Markets in the eye of the storm

Damien Klassen is Head of Investments at Nucleus Wealth has penned an excellent article which is reproduced here with permission:

Investment markets are in the eye of the storm. The initial storm danger came as COVID-19 hit, decimating jobs and smashing demand. Governments and central banks ably stepped up to stem the damage, and investment markets calmed. But insolvencies and bankruptcies have only been delayed, not avoided and the employment recovery is unlikely to be quick. The eye of the storm is not as safe as it appears.

The disconnect continues

At the risk of sounding like a broken record, the dynamic at the moment is as strange as it has ever been. I have spoken before about the best argument for buying stocks is the ironic case that capitalism is dead, and therefore buy equities. Disconcertingly, there continue to be signs that this is the case.

Governments around the world made significant changes to bankruptcy and property eviction laws.

When the crisis was expected (hoped?) to last for only a few months this was good policy – there is was no sense in shutting down companies due to short term demand issues or kick people out of homes for short term job losses. And the changes have worked:

Which is where the disconnect lies. Australian bankruptcies in the June quarter were down 42%. The US is down around the same. Europe is seeing similar effects. The number of unemployed is 50% higher than the start of the year in most countries. There is clearly a tension that needs to be resolved.

It should be clear now that COVID-19 is not a 3-month “blip” but rather a longer-term structural issue. Now it becomes a question of whether the cure actually turns into the problem.

Some jobs will never return

A Melbourne based specialist delivery company has a niche delivering to hospitals and hotels. Revenues down 75%+. Profits up 50%. Most of the profit increase is JobKeeper. But the owner has also torched middle management and worked out clients are just as happy with larger deliveries less often rather than smaller deliveries more frequently. And so productivity is off the charts. As revenues recover, the middle managers will not be getting their jobs back.

This is just an anecdote from one company, it is not data. But economic history shows a similar effect with businesses across the world. That is what recessions show us – jobs lost take a long time to re-appear. Many older workers will never work again.

Capitalism has bankruptcies for a good reason

There is a good reason for bankruptcies and evictions. When people or companies get into financial difficulty, bankruptcy gives them breathing space by cancelling interest and allowing them to resolve the problem. It forces them to reset their obligations and to come up with a plan to extricate themselves.

Just as importantly, it alerts suppliers, employees and other partners to the problem. The reason this is useful is that without bankruptcy, companies and people can simply use up credit with one supplier and then switch to another. If this is allowed to go on, then the suppliers start to go broke, and it creates a domino effect of economic issues.

Evictions are similar. Say someone cannot afford a $1,000 a week rental/mortgage because of job changes but could afford $600 per week in a different suburb. How long should they be allowed to stay in the $1,000 per week house? The longer that person is allowed to stay, the more likely it is that the landlord also goes into financial stress. Or, the bank has to reduce lending elsewhere, creating another domino effect.

Keep in mind that for the most part, rental debts or interest is still accruing, the burden is getting larger and the capital smaller. These are highly emotional issues, and in both cases, we absolutely need a safety net. But, a small debt can conceivably be paid off through a restructure. In contrast, larger debts become all but impossible to pay.

Cruel to be kind?

Say you have someone who is bankrupt, owing $25,000 to a range of credit card providers, utilities and landlords. If they go bankrupt or are forced to sell their house, then it can be a devastating event. But if the jobs are not coming back quickly then if you give that person six more months, then compounding interest and more bills might turn the amount into a much higher figure.

For the borrower, it is far crueller to be under six months or twelve months more emotional and financial stress. During this time they go from a small debt to a far larger debt while hoping for “something to come along” to fix the problem. Better to bring the issue to a head earlier.

For the debtors, an early resolution is also much better as each debtor has a lower exposure and might get paid out something. At high debt levels, individual debtors end up with almost nothing.

How long can capitalism be suspended for before it becomes a problem?

So there are two competing macroeconomic effects.

We don’t want bankruptcies to snowball into more job losses, into a housing market crash, into more defaults and so on. So, by delaying the start, it creates a calm spot, the eye of the storm.
We don’t want the lack of bankruptcies to mean that the over-indebted who aren’t paying their bills start bringing down people who weren’t over-indebted. This is the second half of the storm.

Governments were hoping for a short sharp shutdown and recovery, or a cure or a vaccine. It didn’t happen.

Governments are tempted to pull the first lever again and hope. The issue is that the second grows bigger every day. By pulling the first lever again, if we don’t get a cure or vaccine, then there is now a much larger problem.

If the last ten years have taught us anything, they have taught us that given a choice between:

taking a little short term pain for a large amount of economic gain or
taking a little short term gain for a large amount of economic pain

That politicians will take option (b) way more often than more sober observers would prefer.

The rules are rolling off around the globe, my expectation is that this will create at least some sense of normalcy. But there are already countries extending provisions until the end of the year or beyond. Which makes it difficult to assess when the eye of the storm will pass, and the second half will begin.

There is an alternative possibility: that markets are now entirely dependent on central bank support, so economics and fundamentals no longer matter. We have a checklist of a dozen decisions that governments and central banks can make that will eventually suspend capitalism.

A few of the items have already been checked off the list. The more that get implemented, the closer we get to a genuinely new paradigm. But, we do not believe this to be a likely outcome. The steps taken must become increasingly radical: effectively central banks and governments bailing out and propping up most failing businesses, turning the world’s capital markets into a herd of state-owned entities that will ‘kill the village in order to save it’.

Bubbling along

The economic and virus progress has mainly been as we expected. So, our asset allocation and superannuation portfolios remain conservatively positioned.

In the direct holding stock portfolios, our virus-sensitive positions have driven outperformance. Since the crash, we found value in commodities. First oil, then iron ore, and now gold miners. We remain very wary of banks. However, the economy and the stock markets have disconnected. The stock market is at valuations that discount no risk.

Wrap up

We changed most of our quant models a few months ago to put much less focus on the last 12 months of earnings, or the next year. The focus instead is on a mix of inflation-adjusted historical earnings and the earnings from the second year of earnings. The problem with this is:

Historical earnings don’t capture growth companies very well.
Analysts are not very good at forecasting the second year of earnings in the best of times. We are not in the best of times.

Which is an indication of the environment. You have to understand the limits of your models. The key to navigating as we exit the eye of the storm will be to not lose track of the principles of good investment while changing models enough to reflect that times are not normal.

We have a shopping list of high-quality companies that we want to own for our investors at lower prices for the very long term. Which is easier said than done. We picked up a few in March, but the problem with these companies they also bounce back the fastest once panic subsides.

Given a toxic mix of low-interest rates, volatility and expensive markets, investors will need to be significantly more nimble than in the past.

Understanding my Australian Property Investment Breakeven

Here is an excellent article from Nucleus Wealth which spells out the true issues around property investment. So many investors have their heads in the sand!

The net effect is that at current prices, finding scenarios where property won’t lose you money over ten years is not that easy. Which means most buyers in today’s market should be doing so as a lifestyle choice rather than as an investment choice.

Recently, we have seen a few Nucleus investors cash in their capital and profits and take the real estate plunge. This, of course, is sometimes more a lifestyle choice than an economic one. Being locked five months in a small flat with a partner and boisterous progeny while working off a kitchen table can often change one’s perspectives.

So what can economic conditions do I need to retain my deposit?

Given this is more about sanity than economics I start from the position that I am happy to walk away with no real profit after 10 years but I want to at least retain close to my initial capital.

To look at the various implications we will use the Nucleus Wealth Property calculator. To start I need some initial details. Let’s take the case of my son as a working example. Say he is in Melbourne, has $100K saved for the deposit and has found his dream house available for $1m. The banks are willing to lend him the balance – no mean feat in this credit environment. Let us assume he intends to live in this house so there are no negative gearing tax benefits and he intends selling it in 10 years to move to the Bahamas as he expects to be an empty nester (a true dreamer).

Thus using our Property Calculator and given we are optimists expecting a recovery from the COVID downturn we choose “Good Economic Conditions”, and use all the designated defaults to get:

Gulp!.. that’s not good… The problem with good economic conditions is that interest rate rises will limit your capital growth, and with 90% debt load the interest payments hurt. Note we are using rent received as rent “avoided” in these scenarios.

Perhaps we need to be even more optimistic so we choose “Property Paradise” conditions…which yields:

That’s more like it!! he can now afford a jacuzzi and a seaview. However a quick look at the underlying assumptions for Property Paradise yields …

While we are optimists, alas I am also a realist…. I tell him it is highly improbable he can lock-in 2.75% for 10 years, nor do I believe a 6% nominal Rent Growth year after year is realistic.

Thus we decide to input our own assumptions.

The first thing to note about the calculator is that by default it is designed for property investors that intend to rent their property. Thus as an owner-occupier (and as we are misers) we can reduce the re-investment in the property (depreciation rates to $600+halving repair assumptions) and dial down the other costs. The rental income should be viewed as money saved not paying rent, so the variables about lost rent/vacancies can be dialled down to 0.

That done, now we come to the key assumption for the calculator (and the investment outcome). What is my expectation for property prices? Investing in property implies we have an expectation property prices will recover over the next 10 years. This expectation of a property price rise can be incorporated into the calculator in a number of ways:

decreasing the Gross Rental yield
increasing the Mortgage Cost / Wage ratio
increasing the Property Price / Wage ratio
or increasing the default setting of the Mortgage Cost / Rent ratio.

We choose to alter the ratio of Mortgage Cost to Rent ratio as it is probably the easiest ratio to get a handle on. Data suggests this ratio is currently at 134%, but the long term graph suggests the 10-year average is closer to 160%.

With our expectation of post-COVID economic recovery and a resumption of Immigration to drive property demand, we take the view that this ratio should retrace toward its 10 year average of 160% (I chose to use 148% a rough midpoint between these values).

With that key assumption locked in, it is time to pull the various economic levers (inflation, rental growth, mortgage rate) to find a breakeven investment such as:

So what economic expectation does my break-even result imply?

The inflation rate would need to be 2%. This is at the lower end of the RBA band of 2-3% so not an unreasonable forecast over ten years, even if inflation is unlikely to be there anytime soon.
Rental growth needs to be 2.5% (+0.5% real). Over a ten year period this is possible. Given the slump in rents, and lack of immigration it is going to need a lot of growth in the second half of the decade.
Lastly, I need to pay an average 4% mortgage rate over the 10 years. While historically this is unprecedented, we are in atypical times and low-interest rates look to persist. A quick internet search shows Credit Unions are offering a 10 year fixed rates that are not too far off this mark, so perhaps it is an achievable goal.

As a good cross-check, using the “Compare Renting vs Buying” function in the calculator, we can confirm we are near break-even (with an assumed 0% return on the $100K over the period).

The calculator also highlights how the benefit of a geared property is mostly achieved at the tail end of the investment. i.e. if he only stays in the property for 5 years, he will be about $60k worse off than if he rented for the same period. i.e. on the assumed property with stamp duty, mortgage insurance and other entry costs he will be out over $80k. Add in $20k to sell the property on the other side and his $100k is gone, relying on capital growth to make up the difference.

Where to from here?

Using the calculator we can thus find other scenarios that achieve break-even property result (1.5% inflation, 2% real Rental growth which then means I can lock in a more attainable 4.5% mortgage rate). Alternatively, a more aggressive property price forecast of 160% (i.e. the 10-year average) mortgage cost to rent ratio means inflation could be 3%, rental growth of 3.5%, and my mortgage interest rate can now be a very achievable 5%.

Armed with these base-line cases a user can now test the sensitivities of these assumptions or explore their own expectations to assess the risks/benefits involved in not persevering with living and working on that kitchen table.

DFA Live Q&A With Damien Klassen

Damien Klassen from Nucleus Wealth joins us for a discussion on Financial Markets. Are markets disconnected from reality? A critical issue at this pivotal time.

This is the edited HQ edition, the original stream event, and live chat is available here: https://youtu.be/bgEZwX_FAPk

Digital Finance Analytics (DFA) Blog

DFA Live Q&A With Damien Klassen

00:00 / 01:29:13

Thursday 12:30 Podcast DFA On Nucleus Wealth: Home Price Outlook

You can join our podcast live tomorrow 12:30 on the link below. I reveal our latest mortgage stress results for March and discuss my latest scenario modelling. You can also ask a question live!

https://t.co/yFRSadxyIL?amp=1

It will also be available afterwards on replay.

Your Industry Super fund is about to lie to you

Damien Klassen, Head of Investments at Nucleus Wealth highlights some important issues….

He runs a superannuation fund that only buys liquid assets in separately managed accounts. So, an investor’s return is their return. They can’t rely on tax mingling, unlisted asset revaluations or other accounting tricks that master trusts use. So some may say its sour grapes. But he highlights some surprising facts. Anyone remaining in certain funds bears the brunt of the losses as others chose to leave.

Most superannuation funds, and especially industry funds have significant balances in unlisted assets. Many are telling you that these assets haven’t lost money, or are only down a little despite sharemarkets being down close to 30%. This gives rise to perverse incentives for superannuants:

If you leave one of these funds now, you will get paid at the high prices for unlisted assets
Anyone left behind bears the brunt of the losses

Rough numbers? I suspect right now that the median superannuation fund will pay you about 7% to leave.

Background

Chant West gave us a quick preview of superannuation fund returns for March:

From Chant West:

“Growth funds, which is where most Australians have their superannuation invested, hold diversified portfolios that are spread across a wide range of growth and defensive asset sectors. This diversification works to cushion the blow during periods of share market weakness. So while Australian and international shares are down at least 27% since the end of January, the median growth fund’s loss has been limited to about 13%.”

Calculation

Some quick maths.

Chant West’s definition of a growth fund is one that has 60-80% of its assets in growth equities.

Let’s call it 70% exposure to shares, 5% cash and 25% to a composite bond fund.

If shares are down “at least” 27%, cash is unchanged, and a composite bond fund is down about 5%, then the implied return is a loss of -20%.

Chant West says the loss is only 13%.

There is 7% missing.

And that assumes that the 25% is in composite bonds, more likely it is higher risk unlisted assets.

So where is the missing money?

Now, individual funds will have different performance obviously. Our own growth fund is down less than 1% over the same time frame, but we took dramatic and aggressive measures at the end of January that I know others did not.

The superannuation market is $3 trillion. It is the market. If, somehow, almost every superannuation fund worked out the same thing we did and sold equities at the end of January, the market would have fallen in January. They didn’t.

The answer is superannuation funds have unlisted assets that they are not writing down. They are pretending that the prices are mostly unchanged from January.

What about the recently announced writedowns?

A few industry funds have written down assets. For example, AustralianSuper has revalued its unlisted infrastructure and property holdings downwards by 7.5%.

Um, have they looked at the rest of the market? The listed property sector is off more than 40%. Airports? Down 30%+. Private Equity? Ha! You are telling me that illiquid shares are worth a few per cent less while listed shares are down 25%+ and illiquid bonds aren’t even trading?

The writedowns help, but are nowhere near the level the assets would sell for today.

Financial Crisis Comparison

A great example is unlisted property funds during the financial crisis. Unlisted property funds invest in effectively the same assets as listed property funds, the underlying properties are worth the same, the performance differs because of how it is reported:

In 2009, listed property was down 60%, unlisted property reported gains

The perverse superannuation incentive

The problem is that if you own a fund that reports like this, you can be diluted if other investors leave. And any contributions you make now are at inflated prices. To illustrate with an extreme example, let’s say:

You and I are the only investors in a super fund with $100 each invested
The fund owns 50% an unlisted asset and 50% cash. So, the total value of the fund is $200 made up of $100 in the asset and $100 in cash.
The asset falls 60% ($60) in price, so our fund is now only worth $140 ($70 each, we both should take a 30% loss), but the fund doesn’t revalue the asset and so reports the fund still being worth $200.
I decide to redeem my holding in the fund.
The unlisted asset can’t be easily sold, and so the fund pays me $100 cash being half of the $200 that the fund is still being officially valued at. I’ve broken even!
This leaves you with $40 of unlisted assets – a 60% loss which is double the loss that you should have taken.

Adding insult to injury

The other problem with a typical superannuation fund (but not some of the newer ones that use a separately managed account structure) is your tax is mixed with other investors. Rodney Lay from IIR recently highlighted the issue:

…unit trust investors face another risk – being subject to the taxation implications of the trading activities of other investors. Net redemption requests may require the manager to sell underlying portfolio holdings which, in turn, may crystallise a capital gain… …During the GFC some investors had both (substantial) negative returns plus a tax bill on the fund’s crystallised gains. Good times!!!

Net effect

So, if you are a loyal soldier sticking with a superannuation fund that continues valuing unlisted assets at last year’s prices then:

You are going to absorb the losses of anyone that leaves
You might even get an additional tax bill because the people that leave trigger a CGT event for you

But at least your superannuation fund will be able to “report” higher returns.

Under Property’s Skin

We discuss the rent buy decision with Damian Klassen Head of Investments, Nucleus Wealth, and the broader issues of asset allocation in these uncertain times.

Note Nucleus Wealth DISCLAIMER: This presentation has been prepared by Nucleus Wealth and is for general information only. Every effort has been made to ensure that it is accurate, however it is not intended to be a complete description of the matters described. The presentation has been prepared without taking into account any personal objectives, financial situation or needs. It does not contain and is not to be taken as containing any securities advice or securities recommendation.

Furthermore, it is not intended that it be relied on by recipients for the purpose of making investment decisions and is not a replacement of the requirement for individual research or professional tax advice. Nucleus Wealth does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this presentation.

Except insofar as liability under any statute cannot be excluded, Nucleus Wealth and its directors, employees and consultants do not accept any liability for any error or omission in this presentation or for any resulting loss or damage suffered by the recipient or any other person. Unless otherwise noted, Nucleus Wealth is the source of all charts; and all performance figures are calculated using exit to exit prices and assume reinvestment of income, take into account all fees and charges but exclude the entry fee. It is important to note that past performance is not a reliable indicator of future performance. This document was accompanied by an oral presentation, and is not a complete record of the discussion held. No part of this presentation should be used elsewhere without prior consent from the author.

How To Invest During The Coronavirus Pandemic | Nucleus Investment Insights

Governments have turned a corner on the Coronavirus, now prioritising preventative measures to combat its spread rather than minimising economic and market impact.

In today’s webinar, hear from Nucleus Wealth’s Head of Investment Damien Klassen, Chief Strategist David Llewellyn Smith and Head of Operations Tim Fuller, as they cover “How to invest during Coronavirus pandemic”

In this episode, we cover why the economic impacts of Coronavirus will far exceed that of SARS did in 2003, the time for cautious investing being now, countries and sectors to avoid investment in, and as always our investment implications wrap-up.

To listen in podcast form click here: http://bit.ly/NucleusPod

Damien Klassen and Tim Fuller are an authorised representative of Nucleus Wealth Management. Nucleus Wealth is a business name of Nucleus Wealth Management Pty Ltd (ABN 54 614 386 266 ) and is a Corporate Authorised Representative of Nucleus Advice Pty Ltd – AFSL 515796.

MMT: coming to a politician near you! With Dr. Steven Hail | Nucleus Investment Insights

Nucleus Wealth’s Head of Investment Damien Klassen, Tim Fuller, and Dr. Steven Hail discuss cover “MMT: coming to a politician near you!”

Dr. Hail holds a PhD in Economics and is a lecturer in the topic at the University of Adelaide, where he uses a modern monetary frame to understand macroeconomic issues.

Topics on the agenda included: background on Modern Monetary Theory, countries closest to considering MMT and how Australia could potentially employ it, MMT’s relationship to Bonds & Inflation, legistlative hurdles in the way and much, much more

To listen in podcast form click here: http://bit.ly/NucleusPod

The information on this podcast contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen and Tim Fuller are an authorised representative of Nucleus Wealth Management. Nucleus Wealth is a business name of Nucleus Wealth Management Pty Ltd (ABN 54 614 386 266 ) and is a Corporate Authorised Representative of Nucleus Advice Pty Ltd – AFSL 515796.

Is Inflation Back From The Dead? Nucleus Wealth Podcast

Nucleus Wealth’s Head of Investments Damien Klassen, Head of Operations Tim Fuller, as well as ex-fund manager, Analyst, and blogger Kevin Muir of ‘The Macro Tourist’ discuss ‘Is Inflation back from the Dead?’

Topics this week include a background on world markets and why growth and inflation have been so stagnant, Modern Monetary Policy, why Kevin believes inflation is just around the corner and the best option to deal with global debt, and their outlook on where China and Australia’s economy moving to.

Note: DFA has no commercial relationship with Nucleus.