Rudi’s View: Navigating The Post-August Complexities

Rudi's View | Sep 20 2023

In this week's Weekly Insights:

-Navigating The Post-August Complexities
-Best Ideas and Conviction Calls
-FNArena Talks

Navigating The Post-August Complexities

By Rudi Filapek-Vandyck, Editor

Active fund managers. They are usually brimming with optimism because, as some like to remind us all, pessimists don't make much money.

Yet, at a recent industry panel conversation none of the managers on stage expressed anything other than caution and trepidation for what investors should expect from the Australian share market in the next 12-18 months.

The same reluctance dominates most strategy updates post-August from investment banks and stockbrokers; there are no repeats of the more dire warnings some issued in early 2022, but all seem to temper what could be too-high expectations for the months ahead.

This might somewhat surprise for it is not as if the local share market has rallied hard this year. After a slightly negative return for 2022, year to date in calendar 2023 the ASX200 Accumulation index is up circa 6% but half of that stems from dividends. The ex-dividends gain of less than 3% could easily disappear throughout what is traditionally the weakest period of the year up until mid-October.

The recent August results season in Australia wasn't an all-out inspiring event, but any massacres remained confined to individual companies and, overall, there have been plenty of positive surprises on forecasts that had become too cautious.

The main worry, however, is more directly linked to asset valuations generally.

We need to talk about valuations

In your typical industry lingo, we're now talking about the Equity Risk Premium, short cut ERP. This is the mathematical comparison investors apply for listed equities relative to government bonds. The higher the ERP, the lower the valuation and return from equities. What has many an expert puzzled is how low this ERP has become, and nobody genuinely knows why.

Traditionally, during times of heightened risks and uncertainties, share markets price in a higher ERP which equals cheaper share prices to account for the extra risk of disappointment, but this time around the ERP has simply shrunk, and shrunk further. The good news, as we all witnessed over the past 18 months or so, is that none of the more dire scenarios have (thus) played out.

The flipside of this market observation, as explained in a recent strategy update by UBS, is that the ERP for US equities has only been lower on two occasions over the past one hundred years; in the late 1920s/early 1930s and in the late 1990s/early 2000s. As every investor knows, in both cases what followed next is best avoided as first followed the Great Depression and later on the bursting of the TMT bubble.

Nobody is making any such prediction this time around, also because the ERP is not a reliable instrument for timing the next downturn. But UBS strategists do make the point historically there is a "decent" relationship to medium and long term investment returns. Whenever equities have in the past been priced as expensively, relative to bonds, the return for the following decade has only been a paltry 3% per annum.