Father Christmas and the 2017 Outlook

Christmas is almost here again and another year is done and dusted. For sharemarkets it was a reasonable year. The Australian market has increased by 6% and the US market is up 8%. On top of this we have dividends of course. Interest rates continued to be very low. Australian 10 year government bonds were 2.8% at the start of the year and are currently about 2.8%. US ten year bonds were similar kicking off 2016 at 2.3% and are currently about 2.4%. Still that’s history as they say. What is in store for next year?

A curly question indeed. As questions about the future always are. Pondering this I consulted that most eminent of investment experts Father Christmas. The following is a transcript of the interview.

CT

Curtis Taylor from Lifestyle Financial Services Father Christmas. How are you? And thank you for giving me some time I appreciate it’s a very busy time of the year for you.

FC

I am very well indeed thanks Curtis. And yes it is a busy time. Just let me finish checking the reindeer forage futures and I will be right with you. It’s an important part of my cost structure you know. I looked at making Dasher, Dancer and their mates redundant a few years ago and moving to oil based toy delivery systems but wasn’t comfortable with the impact it might have had on our planet and didn’t want to say goodbye to my best friends so I am sticking with my reindeer. Although it is certainly not true to say they are emission free. Just this morning I went behind Donner and Blitzen at the wrong time and phew it was industrial grade strength. Ok I have finished checking the futures now.

CT

We would all like to know what investment markets have in store for next year.

FC

Well no one knows the future of course. I did have a lovely red crystal ball but many years ago Rudolf broke it when he stuck his nose in it. Still one can make observations about what may happen. And in particular identify some areas where the risk reward equation is poor i.e. a realistic potential return is swamped by the potential downside if the risk eventuates. Poor risk reward equations are like Comet and Cupid playing the pokies. The more they play the more likely they will lose their fodder sooner or later as probabilities catch up with them.

CT

So where are the potential risk areas Father Christmas? After all we have just had a year of respectable returns and the Dow Jones hit an all-time record high just a few weeks ago. Isn’t everything hunky dory?

FC

Things may look benign on the surface but there are some big potential risks now. What is most notable recently has been the rise in government bond yields. While the yields may be similar to a year ago yields declined earlier in the year and since then there has been a sharp increase in yields in recent months. The US ten year government bond yield has increased from 1.4% in July to 2.4% and Australian ten year government bond yields have increased from 1.8% to 2.8%.

CT

So there has been a change of 1%. That’s not much. Why is that a big deal?

FC

Increases of 0.6% to 1% may not sound large but, as you know, the capital value of bonds fall if interest rates increase and vice versa. If a bond has a short period of time to maturity there is minimal impact on the capital value of the bond however if it’s a long term maturity the impact on the capital value can be quite dramatic. For example let’s look at how capital values of US government bonds have fallen as a result of the above interest rate increases. And this for government bonds which prima facie sound pretty safe. The capital value of US two year government bonds have fallen about 2% annualised however thirty year bonds have fallen in value by 33% annualised. Far out even Prancer would choke if his oats allowance was exposed to that.

However as always it’s the future we need to be considering. We have had a thirty year period of falling interest rates fueled since the GFC by central bank policies that are unsustainable. Rates can’t keep on falling forever. Everything reverts to the mean sooner or later. So there is a real risk of further interest rate increases and given the low base that we are coming from there is a real risk of capital losses in investments that are exposed to bonds or behave similarly to bonds.

CT

Ok so what types of investments would be at risk from rising interest rates?

FC

There are a number of potential trouble spots for Australian investors in a rising interest rate environment.

Probably of the most concern would be investments or investment funds that are directly exposed to bonds or similar. If you (i.e. the investor) have in your portfolio investments called bond funds or fixed interest funds or similar you should be having a closer look. Now not all of these funds have the same risks it does depend upon the composition of the specific fixed interest portfolio. But at least be aware of what your potential risk is.

What bothers me most is that these types of funds are usually regarded as being part of the defensive component of an investor’s portfolio. And many investors seem to understandably think that if an investment is called a defensive investment it should mean no significant if any loss of capital.

A grizzled old veteran like myself still has vivid memories of 1994 when bond rates increased sharply over a short period of time. It was carnage. Back in those days we had what were called capital stable funds. Which turned out to be anything but. As an adviser it was a real hoot trying to explain to investors why they were losing money in what were called defensive investments. We now have the potential for 1994 to happen again but this time coming from a lower level of rates. If we get sharp rises from these low levels there will be the dickens to pay. No one (including their advisers for that matter) who is under age 50 has experienced how savage a sharp rise in interest rates can be on these types of so called defensive investments. At the end of the day the ongoing income yield from these types of investments is at best 3-4% which isn’t anywhere near enough to compensate for the risks. Which means that term deposits paying 3% with no risk of loss look mighty attractive by comparison indeed.

CT

Ok for defensive then we should really be looking at cash and term deposits and maybe some income securities which have variable rates and thus don’t have the same risks from rising interest rates then. Any other potential trouble spots?

FC

Yes there are. Investments that behave similarly to bonds that is there is a steady flow of income which is unlikely to rise or fall much. That’s good if the investment isn’t overvalued but high risk if the investment is overvalued and the only value support is that the return is higher than that from a term deposit. Here we have some of the favourites of investors chasing yield in recent times in particular infrastructure and property funds. Already with the recent rise in bond rates we find falls in prices.  By way of example since July Transurban is down 20%, Sydney Airports down 19% and SPDR Listed Property Fund ETF (ASX Code SLF) is down 16%. Which swamps the higher income return available (maybe 2% to 3%). Further rises in interest rates will not treat these stocks kindly.

The impact of rising interest rates on shares is more variable and it really comes down to the individual business. If the stock has a growing income this may more than offset the effect of rising interest rates particularly if the stock is not overvalued, if it is high quality and there is the potential to increase in value. In a general sharemarket downturn these stocks would still probably experience shorter term price declines but could be expected to recover strongly when the downturn was over. Stocks that are significantly overvalued and/or are not of high quality or have limited income growth potential have an increased risk of loss of capital that may take years to recover if there is a full recovery in price at all.

CT

But interest rates may not rise further next year? After all central banks still seem to be pushing the types of policies that caused the low interest rates in the first place.

FC

That could quite easily be the case and interest rate increases may get pushed out further into the future. If that happens then investors in potential trouble spots may well get away with it. At least for the time being. But that misses the point. In Southern Tasmania each summer you have a significant bushfire risk. That does not mean there will be a bushfire this summer. Does that mean a property owner should not be proactive about managing this risk? When should homeowners take steps to prepare their properties for the possibility of a bushfire? Before it happens or wait until the fire is on the perimeter of their property? If a bushfire doesn’t eventuate this year they still have their property. Similar for investors. Money printing by central banks has resulted in a big buildup of fuels in the form of elevated asset prices. It’s amazing that some types of investments have become so overvalued so soon after the collapse of overvalued investments in 2000 and 2007. If, however, you wait for confirmation that a risk is actually happening before taking risk mitigation steps it may be too late. Proactive investment is not about successfully predicting what is going to happen. It is about managing risk. In other words investments that can be identified as having a poor risk reward equation should be exited or avoided. Investments with a favourable longer term risk reward equation should be retained or invested in. If investors do this they will have probabilities working in their favour over time.

Well time to get my team out and delivering the toys. So we will have to call stumps there.

CT

Thank you very much Father Christmas for your thoughts. Merry Xmas.

FC

You are welcome. And a merry Xmas to you. May your portfolio stockings be stuffed with term deposits for defensive and high quality shares with favourable prospects bought at a rational price for growth. Ho ho ho ho ho.

It should be noted that this blog contains no recommendations it is just providing information and comment. You should seek advice if you are considering buying or selling any investments. If you would like to discuss with me anything in this blog you are welcome to do so. Contact details are at www.lifestylefstas.com.au.

There will be no blog in January. If you really cannot find anything better to do over the Xmas season you can always read previous blogs at www.lifestylefstas.com.au. Merry Xmas and a happy new year.

Regards

Curtis