In the wake of the election of Donald Trump as president of the United States, what should Australian investors consider?
- Prepare for an inflationary environment.
Donald Trump’s main policies of tax cuts, increased infrastructure spending and protectionism are a cocktail that will likely see inflation rise in the US, which will drive global inflation, pushing up the price of goods and services.
Inflation will have an impact on bond markets. This will impact interest earned from cash deposited in banks and interest rates on loans.
Thus it is important that any fixed-income asset/bond allocation in investment portfolios be of short duration. This means that these bonds are all likely to mature within the next three years. If you have a long-dated bond with a low interest rate, the value of that bond will become less in an environment where there is inflation and rising interest rates.
To prepare for this, reviewing fixed-income asset/bond allocations will ensure the return on these bonds will remain relatively the same in a rising inflation/interest rate environment.
Higher inflation will lead to the increased likelihood of interest rate rises over the medium to long term (two years and beyond).
- It’s a good time to consider starting to fix interest rates.
Rising inflation is likely to result in rising interests rates. We still have to see if a President Trump is dogmatic in trying to implement his agenda or whether he will be pragmatic. This may cause some short-term market volatility and if that continues there may be a case for another interest rate cut locally.
However, the odds are pointing to rising interest rates to counter inflation So now is a good time to consider fixing interest rates on your loans.
First, you need to determine how much of your loans should have a fixed rate. I never recommend a fixed rate on all debt. Look at your free cash flow and determine how much debt you could pay down over the time period for which you are considering fixing the rate.
I then generally add a 20% margin to this amount and leave this portion under a variable interest rate. There is nothing worse than having the capacity to pay down debt but being restricted by the fact that your debt has a fixed rate. The penalties for breaking a fixed-rate loan can be high.
The portion of debt that you see you cannot pay off within a set period of time can be fixed. Any investment debt should be placed under a fixed rate ahead of non-deductible debt such as a home mortgage.
For example, let’s say a couple have $400,000 of home loan debt and $350,000 of debt used for an investment property. Over the next five years they feel it is achievable to save $20,000 a year to make additional repayments to reduce their mortgage. Thus they would keep $120,000 (including the 20% margin) of the home loan as a variable loan. At this stage they may hold off on fixing the $280,000 of home loan debt, but fixing all of the investment property debt now makes sense as this is tax deductible. They would focus on paying down the mortgage before any investment debt is paid down.
- Don’t be afraid of using market volatility to top up your investment portfolio.
Warren Buffet, one of the most successful share investors of all time, famously said, “Be fearful when others a greedy. Be greedy when others a fearful.” I’m not advocating spending all your spare cash now by buying shares. However, when the market drops in volatile times we need to stand back and look at the broader fundamentals. The US and Australian economies are performing well. The result of the presidential election is not going to have major impacts on the finance, tourism, mining and mineral, healthcare and agricultural sectors in Australia.
Yes, it is likely we will see some short-term volatility with sharemarkets until we get a feel for the style and substance of President Trump.
Let’s look at a simple example of the iShares Core S&P/ASX 200 exchange traded fund (ASX: IOZ), which invests in the top 200 companies on the Australian stock exchange. This ETF is currently providing a dividend yield of 6.45% (after franking credits, that yield increases to 7.79%).
Since 1970, Australian shares have returned an average of 10%pa in both dividends and capital growth. For the dividend yield component to be so high is not normal. Thus we would only need to see an annualised capital growth rate of between 2.21% to 3.55% to achieve long-term returns. The average capital growth of Australian shares has been around 4.5%pa.
If your investment time frame for deploying cash is beyond five years, now may be a good time to top-up your share portfolio given the good dividend yield from Australian shares relative to the risk of buying a diversified basket of shares through an ETF.
Remember Brexit in the middle of this year? The sharemarket immediately reacted negatively to the news of the UK deciding to leave Europe. But once the dust settled global sharemarkets quickly recovered within the next month.
The political pendulum is always swinging. Bad news and fear sell newspapers (or gain clicks online). The global economy is a complex array of relationships between governments, corporations and individuals. Change will not happen quickly from an event such as an unexpected win from an underdog presidential candidate.
We see changes ahead with inflation, interest rates and market volatility that are somewhat, but not entirely, influenced by the election outcome. Planning your financial strategy is always about reviewing the current economic, social and political environment.
The three strategies of preparing for an inflationary environment with increasing interest rates and market volatility will help to ensure smart management of cash flow and positioning yourself to create wealth over the medium to long term.