InvestSense October Market Update

Q&A

Q: What role does InvestSense play in the building and constant reviewal/rebalancing of portfolios?

A: If you can try and imagine a day at InvestSense, it’s one never-ending investment committee, where every day we look at markets and financial news, and we analyse stuff. From that perspective - thinking about portfolios is not something we do once every quarter. It is really an ongoing enterprise, and whenever we come up with a good idea, or something that has to be done, we give you guys a call, discuss it, and implement. Through what is called ‘managed accounts’, every time we make a decision, it gets implemented instantly to all client accounts at the push of a button. This is important if we want to buy or sell something, so that it can be done in a timely manner.

Q: What is valuation investing and what are the key benefits?

A: Without getting too technical right away – essentially, valuation analysis means that we’re looking at the information that is currently available to all participants (and that's important because it's an objective methodology, it’s not our view of what’s going to happen, it's really just taking the information at hand and deriving a view of future expected returns). Just to bInvete clear, we don’t have a crystal ball. Especially in the short-term. We have no idea what's going to happen tomorrow, next month or even what's going to happen next year, but the valuation methodology allows us to have a pretty accurate view of what’s going to happen over the next 10 years. And that is essentially everything that we are trying to achieve. By looking at all of the available investments; Australian shares, US shares, European shares, bonds here and overseas, and saying, “how much are we likely to get paid for that? Is that a good return relative to other available investments? And most importantly, what risk am I incurring by taking that venture. If something goes wrong, how much might I lose?” And then therefore everything becomes a risk-return analysis. “Here's my expected return, here’s my expected risk, and is that a good trade-off?”

Q: How do the fixed interest and cash positions help in a situation such as this?

A: That's probably the most difficult question I’ll have to answer today. The interesting thing about valuation investing is that you can be wrong in the short-term in order to be right in the long-term. As I said, we don't know what's going to happen in the near future, and therefore the decision we make may or may not work right away, but there's a high likelihood of it working in the long-term. What this means for us now is that as things are getting uncomfortable for investors, and as share prices are going down, paradoxically for us, things are actually becoming more attractive. That means that the future expected returns from this point onwards are actually higher. Years like these are spent trying to find attractive investments that have popped up. We don't spend most of our time thinking about how to get more defensive, because again that's quite short term. We cannot predict if markets are going to rebound here or continue to go down. However, we can observe that over the next 10 years some things are starting to look a little bit more attractive, and that's really where we’re focusing our efforts. Overtime, as things are getting cheaper and cheaper, the plan is to actually increase risk and start buying more. Now, we haven't reached that stage yet. We're still positioned fairly neutral across the portfolios, so the usual balance of growth assets (i.e. shares) and defensive assets (i.e. bonds or cash). But, at one point in that process, there will come a time where we will probably feel the most uncomfortable, and that is when we will start adding risk to the portfolios.

Q: How do the fixed interest and cash positions help in a situation such as we’re currently seeing?

A: Normally that would be a fairly simple question to answer, but so far this year, it's become a bit more difficult. Typically, what I would answer is that cash, and especially bonds, are there to provide a counterweight to equities. So in normal times, from bonds you’re collecting a coupon (like a dividend that gets paid for holding the bond) and the value of the bond is fairly stable. Typically, they are defensive instruments because when equities go down, the price of bonds tend to go up. In normal times they grow slowly, and in bad times they kind of protect the downsides a little bit. What’s been happening this year is different and unusual. Equities have gone down, and one of the reasons they’ve been going down is because interest rates are going up, again not trying to get too technical here, but interest rates going up means the price of bonds also go down. So, we have this very unusual situation where both equities and bonds have gone down at the same time, and that is a challenge for people like us who are building portfolios. In that instance, the only true defensive asset is cash, and we hold a fair amount of cash. Probably one of the things that we have been most successful at is investing in bonds that actually have turned out to be defensive, even in this environment. We had to think a little bit outside of the box here and make a few calls that were a little bit off the beaten path and invest in non-traditional bonds. That has been probably the most helpful decision we made over the last few years.

Q: What are the primary causes of the international inflation hike?

A: We could spend hours talking and debating that. It all starts with COVID, in that governments in Australia and almost everywhere in the developed world stepped in to help the population financially. Here in Australia, we had JobKeeper and JobSeeker. The rest of world had similar intentions which was to divide cash in the hands of consumers and to help them through this difficult period. So you have incomes around the developed world going up. Everybody had more money, and were therefore able to spend more money. At the same time, you had a disruption in the production of goods. A lot of the goods manufactured in China, for example, were not being manufactured anymore. A lot of businesses stopped producing because of lockdowns. So we’re in a situation everybody has more money to spend, but there’s actually less goods available. That's a very simple supply and demand imbalance. If you have more money but there’s less goods, the price of those goods has to go up in order to meet that demand. That's what’s started to happen and we continue to see the ripple effect of that. That's probably the primary factor, I would say.

The second, which is slightly related, is the supply chain disruptions of COVID and of geo-political tension that have caused the contraction in the amount of available goods, shipping, etc. Everyone thought that this supply-chain disruption was a fairly short-term thing. As it happened, once the genie was out of the box, it was really hard to put it back in, and it's taking months and years for those disruptions to be fixed. We are starting to see signs now of things improving. The third major factor is obviously the war in Ukraine, which has disrupted a lot of commodity markets, but especially the price of gas and oil. Energy prices feed into pretty much everything that has to be manufactured. Even services use energy. And therefore, if energy prices are going up, everybody else has to increase their prices, and that's had a big effect on inflation. Finally, the last thing that I would mention is ‘inflation expectations’. When people expect inflation to occur (as is the case today), people change their behaviours around that. If I know that I need to buy a TV and I’m worried that TVs are going to be more expensive in 3 months’ time, then I'm purchasing it now. So actually, people are bringing forward their purchases. If I know that my cost of living, because of rent, energy, etc. is going up, I'm going to go to my boss and ask for a raise. In order to pay for the raise, my boss is going to have to increase the prices of whatever goods or services they are selling. All of these things combined are lifting inflation.

Q: In light of the inflation hike, why are central banks increasing interest rates, and what is the difference between a potential recession or a ‘soft landing’?

A: Remembering what I said about inflation, there is an imbalance between high demand and low supply, and that is the case for goods and manufacturing, but also for services. Everybody is experiencing shortages of staff, and the price of services is going up as well, because employers need to pay their staff more. Central banks cannot easily solve the supply problem. If there is a shortage of energy, the central bank cannot pump more oil out of the ground. They cannot easily encourage people to come out of retirement and start working, nor manufacture more goods. The supply-side is very hard to solve. It instead has to be solved by governments and private enterprises, and usually happens over a number of years. What the central banks can easily do is solve the demand issue. “If I can’t bring up the supply, then I can only bring down the demand”. And that’s what the purpose of increasing interest rates is. So by increasing interest rates, the central bank is essentially making our lives more difficult on purpose. It means mortgage payments are going to go up, and therefore we’re going to have less money to spend on other things. And that is what the central banks in Australia and pretty much all of the developed world want to do at the moment, is to make us consume less, in order to lower demand and inflation. To the second part of your question, they’re trying to fine-tune that, so trying to lower demand and in essence slow down the economy (inflation is a sign of an ‘overheating’ economy), it's very hard for them to get it perfectly right. The problem is that if you slow down the economy too much, you end up in a recession. A ‘soft landing’ is the scenario where they lower economic growth just enough that it lowers inflation, but doesn't push the economy into a recession. That's the ideal scenario that everybody is striving for. The other scenario is where they have a conscious choice to make. They are very worried about inflation, and that becomes an even bigger threat than a recession. And therefore, they are almost willingly pushing the economy over into a recession because it's the lesser of two evils.

I find the first part of your answer to our question quite interesting in relation to the valuation-based model and philosophy, in that when they do ‘pull the handbrake’ on the economy, you spend a little bit less, but you do have to spend money on the needs in life, and then you obviously sacrifice the wants. It's no surprise that on the back of that, we don't have a lot of tech and consumer discretionary exposure in our portfolios, particularly in a time like this. So, if you looked at our portfolio, there a lot of companies that you more or less need to spend your money on; petrol, utilities, supermarkets, those kinds of things, versus a tech stock or retail store.

A few words on that. I think for the first part of the year, the focus was on companies that can pass on inflation. (i.e. “Who’s got the pricing power to pass on inflation to consumers and therefore protect their level of earnings?”) Whereas, I think increasingly as you mentioned, the focus is going to be on “which are the companies that are more likely to do well in a recessionary environment?”. And as you mentioned, it tends to be those defensive companies; consumer staples, etc.

Q: The war in Ukraine has been going on for a while now, and we were talking earlier this week about how it kind of feels like “yesterday’s news”. It’s obviously still very much ongoing and seems to really be ramping up in recent weeks. Do we expect its significance in the world’s economy, and particularly share markets, to continue to dwindle away like it has felt, or could we still see some significant market consequences to come form that?

A: When we discuss those things, I think it’s important to make it clear that although we do spend quite a bit of time reading about the geo-political events, and we definitely take those into consideration in our investment decisions, at the end of the day, we are very much guided by the valuation framework that we described earlier, long-term views, objectives analysis, etc. And having said that, I think the major impact that the Ukraine war has had on markets so far has been in energy markets. There has been others, but that’s really the essential one. That hasn't gone away, and I think given recent developments it seems that it is unlikely to go away anytime soon. The recent events I am referring to is there was a gas pipeline connecting Russia to the rest of Europe called Nord Stream. There has been an incident where something in the pipe has broken (or exploded, depending on your interpretation). The outcome of that is definitely going to be even less energy flowing from Russia to the rest of Europe. And therefore, the disruptions that we have seen seem likely to sustain. It doesn't seem like we're nearing a resolution anytime soon. At the same time, other energy producers haven't been willing to increase their production, and are maybe unable to increase their production, so we still have exactly the same dilemma that we had at the beginning of the conflict, which was that the price of energy is expected to be relatively high for the foreseeable future. And that flows through the rest of the economy. I think that's the major takeaway, but as I said, that's more a subjective opinion.

Q: Does the share market volatility have a direct correlation/influence on the chances of a recession? If share markets are falling, does this directly affect GDP?

A: That’s almost a deep philosophical question, but if I can answer at a headline level, I think it’s the other way around. Basically, the share market is forward-looking. Investors collectively don't just look at what happened in the recent past, or what’s likely to happen in the future, but everybody thinks for the long-term. Especially equity markets (i.e. “whatever is likely to happen in the next few years, I'm going to bring into the price today. Even if I'm worried about a recession in a year or two-years’ time”). And this is why shares are going down today. It’s almost as if the share market is a thermometer, if you will. The fact that the share market is going down today isn’t what’s going to cause GPD to go down, it isn't what's going to cause a recession, it’s actually a reflection of the fact that investors are worried about GPD going down in the future. At a deeper level, I think there’s definitely a psychological effect where the share market is going down and people are pulling their horns in. There is less liquidity available, meaning less money to investments. If a firm is looking to invest into a new production plant or whatever it is, they need to raise money for that, but that’s going to be more difficult to achieve in an environment where shares are going down, where investors aren’t willing to lend money, so you can see that that definitely has a flow-on psychological impact, and that impact can last for a while.

Q: Why is the UK buying up so many bonds this week?

A: That is a very unusual thing that happened in the UK. As you probably know, there was a new government that was sworn in with a new Prime Minister and Treasurer, and the new Treasurer almost immediately implemented a revised budget that was not exactly what markets had expected, or maybe contrary to what markets wanted. The key aspect was cutting taxes. But, they’ve not reduced expenses. This essentially means that the government ‘deficit’ is going to grow. There is already quite a large deficit; a lot of government debt on their books. So they’re saying they’re just going to add a lot more debt to that. That’s going to have to be financed by a lot of bonds; they’re going to have to issue a lot of bonds which they’ll have to pay for. Essentially, the market started losing faith in the UK government, and therefore in their government bonds. The price of UK government bonds went down close to 25% in a matter of days, which is something we’ve never seen before, at least not in developed markets. That has essentially almost forced the central bank in the UK to intervene, to say “we can’t allow that to happen, that’s too much of a disruption to the normal-function of markets and the economy, and therefore we need to support the price of our bonds.” And therefore, the central bank does what it can do, which is to step into markets and start buying bonds. And we have seen the price of bonds come back almost all the way up to where it was before. The implication is that when the central bank buys bonds, it essentially injects liquidity (i.e. money) into the economy. That's a ‘stimulative’ measure. That's usually what the central banks do in times of a recession. It's what the central banks did during COVID. The problem now is that the central bank, as we discussed earlier, is actually wanting to do the opposite. They’re not trying to stimulate the economy, they're trying to slow down the economy. That puts a few question marks on what the outlook for inflation is going to be in the UK. We haven't seen anything like that from the central bank here in Australia, just to reassure investors here. We don’t have anywhere near the same debt levels and we haven’t seen anything like those kinds of disruptions to our bond markets that would force the central bank to do what they did in the UK.

Q: In light of everything that we've discussed today, and the things that have happened in the global economic environment, not just in the last 12 months but probably the last two or three years, the obvious question is: are you at all surprised about the market volatility both domestically and abroad that we've experienced?

A: That’s more of a personal question, which I’m very happy to answer. As I mentioned, I started my career over 20 years ago. I started back around 2000-2001. I've been through the NASDAQ tech crash, the GFC (and I was actually still working in New York, very much in the heart of it at the time) and through COVID, so in a relatively short period of 22-23 years, I’ve lived through three major crises. And especially when you start with a crises, you kind of grow to expect the crises almost at every turn. A lot of people say that the year people start their investment career usually defines whether they going to be always optimistic or always pessimistic. I guess I fall in the slightly pessimistic camp. That’s also part of what we do at InvestSense. We’re trying to think about what might go wrong. Not necessarily what will go wrong, but what are the risks. So I haven't been surprised, to some extent I think it was fairly assumed that COVID represented such a disruption in so many different ways, that the impact and the ripple effects were going to last a few years. Probably the most important part is that while these periods of time are scary and unsettling, they also represent opportunities over the long-term.

I think what’s important to keep in mind is that most of your clients are relying on that money for retirement. And for younger clients, that is the good news, in that your Super money is not something you’re going to need to pay your rent. It is something that you will need in your later years in life. And there's good news there which is that you are today buying assets every time that you have a Super contribution. Today you're buying assets at a 20-30% discount to what you bought them 9 months ago. That's a great deal for investors. It doesn't matter if things continue to go down because you've already been buying at a great price. So I think looking forward, this should actually be interesting or even exciting times for investors, even if it doesn’t feel that way.