Why investors should learn to expect the unexpected

One of the biggest challenges that investors face is working out what impact economic, financial, political, commercial or social events will have on their investments. And you don’t necessarily need a crystal ball, as Edward Smith points out.

There are any number of events that may impact local markets. They can be international, regional or local, as well as being large or small, known or unknown. 

One of the key tasks of any team supporting investment managers is to keep a look-out for possible events or issues.

They must determine the likelihood of them happening, assess the potential scenarios that might arise from them and the effect these might have on investments. 

An example of a major international event is the recent political brinkmanship in the US, with the government shutdown and last minute deal on the debt ceiling.

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It was, to many, one of the most potentially catastrophic events for global markets since the collapse of Lehman Brothers. 

In reality, even while the political grandstanding went down to the wire, it caused little more than a blip on markets.

It seems markets expected that common sense would prevail, an agreement of some form would be reached, and disaster avoided. 

However, as an issue with the potential to affect markets, it isn’t all over yet and could flare up again in January. 

Another ongoing international event of major risk to markets that hasn’t had anything like the same visibility recently – and is still very real – is the continuing issues in Europe. 

Again, markets appear to have decided that the likelihood of a real calamity is unlikely and that the problems will eventually be ‘fixed’. 

However, this can easily change and if there is a political stand-off in the US that is pushed past, rather than to, the wire; and if at the same time there is a problem unearthed in any European country, this could result in a very nasty reaction around the world. 

It is the potential unknowns such as these that have to be considered when assessing the future of different investment classes. 

From the investor’s points of view, it can be easy to get lulled into a false sense of security and come to the conclusion that, although there are still many economic problems around, they will eventually be solved, and everything will turn out okay.

But we have seen in the recent past this doesn’t always happen, and it is professional investment managers who are more likely to consider the impact of emerging scenarios and take them into account in their decision-making. 

When considering global issues, it is often those things that are still unknown, or seem insignificant in their early days, that suddenly emerge from left field and quickly develop in a way that brings about fundamental change to the global landscape. 

The internet is a good example. Few people predicted the introduction of a global electronic information network that had the potential to link every household, business and government in the world with data and news every second of the day. 

The impact of this has clearly been enormous, not only in the way business is done and the way we interact socially, but in the investment opportunities it has created. 

Within our own region there are also a number of issues that have affected our economy recently, which will continue to focus the attention of investors because of their ability to impact on markets in the future. 

China’s development will continue to affect many Australian companies, not just those in the mining industry but in areas such as tourism, primary production, professional and service companies. 

The Kiwi experiment 

Another example, even more local, that could have implications in Australia, is the move by the Reserve Bank of New Zealand (RBNZ) to limit how much lending banks can make on residential property. 

It is a very timely issue to consider as we are currently seeing much the same debate in Australia as that which triggered the step in New Zealand. 

The idea behind the move is that the residential property market in New Zealand is overheating and has the potential to become a bubble.

To try to manage this and prevent things getting out of control, the RBNZ has introduced a measure that restricts the amount of residential lending that banks can make with high loan-to-value (LVR) ratios.  

From 1 October 2013, banks in New Zealand have been required to restrict new residential mortgage lending at LVRs of over 80 percent to no more than 10 percent of the dollar value of their new housing lending flows. 

It is hoped that this will help limit property speculation and curtail bank exposure to high risk loans, forcing banks to pay more attention to the credit-worthiness of their borrowers. 

It’s a bold move that will be unpopular with the public. It also has the potential to improve housing affordability by taking some heat out of the property market. New Zealand politicians are already weighing in to attack the banks that deny loans to their customers. 

But if it works, it could resolve a problem that has plagued bankers for a while, and indeed cut to the root of issues that initiated the global financial crisis. 

While New Zealand may be the first to consider such an approach, it is unlikely to be the last. Regulators and opinion-formers around the world – including in Australia – take great interest in how such experiments work out.

For example, if implemented here it may make it easier for the Reserve Bank to reduce interest rates as it makes it less likely that a cut will fuel house price inflation. 

It seems quite possible that if the measure proves to be successful in New Zealand, we could expect to see a similar step in Australia, and such an outcome will affect investors as there could be a number of unintended and unpredictable knock-on effects from the restrictions that could have significant consequences for the economy. 

For instance, if adopted, there will be an impact on how banks grow their market share.   

After all, lending to lower quality credits generates higher profits, and banks in Australia are renowned – notorious in some circles – for their high profit levels.

Over the last year or so, many Australian investors, especially retirees, have come to rely on the dividend payouts and capital growth provided by bank stocks. If this changes it could create income and capital gain problems. 

So what started as a straight-forward measure to achieve one specific goal in a neighbouring country, could result in a number of other outcomes that policy-makers and commentators haven’t yet taken into account. 

Then there are domestic issues and events. The stock market clearly liked the recent change of government and reacted accordingly. 

However, the unknown is what the market reaction will be in the longer term when policies are implemented and the Government’s ability to manage the economy is tested. 

All these events are not happening in isolation, but have to be considered simultaneously, while at the same time making an assessment of any impact of one on the other. 

It is a powerful argument in favour of investors using investment managers and their support teams rather than going it alone, as few individual investors can hope to keep aware of the many events and signals that can influence investment markets, much less interpret them. 

Edward Smith is head of portfolio management at Australian Unity Investments.