Taking stock of stock markets

Taking stock of stock markets

So far, 2021 has been another year of stellar stock market returns across the developed world. To the end of November, the Australian share market has delivered 14 per cent, the US 25 per cent, and even dusty old Europe has managed to rise 14 per cent, with the only real laggard being the emerging markets, which have struggled under the deadweight of a Chinese market coming to terms with new regulatory concerns, returning 8 per cent.

As we approach the end of the year, it’s an opportune time to take stock of what the drivers of those strong returns have been and the likelihood of them being sustained.

At the heart of the global economic bounce back over the past 12 months, and helping to underwrite the strong financial markets, was the massive government stimulus payments to compensate for the expected drag from COVID. The OECD estimates governments around the world spent more than $19 trillion combined on COVID-related support programs. You have to go back to global wartime to find a comparable period of fiscal spending.

All that money has to go somewhere, and whilst some of it has been saved, much entered the economy and inevitably found its way into company revenues. Australian companies reported close to record earnings growth of more than 26 per cent for F2021 and paid out a record total of $67 billion in dividends. In the US, analysts are forecasting companies to report 40 per cent earnings growth over this calendar year and globally it’s an amazing 48 per cent.

Over the long run, earnings growth is the principal driver of share prices, and Citigroup’s forecast for global earnings growth drops to a far more typical 8 per cent for 2022.

There are also short-term drivers of share prices. In what’s come to be known as the ‘TINA’ effect (There Is No Alternative), money has flooded into equities chasing higher potential returns than what’s on offer through anaemic bond yields.

According to Bank of America Merrill Lynch, rolling 12 month flows of money into equity funds topped more than $1.5 trillion earlier this year, almost four times its previous highest peak. Incredibly, the $1.25 trillion invested into equities funds between January and November this year is more than the total amount over the same period for the previous 19 years combined!

That remarkable amount of liquidity has also underwritten a record year for global initial public offerings (IPOs), or company floats, worth more than $830 billion.

Another short-term driver is referred to as ‘seasonality’, which is the average performance of stock markets over a year. If you look over a long enough period it becomes apparent that money flows follow a pattern. The chart shows the Australian share market tends to experience a rally around April and October each year, which is after dividends have been paid, and for both the Australian and US markets, the December quarter is normally the strongest.


Seasonality of the Australian and US share markets, 1991-2020

AFR article chart

Another influence on share markets has been the reluctance of central banks to temper their super accommodative monetary policy, despite coming under concerted pressure from the bond market in the face of sharply higher inflation data.

Although the Reserve Bank of Australia abandoned its quantitative easing policy, it has retained a record low cash rate of 0.1 per cent and insists it’s not even close to raising it. Meanwhile, the US Federal Reserve has kept both its low rates and its QE program in place, and likewise assures markets it’s in no hurry to tighten.

As always, like placard waving protesters, there are bears who are keen to spoil the party. Valuations have undoubtedly become a lot more stretched over the year, and amazingly the total market capitalization of US companies with a price to sales ratio of more than 20 times has rocketed from about US$300bn to more than US$4.5 trillion in just the last 18 months, a level 25 per cent above the notoriously bubbly dotcom boom of 2000.

So, between the biggest peacetime government spending program in history and the lowest cash rates in history, perhaps it’s not surprising share markets have done very well this year, until you throw in that it’s happened during the worst global pandemic in a century. It makes you wonder what 2022 holds in store.

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Inflation gives investors the chance to profit from shares

Inflation gives investors the chance to profit from shares

Inflation is once again in the headlines, after Australia’s September quarter CPI data showed prices increased by more than three per cent over the year. The Reserve Bank looks through the more volatile prices, like food and energy, but even its preferred ‘core measure’ came within its two to three per cent target range for inflation for the first time in six years.

Underlying the spike in inflation are higher energy prices, especially across the northern hemisphere, colliding with ongoing supply chain pressures, which were frequently referred to in recent results by both US and Australian companies, due largely to a global spike in demand for goods underwritten by the enormous levels of government stimulus pumped into the economy to offset COVID pressures.

Inflation is like kryptonite for bond markets, and its re-emergence has really spooked them. The Australian 10-year bond yield just about doubled in the two months to the end of October, to a yield of 2.08 per cent, while the US yield tripled to 1.56 per cent (remember, if a bond’s yield is going up, that means its price is going down). Bond markets are seen as betting the Reserve Bank, along with other central banks, will be forced to raise interest rates much earlier than they have been guiding since last year.

The sharp negative response in bond markets has not really been reflected in equity markets. Over the same period, the ASX200 fell four per cent from its recent all-time high (which included going ex a record amount of dividends), while the US’s S&P 500 rose three per cent to reach a new all-time high.

There has been a lot of commentary and speculation that equities markets are being too complacent in the face of a potential change in the inflationary picture and the risk of rising interest rates. Before rushing to make any decision on that either way, it pays to look at how shares have performed in past periods of high or rising inflation. The results may surprise you.

Table 1 shows that in the 12 years that reported the highest annual rates of inflation since 1960, which were all clustered around the 1970s to 1980s, there were five years where the All Ordinaries index fell, with the worst being a drop of 27 per cent, while the strongest year saw a mighty increase of 67 per cent. Overall, the average rate of inflation was a touch over 11 per cent, while the average share market return was more than 18 per cent. It’s fair to conclude there is no discernible relationship between the two.

Table 1

When looking at the 12 years that reported the highest annual increase in inflation, they were more scattered across the six decades. Of the four years where the All ordinaries fell, the worst was 2008, with a drop of more than 40 per cent, while the best year was 1986, which saw a rise of more than 52 per cent. The average increase in inflation was 2.6 per cent, while the average increase in the share market was 6.5 per cent. Again, there is no discernible relationship between the two.

Table 2

Importantly, smart investors should be aware that when the inflationary environment changes, the companies that drive share market returns may also change. In a low inflation environment, companies that can generate growth independently of macro considerations, known as ‘growth’ companies, will do well. This is exactly what we’ve had over the past five to ten years. Conversely, when inflation strikes, it’s those companies that have pricing power and can pass on higher costs, which are usually ‘value’ companies, whose earnings will be least affected.

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Interest rates and inflation vs reality

Interest rates and inflation vs reality

With inflation once again taking centre stage in the financial media, speculation is rife that central banks will have to respond. Conventional wisdom says the way to do that is to raise interest rates, the theory being that it moderates demand which feeds through to reduced prices. This playbook comes largely from how the US Federal Reserve dealt with the worst inflationary period of the modern era, at the end of the 1970s.

The narrative is that “Tall Paul” Volcker, the US Fed Chairman who stood 6’8”, crushed the US’s 14% inflation rate of 1980 by driving interest rates to a record high of 20%, throwing the economy into a savage recession. While he became one of the most hated men in America, by 1982 inflation averaged just 3.8% for the year. The message was clear: raising interest rates kills inflation.

Or does it? If interest rates are that powerful, how come central banks failed to increase inflation by keeping them super low for the past 10 years? There is an alternative view about inflation that begins with the premise that modern economies are incredibly complex; so complex in fact that to suggest using one single tool, the overnight cash rate, to control it is fanciful. To explore this view, it helps to have some context: a quick overview of the 1970s oil crisis.

Crude oil prices (log scale)
Crude oil prices (log scale)

In the 1960s the US was largely self-sufficient for oil, and prices were kept super stable by the Texas Railroad Commission setting quotas. However, in October 1973, when the US was more dependent on foreign oil than it had ever been, especially from Saudi Arabia, OPEC declared an oil embargo against those countries that had supported Israel in the Yom Kippur War. The oil price just about tripled from US$3.60 per barrel to more than US$10 per barrel only six months later.

Oil, of course, is completely woven into modern economies, from transport, to energy production, to forming critical components of an almost endless list of manufactured products. Prices started to rise across almost all goods as producers passed on the higher input costs at each stage of production, and US inflation rates went with them, rising from an annual rate of 3.4% in 1972, to 8.7% in 1973, to 12.3% in 1974.

US annual inflation rate
US annual inflation rate

By the time Jimmy Carter was elected president in 1976, oil was trading at $13.90 per barrel and  US oil imports had shot up 65% annually since 1973 to be 48% of total consumption. In 1976 the nation was consuming one-quarter of all of OPEC’s production and was woefully wasteful in its energy use, with consumption per capita 2.3 times the average for nations in the European Economic Community and 2.6 times Japan’s.

Adding to the general inflationary pressures was the US$ index (DXY, which is a weighted measure of the US$ against its major trading partners) fell from 115 in 1971 to 80 in 1977 after the US abandoned the gold standard. That meant all imports cost 30% more over that six-year period, on top of the oil price rise.

US dollar index 1967-2015

Then in 1978 the Iranian revolution prompted a strike at the nationalized oil refinery, reducing production from 6 million barrels per day to 1.5 million. While that only represented about 4% of global supply, the oil price jumped again to $39.50 by 1980. All told, the oil price had risen 1000% in seven years and the inflation rate hit a post-war high in 1979.

What followed, however, was a classic combination of market and regulatory responses that brought about a remarkable reversal in oil prices thanks to tectonic shifts in both supply and demand.

In 1978, Carter deregulated oil and gas prices, which prompted an increase in oil exploration and led to a huge increase in the domestic supply of energy over the following years. By the time Carter left office in 1980, foreign oil had fallen to be 40% of US consumption, a reduction equivalent to 1.8 million barrels per day, oil inventories had risen sharply and there was a surplus of gas. Then between 1980 and 1985, domestic US production increased by almost 1 million barrels a day, while imports of crude oil and petroleum products declined from 8.2 to 4.5 million barrels a day.

On the demand side, automobile fuel economy standards were introduced in 1975 that required a doubling of efficiency by 1985, and stories abounded of households yanking out their old oil burning heaters to switch to gas, which was in surplus. All in all, by 1986 the oil price had fallen more than 70% to $10.40 per barrel, aided in part by a resurgent US$ that doubled in value between 1980 to 1985.

Not surprisingly, the alternative view about how the record level of inflation in the 1970s was crushed by the mid-1980s revolves around the real world effects of a huge rise in the most critical commodity, followed by a huge decline.

While suggesting the single act of raising interest rates solved the inflation problem is an appealingly simple solution, and it may indeed have contributed, when you account for the incredible complexity of a modern economy, it shouldn’t be surprising there would be a lot more to it. Not all price increases are going to be effectively resolved by increasing the cost of money.

Professor Stephanie Kelton of Stonybrook University, a recognised advocate of MMT, puts it this way: if the Affordable Care Act (Obamacare) was to be struck down, depriving many people of health insurance and allowing insurers to price based on pre-existing conditions, it’s estimated health insurance premiums would rise by up to 30%. If that happened, it would show up in the inflation numbers. How would raising interest rates reduce that kind of inflation? Reducing people’s access to money or credit won’t drive down health costs. However, regulating the cost of health insurance would, or the cost of drugs and medical care.

In the context of our current elevated rate of inflation, much has been made of the 10-fold rise in the cost of shipping containers. Already though, there are ways that is being addressed:

  • The port of Los Angeles recently allowed containers to be stacked four high instead of two, freeing up space for ships to empty their cargo
  • Up to 70% of container space is fresh air and new software packages using AI are available to guide companies on the most efficient way to pack their goods
  • Astonishingly, container contracts are currently unenforceable, simply changing that would increase certainty for companies
  • There is a website being developed to establish a ‘secondary market’ so that companies that have spare container space can put it on the market

These are practical ways of reducing pricing pressures that simply raising interest rates, which can only change the price of money, could not achieve.

The conventional view that the way to fight inflation is by central banks increasing interest rates arguably stems from a misinterpretation of correlation and causation dating back to the 1980s. Interest rates undoubtedly have a role to play in managing a modern economy, especially with respect to house prices where a high proportion of transactions rely on borrowing money. As for the rest of this very complex economy, a better approach could be to see them as part of the solution.

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Headwinds for Australian shares

Headwinds for Australian shares

The eighteen months from the end of March 2020 to September 2021 will go down as one of the most astonishing periods for the Australian share market. The ASX200 Accumulation Index jumped more than 50 per cent, taking pretty much everyone by surprise after expectations had been hammered by the wholesale closure of the global economy.

The 2021 financial year saw Australian companies report 27 per cent earnings growth, the best in more than 30 years, albeit bouncing off a low prior year comparison. After companies slashed dividends the previous year, cash holdings surged to a record $211 billion and dividends bounced back ferociously, almost doubling year over year.

Record iron ore prices underwrote spectacular dividends from the big miners; banks were awash in capital with a surging housing market and record low funding costs, and retailers reported record years as households spent up on tech and home improvements. There’s no question, the last 18 months have been very good to Australian share investors.

However, investors should be wary of presuming the Australian economy will continue to show the same resilience. There are at least three identifiable headwinds that warrant keeping a careful eye on.

The first, and by far the most influential, is the dramatic reduction in federal government support for the economy, particularly while the two most populous states have been hobbled by lockdowns.

In 2020, federal government programs such as JobKeeper and the JobSeeker supplement saw the injection of $251 billion into the economy. By contrast, between 1 June to 23 August of this year, Deloitte Access Economics calculated it injected just $3 billion.

JobKeeper alone injected an average of $1.7 billion per week and peaked at $2.5 billion. As of 23 August, the new federal COVID Disaster Payment was averaging only $217 million per week. Many businesses and workers will receive a fraction of the financial support they got last year, if they get any.

Household savings are still much higher than pre-COVID levels at almost 10 per cent, and there is every chance there will be a surge of spending when lockdowns finally end, but it’s unlikely to be the spending spree we saw last financial year and understandably much of it may be spent on doing things, rather than buying more stuff.

A second headwind might come from the red-hot housing sector. One of Australia’s highest rated economists, Tim Toohey of Yarra Capital Management, points out the federal government’s HomeBuilder program was wildly successful, with single home building approvals jumping more than 30 per cent to a record high.

At the same time state governments were offering other incentives to home buyers and the big banks were given access to $200 billion in super cheap funding. The result: the housing market has rocketed.

However, those housing approvals are simply drawing demand forward, creating a spike now with an inevitable trough on the other side, which Toohey points out will be exacerbated by immigration stopping dead. Toohey’s base case is 150,000 excess dwellings by 2023 and an inevitable slowing of the important housing construction sector.

The third headwind could come from China, where the regulatory upheaval from Xi’s common prosperity dictums is having a profound impact, especially on the real estate sector, which accounts for 17 per cent of the country’s GDP. Purely for context (as opposed to drama), at the height of the Japanese and US real estate bubbles the sector accounted for about 7 per cent of each country’s GDP.

It’s unclear how the Chinese government will deal with the fallout from excessive debt levels of companies like Evergrande, and autocratic governments can do things politically accountable governments can’t, but it’s possible the property sector will need to undergo comprehensive restructuring which will reduce activity. The significance being China accounts for three times the value of exports compared to our second largest trading partner, Japan.

It is entirely possible these three headwinds will be more than offset by the ongoing circulation of last year’s unprecedented fiscal injection and the unleashing of animal spirits when lockdowns are finally lifted and the urge to spend those accumulated savings takes hold. However, as always it pays to be mindful those headwinds don’t knock you off course.

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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.


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.