6th April 2023

Last week, the director of AFR insights James Daggar-Nickson, received an unsolicited text. It was supposedly from a 22 year old woman from China eager to make the acquaintance of a ‘well-mannered’ man (and presumably obtain his bank account details).

The message couldn’t have been more fortuitous, not only because we’re sure James probably does have lovely manners, but because he was at that moment emceeing The Australian Financial Review Banking Summit, at which scams was the central theme.

Assistant Treasurer Stephen Jones told the Summit that scams cost the economy $2 billion in 2021. Last year, that figure doubled to $4 billion. For context, this is roughly the same figure paid out as compensation by the big banks to victims of poor financial advice since the royal commission five years ago.

It is little wonder that banks no longer want to foot the bill (AKA forced to refund) for any and all customers of scam-related losses. There is now a push for social media and tech giants to shoulder an equal share of the burden – scammers use their products to reach their victims, so it is probably a fair argument.

Needless to say, we can’t rely on banks (or others) as a fail-safe forever, and investors need to be particularly vigilant. According to Westpac’s head of fraud, Ben Young, “investment scams lead the pack, and those are the ones where really life-destroying amounts of money can be involved”. See our below article on tips for minimising the risks of investment fraud.

Also, in this View, an update on markets (post banking failures), 10 investment themes for 2023, franking credits, some retirement wisdom and more.

We wish all our readers a safe and happy Easter break.

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Market update: March 2023

The collapse of US regional banks, Silicon Valley Bank and Signature Bank, along with the forced merger of Credit Suisse and UBS in Switzerland, saw bank share prices fall through March. Government bond yields, on the other hand, fell materially as investors price in rate cuts due to the banking system stress, which is expected to slow lending and economic growth.

Global economic data in the first part of 2023 has generally been stronger than expected, with unemployment, retail spending and non-manufacturing business surveys pointing to a re-acceleration in global economic growth. Although headline inflation has eased, other inflation measures have remained sticky. Meaning that prior to March’s banking issues, investors were pricing in further rate rises in the US, Europe and Australia throughout 2023 with no rate cuts until 2024.

A few weeks and some banking failures later, and markets have moved to price in only around one more rate hike this year across most economies.

While it is likely that most banks will need to hold more cash, become more competitive with deposit rates and tighten lending, it seems unlikely that the banking issues will morph into another global financial crisis or sharp credit crunch. Equity markets are certainly not pricing in this eventuality and, as a whole, seem to be ignoring the greater recession and banking sector risks.

In our view, the most likely scenario is that central banks pause their rate rising until the dust settles (as we saw here in Australia this week). Once it becomes obvious that inflation is still too high and that deposit nervousness is not spreading, they will return to rate lifting.

On Equities

Although bank stocks had a tough March, equities held up relatively well. This was due to stronger than expected economic momentum and partly because ‘bad news is good news’, meaning the banking failures lowered bond yields which in turn lifted equity valuations. We remain somewhat cautious and see limited equity upside over the coming months, and risks remain mainly to the downside. The key driver of equity returns, earnings, do not show a lot of expected growth this year as profit margins are expected to continue contracting.

On Property and Real Assets

Global listed property was the worst-performing asset class in March for a few reasons.

1. Several institutional office property owners (US) defaulted on loans
2. Higher office vacancies due to work-from-home trends
3. US regional banks are large lenders to the commercial real estate market, so the expected tightening of credit conditions is another headwind for US commercial real estate.

Unlike listed property, global listed infrastructure has benefited from its more defensive long-term inflation-linked income streams and the decline in bond yields.

On Alternative Assets

Liquid alternative assets (private equity, unlisted infrastructure, hedge funds etc.) posted a loss of 1.2% in March (HFRX Global Hedge Fund Index). Merger arbitrage, convertible arbitrage and growth-focused equity long/short funds posted positive returns.

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10 Investment Themes for 2023

According to Capital Group, there’s a new reality taking shape that could define global markets over the next decade.

Although many investors are expecting a return to normal after inflation subsides and central banks stop raising interest rates, they believe markets are undergoing significant changes, and investors will need to reset expectations in this new environment.

One change that’s already underway is the shift from narrow to broad market leadership. A handful of tech stocks dominated markets for years, but it is expected that a much wider range of investments will drive portfolio returns going forward.

While growth investing isn’t going away, other sectors may have more room to shine — such as health care, where we are witnessing a golden age of drug development.

Opportunities could also arise as dividend stocks return to prominence on a global stage.

Over the coming Views, we will take a deeper dive into Capital Group’s report and share the ’10 long-term themes’ that many investment teams are focused on right now.

Theme #1 – Industrial Renaissance

Capital expenditure is on the rise, and it could be setting the stage for an industrial renaissance.

Capital Group portfolio manager Cheryl Frank is paying close attention to how increased CapEx will benefit suppliers across industries — “what I call pick-and-shovel companies”. Investors sometimes overlook these businesses, but they often have more stable cash flows and lower risk profiles compared to the companies they service.

Record-breaking cash flow over the last 12 months has left oil producers with some of the strongest balance sheets in history. When energy companies profit, they typically expand exploration and production, which requires more machinery and services. Of course, as companies look to a low-carbon future, these profits could possibly be re-directed towards R&D and sustainable energy power. Regardless, this could be a source of growth for companies that provide technology, products and services to the energy industry.

Another interesting trend is how much money has flowed into healthcare research and development (R&D). Pharmaceutical companies that successfully developed vaccines and anti-viral treatments, like Pfizer, piled up cash. Much of this capital will likely be funnelled into more R&D for companies that support the biopharma industry.

Investment teams also have an eye on other multi-year trends that could lead to increased capital investment and drive opportunity for a wide range of industries. These include Europe’s focus on energy security, rising aerospace and defence spending, and reshoring supply chains.

As at 17/1/23, company examples reflect some of the largest constituents (ranked by descending market value) within the MSCI ACWI that fall into GICS sub-industries that supply products and/or services aligned with the factors expected to contribute to capital expenditures listed above. Sources: Capital Group, MSCI

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The danger in Labor’s franking credit proposal

We all remember the 2019 franking credit proposals that contributed materially to the Labor Party’s election loss and helped to deliver Scott Morrison’s “miracle”. A major problem with that proposal was that it had many unintended consequences. The same can be said for Labor’s latest proposal to stop the payment of franked dividends funded by raising capital.

In Australia, current accounting standards allow dividends to be paid from profits (or retained earnings), loan funds or funds attained through capital raisings. Any excess franking credits in a company’s franking account can be attached to these dividends to avoid double taxation in the hands of the recipient. Labour’s proposed changes seek to prevent franking credits from being attached to dividends paid from funds attained through capital raisings.

It would seem that the tax office intends to have discretion over whether or not a dividend can be declared ‘unfrankeable’. Aside from the unmanageable complexity this proposal creates, there are a number of consequences.

By way of example, take companies who invest their profits in R&D and then seek to strengthen their balance sheet through capital raising concurrently with the payment of a dividend. Under this scenario, the tax office may declare the dividend unfrankable.

As mentioned above, the current proposal does not preclude attaching franking credits to funds raised through debt. This will encourage a return to the bad old days, when companies were fuelled by debt rather than equity.

The proposal claims to be designed to stop this practice at the big end of town, but the irony is that the big end of town has better access to debt funding than many smaller, more dynamic companies hence risking investment in R&D and innovation.

Given the modest revenue this change is projected to provide, it seems like a lot of trouble and politics for minimal gain. One wonders if this is a passionate ideology or the thin edge of the wedge.

A good summary of the issues can be found here.

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Minimising the risks of investment fraud

How do successful, financially intelligent people fall prey to investment fraud? Researchers have found that investment fraudsters hit their targets with an array of persuasion techniques that are tailored to the victim’s psychological profile. Here are the red flags to look for:

If it sounds too good to be true, it is. Watch for ‘phantom riches.’ Compare promised yields with current returns on well-known stock indexes. Any investment opportunity that claims you’ll receive substantially more could be highly risky. Be careful of claims that an investment will make “incredible gains,” is a “breakout stock pick”, or has “huge upside and almost no risk!” Claims like these are hallmarks of extreme risk or outright fraud.

‘Guaranteed returns’ aren’t. Every investment carries some degree of risk, which is reflected in the rate of return you can expect to receive. If your money is perfectly safe, you’ll most likely get a low return. High returns entail high risks, possibly including a total loss on the investments. Most fraudsters spend a lot of time trying to convince investors that extremely high returns are ‘guaranteed’ or ‘can’t miss.’ They try to plant an image in your head of what your life will be like when you are rich. Don’t believe it.

Beware the ‘halo’ effect. Investors can be blinded by a ‘halo’ effect when a con artist comes across as likeable or trustworthy. Credibility can be faked. Check out actual qualifications.

Watch out for pitches that stress how ‘everyone is investing in this, so you should, too.’ Think about whether you are interested in the product. If a sales presentation focuses on how many others have bought the product, this could be a red flag.

Pressure to send money RIGHT NOW. Scam artists often tell their victims that this is a once-in-a-lifetime offer and it will be gone tomorrow.

Reciprocity. Fraudsters often try to lure investors through free investment seminars, figuring if they do a small favour for you, you will do a big favour for them and invest in their product. There is never a reason to make a quick decision on an investment. If you attend a free lunch, take the material home and research both the investment and the individual selling it before you invest. Always make sure the product is right for you and that you understand what you are buying and all the associated fees.

Protect yourself online. No explanation required!

In the spirit of guidance around cyber security, we think it is important to understand the strategies deployed by investment scammers and fraudsters in this context. More information on general cyber security can be found here.

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This week the ESG investing market has been thrown into the spotlight once again, with the Government indicating it will subject ethical, sustainable super funds to the previous Coalition government’s performance test, which compares funds to market benchmarks in relevant asset classes.

Until now, the test has applied only to MySuper funds (that is, low-cost funds that most employees are defaulted into early in their careers). But the extension of the test to “choice” funds is more complicated, given they offer a much wider range of investment strategies and styles (including green and sustainable-themed approaches).

Consumer advocacy groups are very happy touting “just because investors opt in to an ethical theme doesn’t mean they should forgo the right to have their retirement savings managed in a low-cost, transparent way”, says Xavier O’Halloran of Super Consumers Australia.

But there is also a legitimate counter-argument that ESG funds, which may seek to achieve an environmental or social objective beyond just short-term financial returns, could suffer by being subjected to a crude test that ranks them against the broad market index. They could be penalised for ditching fossil fuels, for example, or loading up on stocks with high ESG scores, even though that is arguably what their customers would expect.

Then again, remember that ESG is a fluid definition at this point in time. The more cynical amongst us question whether ESG fund providers are actually just worried the test will force them to drop their premium fees or be more honest about their holdings than they may like.

The latter is especially topical as regulators around the world crack down on “greenwashing” (in which funds or stocks fall short of the ESG claims made in marketing materials). Last month, global index provider MSCI made changes to its methodology. As a result, thousands of managed funds in Europe are expected to be stripped of their ESG status. This is going to be an interesting space to watch.

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Chart of the Week

Consumer sentiment has been down around recession levels for some months now. However, unlike previous cycles, people’s job confidence has been moving in a different direction. This exuberant confidence is now beginning to slow. An indicator that the Australian consumer is starting to weaken.

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Quote of the Week

“An investment in knowledge pays the best interest.”

Benjamin Franklin

When it comes to investing, nothing will pay off more than educating yourself. Do the necessary research and analysis before making any investment decisions. If you don’t have the time or inclination, outsource it to an expert (someone you can trust will consider your best interests first and foremost).

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Retirement Wisdom

On winning both the “Best Exterior Design” and “Finest New Superyacht” awards at the Monaco Yacht Show back in 2019, Billionaire Businessman Herb Chambers had this to say:

For many people, the journey can be more exciting than the end destination. Markus Persson, the creator of the wildly popular videogame Minecraft, sold his company to Microsoft for $2.5b, only to subsequently lapse into depression. When he sold his company, he also sold his reason for getting up in the morning.

So, what can we learn from these stories of gleeful and melancholy billionaires? The thrill is in the chase. It’s all too common to hear about someone feeling lost after they retire or when their kids leave the nest, as their careers and/or family had been their main source of purpose and daily structure for decades.

As financial advisers, our role is to help our clients live their best life by helping people to identify their purpose and matching this with the prudent management of their money – Money is a means to an end, not an end in itself. What does your best life look like after work and kids? It certainly requires some deep thought.

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Inflation V Politics

The recent NSW state election demonstrated a problem facing the Reserve Bank in slowing the economy. While Governor Philip Lowe tries to reduce consumer spending by increasing cash rates, voters are offered energy subsidies, road toll relief, increased infrastructure spending and business subsidies. It’s similar at a Federal level, with the Government struggling to find meaningful spending cuts but plenty of reasons for handouts. Not a lot Lowe can do about this.

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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.