 Good afternoon. Welcome to the Fig Security Smart Income Investment Strategies webinar. My name is Elizabeth Moran and I'm Director of Education and Research at Fig. Today I have with me Craig Swanja, our Senior Economist. Now Craig has over 20 years in finance including 15 at Macquarie where he was Chief Investment Officer. He spent a lot of time around the world in wealth management. We're very delighted to have him here today. So without further ado and I'm really going to hand over to Craig now because I'm tongue tied at the start of the seminar which isn't good. But Craig, welcome. Thank you for being with us here today. Thanks Liz. So as per the introduction, I've been in investment markets for 20 years and when I was at Macquarie in particular had clients from India for example where we would do seminars. There'd be five or six thousand people in a room and the so-called bum and dad invests all the way through to some of the world's largest pension funds in Europe and endowments in the US, very sophisticated investors through to normal people and the questions were always the same. Whenever we got to one of these points in the cycle, the LTCM crisis in 98, the dot-com bust in 2000, then we had 2007 and then we had 2009. So we had one crisis after another, questions the same every single time. Is this time different? And real investors ask the question. Media and Wall Street will tend to try and answer the question by saying this time is different. In my experience, it's never been different and it's not different this time. It's a different excuse but there's one thing that persistently drives all sorts of investment markets whether you're talking about equities or currency or commodities or property or even bonds, fear and greed are the things that change prices on a day-to-day basis. And so we always talk to investors particularly when we're talking about the more conservative part of your portfolio being cash and bonds that your investment plan really needs to be based on taking a step back and looking at the fundamental drivers of real asset value. Try and figure out what assets you want to have, what investments you want to have in your portfolio because you believe that they are fundamentally strong, secure assets that are going to deliver what you need from that part of your portfolio. So if it's for growth then you're buying into a share that you think's got some upside. If it's for income then you believe that you're going to get that income on a reliable basis year in, year out. So there's some assets for example that I personally just won't invest in because I just really struggle to understand how I can value them on a fundamental basis or I just don't like them no matter what the price is. Gold for example is really hard to figure out what its real value is. It's used for jewelry and that can set some sort of a price but actually it's more traded as a hedge. It doesn't have a fundamental value. Chinese equities is another good example where it doesn't matter what the price is. I'm not buying that asset and that's a personal bias just around not really having a lot of faith in the transparency of the market. So no matter what the price is, I don't believe in the fundamentals so they're not going in my portfolio. So that's the first question and the second question is around price and that's what greed and fear drive. So only if I like the asset based on fundamentals then I'll look at the price and try and determine whether or not the cycle we're going through right now the level of the price right now means I should be buying it. So I like for example Sydney property but I don't like Sydney property right now because it's too high a price whereas gold and Chinese equities it doesn't matter what the price is I'm not buying. So that's the starting point for when I do these seminars regardless of who I'm talking to or meetings is we're here to talk about fundamental drivers of asset value not what the market's going to do in the next 10 minutes or the next day or the next week. That's called day trading and the other one's called investing. So a lot of the presentation today is about investment strategies and it makes an assumption that whether you've actually written it down or not you have an investment plan right now and most people if they're honest they'd say well I haven't ever written down my investment plan but I've got an idea of what I'm doing and what I like and what I'm investing in. So we're assuming that you've got a plan and so what we're going to talk about today really is the five biggest risks that we see to Australian investors that give you cause to ask how would my investments in my plan go should these risks come to fruition? What can I do with my portfolio to create a bit of a buffer or some protection to make sure if this risk was to come true then I wouldn't be as impacted. My lifestyle wouldn't be as impacted. I wouldn't lose as much of my wealth. I wouldn't have as much stress. Or alternatively on the flip side of that risk there's usually an opportunity. What can I do in order to be able to profit from that risk? So all the media at the moment talking about the fear and greed cycle it's meaningful. Anyone who tells you it's not timing the market it's all about time in the market. It's only half true. It's meaningful to watch the markets and how they go up and down but it's really about finding the right time to buy or sell the assets that you fundamentally like. You've got to like them first. So I'm going to go through five different risks. I'm going to start from out of those five the one that I think is the least risky the least impactful for Australian investors. By the time I get to the number three on the list I'm going to then start talking about some specific asset allocation themes. Now despite the fact that this is a fig presentation we're not just going to talk about bonds. We're going to talk about all asset classes, your overall asset allocation because frankly talking about bonds for one hour is really hard work. So we're going to give you a broader context to talk about and with a real focus on income producing assets and obviously because we're talking about income producing assets we will talk about bonds quite a lot. I'm going to try and keep it to the allotted hour. As Liz said there's a lot of people online with a lot of questions so we'll try and jump in from time to time and answer some of those questions but if you hear me start to pick up the speed towards the end it's because I'm trying to keep you on your time schedules and wrap this up in one hour. So there's a really small font disclaimer there that if you want to see that it's on our website as well. Let's get into it. The number five risk and this is all about obviously the EU break up. So with each of these risks I'm going to talk about three components of risk and we'll talk about the impact on Australians were this risk to come to fruition and I'm talking about Australian investors here in general. Most of us have some assets overseas. Most Australian companies these days are dependent on the global economy but if you there might be some exceptions of people who are only invested in TDs in which case sorry term deposits in which case you may not be impacted. I'm talking about the average Australian and in this case I'm saying were the EU to break up the impact on Australians would be minor. As an investor the impact would be something but minor. I'm going to talk about the probability with each of these risks and in the case of the EU breaking up it's small but it's going the wrong way. It's a growing risk and I'm going to talk about the timeframe being long term. So if something has a high impact a high probability and an immediate timeframe that's the biggest risk we can get and you'll see as I go towards number one that those all start to step up. Over the last few months we've heard a lot about Greece and it seems strange to talk so much about a country that has an economy roughly the size of the Victorian economy in the context of being such a global issue. Greece is not about Greece. The issue with the EU that we've seen for the last few months is not about Greece. The issue is the way that the two powerhouses of the EU Germany and France dealt with the Greek issue and the way that the Germans on one hand wanted to punish the Greeks for spending too much, not being sensible with their fiscal budget and the French wanted to say well but you're part of the EU so we need to look after you and they bickered for so long that the result was actually worse than some of the deals that have been put on the table along the way. So if you remember the Greeks actually voted on one of the austerity packages, rejected it, but then the one that they wound up with in the end was worse. So all they've really done with the final agreement is pretty much ensured that Greece will eventually wind up with a major issue if not a default because they've created such tight austerity measures around what the government can spend and increase taxes that the economy is almost certainly going to flat line or get worse and they'll never be able to collect enough money to balance the budget so eventually there will be a problem. It's a relatively small problem because it's Greece but as I say the issue is the fact that the EU couldn't even deal with that. So what happens if it happens again? What happens if we see a bigger economy go back to the same table and France and Germany have to deal with it again and we have a repeat. So on this chart we've got the debt to GDP ratios for a number of countries. You might remember a few years ago we talked about the pigs. The pigs were Portugal, Ireland, Italy, Greece and Spain and they were the five countries that had the worst debt to GDP ratios. In other words the size of the government debt relative to the size of the economy and you don't want that number to be too far above 100% because after a while it starts to spiral out of control. So Greece is 177% at the time we did this chart a little bit higher now but the change in the last eight years between the old pigs has been quite extraordinary. Ireland got on with the job of pulling off the proverbial band aid, warsome pain, property prices collapsed, they changed their tax regime, they pulled in fiscal spending and they've got that number down to around 100%. They've got it under control and heading in the right direction. In fact GDP growth, the economic growth in Ireland last year was 6%. Fantastic outcome. Belgium's now showing up on the chart as being over 100 so that's a new one that wasn't in the pigs, heading the wrong way but again relatively small economy so we're not that fussed about it. Spain is actually again much like Ireland managed to get their debt situation under control. The economy is in ruins, mind you, if you're under 25 you've got an equal chance of being unemployed, 50% unemployment rate but they've managed to balance their economy so they will head in the right direction. Portugal we've got up there is 130% gone nowhere, not getting better, not getting worse so we're not that worried about that one. Italy is the concern. The Italian economy is large. It's the third largest economy in the EU after France and Germany. Were it to face serious issues around the ability to repay its debt or a global recession were to occur and Italy suffered even further drops in its tax revenue then we'd have a real problem and if the economy the size of Italy were to slide and be even considered to be let go from the EU then that's the end of the EU. All we really worry about with the EU is the break up because the impact on us is it changes the world economy, it changes trade flows, it's going to hurt currency markets and it'll cause a huge amount of volatility in equity markets. We're not worried about it right now, this is a long term issue but if you start to see Italian debt appear in the newspapers initially it'll be one mention and then two months later another and then another few weeks later and then suddenly it becomes headline news like Greece that's when you know there's going to be an issue with the EU and if it's Italy it's going to be a big one. But as we say, I think that's pretty small risk right now and it's a long term thing. It's not going to happen in 2015 or 16 if at all at 17 or 18. I've got a question for you Craig from RET. He asks, given the high level of global debt sovereign, corporate and household is any investment safe? Yes, is the short answer. Debt is not bad in itself. So looking at these debt to GDP ratios can be misleading. Japan has a much higher ratio. Last time I saw it was 190 something percent. But Japan is actually a relatively self-contained economy. It runs a surplus on a current account basis in other words it has capital coming into the country and most of its pension funds are investing in its own country. So it owes money to itself. So we don't worry so much about that ratio. So long as debt can be paid back and can be recovered and there's assets behind it and there's income then debt's not a bad thing. No number is the wrong number. Where you get concerned is where there's like if you're lending money to a friend or you're lending money on a mortgage basis or you're lending money to a country the thing that concerns you in all three cases is are you lending money to a responsible borrower and Greece was not responsible? No. So when you're talking about debt you're really talking about bonds as well aren't you? So the bond market. Fantastic. Okay so we go on to number four. Number four risk for Australian investors is that the US economy stalls. And by stall I mean that the you're right now the US economy is the powerhouse of the global economy. China is actually adding more value to the global economy than the US but it's pretty volatile. And so what we really don't want to see is the US economy start to stall because that's really our at the moment the last great hope of the global economy. Every week that goes past the risk of the US economy stalling goes down. Every point of data that we see and we as an industry and as investors getting pretty obsessive about it now because we want to see the US economy continue to produce great data and it is. Jobs data came out last week strong. Consumer confidence comes out strong. Business conditions strong. It's I think Warren Buffett was quoted a couple of days ago saying good but not great. And that's the best way to describe the US economy right now. If it stalls however the impact on Australian investors is significant. The probability I think is small and probably falling. And so if it's going to happen at any time in the next few years it's going to happen immediately because as I say each week that goes past the risk of this happening falls because it's just continuing to give us some great outcomes. So Craig if the Fed increase interest rates is that a chance in it that the economy may stall? Is that one of the things there's a lot of discussion will they won't they this month, December? Can you give us your thoughts on that? All of the chatter at the moment really comes down to different issues. One, if the increased interest rates 25 points, 50 points it doesn't really matter for the economy say for one big issue. And that one big issue is confidence. And the problem that the Fed now has it's been so long. The Fed just for everyone's information is short for the Federal Reserve it's America's Central Bank like our Reserve Bank of Australia. The problem the Fed has right now is if they move part of the market is going to be shocked and part of the market is not going to be shocked. No matter what they do right now thanks to the volatility created by China no matter what they do there's going to be volatility on equity markets and equity markets are looking very, very nervous. So if there was a collapse caused by a relatively small issue like the Federal Reserve increasing rates then that goes straight to consumer confidence which is actually the thing that's driving the economy so strongly. So they're sort of stuck between a rock and a hard place in that they have to increase rates at some stage. You can't leave them at zero otherwise you have no bullets to fire in the case of a real recession coming down the track in a few years. But if they increase right now they're going to shock the equity markets and that could stall the recovery. So that's something to watch for in the coming months. Yeah that's right. So we don't fuss too much about whether it's September or December because as bond investors we're really, we know it's going to increase and it's already priced into bond prices that there'll be several increases in the Federal Reserve's base interest rate. Ten-year bonds in the States were 2.19% last night from a zero or near zero cash rate. So in other words markets are pricing in probably about 10 increases by the Federal Reserve over the next 10 years if not more, not just one or two. So that's already priced in. The issue that equity markets get very nervous about is September or December because equity markets focus on the next 10 minutes, one hour, one day, one week. They're traders. So that creates a lot of noise and a lot of angst but we tell people to make sure to just keep an eye on again fundamentals, long-term, you're investing in bonds not trade them but because you're looking for a long-term income source and so really all this noise creates is an opportunity to jump in when markets are going the wrong direction. In this chart I'm showing two different economic two different unemployment curves. So and it's quite timely actually because Australia's unemployment figure literally just came out. The media talks about unemployment and when they talk about it, they talk about the blue line at the bottom of this chart. So you'll hear the global media talk about the US unemployment rate being 5.1%. And that's great and in historic terms that's actually below average. So on that basis the US economy is doing very well. So you ask the obvious question then if it's doing that well, why would the Federal Reserve not be putting up rates? Because the headline rate in this case in America's case 5.1% or in Australia's case it just came out as a 6.2% measure. That's not the real unemployment rate. The real unemployment rate on this chart is the red line and in America they call that the U6 unemployment doesn't stand for anything else. U6 measures not just the people who are collecting an unemployment check but those people who don't have as good a job as they would like. That's a layman's definition but it really means if I'm working 10 hours a week and I'd rather work 20 hours a week then I'm measured in U6 but not in U3. I'm in the red line but not in the blue line. If I'm working as let's say a nurse and I'm doing shift work and I'm not guaranteed 40 hours a week and I want a permanent job then I'm measured in the red line and not the blue line. And so what the Federal Reserve is really looking at is that red line because they want to know that the economy is as productive as it could be. Think about it, if you owned a factory and you had 100 people working in that factory and 50 of them were working really well and the other 50 were prone to taking a few too many sickies and smokers you're not happy because your factory is not at full productivity. They've got jobs, they're just not working as hard as they could. Really the Federal Reserve's job is looking after a factory except that's 150 million people instead of 100 people and they want to know that people are working at their maximum productivity. And so that's what they watch is the red line and at the moment the U6 rate is still about 8.3% and that's actually well above long-term averages I'm sorry 10.6%, they wanted to get it down to 8.6%. So it's still a long way above long-term averages and that's because while people have got jobs they're not as good as what they want. And so you'll hear about real income being down, American household income is down over the last 10 years and that's right. As a nation they're earning less now than they did 10 years ago because their jobs aren't as good or aren't as full-time as they were before. And there's no wage inflation, isn't that right as well? Wage is fairly static and very low and... That's exactly the point the Fed is looking for. They watch wage inflation because an employer is only going to pay someone more money than they did yesterday if they're worried that that person won't take the job. That's why you pay more money. And if there's plenty of other people out in the workforce who would love to work 40 hours instead of 20 hours then they don't have to pay you more, they'll go and hire someone else instead especially in the U.S. with labor laws. So there's a long way to go before the Fed needs to worry about wage increases and if they don't have to worry about wage increases then they don't have to worry about inflation and therefore they don't have to worry about putting up interest rates. They will put up interest rates because as I said before when you're at zero, you've got no bullets to fire. You can't put them down and so if a downturn did come along they've got nowhere to move so they need to put them back up again to create some slight but there's no rush at all. So this is just number four on our list. Its impact would be significant. The probability however is small and falling and if it's going to happen it's going to happen soon only because it's just getting better and better in the U.S. The only thing that could derail the U.S. now I think is a major global recession and obviously the biggest risk to that is China which we'll come back to. So on to number three and so you know we're dealing here with risk to Australian investors. We love our property. What could be a bigger risk than a fall in the Australian housing market? This slide talks about an Australian housing market. Crash is being the risk. I don't like the word crash. It's hard to see that scenario but I do always qualify that statement by saying I'm the son of a Gold Coast property developer so it's very hard and as an Australian with a natural bias to property it's almost impossible for me to imagine a scenario of housing crashing. I'm sure the IRS said the same before the Dublin housing market crash as well but that's my qualification and I think the probability is still small but I do think the risk of a decline or a flat line in Australian housing is growing quite quickly. Both Sydney, sorry both Melbourne and Brisbane are shifting from what's been quite a long period of having an under supply of housing to now having an over supply of housing. Not a major one but it's gone through that line and so there's now enough housing which has been putting a lot of pressure on prices and that pressure will now be eased. Sydney's still got a couple years of building to go before it catches up but in the event that there's not a some other reason for there to be an increase in demand for housing an over supply will see a big slowdown in housing market prices and so were there to be a hit to the economy then a correction is possible. So remembering that with all of these risks at the moment where if I was to put, I'll break the standard economist rule and actually put a number on one of these risks, I think the risk of a housing market correction in Australia is still only about say 20%. So it's a long way from being what we'd expect. So you look at this and you say okay it's a relatively low probability it's not meaningless, 20% still a number but it's not the base case. So I'm not going to change my entire investment strategy to get ready for a housing market crash. I'm just going to think okay if this did happen what would that do to my portfolio? What would that do to my income? What would that do to the value of my assets shares, property, bonds whatever else I'm holding? And is there something I can do to reduce the risks in my portfolio or is there some way I can profit somehow from housing pricing falling? In this case actually not very easy to profit from that. So we're really talking about preparing yourself for that. Some people will think that there's a higher chance of a housing market crash or a correction in Australia, many of you will in which case you want to be thinking through the answers to those questions quite carefully and others will be saying no chance so I'm just waiting for the next slide. That's the whole point of this discussion is figure out what it is you believe and then when we get to the next slide we'll start talking about well what could you do about that if you wanted to protect yourself or maybe even profit from this scenario? I know like some of the regional centres for property have gone through some quite tough times. I was in Perth a couple of weeks ago a gentleman was telling me about a property that had been bought at the top of the cycle for $1.3 million and had just sold for $400,000 so I guess there's going to be spots that don't do so well and others that will withstand the market better so maybe if you have individual property investments you might want to think about where they are and the chances of those markets coming under some pressure. Which is always the case with, that's a mining related story so it's always going to be the case with assets like that. Sadly we're going to sort of deal with the big population bases but it's thinking about housing market corrections is easy to go to property but then there's a lot of other assets that will be impacted as well with that and actually one of the reasons for that is on this chart where we've shown the thick blue line is bank loans to investors in residential property. So not owner occupied but bank loans to investors in residential property as a percentage of the size of the economy. And we do that just to, if we did it as a dollar figure that would be a very steep line. The Aussie economy has grown a lot in this 20 year period so what we really look at is compared to the size of the economy our banks lending more or less to investors in residential property and clearly the answer is more it's five times more so it's gone from 24% to nearly 120% in a 20 year period unhealthy. It's gone too far there's been a lot of press on that already. It's not the bank's fault it's actually us as a collective investor adding a few extra overseas investors now as well it's tax policy there's a whole range of reasons it's not about blame it's just thinking about well if there was a downturn how did the banks look? How did the banks go if there's a major downturn in Aussie property? The good news is an app or the banking regulator has done a lot of testing on this that you could see a 40% fall in Australian housing prices and the banks would still be safe the share prices wouldn't look great the hybrid wouldn't look great the bonds would be fine and the term deposits would be fine they would survive which is what the banking regulator is looking for 40% is a very unlikely scenario because Australia has immigration it's a stable economy we think it's pretty bad right now but we're still growing a 2% per annum so it's not that bad but the point is that don't go rushing down to your local branch and pulling out your money this doesn't mean the banks are going to be in trouble it's just thinking about if so much of the bank profit comes from mortgages if the default rate in mortgages does go up a little bit it will have an impact on earnings growth and then therefore on bank shares I add the red line into this more for an opportunity to jump up on my soap box bank loans to small to medium enterprises SMEs in that same period of time has gone from 60% to low 40s so that's the real economy that's where jobs come from they're lending less to small businesses and more to investment property it's got nothing at all to do with bonds but I like to talk about that one it annoys me on this risk I'm going to start talking about what you can do about it asset allocation so the one area that you could potentially profit from a fall in Aussie housing prices is actually by going short the Australian dollar currencies can be confusing you don't go out and buy a short Australian dollar but as an Australian when you buy US dollars by definition you are short Australian dollars you've chosen to sell your Australian dollars and buy US dollars and the reason why that would be a profitable strategy in this scenario were Australian housing to fall no other economy around the world maybe other than New Zealand would be impacted the Australian economy would be the only economy really severely impacted by an Australian housing market crash and that would cause international markets to sell the Australian dollar which down the Aussie dollar even further than what it is already on top of that the reserve bank would lower rates because clearly with a drop in the housing market consumer confidence will be hit very hard and that means less spending which means a slow down in the economy so they will lower rates to try and boost that up I think in this sort of scenario if it's a correction or a crash the Aussie could stand to lose 10 to 30% from its current levels so in other words low 60s all the way through depending on the severity of that crash it's quite significant and so if you're holding US dollars instead of Australian dollars in that scenario then you profit by 10 to 30% on whatever you're holding in that currency the next asset allocation point is reduce Aussie equities to be really clear this does not mean reduce equities it means reduce Aussie equities no other market around the world is going to have any meaningful correction or response to Aussie housing falling unless it's driven by say a shock in China or somewhere else but if Aussie housing were to go through a correction it's going to be a local issue so really the only equities that are going to be impacted those on our exchange clearly the banks will be pretty heavily impacted but construction will take a hit consumer confidence will go down so anyone who relies on consumer spending those stocks will be hit as well a general decline in the ASX of a pretty severe nature could be expected depending again on how far the housing goes down 20 to 50% is not unreasonable to expect so where do you go? You go into international equities where do you go into international equities unhedged or then you're in foreign currency as well so you've done the short Australian dollar and you've kept money in equities presumably because you want growth alternatively you buy into high quality credit in Australia so you go for higher quality in this scenario because if housing falls the Aussie economy slides higher risk corporate bonds will be at a greater risk of default in that scenario still low but greater so you'd be going for on the slide we talk about IG credit which is investment grade credit it's a strong source of returns through a recession because default rates are still very very low and fixed bonds fixed rate bonds climb when rates fall so you're making a gain on the fact that the yields will fall it's a no brainer to say reduce bank equity exposure what's less obvious is that hybrids are actually equity this is a whole webinar seminar itself so I'll just make the very quick point that hybrids will trade in a downturn like equity in 2008 I think the CBA hybrids fell about 30% and the shares were down 50% they go down because there's a perceived increased risk that you'll be forced as a hybrid holder into equity which is what can happen under the current types of hybrids and because actually the liquidity is very low so if there's a lot of sellers the prices drop quite a lot in fact we've even seen that with Perl's 7 is now trading below $90 because risk is off the table as they say it's unbelievable the new Westpac hybrids on issue first day down 2.5% that's shocking really you wouldn't think that you should buy an asset and on the first day it starts to trade you lose 2.5% value that's how many coupons and can you sell into that market at that price interesting an IPO comes out and it's down 2.5% made a bad pick I'll win next time because they can go up 40% on flow or down 20% and they can do anything that's an equity and so hybrids are nowhere near as risky as equities but they're a lot riskier than bonds for that reason they do trade a lot not many people will have mezzanine debt but I do mention it because almost all mezzanine debt which really means somewhere between senior and equity is to the property construction industry you're the last person to be and you've lent the mezzanine debt you're the last one to be paid you can almost guarantee in a downturn you won't get paid so if you've lent money to someone in property and the interest rate on that is say 15% you're in mezzanine debt and not the place to be if the construction cycle suddenly ends I've got a couple of questions Craig about property here's one from Steve how does a level of 120% of GDP for residential property investors compared to comparable economies overseas and he states surely this is at the expense of small business which brings real economic growth do you have any comment around that yes excellent point it's very very short this is again my soapbox point so small business lending in Australia is pretty woeful compared to the US and UK I blame the fact that it is so favourable to the tax point of view to invest in property plus we love property so we have a cultural bias and a tax bias that add up to a problem for our economy right now particularly right now when big business mining is no longer booming we actually need small business to be reposition how does 120% compared to overseas markets the data is really unreliable so every country collects the data differently that said there's been almost as many articles written by international magazines like The Economist saying that the number is way too high as there have been articles written saying it's okay so there's just so many different ways you can cut it and I can't even say I'd love to be able to say actually I think it is too high I just I don't have 120s wrong I just don't like 24% growing to 120 in 20 years that doesn't feel healthy no so Russell is asking can we explain what the 120% of GDP is so so GDP in Australia is about $1.2 trillion or $1.2 million million dollars if investment loans are 120% of that we're saying it's about $1.5 trillion of investment lending in Australia so many zeros that it gets very hard to count so that's why they start going into ratios versus the size of the economy Excellent I've got a question from David and from Michael they're both wanting to know what are some of the possible triggers for property price falls David suggesting unemployment up Chinese investor withdrawal what else could you perhaps suggest Yeah unemployment up isn't going to sneak up on us it's not going to suddenly jump so yes if you read the economics books and fundamentally that should be the reason why and if you had a view that in the next 10 years when unemployment was going to stick around the current levels then Australian property is not a great place to be but we're a very strange market and this is what magazines like The Economist don't understand people want to live in this country for obvious reasons we're sitting here in Melbourne today looking out the window and I can see about 50km out the window across the bay it's fantastic and I dare say Sydney might even be better but that's probably fairly controversial I'm from Brisbane so I'm just happy to be in Melbourne Everyone wants to live here and you know you imagine if you've got a substantial amount of wealth in China it's a bit of a no brainer to have an exit plan if you're dealing with a centrally controlled government you want an exit plan so no no surprise that a number of those people will be buying property as an exit plan here in Australia Sydney has seen that in a really big way it's like Mosman and the East it's not really driving up prices for the first home buyers like a lot of accusations being flung around at the moment it's driving prices up in more like the 2-3 million zone but it's real and that migration is going to continue to prop up our economy so long as we can manage it and people aren't hurt as a result of it they don't lose their jobs they don't have control we are the lucky country from that point of view and because the Chinese population is less favourable to moving to the US or Canada or New Zealand or England than they are to Australia that's a good thing however if there's a short term shock and what really worries me about the last couple of months is there is a short term shock to the middle class of China which by the way is 50 million people when we talk our upper middle class the people who can afford to buy Australian property they have lost substantial wealth in the downturn of their equities market and their confidence will be down if that takes the edge of unit buying apartment buying in Sydney, Brisbane and Melbourne that could be enough to trigger a bit of a downturn it could just tip us over the edge and then we start to lose confidence and we stop buying property and that's where you get a bit of a flat lining but I think with migration being as strong as what it is and fundamentally no reason for that to change in the next 20 years it will be more like a flat lining or a minor downturn than a crash so Donald asks perhaps could you comment on listed property trusts and industrial property I like industrial property just because of the fundamentals listed property trusts are really tricky leverage is no longer as big a concern as it was but with listed property trusts you've got to look at two things one, fundamentally what am I buying and two, what's the premium to net tangible assets so $100 worth of property once it's listed on the exchange could trade from anything from $60 in other words great value to $140 in other words not very good value so you've got to watch that discount to NTA as well at the moment feel pretty good value actually so at an asset allocation point of view that's what we talk about the places to go in the case of an Australian housing market downturn now I'm going to talk about and I'll have two or three of these through the presentation some specific bond portfolios that a lot of our clients are engaging in right now the more this market volatility occurs in equities and they're taking a longer term look at their overall wealth and how that's protected in these scenarios the more we're having conversations about a portfolio construction strategy which is great and they're the sort of conversations that obviously that we want to have this is one that has proven very popular with our more conservative clients infrastructure bond portfolio so before I get into what's on the left-hand side I'm going to talk about the chart on the right-hand side why this strategy infrastructure which is basically anything that is fundamental requirement for an economy to run if we didn't have roads our economy doesn't work if we didn't have trains or airports or power or water our economy doesn't work we can actually do without restaurants things will go on, won't be as fun but things will go on but airports we can't do without so infrastructure tends to perform very well in a recession on this chart I've used the US for data because actually they had a severe recession very recently so what I've done is compared activity between 2007 and 2009 on a range of different parts of the economy so if I'm talking about activity in water which is the left-hand most are that's lit as a water how much water did people use in 2007 compared to 2009 and it's actually gone up people use more water in the recession than they did prior to the recession I think that's probably something to do with the fact that agriculture in a big way picked up when the US dollar fell agriculture in the US picked up and they started exporting a lot of food to China so that's probably got a lot to do with it but the point is it barely moved it's up 1% miles driven how many kilometres did cars and trucks and motorbikes and so on do on roads in a recession it also has barely moved it was down 4% you would expect it to be down a lot more than that but most people were still working goods still needed to be transported across the country and if you're not working you're looking for a job and you've still got to take the kids to school life goes on so if you own a road and it collects money on a toll basis or you own water pipes which collects money for every litre that's used you're barely impacted by the recession electricity more or less the same thing I'll skip over groceries and come back to that health that's also infrastructure other than things like cosmetic surgery the health industry is barely impacted by a recession you need to go to the doctor it doesn't change anything implements is a fancy word for getting on a plane that was impacted more down 7% because there's some discretionary travel like holidays but again most of the economy continues on people continue getting on planes and airlines tend to discount in a recession so if you own the airport you tend to do pretty well during a recession anyway you're not that fast but then we jump to something like say clothing which is the bar sort of in the middle a little larger than the others down 13% so you need clothing still but there's a discretionary item that you're not going to buy and that you'll buy less of in a recession so if you own a clothing manufacturer or a retail outlet you'll do much worse in a recession construction and lending in other words banks finance were the most severely impacted out of any of these categories down 33% so if you own one of those in a recession then you've done very poorly this chart describes why we like infrastructure assets in economic downturns I've used the recession because it creates a better looking chart it describes the extreme I'm not using recession as a word because I think that's where Australia is heading because I don't but in a downturn which is what we would certainly see in the housing market correction infrastructure assets will do much much better than the general economic assets certainly shows how protective they can be of your cash flows if you're buying into infrastructure bonds because obviously if they keep earning their cash flow keeps coming in they can keep paying you so perfect for us to try a recession preview portfolio exactly and in fact the same applies to the equities which we come to in a later slide then infrastructure equities are much lower risk in this sort of environment than commodity equities or bank equities or retail equities we like infrastructure because right now in Australia in fact you can combine capital index bonds and index annuity bonds two different type of infrastructure bonds and there's a great strategy that Ryan Potham will follow has put together that when you put those two together you're getting really good value in terms of the return you're getting and you're still sitting with investment grade in other words triple B single A, double A, triple A assets with your portfolio lower volatility, revenue drivers underneath high quality investment grade bonds no reliance on corporate earnings like construction and finance and restaurants and so on basically no reliance on Chinese growth even Chinese tourism numbers barely make an impact on Sydney airport and if the Aussie dollar continues to fall those numbers go up anyway so and very strong relative value right now because you know the typical fund manager doesn't tend to buy into infrastructure bonds because it doesn't suit their mandate not because they don't like them it's just they've got a mandate that doesn't allow them to buy it so you get good strong value for those bonds right now I have a quick question from Helen and she wants to know does education factor as infrastructure definitely that's a great example of infrastructure our economy cannot operate without education we might last a day or a week or a month but not much longer we have to continue to educate children and adults regardless and isn't our third export biggest export yeah yeah for a while it was second it's a fantastic export earner as well so that's more at the discretionary end and that will go up and down depending on how the rest of the world's doing in an Australian market there's a downturn where the rest of the world's doing well education's a brilliant place to hide because dollar goes down that means but the Chinese economy and US economy Asian economies haven't been hurt as much so they come here to get educated it's cheaper now we mentioned infrastructure equity on this slide I just wanted to touch on a common misunderstanding around investing and I guess I talked a lot about this at the start understand what assets you want to buy because you believe in their fundamental drivers of their earnings you understand what it is about this property farm, airport, chair company whatever that is going to mean that you're going to get what you need out of the growth or income so that's called substance and so substance over form is a buffered expression but it's a way of describing that you know invest in substance not form if you like Sydney airport there'll be times in which buying Sydney airport shares will make more sense than buying Sydney airport bonds and there'll be times in which it makes more sense to buy the bonds not the shares if your outlook is for more risk rather than less in other words you think the world is getting riskier you shift to bonds if your outlook is for more growth the world is heading into a growth period you buy the shares if everyone rushes into the bonds and they suddenly become expensive then wait or buy the shares it's a horses for courses argument but the point is you've done the hard work to understand what Sydney airport does and why it's going to keep making money and it's an infrastructure asset once you've done that hard work you've got three different options in Australia buy the shares or there's two different bonds in fact there's a number of other bonds as well that is harder to find but there's at least three options that you can find that you can buy in Sydney airport Qantas is another great example if we're keeping on this theme Qantas is far more impacted in a recession for shares than it will be for its bonds Qantas won't run out of money because of a recession because actually typically what happens is again our dollar dies more people come to the country all prices tend to be lower a number of other factors will mean that the company will be fine it just won't have growth in earnings so the share price will fall but the bonds will stay safe as we saw a couple years ago when Qantas came out of its trouble if you jumped into the shares then I think at one stage you can get it below a dollar you've done brilliantly hopefully there's a few people on the call who did exactly that and you're never going to make anywhere near those sort of profits on the bonds I think a lot of our clients went into the bonds and it did well but you're never going to double your money on bonds so if you think it's looking really rosy you buy the shares if you're worried about the future risk you buy the bonds it's interesting with Qantas because they haven't paid a dividend for five years so that's you know but whereas if you're a bond investor they always pay their coupons on their bonds so you know that's the difference too you get that added protection with the bonds so if you really rely on the income or you want the income I think the bonds probably the better bet that's a great example because the Sydney airport the bonds and the shares actually from time to time pay the same income but not every stock is like that Qantas hasn't paid a dividend for years Newcrest doesn't I think it has a very small dividend it doesn't have a dividend so if you like Newcrest substance tech I like the company but I need income so I won't buy the shares I'll buy the bonds and sometimes you get that choice and sometimes you don't and sometimes it works the other way Telstra every time I've ever looked at Telstra bonds the income is awful because they're so popular so but the shares relatively stable yeah they go up and down but relatively stable and the income is good so it's very rarely a chance to buy a good time to buy the Telstra bonds because it's just not great value but they also have that infrastructure link don't they so now we're down to number two and it's probably fairly scary at this stage to say that the second worst risk for Australian investors is a China hard landing it'll make a lot more sense when we get to the next slide so we're dealing still with risks that are less than a 50% chance of happening these are risks as opposed to what we think is going to happen when we talk about a China hard landing the term hard landing really means that the economy slows down too quickly imagine it like you're driving a car down your street and rather than slowly drop the speed before you turn into the driveway you plow on the brakes pull up the handbrake and skid into the driveway one's a hard landing it's uncontrolled it's dangerous and the other one is what you should do the Chinese economy cannot keep growing at 7% that's scary it's a very large economy it's about 8 to 10 times the size of ours and it's nearly the size of the US so growing at 7% is frightening we want it to slow so that it's controlled in percentage growth terms but we don't want it to drop something to 2 or 3% that would be very bad and that's what we call a China hard landing the impact on Australia would be severe as bad probably worse than a housing market crash a really big part of our economy is now dependent on China the probability was small but certainly growing I don't think it's growing because of what happened to the equities market it was growing when we wrote the 2015 smart income report earlier this year what's really happened with equity markets is they've finally come to the same realisation there has been a risk for China for some time because of leverage and they're struggling to make the transition from a construction infrastructure asset driven economy and investment driven economy to a consumer driven economy they'll get that if I can make an investment in China that I could put in the drawer and I never have to hear about its price day to day and then 10 to 20 years I pull it out that would be my favourite investment but I can't make that one because it doesn't exist I have to keep picking up the newspaper and finding out what's happened to it so it's going to be a scary ride for the near return if it's directly in China if it's a scary ride the whole world is worried about then Australian assets will be punished Australia has become a bit of a proxy for emerging markets because we're a commodity driven economy and all that really just goes towards is volatility we're expecting more volatile global environment that we need to either defend or put more defensive assets into our portfolio be happy with what we've got we'll be happy to accept the volatility to accept the volatility that's right the two worlds should be separate traders and investment markets should be able to do their thing and buy and sell off each other madly on a day to day basis and high frequency trading all that sort of stuff and the real economy continues on and most of the time they're separate where there's contagion between the two of them is if financial markets have too much volatility and mum and dad investors get nervous spending on the next car, the next couch the next dress that hurts the real economy then the real economy falls and then share markets fall further and you get into a cycle and so that's what we mentioned before about the Fed in the US that's why they're nervous about increasing rates right now is because they don't want to create a bigger impact on confidence than what they might already be and that impact on confidence has actually come from the Chinese share market that's falling so heavily there aren't that many people around the world who invest in Chinese equities directly so it shouldn't be that big an impact but it's the proverbial canary on the coal mine it's interesting you're talking about confidence because we had a question from David and he said do you regard the plethora or overload of financial commentary at present having any material adverse effect on investor confidence yeah I do in short I think it's having a major impact and I'm quite critical about the commentary and it's not the media per se or half the time they're just reciting what Wall Street is telling them and the other half the time is they're selling newspapers and so the headlines tend to be far more in a bull market far more optimistic than they need to be and in a bear market like right now far more pessimistic than they need to be there was quite a good piece actually written by I won't try and get his name right I think we've just put it up on the wire but he's the global economist for city and he's also used to be a part of the bank of England's interest setting interest rate setting committee and he's just come out with a view that he thinks there's a 55% probability very specific number that the global economy will go into a recession next year he didn't mean that the global economy will go into a recession next year that sounds strange and that's what he said but economists have all these terms and jargon that they use that can be really confusing he thinks that the global economy will fall to around about a 2.5% growth rate next year well growing economy is not a recession but the usual definitions he calls it a recession because it's a big fall and the economy is under producing by substantial amount what it should be so technically in economics terms you could call that a recession sadly he put that in the headline the global media if you google that you'll find about 55 articles written with the headline senior economist calls recession global and so that causes fear which then hits markets which then can hit the real economy very critical of that sort of thing it's a really good piece of analysis sadly he doesn't understand human nature and he put the headline saying 55% of the chance of recession but he's really talking about this point here about China hard landing he's saying that this far too much capacity too many empty roads, too many empty houses too many empty factories in China relative to the amount of demand for their goods and that there's going to be a very rapid slowdown in their economy for a few years and that'll hurt financial markets sounds reasonable, I've got a question from Rajesh who's asking where do you think all the growth is going to come from all the Asian infrastructure assets are hugely debt ridden Asian banks are sitting on huge losses and have lost appetite for further lending, who do you think will fund the growth the Chinese government has fairly substantial cash reserves so it's able to fund it from cash at the state level or the local level hopefully they're not going to be borrowing money to build those infrastructure assets because that would be concerning the few that they've announced so far are funded at a national level a number of Chinese Asian assets are heavily leveraged but actually by and large most aren't so private infrastructure around the world by and large is heavily leveraged not in Australia so much not in the UK so much but certainly in the US and the rest of Europe China hasn't really done that so much so far but you really don't want to see some of the local provinces start to do the big infrastructure spending that they were doing five or six years ago I think at one stage in China there are 120 airports being built at one time so that's excess capacity the size of it and the size of those empty apartment buildings is just their whole city available I've got a couple of other questions which we'll just follow through I'll let you finish in a moment and I'm sorry if I pronounce your name incorrectly Harmenja is asking can energy hungry India provide a hedge against our exposure to China? Great question because this has come up I think we've now done about 10 or 12 of these seminars over the last month with these themes and that one has come up literally every single time and the following question being how do I mess in India? Yes India over the next 20 years is going to be a great hedge or buffer for China we won't be as dependent on China we'll also have India coming through I say 20 years and not 5 because having spent an enormous amount of time in India over the last decade I think I've done about 28 trips to India the infrastructure there is woeful and it is a democracy not like China so they can't just go and move villages to build bridges and roads until they can get that infrastructure fixed it's going to be a very slow recovery which is what you tend to see every time there's strong growth inflation kicks in because they can't move the goods around you can't move food from A to B as fast as you need to to keep up with demand so you'll get growth, inflation, growth, inflation and it'll take longer to get there so 20 years from now India will be fantastic Australia again is really well positioned and keeping the environmental impact to the side for the moment you've got coal and uranium as being India's two chosen ways of producing energy where we happen to have plenty of both of those if we choose to sell it to them we're really well positioned but that's not going to be a panacea for the next 5 years India is not going to be able to save us there's a couple of other questions but I'll leave those to the end of the seminar that you wind up with number one, I'm sure everyone's waiting we've got a little bit to go on this one but I will, I think I need to speed it up a little bit one of the concerns with China obviously is leverage and in particular if you look at this chart now shows the amount of marginal lending done, that institutions, banks don't do marginal lending they lend money, they have to lend money they don't borrow money to buy stocks this is about the upper middle class, middle class China borrowing money and to grow from $80 billion in July of last year to $500 billion at its peak in June of this year is phenomenal if you borrowed money in July of last year to go into Chinese equities you're still really well off actually you're about 25% up before the leverage probably 50% up if you geared the scary part though is that most that money was borrowed after January 2015 in which case you're in the red and you've borrowed money to do that that amount of money relative to the size of the Chinese economy is not material it's meaningful but not material but it's the impact on confidence so the middle class of China has been the great growth story for Australia, they're the ones who've been buying our products they're the ones who have been effectively buying our resources and so if they stop buying then it's a big concern for our economy this is just one small part of it, imagine if the same thing happened with Chinese property and other Chinese assets and their confidence really started to get rattled then we would have a big impact so leverage is considered to be the biggest risk for China and China is considered to be the biggest risk for the global economy right now what do you do about that? I'll just cover on this one quickly why is Australia so dependent on China? we've actually during Chinese growth period over the last 20 years we've done a fantastic job at capturing a large share of the export market from Australia into China or capturing a large share of their imports so we've gone in the last 10 years from $230 billion worth of exports in total to 50% increase, fantastic and most of that's come from the fact that we used to have 8.5% of our exports to China now it's 32.5% so we've really captured a lot of that but it has squeezed out a number of other important trading partners and if China slows down we need them so if you look for example at the US we used to have nearly 10% of our exports going to the US and now that's 5% so it's nearly halved that's bad because actually the US as I said at the start is the world's strongest economy right now it's the biggest and strongest South Korea we've kept up with so that's okay Japan we've kept up with but we've managed to squeeze out some of our old trading partners like New Zealand, the US and the UK and that's going to cost us if China really slows down hard so if that was excuse me if that was to slow that's why we take such a big hit massive no one would want to take a 6% pay cut so no that's right what do you do about that short Australian dollars again same thing so we are a proxy for China GDP for the Chinese economy we're a very liquid currency so when currency traders get worried about China they sell the Australian dollar in the event of a China slow down the Reserve Bank would cut rates so again that's a good reason to sell down the Aussie a very sharp fall in China will again see the Aussie fall very steeply our base case on currency is 65 to 70 cents we started saying that August last year we're now into that we've touched on it a few times and as we speak it's still high 69s but in this scenario a hard landing to happen then you would see the Aussie fall to low 60s high 50s you would reduce equities but this time unlike when I talked about Aussie housing if China has a hard landing no equities will be safe to hide it US equities we've seen already have a massive amount of volatility because they started to get worried about China the US economy would be hurt nowhere near as badly hurt as us but it would take a hit and the growth for US companies all companies around the world would slow and therefore share prices would fall so where do you hide obviously you don't want exporters either there's two things you can do in this scenario one is around currency the other one to watch for other than obviously just reducing risk in general is if the Aussie does fall that hard and that fast then we'll see inflation rise and it will rise in imported goods and for particularly for retirees a lot of our pharmaceuticals come from overseas a lot of the medical equipment comes from overseas a lot of insurance comes from overseas so the cost of living for retirees will increase even faster than the natural rate of CPI so inflation hedges which really means infrastructure bonds at this time if you're worried about China is a good idea now we have this thing called the short China portfolio not terribly creative and it's naming but really the short China portfolio is that infrastructure bond portfolio I talked about before which is really a safe harbor portfolio but with an additional investment in foreign currency sadly you can't buy foreign currency denominated bonds unless you're a wholesale qualified investor but there's a lot of ways to buy foreign currency you can go to OSFOREX you can buy BetaShares, US Dollar, ETF there's a number of different ways to do that but this fixer we'll talk about it in bond terms the short China portfolio is a combination of a safe portfolio of infrastructure bonds investment grade rated not reliant on China or the economy and foreign currency investment grade preferably bonds well diversified in US dollars and pounds a lot of people ask me what's my favorite currency last August I said there's really only one currency to go into and that was the US dollar two or three months ago I started to say actually the pound was a good place to go as well the UK economy is in a good position I think at that time we had just slipped through 50p we're now I think high 45, slow 46 is still good value the point here though is you're short Australian dollars you're not investing into US dollars or pounds because you love those economies you just want to be out of the Australian dollar because if China crashes the Australian dollar goes so if you're going to go out of Australian dollars where do you go I'd be picking the pound at the US because they're relatively safe this chart has a lot of noise on it a lot of squiggly lines the red line is the currency we've all seen that it's down in fact it's lower than this chart now shows the blue line is volatility of our currency and interestingly whenever we start to see a spike in that volatility we drop through another step so your last we started talking about that the Aussie was going to fall from its 94 cents against the US at that stage we set 70 to 75 and shortly after that we saw a drop because volatility was very high and it drops down to high 80s and then volatility calmed down it sat in the high 80s for a while actually at the time we changed our view to a 65 to 70 cent position for the Aussie volatility then picked up and down it goes again and it fell to a new plateau and kicked around at low 80s for a while and then dropped to another level and right now we're seeing it drop down to probably start to stabilise in the high 60s unless there's a really big shock to China but that volatility right now in currency markets is very high so Craig you're thinking the dollar's getting close to where it should be or you're thinking it might step down again I think on our base case which we'll get to on the next slide I think on our base case 65 to 70 is a fair value we tend to take very long term views we're looking again at fundamentals here not at trading so a lot of the banks and fund managers will change their view week to week month to month not really interested in that game for us there was a big difference between fair value and where the Aussie was it got back down to that 65 to 70 so it's the top end of that it could go down a fair bit more but if there were a hard landing in China then that bets off so if you see us change our forecast from the 65 to 70 zone to something lower it's because we got more worried about either Aussie housing or more likely China the safe harbor portfolio I'm going to come back to the chart here so ignore that for the moment but safe harbor portfolio really is much like the infrastructure bond portfolio from earlier and a safer version of foreign currency bonds so you could go into foreign currency bonds in high yield and earn a nice high income from riskier corporate bonds a high yield bond is still safer than the equity in the same company or a safe harbor portfolio would go into high quality foreign currency denominated bonds something that's say A rated or AA rated US dollars or pounds in fact the pound corporate bond marketer has a lot of financial services senior bonds on as well so you tend to find a lot of great safe assets sitting in pounds so then what you do is you take the credit out of the equation the credit risk and you just it is that true hedge against the currency exactly and I'll come back to this chart on the P ratio because it is important so we're on to the number one risk and after China you'd have to be thinking how could this one possibly be higher this to me is the biggest risk facing Australian investors mostly because it's probability is high all of these risks are based on what's the impact what's the probability what's the time frame I think this is an 80% probability because this is the base case and it's because we believe that the world economy in particular has got to a position where it's going to see lower GDP growth lower economic growth for the next 10 to 20 years then we've seen over the last 10, 20, 30 years and there's a number of factors driving that you know I've got to sort of qualify that by saying actually generally I'm an optimist I find myself in a very unusual position having these sort of presentations now because by and large I'm biased on the positive side so for me to make this sort of statement feels very out of character but there's too many fundamental factors driving a future scenario that looks it's not bad it's not a recession it's just mediocre and those are in the western economies baby boomers they're retiring so they're not going to be producing assets and actually spend less people tend to spend less when they're retired than when they're working you've got emerging markets simply cannot grow the same rate they have in the past there is just not the capacity there and then you've got debt as per one of the questions that was asked earlier you know what good can come of these very very high debt ratios whether they're too high or not it doesn't matter we're all worried about them being high so governments will spend less which means less money going into the economies as well so you've got three really long term 10, 20 year issues all colliding with each other baby boomers in the western economies slowing down their growth potential emerging markets slowing down simply because they're starting to reach capacity themselves and the fiscal responsibility trend picking up and it's hard to see any of them ending anytime soon so the new mediocre is actually a quote from Christine Lagarde who's the managing director of the International Monetary Fund we call it the new normal which other way you look at it it means lower rates for a lower period of time but more volatility because there's simply more money sloshing around looking for places to go to invest and that's what we're seeing right now there is a bias in in financial markets that's very natural it's an optimistic bias people humans in general like to look for the blue sky they like to see the upside but I've never seen an outlook or a period of time like what we've seen for the last few years where year after year people are overestimating how well the economy is going to grow so on this chart we look at the IMF's forecast International Monetary Fund's forecast versus what actually happened I've picked on the IMF here not because they're bad actually they're one of the best forecasts many worse but I've picked on them because they shouldn't have a bias they're not making money by overestimating or underestimating an outcome they should be completely unbiased but for six years they've got a pretty horribly wrong 2009 at the start of the year 4.6% GDP growth globally came out at 4.2 so the following year they thought I'll just double down on that let's call it 4.6 again no 3.4 next year they went we've got it wrong the last two years surely it has to catch up let's call it 4.7 wrong again 3.2 they're in a scenario where they're not able to their models aren't able to tell them what's happening because they've got this collision of these three major factors all occurring at the same time and they believe that QE quantitative easing or pumping money into economies by US at first now Japan and Europe they believe that QE was really going to have a much more immediate impact than it has had and it hasn't so they've started to lower their forecast in fact now it's not at 4% where they forecast the start of the year they've already dropped down to 3.6 for this year and they'll be wrong again and it's a concern when year after year that's happening so it's telling us that the global economy is not as healthy as what we think it is and there's something long term driving that issue this is not a normal sort of 7 year fixed cycle this is a bigger cycle so just a moment ago you were talking about 10 to 20 years this cycle so is that sort of your time span for low interest rates is it a 10 to 20 year we're looking at much much longer than anyone expects and that really we have to get our heads around very low rates for sort of 10 to 20 years is that your sort of cycle yeah it's it's that's right that's the base case and it's driven by it's hard to see what's going to drive inflation up maybe in Australia goes up a bit because of our currency but we're a very small part of the world economy you've got three of the biggest economies in the world engaging in a currency war right now they're trying to lower their currency so that their exports become cheaper and they do that by lowering interest rates or using QE if they all do it at the same time it's ineffective because they're competing with each other and it's also meaning that the US won't put interest rates up as much as they should because if they were to pump up rates by one or two percent the rest of the world say at zero the US dollar will go through the roof and their exports will become very unpopular very quickly and slow their economy down so they won't do that so vicious cycle is it it is it is and you know there's a lot of negativity and criticism about QE and it's it's far too far too complex to get into here but the biggest criticism I think is what we're seeing right now is it's hard to pull out of we're now become so addicted to quantitative easing and this liquidity that it's now proving very very difficult to pull out of and we're we're actually creating a self-fulfilling prophecy of now we have to have low rates or you know there's going to be too big a shock which will actually force us to then have low rates just sort of that sort of leads into a question from Courtney who's holding quite a lot of cash in her self-managed super fund and she's saying well what's the right time to buy and you know what should I buy she's obviously been looking from her question at shares Aussie shares and she's asking also about names that have exposure to the US in Australian dollars so if you had any advice for someone holding a lot of cash and what to do with it I mean we've talked about inflation link bonds that's obviously an area where you think it's good to invest in in terms of if she's a retail investor I don't know Courtney if you are or not but then she's not able to buy foreign currency bonds one of the ETFs one of the in US dollar ETF bond type yeah there's a beta share beta shares or beta shares have been pronounced US dollar ETF and you don't get an interest on it because you don't get an interest rates in the states right now and you pay a very small fee but it's an easy way to get exposure to US dollars un-hedged international share funds, un-hedged international bond funds there's a range of different ways to do that you can't just go and open up a US dollar bank account and you wouldn't because it's very expensive to do but the other way is all work in terms of when you go into equities they call it the trying to catch a falling knife you can imagine the imagery of that if you grab it too soon you cut your fingers off catch it too late and it's already hit the ground so it's hard to pick the bottom of a market like this and then you get into personal advice you know if you're of an age where actually you can't afford to lose more of your wealth than shares not as good an idea then if you're younger and you can get in what I can say is that for the first time since the mid-80s when I'm out of shares I've not been out of the share market for all that time and it's not because I'm worried about the share market or I don't like it it feels like there's going to be a great time to buy sometime in the next 12 months but I want it to fall and have that cash on the sidelines. We talk about with this risk which is the new normal that cash if you're reliant on the income from cash which I'm not because I've still got a job and if you're reliant on the income from cash that's a bad investment strategy because if for 10 years you're going to see interest rates at this level or lower and you're hoping it's going to bounce back we just don't think it is so relying on cash is not the thing to do sitting on cash temporarily because you're waiting for a good time to jump in I can't say that's a bad idea because that's what I'm doing now on this slide we've got P ratios for the US market again really messy slide I just want to make one quick point on it which is long term PE ratios which is the price to earnings ratio if a company makes a dollar and it's got a share price of $10 you're paying $10 to buy $1 of earnings or a 10 PE ratio the higher the PE ratio the more expensive it's a bit like a rental property yield the lower it falls the more expensive effectively it is so when PE ratios are high we say stocks are expensive right now long term PE ratios even taking into account bond yields in the US are at very high levels despite the pullback in the last month we've only seen them at these sort of peaks three times before 1929, 1999 and 2007 sorry Craig I've just had a question from David he's wondering the time scale on the graph he can't quite read the year so are those peaks at the recessions the peak recessions sorry I'm not sure what's happened to the data that's 1900 the very left hand side is the year 1900 and the very right hand side is now August 2015 115 years worth of data so that first big spike in the light blue line is 1929 so the PE ratio at that time went way past these current levels so still could be plenty of money to be made from share markets based on that historic measure and came down even harder and then we had if you bought in at you know sort of 1930 then it took you 25 years to get your money back and then again we had when we went through the 1999 spike the big Nasdaq boom it went all the way to 44 a PE ratio of 44 and then it came down very hard after that so there's a long way it can go up in a bubble but you are at historically very expensive level so US equities really concern me right now because of this reason the only way that this PE ratio can be justified is if earnings would increase quite dramatically and the US economy is doing well but not great, good but not great as Buffett said so it's hard to see how you're going to get extraordinary earnings growth in a moderate mediocre economy so US equities to me not a great place to hide right now for that reason well that's actually the darker blue line isn't it and that's getting up towards that it's surpassed you know the S&P 500 index it's surpassed all other levels so the steep climb often you know precedes a steep fall that's right, yeah when we look at PE ratios because the S&P index is always going to go up because the economy is getting bigger, companies are getting bigger so the ratio the light blue line is it's like a rental yield on property is $500,000 expensive for a property well tell me what the yield is and I'll tell you whether or not that's expensive the S&P at 2000 is that expensive well I don't know what's the earnings ratio 27 times long-term earnings ratio that's expensive so right now it's actually pulled back a bit so it's around sort of 24 or so that's still a long way above the average in the long term more like sort of 14 or 15 that would imply a Dow of about 11,000 not 16,000 at the moment for bonds mediocre is good and particular when we have this persistent optimistic bias so much like the IMF chart I showed before this chart is Wall Street's forecast of US 10 year bonds at the start of each year and the actual by the end of that year the lighter blue is their forecast of the start of the year and the actual is the 10 year bond rate by the end of the year since 2004 they've got it wrong in the same direction every single year now remembering this is Wall Street so Wall Street is paid more if equities go up than if they go down it's hard to do an IPO, it's hard to do investment banking in a falling market so they are naturally biased they are forecasting a positive economic outlook because that means that equities earnings will go up and if an economy is looking stronger that actually means that bond yields will also go up and so year after year they've been far too optimistic and sometimes quite dramatically so and so the start of this year there was a forecast for US bonds to be 10 year bonds to be over 3% by the end of the year 1.19 at the moment there's very little chance that they'll wind up anywhere near that forecast and in our view that as we talked about with the global economy being much slower for much longer and the Fed being in a position where it can't put up rates too high without killing its export markets we actually think that long term bonds should be much more like 1.5 or 1.7% so in answer to the question earlier about where do you put your money other than cash right now with bond yields at these sort of levels you're getting good value, you're getting better yield and if they were to fall to these sort of levels that even the market in general thinks they will but if they were to fall to the sort of levels that we believe that they should be at then you'll make small gains from that but you'll also get your income and I emphasize small because you don't invest in bonds for massive capital gains it's just that you're getting good income right now if you can get in that yield on US and Australian bonds has really jumped around a lot in the last couple of months so coming back to our core theme buy on the fundamentals or choose what you want to buy on the fundamentals and pick the timing based on the fear and greed cycle right now there's a lot of fear and greed so some days you get great value the next day you don't the US 10 year bond level 0.95 only 3 weeks ago now it's a 2.19 so in other words you're getting 24 basis points 0.24% more over a whole 10 year period but exactly the same risk simply because the market changes mind but it's a 10% change in 2 weeks so I know one of the traders are happy volatility is good for them and so for longer term investors pick your strategy and then talk to someone who watches the market minute by minute to understand when the right time is to jump in I've got a few other questions here do you want to finish off and then we'll go to the questions yep so these themes actually we've already had on a number of the others the short AUD came up on a number of the big risk but this is the base case so now we're talking about what we think is an 80% chance of happening this is the norm and not surprising we've got short AUD on there because we've been calling for a falling Aussie for some time so it's the right place to be if you believe the base case and it's the right place to be if you think some of those other less likely shocks would have happened as well in this scenario though you reduce US equities they are priced for perfection we saw that on one of the previous slides if they would have come back to normal levels it's a 20% or 30% drop should you be in Chinese equities it's a similar story EU and Aussie equities actually are reasonable values I'm not buying at this stage because it's just reasonable and if the US did fall that much I'm sure about seeing our market fall as well then there's good value but right now some of the commentary around about Australian equities being expensive I'm not believing that one actually there are reasonable values some sectors the banks are still pretty expensive some sectors are but by and large it's alright there's not a lot of value in short duration government bonds you're barely getting paid what you would for your cash so why bother ETFs exchange traded funds and passive managed funds those who follow an index will have very high allocations to these so not a great time to be there in this scenario you increase corporate bonds why well in a flatter economic scenario earnings growth is lower that means that share prices are harder to justify and tend to be either flat or falling whereas corporate bonds in a mediocre environment the economy is okay it's just boring and so cash is there corporate bonds will pay all their coupons and repay their capital and so in those environments actually it tends to outperform equities reduce reliance on cash to the point I made before I don't rely on cash so I can sit in cash for a short while don't sit in cash for 10 years if you need it to pay the bills and hedge against inflation we've covered already I think we're better head into the wrap up so if you've got a few more questions we've gone well over time so sorry about that I'm going to ask a couple of quick questions what is Craig's view on the risk of deflation in Australia and the US that's asked by Anthony US inflation really hard to see how that's going to occur really hard to see there's a lot of deflationary pressures around the world those three big economies I mentioned before Japan, China and the EU despite the fact that the US is massive they swamp it so the EU and China are nearly the same size as the US and so when they start exporting deflation which means they're trying to push down their currencies and then export goods into the US it keeps a little inflation for the US Australia's inflationary risk is all about its currency for hard goods the things we import the most electronics and so on we'll definitely see inflation for others we won't the only thing what world inflation is oil but the right now the world has a lot more oil capacity than it has demand China's been a big part of the demand that's not going to come back dramatically and there is literally a capacity war going on between the US who won't back down because they want to be independent and finally they've got a chance to be independent compliments of shale and OPEC who won't back down because they don't back down so right now there's a lot of capacity with oil it's not going to go back up $60-70 anytime soon so inflation risk I think it's an Australian issue I think it's a longer term issue the reason I like the infrastructure bonds as an inflation hedge is you're really not paying that much for the hedge you're getting good income if there is no inflation you just get better income if there is some of those margins are very much like the term deposit rate so it's like a free inflation hedge I agree just one last question from Courtney so is the US looking like China, expensive than a crash it won't be anywhere near as severe as China China's crash was driven by actually it looked a lot like the 1999-2000 US tech wreck you remember when we were buying stocks because companies had more eyeballs we just bought them because they had more eyeballs apparently and that was a great thing, more clicks and the irrational exuberance went out of control China is much the same so it was the mums and dads, finally given access and given marginal ending they doubled up, it became literally like going to the TAB and betting on horses the US is not like that but the US has got addicted to QE, cheap debt and that's an institutional level so with rising rates the big concern is that slow release of the bubble will cause prices to come down if people get too scared too quickly and hit the panic button then you'll get a crash it won't be 50% like China has been, it'll be 20% do you want to just summarise your thoughts for everyone because we've covered a lot today and I think it's been fantastic but perhaps if you can just give us a very brief summary and then we'll finish with this slide economists try very hard not to give you specific numbers, I tend to break that rule a lot the new mediocre or the new normal to me is the base case scenario give it an 80% likelihood and in that scenario rates in Australia and the US, UK the long rates are not justified so markets are pricing 10-year bonds whether you're talking about government or corporate, they're pricing those bonds at higher yields than what we believe we're going to see and that's because of this persistent optimism, human nature wallstreet driven optimism about recovery that if they haven't seen from getting it wrong for 10 years yet there's some naivety going on and we believe eventually that markets will catch up with that and we started the year by saying we thought that the year was going to be about emerging markets in China and the concerns there that the Aussie dollar would eventually fall down into the 70s that US rates would fall and so these are the same sort of things you just don't know is it going to happen next month or the month after but we strongly believe that over the next 6 months, 12 months, 18 months bond yields will fall and that means if you're holding them right now you're getting more income than you will if you buy in in 12 months time the US interest rate cycle will start in December, won't go for long they'll put up rates maybe 3, 4, 5 times maybe get into 1.5% and then it'll end because no one else will be increasing rates so they don't want to kill their market. A hard landing that 30% probability there is what we believe at the moment that's unfortunately going the wrong way probably is getting higher and higher city groups at 55% who's right, who's wrong, we don't know but the point is it's getting worse and as Australians that's bad, there's nothing good about that, downturn is the less likely of all those scenarios luckily the hedges against the downturn are actually more or less the same against China falling, so if you believe either of those scenarios or both then the way to protect yourself against that is go into more like infrastructure bonds and the way to profit from it is to go short the Australian dollar. Thank you so much Craig, I really appreciate you giving your time today to help everyone understand some of the risks out there and some of the courses of action they can take to help protect their portfolio so thank you very much for joining us this afternoon, I hope you've learnt quite a lot, we certainly have but good afternoon this now concludes the presentation.