Reviewing the economic outlook and the investments held across our members' portfolios is an important and ongoing part of the investment process. Our most recent review has been considerably more time-intensive than usual, reflecting what we believe is an intricate environment for investors.
On one hand, some investment markets have demonstrated considerable strength, supported by technological innovation, corporate earnings growth and optimism surrounding artificial intelligence. On the other, we continue to see significant economic headwinds, including persistent inflation, elevated interest rates, geopolitical uncertainty and increasingly concentrated equity market valuations. It's an unusual combination that presents both opportunities and risks, and one that we believe warrants particularly careful consideration.
As part of this review, we've spent additional time challenging our economic assumptions, testing how different investments might perform under a range of scenarios and comparing alternative investment strategies. We've also considered whether the balance of investments across our portfolios remains appropriate, particularly given our preference for greater resilience in an environment where future returns may be harder to achieve.
We’re resultantly proposing some meaningful changes across portfolios with the aim of improving portfolio diversification, further reducing investment costs and strengthening resilience, whilst retaining meaningful exposure to the opportunities we believe will support long-term wealth creation.
1. Our Economic and Investment Outlook
Market valuations and concentration
We’ve previously expressed concern regarding the increasing concentration of global equity markets, particularly in the United States, where a relatively small group of exceptionally large companies now represents a substantial proportion of the share market.
Many of these businesses belong to the group commonly referred to as the Magnificent Seven, including Microsoft, Apple, Nvidia and Alphabet. Their growth has been supported by strong earnings, considerable competitive advantages and substantial investment in emerging technologies, particularly artificial intelligence.
We remain positive about the long-term prospects of technology and recognise that many of these businesses may continue to grow successfully. Our concern is that their current valuations already reflect considerable expectations for future earnings.
When investors are paying a substantial premium for future growth, companies need to continue delivering strong results to justify those valuations. Even successful businesses can experience share-price declines if their earnings fall short of expectations.
Historically, periods of unusually high market concentration have often been followed by a broadening of investment returns, where smaller businesses and companies outside the dominant sectors perform better on a comparative basis. This doesn't necessarily require the largest companies to decline in value; they may simply grow more slowly than other parts of the market.
We believe this supports maintaining meaningful US equity and technology exposure whilst ensuring portfolios aren't unnecessarily dependent on a handful of businesses continuing to outperform.
Inflation, interest rates and economic conditions
We're also concerned that inflation may prove more persistent than many anticipate, resulting in interest rates remaining elevated for longer.
Geopolitical instability continues to create uncertainty around energy prices and international supply chains, while investment in artificial intelligence is increasing demand for electricity, computing infrastructure and other resources. Although these developments may deliver considerable productivity improvements over time, they are very likely to contribute to inflationary pressures in the shorter term.
Higher interest rates affect much more than household mortgage repayments. They increase financing costs for businesses, place pressure on consumer spending and influence the valuations investors are prepared to pay for future earnings.
Our current expectation is that significant interest-rate reductions are unlikely in the immediate future unless economic circumstances deteriorate materially. We're therefore approached portfolio construction with an eye on a ‘higher-for-longer’ interest-rate environment.
Australia faces additional challenges, including relatively weak productivity growth, high household indebtedness and continued pressure from living costs. Our reliance on imported refined transport fuels also leaves the economy exposed to international energy disruptions, with higher fuel costs flowing through to freight, transport and consumer prices.
We aren't forecasting an Australian recession. Our banking system remains well capitalised, many households retain financial buffers, and Australian businesses have demonstrated resilience through previous economic challenges. Nevertheless, we believe there is a meaningful risk that domestic economic conditions could weaken, particularly if elevated interest rates persist.
These considerations support a slightly more cautious approach to Australian equities, although we continue to recognise the benefits of domestic investment, including franking credits for eligible investors.
Where we see opportunities
Despite these concerns, we remain constructive about the longer-term outlook for investment markets.
Technological innovation, improvements in productivity and ongoing investment in infrastructure have the potential to support future economic growth. We also believe there are opportunities outside the largest US companies, particularly among businesses operating across Europe, Japan and other international markets.
The challenge is distinguishing between attractive long-term opportunities and investments where valuations already reflect much of the expected growth.
We're particularly interested in businesses with relatively predictable earnings, sound financial positions and valuations that provide reasonable opportunities for future returns. Infrastructure is one area where we see merit, particularly businesses providing essential services through regulated or contracted revenue arrangements.
These characteristics don't eliminate investment risk, but we believe they offer useful diversification when combined with more conventional equity investments.
Our broader conclusion is that this is an environment where we would prefer to pursue sensible long-term returns through thoughtfully diversified portfolios, rather than chasing returns by taking increasingly concentrated risks.
2. How We're Positioning Our Portfolios
Our review hasn't been driven by a desire to materially reduce exposure to growth investments. Instead, we've focused on improving the underlying investments, their diversification and the way they might respond to different economic conditions.
Geographic diversification
We're adopting a minor underweight to Australian equities relative to conventional Australian diversified portfolios, alongside a more deliberate underweight to the United States relative to its representation in global equity indices.
The resulting exposure is being directed towards other international markets, particularly Europe, and a meaningful allocation to global infrastructure. We believe this creates a more diversified portfolio with less reliance on either the domestic Australian economy or the continued outperformance of the largest US companies.
Importantly, we're retaining exposure to both markets. Our intention is to manage concentration rather than make aggressive predictions about which region will deliver the highest returns.
Currency hedging
Currency exposure has been a particularly challenging part of our review, as there are reasonable arguments for both a stronger and weaker Australian dollar depending on the timeframe considered.
In the shorter term, further Australian interest-rate increases could support the AUD, particularly if Australian monetary policy becomes more restrictive relative to the United States. This creates a reasonable argument for retaining some currency hedging.
Over the medium to longer term, however, we believe the relative strength of the US economy, its productivity prospects and its capacity to attract investment could support the US dollar against our local currency.
We're also mindful that the AUD has historically weakened during some periods of global market stress. For investors holding unhedged international equities, this can partially offset losses experienced in overseas share markets.
We've therefore seeking to hold a combination of hedged and unhedged international investments, allowing portfolios to benefit from currency diversification without relying on a particular exchange-rate outcome.
We generally see a greater role for unhedged international equities in growth-oriented portfolios, while defensive fixed-interest investments have a stronger case for currency hedging given their responsibility to provide stability in Australian dollar terms.
Defensive investments and interest rates
We've spent considerable time assessing how different defensive investments might perform if inflation remains elevated, economic growth weakens or corporate credit conditions deteriorate.
Our portfolio positioning reflects the view that interest rates could remain higher for longer, with an emphasis on generating income while managing sensitivity to further increases in bond yields.
However, defensive investments have different strengths and weaknesses. Corporate bonds can provide attractive income but remain exposed to credit risk, while government bonds may offer greater protection during some recessions but can suffer when interest rates rise.
If economic conditions deteriorate materially, we may see a sudden reversal where interest-rate reductions become more likely. This is an area we are watching closely as it may require us to increase exposure to longer-duration fixed-interest investments, which tend to outperform shorter-duration equivalents when cash rates fall. In simple terms, we’re positioning portfolios for the environment we currently consider most likely, while recognising that significant economic changes may require us to adjust our approach.
Investment management and costs
We're continuing to combine low-cost index investments with selected active managers where we believe specialist investment processes can add value.
Index investing remains an efficient way to access diversified markets, although it can result in substantial exposure to the largest companies regardless of their valuations.
Active management provides an opportunity to make more deliberate decisions about company earnings, financial strength and investment valuations, although the additional fees and risk of underperformance must be justified.
Within our own portfolios we've identified opportunities to meaningfully reduce overall investment management costs - in some cases by over 50% - whilst improving diversification. We see this as an important part of enhancing long-term outcomes for members.
Sustainable investing
One consequence of the proposed changes is that some portfolios have lower exposure to investments carrying explicit sustainability or ESG screening criteria.
This hasn't been an objective of our review, and we maintain that sustainability considerations can contribute to sound long-term investment decisions. However, we've encountered areas where the available sustainable alternatives involve higher costs, narrower investment opportunities or exposures that don't align sufficiently with our portfolio objectives.
We further note that recent market conditions have been unfavourable for many sustainability-focused investments. The repricing of software businesses, including the disruption commonly described as the ‘SaaS-pocalypse’, has affected strategies with meaningful exposure to that sector. Meanwhile, strong performance from traditional energy businesses has benefited conventional indices – whereas these companies tend to be excluded in sustainably-based allocations.
We regard most of these pressures as cyclical, although the timing and extent of recovery remains uncertain.
We remain committed to considering sustainability as part of our investment process, while ensuring that diversification, investment quality and costs are appropriately balanced.
3. Next steps
The economic outlook and investment considerations outlined in this update form part of our ongoing approach to managing our members' wealth. As a result, we've identified several changes that we believe will improve diversification, manage investment risks and support long-term investment outcomes within our Northeast Wealth portfolios.
Importantly, these changes won't apply to every member. Many of our members hold investments through industry superannuation funds, externally managed portfolios or other investment arrangements whereby the existing approach may remain appropriate for your own individual circumstances.
For members invested through our Northeast Wealth portfolios, we've assessed the proposed changes against existing portfolios and, where appropriate, we'll provide individual advice documentation outlining the recommended investments, allocations and reasons for those recommendations.
There's no action required from you based on this update. As always, our focus remains on ensuring your investment strategy is appropriate for your circumstances and continues to support your longer-term financial goals.
The Northeast Wealth Team
General Advice Disclaimer
The information contained in this article is general in nature and has been prepared for informational purposes only. It does not consider your personal objectives, financial situation or needs and should not be relied upon as personal financial advice.
Before making any financial or investment decisions, you should consider whether the information is appropriate for your individual circumstances and seek professional financial advice where necessary.
Any views, forecasts or expectations expressed reflect our assessment at the time of publication and are subject to change. Past performance is not a reliable indicator of future performance.
Where specific financial products are discussed, you should obtain and consider the relevant Product Disclosure Statement (PDS) before making an investment decision.
James O’Reilly is the Director of Northeast, a fast-growing financial advice firm that empowers members to achieve meaningful financial progress and well-being. He's also the co-host of the Australian Retirement Podcast, one of Australia's fastest-growing podcasts.