In recent blogs I wrote about quantitative easing, the European Union referendum and the impact these were likely to have in global markets. My predictions did, in fact, come to pass. Markets do not like uncertainty, and we are living in uncertain times. I do not think those times have now come to an end. We are probably looking at even more volatility in the near future, and possibly more long term adjustments. Assuming I, and many highly qualified economists, am right, I want you to think about the effect this could have on your practice if any of your practice income is derived from money under management.
Even if you are sceptical you should consider the possibility and be prepared to modify your strategy.
Banks have to undergo stress testing to see whether or not they can survive in given adverse conditions. I am suggesting we all need to do this with our practices too.
Do this three step exercise:
First note down your total money under management and the average percentage of this you receive as a fee. How much does this come to?
Second, what is your expected profit this year?
Third, subtract the first figure from the second. Where does that leave you? Could your practice survive?
That, of course, is a worst case scenario. It assumes all your clients decide to withdraw all their money from investments and leave it in cash. Or even, given the information I have shared previously and expand on below, that you decide a cash strategy is in the best interests of your clients and advise them all to move into cash.
If that worst case scenario did come to pass, where would that leave your practice?
But let’s now assume something perhaps a little more realistic. Your clients remain invested but there is a substantial correction and the value of your money under management goes down considerably.
Looking at your previous calculations, how much would a 10% drop in your income from money under management impact on you? Would that immediate drop in income cause any difficulties? Or how about a 20% drop? 33%? Even 50%?
If you look at the difference between the highest and lowest values over the month, in October 1987 the FTSE dropped by over 33%. A 33% drop in just one month. The crash started on 19th October with a 7.7% drop, followed by nearly 12% the following day, over 4% the next and nearly 11% the following day.
This was not limited to the UK though. In that month the Hong Kong market dropped by over 45%, Australia by nearly 42%, and both the United States and Canada by nearly 23%.
Imagining a worldwide drop of anywhere between 30% and 50% is therefore not at all unreasonable. Stress test your own practice with a 30% drop. How uncomfortable would that be? Then try it with 50%. Do you have a structure that will survive this?
Why might we might expect a serious, imminent correction in markets? We have already looked at the possible effects of quantitative easing in a number of large economies. There are several other factors we should also consider.
Have you checked the price of oil recently? It has plummeted hasn’t it! This could actually affect markets either way. Oil stocks will go down if the price of oil plummets, but there are also a lot of other industries that are linked. Of course, there are many industries that should do better when the oil price is low – for example airlines. The point, though, is that such a large drop in the price of a major commodity causes high volatility and that leads to greater uncertainty. Markets do not like uncertainty.
Have you noticed how many countries have a very high debt to gross domestic product?
Excluding San Marino and Vatican City, which could be viewed as special cases, there are only 5 countries in the world that have no national debt. These are Macao, British Virgin Islands, Brunei, Liechtenstein and Palau. With the exception of Brunei, which produces oil, none of these countries really produce much more than finance, tourism and gambling.
In the Eurozone, only 8 of the 22 Euro countries have a debt to gross domestic product ratio below 60% – which is the requirement for joining the Euro in the first place.
Such high borrowing has to be curbed, and the measures that will eventually have to be taken to do this are quite likely to cause share prices to drop.
It is said that the only future certainties are death and taxes. Everything else in the future is an unknown. We can guess what might happen, and an educated guess might be pretty good. But there are no certainties.
Whether or not your stress test indicates your practice is robust enough to survive another global market crash, it would be sensible to look very carefully at the way you have structured your practice. Re-design it if necessary so that you are far less reliant on fund values.
There are a number of very effective actions you can take to do this. More on that later!