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The Elephant in the room

It has been an amazing run for investors. So, can it continue, when will it end and what might come next?

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Frank Jasper, Chief Investment Officer

Frank Jasper
Chief Investment Officer | Email Frank »

06 August, 2019

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Spoiler alert. No one knows.

No one knows when financial markets will go from greed to fear or when economies are likely to change direction. But we know they will. They always do.

Just because we can’t put a date on when this will happen doesn’t mean we shouldn’t think about what comes next. Some smart people have been doing just this and have useful insights on how we might position portfolios when market dynamics do finally change.

 

It has been an amazing decade for investors 

It’s more than a decade since the depths of the global financial crisis (GFC). Shares have performed remarkably over this period. The New Zealand market has been a standout, generating a return of 15.5%pa from its low on March 3 2009. 

It isn’t just NZ that’s doing well. The US share market has had its strongest start to a calendar year since 1997. The current US economic expansion is the longest on record. Ever.

The length and strength of the rally over the past decade, is making a lot of people question what’s next. 

Two investors who I immensely respect have written on this over the last month. 

Unfortunately, neither of them has a ball so crystal clear that can tell us when things might change, but their thoughts provide quality insights on how where the world might be heading.

 

Financial market history can be broken down into periods of stability with clear and volatile shifts to new paradigms

Ray Dalio, the CIO of one of the biggest hedge funds in the world, recently published a note entitled “Paradigm Shifts.”

He argues that markets and economies go through extended periods where they behave in a consistent fashion. Then something changes and the paradigm shifts. As we enter a new paradigm economies and markets behave very differently than they did in the old paradigm. 

A number of characteristics have defined the period since the GFC.  These characteristics define this paradigm. Interest rates have been falling, economies have posted tepid growth, inflation has been low and well contained. Central banks, like the US Federal Reserve, have been remarkably supportive of markets, often coming to the rescue with lower interest rates in times of stress. 

There are dangers in this paradigm. Low interest rates, low economic and market volatility and central banks that act as a backstop to markets create a misperception and mispricing of risk. It makes investors too comfortable. Comfortable investors take on too much risk. 

We see evidence of this. Too many companies are borrowing too much making them vulnerable. The pricing of some private equity and venture capital transactions looks reckless. Investors are chasing yields on increasingly speculative activity.

Excessive risk-taking and too much debt become a volatile cocktail that will, eventually, spell the end to this paradigm.

Ray Dalio highlights three things that will signal this. When interest rates can’t go any lower; we are almost there now. When prices for risky assets like shares rise to levels that imply future returns will be cash like; when you get no extra return for taking risk. And when demands for money for government expenses like pension payments, healthcare and debt service begin to head higher, which they are set to in coming years.

 

Governments to take a bigger role in our lives

In his view, the paradigm that will follow will see a shift away from the dominance of central banks towards governments and fiscal policy. That means more government spending, higher taxes and potentially outright printing of money. He expects more inflation and more social unrest. It will be a very different investing environment than today.

Ray Dalio advises investors to add gold to their portfolios. While I personally struggle with this asset class, many people don’t share that view including some of my colleagues! 

Viktor Shivets, of investment bank Macquarie, has similar views to Dalio.  He expects the state to play a more dominant role in all of our lives. He recommends investments that will be beneficiaries of newfound government largesse. That includes companies that are more local than they are global and companies that will benefit from government spending in areas like infrastructure.  

He also sees a pivot away from a strict focus on shareholder value creation by companies, driven by increased government regulation. Instead, firms will need to be more attuned to the role they play in society. The current controversies over the role of the internet giants hint at this change.

While we take a company by company, investment by investment approach to building portfolios, we are already making changes in the direction as outlined by Dalio and Shivets. We have added assets that would benefit should inflation rise. A number of our new share investments have been in domestically focussed businesses.

The elephant of a paradigm shift remains firmly in the room. Our job is to be vigilant and begin to acknowledge the presence of the big grey creature. We have started.

 

 



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