Challenging times for offshore equities

HUGH SELBY-SMITH is co-chief investment officer at Talaria Asset Management.

The US equity market is currently not doing investors any favours in their search for income, Hugh Selby-Smith writes.

An SMSF must pay age-based minimum amounts each year to a member from their pension account. As a response to the disruption caused by COVID-19, the federal government temporarily reduced these minimums by 50 per cent.

However, on 1 July 2023 the minimums will revert to pre-pandemic levels. For example, an SMSF member aged between 65 and 74 will have to take as income a minimum of 5 per cent of their account balance, up from the current 2.5 per cent.

At all times the challenge for SMSF members is to grow or at least preserve their capital while satisfying the rules regarding withdrawals. In cases where the assets of an SMSF portfolio generate less income than the required minimum drawdown, retirees must sell down capital to fund the shortfall. This becomes a problem if they are forced to do this at the wrong time.

For investors in global equities, this risk of being what is known as a forced seller is currently acute.

Valuations are high

Take the United States, which is the preferred international country exposure for many investors. US shares are expensive. At 30 times, the widely referenced, cyclically adjusted Shiller Price Earnings Ratio has hardly ever been more costly. What this means for the contribution to total return from capital

1: S&P 500: 137 years of monthly contribution to total return from dividend income

Continued from previous page growth and dividend income is telling. As Table 1 shows, at or above the current valuation, dividend income has been all the S&P 500 total return about 80 per cent of the time. It may be obvious, but when dividend income is the entire total return, capital growth is zero or negative.

Cyclical challenges

In addition to valuation challenges, the equity market cycle is a problem. This cycle is based on the lagged effects that changes in interest rates have on corporate profits and share prices.

There are precise technical definitions for each stage of this cycle, but the intuitions are simple: risk-on, the outlook for corporate profits is improving; risk-off, corporate profits are growing but at a slowing rate; risk-averse, corporate profits are falling and deteriorating.

The charts below show the US equity cycle is in the risk-averse stage. The first chart shows the close relationship between the cost of money and the level of the ISM manufacturing new orders index 18 months later. The second shows the same for the ISM manufacturing new orders index and earnings per share growth three months later. Already below zero, earnings per share are heading further south assuming the strong historical relationship between the cost of money, the business cycle and corporate profits holds.The implications for a market in the risk-averse stage of the equity market cycle are disturbing. In the past 25 years there have been three complete periods of risk-aversion for the S&P 500. In each case the return was negative and on average annualised at -21.6 per cent.

Pressures on US corporate profitability

As if valuations and the equity cycle were not enough, the outlook for US corporate profitability is poor. The budget deficit and household savings are normalising from the pandemic’s sugar rush levels. Unit labour costs are rising, perhaps structurally so. Interest costs are increasing as inflation has consigned zero and negative interest rate policies to history. Business taxes are also increasing.

After the extraordinary COVID-19-related blowouts, the budget deficit and personal savings rates are normalising. This is a negative as the bonanza they delivered helped push margins to all-time highs. Congressional forecasts say the budget deficit will move back to around 5 per cent to 6 per cent of gross domestic product (GDP) from around 15 per cent at its 2020 peak. Having hit an eye-watering 33.8 per cent in April 2020, the latest figures show the savings rate at less than 5 per cent, which is about in line with historic levels.

Unit labour costs are on the up. The US Bureau of Labor Statistics gives data on the ratio of job openings to the unemployed. This is a simple but effective measure of whether the labour market is tight or loose. Currently there are twice as many job openings as unemployed persons, which is about as high as it has been since the global financial crisis. The consequences of worker shortages are showing up in median wage growth, which has accelerated since the start of 2021.

Business taxes are also on the rise, with Continued on next page

Continued the rate-cutting Trump administration’s 2017 Tax Code and Jobs Act looking like a fiscal last hurrah.

In 2022, US Federal Reserve principal economist Michael Smolyansky published a paper arguing the “very substantial contribution” lower interest rates and taxes have made to profit margins “is unlikely to continue”.

Of course, no one is forcing investors to hold US shares, but their influence goes beyond borders. The US has the biggest savings pool, it is home to the biggest publicly listed companies and US equities have the biggest weighting in global indexes. Though it may be in poor taste to say it after the pandemic, but in financial markets when America sneezes the rest of the world catches a cold.

Look for alternatives to dividends as income sources

The understandable response to these challenges might be to focus on dividends. But investors will understand dividends are no income cure-all. They tend to rise and fall with earnings. They tend to be cut when investors need them most and dividendchasing investors risk concentrating their holdings in certain regions and sectors. Such concentration is in direct opposition to diversification, one of investing’s fundamental principles.

In view of the above, it makes sense to look for alternative sources of return, preferably in the form of income.

One to consider is option premium. This is an income generator that not only exists outside corporate profitability, but even benefits at times of down earnings and higher volatility.

Options can worry investors, but when they are fully cash backed, that is, without leverage, listed on exchanges, of sufficient liquidity, risk reducing and in shares that represent excellent value, they are tremendously useful.

In view of the challenges facing SMSF members, accessing strategies that take advantage of option premium makes more sense than ever.

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