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Newsletter 31

22 Sept 2021

High Asset Prices and Stagflation

Global Markets:  All asset classes are expensive

As you will be aware global markets have recently been volatile. Specifically, on 20 September 2021 there was a US equity market correction where Dow Jones Industrial Average (DJIA) went down by 1.78% and Nasdaq went down by 2.1% after falls the previous week. As expected, the Australian equities market, as do all international markets take their lead from the US.

It is important to watch debt markets as it is this market where a financial crisis usually has their roots, e.g. the Global Financial Crisis of 2007/2008 was because of Mortgage Backed Securities (MBS) and Collateral Loan Obligations (CLOs) and much of the the current market jitters are around Evergrande, a major Chinese property development company which has massive debts and is in financial trouble. Unlike in 2007/08 when the MBS and CLO problem could not easily be quantified it then became a global problem, the Evergrande appears to be substantially limited to China and the risk can be quantified. However, it is possible there could be a negative impact on consumer and investor sentiment which could have a knock on effect of spooking markets.

It is not possible to predict the direction of markets although there appears to be downward pressure because the world has never seen a situation where nearly all asset prices, e.g. property, equities, bonds and precious metals are simultaneously close to all times highs and there are high debt levels and negative real interest rates. Historically, one asset class will be underperforming which opens the door to rolling funds across into it and out of the higher priced asset. This is not the case.

As asset prices are close to all-time highs should you sell? The answer depends on what your long term goals are and what is the alternative investment, i.e. where do you put your money? Cash is not earning anything. Selling also means you are realising any gains/(losses). If your time horizon is longer than 5 years, then holding on and riding out any market correction is the best solution. This is demonstrated by the 2007/08 crash. It took the S&P 500 index and S&P/ASX 300 index 4.5 years and 13 years respectively to return to their pre-crash peaks. This time period is referred to as left-hand tail risk. It is possible to hedge a “Black Swan Event”, i.e. a major market correction by buying out of the money put options. This is costly, although the cost must be weighed against the opportunity loss of holding an unrealised loss.

A falling market does present opportunities for finding good value in the market. Whereas, a rising market contains more risks of over valuation. Short-term volatility is an inevitable part of investing and it is smoothed over the long term. As you will be aware our focus is on capital protection and long-term performance.

Stagflation:  Not inflation or deflation

We believe that Australia is heading into a stagflation environment where there is both rising prices and low economic growth because of the high levels of private and government debt. We have seen non-discretionary products, e.g. food and petrol prices increase which means consumers will have less disposable income to spend on discretionary items, if their wages do not keep pace with price increases. It is anticipated there will be a kick up in GDP growth as folks celebrate the end of lock downs by spending. People will get haircuts, go to the movies and restaurants, and plan Christmas/New Year events and holidays. However, once February comes around with school starting again and summer holidays ending many households will take stock of their finances and they will observe the economic stagflation. The GDP growth figure in March 2022 will reflect this spending spree and not sustainable economic growth that comes from increasing production.

We are exploring the best solutions for a stagflation environment and depending on your asset allocation will be writing to you about the strategies we propose.

If you have any questions, please feel free to call.

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