Advanced SMSF Strategy Doubling Up!

Because tax-concessional contributions to superannuation allow you to claim a tax deduction against personal income, they are a valuable entitlement for anyone wanting to minimize their taxable income. While the annual opportunity to make concessional contributions  is  restricted  to  just $25,000, there is a advanced strategy available where you can double this to $50,000 using a bring-forward strategy.

If you satisfy the “work test” and are under 70, you are able to make two tax-deductible concessional contributions in the same tax year to super-annuation including your (SMSF) as long as the first is paid in by March of the tax year.

A person who is eligible to make tax- concessional  contributions  to super –without a work test if they are under 65 or between 65 to 75 if they satisfy the “40 hours in 30 days” employment test – can make two sets of up to $25,000 tax-deductible contributions in one financial year. This obviously is a very effective way to manage a tax liability or event for funds held outstide superannuation.

The timing of the first contribution is not relevant, but that of the second is most important. It must happen in June to allow it to be allocated before July 28 in the following financial year. Super legislation requires member contributions to be applied to a member’s account within 28 days after the end of the month in which the contribution is made. The employment or work test requires someone to be gainfully employed – meaning they are paid for the work they do – for at least 40 hours in a period of 30 consecutive days in each financial year in which the contributions are made.

It needs to be executed in the right order

A fund can only split two concessional contributions between two financial years. If it is made in any other month it can’t be allocated to the next financial year.

Where  the  second contribution is made to an SMSF in June, it is possible to delay the application to a member’s super account until the next month which takes you into July in the next financial year. It is important the second contribution is quite separate from the first, which suggests it should be made on separate days to enable the contribution to be carried over.

One reason why this double contribution process might be followed is to achieve a higher tax deduction in a year when higher taxable income is received and a higher marginal tax rate applies relative to a normal year.

For instance say a couple owns a $2 million investment property purchased in joint names in 1990 with a cost base of $1.6 million. After applying the 50 per cent CGT discount, each member faces a taxable capital gain of $100,000. If  they  are  both  eligible   to   make $50,000 of personal concessional contributions to super through the reserving strategy, although the super fund will pay 15 per cent tax on these contributions, overall they will save $12,000 each in personal tax.

In specie transfer

Another time when the strategy can be attractive is where a member wishes to make an in specie transfer of shares owned outside super into their SMSF. While this allows them to keep a share portfolio intact, it can create personal tax CGT issues.

Allocating up to $50,000 of the in-specie transfer as concessional contributions  under  this reserving strategy can help manage this.

What is very important about this strategy is that each contribution should fall within the concessional contribution cap of $25,000 per annum, which also includes any employment-related contributions that have been received.

Care needs to be taken with any employment-related contributions which might be received in the subsequent financial year to ensure the $25,000 concessional cap is not breached.

Both contributions can be claimed as tax deductions in the year in which they are made. As far as the second contribution that is carried over to the next financial year, it is counted against the concessional cap in that year.

Don’t forget the paperwork

Appropriate Australian Taxation Office forms need to be completed to acknowledge the carryover of the contribution. The relevant form in this instance is a Request to adjust concessional contributions (NAT 74851-07.2015).

When reviewing the strategy as part of the annual audit, an SMSF auditor will firstly make sure any second  contribution  was  made  in June and then allocated to a member by the following July 28.

That an SMSF can claim both contributions in the year they are made is confirmed in an ATO interpretive decision ( ATO ID 2012/16) and a subsequent tax determination (TD 2013/22).

According to a guide that comes with the necessary ATO  Request to adjust concessional contributions form, an SMSF must record and keep documents to support the strategy.

This includes a resolution by trustees that states they have decided not to allocate the contribution when it is made but to accept it into a reserve in accordance with their fund’s governing rules.

This must be followed up with a resolution by trustees to allocate the contribution from the reserve in the next year.

In its guide to the strategy, the ATO says the form may be completed any time after the contributions have been made and allocated. It recommends it be lodged either before, or at the same time as, both the fund’s SMSF annual return and a member’s own individual income tax return.

By following this recommendation a member may avoid needing to deal with incorrect assessments.

This makes it another strategy where the more information you provide, the less chance there is of having the strategy queried by the ATO.

Gold Returns!

Our unconventional investment idea of holding physical gold in a mainstream investment portfolio is quickly becoming a very conventional idea. In recent months, gold has gained momentum, rising 20% and taking its return over the past 12 months to almost 30%. Gold is once again a front page story for many investors. Gold, as an investment asset, has enjoyed a complicated relationship with many investors and their portfolios. It’s often viewed as a ‘hedge’ against both inflation and stocks (gold tends to have an inverse relationship with the stock and property markets). In fact, during the majority of major stock market crashes gold has provided excellent returns (see table below).

Apart from the substantial geopolitical tensions currently affecting the world,  something  else more substantial has changed. Historically, many investors avoided gold, or other physical commodities, as they didn’t produce any income. Investors would compare such investments with, say, an investment in a yielding term deposit. This was fair enough, but times they have changed, and the U.S. long-term real yields have moved into negative territory as of June. As mentioned in our lead article, over a quarter of developed market sovereign debt is now negative yielding. Falling real yields have historically been highly positive for gold. When real rates are positive, there is an opportunity cost for holding non-yielding assets such as gold. But at the moment the opportunity cost is nearly zero.

If you hold cash, you’ll get one percent if you are lucky (and rates are going lower) or hold gold and have something that will make your portfolio less risky.

It isn’t just private investors that have rekindled their interest in gold, as central banks bought 224 tones of gold in Q2 2019, representing a 47% year-on-year increase. Net purchases over the past 12 months are up 85%, with the largest buyers being Poland, Russia, China and Turkey. Couple this demand with jewellery (48% of all demand) then the demand side of this asset looks very strong. The supply side has issues that is also adding to the pricing pressures.

There are many ways to get exposure to gold. There are gold miners, such as Newcrest Mining Limited (NCM) that provide a leveraged-type exposure to gold, or fund managers that select a combination of gold- related companies, or an ETF that followd an index of gold miners around the world, like NYSE Acra Gold Miners Index.

In our view, buying a company that is exposed to gold, through mining or exploring, should really be counted as an investment in your equity portfolio. In fact, the above graph shows that, over time, investing into gold equities as a whole is much worse than just buying physical gold.

While we still suggest that it is prudent for investors to include at least some gold in their portfolio, the level and percentage is  a harder question to answer, and depends on the risk profile of the individual. However, the starting point for buying gold should always be in physical bullion. For anyone that has seen a bar of gold, it is something you could quickly and easily fall in love with.

If you’re looking to buy your very own bar of gold, we would recommend the Perth Mint.  The  Perth  Mint has a range of services, from buying a bar of gold to take it home and store under your bed, to a buying and holding service (for a small fee of course). The Perth Mint provides a government guarantee that all their gold is 99.99% pure.

However, the easiest way for the average investor to gain exposure to the yellow metal is through Exchange Traded Funds (or ETFs). A gold ETF represents a share in a store of physical bullion, often held in a bank vault or other secure location. If the gold price appreciates, your share in the ETF should also appreciate, as the holding becomes more expensive.


There are two major options for Australian investors who want to pursue this avenue on the ASX. The ETFS Physical Gold ETF (ASX: GOLD) is the largest gold ETF traded in Australia and represents 358,600 ounces of physical gold held in the London bank vaults of HSBC. It charges a management fee of 0.40% annually for storage and other costs.

Like many international commodities, gold is universally traded in US dollars, which means that for Australians, the price we can buy gold at is affected by the gold spot price as well as the price of our dollar relative to the greenback (we have to buy US dollars in order to buy gold). This adds a layer of complexity and volatility that our American friends don’t need to experience. The BetaShares Gold Bullion ETF – Currency Hedged (ASX: QAU) is another option for those who would like to take the currency risks out of the equation. This ETF also stores physical gold in a London bank vault (owned by JPMorgan), but actively hedges against currency movements between the US and Aussie dollars, to give a “purer exposure” to the gold price. This comes at a cost however, with QAU charging a higher fee of 0.59%.

Gold is an easily understood investment, and a true diversifier. These two ETFs make it easy to buy and sell, and to hedge or unhedge your currency exposure to gold. With the alternative of holding a yield cash deposit more or less disappearing, we encourage investors to consider their exposure to gold, more than ever.


Neuberger Berman Global Corporate Income Trust

We have highlighted on many previous occasions, the extraordinarily low interest rates around the world are forcing investors to take on more risk just to sustain (rather than grow) their income each year. Now, this is all well and good if these investors have undertaken due  diligence  and understand what it is they are investing in. Unfortunately, this isn’t always the case.

As independent financial advisers, we are regularly approached by any number of fund managers seeking to distribute their latest  product  to as many people as possible. Listed investment companies have been increasing popular in recent months, with the sector doubling since 2014 due primarily to the fat commissions they offer financial advisers for recommending their products. The obvious  risk  in  this instance is that it is not unlike what occurred with the likes of Timbercorp and Great Southern, that many revenue driven advisers shirk the need for due diligence and focus simply on the commission they will receive. Interestingly, with the move to discretionary managed accounts, the investor may not even know they hold the product until well after the fact.

Of course, we aren’t saying that all listed investment companies are justified solely by their commissions, but that it’s important to understand what it is your investing in.

With this mind, we wanted  to  take a closer look at the very popular Neuberger  Berman Global Corporate Income Trust. Incredibly, despite the fund manager and strategy having no previous exposure to the Australian sharemarket, they were able to raise close to $1bn from investors. The fund was distributed by an extensive list of brokers, joint leader managers and ‘co-managers’ including Evans Dixon, Morgan’s, National Australia Bank, Ord Minnett, Bell Potter, Paterson’s, Shaw and Partners and Wilson’s. The fund was also marketed heavily by Peter Switzer’s media business and conference program.

We have broken our analysis down into a few simple sections:

Who is Neuberger?

Neuberger is a New York based fund manager with expertise  across most sectors of the market including equities, fixed income and alternatives. They were established in 1939 and have over $455bn under management globally with closer to $7bn under management in Australia, primarily with institutions. It’s important that investors do not confuse size with security, as whilst the manager itself is extremely successful and  huge by Australian standards, they do not control the performance of the underlying investments.

What is the fund?

The Corporate  Income  Fund  is  a specialist income focused fund that invests solely into senior bonds issued by global listed companies. This includes secured and unsecured senior debt which are both positioned at the top of the capital structure and first in line in the event that an issuer defaults on their obligations or moved into bankruptcy. The fund targets an annual income of 5.25% delivered monthly through regularly distributions and to complement this through active management and  investment  selection  with   an absolute positive return the secondary aim. The fund is run by one of the largest non-investment grade fixed income teams in the world, with over 50 dedicated staff.

What does it invest in?

The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The underlying portfolio is heavily diversified, which in some instances would be considered as   a way to reduce the risk of yourThe Corporate Income Fund invests into what is commonly referred to as ‘junk bonds’, ‘high yield’ bonds or unrated credit. At present, the portfolio holds less than 1% in what are considered investment grade bonds, with a rating above BBB with the remainder allocated as follows:

The fund is managed according to a number of overriding allocation restrictions with the primary one being an asset allocation of 60% to the US, 20% to Europe and 20% to emerging markets. Management aim to hold between 250 to 350 individual bonds with an external rating by one of the majors of BB or B. The underlying portfolio is heavily diversified, which in some instances would be considered as   a way to reduce the risk of your investment. The geographic and sector allocations are as follows:

Thus far, the fund has delivered on its objectives, delivering a  return of 6.63% since inception including an income of 4.74%. The fund  has, however, only been operating since   September   2018, which is an extremely short period of performance to review.

What are the risks?

In our view, the risks of this investment are substantially higher than many of both its investors and the financial planners who recommended it truly understand. The fund invests into fixed rate, senior bonds, issued by institutions that fall many rungs below the likes of the Commonwealth Bank on the credit ratings scale. For instance, the largest current holding is Petrobras bond, lending money to the Government-backed Brazilian gas and oil producer. Being fixed rate securities, the entire portfolio is subject to the risk that prevailing interest rates, primarily in the US, begin to rise once again, whether due to inflation or a stronger economy, resulting in a reducing value of these bonds and potentially a capital loss on the investment.

More importantly, however, investors are exposed to an immensely higher risk of default on the loans made through this fund than through  the likes of a Bond  Fund  issued  by PIMCO or Schroder’s. Yet the managers are extremely clear with this fact in all their publications reporting that essentially none of the underlying investments would pass the investment grade requirement. This represents a substantial  risk  to investors for many reasons, but primarily, the risk of default is substantially higher. The bottom right table shows the probability of default for various bonds rated by market-leader Standard and Poor’s (S&P) over many decades. As you can see, the CCC rated bonds, with makeup  11% of fund today,  have  a 26% probability of defaulting in the first year of their issue, which increased to 50% (yes 50%) after just 8 more years. The trend improves as you move into B rated  bonds that make up 45% of the portfolio, but at 13% after three years, this is substantially higher than the .08% probability of one of Australia’s banks going bankrupt.

Of course, this is all well and good if the investor is aware of the risk and secondly, comfortable with the level of volatility that may be ahead. The managers rely on a substantial amount of diversification to reduce the impact of any one issuer defaulting, however, in many cases this sector of  the  bond  markets  is already highly leveraged. For instance, the largest exposures are to cyclical or struggling sectors including energy, basic industry and media all of which are being disrupted on a daily basis and potentially entering a structural decline. The threat of higher interest rates isn’t limited to the value of the fixed rate bonds, but the viability of the companies issuing them in an increasing competitive environment.

Our View

Be careful what you wish for. To  be honest, we don’t believe an investment of this risk level is suited to the majority of superannuants, pensions and mum and dad investors that make up its share register. The fund was opportunistically listed at a time when Australian investors were seeking alternatives to fully franked dividends under the threat of a Labor Government; to this we say well done. The managers were able to leverage off  this  concern to raise close to $1bn in ‘forever capital’. If you were not aware, the benefit of an LIC or LIT (listed investment trust) for managers is that the capital raised will remain forever, there are no redemptions or purchases, the units are simply traded on the stock exchange. So Neuberger have effectively locked in 0.85% of management fees on $1bn in perpetuity.

We believe this type of strategy may be appropriate for large institutions seeking to complement high quality Government bonds or cash balances with a small allocation to unrated bonds and who have sufficient capital to offset any losses as they occur. We do not, however, believe the strategy is particularly suited to the conditions in which the global economy currently finds itself. An investment in junk bonds is generally best made when interest rates are high and falling, as this provides both earnings and valuation tailwinds. With the launch of this fund in Australia coming towards the obvious end of a 10 year bull market and with US rates increasing, the timing in our view is questionable. The largest issuers in this sector have and will remain companies under pressure, as few others are willing to lend to them. Whilst these may be large companies by Australian terms, the pitch presentation relied upon a comparison of the ‘median’ revenue of these companies being $7.67bn versus the ASX 200  of just $1.41bn, this comparison is irrelevant given Australia represents just 2% of global sharemarkets and it’s the quality of the underlying businesses that matter most.

One of the less considered risks of this LIT is that many of the underlying bonds that form this portfolio, whether in smaller US companies, or emerging markets, are substantially less liquid than traditional bond markets and in many cases are traded over the counter rather than on a listed exchange. We have always been wary of investment strategies offering investors exposure to less liquid investments via highly liquid structures like listed shares.

In conclusion, we believe this strategy has no merit and the 5.25% promised monthly income is not sufficient to offset the substantially higher risks of default.

Paradigm Shifts

By Ray Dalio, Co-Chief Investment Officer & Co-Chairman of Bridgewater Associates, L.P.
Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.


Over  my  roughly  50  years of being a global macro investor, I have observed there to be relatively long of periods (about 10 years) in which the markets and market relationships operate in a certain way (which I call “paradigms”) that most people adapt to and eventually extrapolate so they become overdone, which leads to shifts to new paradigms in which the markets operate more opposite than similar to how they operated during the prior paradigm. Identifying and tactically navigating these paradigm shifts well (which we try to do via our Pure Alpha moves) and/or structuring one’s portfolio so that one is largely immune to them (which we  try to do via our All Weather portfolios) is critical to one’s success as an investor.

There are always big unsustainable forces that drive the  paradigm.  They go on long enough for people to  believe  that  they  will  never  end even though they obviously must end. A  classic  one  of  those  is an unsustainable rate of debt growth that  supports  the  buying  of investment assets; it drives asset prices up, which leads people to believe that borrowing and buying those investment assets is a good thing to do. But it can’t go on forever because the entities borrowing and buying those assets will run out of borrowing capacity while the debt service costs rise relative to their incomes by amounts that squeeze their cash  flows.  When  these things happen, there is a paradigm shift. Debtors get squeezed and credit problems  emerge,  so  there  is a retrenchment of lending and spending on goods, services, and investment assets so they go down  in a self-reinforcing dynamic that looks more opposite than similar to the prior paradigm. This continues until it’s also overdone, which reverses in a certain way.

Another classic example that comes to mind is that extended periods of low volatility tend to lead to high volatility because people adapt to that low volatility, which leads them to do things (like borrow more money than they would borrow if volatility was greater) that expose them to more volatility, which prompts a self- reinforcing pickup in volatility. I want to emphasize that understanding which types of paradigms exist and how they might shift is required to consistently invest well.

That is because any single approach to investing—e.g., investing in any asset class, investing via any investment style (such as value, growth, distressed), investing in anything—will experience a time when it performs so terribly that it can ruin you. That includes investing in “cash” (i.e., short-term debt) of the sovereign that can’t default, which most everyone thinks is riskless but is not because the cash returns provided to the owner are denominated in currencies that the central bank can “print” so they can be depreciated in value when enough money is printed to hold interest rates significantly below inflation rates.

In paradigm shifts, most people get caught overextended doing something overly popular and get really hurt. On the other hand, if you’re astute enough to understand these shifts, you can navigate them well or at least protect yourself against them. The 2008-09 financial crisis, which was the last major paradigm shift, was one such period. It happened because debt growth rates were unsustainable in the same way they were when the 1929-32 paradigm shift happened. Because we studied such periods, we saw that we were headed for another “one of those” because what was happening was unsustainable, so we navigated the crisis well when most investors struggled.

I think now is a good time 1) to look at past paradigms and paradigm shifts and 2) to focus on the paradigm that we are in and how it might shift because we are late in the current one and likely approaching a shift. To do that, I wrote this report with two parts:

1) “Paradigms and Paradigm Shifts over the Last 100 Years”  and

2) “The Coming Paradigm Shift.” They are attached. If you have the time to read them both, I suggest that you start with “Paradigms and Paradigm Shifts over the Last 100 Years” because it will give you a good understanding of them and it will give you the evolving story that got us to where we are, which will help put where we are into context.

Part 1:

Paradigms and Paradigm Shifts over the Last 100 Years

History has taught us that there are always paradigms and paradigm shifts and that understanding and positioning oneself for them is essential for one’s well-being as an investor and beyond. The purpose of this piece is to show you market and economic  paradigms  and their shifts over the past 100 years to convey how they work. In the accompanying piece, “The Coming Paradigm Shift,” I explain my thinking about the one that might be ahead.

Due to limitations in time and space, I will only focus on those in the United States because they will suffice for giving you the perspective I’d like to convey. However, at some point I will show you them in all significant countries in the same way I did for big debt crises in Principles for Navigating Big Debt Crises because I believe that understanding them all is essential for having a timeless and universal understanding of how markets and economies work.

How Paradigms and Paradigm Shifts Work

As you know, market pricing reflects expectations of the future; as such, it paints quite detailed pictures of what the consensus expectation of the future is. Then, the markets move as a function of how events transpire relative to those expectations. As  a result, navigating markets well requires one to be more accurate about what is going to happen than the consensus view that is built into the price. That’s the game. That’s why understanding these paradigms and paradigm shifts is so important.

I have found that the consensus view is typically more heavily influenced by what has happened relatively recently (i.e., over the past few years) than it is by what is most likely. It tends to assume that the paradigms that have existed  will  persist and it fails to anticipate the paradigm shifts, which is why we have such big market and economic shifts. These shifts, more often than not, lead to markets and economies behaving more opposite than similar to how they behaved in the prior paradigm.

What follows is my description of the paradigms and paradigm shifts in the US over the last 100 years. It includes a mix of facts and subjective interpretations, because when faced with the choice of sharing these subjective thoughts or leaving them out, I felt it was better to include them along with this warning label. Naturally, my degree of closeness to these experiences affects the quality of my descriptions.

Since my direct experiences began in the early 1960s, my observations of the years since then are most vivid. While less vivid, my understanding of markets and economies going back to the 1920s is still pretty good both because of my intense studying of it and because of my talking with the people of my parents’ generation  who  experienced  it. As for times before the 1920s, my understanding comes purely from studying just the big market and economic moves, so it’s less good though not nonexistent. Over the last year, I have been studying economic and market moves in major countries going back to about the year 1500, which has given me a superficial understanding of them.

With that perspective, I can say with confidence that throughout the times I have studied the same big things happen over and over again for essentially the same reasons. I’m not saying they’re exactly the same or that important changes haven’t occurred, because they certainly have (e.g., how central banks have come and gone and changed). What I am saying is that big paradigm shifts   have   always    happened and they happened for roughly the same reasons.

To show them, I have divided history into decades, beginning with the 1920s,  because  they  align well enough with paradigm shifts in order for me to convey the picture. Though not always perfectly aligned, paradigm shifts have coincidently tended to happen around decade shifts—e.g., the 1920s were “roaring,” the 1930s were in “depression,” the 1970s were inflationary, the 1980s were disinflationary, etc. Also, I believe that looking at 10-year time horizons helps one put things in perspective. It’s also a nice coincidence  that  we are in the last months of this decade, so it’s an interesting exercise to start imagining what the new 20s decade will be like, which is my objective, rather than to focus in on what exactly will happen in any one quarter or year.

Before briefly describing each of these decades, I want to convey a few observations you should look out for when we discuss each of them.

  • Every decade had its own distinctive characteristics, though within all decades there were long-lasting periods (e.g., 1 to 3 years) that had almost the exact opposite  characteristics  of what typified  the    To successfully deal with these changes, one would  have had to successfully time the ins and outs, or faded the moves (i.e., bought more when prices fell and sold more when prices rose), or had a balanced portfolio that would have held relatively steady through the moves. The worst thing would have been to go with the moves (sell after price declines and buy after price increases).
  • The big economic and market movements undulated in big swings that were due to a sequence of actions and reactions by policy makers, investors, business owners, and workers. In the process of economic conditions and market valuations growing overdone, the seeds of the reversals germinated. For example, the same debt that financed excesses in economic activity and market prices created the obligations that could not be met, which contributed to the declines. Similarly, the more extreme economic conditions became, the more forceful policy makers’ responses to  reverse them became. For these reasons, throughout these 10 decades we see big economic and market swings around “equilibrium” levels. The equilibriums I’m referring to are the three that I provided in my template, which are:

1. Debt growth that is in line with the income growth that is required to service debt;

2. The economy’s  operating  rate is neither too high (because that will produce unacceptable inflation and inefficiencies) nor too low (because economically depressed levels of activity  will produce unacceptable pain and political changes); and

3. The projected returns of cash are below the projected returns of bonds, which are below the projected returns of equities and the projected returns of other “risky assets” (because the failure of these spreads to exist will impede the effective growth of credit and other forms of capital, which will cause the economy to slow down or go in reverse, while wide spreads will cause it to accelerate).

  • At the end of each decade,  most investors expected the next decade to be similar to the prior decade, but because of the previously described process of excesses leading to excesses and undulations, the subsequent decades were more opposite than similar to the ones that preceded them. As a result, market movements due to these paradigm shifts typically were very large and unexpected and caused great shifts in
  • Every major asset class had great and terrible decades, so much so that any investor who had most of their wealth concentrated in any one investment would have lost almost all of it at one time or
  • Theories about how to invest changed frequently, usually to explain how the past few years made sense even when it didn’t make sense. These backward- looking theories typically were strongest at the end of the paradigm period and proved to be terrible guides for investing in the next decade, so they were very damaging. That is why it is so important to see the full range of past paradigms and paradigm shifts and to structure one’s investment approach so that it would have worked well through them The worst thing one can do, especially late in a paradigm, is to build one’s portfolio based on what would have worked well over the prior 10 years, yet that’s typical.

Below, I have summarized the picture of the dynamics for each decade with a very brief description and with a few tables that show asset class returns, interest rates, and economic activity for each decade over the last nine. Through these tables, you can get a feel of the dynamics for each decade.

1920s = “Roaring”: From Boom to Bursting  Bubble.  It  started with a recession and the markets discounting negative growth as stock yields were significantly above bond yields, yet there was fast positive growth funded by an acceleration in debt during the decade, so stocks did extremely well. By the end of the decade, the markets discounted fast growth and ended with a classic bubble (i.e., with debt-financed purchases of stocks and other assets at high prices) that burst in 1929, the last year of the decade.

1930s = Depression. This decade was for the most part the opposite of the 1920s. It started with the bursting reactions to  high  levels  of indebtedness and the markets discounting relatively high growth rates. This debt crisis and plunge in economic activity led to economic depression, which led to aggressive easing by the Fed that consisted of breaking the link to gold, interest rates hitting 0%, the printing of a lot of money, and the devaluing of the dollar, which was accompanied by rises in gold prices, stock prices, and commodity prices from 1932 to 1937. Because the monetary policy caused asset prices to rise and because compensation didn’t keep  up, the wealth gap widened,  a conflict between socialists and capitalists emerged, and there was the rise of populism and nationalism globally. In 1937, the Fed and fiscal policies were tightened a bit and the stock market and economy plunged. Simultaneously, the geopolitical conflicts between the emerging Axis countries of Germany, Italy, and Japan and the established Allied countries of the UK, France, and China intensified, which eventually led to all-out war in Europe in 1939 and the US beginning a war in  Asia in 1941. For the decade as a whole, stocks performed badly, and a debt crisis occurred early, which was largely handled via defaults, guarantees,   and    monetization  of debts along with a lot of fiscal stimulation.

1940s =  War  and  Post-War.  The economy and markets were classically war-driven. Governments around the world both borrowed heavily and printed significant amounts of money, stimulating both private-sector employment in support of the war effort and military employment. While production was strong, much of what was produced was used and destroyed in the war, so classic measures of growth and unemployment are misleading. Still, this war-effort production pulled the US out of the post-Great Depression slump.

Monetary policy was kept very easy to accommodate the borrowing and the paying back of debts in the post- war period. Specifically, monetary policy remained stimulative, with interest rates held down and fiscal policy liberally producing large budget deficits  during  the  war and then after the war to promote reconstruction abroad (the Marshall Plan). As a result, stocks, bonds, and commodities all rallied over the period, with commodities rallying the most early in the war, and stocks rallying the most later in the war (when an Allied victory looked to be more likely) and then at the conclusion of the war. The pictures of what happened in other countries, especially those that lost the war, were radically different and are worthy of description at another time.

After the war, the United States was the preeminent power and the dollar was the world’s reserve currency linked to gold, with other currencies linked to the dollar. This period is an excellent period for exemplifying 1) the power and mechanics of central banks to hold interest rates down with large fiscal deficits and 2) market action during war periods.

1950s  =  Post-War   Recovery.  In the 1950s, after  two  decades  of depression and war, most individuals were financially conservative, favoring security over risk-taking. The markets reflected this by de facto pricing in negative levels of earnings growth with very high risk premia (e.g., S&P 500 dividend yields in 1950 were 6.8%, more than 3 times the 10-year bond yield of 1.9%, and earning yields were nearly 14%). What happened in the ‘50s was exactly the opposite of what was discounted. The post-war recovery was strong (averaging 4% real growth over the decade), in part through continued stimulative policy/low rates. As a result, stocks did great. Since the government wasn’t running large deficits, government debt burdens (government debt as a percent of incomes) fell, while private debt levels were in line with income growth, so debt growth was in line with income growth. The decade ended in a financially healthy position, with prices discounting relatively modest growth and low inflation. The 1950s and the 1960s were also a period in which middle- class workers were in high demand and prospered.

1960s = From Boom to Monetary Bust. The first half of the decade was an increasingly debt-financed boom that led to balance of payments problems in the second half, which led to the big paradigm shift of ending the Bretton Woods monetary system. In the first half, the markets started off discounting slow growth, but there was fast growth so stocks did well until 1966. Then most everyone looked back on the past 15 years of great stock market returns and was very bullish. However, because  debt and economic growth were too fast and inflation was rising, the Fed’s monetary policy was tightened (e.g., the yield curve inverted for the first time since 1929). That produced the real (i.e., inflation-adjusted) peak in the stock market that wasn’t broken for 20 years. In the second half of the 1960s, debt grew faster than incomes and inflation started to rise with a “growth recession,” and then a real recession came  at  the end of the decade. Near the end of the ‘60s, the US balance of payments problem became more clearly manifest in gold reserves being drawn down, so it became clear that the Fed would have to choose between two bad alternatives—i.e.,

a) too tight a monetary policy that lead to a weak economy or b) too much domestic stimulation to keep the dollar up and inflation down. That led to the big paradigm shift of abandoning the monetary system and ushering in the 1970s decade of stagflation, which was more opposite than similar to the 1960s decade.

1970s = Low Growth and High Inflation (i.e., Stagflation). At the beginning of the decade, there was a high level of indebtedness, a balance of payments problem, and a strained gold standard that was  abandoned in 1971. As a result, the promise to convert money for gold was broken, money was “printed” to ease debt burdens, the dollar was devalued to reduce the external deficits, growth was slow and inflation accelerated, and inflation-hedge assets did great while stocks and bonds did badly during the decade. There were two big waves up in inflation, inflation expectations, and interest rates, with the first from 1970 to 1973 and the second and bigger one from 1977 to 1980-81. At the end of the decade, the markets discounted very high inflation and low growth, which was just about the opposite of what was discounted at the end of the prior decade. Paul Volcker was appointed in August 1979. That set the stage for the coming 1980s decade, which was pretty much the opposite of the 1970s decade.

1980s = High Growth and Falling Inflation (i.e., Disinflation). The decade started with the markets discounting  high  inflation  and  slow growth, yet the decade was characterized by falling  inflation  and fast growth, so inflation-hedge assets did terribly and stocks and bonds did great.  The  paradigm  shift occurred at the beginning  of the decade when the tight money conditions that Paul Volcker imposed triggered  a   deflationary   pressure, a  big  economic  contraction,  and   a debt crisis in which emerging markets were unable  to  service  their debt obligations to American banks. This was managed well, so banks were provided with adequate liquidity and debts weren’t written down in a way that unacceptably damaged  bank  capital.   However,  it created a shortage of dollars and capital flows that led the dollar to rise, and it created disinflationary pressures that allowed interest rates to decline while growth was strong, which was great for stock and bond prices. As a result, this was a great period for disinflationary  growth and high investment returns for stocks and bonds.

1990s = “Roaring”:  From  Bust to Bursting Bubble. This decade started off with a recession, the first Gulf War, and the easing of monetary policy and relatively fast debt-financed growth and rising stock prices; it ended with a “tech/ dot-com” bubble (i.e., debt-financed purchases of “tech” stocks and other financial assets at high prices) that looked quite like the Nifty Fifty bubble of the late 1960s. That dot- com bubble burst just after the end of the decade, at the same time there were the 9/11 attacks, which were followed by very costly wars in Iraq and Afghanistan.

2000-10  =  “Roaring”:  From Boom to Bursting Bubble. This decade was the most like the 1920s, with a big debt bubble leading up   to the 2008-09 debt/economic bust that was analogous  to  the  1929-  32 debt bust. In both cases, these drove interest rates to 0% and led   to central banks printing a lot of money and buying financial assets. The paradigm shift happened in 2008-09, when quantitative easing began as interest  rates  were  held  at or near 0%. The decade started with very high discounted growth (e.g., expensive stocks) during the dot-com bubble and was  followed by the lowest real growth rate of any of these nine decades (1.8%), which was close to that of the 1930s. As a result, stocks had the worst return of any other decade since the 1930s. In this decade, as in the 1930s, interest rates went to 0%, the Fed  printed    a lot of money as a way of easing with interest rates at 0%, the dollar declined, and gold and  T-bonds were the best investments. At the end of the decade, a very high level of indebtedness remained, but the markets were discounting slow growth.

2010-Now = Reflation. The shift to the new paradigm, which was also the bottom in the markets and the economy, came in late 2008/ early 2009 when risk premiums were extremely high, interest rates hit 0%, and central banks began aggressive quantitative easings (“printing money” and buying financial assets). Investors took the money they got from selling their  financial  assets to central banks and bought other financial assets, which pushed up financial asset prices and pushed down risk premiums and all asset classes’ expected returns. As in the 1932-37 period, that caused financial asset prices to rise a lot, which benefited those with financial assets relative to those without them, which widened the wealth gap. At the same time, technological automation and businesses globalizing production to lower-cost countries shifted wages, particularly for those in the middle- and lower-income groups, while more of the income gains over the decade went to companies and high-income earners. Growth was slow, and inflation remained low. Equities rallied consistently, driven by continued falling discount rates (e.g., from central bank stimulus), high profit margins (in part from automation keeping wage growth down), and, more recently, from  tax cuts. Meanwhile, the growing wealth and income gaps helped drive a global increase in populism. Now, asset prices are relatively high, growth is priced to remain moderately strong, and inflation is priced to remain low.


The tables above show a) the growth and inflation rates that were discounted at the beginning of each decade, b) growth, inflation, and other stats for each decade, c) asset class returns in both nominal and real terms, and d) money and credit ratios and growth rates of debt for each decade.

Part 2:

The Coming Paradigm Shift

The main forces behind the paradigm that we have been in since 2009 have been:

1. Central banks have been lowering interest rates and doing quantitative easing (i.e., printing money and buying financial assets) in ways that are unsustainable. Easing in these ways has been a strong stimulative force since 2009, with just minor tightenings that caused  “taper   tantrums.” That bolstered asset prices both directly (from the actual buying of the assets) and indirectly (because the lowering of interest rates both raised P/Es and led to debt-financed stock buybacks and acquisitions, and levered  up the buying of private equity  and real estate). That form of easing is approaching its limits because interest rates can’t be lowered much more and quantitative easing is having diminishing effects on the economy and the markets as the money that is being pumped in is increasingly being stuck in the hands of investors who buy  other investments  with it, which drives up asset prices and drives down their future nominal and real returns and their returns relative to cash (i.e., their risk premiums).

Expected returns and risk premiums of non-cash assets are being driven down toward the cash return, so there is less incentive to buy them, so it will become progressively more difficult to push their prices up. At the same time, central banks doing more of this printing and buying of assets will produce more negative real and nominal returns that will lead investors to increasingly prefer alternative forms of money (e.g., gold) or other storeholds of wealth.


As these forms of easing (i.e., interest rate cuts and QE) cease to work well and the problem of there being too much debt and non-debt liabilities (e.g., pension and healthcare liabilities) remains, the other  forms of easing (most obviously, currency depreciations  and  fiscal  deficits that are monetized) will become increasingly likely. Think of it this way: one person’s debts are another’s assets. Monetary policy shifts back and forth between a) helping debtors at the expense of creditors (by keeping real interest rates down, which creates bad returns for creditors and good relief for debtors) and b) helping creditors at the expense of debtors (by keeping real interest rates up, which creates good returns for creditors and painful costs for debtors). By looking at who has what assets and liabilities, asking yourself who the central bank needs to help most, and figuring out what they are most likely to do given the tools they have at their disposal, you can get at the most likely monetary policy shifts, which are the main drivers of paradigm shifts.

To me, it seems obvious that they have to help the debtors relative to the creditors. At the same time, it appears to me that the forces of easing behind this paradigm (i.e., interest rate cuts and quantitative easing) will have diminishing effects. For these reasons, I believe that monetizations of debt and currency depreciations will eventually pick up, which will reduce the value of money and real returns for creditors and test how far creditors will let central banks go in providing negative real returns before moving into other assets.

To be clear, I am not saying that this shift will happen immediately. I am saying that I think it is approaching and will have a big effect on what the next paradigm will look like.

The chart above shows interest rate and QE changes in the US going back to 1920 so you can see the two times that happened—in 1931-45 and in 2008-14.

The next three charts show the US dollar, the euro, and the yen since 1960. As you can see, when interest rates hit 0%, the money printing began in all of these economies. The ECB ended its QE program at the end of 2018, while the BoJ is still increasing the money supply. Now, all three central banks are turning to these forms of easing again, as growth is slowing and inflation remains below target levels.

2. There has been a wave of stock buybacks, mergers, acquisitions, and private equity and venture capital investing that has been funded by both cheap money and credit and the enormous amount of cash that was pushed into the system. That pushed up equities and other asset prices and drove down future returns. It has also made cash nearly worthless. (I will explain more about why that is and why it is unsustainable in a moment.) The gains in investment asset prices benefited those who have investment assets much more than those who don’t, which increased the wealth gap, which is creating political anti- capitalist sentiment and increasing pressure to shift more of the money printing into the hands of those who are not investors/capitalists.

3. Profit margins grew rapidly due to advances in automation and globalization that reduced the costs of labor. The chart on the top left shows that growth. It is unlikely that this rate of profit margin growth will be sustained, and there is a good possibility that margins will  shrink in the environment ahead. Because this increased share of the pie going to capitalists was accomplished by a decreased share of the pie going to workers, it widened the wealth gap and is leading to increased talk of anti-corporate, pro-worker actions.

4. Corporate tax cuts made stocks worth more because they give more returns (top right chart). The most recent cut was a one-off boost to stock prices. Such cuts won’t be sustained and there is a good chance they will be reversed, especially if the Democrats gain more power. These were big tailwinds that have supported stock prices. The bottom chart shows our estimates of what would have happened to the S&P 500 if each of these unsustainable things didn’t happen.

The Coming Paradigm Shift

There’s a saying in the markets that “he who lives by the crystal ball is destined to eat ground glass.” While I’m not sure exactly when or how the paradigm shift will occur, I will share my thoughts about it. I think that it is highly likely that sometime in the next few years, 1) central banks will run out of stimulant to boost the markets and the economy when the economy is weak, and 2) there will be an enormous amount of debt and non-debt liabilities (e.g., pension and healthcare) that will increasingly be coming due and won’t be able to be funded with assets. Said differently, I think that the paradigm that we are in will most likely end when a) real interest rate returns are pushed so low that investors holding the debt won’t want to hold it and will start to move to something they think  is better and b) simultaneously,  the large need for money to fund liabilities will contribute to the “big squeeze.” At that point, there won’t be enough money to meet the needs for it, so there will have to be some combination of large deficits that are monetized, currency depreciations, and large tax increases, and these circumstances will likely increase the conflicts between the capitalist haves and the socialist have-nots. Most likely, during this time, holders of debt will receive very low or negative nominal and real returns in currencies that are weakening, which will de facto be a wealth tax.

Right now, approximately 13 trillion dollars’ worth of investors’ money is held in zero or below-zero interest-rate-earning debt. That means that these investments are worthless for producing income (unless they are funded by liabilities that have even more negative interest rates). So these investments can at best be considered safe places to hold principal until they’re not safe because they offer terrible  real returns (which is probable) or because rates rise and their prices go down (which we doubt central bankers will allow).

Thus far, investors have been happy about the rate/return decline because investors pay more attention to the price gains that result from falling interest rates than the falling future rates of return. The diagram below helps demonstrate that. When interest rates go down right side of the diagram), that causes the present value of assets to rise (left side of the diagram), which gives the illusion that investments are providing good returns,  when  in reality the returns are just future returns being pulled forward by the “present value effect.” As a result future returns will be lower.

That will end when interest rates reach their lower limits (slightly below 0%), when the prospective returns for risky assets are pushed down to near the expected return for cash, and when the  demand for money to pay for debt, pension, and healthcare liabilities increases. While there is still a little room left for stimulation to produce a bit more of this present value effect and a bit more of shrinking risk premiums, there’s not much.

The enormous amounts of money in no- and low-returning investments won’t be nearly enough to fund the liabilities, even though the pile looks like a lot. That is because they don’t provide adequate income. In fact, most of them won’t provide any income, so they are worthless for that purpose. They just provide a “safe” place to store principal. As a result, to finance their expenditures, owners of them will have to sell  off principal, which will diminish the amount of principal that they have left, so that they a) will need progressively higher and higher returns on the dwindling amounts (which they have no prospect of getting) or b) they will have to accelerate their eating away at principal until the money runs out.

That will happen at the same time that there will be greater internal conflicts (mostly between socialists and capitalists) about how to divide the pie and greater external conflicts (mostly between countries about how to divide both the global economic pie and global influence). In such a world, storing one’s money in cash and bonds will no longer be safe. Bonds are a claim on money and governments are likely to continue printing money to pay their debts with devalued money. That’s the easiest and least controversial way to reduce the debt burdens and without raising taxes. My guess is that bonds will provide bad real and nominal returns for those who hold them, but not lead to significant price declines and higher interest rates because I think that it is most likely that central banks will buy more of them to hold interest rates down and keep prices up. In other words, I suspect that the new paradigm will be characterized by large debt monetizations that will be most similar to those that occurred in the 1940s war years.

So, the big question worth pondering at this time is which investments will perform well in a reflationary environment accompanied by large liabilities coming due and with significant internal conflict between capitalists and socialists, as well as external conflicts. It is also a good time to ask what will be the next- best currency or storehold of wealth to have when most reserve currency central bankers want to devalue their currencies in a fiat currency system.

Most people now believe the best “risky investments” will continue to be equity and equity-like investments, such as leveraged private equity, leveraged real estate, and venture capital, and this is especially true when central banks are reflating. As a result, the world is leveraged long, holding assets that have low real and nominal expected returns that are also providing historically low returns relative to cash returns (because of the enormous amount of money that has been pumped into the hands of investors by central banks and because of other economic forces that are making companies flush with cash). I think these are unlikely to be good real returning investments and that those that will most likely do best will be those that do well when the value of money is  being  depreciated and domestic and international conflicts are significant, such as gold. Additionally, for reasons I will explain in the near future, most investors are underweighted in such assets, meaning that if they just wanted to have a better balanced portfolio to reduce risk, they would have more of this sort of asset. For this reason, I believe that it would be both risk-reducing and return- enhancing to consider adding gold to one’s portfolio.


‘Forecasting is the art of saying what will happen, and then explaining why it didn’t’

We didn’t think the final quarter of the financial year could be explained any better than through this quote. Throughout the period we were provided with  further   evidence as to why both opinion polls and economic forecasters should be given little heed and why it’s important that investors do not adjust their investment approach before an ‘expected’ or ‘guaranteed’ event occurs. The most obvious case in point was the Coalition election victory in May, which polls suggested was unwinnable, but eventually saw sectors ranging from infrastructure to private health insurers, the banks and hospital operators rallying on the back of a status quo government.

In the lead up to the election the noise in the media and throughout the financial industry was immense. Our office seemed to be a revolving door of investment managers selling listed investment companies investing into high yield (and high risk) debt, property development or unrated corporate bonds as alternatives to high yielding shares. As you would have noticed, not one of these ‘unique’ opportunities was of sufficient quality to meet our due diligence process, yet most have seemed to have raised hundreds of millions of dollars without us. We aren’t sure what their investors are thinking now, with many trading at a discount to the value of their portfolio and high yielding Australian equities having delivered the strongest return of all markets around the world for the first half of 2019.

As we outlined in previous issues of UWJ, the additional yield provided by franking credits either in the form of a refund or tax saving, could not easily be replaced without moving further up  the  risk scale. On this basis and given the growing concern throughout the country about this and several other proposed tax policy changes, we did not believe it was prudent for clients to sell down higher yielding (but more importantly high quality) companies solely because they wouldn’t provide the same income as before. The market reaction the day after the election was telling, with most banks up in excess of 5% and now signs that the property sector may be recovering.

The failed predictions continued  in the forecasting of interest rates, with the majority of economist calls made as recently as a few months ago proven wrong as the RBA elected to hold rates in May and then eventually cut in June. This comes just 12 months after most experts were predicting rate hikes to occur amidst a booming global economy. All these events do is solidify the central tenet of our approach to investing your capital, which is to invest for many scenarios, and not assume the expected will happen. In fact, we know that as investors you will need to do with the unexpected occurring regularly.

Worried about growth

There were some concerning signs creeping into the market in the June quarter which suggest to us that there may be a little too much money floating around the ASX. Whilst merger and acquisition levels are not at pre-GFC levels, management and boards appear to be chasing growth at any cost in looking at what appear to be purchases and investments in non-core businesses. There were several cases in point, the first being Wesfarmer’s sudden decision to seek investments in the growing but speculative rare earths and battery industry and secondly, AGL Energy’s decision to lodge a big for Vocus Telecommunications (only to withdraw the bid within    a few weeks). Then there was the continued push into private equity and takeover activity by the industry fund sector who are increasingly concerned about the outlook for growth.

We admit that we fall on the conservative side of investing and find it difficult to justify investments in loss making companies trading at astronomic multiples. It has been these companies that seem to defy gravity and have been leading the broader index higher. Yet Australian companies have a chequered history of pursuing growth through acquisitions, with our largest miners a case study in how to buy assets  at the top of the market. We also have a track record for our ‘growth’ companies to be valued at 2 to 3 times what a more sophisticated market like the US values similar companies. It is at times like this that we stress the importance of sticking to your investment policy and not capitulating to momentum or positive sentiment.

Our approach has and will always be predicated on Bucket allocation, particularly ensuring your portfolio holds sufficient Capital Stable assets to withstand an extended  period of market weakness. Further, we seek to ensure your portfolio is constructed of high-quality assets, trading at reasonable multiples or valuations and which offer exposure to the most important themes occurring around the world. At times our recommendations may seem contrarian, or unwilling to embrace the most popular themes, this is because we are seeking to deliver consistent returns over the long-term rather than chase risky short-term gains.


The US-China Trade War was the primary driver of volatility during the beginning of the quarter. It was then the Federal Reserve and other global central banks that took the reins and pushed both bond markets and sharemarkets around the world to all-time highs and lows. It is that interesting paradox where the outlook for the global economy is sufficiently weak to warrant cuts to global interest rates and continued stimulus, yet sharemarkets continue to move towards multi-year highs with little concern for corporate profits. Perhaps this is why gold bullion has delivered one of the strongest returns over the last two years.

In the table above we have provided a summary of the major investment indices for the quarter and financial year:

As you can see, the highlights were the Australian and US markets which delivered the strongest financial year returns after continuing to rebound in the final quarter. The European and Chinese markets showed signs of recovery but remain well behind due to the continued political impasse and trickledown impacts of slowing Chinese imports. The table provides an interesting insight into the why the first six months of 2019 have seen the fastest growth in over 20 years, a core reason being the heavy sell- down experienced at the end of 2018 which means financial year results are well below those levels.


At this point the global economy and sharemarkets are in unfamiliar territory. One of the most important inputs or factors that must be considered when making investment decisions for today  and for the next 10 years is where you expect interest rates to move throughout this period. It is interest and bond  rates  that  determine the availability of debt to fund investments, the return  required  to warrant further investment in Risk assets like shares and the pain that comes with continuing to hold excess funds in cash. It is this pain that tends to send sharemarkets higher as investors need to do something with their capital.

If you believe interest rates  will  fall further over the next decade,  or at least remain at all-time lows, than an aggressive investment approach targeting higher yielding investments would be warranted. Falling interest rates would suggest assets like property, infrastructure, Government bonds and utilities will increase further in value. Increasing interest rates suggest a more inflationary and higher growth environment, in which case cyclical business-like mining, materials, those facing consumers and even gold bullion will benefit, and the likes of property and utilities will struggle.

Increasing interest rates will lead to lower valuations of most assets and businesses around the world but particularly those whose incomes have already been couponised. Looking short term, however, we believe there remains substantial further downside in rates as some of the world’s overleveraged developed economies, like Australia, come to terms with  a  slowdown in  global  growth.  The  result  is   a portfolio that is positioned for both events to occur  and  a plan to navigate this unfamiliar period whilst keeping your capital intact.

Too Much Money Chasing Too Little Growth

‘Negative yielding debt balloons to $15 trillion’ – CNBC

No you didn’t misread that quotation, the value of bonds around the world that investors are willing to lose money by purchasing now exceeds USD$15 trillion. Is it simply the start of another trend, or is it something we should be concerned about?

Everywhere you look around the world investors are being forced into higher risk assets in the search for income and growth from their capital. They are doing this because unconventional monetary   policy is bringing cash, bond and other associated interest rates ever closer to 0%. For instance, in Australia you receive just 0.8% on an at call account or 1.6% for a multi-year term deposit.

Why is this happening? Policymakers and economists believe that by making saving money such a poor investment decision they will be forced to consume, invest or generally stimulate the economy. Yet after a decade of these policies both the US, Europe and Japan are all staring at unexpected recessions. There is a growing consensus that these policies are simply inflated the value of risky assets and delaying the inevitable, a view we believe has some merit.

In this issue of Unconventional Wisdom we have sought to highlight both areas where we believe risk has been forgotten in this never ending search for yield and opportunities that offer more appropriate risk- reward profiles in this increasing difficult environment. For the remainder of this article, however, we will  highlight  and  summarise a few key themes that are of growing concern to our Investment Committee.

Credit Ratings

One of the most interesting recent developments was the seeming repeat of past mistakes by the major credit ratings agencies around the world. It seems the multi-billion dollar fines issued following to many of these agencies following the GFC have not been enough to force a more transparent approach to risk assessment.

According to the Wall Street Journal, the introduction of more competitors in the credit ratings space  has simply seen their recommendations become more aggressive in the pursuit of growth.  For  instance, the new competitors in the  sector are consistently providing higher credit ratings than the old fashioned duopolies.  As  always,  they   are paid and employed based on the ‘recommendations’ they provide. Now, this may  be  well  and  good for institutions with their own risk management teams, yet as usual those most likely to lose out are the retail investors who inevitably  end up in the products full of these newly issued bonds.

Margin Debt

Along with credit ratings, the proliferation of margin debt, or margin lending in Australian terms, was one of the many factors that contributed to the eventual depth of the GFC. It is margin lending, where the only security offered for a loan is a portfolio of listed and therefore volatile securities that contributes to wild market swings.

This is because market falls result in margin calls on investor accounts and with most people unwilling to contribute additional capital at these times their portfolios tend to be sold off. As can be seen in the chart above, margin debt in the US has followed the S&P 500’s march to all-time highs, with levels now far exceeding those before the GFC and until recently, growing at a substantially faster pace.

Margin debt alone isn’t necessarily a bad thing and as many readers will now, if margin debt grows at the same pace as the market then the loan to valuation ratio should remain the same; so investors aren’t necessarily taking on more risk than usual. The bigger question in this case is whether market valuations are inflated, driven by ever lower interest rates, meaning the experienced volatility of these strategies may be substantially higher.

ETF’s, leverage and synthetics

The huge growth in ETF’s may actually be increasing the risk of margin lending strategies, as they tend to give no consideration to value, allocate more capital to  businesses as they become more expensive and react automatically to changes in the market. Further to this, the search for yield and a growing concern for volatility has spawned an increasing number of leveraged and synthetic products. By leverage, we  mean these ETF’s (and some managed funds for that matter) either borrow funds, employ long-short strategies or through various derivatives take your market exposure as high as 300% of the capital you invested. In terms of synthetic, this refers to ETF’s and listed investment companies that don’t actually hold the assets to which they provide an exposure. One example would be those securities offering exposure to the Volatility or VIX index and some single commodity exposures, which own futures or options, rather than the underlying commodities. It is yet to be  seen how these securities will react when markets really get volatile.

Availability of illiquid products

As the search for yield intensifies, investors are increasing being offered less liquid products. For instance, the industry fund HOST Plus, recently launched an SMSF Invest option that allows their main competitors to invest into the Direct Infrastructure investment option. Interestingly, it has been this investment option, managed by Industry Funds  Management, that  has delivered  c10%   returns for the last decade and been the driver of that sectors out-performance over the same period.

So why now, after seeing interest rates fall from close to around 7% to 0% and increase the value of these assets substantially, has the fund decided to offer access to everyone else. In addition to this option, the likes of AMP Capital, Infrastructure Partners Investment Fund and many others are bringing these options typically reserved to pension funds to the masses. Is it a sign of greed, seeking to capitalise on the search for yield? Or is it really a good time to be investing in illiquid, interest rate sensitive assets.

Classification of risk

As is the case in  any  market boom, the classification of what is considered high or low risk becomes increasing  stretched.  One  needs to look no further than the pages of Australian Financial Review  and the many advertisements throughout. In this case, we aren’t referring to the regular plastering of the increasingly irrelevant, vertically integrated Evan’s Dixon financial advisers, but rather the series of products offering incredible yields as an alternative to term deposits. The case in point is IPO Wealth, an investment opportunity that is restricted to wholesale investors,  or those with over $2.5m to invest. The headline itself attracts people due to the appearance of exclusivity; yet it isn’t exclusive at all. As an investor in IPO Wealth, you will receive a return of 3.75% on the  12 month option or 4.95% for the five year option; sounds great right? Perhaps   if   you   are  comfortable investing into high risk pre-IPO smaller companies, as that’s what your investment is used for. Your contribution to the fund will be lent to business seeking to list on the ASX in future years, many of which may not. According to external research the fund is structured such that if the investments are successful, your return will be capped, and if it is not, you will be fully exposed to the downside risk…..IPO Wealth has recently been joined by its sister company Mayfair Platinum, which appears to offer a similar product.

Complex Debt Products

The reduction in lending by the major banks has resulted in a surge in the non-bank lending sector. As the increased demand for loans increases, so does the need for capital. The result has been the likes of Wingate Partners, Trilogy Funds, Latrobe Financial and Think Tank, entering the market with high yielding products. Now we aren’t saying there is anything wrong with these products, but its important for investors to understand what they are investing into. The funds issued by each of these managers are used to fund loans, some simply mortgages but others mezzanine construction finance, unsecured corporate lending and the like. Further, many of these products are tranched in that different investors agree to different terms in the event of capital loss, in return for higher or lower expenses. The structures are complex and not for the uninitiated. Take for instance the recent bankruptcy of developer Ralan, which owed $500m to creditors including Wingate Partners and Westpac. We’d suggest these events will only become more regular in the years ahead.

Questionable Investments

We will highlight this in greater detail later in this issue, however, recent conversations with a number of industry participants raised some concerns about a number of highly popular investment strategies. The first was the growing Peer to Peer lending sector, where an investor is able to lend directly to a borrower, outside of the restrictions of a bank. This all sounds well and good, however, the question is why these people aren’t borrowing from  a bank rather than paying the 10-20% interest they are charged. We heard anecdotal evidence of soon to be incarcerated borrowers taking out hefty loans, borrowers taking loans to pay out other loans and defaults increasing exponentially. The second case, was the recent ASX-listing in the ever popular Listed Investment Company space. The fund was promising an incredible yield through a diversified portfolio of loans to corporate businesses, but looking more  closely  the entire   portfolio of loans was below BBB and not considered investment grade. As we highlight later, the probably of default as companies move from AAA to CCC grows quickly.

Inflated company valuations

Many people will say we are simply jealous that we missed  out  on  the incredible growth of the likes of Afterpay; yet the companies valuation beggars belief. It doesn’t have a price earnings ratio because it has never made a profit. The company is now valued at $5.9bn, making it the same size as AMP, which has over $300bn in assets under management, yet all it does is offer a technologically advanced lay- by service. Of increasing concern is the manner in which investors are reacting to bad news in relation to this and other similar growth companies. When news of inappropriate loans, increasing delinquencies, the legal appointment or external auditors or reprimands from the Australian Money  Laundering  Task  Force are announced, the company simply continues to march higher. What is most concerning to us in the case of Afterpay, has been the ‘changing of the guard’ that has occurred in last 6 to 12 months and highlighted by Commsec. Basically, the early backers of Afterpay, being institutions, fund managers and sophisticated investors, have been selling out quickly with the buyers being mum and dad retail investors trading through Comsec.

Companies reaching too far for growth

As experienced before the GFC, management and boards have a tendency to be overly enthusiastic about investment opportunities when money is cheap.  Some notable examples last time around were the likes of Slater and Gordon expanding into the UK (and nearly going bankrupt), Newcrest buying the troublesome PNG Lihir mine and BHP Billiton making its ill-fated expansion into the shale oil sector. The story seems to be coming around again with a number of culprits domestically and globally popping up. Consider for example Japan  Post’s  purchase of Toll Holdings and subsequent writedown by $4.7bn, electricity retailer Origin Energy’s cancelled acquisition of telecommunications provider Vocus Group, after stating that its service was considered a ‘new type of infrastructure’. More recently Wesfarmers, free from its disastrous UK expansion and the sale of Coles Group, announced offers for a number of high risk commodity plays linked to the still unfounded battery storage thematic.

‘It’s only natural’

As Crowded House sang in 1991 during our last recession, it’s only natural that  we  should  seek  yield  in an interest starved world. It’s all well and good to benefit from higher returns in the short-term whilst the economies supporting these markets remain solid, but will the relative peace continue? Or are we bound for a difficult period for markets? If your concerned about the US trade war  or the growing likelihood of a global recession, it will pay to know exactly what it is you are invested into.

The Wattle Watch

In any given month, Wattle Partners meets with many different professionals offering a new investment product, idea or scheme. Most are a pass from us, but now and again some pique our interest. 

It was a busy few weeks for the Investment Committee with a number of interesting managers presenting in the Wattle Partners office. We will cover these in future issues but one particular highlight came from Sanaka Capital.

Sanaka Capital is a specialist Indian private equity player run by Shankar Narayanan, who spent many years at global private equity giant Carlyle. He has extensive experience on the ground in India and has acted as CEO of many investee companies over several decades.

The fund is seeking to raise USD$500m for a 10 year investment period with most companies falling in the small and mid-cap size range. They plan to invest a minimum of $10m in each company and are targeting the highest growth but somewhat defensive themes including consumer staples, financial services, healthcare, manufacturing and chemicals.

The strategy will focus on investing into companies with a track record of profitability, rather than loss makers, and which are servicing niche sectors of the economy where 75-100% of the fund will be invested. They will be encouraged to use the capital and expertise of the manager to expand into under serviced areas of India that offer both community and investment benefits.

India remains one of the highest growth economies in the world, expected to grow at 7.8% in 2019, after increasing 7.4% in 2018 and is quickly undergoing a huge transformation under a re-elected Modi Government. India is the youngest large economy in the world, the number two population online internet users at 462m and the number two producer of fruit’s and vegetables.

Management noted the major reasons behind each sector as follows:

  • Consumer – favourable demographics, rising income levels, growing awareness, improving access and a shift to branded goods.
  • Healthcare – increasing life expectancy, rise in chronic diseases, increasing insurance penetration and medical tourism.
  • Financial services – economic growth, high savings rate and increasing need for credit and savings account;
  • Technology – skilled english speaking workforce, highly qualified talent pool with signficant scale potential;
  • Manufacturing – huge semi-skilled labour force, Made in India initiative, and a quality engineering and technical talent pool.

The fund typically targets investment opportunities that have the ability to deliver annualised returns exceeding 30% per year over the 3 to 5 year investment periods. The managers charge a standard private equity fee of 2% for annual managemet and 20% of outperformance over 8%. This fund typically requires a minimum investment of $1m but is accessible exclusively through Wattle Partners at substantially lower levels.