Like many, I wrongly predicted that Britain would vote to remain in the European Union. I expected gold to give up recent gains on a “remain” vote and Australian stocks to rally. But the “leave” campaign prevailed, gold rallied and stocks initially tumbled.
I also expected wealth managements stocks, particularly those with a high proportion of UK earnings, to rally on the “remain” vote. Stocks such as UK-based fund manager, Henderson Group, tumbled early this week and may have further to fall.
Brexit is not the spark for another global financial crisis. It will take years for Britain to negotiate and implement its exit from the EU, and authorities are well prepared for it. The US Federal Reserve will probably take longer before it raises interest rates again. A market bounce this week suggests investors have priced in Brexit.
But make no mistake: Brexit adds a significant layer of uncertainty to an already fragile global economy. Nobody knows for sure how Britain’s exit from the EU will play out over coming years, or its effect on trade, consumer sentiment and global confidence. A British recession is a strong possibility as companies delay investment.
My fear is that it will increase sovereign risks as other European countries look to exit the EU and that it is part of a bigger public backlash against globalisation. The surprise success of US Presidential candidate Donald Trump shows how more voters on both sides of the Atlantic are becoming disillusioned with globalisation and want protectionist policies that create jobs.
Voters are shifting further to the left, fearful about job security and low wages growth. They are less interested in economic rationalist policies that add to economic growth in the medium term. This shift to the left will constrain economic growth and adds another layer of uncertainty.
Growing sovereign risks add to the risk premium for equity markets. Expect the Australian 10-year government bond yield to fall even further, probably below 2 per cent and more likely to around 1.9 per cent as financial markets downgrade our economy’s prospects.
Investors will have to get used to even lower average returns on their investments and savings. They will do well to achieve a 6-7 per cent total return on equity investments, on average, without taking excessive risk. That’s not too bad with inflation below 2 per cent, but a significantly lower average return than in years past.
Few commentators have picked up on the long-term damage of lower average returns from equities. Those in the asset accumulation phase have had years of lower superannuation returns since the 2008/09 Global Financial Crisis and have more ahead. The cumulative effect of lower returns on superannuation, particularly if they persist for longer than expected, will weigh heavily on long-term wealth creation to fund retirement.
Investors should consider these eight steps in the light of heightened global investment risk:
1. Review your investment plan and superannuation strategy: This is no time to go it alone. Be prepared to pay for good advice and have an up-to-date financial plan. Understand how persistently low investment returns will affect your retirement planning.
2. Prepare for even lower interest rates: Brexit strengthens the case for the Reserve Bank to cut the official interest rate again in August from 1.75 per cent to 1.5 per cent. My base case was for two more rate cuts in this cycle: I now expect three and a cash rate of 1 per cent by late 2017. That will further hurt savers and force more people to pay too much for high dividend stocks.
3. Ensure portfolios have adequate cash: Experts talk about having an adequate cash allocation in portfolios, but too few investors follow their advice in my experience. They mistakenly become over-exposed to equities, unable to buy stocks during bouts of market volatility and are hostage to big market falls that decimate their wealth. Always receive dividends in cash – not extra shares – and build an appropriate cash buffer in portfolios.
4. Gold exposure for protection: Consider adding more gold exposure to your portfolio as a form of portfolio insurance. Gold, considered a safe-haven during market volatility, came to the fore in the lead-up to and after Brexit. Retirees who need income might avoid gold, which has no yield. Those in the asset accumulation phase might allocate up to 5 per cent of their portfolio to gold bullion.
5. Focus on high-quality companies: It almost sounds like a cliché to suggest that investors stick with exceptional companies and avoid speculative ones. More than ever, investors should focus on strong companies that can weather market turmoil and have some pricing power. Seek companies that have a high, rising return on equity (above 15 per cent), low or preferably no debt, strong free cash flow and a clear competitive advantage. The challenge is buying them at an acceptable price.
6. Avoid set-and-forget investment strategies: Investors need to be more active in a low-return environment, to earn decent returns. That does not mean day-trading or taking wild bets; rather, being prepared to take a profit and rotate into undervalued stocks, and not focusing only on blue-chip stocks and believe they only ever rise in the long-run.
7. Reliable dividend yield is key: I expect most of the total return for many stocks in the next 12 months, probably longer, will come from yield rather than capital growth. The key is finding stocks that can maintain or increase their dividend yield, offer full franking, and are not damaging the business in the long run by excessive dividend payments.
8. Use volatility to your advantage: Big market falls, terrifying as they are, create opportunity. The market is inevitably wrong at peaks and troughs and the big sell-offs provide a window to buy exceptional companies with reliable yield, at lower prices. Doing so requires patience, resilience to withstand further falls, conviction in your investment strategy, and having cash on the sidelines to pounce when Brexit, or the next market shock, throws up value.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without taking into account your objectives, financial situation or particular needs. Before acting on the information in this article you should consider the appropriateness of the information, with regard to your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at June 29, 2016.