Investment update: How to navigate current uncertainties

By October 20, 2020 Financial Planning
investment update

There is never a perfect time to invest. The stars never align. In reality, there will always be reasons why investing now feels risky. The solution is to learn to dance with uncertainty.

Generally, most people can achieve this by doing two things. Firstly, focus only on generating quality investment returns in the long run. Ignore any short-term outcomes, as they are rarely relevant. Stick to proven investment fundamentals. Only adopt evidence-based strategies. Playing the long game often inspires higher levels of confidence. 

Secondly, embrace the fact that uncertainty is your friend. Potential investment profits are greatly improved during times of higher uncertainty. Early April is a good example. We helped many clients invest in the share market during April and subsequent months. Whilst we are fixated on maximising long term investment returns, our clients have generated very good returns in the short run.

Investment update:

With this in mind, I thought it would be useful to share my thoughts on a number of risks (read: opportunities) that present themselves at the moment, and how I think you best navigate these.

The US election

The first thing to realise is that markets focus on policies, not personalities. From a pure market/economics perspective, a Trump victory is probably more attractive, at least in the shorter term. The reason for that is Trump’s agenda is to continue reducing taxes, whereas Biden wants to wind back some of Trump’s previous cuts. It is questionable whether now is the right time to raise taxes, especially since the US economy needs all the help that it can get at the moment. That will be ‘the markets’ primary concern.

There is also some divergence in energy policies. It is fair to say the Biden’s energy policy generally favours environmental protection (Biden plans to impose a ‘carbon adjustment’ fee).

Of course, whether a President can implement their policy agenda depends on whether they control the House of Representatives and Senate. The Democrats already have a majority in the House of Representatives, so it needs to win the Senate in next month’s election to control all three arms of government. If they don’t, the Republicans can block legislation unless the Democrats can get rid of the filibuster, which you can read about here.

The big question is whether Trump will go quietly. I’m sure most people would agree that this is unlikely. A refusal to leave the white house, a legal challenge and who knows what else are all possible outcomes. Market’s dislike uncertainty and such events will probably result in higher levels of share market volatility, which investors must be prepared for.

In addition, any delay in inaugurating a new president will further delay the approval of a second trillion-dollar stimulus package which could exacerbate economic damage.

There is nothing long term investors can or should do to accommodate these risks. It is merely a case of acknowledging that this volatility could arise, but it’s unlikely to persist for more than a few months (hopefully).

US tech sector valuations

The chart below eloquently illustrates the impact that the FAANGM stocks have had on the overall US share market index’s performance (the FAANGM stocks include Facebook, Apple, Netflix, Google, Amazon and Microsoft).

These six stocks have contributed approximately 40% of the index’s return (i.e. the return over the past 7.5 years was 10.4% p.a. or 7.4% p.a. excluding the FAANGM stock).

investment update

This creates a number of risks:

  • Will (can) these large tech stocks continue to deliver these high levels of returns in the future?
  • If you invest in the S&P500 index, you must realise that it is heavily weighted towards these tech stocks compared to say 10 years ago. These FAANGM stocks account now account for approximately 26% of the total index.
  • It is true that these tech companies have massive scale. They have benefited from the impact of Covid i.e. more online shopping and working from home. They will play a significant role in the economy in the future and drive increased productivity. All these things are true. But it is also true that these are fully reflected in current prices. In fact, current tech valuations are reminiscent of the early 2000 dotcom bubble. What impact will the ‘tech bubble busting’ have on investment returns?

My general advice is to ensure your portfolio is underweighted in the US tech sector. You can achieve this by adopting alternative evidence-based index methodologies (i.e. not traditional market cap) such as fundamental indexing and Dimensional’s approach. It is still important to have some exposure and you most definitely need to have exposure to the US market (as it’s the largest developed economy in the world).  

Covid impact on the property market

I have written a lot about my expectations for the property market over the past few months. My most recent article in The Australian newspaper earlier this month highlighted the reasons why I expect the $1 million plus property segment to lead the recovery.

For those that are contemplating a property transaction (sale and/or purchase) in an investment grade location, I see no reasons for delay. But, by the same token, there is no need to rush either. Proceed as quickly as your circumstances allow.

In the long run, the fundamentals for investment-grade property locations remain largely intact.

Covid’s impact on overseas immigration

Of course, due to the closure of international boarders, Australia’s overseas immigration is non-existent. It may take two to three years for immigration to return back to pre-Covid levels. This is likely to have an adverse economic impact and a limited impact on investment-grade property.

Two thirds of Australia’s population growth comes from overseas immigration. Population growth is incredibly important for economic growth because a higher population leads to increased productivity and consumer demand. Therefore, in the short term, lower immigration levels will adversely weigh on economic activity. Of course, the aim of the government’s Federal budget is to stimulate economic activity to offset some of this impact.

It is unlikely that overseas immigrants contribute materially to the demand to purchase properties in investment grade locations. Instead, more immigrants will be renters, not homeowners as most are on temporary visas. Therefore, lower immigration levels may lead to lower rents in the short run, particularly in the student accommodation sector.

The main reason we invest in property is for capital growth. For the reasons mentioned above, temporarily lower immigration levels are unlikely to have a material impact on capital growth rates in investment-grade locations.

What’s the impact of interest rates being lower for longer?

A few weeks ago, I wrote about how interest rates will likely remain very low for an extended period of time and how fixed rates are approximately 0.50% p.a. lower than variable rates. Home loan fixed rates (3 years) are now in the low 2%. Approximately 5 years ago the inflation rate was higher than this!

These ridiculously low interest rates have two consequences. Firstly, they will inflate asset prices including property values. Secondly, it makes ‘investing in your home’ probably one of the most attractive investment strategies. I wrote about this in April here.

I have always advised clients to buy an investment-grade property as a home, where possible. However, now more than ever before, this is an increasingly powerful strategy.

Most ‘risks’ are not real

Perhaps the common theme from the above commentary is that these “risks” tend to fall into two categories. They are either events that are short term in nature which investors should ignore and remain focused on long term outcomes. Alternatively, they create opportunities for those that are willing to look for them (such as low interest rates).