March 4, 2019

Casino Royal – what will we end up with?


Mark Causer


A study by Cambridge University suggested that a ‘bad news day’ increased magazine circulation by as much as 30% and a ‘good news day’ resulted in a 66% decrease in readership – the latter being online material.

A study by Cambridge University suggested that a ‘bad news day’ increased magazine circulation by as much as 30% and a ‘good news day’ resulted in a 66% decrease in readership – the latter being online material.

The financial media is currently awash with many bad news stories, so today we will recap on some ‘bad news’ and try and look through more ‘bad news’ for the ‘good news’.

Starting with the Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, which was released by the Government earlier this month.

After 68 days of hearings, 130 witnesses, over 10,000 public submissions and an estimated cost to the taxpayer of $75 million, the final 76 recommendations were released. Some of the key take outs emanating from the Royal Commission recommendations include;

  • annual opt-in advice provisions
  • disclosure of ‘independence’ in the advice process
  • the removal of grandfathering provisions
  • a new disciplinary system for financial advisers and
  • no structural separation of product and advice.

The real consequence of the Royal Commission’s recommendations is likely to be the way in which the regulator, ASIC, applies the principles which Hayne has enunciated. A rigorous focus on advisers meeting the Best Interest Duty and a heightened awareness of adviser compliance are both likely to lead to greater structure and systematisation in adviser practices. In terms of Financial Keys specifically, we expect little to no impact from the proposals as we already incorporate these aspects when advising and dealing with clients. We welcome the proposed changes for the industry as a whole in the hope that it may ‘level up’ the quality of advice and service provided to consumers.

While the Royal Commission’s Final Report was scathing in many respects of the Australian financial services industry, highlighted with several appalling human examples, both sides of Government have hastily agreed to take action on – the Treasurer, Josh Frydenberg initially suggesting the  Government will take action on all 76 recommendations.

In recent weeks however, both sides of parliament have stepped back into the shadows after pressure from various groups – a good example being the initial recommendation to remove commissions from mortgage brokers, to be replaced by a fee for service arrangement.

No doubt there will be changes from here.

There will be much debate around the 76 recommendations but unfortunately we will not see any material changes and any forward momentum as the debate will be stifled by the NSW State elections in March and Federal election in May – with campaigning likely to ruin Easter 2019.

It is very likely that whoever wins the Federal Election in May, will not start the process of governing until next financial year.

Good news, bad news - where are we at?

The good news is that investment markets have bounced back strongly since the start of 2019 following some of the biggest declines in asset prices since the global financial crisis.

In the December quarter, Australian equities were down over 8%, global equities down over 11%, whilst the US technology heavy NASDAQ was down over 17%. In light of that, the recovery calendar year to date has been impressive with Australian equities up over 8%, global equities up nearly 9%, and the NASDAQ up over 11%.

The question on everyone’s mind is whether the bounce is sustainable in light of slowing economic data and significant event risk coming in the next few months.

A quick re-cap of why the fall in asset prices occurred

The last few years has been littered with risk events that investors have mostly ignored or looked through. The main reason for this has been central bank policy and intervention. Central bank cash rates at 0%, or negative in some regions, and central banks stepping into markets to purchase assets with newly created money and hence enlarging their balance sheets, are policies all geared towards inflating liquidity, depressing volatility, and enhancing investor risk tolerance.

That all changed in the second half of 2018 as three major risks, which weren’t new risks, were observed and absorbed very differently by investors at a time when fundamentals hadn’t changed a whole lot. Those three risks were a slowing Chinese economy (absent Chinese government stimulus nee bazooka), a US Fed suddenly turned hawkish and supposedly on “auto-pilot”, and US-China trade wars playing out through Twitter with deep nationalist fervour. A hawkish Fed also brought forward expectations of a potential US recession, whilst politicians in the UK did their best to make Brexit about them rather than their constituents.

As I mentioned, none of these were unknown risks. However, the probability assigned to those risks escalating rose very quickly at a time when investor complacency was probably at its highest.

What changed to set off the most recently market rally?

Quite simply, the probability assigned to those risks de-escalated as investors got comfortable with selective and targeted Chinese government stimulus / intervention, a more rational US Fed moving from “auto-pilot” policy to data dependency with a self-realisation of how close they were to “neutral” settings, and a deal to be had between US and Chinese leaders to quell any further trade war fears or escalation.

The risk de-escalation allowed investors to be more rational and hence see that underlying fundamentals hadn’t changed a whole lot between September 2018 and now.

Does that mean the risks are gone and we’re off to the races again?

Definitely not. The risks remain and the potential for them to escalate yet again is real, especially with plenty of event risk coming up in March/April with both trade war agreement and Brexit deadlines approaching, likely greater clarity on the US Fed’s position leading into the second half of the year, a US economic growth number which is likely to be low enough to invoke recession fears, and closer to home, NSW state elections (which will be seen as a barometer for upcoming Federal Election) and the Federal Budget.

With that backdrop, consensus has been firming that the 2nd half of this year should be more pleasant than the first half. Given the strong recovery we’ve had calendar year to date, that seems to indicate that the next few months will be tough for investment markets.

What are your expectations for 2019?

We like market environments where underlying fundamentals drive markets movements. It means we can get a reasonable handle on directionality and also means we can be reasonably comfortable with setting expectations. Unfortunately, we think this year will be driven by everything but fundamentals, including potential political, foreign policy, economic policy, and fiscal missteps, which will likely mean we find ourselves being more reactionary than proactive.

On the three main risks mentioned about, we’re reasonably optimistic that the Chinese engineering a soft landing, that the Fed has maybe one or two rate rises left in them over the next two years, and that US-China trade wars de-escalate but don’t go away.

What should investors do in light of that?

Whilst we think volatility will continue to rise and that markets will be less fundamentally driven, it doesn’t mean we’re necessarily bearish or negative on markets. As it stands right now, equities globally look to be trading around fair value (based on forward earnings estimates), with Asian and emerging markets the most attractive. Property and infrastructure valuations don’t look out of whack in light of a Fed who has clearly paused, whilst defensive bonds performed admirably well in 2018 proving once again the role they play in a diversified portfolio. As such, we’re reasonably benign (neutral) in our expectations for this year based on current fundamentals.

Key is to ensure portfolios are adequately diversified across country, region, style, and product provider, whilst taking advantage of market mispricing as it occurs.

Can you shed some light on matters closer to home?

The Australian economy is clearly softening and this is likely to continue for at least the next couple of years. The softening comes off the back of a high debt load carrying and budget constrained household sector, a lack of private sector investment / expansion given political risk and broader lack of confidence, and a government which is too focused on budget restraint and an opposition party which is too focused on redistribution), both at the detriment of a slowing economy.

We expect residential house prices to continue falling over this year given the changes in bank lending practices and rising unemployment, as job losses begin to appear in the construction and financial sectors. With that backdrop, economic growth and inflation will both slow, putting pressure on the RBA to cut rates further.

We think the hurdle for further rate cuts has been set incredibly high by the RBA, which will mean that stimulus will have to come from government through investment, reform, and a less fiscally constrained approach to the budget. This concerns both us and many others given the current state of politics in this country. We’re not in the recession camp locally (nor globally), but we expect softer economic conditions ahead.

Against this ever changing backdrop, the Financial Keys Investment Committee continues to strive to be in front of the curve and that our investment ideas or thesis remains as current and relevant as is possible.

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