February 8, 2022

Market Update – February 22

Investments

THE WORLD has become a more dangerous place for investors in the last few weeks. There are a number of disruptive factors which have emerged:

   >> The continued surge in Covid cases and the emergence of yet more variance which will contribute to more voluntary self-imposed lockdown by consumers and workers, reducing demand and disrupting supply in many industries.  

   >> A shift in the rhetoric of the Federal Reserve, indicating that it is more concerned about the persistence of inflation and its readiness to act strongly to curtail it. This would involve a faster increase in short-term interest rates and a faster withdrawal from quantitative easing.

   >> The apparent threat of a Russian invasion of Ukraine which would lead to U.S. sanctions against Russia, disrupting an important part of World Trade and increasing the price of oil and gas.  This would further feed inflationary pressures

   >> An increase in the sensitivity of investors to shifts in the growth rates in revenues of major tech companies such as that which lead to a 25% one day fall in the stock price of Meta, the parent company of Facebook.

These factors have added to the already high uncertainty in the operating environment for investors. Notwithstanding the level of uncertainty, some elements of the future are discernible:

  1. Inflation in the USA and Australia, and in other developed economies, will step up to a higher level, averaging somewhere between 3% per annum and 5% per annum over the next ten years. This is significant, but not catastrophic.

  2. Interest rates will rise over the next three to five years, with long-term bond yields rising by at least 1% p.a. and perhaps by as much as 3% p.a. This will impair the defensive characteristics of fixed interest assets. Investing in floating rate rather than fixed rate securities will be more defensive.

  3. The discount rate for the valuation of equities, real estate and other growth assets will be higher, reducing the value of longer dated cashflows from growth-oriented assets. There will be some companies whose cash flows will grow fast enough to offset this effect on their value, especially in a higher inflation environment.

  4. If there is a war in central and eastern Europe, it will probably not last more than 5 years. The longer it lasts the more it will damage economic growth.  It may also lead to much higher inflation such as that seen after World Wars 1 and 2, the Korean war and the Vietnam War.  In the absence of a war involving major countries the long-term valuation of equities is fair relative to bonds and cash and offers an equity risk premium of between 3% p.a.  and 6% p.a., with the exception of China and India which are expensively priced.  

In the absence of war investors should, due to the continued support from fiscal deficits and very low interest rates:

  • Maximise the asset allocation to equities subject to meeting their perceived need for a reduction in the shorter run volatility of portfolio returns.

  • Maintain a portfolio allocation to equities of at least 100% of the neutral or benchmark or long-term strategic weight for the relevant risk profile within the framework that applies to the portfolio.

  • Overweight developed market international equities and underweight emerging markets.

  • Underweight Australian equities, due to its concentrated composition and the risk inherent in its reliance on the Chinese economy.

  • Invest any defensive assets (cash or fixed interest) with a shorter duration or floating rate securities (to avoid losses if bond yields rise)

  • Refrain from investing in cash or fixed interest that has significant corporate credit risk, unless it is via a fund managed by managers with proven credit risk assessment skills.

If a more cautious approach is needed due to the short to medium term risk posed by either the outbreak of war or the emergence of newer COVID variants, then accumulate cash rather than fixed interest or equity investments and deploy into equities later when the uncertainty subsides to some degree. This may involve having the portfolio weighting to growth assets below 50% of its long-term strategic asset allocation.

Keep all of this under regular and sceptical review.

 

This information is general advice only and does not take into account your personal circumstances, goals and objectives. Therefore, you should consider its appropriateness for your circumstances before acting on this information.  

For strategic advice tailored to your personal situation, please reach out: info@genesisfp.com.au.

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