Opportunities loom beyond the sharemarket

Diversification at all times helps measure the risk and reward equation.

The dramatic dividend cuts across the market remind us that share investing should be just one part of a diversified portfolio.

Regular readers of this column will know I am not a fan of the overreliance that many self-funded retirees have on fully franked dividends.

Nowhere is the risk of relying on them too much more apparent than in the current times when we have just seen cuts or deferral of dividends by three of the big four banks.

These represent a significant cut in investment income, particularly retiree income. Moreover, the equity raising announced by NAB further dilutes the equity value of those holdings.

What does it mean for self-funded retirees? They have in effect experienced a pay cut, and unfortunately I believe there is more pain to come. When we enter reporting season in August we can expect to see more companies cut or suspend dividends.

Despite the rally in equities during April, the full impact of what we are experiencing in the real economy will take months to play out.

Meanwhile, the lower dividend income for retirees reduces the demand side of the demand/supply equation which, in turn, has a further negative effect on our economy.

Diversification at all times helps measure the risk and reward equation. Ideally, it should have dampened volatility in a portfolio and therefore negative returns over the past few months.

Alan Macfarlane from Dundas Partners in Scotland observed in a recent client webinar that equity investors take an oath of optimism. In other words we approach things on the basis that matters will improve and swing back upwards.

However, as we have seen in the cold light of the COVID-19 pandemic, in the face of extreme uncertainty diversification becomes important for income as well as reducing portfolio volatility. There was an equity market rally in April but essentially I expect we are moving through a longer bear market cycle.

Indeed, the rally in markets is discounting a poor second and third quarter, as well as a short and shallow recession. What’s more, unfortunately it is no longer as “V shaped” as many including myself originally predicted. The width of the “valley” looks more “U shaped”. As a result I fear what equities markets will actually experience as a result of the rally is going to be “W shaped”.

Intervention at government level has and will increase. We have all experienced the lockdown measures introduced since March. Many companies and industries will be socialised by government bailouts simply so a service can survive. As I mentioned in these pages a month ago, “you don’t get something for nothing”.

What should investors therefore do now? Again, it is worth repeating that asset allocation is absolutely crucial and has been important to minimise the impact of the current pullback. It will be an even more vital factor so going forward as centralist and protectionist policies in economies take hold.

● Equities: the recent rally we saw in equities means many investors are now discounting bad news. With so many corporates withdrawing their earnings guidance the question must be asked as to how analysts can forecast forward earnings — the “E” in the PE.

My suggestion is to wait until the full economic effects are clearer and then dollar-average in. This market will pull back further before it rises.

● Fixed income: With a flat yield curve and fiscal policy favouring the issuance of bonds I cannot get excited about government bonds.

● Credit: as investors become more optimistic about solvency and coupon stability, this area will gain support especially as high-yield spreads have widened. There are opportunities here but you must be very selective.

● Illiquid investments: despite all the negative headlines around forced redemptions, if your risk appetite can sustain illiquid assets such as infrastructure, real estate and private equity (and you are not forced to redeem), there will be fantastic opportunities in these areas. That’s because the illiquidity premium widens for sectors with strong balance sheets.

● Cash: this is a most misunderstood asset class as it is not about the low coupon this asset class pays out but rather the opportunity it can provide to survive difficult times (by not being forced to sell other assets). Cash allows you to undervalued assets and not waste a crisis.

Let’s be clear: no one knows what will happen next or how this will play out. Yet it is important to have a conservative strategy built around asset allocation — and stick to it. Understand too, that the level of emerging government debt will burden economies for generations to come.

If you relied on Australian equities and cash as your strategy, this should change. In any event, this should never have been your strategy. Returning to my initial point, investors need to realise that the days of relying on fully franked dividends as an annuity stream are over.

Will Hamilton is managing partner of Hamilton Wealth Partners.

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