Investors on tenterhooks over inflation

Investors on tenterhooks over inflation

A frustrated US President Harry Truman apparently pleaded for someone to find him a one-handed economist, so he wouldn’t constantly be told “on the other hand”. Right now, inflation is at the centre of ongoing debate among economists with opposing views that are critical for financial markets.

Why is it critical? It’s a broadly accepted tenet of financial markets that low inflation supports higher asset valuations, such as higher PE (price to earnings) ratios. Likewise, the lower inflation is, the lower long-term bond yields are, which means the discount rate used to calculate a discounted cash flow (DCF) valuation is lower, which results in higher asset valuations.

Low inflation has provided a powerful tailwind to the post-GFC bull market in global equities. The Australian ‘core’ inflation measure, which strips out the effect of the more volatile prices like food and energy, peaked at about 4.8 per cent in 2008 and trended down to 1.1 per cent in 2020. In the US, core CPI has varied around 2 per cent for most of the post-GFC period, while in Europe it’s been around 1 per cent.

Financial markets are concerned that a meaningful rise in inflation will force central banks to raise interest rates, which will flip the story to a serious headwind. The potential PE de-rating would hit the higher priced tech stocks especially hard, meaning the US share market would be particularly vulnerable. And as the old saying goes about America sneezing…

So why the concern now? Inflation measures around the world have spiked this year. Australia’s headline CPI rate jumped from 1.1 per cent in the March quarter, to 3.8 per cent in June, and in the US the CPI leaped from 1.7 per cent in February to a 13-year high of 5.4 per cent in July. While the respective core rates were lower, nevertheless they too saw a substantial jump.

What has economists divided though, is whether this spike is transitory and inflation will drop back down, as the central banks argue, or structural and so will continue to rise.

On the one hand, the transitory camp argues that because prices collapsed after multiple countries locked down between March and June last year, it was always going to look like a huge increase this year after those same prices had largely recovered.

An excellent example of this is the oil price. Over the year to Australia’s June 2021 CPI figure, the oil price increased 200 per cent, from $25 per barrel to $75. Automotive fuel prices rose 27 per cent over that same period, which, by itself, added about 1 per cent to the overall 3.8 per cent increase in the CPI. If fuel prices stay the same for the next 12 months, and nothing else changes, inflation should drop back to 2.8%.

Likewise, May saw the largest year on year increase in the US CPI since 1992, but three categories that comprise about 5 per cent of the core CPI drove 50 per cent of the monthly increase, and they were all associated with transport and mainly reflected used car prices jumping by almost 50 per cent over the year.

Proponents of the transitory view point to the 10-year government bond yield, which, at 1.25 per cent, shows the financial markets are sanguine about the prospects of higher inflation. Sceptics argue that simply reflects the heavy involvement of central banks.

On the other hand, the economists arguing inflationary pressures are likely to persist point to the sweeping changes many companies are making to supply chains as they prioritise security of supply over cost, undermining the disinflationary effects of globalisation. Also, rising wage pressures, more so in the US than Australia, will increase aggregate demand and could force companies to increase prices. Finally, some argue once the acceptance of rising prices is entrenched, it becomes a self-fulfilling prophecy.

Inflation is awesomely complex and there is no cogent, complete model for it. Research by Ulrike Malmendier, Professor of Economics at Berkeley, shows peoples’ inflationary expectations are shaped by their lifetime experiences, regardless of their level of expertise. So those economists that lived through the stagflation of the 1970s might therefore be expected to be more cautious than those who didn’t. Smart investors will be well advised to watch carefully for inflation, but as usual, it’s likely the markets will pick it up well before we do.

What you need to know about property investing in your self-managed super fund (SMSF)

What you need to know about property investing in your self-managed super fund (SMSF)

“We want to eventually retire to the coast so we will buy a property in our self-managed superfund and rent it out in the meantime. The value of the property will rise over time and when we’re ready to retire we’ll just move in.” 

We’ve heard this statement many times, but if only it was so easy. At a time when property markets are buoyant and interest rates so low, many people are considering property investment within their SMSF but the laws around what you can do, and can’t do, with the property are complex. 

Investing in residential property

Firstly, residential property purchased through an SMSF cannot be lived in or rented by you, any other trustee or anyone related to the trustees – no matter how distant the relationship. Buying a coastal property in your SMSF and moving in when you retire is therefore not allowed. When you retire you must first purchase the property from the SMSF, perhaps from the money you receive from selling your city residence. This is just like buying a regular property except you won’t have to deal with negotiations. The transaction must take place at a fair market value, based on objective and verifiable data, and will involve additional costs such as stamp duty and legal.

Investing in commercial property

Rules regarding related parties that apply to residential properties do not apply to commercial properties. They therefore can be sold to an SMSF by its members, as well as being leased to SMSF trustees or an individual or business related to them.

This exception makes SMSF commercial properties appealing to many small business owners such as barristers to buy their chambers or manufacturers who can purchase a warehouse/factory. This allows the business to pay rent to their superfund rather than ‘dead money’ to a landlord. Again, it’s important the lease agreement is at market rate and must be paid promptly and in full at each due date. 

Regardless of whether it’s a residential or commercial property, the investment must also satisfy the overarching function of the SMSF, which is to provide retirement benefits for its members (a concept known as the sole purpose test). You must consider the yield or potential capital appreciation when selecting the property and if neither makes good investment sense, you should reconsider.

The loan

Lending through your SMSF must be done by a limited recourse borrowing agreement (LRBA). The property must be owned by a separate ‘bare’ trust that sits outside of the SMSF structure and has its own trustee. All the property-related income and expenses are then made through the superfund’s bank account. These loans are specifically designed to ‘limit the recourse’ so that if the terms of the loan are breached the lender can only access the property and other superfund assets are protected. 

Given the unique characteristics of the loan, SMSF loans generally attract significant application fees and higher rates than standard home loans. The lending criteria are also much stricter and can involve things such as reduced loan to value ratios (LVR), shortened loan terms resulting in higher repayments, and often borrowers require a minimum percentage of liquid superfund assets available to make loan repayments if needed. There are also additional legal costs associated with the setup and ongoing compliance of both the SMSF and bare trust structure. These costs must be factored in to decide if purchasing in your SMSF is the right option for you.

Renovating

The idea of renovating a residential property within an SMSF to improve capital value is also more complicated than it first appears. Whilst general maintenance and repairs can be made, any significant renovations must be funded by available cash already held within the superfund and not by the loan or borrowed money. Even if funds are available, you are not allowed to make significant changes to the original property that was purchased using the limited recourse borrowing arrangement. Renovations that substantially change the asset will require a new LRBA.

Given the right opportunity, there is no doubt that buying property in your SMSF can be an excellent long-term strategy but there are clear complexities. The considerations presented in this article are by no means exhaustive and investing through your SMSF should always be done in consultation with your financial adviser and an experienced mortgage broker. 

Contact us today to discuss whether buying a property in your SMSF could work for you.

We’re hard wired to listen to doom and gloom merchants

We’re hard wired to listen to doom and gloom merchants

It’s an old adage that financial markets climb a wall of worry, and the higher markets climb, the more worried we get about the next inevitable selloff.

Just this year, to mid-August, the ASX 200 has hit 19 new all-time highs, the US’s S&P 500 has hit 49 and even Europe’s STOXX 600 has made 31. So it shouldn’t be surprising that the worriers are sounding the alarm that the good times can’t go on forever and that a return to harsh reality is right around the proverbial corner.

As long as there have been financial markets, there has been a thriving industry of tip sheet spruikers and self-proclaimed gurus jostling for your attention with empty promises of expert insights for the low, low price of a subscription or a book.

Many of these experts make a career out of scaring the bajeezus out of people by forecasting the next imminent crash. People like Harry Dent Jr, whose books include The Great Depression Ahead (2009), The Demographic Cliff (2014) and Zero Hour (2017), and who has forecast 40-50 per cent share market corrections pretty much every year since the GFC, even offering dates for when the catastrophes will happen.

Of course, when the forecasts prove to be wrong each time he has the readymade excuse that it’s ‘because central banks are propping things up, which will only make the coming crash even worse’.

So why is it that, despite sounding ridiculous, people like Dent can always find an audience?

Nobel Laureate Daniel Kahneman, one of the godfathers of behavioural economics, made his career out of analysing why human beings have a tendency to be their own worst enemies when it comes to investing. He identified a number of biases that are ingrained into almost all of us which cause us to behave in ways that are generally predictable and usually make us follow the herd.

One of those is the negativity bias, which is the human tendency to give far more attention to negative details than positive ones. It emanates from the lizard part of our brain that is alert to existential threats, the part that presumes unfamiliar things are bad for us until proven otherwise. While it’s been critical for survival, since without it humans may never have made it past being lunch for sabre toothed tigers, it wreaks havoc with our ability to remain objective in the face of what we perceive to be a genuine threat.

It’s been proven that negative headlines on Google get more clicks, which moves the negative news items up the rankings, which makes more negative items appear in our search results and news feeds. Eventually it makes us feel like we’re surrounded by nothing but bad news. In part it’s our heightened awareness of negative news that makes us susceptible to the gloom and doom merchants who warn of coming crashes.

When markets are at all-time highs, the doom merchants have a field day cautioning that ‘things have never been so uncertain and so expensive’. However, smart investors should pause and reflect that financial markets have never, ever been, nor will they ever be, certain. If they were certain, prices would either be zero or infinitely high.

Adding to the problem is the lizard part of our brain plays tricks on us. Professor Philip Tetlock has found that we perceive bearish people as smarter, and experts who are honest enough to acknowledge the future is inherently unknowable, and instead talk in probabilities, are not only seen as dumber but also less trustworthy.

Another salutary lesson against listening to doom merchants and tipsters in general, comes from a survey undertaken by US firm CXO, in which they assessed 6,582 forecasts for the US stock market published by 68 different gurus between 2005 to 2012. The result: a success rate of 47%. You get better odds from tossing a coin.

Investors are wildly more optimistic than financial professionals

Investors are wildly more optimistic than financial professionals

The average investor across the world has wildly more optimistic return expectations than the average financial adviser.

Boston-based Natixis Investment Managers conducted its eighth annual survey of investors, spread across 24 countries over March and April, and found the average expected long term return among the 8,550 respondents was 14.5 per cent per year. In a striking contrast, the global average amongst the financial professionals they surveyed was only 5.3 per cent per year. For the record, Australian investors expected a return of 14.4 per cent, compared to 6 per cent for the financial professionals.

The difference between investor expectations and those of financial professionals is something Natixis calls the ‘expectation gap’. For 2021 it is 174 per cent, but tellingly, it has jumped by almost half from the 2020 gap, after investors’ return expectations leaped by 25 per cent but financial professionals’ were unchanged.

Conspicuously, as financial markets have continued to rise since the surveys started in 2014, investors’ expectations have gone up hand in hand. In 2014, real returns, that is, after inflation, were expected to be 8.9 per cent, and for 2021 it’s 13 per cent.

The branch of economics that studies human behaviour refers to ‘recency bias’, which is where peoples’ expectations, and not just about financial returns, are heavily influenced by their most recent experiences, whether they be good or bad.

It’s easy to theorise that after seeing share markets rebound spectacularly from the fastest ever 30 per cent sell off, to the second fastest ever 100 per cent gain in the US, that it’s recency bias more than common sense that’s leading investors to expect the good times to keep on rolling.

By contrast, financial advisers keep getting told by highly rated, and highly paid, investment consultants, that successive years of strong, above average market returns will almost inevitably be followed by years of below average returns due to the inexorable force of mean reversion. Trees don’t grow to the sky, after all.

According to Vanguard, over the past 50 years Australian shares have averaged a return of 9.7 per cent per year and for international shares it was 9.9 per cent. However, if we change the horizon to 20 years, the return for Australian shares was 8.4 per cent, and for international it was a far less impressive 4.7 per cent. In other words, the point at which you invest makes an enormous difference.

It’s an argument that makes sense and is backed up by compelling data: the likelihood of strong future share market returns declines the higher are valuation multiples. With global share markets hitting new all-time highs, the noise around valuations grows by the day. The challenge for a smart investor is, of course, which valuation multiple do you use and why?

One of the most commonly used multiples is the Cyclically Adjusted Price to Earnings (CAPE) ratio, which is the brainchild of Nobel economics laureate Bob Shiller. For the US it’s currently above 38, and the only time it’s been higher was in the period leading up to the dotcom bust. Australia’s is a far more modest 24.

Advocates of the CAPE ratio point to its ability to predict future share market returns over the next 10 years, based entirely on what’s happened in the past. For the US, at current levels, it’s about 1 per cent per year, and for Australia, it’s about 9 per cent.

However, critics of the CAPE ratio point out it’s all but useless as a timing tool, given the US has been above its long-term average now for almost the whole of this century. Also, critically, trying to compare today’s macro environment, characterised by record low interest rates and bond yields, super accommodative monetary policy and record fiscal stimulus, to past periods that were almost the opposite, is like comparing the proverbial apples and oranges.

The same argument applies to comparing a normal PE ratio to historical averages: how do you account for vastly different inflation, bond yields and policy settings?

Unfortunately, there is no crystal ball that will tell you accurately and consistently what future returns will be. Investors may end up being right for the wrong reasons, or the conservatism of the average financial professional could prove prescient.

Are cryptocurrencies an investable asset?

Are cryptocurrencies an investable asset?

In a year full of remarkable financial events, there are few issues as remarkable, and divisive, as cryptocurrencies. After peaking in April this year at a collective market capitalisation of almost US$2.5 trillion, or about 1 per cent of the world’s investable assets, global cryptocurrencies have dropped 40 per cent, to about US$1.5 trillion. Bitcoin, which accounts for almost half that total, has fallen 45 per cent from its recent highs, but that’s after rising nine-fold in the 12 months before.

It is perhaps that volatility that inspires such strong feelings among those who see cryptocurrencies as a new and legitimate asset class and those who see it as not much more than thin air with a price tag. Berkshire Hathaway Vice Chairman, Charlie Munger, described bitcoin as “disgusting and contrary to the interests of civilization”, while fellow investing legend, Stanley Druckenmiller, bought some last year.

Recently Finance Services Minister, Jane Hume, proclaimed, “I would like to make something clear: cryptocurrency is not a fad. It is an asset class that will grow in importance.” That brought critics of the unregulated crypto marketing industry out swinging, pointing out there are currently more than 5,000 cryptocurrencies in circulation and a new one can be created in 15 minutes. Of itself, that is really no different to being able to list a new mining exploration company in a few weeks; the timeline is different, but the speculative element is identical.

Whether cryptocurrencies are an investable asset class and whether they belong in a portfolio are two very different questions. The usual criticism of crypto as an asset class is that it’s impossible to value because there are no earnings or dividends to model, but gold and other commodities are no different. Dan Morehead, co-CIO of US crypto fund manager Pantera Capital, points out no fiat currency can be valued either, yet relative values are determined through trading every day.

Morehead’s take on crypto is interesting. While he concedes probably the bulk of bitcoin investors are simply speculators and much of the balance are libertarians convinced of the debasement of fiat currencies, he argues it has definite utility that is steadily becoming more apparent. He sees the internet as having revolutionised countless major industries worldwide, but finance has yet to be fully disrupted. Bitcoin is simply another internet protocol for moving data around, providing the means to send money anywhere in the world instantly and for no cost. After only 10 years it’s still very early days for bitcoin, which exacerbates volatility, but as the number of users increases, he expects that volatility to settle.

Pantera has analysed the growth of bitcoin’s price and user base since its inception in the GFC and concluded there has been a remarkable consistency: both have increased, in lockstep, by five orders of magnitude since 2010, (there was one point where they diverged due to price volatility, but they caught up again 15 months later).

It works out at a US$200 increase for every million new users (exactly how they calculate ‘new users’ is unclear). Based on that, they have calculated a long-term trend, which has proven impressively accurate, albeit with that sometimes gut-wrenching volatility.

Are cryptocurrencies an investable asset chart

In an exercise that is either astonishing or one hell of a fluke, on 15 April 2020, when bitcoin was trading at US$8,988, Pantera used its mathematical model to forecast the bitcoin price month by month out to August 2021. The 12-month forecast, for 15 April 2021, was US$62,968, which required an increase of 601 per cent. The actual price ended up at US63,237, a variance of only 0.4 per cent. Then that volatility struck again, sending the May price 37 per cent below the forecast.

Morehead remains convinced the price will, once again, catch up. He argues investing 1 per cent of your portfolio in cryptocurrencies means you’re in the game if they eventually account for 5 per cent of global investable assets, and if they go to zero, it shouldn’t have hurt too much.

Asset allocation consultant, Tim Farrelly, says that since bitcoin is investable, it qualifies as an asset class. However, until he’s convinced you can get a meaningful forecast for its price and relationship to other assets, there’s no chance it will be included in his portfolios. “Do I see it like gold? I’m prepared to give a nod to 2,000 years of history that gold isn’t going away. I’m not so sure bitcoin will stack up in the same way. I wouldn’t be surprised if in 10 years’ time everyone says ‘what were we thinking?’”

How a hedge can counter currency fluctuations in your portfolio

How a hedge can counter currency fluctuations in your portfolio

In the darkest hours of the 2020 Virus Crisis the Australian dollar collapsed to 55 cents against the US dollar as the Little Aussie Battler was dumped in the rush to secure the safety of the default global currency. Once the panic was over, the Australian dollar began a revaluation journey that has seen it rise back to 78 cents.

Over that same period of revaluation, overseas share markets also staged a spectacular recovery, led by the US, but many Australian investors were left wondering why the returns from their international shares failed to keep up. The answer lies in what is referred to as ‘the currency effect’ due to the rising Australian dollar (AUD).

There’s no question the diversification offered by investing in international assets provides enormous benefits to a portfolio, as well as opportunities that are simply not available in the Australian market. However, on top of the challenge of finding attractive investments, there’s the added obstacle that fluctuations in the currency can have a sizeable impact on returns.

Just like shares, a currency can be cheap or expensive. When the Australian dollar is cheap, it takes more to buy the equivalent amount of a foreign currency, and vice versa. It’s a matter for debate as to what level the AUD needs to fall to in order to be considered ‘cheap’, but over the past 20 years anywhere below 65 cents is a decent rule of thumb, and around 88 it’s getting expensive.

The problem comes when cheap Australian dollars are used to buy an international asset and then the dollar rises strongly, as happened last year.

For instance, buying US$20,000 worth of a US stock when the AUD is at 65 cents, will cost A$30,769 (20,000/0.65). If the share price rises by 10 percent over the next year and the currency remains unchanged, the investment will be worth A$33,846 (22,000/0.65).

However, if instead the AUD had appreciated by 20 per cent, to 78 cents, the investment would only be worth A$28,205 (22,000/0.78). The currency effect has more than wiped out the benefits of the higher share price.

The way to overcome this potential problem is to ‘hedge’ the currency, which eliminates the impact of currency fluctuations. A hedge acts like a form of insurance, so the return will only reflect the change in value of the underlying investment.

To illustrate with an example, VanEck has an ETF listed in Australia that is based on the MSCI World Quality Index (‘quality’ is a filter that targets higher growth), which comes in a hedged and unhedged version.

Between the bottoming of global share markets in March 2020 to the end of April this year, the hedged version, QHAL, went up by more than 73 per cent. The unhedged version of the exact same portfolio went up by only 32 per cent. The difference was entirely due to the impact of the rising Australian dollar.

The impact of currency fluctuations on your portfolio graph

Indeed, any Australian-bought, unhedged international investment will have underperformed a hedged version by the same amount over that same period. The opposite can happen too. In 2011, taking advantage of the AUD trading at US$1.10 to buy unhedged international investments,  provided a multi-year tailwind as the currency gradually fell back toward its long-term trading range.

There are three solutions to address the currency effect on a portfolio. First, if the AUD appears cheap, it is possible to buy some international investments in a hedged version.

Second, there are ETFs that can act as a kind of insurance overlay for a whole portfolio. For example, the BetaShares Strong Australian Dollar Fund (AUDS) is designed to increase by more than 2 per cent if the Australian dollar rises against the US dollar by 1 per cent. Their Strong US Dollar Fund does the opposite.

Third, do nothing. There is research that argues the long-term effects of currency fluctuations are negligible because it tends to gyrate around the average. So those times the Aussie dollar appears cheap simply offset those that it appears expensive