. Home prices have been resilient on the back of a supply shortage. 

4. AI and mega tech continue to grow. 

5. You can now get a solid yield on government bonds and term deposits of around 5%  

6. US GDP unexpectedly high in Q3 at 4.9% 

7. I’d like to say that this list is not exhaustive, but I can’t really think of anything else. 

8. But by all means please let me know if I am missing anything. 

The list of bad or concerning news is longer and more serious: 

1. Interest rates are looking like they will be higher for longer. 

2. Volatility in the price of oil.  

3. Consumer spending is slowing. 

4. Bond losses mounting at banks, pensions funds and other institutions. 

5. The Ukraine war is nowhere near resolved. 

6. Middle East tensions rising and the risk they escalate and spread. 

7. China and Taiwan risk. 

8. China and tensions with the US and Australia.  

9. UK inflation is still at 6.7% with rates trending higher. 

10. Risk of fragmentation in Europe as interest rates increase. 

11. Energy shortage in Europe. 

12. Japan moving away from yield curve control on their bonds. 

13. US Federal Government runs out of money every couple of months. 

14. US Federal Government’s annual budget deficit is around USD $2 trillion pa.  

15. US Federal Government’s debt is now over USD $33 trillion. 

16. Mortgage stress in Australia with 30% in distress according to Roy Morgan report. 

17. US mortgage rates hit 7.5% for the first time since Nov 2000. 

18. Rising insolvencies and bankruptcies at the highest levels since 2010. 

19. Retail sector seeing significant declines. 

20. Office property sector struggling with vacancies and higher debt costs. 

21. Corporate debt cliff as company’s refinance at significantly higher rates. 

22. China’s economy struggling with massive debts and property losses.  

23. Corporate earnings forecasts too high and may be revised downward. 

There are two main concerns with the above list. Firstly, just the sheer number of areas that are currently problematic and heading the wrong way. Secondly, the real issue is that any one of the 20 plus items on this list can escalate into a genuine crisis. What has kept investors complacent and share markets resilient is that while there is a lot of bad news out there not much of it if any has morphed into an ugly crisis situation from an investor or share market perspective.  

I don’t believe that can continue in 2024. I think investors and share markets especially are underestimating the risks that exist in the global economy. The risk that any of these precariously placed bad new events deteriorate and become a major problems that compound other areas and lead to contagion. What’s more there is the ever-present threat of a black swan event, an event no one predicts, eventuating that shocks the system. The global economy has very little room to move now.   

For long term portfolio investors, many of these issues are related and link back to interest rates being higher for longer. Its critical to understand the massive implications this is having on the global economy now and into 2024. Understand the potential risks so you make decisions regarding asset allocation as required and so you are able to take advantage of the opportunities ahead as the cycle progresses.  

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.

Are bonds back?

Normally government bonds are boring, but if you’ve followed the bond market over the last couple of years, they’ve been anything but. Not in a good way either. As US bond yields moved from effectively 0% to now 5% it has created huge losses across the world. Those holding those losses include some of the world’s best investors and biggest institutions. Some of the world’s biggest banks and pension funds are sitting on hundreds of billions in losses. Luckily at this point, not many have had to realise these losses but make no mistake they are there, and they are potentially a problem. 

The higher bond yields go though, and the closer they get to a peak, the more compelling the case for investing in high quality fixed rate bonds. For our portfolios we hold overweight positions in defensive assets already but its primarily made up of cash, term deposits and floating rate bonds and notes. The question becomes whether bonds are becoming more attractive than those assets and indeed whether they are becoming more attractive than equities on a risk adjusted basis. When you consider their much-improved income there is a case emerging for increasing the allocation to high quality low risk bonds. 

During the period of extremely low interest rates, I strongly recommended against holding fixed rate bonds in investment portfolios. Rates at almost 0% were a historical anomaly that were never going to stay that low and when they eventually went back up, the value of bonds fall. Meanwhile, investment managers everywhere seemed to be blindly allocating to bonds as a defensive asset when a unique set of global factors collided to create a once-in-a-lifetime bubble in bond prices.

Who can forget the weird anomalies that the era of super low rates created for bonds? There were the 100-year bonds issued by Austria paying less than 1% pa (they’ve since lost as much as -70% in value. But don’t worry if you hold them until the year 2120, you’ll get your money back). Crazy stuff. Then there were the bond yields for countries such as Germany, Sweden and Switzerland who saw the yields on trillions of dollars of their bonds go so low that they went negative for a period of time. Investors actually paid these countries to hold their money for them. Madness. It was always going to end in tears as soon as a level of normality returned. 

That’s where we are now as far as bond yields go – more normal bond yields. Not much else in the world is normal right now but that’s part of the turmoil ahead as the world adjusts to these changes. However, with bond yields having increased so much it is now time to step back and reconsider fix rate government bonds as an investment. The case for bonds is starting to become attractive on both an absolute return and a relative basis. I expect money from equities will soon enough start flowing into the bond asset class in a substantial way. 

You can now get 5% from US Government bonds, still considered to be the global benchmark for a risk-free investment. What it means is that every other investment needs to pay you more than this to be worth your while. How much extra will depend on the type of investment and the level of risk associated with it. For other countries bonds its similar rates but heading higher, for higher quality corporate bonds it’s more like 6-8% and for lower quality companies more like 9-10%. 

If, like me, you are bearish on the stock market and believe we are still headed for a recession (my base case) or a deep recession (possible) then the case for bonds is becoming more compelling. The more the economy slows, the more likely it is that governments need to lower interest rates down the track. In that case, falling interest rates will deliver bond investors a further gain as bond values increase. While I think there is economic and financial pain ahead for investors if interest rates across the world staying higher for longer, there is a positive for investors as bonds emerge as an opportunity.

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.

AI End Game

This is a partial warning as much as it is my simple and developing view on Artificial Intelligence (AI). It is one of those transformative technologies that has now progressed to the point where I don’t think it’s possible to put the genie back in the bottle. Perhaps its timely that a movie such as Oppenheimer, detailing the Manhattan Project and the creation of the first nuclear weapons has recently been released. It should serve as a cautionary tale for all those blindly espousing the virtues of an AI world as it has the potential to cause great harm and negatively change society as we know it.

I have previously written about the exciting investment opportunities that AI brings to the world. However, I am also convinced that from an existential perspective, in my opinion, AI is also the single biggest threat that the world faces today. More serious than climate change, more serious than nuclear war. Those matters are within our control as humans. AI and its progress from a certain point in the near future are not.

The world is at a similar point to where it was back in WWII when the Manhattan Project commenced. Back then it was the possibility that the Germans may have access to or may soon be able to develop nuclear weapons that lead the USA to actually create them.

Ironically, the best strategy for defending the world against the potential weapons led to the creation of those very weapons of mass destruction that cannot be reversed. But what if the USA didn’t create them, quite possibly it ends up later down the track being something that Germany did create. What happens then? That’s the alternate argument for what happens if we don’t progress with AI hard.

If I sit back and forget the obvious economic and investment opportunities and consider the future of the world (probably something worth thinking about), I am certain that the advancement of AI will lead to catastrophic consequences for humans. The prospect of a dystopian future might sound like science fiction until it happens, then it’s simply called science. It doesn’t keep me up at night because it’s not something any of us can control. The cat is out of the bag.

But unlike many who see the potential for catastrophe, I do not necessarily believe we should overregulate or slow the development of AI. The reason for this is that other countries will not slow down in their development of AI technology. Similar to the rationale for the US racing to create nuclear weapons before the Germans. Whether it’s Russia or China, in a similar vein to the development of nuclear weapons, the risk that enemies advance more quickly is the bigger threat.

AI is more dangerous in an existential sense for the human race simply because we risk not being able to control it once it becomes more advanced. This is self-learning technology, so the technology will advance exponentially to human level, and then beyond to the point where humans become redundant. That day will arrive at some point in the future, whether it’s 10, 50 or 100-years’ time, I don’t know, but it will certainly arrive. When it does, do we want that technology to be a western influenced AI or one that’s been designed and developed in Russia or China?

If AI once debased from the control of humans can cause bad consequences for us, then it stands to reason that it can also create good. So, if we apply the same game theory to this as we did to the development of nuclear weapons then the answer is to move as quickly as possible so that whatever the result it is a consequence that we control as much as possible before others do. It’s the best available decision based on the fact enemy nations may otherwise create the AI that controls the world.

It’s important to note that while for years mutually assured destruction is the theory that has kept the world’s nuclear powers from starting a nuclear war for the past 70-plus years, that will likely not apply to the world of AI. The strategy must move quickly with investment in AI technology from government that can counter the rising danger of AI from enemy nations at the same time as developing AI for the benefit of the world. It is not the best solution, the best solution would be to stop it altogether, but that is unrealistic. It may be counter-intuitive, but I believe the best practical solution is to move as quickly as possible and build the AI resources that can combat those who would do us harm.

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.

Setting Up a New Portfolio

As I speak to our clients and podcast guests, I continue to see extraordinary business owners who are fantastic at running their business but who’ve never managed investments before. It’s a completely different ball game and it can be daunting. You need to learn, but who do you learn from? When you don’t know how to do something the most difficult part is working out who does. I strongly recommend reading books by the very best in the world. But even then, investment philosophies vary so greatly that what works for one investor doesn’t necessarily work for another.

The first rule is to keep it simple. If you’ve been successful in business, you know how to bring information together and make decisions based on what makes the most sense. So, keeping it simple means only doing what makes sense to you. Importantly, it means don’t make investments you don’t fully understand because you think the person telling you to do it knows better. No one cares about your money more than you do. So, it’s critical to understand the investment and the rationale behind the advice. Sayings like ‘If it sounds too good to be true it probably is’ might be a cliche but are also true.

Those that sell their business suddenly have a large amount of capital to invest. Ironically, while that kind of generational wealth brings with it security, it also brings a high level of anxiety. Founders are suddenly confronted with the prospect of not only making investment decisions they often haven’t had to make before, but they are also acutely aware that in many cases this money, regardless of how much it is, is all they have. It’s a very different mindset when you transition from a business owner making millions of dollars a year in profits to an investor where the amount you’re investing is the amount you have for the rest of your life.

Whether you have $10m, $100m or $1b to invest, the process is very similar, especially in such volatile times. In these situations, invest slowly over time. Regardless of how great the investment opportunities are or how great they seem, take your time, and invest progressively. This is simple but an important part of mitigating the risk of markets falling substantially after you invest. Of course, it can work the other way too and markets can jump up but in the current situation, there is more risk to the downside than the upside. But when you are setting up your family for generations, taking months or even years to fully invest protects the downside while ensuring you have funds available for opportunities that may arise in unique situations.

From there it’s a matter of structuring your investment portfolio for the long term. Rule number 2 is to diversify your risk. Diversification across asset classes such as property, shares, bonds, and cash are critical. But so too are the underlying investments within each of these sectors. Spread your risk because when one asset class performs poorly, you expect the others to have performed well and offset your losses. While diversification within an asset class is similar, if you hold 20 stocks and you have a couple of poor performers, you’d expect the good performers to mitigate this. At its most basic level, it ensures that if an investment fails you don’t have too much of your portfolio in any one asset.

So, keep it simple and ensure that you understand the investments you make. Don’t make an investment because everyone else seems to be doing great investing in it. This is the dumbest reason to invest, and I’ve seen more people lose money from investing in these ways than anything else. Diversify, across asset classes and then further in specific investments within those asset classes. Average in over time to hedge your timing risk, especially when investment markets are uncertain and overvalued. 

Lastly, you need to be able to sleep at night. That is the final test, can you sleep at night with the investments you have? If you can’t then it’s either because you don’t understand your investment properly or you’ve taken too much risk. Always make sure your investments pass the sleep test.

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.

How We Are Investing in the AI Boom

From both a business and a lifestyle perspective, AI is the single most exciting technological development I’ve ever seen. It will be the biggest game changer in the history of the world. Not only will fortunes be made here but it’s going to change our lives in so many ways. There are going to be massive gains in productivity and huge reductions in friction in every type of daily task. If I was a young person looking to start a business, it would be in the AI field. If you are in business, you need to be looking at incorporating AI or you’ll be left behind. It is genuinely revolutionary.

But what is the best way to invest in AI from a long-term portfolio investor’s perspective?

How you access this theme depends on the level of risk you are willing to take. For most investors, there are 4 common ways. I utilise 2 of these in our portfolios and 2 I steer clear of.

• Big tech companies

• Listed AI companies

• SPACs or Themed ETFs

• The broader market

The big tech companies are seeing the most immediate impact in share price movements as the market grasps the enormity of the opportunity and those who are poised to benefit the most. The big tech companies such as Microsoft, Alphabet, Amazon, Apple, and Meta have broadly seen a resurgence on the back of this theme. Most of these companies are great businesses and we hold them in our client portfolios. Right now, for a few reasons they are probably close to fully valued though. While the AI angle has driven share prices up the bigger factor is the flight to safety. In times of uncertainty, the big tech stocks have replaced consumer staples as the ‘recession proof’ businesses for investors who believe consumers will continue to use their products no matter what. Similar sentiment drove their prices up in covid too.

Listed AI companies are all the rage right now and most of them are speculative, expensive and will likely fail. I see this every time a new technology arises from the internet dotcom boom and bust in the late 1990’s and early 2000’s through to the crypto and NFT boom and bust more recently. The key point to recognise is that just because a technological theme is real or going to change the world it doesn’t mean all the companies in the space will. This will play out just like those booms and busts before them. There will be some companies that will flourish and will be what Amazon was to the dotcom boom and bust. But it is really difficult to find individual winners in an emerging technological theme. It takes a massive amount of capital investment to get a technology into the mainstream, very few win, most will lose. Go back as far as you want from air travel to the automobile, it’s the same story. For these reasons, we avoid direct investment in listed AI companies in the early phases.

Similarly, Special Purpose Acquisition Companies (also known as SPACs) and Exchange Traded Funds (ETFs) are often created by fund managers in one way shape or form to provide investors access to a theme that is popular. They raise funds and invest in many different companies or shares within a theme on behalf of investors who don’t have the necessary expertise themselves. However, I’ve seen these types of structures surface in different forms over the last 25 years and I have rarely seen them work in practice. Managers charge huge fees and hold millions of dollars in cash to invest in the popular theme, it collectively drives up prices and the funds end up having to invest the funds at overinflated prices in lots of companies that ultimately fail. The theory of diversification to access the theme doesn’t seem to work as well as promised when it’s a new technology. I would avoid these structures and investment vehicles.  

Lastly, AI’s impacts across all industries will see many untapped areas for long-term investors to access the benefits of AI in the same way that worked for many in the internet boom. The introduction of the internet didn’t just provide great results for technology companies, it was ultimately adopted by almost every industry and delivered incredible benefits for revenue, productivity, and cost reduction. There are many examples of this. Just think about the way the banking industry has changed in the past 30 years. There are many blue-chip companies that integrated the new technology and remain blue-chip companies today. But there are also many examples across so many industries from entertainment, retail to newspapers and travel that didn’t and ended up going bust. This is where the real theme of AI will benefit investors over the next decade. Understanding the existing industries that will benefit and those that will be disrupted is key, and then the impact on all the individual companies in your portfolio. It will be just as important to avoid the losers as it is to pick the winners.

The most important thing to remember as an investor is to be patient even though everything seems to be moving fast. AI technology is still in its infancy and as exciting as the opportunities are right now it’s very uncertain and going to be very volatile along the way. Some businesses will be too early, some won’t execute, and many will fail. But make no mistake, this will be a massive opportunity for more than a decade. It is still super early, and AI’s capabilities are going to grow exponentially over the next several years. This is going to be a truly once in a generation opportunity that will manifest over many years in many ways, many we can’t even envisage yet. So become familiar with AI and learn about it because it will impact every company in your portfolio in one way or the other in the years ahead.

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.

Why I’m Selling this Rally

In a world beset by geopolitical tensions, high inflation and interest rates, banking collapses and uncertainty, the stock market has been surprisingly resilient this year. So far in the calendar year 2023, the Australian stock market is up 3.8% while in the USA the S&P500 is up 6.9%. The NASDAQ is up an astonishing 19.4%! That’s more than resilient, that’s almost a bull market. Now obviously stock markets are still well off their highs of 2021, but it does highlight the difference between what is evolving in the global economy and how stock markets are reacting.

I’ve said before that the share market looks out 6 to 18 months ahead of current economic issues. So, does this recent rally indicate that the market is comfortable with where the global economy is heading? I think the answer to that is a simple no. I also think that there is so much uncertainty in the world right now that the usual playbooks have been ripped up and it’s almost become every investor for themselves. Investors are confused and there is little advantage in knowing what others are doing because, well, they are probably wrong.

The big question is are we through the worst? I think that’s unlikely. I think we are only getting to the end of the beginning. As tricky as the last 12-18 months have been, the real economic woes are yet to play out and until we have that phase underway, share markets will continue to be confused. Right now, that confusion has resulted in stocks being higher than they probably should be. I believe this is an excellent opportunity to sell further and add to the cash in our client portfolio’s.

While share markets have been relatively resilient, we are seeing real volatility in markets that are traditionally very stable. For example, the yields on 2- and 10-year US bonds have been moving up and down like a yo-yo in response to the re-rating of risks from bank collapses to inflation expectations. The yield on the 2-year US bond has moved from 4.06% to 5.05% and back to 3.79% over the last 10 weeks. These are incredible moves that are anything but normal. It highlights the conflicting nature of much of the data coming through and just how difficult it is to get a read on critical data. How the data ultimately plays out will determine the direction of both the economy and the share market.

I am still convinced that the share market will pull back as it becomes clearer that we are heading into a global slowdown. I expect the market to retest those lows of 2022 and possibly head lower. To me, there is so much evidence that points to a slowdown that I think it’s prudent to sell further into the current strength we are seeing in the share market. It’s impossible to know where markets go in the short term so you can only ever make decisions that are prudent for the long term. Cash remains king. If the market continues to go up after we sell a little, I am more than happy to sell some more.

As resilient as the share market has been I don’t believe that this is an accurate reflection of where the market should or will be. One of the simplest tests for whether you have enough cash when you enter a downturn is how you feel as the market falls or when the next crisis arrives. Are you excited because of the opportunities you see becoming available or are you worried as markets fall? If you’re feeling nervous, then that’s a pretty good sign that you don’t have enough cash.

Our current focus for our client portfolios is weighted to protecting capital and minimising losses in the event of a market downturn. This is a unique time in the history of the world. There is really no precedent for the current situation and so it is difficult to predict how badly the global economy will be impacted. A lot of this is mitigating those risks and being ready. It is not about making money right now; it’s about protecting it. If in the next year or so the world has muddled through and it turns out there is no major downturn, then that’s great. There will always be opportunities to make more money when times are good or at least more predictable. But in the next year or so we will know for sure just how all the current events and variables have collided and their impact on the global economy. Sometimes treading water is what you need to do to ensure you survive.

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.

Balaji’s Bet

Amidst the emergence of the banking issues, US entrepreneur and former partner at prominent Silicon Valley venture capital firm Andreessen Horowitz, Balaji Srinivasan made a very public bet on Twitter. He bet $2m that the price of bitcoin will go to US$1m in 90 days. Given the price of bitcoin at the time was about US$26,000, it’s an aggressive bet and it certainly gained a lot of attention. The good news is that we will know very quickly just how clever he is. The bad news is that if he is right then the world is in far more trouble than anyone is prepared for. I’ve had a few people ask me about this, so I thought I'd provide my thoughts more publicly. 

Over the past decade, Balaji has amassed a huge following in tech and cryptocurrency circles. He also gained prominence over the past few years for his predictions on a range of topics including how Covid would play out. He is a smart guy and is very influential within the tech and VC space. His views on the banking system and the pace of change are extreme. His rationale for his position is his prediction of imminent hyperinflation, his concerns around the bond losses the banks hold and ultimately the collapse of the USD. He views bitcoin as the likely replacement.

For the record, I think he’s completely wrong for several reasons but it's worth exploring his rationale and the counter points. Financial markets are always a melting pot of diverse views and sometimes the most unusual perspectives prove to be right. Considering different viewpoints in a critical manner is always worthwhile even if it is especially unusual or extreme. It’s always worth understanding the rationale behind someone's position.

Firstly, in the short term, a US banking crisis is likely to be deflationary rather than inflationary. The real risk for the economy right now is if banks tighten their lending criteria and start to hoard cash for their own liquidity. That potentially starves businesses, consumers and the economy of the capital that generates economic activity. This would more likely lead to an old-fashioned credit crunch which would hammer economic growth. So, an escalation of the banking crisis he predicts is not inflationary at all and may well ‘cure’ the inflation problem. 

Secondly, in anticipation of a credit crunch or recession, the impact on interest rates is more likely to change from rate rises to cuts very quickly. The bond market is already telling us rate cuts are coming with 2-year bond yields dropping from about 5.05% to 3.94% in a matter of 3 weeks. Bond markets are now pricing in several rate cuts in 2023 even though the Fed’s position is that this is unlikely. The implications are that the tightening in the banking sector is effectively acting like added interest rate hikes which will further dampen inflation. The hyperinflation argument seems extreme and unlikely. 

Thirdly, any interest rate cuts would quickly erase a sizeable part of the unrealised bond losses that many institutions are carrying on their balance sheet. These unrealised bond losses are a big part of the problem at the banks, and a central part of the Balaji thesis. Whether interest rates come down due to market forces or because the Fed deliberately changes course is largely irrelevant. If interest rates do come down, it will reduce the bond losses that banks carry, which will alleviate the pressure on the bad bond investments in the banking system.

The unrealised bond losses are a significant issue for banks, but it's not necessarily the existential issue Balaji seems to fear. The US govt can simply choose a different interest rate policy. If push comes to shove and the Fed must choose between addressing a bigger issue in the banking system or inflation its likely they choose the biggest immediate threat. That would mean dropping rates due to banking issues and dealing with inflation later.

While there are not many tools at the disposal of the Fed to fight inflation, they have lots of tools to deal with bank issues. In the face of Bitcoin appearing as a threat to US hegemony, I would say that laws in the US would change rapidly. I'm not saying that’s a good thing but I'm a realist. As great as all the tech and VC gurus think bitcoin is for the future of a utopian world, if it’s a threat to the US and its dominance, they will restrict it and suffocate it, or even make it illegal if needed. I would not underestimate the US govt ability or willingness to protect itself by any means necessary if its position is threatened.

While I do think cryptocurrencies may be the future of money, I am not convinced that it will be bitcoin. Even if it should be, the control of the monetary system is far too important for governments to relinquish control. Additionally, there is a major risk in holding bitcoin that it has no intrinsic value and that its price is simply determined by the flow of money in and out. If a more technologically advanced and energy-efficient cryptocurrency ends up being adopted, then bitcoin will end up worthless as everyone moves across to the new coin. 

I think that Balaji’s prediction is a combination of self-promotion combined with limited downside risk. He knows that as money moves out of banks, some will certainly find its way into bitcoin, limiting the downside risk, while all the publicity and uncertainty puts upward pressure on the price. Overall, I suspect as part of the Silicon Valley clique that is very bullish on cryptocurrencies and exposed directly to the collapse of Silicon Valley Bank that he’s just a little too close to the situation to see the forest for the trees. A little like a conspiracy theorist who goes down a rabbit hole and continually reaffirms their theories in an endless stream of combined confirmation bias and group think. 

What’s certain is that you’ll increasingly hear and read these types of Armageddon predictions as the global economy head into recession. But there is an enormous difference between a recession, even a bad one, and the type of predictions the most extreme people will start to espouse. In times of uncertainty fear mongering escalates and is an easy way to grab attention and headlines.

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.

Lowe needs to go.

When you’re in the top job in any organisation if you don’t get it right, you’re out. Whether it’s the coach, CEO, or Prime Minister, they are the first to go when things go wrong. So, it’s beyond comprehension that after getting it so wrong so often that Phillip Lowe is still the chairman of the RBA (Reserve Bank of Australia). He got it wrong on inflation. He got it wrong on rates. He got it wrong when he told the Australian public as recently as 2021 that rates won’t go up until 2024. He’s getting it wrong again now. He is still hoping that inflation is transitory. Even in his speech today he’s indicated a pause in rate rises as soon as May. Yet with interest rates at only 3.6% following yesterday’s interest rate increase, there is a long way to go before the RBA tames inflation at over 7.8%. 

Here's the thing. If you’re too tough on inflation you can drop rates quickly but if you are too soft on inflation and it becomes entrenched it’s a recipe for economic disaster. I appreciate that many of the initial drivers for inflation have been on the supply side and there isn’t much the RBA can do about that. However, inflation is an insidious cancer. If you don’t do everything to remove it, it will find its way into other parts of the economy. This is a genuine concern. This is already happening in the USA where as recently as January it was thought inflation was starting to be tamed. Yet just a month later, data has shown it is likely to re-emerge. Many say Lowe’s doing too much, but everyone continues to underestimate inflation. I don’t think he’s done enough. 

After some horrendous missteps, Lowe now seems more worried about managing expectations rather than inflation right now. Why else would you increase rates by only 1.25% over the last 6 months and say there is still more to come? The RBA are compounding their initial mistake of being far too slow to act by now being far too slow to raise rates. Their argument that it takes time to see the economic impact of rate increases would have been better served by front-loading the rate hikes and doing 0.5% in Oct, Nov and December 2022. It’s a slightly higher overall increase but now they would have had 3 months to observe the effects instead of still talking about what theoretically may happen. 

If Lowe thinks there are more rate increases to come, then get on with the job and increase rates by the amount needed to make an impact. We should have rates at well over 4% right now. There’s far too much mollycoddling all around in my view. If people with mortgages are going to suffer financial pain because they listened to him the first time and borrowed too much, then so be it. That’s how markets work. There’s too much trying to signal intentions and too many cleverly crafted speeches for people to interpret the language. He’d be better off playing it with a straight bat. There are winners and losers. It’s not his job to worry about consumers’ feelings or mental health, it’s his job to manage inflation and that means making the hard decisions that are needed. The overall consequences will be worse if he delays. 

There are really two ways to kill off inflation, the first is by raising interest rates. By doing so Central Banks seek to increase borrowing costs sufficiently that it reduces spending, dampening demand for goods and ultimately slowing the economy and the pace at which prices go up. There is a second, less common solution and that is simply inflation itself. If left to run rampant inflation eventually leads to demand destruction for goods and services resulting in a similar effect to that of rising interest rates, except it's uncontrolled. 

I’d liken raising interest rates to the back-burning of forests. Back-burning results in deliberately burning forests in a controlled, planned manner that is designed to mitigate a disastrous bushfire that engulfs everything. Letting inflation run wild is the equivalent of an out-of-control bushfire with no back-burning. Central banks slowing or pausing rate hikes in anticipation of a slowing economy is the equivalent of not fighting a fire because you hope there is rain coming. Maybe it does, maybe it doesn’t but you can’t afford to take the chance. You fight the fire with everything you’ve got while it’s burning. 

What we’ve got currently are the most difficult set of inflationary economic pressures in 40 years. There is no easy solution. The reality is either way there is going to have to be pain here. Either it’s the pain of inflation or the pain of rate rises. One results in controlled inflation, and one doesn’t. The fact that raising rates will cause many financial pain and hardship does not mean it’s the wrong path. That soft approach to dealing with economic problems only leads to a bigger problem later. At the first sign of pain, the outcry leads to short-term fixes, not long-term solutions. 

Lowe has repeatedly shown he is not capable of getting the basic decisions right. Nor has he been able to navigate the political tensions that arise with making conditions tougher for the economy in the short term for its benefit in the long term. He didn’t take the pain early and now whichever way he turns there is a bigger problem. Conveniently for the Government, when public outrage hits fever pitch later this year because either inflation is too high, or interest rates are, it will be Lowe’s fault. So, the government will not remove him until it is politically necessary. Regardless of that, Chairman Lowe has got it wrong too many times and needs to go. 

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.

Are Industry Funds a Trojan Horse?

With one announcement Prime Minster Anthony Albanese and Treasurer Jim Chalmers have not only reignited the ‘super wars’ they have also signalled their willingness to compromise the integrity of the superannuation system for political gain. Their proposal to tax funds over a $3m cap at a 30% tax rate is a blatant tax grab and moves the goal posts on those who have invested in good faith. The government is now specifically targeting people with legacy funds that have been operating within the rules for decades. It highlights a very real and much bigger problem brewing within the superannuation system and the underlying control of these funds.

Most will understand the Labor Government’s links to the trade unions at a grass roots level and their influence behind the scenes within the political regime. Over the years it’s fair to say that both political parties have seen their traditional power base change somewhat. But while the Liberal Party’s struggles to redefine itself are well known; most Australians are probably not aware of the power shift within the political landscape as it pertains to the Australian Labor Party today. Regardless of your political leaning, most would agree that a balance in power is healthy for a strong democracy. So, it’s important that people understand how the new powerbrokers are influencing the change in the political system.

Industry superannuation funds have grown to become the dominant force in the superannuation industry. Their marketing has been excellent, and workers have been drawn to them. Low-fee funds run on behalf of members of particular industries. They sound great in theory but as with anything, when power is too concentrated, it’s potentially a problem. Today, in my opinion, the industry super funds have quietly become more powerful and influential than the trade union movement ever was. The big difference between the unions and industry funds is that the amount of capital controlled by these funds is now approaching $1 trillion dollars.

The industry funds history stems from being the default superannuation fund for various industry sectors such as Hostplus for hospitality workers, REST for retail workers and UniSuper for higher education workers. To this day, there remains requirements for “Equal Representation” governance which broadly means that the superannuation fund trustees must include an equal number of directors nominated by employers or representatives of employers, and members of the fund or representatives of members including trade unions.

The more I hear the current government talk about superannuation, the more it appears to me that a level of political ideology is increasingly becoming entrenched in the superannuation system. Superannuation was always for the purpose of investing for retirement. In fact, this aspect was considered so important that there was a piece of legislation that became a cornerstone of governing superannuation funds. The Superannuation Industry (Supervision) Act subsection 62 includes a test called the sole purpose test. It literally defined that superannuation was required to meet this definition, being that superannuation funds are for the sole purpose of providing for retirement and death benefits.

Fast forward a couple of decades and I see Industry Super Fund ads in the media not talking about superannuation investment but rather about the infrastructure projects and jobs being created for everyday Australians. Well, that is very noble, but it has nothing to do with the purpose of superannuation. The obligation on the trustees of all superannuation funds is on managing the money and generating returns for superannuants for their retirement. If there are better returns elsewhere jobs have no place in the discussion and should not even be a consideration.

Now the Labor Government is pushing for changes to redefine ‘the objective of super’. Why? There may be a few reasons. Various proposals push for superannuation to access impact investing in lower-cost social housing, infrastructure, clean energy, and aged care. Many of these are government and political objectives not based on the best investment decision. There should be no crossover, it’s a dangerous and slippery slope. While there are robust governance and rigour in place around these massive pools of money being used to fund projects and create jobs, it’s critical to ensure that there is never any room for the lines to be blurred and for problems to evolve in the future. Superannuation should never be a political weapon. It’s not the government’s money, it’s the retirement savings of hard-working Australians.

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.

The Market Ahead in 2023

In recent months, share markets have been relatively resilient and some of the bear market fear has dissipated. So, is the worst of the share market turmoil over and is it time to buy?

The short answer is no.

My view remains that this market has another big move down ahead. How I think the market and economic events unfold over the next 12 months is this. Europe continues to fall into a deep recession for all of 2023. The US goes into a recession too. Ultimately dragging the rest of the world’s economies into a recession. My priority remains protecting investors’ capital. I am prepared to miss out on short-term gains by being under-invested if I am wrong. In my opinion, this remains one of those periods in time where protecting the downside risks is significantly more important than any potential opportunity. It is prudent to be cautious in this environment. We will still have our capital intact and can invest in great opportunities in due course. What I don’t want to do is invest too early when sentiment is overly positive because everyone wanders back outdoors in the eye of the storm. The real economic storm is still ahead.

In 2022 all the talk was about inflation and interest rates. That will continue in the early part of 2023 as central banks around the world are forced to over-tighten and create deeper problems. My view is that in 2023 the key topics will become company earnings, global recession, and unemployment. Unlike any previous downturns in the last 20 years, where constant bail outs and money printing supported markets, government’s hands are tied this time around. Countries around the world will simply need to endure an economic downturn the old-fashioned way, take some pain and come out the other side with a better foundation for future growth. It’s not the worst thing that can happen and frankly, if we’d all faced up to a couple of downturns in an organic way, we’d be far better off right now.

But in any case, if Europe and the US are in recession, and China continues to battle covid then it’s difficult to see how Australia avoids an economic downturn in 2023. I know everything seems pretty good now and it doesn’t seem like we are anywhere near a recession, but a downturn is heading our way. When you look at how the world is positioned, a deteriorating global economy is pretty obvious. The problem for most investors in accepting the impending economic reality is that there is a major difference in what we all see and experience right now in our daily lives versus what we can’t yet see and experience in the near future. Overlay what most investors optimistically want to see and it’s often only when things are undeniably bad that it’s finally accepted.

Over the next 6 months, I think we see corporate earnings deteriorate and consequently real cost-cutting across the board. Then the job losses really start to kick in. First with European companies, then the multinationals with significant exposure to Europe, before flowing through to the rest of the global economy. They have started in tech already but will become mainstream in due course. The tricky part for investors will be when we start to see inflation fall, share markets will start to celebrate the return of low interest rates. That’s going to be a monumental head fake for markets as the dream of a return to lower inflation and lower interest rates becomes an economic nightmare in the form of a global recession. In 2023 the downturn will get real. The real economy will start to suffer. That’s when stock markets will enter the final phase of this bear market and crash back below the lows of 2022. If inflation stays persistently high, it will only make the downturn worse.

That said, there is an important distinction to make here between the share market and the economy. I expect the economic situation across the world to deteriorate for most, if not all of 2023. But while I expect the share market to fall significantly as the economy weakens, by mid-year, investors will be looking ahead to how the global economy will be starting to recover in 2024. Share markets don’t wait for the actual economic recovery, they are looking 6-12 months or more into the future. So, while I expect more share market pain ahead, the real buying opportunities will present themselves around the middle of 2023, as the deteriorating economic situation is still unfolding. Take note of that because the time to be bold and buy stocks is when it feels like the economy is starting to look quite bleak, but before the economy is at its worst.

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.

Even Keel: What investors can learn from Lebron James

You can learn a lot by watching the highest performing people when they are under extreme pressure, regardless of their field. Their words, their actions, and their body language. In the 2016 National Basketball Association (NBA) playoffs, Lebron James and the Cleveland Cavaliers were down 3 games to 1 in the best of 7 finals series. No team had ever come back to win the NBA championship from such a deficit. In his media interviews when asked about his performance, good or bad, Lebron continued to emphasise the same two points I had heard him repeat in almost every interview throughout the season. He would say:

“I don’t get too high or too low, I stay even keel and will just keep working on my habits.”

To start with, it seemed like the usual ‘athlete talk’ to the media, keeping it simple and not giving anything away as they are trained to do these days. But over the course of the year, it became increasingly clear that this is what he lived and breathed. This insight was as simple as it was profound. He didn’t waiver and led his team as they won the series 4 games to 3 in one of the greatest comebacks in sports history. This is the mindset that makes him one of the greatest basketballers of all time.

Hearing these comments consistently, in interviews during the season and playoffs from one of the greatest athletes ever, highlighted to me what it really takes to perform at the highest level in both the good times and the bad times. The key to performing under pressure isn’t what you may think. It’s not about the spectacular, it’s about the consistent. It’s not exciting, it’s boring. It’s not about the score, it’s about the process and the discipline. If you get that right, if you play the right way, then the score board will eventually take care of itself.

From a psychological perspective, we can learn a lot from elite athletes in managing our own temperament as investors. It’s human nature to get caught up in the hype of the economic good times. Regardless of the macro-economic environment that created it, we expect that is the new normal rather than a boom. Conversely, when the eventual downturn comes, we become overly negative as we see that ‘new normal’ evaporate before our eyes.

As difficult as the past few years have been for everybody, firstly with the pandemic and now moving into an economic downturn and a range of global issues, staying even keel, and working on your winning habits and process are more important than anything else. Remember that nothing is generally as good as it seems and nor is anything usually ever as bad as you fear. There are only certain things you can control, and they are the areas where you need to focus.

So, while I can see there is an ever-growing list of challenges that the world faces the best way to approach it is to be pragmatic. It will not be as bad as many fear and at some point, we will come out the other side to better times. I will always be optimistic about what the future holds for us as investors and for the future of the world more broadly, regardless of how difficult conditions feel. But in the meantime, there is work to be done so we may as well just get on with it. There will be great businesses that emerge from the toughest times, and great investments to be made too.

Stay even keel and keep working on your habits.

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.

Cash is still king (for now)

Right now, we are in one of the most unusual times for investors in history. The reversal of easy money as inflation bites for the first time in over 15 years has made managing money especially difficult. Where do you put your money? Where do you hide? There is no simple answer. Almost every asset class is going backwards. Shares down 20%. Bonds down 12%. Fixed corporate bonds down almost 20%. The property fall is starting now that rates are rising. None of these are great returns when considering where to deploy cash, so we wait and continue to hold a significant portion of our portfolios in cash.

Why do we hold so much cash? When you’re getting somewhere between 0%-3% and inflation is 5.1% it’s still not a great option. In real terms you’re going backwards. But where else would you rather be when every asset class is falling? In the past 6 months cash has been easily the best performing asset class. While other asset classes continue to fall and opportunities emerge, I still believe it is very likely many of those same assets will be cheaper in the next few months. So, while we look forward to investing our cash as soon as possible, there are very few places to deploy funds right now.

One of the lasting lessons I took from the GFC 15 years ago was that the most experienced investors and companies were not only in great shape going into the downturn, but they also used those times to buy assets at prices that were previously unimaginable. In the midst of a once in a generation economic collapse, while everyone else was worried about survival, they were able to take advantage of a once in a generation opportunity to invest when no one else would or could. There were many examples but there were 2 deals that stood out to me at the time. 

The first, was Warren Buffett coming to the rescue of the banking system in the fall out from the Lehman Brothers and Bears Sterns collapses. He invested US$5 billion in banking giant Goldman Sachs. But he didn’t just invest. He structured the deal on terms completely in his favour. He bought shares at record a low price, but they were structured as preference shares, so he was higher up the security chain and also received a 10% interest pa for his investment and a range of other options in the agreement. He had the cash available when it was needed most and was able to negotiate the terms he wanted. 

The second, was the Commonwealth Banks acquisition of BankWest for $2 billion. Only the most unusual of circumstances made this deal possible. Firstly, HBOS (Halifax Bank of Scotland) was on its knees and desperate to raise cash through asset sales for its own survival, so it was very unusual to have a forced seller of that sized asset from such a large owner. Secondly, in normal times there was no way that deal was getting past the competition regulator. But in times of a complete breakdown in the system these things don’t matter as the integrity and function of the market overrides everything in an emergency. US banking giant JP Morgan completed similar deals in the US. The strong get stronger.

What I realised then was that in times of genuine crisis is where the greatest deals of your life are made. Deals that would otherwise never be available. It was also noticeable to me that the main deal makers were the old investors who had seen multiple market down turns. They understood that being prepared and patient was key, and they moved in when others were desperate and almost no one else was buying. There is no benefit in heading into a downturn fully invested or worse, highly leveraged. That is more likely to put you on the other side of the deal equation and ending up a forced or distressed seller. These deals are only available to those who are prepared and waiting for the opportunities to unfold. 

In the current situation, it is impossible to know where the best opportunities will arise, and in reality, we will need to continue waiting to see how it all plays out. A lot will depend on just how bad the downturn becomes and how far markets end up falling. There are early signs that technology companies and those in the retail and banking sectors will be likely candidates in due course simply because of how beaten up those stocks are already. When the dust settles in the months ahead those who have been most patient will be in the best position to take advantage of the opportunities that have become the most attractive. 

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.

How Much Further Will Share Markets Fall?

We’ve finally moved into bear market territory. We’ve been sitting on an overweight cash position for most clients for months and waiting for markets to fall sufficiently to deploy these funds. For existing portfolios, we typically have between 20%-30% in cash (or similar) depending on the client and for new clients who joined in the last 6-12 months we’ve held 60%-80% in cash. The main question I’m being asked right now is this:

Is it time to buy?

My answer is no, not yet. The time to buy will most likely be when people stop asking. Investors are simply not yet scared enough. When markets are driven by fear, people no longer want to buy. For all the volatility and the fall in the market to date, we haven’t seen markets truly capitulate into a free fall. That’s when the best buying opportunities will be available – when no one wants to buy. We haven’t seen real fear and I think we need to see that before this market reaches a bottom. The next question I get after that is this:

Just how much further do you think markets will fall then?

Obviously, that’s a difficult question to answer because there are so many variables, and we just don’t know how they will ultimately play out. But I think the falls in share markets so far are really just in relation to interest rate rises being factored in and markets making a one-off adjustment from extremely good times of low inflation and low rates to the opposite. In my opinion, markets haven’t really adjusted for bad news or a bad economic environment. It seems increasingly likely that is just around the corner. I think there are lower corporate earnings ahead and slower economic growth. All of these are yet to be properly forecast by the big institutions and that will likely come next in the form of downgrades. I think there is some way to go before the market finds its low point.

Additionally, we have the prospect of higher interest rates than markets expect. If that plays out, markets will likely fall further to adjust to the shock of a second round of rate rises. For a while, the consensus was that central banks in the US and Aust may end up at around 3% but it looks increasingly like that it is going to be north of 4%. Keep in mind that central banks are always behind the curve on these calls and then they panic and over tighten. We’re starting to see talk of bigger rate rises at the next meetings of 0.5% and 0.75% but to me, they are not panicking yet, that’s just them catching up to reality. The Central Bank panicking comes later when it’s obvious to everyone that they’ve caught up, but they keep raising rates.

This is clearly a once in a generation recalibration for the global economy. However, the flipside is that I don’t believe (at this stage) it becomes a GFC style event where markets fall 56% or a 1929 style crash that led to The Great Depression where markets fell 89% (not a misprint!). At this stage, there is no evidence of the level of systemic problems within the global economy that occurred during those events. The global banking system is strong, and markets are functioning relatively well so far. That’s not to say it can’t happen and I am acutely aware of the potential for black swan events to emerge from left field when there are just so many volatile situations in the world right now.

But my expectation at the moment is that markets finish down from their highs somewhere in the range of 25%-40%. I think that’s fairly realistic. I would be surprised if we are at the low point now. We are certainly getting closer, with markets broadly down 20%, but I don’t think we are there yet. As we enter the next phase, that’s when we will start seeing the sort of buying opportunities emerge that we have been waiting for. That’s not to say there are no opportunities to buy now because as markets fall, I am increasingly seeing specific opportunities in areas or companies I am comfortable buying. But in terms of deploying the large cash positions we have been holding, we will continue to be patient.

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.

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

Will Property Prices Fall?

There are so many issues for investors to navigate at the moment. We’ve got several once in a generation events colliding to create volatility and distortions in not only financial markets but for every type of asset. Any one of these issues would be the leading story of the day in their own right in more normal times.

War in Europe, Global inflation, Rising interest rates, Global food shortage, Energy sanction and shortage, Pandemic, China lockdowns, China slowdown, Supply chain crisis, Rising bond yields, Tech stock price collapse, Yen vs US drop, Sri Lanka crisis.

While it sounds like the missing verse of ‘We didn’t start the fire’ by Billy Joel it has been our reality for the past year or two. Many issues are interlinked to be sure and while they all impact the world it is less obvious in many respects how these all flow through to impact the daily lives of ordinary Australians.

The one issue that will have the biggest direct impact for most Australians, or at least be most relevant in the year ahead, is rising interest rates. This brings me to the elephant in the room.

Australian property prices.

We really aren’t prepared for higher interest rates and their flow on effects. As with most events lately, this will have a once in a generation impact on people with mortgages and force property prices significantly lower. Most are already aware of it but don’t give it much thought as it seems so far away. But the RBA raising rates now puts this firmly on the table. 

Do I think house prices will fall? Yes.

We’ve already seen big falls in bond markets and stock markets globally and property has its turn ahead. I think we are looking at a 20%+ fall in residential property prices here in Australia in 2023.

You have to go back to early 1990’s for the last time there was a property crash. The current environment is set up for a similar repeat. While we are not going to get anywhere near the huge interest rates of the ‘90’s, that won’t stop the problems for the property market. Rates have been so low for so long that a few percent increase is going to cause a lot of pain.

Only a few months ago, the Commonwealth bank warned the RBA if they raise rates by just 1.25% that many borrowers will have financial problems. I think rate increases will go past that level. Many homes owners are overextended already. They go to the bank and ask how much they can borrow. When rates are 2% that amount is a big number. When home loan rates are 6% or higher, those borrowers have a serious financial problem.

Many won’t be able to afford the home, it will result in urgent sales, defaults and forced sales. When this happens at scale, the market becomes flooded with distressed sales and the price of property drops accordingly. Making matters worse is that when people expect asset prices to fall, they stop buying. They wait for a cheaper price which only compounds the problem for the distressed sellers.

Of course, this situation only serves to compound the problems for consumers who are already having to adjust for higher energy and food prices. The wage increases they demand will likely add to inflationary pressures but are not likely to maintain their standard of living. Consumer’s discretionary spending will fall further as they are forced to allocate more of their income to paying their mortgage.

None of this is rocket science, it’s mainly common sense when you simply think through the flow of money and impact of the situation. The reason for hesitance in accepting how this will play out is the cognitive dissonance we experience in understanding what we see right now, which is broadly good economic times still, compared to what this rationalisation tells us is going to happen.

For stock markets, this will have a huge impact in the year ahead. Some sectors will be beneficiaries and others will be causalities. This flows through to sectors as diverse as retail, hospitality, and entertainment. It flows through to the banks, long the mainstay of the Australian share market they will see much lower growth in new business while simultaneously experiencing a rise in bad debts and defaults. From a portfolio perspective careful stock selection has never been more important.

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.

Feels a Lot Like a Bear Market

In a bull market, momentum relentlessly drives stocks higher. You’ll get occasional pull backs and profit-taking but then it just goes again. We’ve seen that for much of the past decade. Bear markets are basically the opposite and are typically defined as the market falling by 20% from its highs. So far this year, the S&P500 in the US is down about 13%, so we are not there yet, but I think that’s where we are heading soon enough.

One of the problems as you progress through a bear market is that no one wants it to be the case. They want the good times of the bull market to keep going. So, when markets bounce as they did in mid-March everyone likes to think everything is back to normal. Denial kicks in, but the inevitable drop after the bounce comes soon enough. This is called a ‘dead cat bounce’ for exactly the reason the imagery of the phrase conveys.

The S&P500 in the US fell steadily from Jan-March. But then surprisingly (to me at least) it rose 11% in the 2 weeks to the end of March for no good reason, only to fall by the same amount in April. Dead cat bounce. There were a whole range of factors contributing but the most surprising part was just how much it went up. I raise it only to point out the vagaries of the stock market and why you need to be more cautious in bad markets and difficult times. In a bull market, you can buy the dip. In a bear market that is generally a mistake. In a bear market you are best served by waiting. You buy when there is blood in the water.

Perhaps being so cautious will mean you miss out on some upside if the global situation suddenly changes. If that happens, then so be it. The aim of the game in this environment is the preservation of capital in the first instance. Genuine bear markets are not all that common, but they do happen from time to time. As they unfold investors will find every way to talk themselves out of it until it’s impossible to deny. We are getting closer to that point now. Frankly, it’s kind of obvious.

In a bull market, investment and business conditions converge to provide stocks with all they need to rise ever higher. Everything about the economic and geopolitical conditions are favourable and trending up. Currently, the opposite is true, everything looks ugly and is trending the wrong way. Inflation is high and will force central banks across the world to hike interest rates far more dramatically than many expect. The war in Ukraine is causing all sorts of significant flow on effects. Many won’t be felt for months, some years. China’s economy is forecast to slow dramatically especially on the back of their massive lockdowns with covid. The list goes on.

The likelihood of recession globally is increasing. Markets won’t wait for the recession to be here to retreat. They are already retreating in anticipation and as it becomes more apparent in the weeks and months ahead, they will retreat further. So, make no mistake, markets are forward looking. By the time the consumers and businesses across the world are dealing with the reality of a hard economic landing at some point in 2023, markets will already be looking ahead to the recovery. So do not confuse the current economic conditions with what the share market will do. They are operating on different timelines. One (the economy) is the actual conditions and the second (the share market) is anticipating the future conditions.

The earnings numbers for last quarter and guidance for the following one coming from the mega tech this week will be critical to just how quickly markets adjust. Normally, I don’t put that much weight on the quarterly reporting and prefer to focus on the long term. But in this market the quarterly numbers are going to have an outsized impact on the market from here. We’ve seen it recently with Netflix being smashed after failing to deliver. If the mega tech companies report revenue and profit in line with expectations or better, markets probably hold up ok for now. But a miss will be a completely different story.

I expect the next couple of months to be tough. Markets need only a couple of bad news events to really drop their bundle from here. A reality hit confirming what most are concerned about, a consumer lead recession, will sharply turn sentiment negative and potentially push markets into bear market territory. Right now, there are several risk factors that can easily flare up in the next month or two and become the catalyst for the market to react negatively and take a further leg down. There will be great opportunities once markets settle but for now, I remain cautious.

We remain defensively positioned expecting further downside risk. We are overweight cash, floating rate notes, and commodities, especially energy.

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.