Low inflation explains everything

Low inflation explains everything

by | Sep 13, 2019 | Financial Planning, Markets and Economy, Wealth Management

Low inflation is a global phenomenon that has central bankers tearing their hair out: nobody can tell you exactly what’s causing it and, so far, nothing seems to be able to stop it. And its effects on financial markets, and therefor every investor’s portfolios, are profound. In fact, this very low inflation environment can explain an awful lot of what seems to be peculiar in markets at the moment.

Just how low is inflation?

Australia’s ‘core CPI’, which excludes the more volatile prices like food and energy, averaged 3.7% since 1983, compared to the June reading of 1.6%. That’s not far off one-third of the average.

The poster child for low inflation is, of course, Japan, where, over the past 20 years, the core CPI has averaged -0.2%.

Lower bond yields

Inflation is like kryptonite for bonds: the higher inflation is, the weaker are bond prices, and vice versa. Across the world bond yields are plumbing record lows, including Australia where our 10-year bond yield is comfortably (or is that uncomfortably?) below 1%.

You might read how low bond yields indicate the bond markets are pricing in disastrous economic growth scenarios. In fact, what they’re pricing in is low inflation, and conventional economics dictates that you only get low inflation as a consequence of low economic growth. That may or may not happen, the truth is, nobody knows.

It can explain negative bond yields

There are experienced bond fund managers saying negative bond yields make no sense at all and pointing the finger at ‘central bank manipulation’. Bond markets are massive, reflecting the wisdom of a very big crowd, and they’re driven by a combination of human sentiment and some pretty funky mathematics.

If an investor has a view that disinflation (where inflation rates decrease over time) is here for the foreseeable future, then it’s perfectly rational to prefer the certainty of losing 0.4% of the value of their capital by buying a negative yielding bond, than sticking it under the mattress and losing 0.5%.

It can explain rising equity valuations

Investing 101 will tell you that a share price is supposed to reflect the net present value of a company’s future cash flows. To make that calculation you need to use a ‘discount rate’ that you apply to those future cash flows so you can work out what they’re worth in today’s money, the lower the discount rate the higher the valuation in today’s money.

That discount rate will normally be based on the ‘risk free rate’, which is typically the 10-year bond yield, but most analysts will add a bit extra to account for what they think might happen to bond yields going forward, or to reflect what they reckon might be added risks associated with the company they’re analysing.

In a recent interview, the well-known Magellan fund manager, Hamish Douglass, explained how small changes to your discount rate can have a magnified effect on a stock valuation: by reducing your risk free rate from 5% to 4%, the valuation of a business with 4% earnings growth increases by almost 20%, and a reduction from 4% to 3% sees a 25% increase.

Nothing else has changed, just your view on how long inflation will stay low, but now you’re prepared to pay significantly more for the same share. No wonder a talented fund manager friend of mine likens a DCF valuation to the Hubble telescope, where the tiniest shift can have you looking at a whole new galaxy.

Now imagine the pressure on fund managers across the world this year, with bond yields grinding downwards, forcing them to wrestle with whether or not they lower their discount rate and increase their valuations.

It can explain why so many fund managers have underperformed

Over the past nine years, so-called ‘value’ stocks have substantially underperformed ‘growth’ stocks, for example in the US by almost bang on 100%.

It’s probably not a coincidence that, according to Mercer, in the 2019 financial year, 87% of large cap Australian equity fund managers underperformed the ASX200, and in the 2018 calendar year it was roughly the same in the US. Not surprisingly, you’ll also read confounded fund managers, sounding like jilted lovers, complaining that markets are super expensive and being driven by a narrow cohort of sometimes defensive and sometimes growth stocks.

The problem is, if your frame of reference for valuations is the last, say, 40 years, you’re comparing a time of radically different inflation rates and bond yields – and therefor valuation metrics. It would not be surprising to find a lot of those underperforming fund managers are either resolutely (stubbornly?) sticking to their higher discount rate valuations or chasing their valuations higher as they begrudgingly accept lower and lower bond yields.

Those fund managers complaining about markets being expensive may end up being right, maybe inflation will go up and things will look like they used to once again, a process they call ‘normalisation’. Then again, maybe it won’t, and they’ll be left failing to adapt.

How long will low inflation last?

Because we can’t be sure of what’s caused inflation to be so low, nor can we be sure of how long it will stay that way. Who knows, this time next year we might look back wistfully on the days when we worried about inflation not being high enough, or in 10 years we may look back on the days when inflation was positive.

What you need to know about fixed income

What you need to know about fixed income

by | Aug 22, 2019 | Investments, Wealth Management

This article appeared in the Australian Financial Review

Every interest rate cut is another turn of the screw for investors looking for a decent, low risk return. Many a risk averse investor is finding they’re no longer able to rely on cash or term deposits to generate a reasonable return, and are instead considering other fixed income alternatives, of which there is an almost bewildering range. As usual, however, for every extra percent of return you try to get, you have to accept higher risks, so to avoid nasty surprises, you need to understand what those risks are.

 The explosion in the number of fixed income managed funds, ETFs and LICs over the past couple of years has come as product providers sniffed an opportunity to meet the demand for income in a low interest rate environment. According to BetaShares, in F2019 more money went into fixed income ETFs than any other category, in fact, 60% more than Australian equities.

Investors need to be aware the name ‘fixed income’ covers an enormous range of products, and they come with an equally enormous range of risk. The last thing a risk-averse investor should be doing is dumping a bunch of money into the highest yielding fixed income product they can find, without knowing what they’re getting in to.

Here are some basics to help you understand what you’re buying:

  1. What is a bond?

A bond is a security that a government, or some other kind of entity like a company, issues that says ‘if you lend me $100 today, I’ll pay you an interest rate on that money (the yield), and every year I’ll pay you the coupon (the technical name for the amount of money paid, so if you have a $100 bond with a yield of 10%, the coupon will be $10) every year until the bond matures (it could be anything from 30 days to 100 years), and at the end of the bond’s life, I’ll give you your $100 back.’ It’s similar to a term deposit, except being a security, it can be bought and sold.

  1. A bond’s maturity is usually fixed

Most bonds, especially government bonds, will have a set maturity date. There are some perpetual securities but they’re few and far between.

  1. A bond’s yield will reflect the issuer’s credit worthiness

The less risk you’re taking to get your money back the less yield you’re going to receive. That can be reflected in an issuer’s credit rating from a company like Moody’s or Standard & Poor’s, but other factors also come into it. Interestingly, there are only 11 countries with a AAA credit rating from S&P, Australia being one of them, while the US’s rating is only AA+.

  1. Bond yields can be fixed or floating

A bond’s yield can either be ‘fixed’, meaning it will pay the same coupon until it matures, or ‘floating’, meaning the coupon will be above some kind of benchmark (like the Bank Bill Swap Rate or LIBOR) and will be reset to reflect that rate from time to time.

  1. Bond prices are not fixed

Bond prices can fluctuate, a lot. The average investor is almost certain not to buy an actual bond, but instead will invest in a fund or ETF, and it’s important to realise a fund’s unit price can jump around, depending on what kind of fixed income securities it invests in.

  1. What makes a bond’s price change?

There can be a number of factors, but the main influence is expected inflation. If the market thinks inflation is falling, as it has recently, it will happily accept a lower yield to compensate for the reduced risk of the value of any future payments being eroded by inflation. If a bond’s coupon is fixed, meaning a 5% bond will pay no more or no less than $5 per year for every $100 bond, then it’s the price you pay for the bond that will increase instead. This is where you end up with the what seems weird at first: as a bond’s yield goes down, its price goes up, but in fact, it’s exactly the same as shares: if a share price goes up, its dividend yield goes down.

  1. Duration risk: the bond price’s sensitivity to changes in yield

A bond’s ‘duration’ tells you how much the price should change when the yield changes. For example, according to JP Morgan, the Australian bond index has a duration of 5.4 years, which means if interest rates go up by 1%, the price should fall by 5.4% (and vice versa if rates go down).

That’s really important because the longer a bond’s life, in normal times the higher should the yield be, which appeals to income-oriented investors, who are normally more conservative. However, while a bond’s maturity and duration are not the same thing, the longer a bond’s life the more duration risk it has, and with interest rates already so low, there is heightened risk they could go back up, and even if that’s only by a little bit, those longer bonds could lose a fair bit of their value.

  1. Credit duration: the bond price’s sensitivity to changes in ‘credit spreads’

Bonds issued by a company will typically pay a yield premium to reflect the increased risk that you might not get your money back. That premium is normally calculated as a certain percentage above some kind of benchmark, like the 90-day bank bill rate, and the gap between the two is called the credit spread.

‘Credit duration’ measures how much the price of the bond will change if the credit spread changes; a bond with credit duration of 3 years will fall 3% if the credit spread goes up (widens) by 1%, and vice versa.

Bonds have had an extraordinary start to the year, with the benchmark Bloomberg Composite Index rising 6.5% to the end of June. But almost all that return is because bond yields have fallen, with the 10-year Australian government bond yield dropping a full percent to 1.32% to the end of June, and it’s now even lower at 1.09%.

In fact, bonds have been a great investment since the GFC as yields have plumbed record lows. If you’re going to invest in fixed income securities now, you are, in part, placing a bet that yields will continue to fall, which may or may not happen. For investors looking to replace term deposits, you just need to keep in mind that fixed income does not necessarily mean low-risk.

Does your portfolio have an airbag?

Does your portfolio have an airbag?

by | Apr 10, 2019 | Investments, Wealth Management

The December stock market correction was a timely reminder to get you thinking about whether your portfolio has enough built in safety features. But just like a car crash, it’s safer and smarter to worry about those features before you find out you really need them.

How much risk you’re prepared to take on in your portfolio is the single most important decision you’ll make. If you take on too much you’ll be lying awake at night worrying about when a market correction’s going to stop and battling the temptation to dump your shares and hide in cash, but if you don’t take on enough risk your portfolio could struggle to support the lifestyle you want.

The ‘risk’ in a portfolio largely comes from its exposure to growth-oriented investments, like shares and property, while the ‘air bags’ come from defensive assets, like bonds, cash and, sometimes, so-called ‘alternative investments’.

Obviously, a portfolio that’s split equally between growth and defensive assets is going to be far less volatile, but over the long-run will be expected to have lower returns, than one that’s 90 per cent growth and 10 per cent defensive.

Even defensive assets have their risks

Cash is pretty much the best air bag available for a portfolio: it has zero volatility; perfect liquidity, meaning you can access it whenever you like and in whatever amount you want; bank accounts up to $250,000 are government guaranteed, and it also has what you might call ‘option value’, in that it enables you to take advantage of opportunities if they arise.

The price you pay for that security is a low return, in fact, money held in an ordinary bank account is usually going backwards after accounting for inflation. Even the average return on a three-month term deposit after accounting for inflation has been only 0.4 per cent per annum over the past 5 years, and less if you’re paying tax on it.

Bonds are the next best defensive asset, but you need to be careful about what type of bonds they are: government or corporate.

Corporate bonds are issued by a company as a way to fund itself instead of going to a bank. Obviously there are big, safe companies that are far less likely to default on their debt obligations and they get a higher credit rating, like A-grade, and there are those that are not so safe and reliable that can get rated as ‘junk bonds’ or ‘high yield’, which is anything below a BBB rating.

It makes sense that the market’s view on a corporate bond will change in line with how that company’s performing. If a company’s struggling investors will demand a higher yield to compensate for the rising risk of default, which means the price of the bond goes down, so it’s entirely conceivable you can lose money on that company’s bond.

The problem is that same struggling company’s shares will probably also be going down at the same time. That means corporate bonds are often ‘positively correlated’ to equities, meaning they go up and down at the same time, which is the opposite of what you want from a defensive asset. Not surprisingly, corporate bonds are normally categorized as a growth, or semi-growth asset – no airbag there.

Government bonds will also have a credit rating, so if you buy the bonds of a steady, developed nation like Australia or the US, the chances of them defaulting are almost nil. Again though, the price you pay for lower risk is a lower return. But think of it like this: if you were told airbag A reduces the risk of injury by 50% and costs $500, whereas airbag B reduces the risk by 90% and costs $1,000, what would you do?

There are a few tricky parts to government bonds: first, to get exposure you’re going to have to use a fund of some sort, either an ETF which just follows an index, or a managed fund that tries to earn a bit extra; second, ‘real’ returns after inflation can be surprisingly low again – over the past five years Australian 10 year bonds have averaged a smidge over 1% – but remember their job is to be defensive; finally, and importantly, over time the correlation of bonds and shares can change.

Typically investors presume government bonds are going to zig when equities zag, meaning they are ‘negatively correlated’. A great example was in 2008 when Australian shares fell 38%, while Australian bonds rose 15% and international bonds went up by 9%. But the chart below shows that since 2001, while the average of the rolling six-month correlation between US shares and bonds was -0.35, it never stood still and covered a broad range, from -0.8 to 0.4. In other words, while government bonds tend to perform well during a share market correction, there’s no guarantee.

Does your portfolio have an airbag_chart

How did bonds go over the course of the recent correction?  US shares fell 20 per cent from their peak on 20 September to the December low, while the iShares Core US Aggregate Bond ETF rose 0.5 per cent over the same time.

Here in Australia the Accumulation Index (which includes dividends) fell 13 per cent from its August peak to the late December low, while the iShares Core Composite Bond ETF, which is about 90% government bonds, went up by 1.0 per cent.

As usual in investing, there is no perfect solution to finding an airbag for your portfolio, but the right exposure to the tried and true defensive assets of cash and government bonds should at least help stop you losing sleep worrying about the next crash.

The gift that keeps on giving

The gift that keeps on giving

by | Dec 5, 2018 | Financial Planning, Investments, Wealth Management

If you’re tossing up what to give your kids who are a little more grown up for Christmas this year, there’s a gift that will keep on giving for years and years to come; in fact, you can rest assured they’ll be thanking you for it after they’ve retired. Make a contribution to their super fund.

One of the most powerful forces in finance is compounding – earning interest on your interest. And the longer you allow something to compound the bigger it gets. One of the attractions of giving your child a contribution to their super fund for Christmas is that they can’t touch it until they retire, so it’ll have decades to grow, and grow.

To illustrate the power of compounding, and the benefit of starting early, consider this classic example, represented in chart 1. Let’s say we find an extraordinary 18-year-old who decides to build up her nest egg by investing $2,000 a year for the next ten years at a return of 7% p.a. By the time she reaches 65, that $20,000 she invested has grown to be worth just shy of $387,000, as shown by the blue in the chart.

Now let’s say her friend finds out about the plan after year ten and says, hey that’s a great idea, but you know what, I’m going to put away $2,000 every year until I’m 65 in that same 7% investment. By the time he hits 65 the $72,000 he’s invested over those 36 years has grown to be worth only $369,000. And as the orange part of the chart shows, he never catches up to our early starter. That’s the power of compounding.

Chart 1: Despite investing more the late starter never catches the early bird due to compounding

If your child has a superfund already set up, which could be from as young as 15 with a part time job at a supermarket or something, you could make a contribution that starts working today and will pay off hugely in their future. (Another big tip, do them a favour and make sure there aren’t any fees for things like life insurance being deducted, which will just devour any returns.)

For example, if you were to contribute $1,000 to your 20 year old child’s super fund and it earns 7% per annum, by the time they reach 65 it will be worth $23,123; at 8% per annum it would be worth $36,164. You can work in multiples of that amount, so if you deposit $100 at 7% it’ll be worth $2,312 and if you deposit $10,000 it’ll be $231,235. It would be a great way to kickstart their retirement savings.

You should also, of course, make sure your child hasn’t hit their contribution caps.

For anyone looking to give something they can be sure won’t go out of fashion or never be looked at a second time, boosting your kid’s superfund really is the gift that will keep on giving.