By Chad Padowitz*
It can seem a paradox that while investors are generally buying assets for long-term growth, it is short-term fears that drive market sentiment.
At the moment, there is a lot to be concerned about in the short-term but the reality is that most of today’s economic concerns are part of a long-term trend that started decades ago.
Fears of a double-dip recession in the US; concerns about Greece’s future in the European economy; and talk of a slow-down in China; are all serious issues that are understandably worrying investors at the moment.
The big picture of what is happening in the world at the moment – basically, a mass deleveraging that is creating a major hangover for most economies – started well before the global financial crisis and the subsequent debt concerns in Europe and the US.
Since the end of World War II, the world has continued to find new ways to borrow more money, creating a situation of huge leveraging (see chart A for the US example). Population growth has helped drive-up asset prices which have provided a platform for the leveraging, but in the long-term it has not been a sustainable situation.
CHART A
It’s not normal, and not possible, to have this kind of debt accumulation without, at some point, needing to start to pay it back, and this is the phase that the developed world is now entering.
As a result, we have switched to a deleveraging phase for the first time in over sixty years.
Most working Australians simply can’t remember a time when borrowing wasn’t the norm, and therefore need to learn about new ways of doing things, as the old ways – including borrowing to the hilt – simply don’t work any longer. Property is a good example of this – the experience of the last generation has been that property prices go up, and can be sold for more than it was bought for. The last few years have taught many people that this isn’t necessarily the case, a hard and expensive lesson to learn.
Deleveraging
Deleveraging hasn’t been unheard of in the post-War era. For instance, the Spanish inflation crisis between 1976 and 1980 was triggered by (or triggered) deleveraging in that country, and resulted in 50 percent of Spanish banks being nationalised. The sovereign default in Mexico in the 1980s saw inflation reach 130 percent. In Malaysia, a financial crisis between 1998 and 2008 saw the stock exchange fall 65 percent, while during the Finnish financial crisis in the 1990s, house prices fell 50 percent.
So deleveraging does happen – and when it does, it hurts. This is something that Australian investors – as well as UK and US investors – are just starting to learn. It is likely to lead to a lower living standard, less certainty about the future, and market returns being much less linear, with sharemarkets more volatile, and less likely to trend upwards.
There are three ways for governments and central banks to try to stop these trends. They can either pay down debt; inflate the debt away; or default.
If the ratio between debt and GDP is greater than 100 percent and the first two options are not feasible then default may be the only option remaining. This is always a bad outcome for workers, governments and retirees, but it does have the benefit of allowing a “reset”.
Impact on Australia
Australia is certainly not immune from these problems, particularly if China wobbles. Outside the mining sector, we have a relatively uncompetitive economy, and there is little diversity in the Australian sharemarket. The major sectors represented – resources and banks – are both vulnerable; resources to Chinese overinvestments, and banks to overvalued property prices.
Gross domestic product (GDP) growth rates will also be lower and it will therefore be easier for countries to slip into recession. We are already starting to see evidence of this, with some market commentators believing that Australia has entered a new expansion phase, and others convinced we are about to enter a recession. The gap between the two has narrowed, and it is increasingly possible to see good evidence for both outcomes.
At the same time, although Australian household debt is declining, it is still at historical highs and has a long way to go to achieve more sustainable levels (see chart B).
CHART B
For investors, this “new normal” means there are fewer places to turn. Bonds are a good example. Historically, bonds could deliver returns of around six or seven percent, and still be low risk. Today, low risk bonds from stable countries are returning just one or two percent – Australia is at least for now a rare exception.
Returns from cash will likely be eaten away by inflation, and the deleveraging of property markets means that this asset class is also less attractive to investors, as property needs leverage to appreciate in value.
International opportunities
International equities still offer some good opportunities and benefits. They are reasonably cheap by historical standards and, for Australian investors, the still-strong currency means that they are very good value. There is risk, but this can be managed by avoiding anything with leverage, and seeking income from shares rather than only capital growth.
At Wingate, we also look for high quality international companies that have the resources to manage their way through difficult times, and have no, or very little, leverage risk. We also look for companies that earn their money from different countries. Nestle and Coca-Cola are good examples of this. Similarly, we prefer to invest in a global energy producer rather than one focussed on one market – for instance an oil company that derives most of its income from the UK is very vulnerable to policy changes in that country such as an increase in the oil tax.
So it isn’t all doom and gloom, but it does mean that investors need to be even more vigilant and disciplined than ever before. The last 50 years are not how the world works, and this deleveraging, while painful, is needed. Sharemarkets will most likely track sideways for some time, and investors need to benefit from careful stock selection in order to ensure solid returns and minimum risk.
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* Chad Padowitz is the chief investment officer at Wingate Asset Management, an international equities boutique fund manager formed through a joint venture with Australian Unity Investments.
The information in this document is not based on the financial objectives, situation or needs of any particular investor. You should therefore consider whether this information is appropriate for you.
