Take your foot off the accelerator

Before it's too late, investors should brace their portfolios for a slowdown

- Max Riaz

Australia’s economy is set to slow in coming months as a record string of interest rate hikes finally reaches a choke point for consumers. Corporate earnings and share prices will likely respond by flirting with lows not seen in a while. As we head into the next six months of elevated risk of earnings and dividend cuts, a 20% sell-off is not out of the question. This would take down valuations and share prices with them.

I believe the full-year results will, by and large, come in okay as there was enough momentum in the economy closer to June 30 to get most companies over the line without negative surprises. But the months ahead will be very interesting. Surprises among the large-cap businesses will start to emerge in the December 31 accounts. But let me just add that the market may start to bake in the potential for negative surprises ahead of time.

The simple maths is that equities need to earn an annual investment return of circa 10%-plus (a risk-free rate of 4%-5% plus 6% risk premium) and credit investments need to earn a real return (ahead of inflation) on income paid. If equities’ earnings are not delivering that level of return, the share prices will reduce enough to be commensurate with that level of return.

Backwards in real terms

And in the case of fixed income, unless you are reinvesting that income fully, which most retirees don’t as they are in drawdown, then in real terms your principal invested in credit investments is going backwards. This is because the principal you invest in today’s nominal dollars will be paid back in future in a depreciated currency due to the impact of inflation.