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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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.

Steward Wealth’s Co-Founders named as ifa Excellence Award finalists 2021

Steward Wealth’s Co-Founders named as ifa Excellence Award finalists 2021

Anthony Picone and James Weir – Directors & Co-Founders of Steward Wealth have been named as finalists in the ifa Excellence Awards for SMSF Adviser of the Year & Industry Thought Leader of the Year.


The finalist list, which was announced on 24 August 2021, features over 210 high-achieving financial services professionals across 27 submission-based categories. 
 

The ifa Excellence Awards is the pinnacle event for recognising the outstanding achievements and excellence of exceptional professionals across Australia’s independent advice sector.  

The awards were created to acknowledge and reward the contributions of professionals leading the charge within the financial advice industry, noting their dedication to their profession. 

After the past year of uncertainty and challenges brought on by the pandemic, now more than ever, it’s important to stop and take a moment to celebrate both your accomplishments and those of your peers. 

 “At a time of change and upheaval for the industry, and after another year of business and family disruption as a result of COVID, it’s so important to take some time and recognise the achievements of the industry and the fantastic innovations that are going on inside advice businesses,” says ifa editor Sarah Kendell. 

“A huge congratulations to all of this year’s finalists for their outstanding dedication to client service through such a challenging time and the excellent examples they are setting for their peers around adaptation and success through adversity.”  

James Weir, Director and Co-Founder at Steward Wealth, said that he was extremely proud to be recognised and endorsed as a finalist in the ifa Excellence Awards 2021.  

“This recognition for our contribution to the financial planning industry reinforces the strength of our services and capabilities as we continue to grow. Highlighting our dedication to connecting with the community and engaging with clients,” Anthony Picone, Director and Co-Founder at Steward Wealth added. 

Looking for an industry endorsed SMSF advisor?

Find out more about our SMSF services below or call Steward Wealth today on (03) 9975 7070.

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.