A Finsec View – Inflation and rates – how much more?, Subjective value, The bigger picture and More.

7th October 2022

How financially smart do you think you think Australians are? Be honest.

In a finance quiz by think tank The Conexus Institute in June, less than half of the 1040 respondents got all six questions correct.

How best to arm Australians with more financial knowledge is a pertinent question, especially as Treasury considers how to expand access to and improve the quality of financial advice.

Even more so when you consider rising interest rates and the effect on millions of homeowners and investors. For first-home buyers, it is posing a particularly big problem.

For many Australians, the cost of advice has become out of reach and only considered a ‘necessity’ a decade or so from retirement – often becoming a ‘mad dash’ rather than a well-executed plan.

The fundamentals need to be learnt and applied early on. What is your current budget? Have you identified where you spend your money? Can there be some reallocation and so on. Basic financial literacy starts with understanding personal cash-flow. Knowledge is power and having an acute awareness of your financial position puts you in a prime spot to make more informed decisions.

With so much technology out there, we can only hope that more thought is put into advancing our nation’s financial literacy.

This week in the View inflation and rates and a look at where we are in the market cycle, retirement findings that paint are far bigger picture than wealth, ode to a legend retiring and more. We hope you enjoy the read.

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Market update

Share markets were down across the board in September as Central Banks continued their attempts to slow spending (interest rate rises) and bring down inflation. The exception is China, where the government is desperately trying to boost growth and spending in a bid to prevent the spread of the property/construction fallout (Chinese stocks have fared the worst among global share markets this year).

Note: Although all stock markets have fallen heavily this year, it is important to remember the US market is still above pre-covid levels, and Australia is back to square.

The first week of October brought with it some reprieve, with US stocks rallying, notching their largest daily increase (Monday) since August. This was driven by new data showing US manufacturing activity grew at its slowest pace in nearly 2.5 years, injecting some life into equities on the thought that this economic weakness could slow inflation and in turn rate hikes.

And in Australia, shares powered to their strongest session in more than two years after the Reserve Bank did in fact surprise markets by slowing the pace of monetary tightening (Tuesday), sparking a decline in local bond yields and the Aussie dollar.

Inflation and Interest rates

How long it will take to flush inflation out of economies, no one knows, and it will be different for each country (the Fed predicts around 2025). While inflation is running at levels not seen since the 1970s and 1980s, even after the raft of rate hikes this year, interest rates are still barely a fraction of the levels they were when fighting inflation back then – they will need to go higher, but how far?

Much of the current inflation is temporary, resulting from covid shutdowns, Russian invasion disruptions, and other unrelated factors such as weather events. Also, temporary is the current consumer spending boom (see our chart of the week) funded by the massive global build-up of household savings from stimulus programs.

In fact, already there are some early signs that headline inflation may be starting to come down. Capital Economics in the US produces an index of product shortages. It suggests a fall in inflation is coming based on reducing fuel prices, easing global supply constraints, cheaper travel costs and lower food prices.

The key to global markets is, of course, the US Fed, who have been clear since the end of August’s Jackson Hole meeting that they are committed to rate rises in order to bring down inflation, even at the risk of a deep recession. And, nothing scares investors like talk of a recession.

History has shown, however, that economic contractions have almost always been good for equity markets. Why? Generally, what causes share prices to fall is the fear of the impending recession, not the recession itself or when the recession finally arrives. Share markets have almost always rebounded out of the middle of recessions while the economy is still contracting and while the news cycle is full of “doom and gloom”. In fact, the broad share market index in Australia has actually risen during the majority of most recessions, and the same is true for the US share market during US recessions.

We recently came across this illustration from esteemed colleague Stanford Brown in which Chief Investment Officer Ashley Owen explains the market and economic cycle:

A – Share prices fall in anticipation of economic slowdown and falling profits.

B – Economic activity starts contracting (negative growth in real GDP), usually well after share prices start falling (A) due to delays in reporting economic numbers.

C – Aggregate company profits start falling due to slower revenues and often rising rates, usually well after share prices start falling (A) and economic activity starts contracting (B) i.e. company profits are still often surging well into contractions as they still have operational and financial leverage.

D – Dividends start falling after profits start falling (C). Cutting dividends is usually the last resort of company boards in a crisis i.e. they will do what it takes to retain investor confidence and support the share price.

E – Share prices start rebounding in anticipation of future profits (G) and dividends (H).

F – The economy starts growing again well after the rebound in share prices (E).

G – Aggregate company profits rebound well after the rebound in share prices (E) and economic growth (F)

H – Dividends are finally raised as balance sheets and profitability are restored.

The net result of this consistent pattern is that the share market has risen during the vast majority of economic recessions (points B to F).

Definitive answers (forecasts) are, of course, impossible, but our aim here is to provide some helpful context.

Where to from here?

While many of the temporary inflationary forces will ease in time, the reality is they will most likely persist above target levels for some years to come. Central Bankers are looking increasingly likely to press on with rate hikes despite slowdowns that cause economic contraction, job loss and collapses. These are almost certain.

For share markets, it is our view that much of the falls are probably now behind us, albeit some sectors, such as speculative US tech, remain unprofitable and potentially overpriced. The wild card here is, of course, Putin and his nuclear option, which doesn’t help investor sentiment.

Despite the “doom and gloom” the 24 news cycle may bring – in every one of the cycles we have studied, the rebound for markets is always stronger, faster and more broad-based than expected.

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Chart of the week

Australians are out and about and spending, and it would seem we are happy to pay despite some hefty price hikes. While much of the inflation talk is about global energy prices, blocked supply chains and labour shortages it is the public’s ready acceptance of higher consumer goods prices that is playing a major factor.

As our chart of the week depicts, it would seem there is far more spending than complaining, as the latest ABS data shows.

Acceptance of inflation (inflation psychology as we have labelled it in past Views) is now a “broken spell“, says Ross Gittins, writing in The Sydney Morning Herald:

“Suddenly, some big price rises are announced, the dam bursts and everyone – from big business to corner milk bars – starts putting up their prices. The spell has broken, and I doubt we’ll go back to the weird world we were in.”

The old “weird world” Gittins refers to is a reluctance of businesses to increase prices – this world is gone.

As mentioned in our previous article, household savings still have some major catching up to do. Our propensity to spend was altered during Covid (we couldn’t go out and about, we couldn’t travel overseas etc.) and we purged on stimulus. This spending will ease as we get it out of our systems and begin to ‘normalise’.

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Wealth Wisdom – Subjective Value

We’ve all heard that beauty is in the eye of the beholder, but what about value? Is a $50 schnitzel a good deal? If you hadn’t eaten in a week, you’d probably pay hundreds of dollars for a meal, so $50 would be a bargain. If you were a vegetarian, the world’s finest schnitzel could be offered to you for $1, and you would most probably decline. This is just one example of subjective value, where the value of a good can vary from person to person depending on their preferences or circumstances.

Subjective value when it comes to finance is known as investment value, referring to the value of an asset for a particular investor. Why would a house sell for $1.5m when its market value is $1m? Perhaps their neighbour thinks they can sell the combined properties to a developer and make $750k, so they would be happy to overpay by $500k.

A young investor and a retiree will pay the same price for Twitter and BHP, yet the chances are that they will value those stocks differently. The young investor will likely value capital gains over dividends, so they would likely avoid BHP shares even if they were offered at a discount. Conversely, the retiree will likely value a steady income stream over capital gains and would thus have little desire to invest in Twitter.

Since the value we derive from investments can vary wildly, a one size fits all approach to financial planning will often be flawed. At FinSec, we believe that a holistic approach to managing your finances is not only the best way to achieve your financial goals but to maximise your well-being. In the wise words of Forrest Gump, after finding out he doesn’t have to worry about money anymore – “that’s good, one less thing!“.

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With interest rates rising, many are realising just how important it is to run a health check of their existing loan – it can pay to shop around.

If you have not had your home loan stress tested in recent years, we recommend clicking here to organise a complimentary review.

Please note: Home loan health checks are a complimentary service provided by FinSec through our specialist debt advisory arm, Finsec Finance (Authorised Credit Representative of BLSSA Pty Ltd No. 424887, Australian Credit Licence number 391237).

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Another Federal Budget

The 2022 calendar year will include two Federal Budgets, and despite a gap of only seven months, they are framed against different backgrounds. Josh Frydenberg delivered his fourth Budget on 29 March, and Jim Chalmers will deliver his first on 25 October. With an eye to the election, which took place on 21 May, Frydenberg focussed on short-term cost-of-living relief, cutting the fuel excise for six months, an increase to the low and middle-income tax offset (LMITO) and an extension of the 50% reduction in super pension drawdowns.

But at the same time that these goodies helped personal bank accounts, the Reserve Bank realised Australia had a serious inflation problem and started increasing the cash rate on 4 May. It could be considered a policy confusion that Jim Chalmers is not looking to repeat. He has already stated that we should not expect new cost-of-living relief, although previous commitments will be honoured:

“we have made it very clear to people that our priority is to implement the cost-of-living relief already announced. That will be in areas like childcare, medicines, TAFE fees, the cost of electric vehicles and also we want to get wages moving in this economy again. The Budget will be about a few things. It will firstly be about how do we provide some cost-of-living relief in a responsible way that doesn’t add to the pressure on the Reserve Bank.”

In looking to get the balance between government policy and central bank policy right, no doubt Chalmers will look to the fallout over the British government’s recent mini-budget and tax cuts package. Delivered by Kwasi Kwarteng, it sparked an intervention from the Bank of England and warnings of a sharp increase in interest rates for those in the UK.

Chalmers has already told Australians not to expect “anything fancy”, and it is thought that bigger projects such as economic reform or changes to Australia’s tax system will be saved for the May budget in 2023 or even later.

It will be interesting to see how the new government responds to the weak outlook for global economic growth, with major economies also experiencing higher interest rates and inflation, supply issues with China, and the tightening of supply in energy markets in Europe.

Indeed, difficult decisions, for difficult times, and we don’t envy those tasked with making them!

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A Bigger Picture Than Wealth

Another interesting report on why retirement planning is so much more than money.

Surveying 1500 Australians over the age of 50, Fidelity International has found that the key drivers of overall life satisfaction for experienced retirees – i.e. those with more than ten years living in retirement – are:

• emotional experience,
• purpose,
• control, and
• confidence.

Topping the list was an emotional experience (in this context, the sense of optimism and contentment that retirees feel). It was found that a positive emotional experience is directly correlated with a well-considered and planned retirement journey, or one in which, despite plans going awry, a ‘Plan B’ existed.

To illustrate the range of possible emotions retirees feel, they created this chart.

The green line shows that the emotional experience of a well-planned and prepared retiree is usually fairly steady, with low-stress levels and a generally positive emotional experience.

In contrast, the journey of reactive retirement is much more volatile. A lack of considered planning can lead to significant swings in lived emotional experience.

The journey of the person forced into retirement (e.g. an unplanned redundancy) is much more unpredictable and can be a difficult period from an emotional perspective. However, the survey found it can also be turned around with the right mindset and/or with the help of a good financial adviser, as the alternative paths highlight.

What were the two most important pieces of advice that late retirees gave to pre-retirees?

#1 Having a positive and optimistic outlook on life (64% of respondents).

#2 Investing in your health, do it early and don’t leave it until too late (also 64% of respondents)

Being flexible and adaptable was the next most popular at 61%, followed by finding purpose beyond work at 58% and taking control early with 55% of the vote. Always having a plan B was also important, with 52% of the vote.

There is a lot to be learned from those that have journeyed before us, and retirement is no different. The full report (note: it is written with financial advisers in mind and is a lengthy 22 pages) can be found here.

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A Legend Retires

September 2022 will go down as one of the more memorable months in tennis history, with the 41-year-old Roger Federer announcing that the curtain will be closing soon on his professional career. Federer has not played since his quarter-final loss in Wimbledon, all the way back in July of last year and has since undergone a series of knee operations. With this on his mind, Federer claimed that he “knows his bodies capacity” and hence chose to end a career in which he won 20 Grand Slam titles, in what seemed to be a golden era of men’s tennis headlined by Djokovic, Nadal and Federer himself.

The dominance Federer displayed at the peak of his career is unrivalled. From 2005-2007 Federer reached ten consecutive Grand Slam finals, of which he won eight. His supremacy was further accentuated by the fact that he won 18 out of 19 Grand Slam titles in the period from 2005 – 2010. He has also spent the most consecutive weeks at the number one ranking, consistency that has the Hall of Famer Billie Jean King labelling his game as “the most complete of his generation”.

What branded Federer as a legend in the sport was not just the fact that he was dominant on the court but that his career elevated the game of tennis for all, and he left the sport in a far better place than before his career had begun. His discipline, structure, ability to overcome adversity and never lose sight of his goals is something to bare in mind as we navigate these turbulent times.

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Stay safe and look after one another. As always, if you have any concerns or questions at any time, please reach out to your FinSec adviser.