Geopolitical risk has gone up a little this year, but not enough to change investment strategy or long term forecasts

The past six months has been marked by dramatic geopolitical surprises:

  • Donald Trump’s victory in the US elections
  • Britain voting to exit the European community
  • The rise of right wing political movements throughout Europe with a breakup of the European Union becoming a distinct possibility.

Domestically, the Australian economy (as measured by GDP) has gone backwards for the first time since 2011.

The doomsayers in the media are again finding their voice.

Sharemarkets haven’t responded as many commentators expected over the past six months

The short-term sharemarket response to these developments has been just as surprising.

Most expected that Brexit would have sent UK share prices tumbling, that a Trump election would have sent world equity markets into freefall and a poor Australian GDP result would have sent Australian equity prices sharply lower.

In all three cases, exactly the opposite occurred. These results have confirmed to us the wisdom of ignoring the news, and instead focussing on valuations and potential for earnings growth over the very long term when making investment decisions.

When looking at market movements from a longer term perspective, such as in Figure 1, we see that share prices have hardly moved over the past six months, which seems remarkable given all that has been happening in the world.

Figure 1: All quiet in the sharemarket these past 6 months

Sharemarket

So, what does Trump, Brexit and the European Union mean for the markets in the long term?

Trump’s policies are not yet clear. A cut to company tax rates seems likely. We estimate this should lift US profits by around 6% p.a. – which is about how much the US market has risen since the US election.

Increased infrastructure spending and personal tax cuts are also likely. Both should stimulate the US economy somewhat. The market expects these moves will increase both inflation and interest rates. We suspect that while this may be true, any impacts will be modest.

The major area of uncertainty is trade policy where Mr Trump has indicated a desire to, in effect, begin a trade war with China. This would most likely be bad for China and her trading partners which, of course, include Australia and, paradoxically, the United States. Around half the sales for the 500 largest companies in the United States come from outside of the US, and so the effect of a trade war on their earnings could be dramatic.

Finally, we have the possibility of a major diplomatic accident, such as in the contested Spratly Islands in the South China Sea, which could create all manner of consequences, none of them good.

With respect to Brexit, we don’t know how it will affect Britain.  Similarly, we don’t know if the European Union will survive and what a possible end of the union could mean for European companies. If European company managements have a credible Plan B, perhaps not too much. If not, a dismantling of the European Union could be a problem.

All of this uncertainty translates into greater risk for investors. By risk we don’t mean short-term market volatility of the kind that showed itself in January 2016 and caused such a fuss in the media. When we refer to risk we mean the chances that long-term returns are lower than we expect.

However, while geopolitical risks are higher than before, they are not unusually high. Investing in equities always carries some risk.

Sometimes the sources of the risks are obvious. At other times, all seems well but the risks are hidden below the surface.  The question we always ask ourselves is whether these are risks worth taking. Whether the additional returns we expect to get from share and property investments are high enough.

And, in particular, if things don’t turn out as we expect, is there a sufficient margin so that we will still earn a return better than the risk free alternatives such as government bonds or term deposits?

What are our forecasts for earnings for sharemarkets?

To illustrate let us look at our 10-year forecast return for International equities and Australian equities in Figures 2 and 3. To estimate 10 year returns we simply add current dividends to our expected growth rate.

We estimate our growth rate by estimating how fast companies can grow profits and whether the market will pay more or less for a dollar of profits in ten years’ time.

This is the impact of sentiment which can cause investors to become wildly optimistic or pessimistic at different times of the cycle. Right now we think investors have it about right so the adjustment we make is small.

 

Figure 2: Australian Equities Forecast 2016 to 2026
Item Forecast Notes
Dividends 5.7% Current yield including imputation credits
Expected profit growth 3.7% Inflation plus 1.5%
Impact of sentiment -0.5% Market slightly more highly priced than usual
Expected 10 yr return p.a. 8.9%  
Source: farrelly’s as at Dec 2016. Includes imputation credits

 

Figure 3: International Equities Forecast 2016 to 2026
Item Forecast Notes
Dividends 2.6% Current yield
Expected profit growth 4.4% Inflation plus 2.5%
Impact of sentiment & currency 0.9% Some currency gains expected
Expected 10 yr return p.a. 7.9%  
Source: farrelly’s as at Dec 2016

Now, the key thing to note about these forecasts is that, in both cases, the returns we expect are a lot larger than the 3% or less that are currently available from term deposits. What this means is that we can have a lot go wrong with these forecasts and still be better off investing in shares than in term deposits.

Even if shares have no profit growth for the next decade, which is possible but would be unusual, we would still get a return of 3.5% p.a. in International equities and 5.2% p.a. in Australian equities, well ahead of term deposit returns.

Now this margin of safety does not always exist. Prior to the global financial crisis, Australian shares were forecast to give returns about the same as government bonds; there was little risk premium or margin of safety. It was a time to be cautious. We expect that such a time will come again and so we monitor a range of markets.

In particular, we know that the more we pay for each dollar of dividends or profits the lower will be our returns in the future.

Given our assumptions for profit growth and dividends this means we can forecast what returns we would earn if we had to pay more or less than current market prices. This is how we put together our Tipping Point Table. It shows what returns we should expect at different prices and at the current market price (the red arrow)

Figure 3: The Tipping Points

Tipping Points

Data as at 12 December 2016.   Source: farrelly’s. No guarantee is implied as to the accuracy of the specific forecasts provided.

Despite the surprising news from around the world, we believe the right strategy is still to remain invested in growth assets

Currently all major markets should give long term returns in excess of term deposits, with only the US market returns showing a smaller than desirable margin of safety.

This means that, despite the heightened uncertainty, despite the bad news stories that we are very likely to hear in the media over coming years, the right strategy now is:

– firstly, to remain fully invested in growth assets, and

– secondly, to continue to monitor valuations within markets.

If and when markets become fully priced, or overpriced, be prepared to become more defensive. But, for now, the strategy is to stay on track.

by Tim Farrelly, CEO of Farrelly’s, and asset allocation consultant to Australian Unity Personal Financial Services

Disclaimer: This article is not legal advice and should not be relied on as such. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice relevant to your circumstances before making investment decisions. Where a particular financial product is mentioned you should consider the Product Disclosure Statement before making any decisions in relation to the product. Whilst every care has been taken in the preparation of this information, Australian Unity Personal Financial Services Ltd does not guarantee the accuracy or completeness of the information. Australian Unity Personal Financial Services Ltd does not guarantee any particular outcome or future performance. Australian Unity Personal Financial Services Ltd is a registered tax (financial) adviser. Any views expressed are those of the author and do not represent the views of Australian Unity Personal Financial Services Ltd. If you intend to rely on any tax advice in this document you should seek advice from a tax professional. Australian Unity Personal Financial Services Ltd ABN 26 098 725 145, AFSL & Australian Credit Licence No. 234459, 114 Albert Road, South Melbourne, VIC 3205. This document produced in December 2016. © Copyright 2016