US real estate billionaire Sam Zell recently lamented the lack of demand in the global economy. “We’re still looking all over the world for demand. And tell me where the demand is?”
It’s a fair question. Emerging markets have soured along with the strong US dollar and falling commodity prices. Europe is still thawing from the global financial crisis, growth is slowing in China, and US economic growth will labour below the long-term average due to the country’s high national debt and low interest rates. This encourages overcapacity in all manner of industries, and ultimately deflation, as the rise and fall of the US shale gas industry has shown.
It’s important to remember that economic growth is not a good predictor of investment returns. Just look at the divergence between the performance of China’s economy and its sharemarket over the past decade. Up until recently Chinese shareholders have had little to show for an incredible amount of economic growth.
Implications for investors
That said, weak economic growth combined with high valuations does have implications for investors. For starters, you can no longer rely on a rising tide lifting all boats. Up until recently, owning a portfolio of the big four banks and the two iron-ore titans had worked out very well, without requiring much effort other than holding your nerve. Credit growth was strong, individual debt levels and interest rates have continued to reach new records and Australia’s economy barely skipped a beat during the GFC thanks to China’s incredible investment boom.
Now that those economic tailwinds are becoming headwinds, we expect much higher dispersion in the outcomes for individual businesses. That means being more selective about the companies you choose to own.
Slower economic growth can lead to more intense rivalry within industries fighting for a higher share of a shrinking pie. Companies with strong competitive positions from having superior products, prices and distribution systems will be better positioned to preserve their profit margins, while relatively weak firms face margin contraction and potential demise.
It’s worth noting that policies such as quantitative easing often reward investors in the weakest companies, as they’re the most leveraged, which isn’t how capitalist systems are supposed to work.
With valuations either high or extremely high thanks to extreme monetary policies, slower economic and profit growth is also slowing the growth in asset values, as investors question the rosy assumptions needed to justify ever higher values.
Weak earnings guidance punished
Companies that publish weak earnings guidance are punished severely as investors look for perceived safety – safety being measured by the likelihood of a stock’s price going up, rather than offering a large margin of safety in the form of a cheap price, which is a far more reliable indicator of satisfactory long-term returns.
Following last year’s annus horribilis for many value investors, the twin dynamics of greater dispersion between individual company outcomes and lower overall returns from financial markets create an environment where disciplined value investors should be increasingly rewarded over time.
Although the Australian dollar has fallen a long way since reaching parity with the US dollar, the case for overseas diversification is still strong. The pillars of most Australian portfolios are the big four banks, which are a leveraged play on the Australian economy. Given the massive increase in personal debt levels, the next 20 years for the banks will look very different to the past 20. That goes ditto for the resources industry, which benefitted from a China’s unrepeatable credit binge.
Intelligently diversify your portfolio
If you can find businesses listed abroad that aren’t totally reliant on a strong economy for growth, and that operate in industries that don’t exist in Australia, then the increasing volatility will allow you to intelligently diversify your portfolio without taking large risks. Given increased volatility is likely to be a permanent symptom of unprecedented monetary stimulus and currency wars, you should be provided with plenty of opportunities to buy low and sell high.
And if Australia’s housing market ever comes back down to earth, then you’ll likely still be able to afford an overseas holiday as the Australian dollar falls along with interest rates.
Producing attractive returns in the sharemarket will require being more nimble than most investors are used to in order to take advantage of higher volatility. If you haven’t got the time or inclination to manage an increasingly complex market environment, make sure you have a trusted partner with a long-term record and process that you understand. Unfortunately there are no easy investment decisions in a low-interest rate, low-growth world that threatens the quality of people’s retirements.
