In this episode, Matt Sherwood, Head of Investment Strategy at Perpetual joins us discuss the outlook for the Australian and global economy, the potential impact of broadening import bans in China and how investors can generate positive returns in risk markets.

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Transcript

Paul O'Connor (POC): Welcome to the Netwealth Investment Podcast series. My name is Paul O'Connor and I'm the head of investment management and research. Today we have Matt Sherwood from Perpetual Investment Management who is the head of investment strategy multiasset strategies. Perpetual is an ASX listed diversified financial services company that was established in 1886. Perpetual consists of three core business units, Perpetual Investments, Perpetual Private and Perpetual Corporate Trust.

The Perpetual Investments division manages approximately 27 and a half billion dollars in funds under management as of March last year. Perpetual offer a broad range of products for both personal investment, superannuation and retirement to individuals, financial advisors and institutions across Australian and global shares, multi asset investments, credit and fixed income and Trillium that offer ESG investment strategies.

There are 14 Perpetual managed funds currently available on investment menus. In addition to the ASX listed investment companies. Matt joined Perpetual in 2005 and he is regularly appeared on Reuters, CNN and Bloomberg in Asia and Sky News, SBS and ABC in Australia, providing his viewpoints and analysis of international developments. His opinions have been included in many newspapers, including the Wall Street Journal, Washington Post, The New York Times and Australian Financial Review.

His current research focus is on the global trade war and whether monetary policy can prevent a serious downdraft in global growth and to regional share market valuations. Matt is a published author of the book titled Intelligent Investing and began his career as a senior economist at the Reserve Bank of Australia. He has a Bachelor of Business from the University of Newcastle and a master's degree in economics covering finance and econometrics from the University of Sydney.

Matt has also held lecturing positions with Kaplan Education, formerly FINSIA between 1997 and 2010 and has also lectured MBA classes from Case Western Reserve University in the United States. Given Matt's background and role, I thought we'd focus today on the global macro economy and particularly the responses by central banks and governments to COVID-19 in the subsequent economic downturn. Good afternoon Matt and thanks for joining us on the podcast.

Matt Sherwood (MS): Hi Paul. It's good to be with you and thanks for having me.

POC: When it became clear in early 2020 that COVID-19 would have a significant impact on the global economy. The monetary response by central banks has been extraordinary via both conventional and unconventional monetary policies. The fiscal response by governments, however, has been slower and numerous central bank heads have commented that stimulatory fiscal policy is also required to complement the monetary policies. So I'll certainly be interested in Matt's thoughts on this issue. For starters, Matt, what have been the major challenges for Perpetual post the COVID-19 outbreak? Did the business adapt from working from home for a period?

MS: Well, it was quite interesting just chatting with our industry peers about how the technology was rolled out. So we work from home in the multi asset team towards the end of February. It actually went pretty smoothly. We're holding two or three, four meetings a week particularly when markets are plunging. The technology was terrific. Fortunately, we done a major IT upgrade across all of Perpetual in the prior two years. So that obviously meant that we didn't have any IT issues, we didn't have any meeting issues. Things like Microsoft Teams were incredibly handy than in Zoom.

It's actually gone very well. And of course, what that means is that our time isn't swapped up on technological issues, we're focused on managing the client's portfolio, protecting capital as best we can during the sell off and of course, growing the capital when things turned a little more normal. But obviously a once in a century pandemic doesn't always go smoothly but the issues have been pretty minor on that front.

POC: It's interesting. I guess the way I see it, it's sort of... COVID-19 has certainly induced a evolutionary change in workplace behaviour. I think it's revolutionary and I think it's more to the fact that we've all really gravitated towards the tools that are at our disposal. Obviously, tools like what we're currently recording this podcast, on a Microsoft Teams. I had hardly used prior to the start of the C whereas it's a daily core form of communication for me and the investment team at Netwealth. So it's certainly been an interesting period to work through in terms of those changes.

MS: Yeah, look, I think some of the interesting things I've read about technology is the level of technological innovation and adaption. This year has been 10 times what it normally is. So we virtually had a decade of adaption in the space of 12 months. Of course, they have all kinds of consequences for work relations, where we do business, how we do business. Obviously this is a rapidly changing situation. We may just be the tip of the iceberg for what are the long term consequences of COVID, both positive and negative?

POC: It's been amazing the way that we've all adapted with the challenges that we've all had to face. The RBA responded quickly to the economic downturn earlier this year by lowering interest rates and convincing non conventional monetary policy through our very own quantitative easing programme. What are your views Matt on the RBA response? And do you think the federal government's fiscal policy response has been appropriate?

MS: Well I think the federal government did very well, as did most governments around the world in the sense that we were faced in once in a century pandemic. We had the meteor estimate for fiscal policy by the Morison government late last year and they were talking about budget surpluses. Probably there have been two key surprises on the government front. The first of all, how quickly the government changed from running surpluses to turn into radically the spender and the employer of last resort in the Australian economy as the pandemic forced economic closures.

They did this even though those spending programmes like job keeper will produce absolutely zero economic bounty at the end. That was one of the big surprises how quickly they change their modus operandi. Probably the second one on the fiscal policy surprise I would argue. It's funny that borrowers now are virtually willing to accept almost zero nominal interest rates in compensation to lending to massively indebted nations. That probably was another surprise.

But I think the government response was quite comprehensive. I think they realised the problem of trying to keep the labour market together and of course trying to bail businesses out so you didn't get a negative left tail event from corporate defaults and businesses shutting down. Overall, I think it's been very good. They've won the war. The challenge now is they have to design policies to win the peace. That is how do you get unemployment down?

So whilst official unemployment in Australia is around 7%, I tend to think the real unemployment rates over nine. We're going to have to have several years of fairly aggressive fiscal policy to give the economy all the support that we can to find jobs for those displaced workers. For central banks also, I think 2020 has been... I think they would see it as a year of success. Given the fact that we had to close the economy down virtually but essential services.

There was massive displacement of workers, and there was risk that the financial system could implode given the amount of bankruptcies there would have been or could have been. So I think I would certainly rate Central Banks very highly this year. But when I look at central banks for the last 40 years, I don't think they've been particularly successful outside of lowering... Sorry, achieving low inflation because central banks changed their modus operandi 40 years ago to... Why did they exist? Well, virtually to avoid recession.

By doing that what they've done is traded inflation targeting against financial stability. So the world now is massively more indebted, it's more and more unstable and of course, interest rates are now at zero. I think they've created or been part of a creation of a massive leverage boom which is unpredictable and which obviously can be exposed to shocks like they were in 2020. What that means is, policy then is going to become even more unconventional.

So I'm not sure the system's any more stable despite the fact that we have low inflation. So to me, I don't rate them highly over the last four decades but certainly in 2020, they saw the problem, they diagnosed it correctly. They did the policy response which was rates to zero, QE, but also loans to business, direct loans. So I think they've done very well this year to really reduce what could have been a mother of all crisis.

POC: It is. It's interesting the way I guess monetary policy to a degree has worked in terms of it's pushed a lot of investors up the risk curve and probably has been one of the key underpinnings of equity valuations. While I have not dropped like we've thought, but do you think the second stage of the fiscal response will be more targeted around infrastructure and those types of areas of expenditure to try and work on that unemployment rate and bring that down?

MS: I'm certainly thinking infrastructure spending will be part of it. The government announced that in the recent budget there was an increase in infrastructure spending. I think probably a more important issue is keeping household cash flows strong. So the more you spend, of course the more employment you can actually create through multiplier effects in the economy. So I don't think the budget is going to have a one dimensional solution to how do we get unemployment down. But it would include all the usual suspects of lower taxes, increased spending for stressed areas.

And also trying to provide some industry assistance. For example, industries like tourism, which are going to be... The impairment there is going to be of a longer duration, the economy is not opening up to international travel for a while yet. Obviously the vaccines got to be implemented. It's got to be successful. There are some industries which are going to have a much longer adjustment process. So fiscal policy will be also targeted at not only helping those industries, but also keeping people skills up and so on.

It's certainly not a 12 month problem the government has, I would argue, it's a three year programme they need and they certainly have initiated this in the budget to provide the economy with maximum support during this very difficult adjustment process. Even though the recession itself is over. It's pretty clear the supply shocks leave lasting damage on economies and that's what the government's trying to address.

POC: Equity markets have run pretty hard post the downturn in March and April of this year. What's the outlook for 2021? Does a possible vaccine mean it's blue sky for investors and we're off to the races again? What's your thinking they Matt?

MS: Well I think the vaccine certainly is a game changer if the actual results of the vaccine are similar to the trial. Our expectation next year is the global economy can grow in the calendar year about 4.75% so just under five. That's among the strongest we've seen in the past two decades. That's driven by partial economic reopening, the impact of the vaccine, and still sustained stimulus as well.

Of course, with all the operational leverage we saw in the last US reporting season where firms work their costs hard, they've increased their margins, a 5% growing economy plus inflation which would make it about six and a half I think then can very easily deliver 20% earnings growth. I tend to think that the earnings are good. The challenge for market is valuation. So I wouldn't say it's blue skies for investors as much as it is necessarily for the economy. Because the challenge for investors is not only is valuations, but it's also well how do you actually diversify risk because markets don't always necessarily recover in a straight line, volatility is usually associated with that.

So it's probably in a bit of a bounce of your time. Whilst we get 20% earnings growth, people may be surprised that we could get single digit returns next year despite that massive earning surge. The key, not only is figuring out exactly how you can generate returns in this environment, but also how you can manage the risks. Because there's still a lot of uncertainties about vaccine rollout. We do also have a negative quarter of growth in Europe in December this year and in the US in March next year.

So the recovery and the inoculation programmes won't really get going until the second half of next year. So there's a lot of blue skies being priced in by markets and people have got to understand that those expectations may not be met within those next 12 months.

(Previous episode) The investment opportunities in global mid & small-cap equities - Fairlight

In this episode, Nicholas Cregan, Portfolio Manager and Partner at Fairlight Asset Management joins us to discuss the recent performance and outlook for global mid and small-cap equities, how they differ from Australian equities and why more investors should consider a global mid and small-cap strategy in their portfolio.

Listen to the episode

POC: So given the equity market and other risk asset valuations are considered high at the present, how can investors generate positive returns in equities and other risk markets?

MS: Yeah, that's a great question. The returns... We know that valuations are high so at the moment, the US share market is trading at a 25 times PE ratio, which historically has been associated with a 2% per annum loss in the next five years. So people are sitting there thinking, "Okay, well how can I actually generate returns?" This is one half of the investors dilemma. The way I'm thinking about it is I start looking at okay, well what sectors have done really well?

That is obviously tech. It's recorded a complete recovery. It's growing its earnings very substantially during that process but the challenge for tech, of course, is its valuation. Us tech shares are trading around 50 times earnings for the mega caps, the rest of the market's at 15. So that's the US share market, the big mega cap tech stocks. How do I manage... How do I get returns. It really depends on what risk premium you're trying to extract.

I try to think about the impact or the combination of evaluation cycle and momentum. So I think valuations a challenge most in tech, so I'm thinking about the other parts of the market. Of course, the parts of the market which have been left behind, at least so far in the recovery has been the traditional value sectors such as energy companies, financials, industrials, consumer discretionary and so on. They're the sectors which need higher nominal growth to actually grow their earnings and I think they're going to get that next year.

So when I look at the global markets, I'm looking for sector six with high leverage or high exposure or high sensitivity to economic growth and also markets which have a higher exposure to those sorts of sectors. It's the value sectors as I said and they have the highest weights in markets like Australia, the UK, Europe. I look at those markets and think, well they're probably... They're trading a bit cheaper than the US and I think they probably have more exposure to the cyclical upside. So that's where I'd be focused in putting my capital to work.

Those sectors have lagged, I think they will have a catch up trade. They're positively exposed to a steepening yield curve. So I think they've got quite a few things in their favour and they're the ones which have generally struggled in the past seven years. So I tend to think those value sectors are certainly going to have their year in the sun.

POC: So I guess my takeaway from that is that potentially investors do not need to take on more risk. However, they need to be more selective in opportunities. You made a comment around the return potentially of value stocks and I think of emerging market equities. So would you agree with that comment map?

MS: Yeah, well emerging markets not only one of the cheaper markets, but it's also one which is exposed to the growth engine that is China. So in the MSCI world emerging market index, about 70% of the index is from Asia. They obviously got good trade links with China. I think that is definitely one area that we have looked at and we've increased our exposure to more recently. At the same time, just to reiterate the message to investors, it may not necessarily be the trend of the market that does well for them, it may be the trend within the market. That's how we're applying it at this stage.

POC: And possibly emphasises the importance to consider active management I guess, Matt. If you've got to be more selective than being able to buy the whole market. Moving on to the balance or the allocation between Australian and global equities, Ozzie equities had such a stellar run from the early 1990s through till about probably three or four years ago. And then global equities have outperformed subsequently. What's your thinking around should investors have a significant overweight to global equities in their portfolios?

MS: Well that tends to be the industry trend at the moment. I think there are some compelling risk premiums you can extract in global markets. But what I also tell investors in that we're in a lower returning world and there's a lot less risk associated with dividends than there are necessarily earnings. So I think the ticks in the box, the reasons why you hold Australian equities in your portfolio is because it's a high dividend paying market. The yields are 5% tax advantaged.

If you're looking to beat inflation by 5%, then you can do it in a low risk way through the domestic equity market. Now of course the domestic equity market applies on minors and banks. That's more than half the capitalization there. So it's really getting a combination of risk exposures within your portfolio. Not just in Australia, not just in global but doing it in a combination which I actually think can really help investors in what is going to be a lower return world. I don't think it's either or. I tend to think each market has got benefits and issues around it. Australia is no exception there to other regions. So it's really a combination of those two, which is really the key.

POC: So perhaps moving now to the defensive sections of the portfolio, interest rates are now at historical lows, and the outlook for returns from bonds is also fairly low. So how should investors think about structuring their defensive portfolio allocations?

MS: Yeah, that's a great question. It's one which I think all fund managers are focused on. If we look back in Australia, for example, for the last 100 years, there's been... Sorry, the last 120 years, there's been 24 occasions when the Australian share market has recorded calendar year losses. The Australian bond market has actually produced positive returns in 19 of those 24 years. It has been a terrific and steadfast diversifier over that period of time.

If you look back, for example, after 1980, so that's 40 years, the average return in bonds when Australian equity markets were negative in a calendar year was 14 or 15%. It's very easy if you're thinking, well equities are coming off the boil. They're expensive, they're volatile. It was so easy to buy bonds at that time because you could get double digit returns in a riskless asset. We saw that in the GSC, in 2008 Australian bond yields were around 7%. So it's easy to buy those. Today they're less than one.

Of course bonds are less than 1% because of all the liquidity from the central bank asset purchase programmes that's distorted other markets such as gold, the US dollars fairly elevated relative to its history even though it is coming down more recently. So the question is, well, how do you actually diversify your risk there because your traditional diversifiers are very expensive and so therefore just can't do the job that they have historically in the past.

The way we tend to do it in our real return fund where we're trying to give inflation plus 5% over rolling five years but with low volatility, is that we have a whole bunch of diversifies in the knowledge that each one of them won't diversify risk as well as they've done in the past. But if you have a collection of them, that actually can really help investors manage what may be significant volatility in the years ahead. So not only do we have government bonds in there and some US dollars, we do have some option protection which is very important. We have some idiosyncratic trades such as the Hong Kong dollar.

So, we think eventually, China's going to break its peg, the Hong Kong's peg with the US dollar. They'll want their satellite city tied to the motherland rather than a strategic rival. So we got some options there. Of course when that peg is broken, there's going to be a massive rise in volatility. So having options there helps manage the risk and also has very significant upside to it.

Other things you do in portfolios as well as those four things I've just mentioned, I do believe that having exposure to growth assets with cheaper valuations and better balance sheets and stronger operating models, I do think that helps manage cycle risk. So there'd be more valuation risk, for example, in US tech than there is the US share market outside of tech. We had those value quality sectors in the portfolio. Gold downside probably isn't that large given all the central bank distortions.

The other way, of course, is by having lower than traditional exposures to equity market data. That's another way of diversifying your risk. You want to do that when valuations are expensive and they certainly are now. So you put all those seven factors together, you still can get significant diversification in your portfolio's even though several one of those diversifiers probably won't produce the traditional offsetting returns that we're used to getting during periods of equity market volatility.

We saw that in September and October. The US share market was down nearly 10%, how did bonds do? Well, bonds sold off then and that's a bit unusual. So investors have to realise that bonds won't work as well as they have in the past. They will still offer some relative protection but they need to be open ended with several of those other trades which I've suggested. That collective force I think can diversify risk during periods of volatility. Even though valuations in those assets individually are a much more challenge than they have been in the past.

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POC: You make some really interesting points they Matt and really thinking hard about trying to diversify that defensive portfolio allocation. As you were talking and you mentioned US dollar to me, it's just... It's rational but I hadn't thought of it before as a potential allocation in a defensive portfolio given that it always rallies when markets moving to a risk off environment. So really interesting there. Maybe moving back to equities and the valuations, what do you believe has driven equity market valuations to their current levels?

MS: It's pretty much central bank liquidity. The asset purchase programmes, they exchange bonds for cash and so a lot of cash lend by banks is put to work and it finds itself in risk markets. Because if you're selling a bond, you're not going to go and buy another bond. What you're going to buy is probably something with a bit more risk. That was much easier this year, of course, because central banks had backstop the credit market. So you could easily pick up a yield spread by buying for example, investment grade securities or equities as a yield of last resort. But the equity market valuations themselves is solely a function of central bank liquidity and really nothing else.

POC: And I guess as equity market multiples just continue to drive up. That's probably an outcome of exactly that central bank liquidity and flooding the market with liquidity. I guess for a want of a better term, trump me on my next question there. I was going to ask about productivity gains and whether you see that as being a key driver behind valuations. Would I be right in saying potentially not at the moment but going forward it could be extremely important?

MS: Yeah, I don't think productivity has any connection at this stage with the valuations in markets. But the key thing that central banks have done by doing QE, forced bond yields, lower forced equity valuations up, we have to keep in mind this. Central banks do not create growth and central banks do not create returns. All they do is pull them forward from the future. What that means is returns henceforth in the next 10 years are going to be much, much lower.

So at the moment, our estimates based on valuations is the global share market will return around four and a half percent per annum on average in the next 10 years. People sit there and hear that and they say, four and a half, that's not bad. Bond yields are less than one but... Equity market returns are not going to be like a term deposit. They're not going to be the same every year. If you have a liquid market for example like Japan, in the last 20 or 30 years, sorry, the last 20 years, it has delivered a four and a half percent per annum average return. But within that you've had nine periods where the market has lost 20% per annum or more.

So, low return doesn't mean low volatility. It actually means much higher volatility. This can be really dangerous for investors such as retirees who expose themselves to sequencing risk and of course they're much more exposed to falling markets given the fact that withdraw superannuation funds every year to fund their standard of living. So it's a much more volatile world in front of us. It's a much lower return world in front of us. It's pretty much the opposite of what investors had experienced in the last four decades.

So in relation to productivity, we also have to remember that productivity has really changed its nature. I hear all the time policy makers and politicians saying, "Oh, we need to raise productivity." Productivity is not like it was in the 1980s and 1990s where it was a case of let's all share the bounty. If you guys work harder or make more profits I'll pay you more. Of course the government collects tax so it's win win win. It's not now about sharing the bounty, it's about outsourcing the costs.

The change in productivities nature is very, very important because it's not the growth panacea that central banks and academics and politicians believe it is. Productivities naturally declining with technological advances becoming more asymptotic and not delivering as much as they used to. And so really the way we need to be addressing the problems we have in the world of high leverage, high valuations, higher unemployment is simply through higher nominal growth. Whilst productivity sounds convenient to drive that, I actually don't think it will be.

POC: So corporate earnings growth has been strong in certain industries and sectors. So can earnings growth match the performance of the last economic cycle?

MS: Yeah, well you certainly hope so. Because when you look at markets like Australia, the UK and Europe, their earnings for the last 10 years only grew 20% per annum in total. So it was incredibly anaemic growth. The only market where you had a significant growth in earnings of course was the US with its tech exposure. Earnings there grew around seven eight percent per annum if I remember correctly per annum for the last 10 years. Of course tech firms grow earnings virtually by stealing market share and being more cost efficient.

I think as these firms get bigger and bigger, it's going to just be harder to steal that market share more and more. So, I think there's also going to be regulatory issues around those tech firms. There's a risk of breakup. Risk of regulatory tightenings of their operations and so on. I think they're probably going to face a tougher decade. Hopefully, that might free the space up for other sectors to grow their earnings. But I do believe we're in a lower nominal growth world.

Despite the fact that central banks and consensus tells us that growth is going to materially improve each year, it's been falling structurally now for the best part of 25 years. I don't see why that would be any different in the next five years. Lower earnings mean you have to be a little bit more nimble to be able to extract out where earnings growth is under priced by the market. Nimble in your portfolio composition. And moving away from the benchmarks also helpful on that front because what it means is that you don't have to necessarily have a set strategic asset allocation to certain risk markets.

Better portfolios to this sort of world are those which don't have strategic asset allocation frameworks. Actually portfolios are simply built from the bottom up and full of sectors and markets and asset classes which can help inflation, sorry, investors beat inflation by 5% or more. I think that's the sort of portfolio construction which is going to be particularly useful for investors in the next decade.

POC: So, Matt, what's your outlook now for the Australian economy? I am very interested in your thoughts around the risks with China. China certainly appears to have a policy that just slowly broaden the bans on Australian imports. I think we've seen beef hit overnight again. So where do you think this will end?

MS: Look, there's no doubt that China is tightening the screws on Australia. Obviously China has been a tremendous source of growth and wealth creation for all Australians in the past 20 years. As a result, our industry policy hasn't been particularly dynamic. A large portion of our exports, namely coal and iron ore to four countries, namely China, Japan, South Korea and India is more than half of our export base. So Australian industry policies been actually fairly lacklustre and certainly we've been living through the great complacency in this country about our economic policy.

I think Australia in the next couple of years is going to do particularly well. So I'm expecting real GDP growth in Australia. 4% per annum for each of the next two years. I think we'll be doing particularly well on that front. We had a fairly solid bounce in the September quarter national accounts despite the fact that Victoria was closed for a large portion of that. Despite the fact that household savings rate didn't really come down much, so not only do we have large scale policy support from the RBA and also from the Morison government, but household savings rate in Australia is down 19% of disposable income. In February, it was four.

So that to me tells me that Australia is going to be doing pretty well in the next couple of years, despite the fact that China is going to be making exports harder. And so, it's very difficult though for them to materially decline our iron ore exports because Australia is a very large producer of global iron ore which we send out via ships and China buys 70% of global seaborne iron ore. Brazil is really our only strategic competitor there. But even then iron ore in Australia is a huge source of export income.

Challenges come of course, we have other areas, particularly services like tourism and education, that's where they can tighten the screws. They're making life difficult for the wine, for lobsters, for beef as you've said Paul but what Australia has to do is look for different export markets. I think that would be very sensible from a portfolio perspective to not just have one buyer of your exports but actually have five to 10 significant buyers that of course decreases your risk of geopolitical issues hitting your economic policy.

But that said, even if China imports less of our goods, that should just be an exchange rate depreciation. But the challenge for Australia at the moment is our exchange rates heading the other way as China is tightening the economic screws on us. So hopefully different export markets can be found. If that's the case, it's probably going to be to Australia's benefit that we diversify away from China, particularly towards India, which is also an emerging market which is going to have a bigger population, they're English speaking, they have respect for rule of law. They're not there stealing intellectual property and of course they have the benefit of having a very young population.

I think there's a lot of camaraderie and respect between India and Australia. So I think that's the market that Australia probably should be targeting. That and Indonesia given they're literally our next door neighbour.

POC: It certainly makes sense your comments there that further deepening the relationship with India there which we have a fairly close relationship. Perhaps not on the cricket field at times but elsewhere. But that's a pretty positive outlook for the Australian economy. I guess in the back of my mind is you were talking about 4% plus GDP growth over the next couple of years. I'm like oh goodness, residential housing. With the savings right up and the growth coming in we'll probably see the continued growth in residential property then.

MS: There's very little doubt about that. We've already started to see prices move, housing activities picking up, Australians love housing and property. They do well at it. Interest rates are at historic lows. So it's pretty hard to see a combination of low rates, strong growth and falling unemployment being bad for property. So I suspect housing activity is certainly going to increase and add to growth and add to household wealth in the next few years.

POC: So maybe just drawing the podcast or conclusion, what do you think are the three key risks markets are not factoring in? Is an inflationary spike over the short term, medium term a potential concern for investors Matt?

MS: Well, certainly. I think that's one of the things that markets probably not pricing in. Now, I'm not particularly concerned about inflation at this stage because of all of the excess capacity that is in both the Australia and the global economy with unemployment close to 10% in... Or the shadow unemployment rate close to 10% in both the US and in Australia and also in Europe. Any inflation spike, I think, would be a real negative for markets and for the economy.

So that's probably one risk that is not being properly priced at the moment even though I still think the risk is fairly minor. Probably the biggest thing I think of next year, is vaccine setbacks. Markets are very aggressively priced for a seamless rollout of vaccines from Pfizer, from Moderna and from AstraZeneca. By my calculations, it's still going to take us 18 months for global herd immunity to be achieved. That means some parts of the global economy are going to have to go through another COVID winter which can lead to economic closures, et cetera.

I tend to think the world's become far too complacent about this including financial markets. So complacency and shocks leads to setbacks for market. Any problem with the vaccine from a health perspective means that less and less people would have it. That's something markets aren't priced for. The other thing I think which is an issue which markets aren't focusing on it's really policy error. I think at some stage in the next year, central banks will begin to wind back the asset purchases. We saw in 2013 when Ben Bernanke said I'm reducing monthly purchases from 85 billion to 75 billion which is an incredibly minor reduction.

Equity markets really became very volatile for several months and there was some large losses there. I tend to think monetary and fiscal pullback at some stage next year could be a source of market volatility. That's why we still have considerable diversification in the real return fund because economies and policies don't always go in the same direction. And as such, policy mistakes or changes in policy, don't have to be mistakes, that can spark high market volatility and with valuations where they are at, markets could have a very sharp adverse price effect if those risks actually become central case.

POC: Matt, thank you very much for joining us on the investment podcast series. I've certainly enjoyed the conversation and found your insights quite fascinating. I guess I must admit to disclaim it here, I always enjoy the discussions with people that work on diversified portfolios because you have to make those decisions between allocating between the various asset classes which naturally means it forces you to have a view on the various asset classes and within the asset class. So again, thank you very much. I'm sure the listeners have very much enjoyed your insights Matt.

MS: Thanks very much, Paul. It's been a pleasure to be with you. I just wish you and all your investors a happy new year. Let's hope 2021 will be better than this year.

POC: Very good point there. To the listeners, I hope you have a great rest of the day and all the best to you and your families for safe Christmas and a merry New Year and let's hope 2021 is up little bit more positive than what we've gone through in 2020.