Time for some hard truths

There is a very real risk that Labor’s budget will push the Aussie economy into recession next year.

As a forward-looking indicator, the stock market may be starting to discount tougher times ahead. It’s struggled over the past few months and hasn’t had many green days since just before the budget, when leaks about the punitive taxes started.

While something needed to be done about the housing market, the remedy proposed is all but useless. Instead of imposing CGT changes on property alone and thereby incentivising capital to flow into more productive forms of investment, the government is increasing CGT across the board, as well as penalising small business owners via the minimum 30% tax on family trusts starting 1 July 2028.

The government’s line is that they’re making the tax on assets and labour more even. The smart way to do this is to lower PAYG tax rates, not increase taxes on investment, which will just lead to capital flight and make us all poorer over the long term.

And basic common sense would tell you to drastically cut immigration rates to reduce housing demand, as well as cut the red tape and bureaucracy that restricts supply.

At the end of the day, this budget means the government is taxing more, spending more and doing nothing for productivity. Although the changes don’t come in for one or two years, this budget will change investor behaviour immediately.

The impact of a property market downturn

Particularly in property, which is the linchpin of the domestic economy.

The property market had already started to slow ahead of Labor’s budget. Their proposed changes will ensure that slowdown picks up pace.

If a falling housing market hits consumer and investor confidence, a recession might not be out of the question.

I say that knowing the government will continue to spend and prop up the economy via high immigration levels. And while the resource sector should continue to bring in money, it’s not a large employer compared to housing and related sectors.

If housing turnover slows and property prices fall, job losses will follow. The market already sees this. Seek’s [ASX:SEK] share price is down 60% since September 2025 and over 20% in the past month.

Higher unemployment means reduced ‘passive’ superannuation flows entering the market, which will take the air out of many high-priced stocks.

The rise of passive flows and systematic trading has been a boon to markets. This capital doesn’t care about valuations or fundamentals. As long as the flows come in, prices keep moving higher. And benchmark-hugging fund managers have to buy to keep up.

When that trend turns, it will have a big impact on markets, especially overvalued stocks. Because the marginal buyer will have exited, and the short sellers will be circling.

According to the Association of Superannuation Funds of Australia (AFSA), $156.3 billion in employer super contributions flowed into financial assets in 2025. To be clear, not all flows go into Aussie stocks. Using data from the September 2025 quarter, 31% went into international shares, while 24% went into Aussie equities.

Furthermore, the system paid out $139 billion in benefits (lump sum and regular pension payments). The net inflow (including personal contributions and other transfers) for the year was $72 billion.

Now, consider what that net figure looks like in a rising unemployment environment. Employer contributions will decline, while benefits will continue to increase as more people move into the pension phase, and hardship claims will rise too.

You could see a situation where super inflows turn into net outflows, having a short-term negative impact on the market.

A recession – or at least a sharp economic slowdown – would hurt housing-related and domestically exposed share prices. The potential impact on super flows could magnify these moves.

Bear markets aren’t much fun. There is mostly pain, and the prospects of future gains seem remote. But if you know the difference between price and value, and have a focus on long-term compounding, buying in bear markets (even if you’re underwater for a while) sets you up for strong returns in the years ahead.

I’m excited about the possibility of deep value coming to parts of the Aussie market later this year. But I want to add an important caveat: I don’t know what the future holds.

As I often say, it’s all about probabilities. I think there is a decent probability that Labour’s proposed changes will start to impact housing, retail, and related sectors. Share prices will respond accordingly. So we want to avoid these sectors for now.

Financials versus real assets

On the other hand, resources and related companies should continue to do well. This will lead to an ongoing shift of capital from financials and those companies leveraged to credit creation and housing debt, into commodities and real assets.

Expect this trend to continue throughout 2026, albeit with inevitable ups and downs.

My go-to chart to demonstrate this shift is the one that shows BHP’s [ASX:BHP] share price relative to the Commonwealth Bank [ASX:CBA].

For the past few years, big super fund flows have gone into CBA to play the housing boom. But now, that money will likely flow (or continue to flow) into BHP to play the data centre boom. (BHP is the world’s largest copper producer.)

In the same way the CBA price went to ridiculous levels, BHP’s price could well do the same. It won’t happen in a straight line, but the trend looks clear.

I will continue to focus the portfolio on resources and real assets and away from financial and debt-related assets. That should provide plenty of firepower (both financial and emotional) to pick up bargains should things get ugly in the housing-related sectors (and resources become relatively expensive).

But that’s a story for another day.

Energy will remain a core part of the portfolio too, despite volatility and uncertainty around outcomes in the Middle East. Former Goldman Sachs head of commodities Jeffrey Currie recently posed a great thread on X recently.

He talked about the Magnificent 7 (tech) versus the Munificent 7 (energy).

The Mag 7 plus Oracle will spend roughly $820 billion on capital expenditure in 2026 — approaching Germany's entire annual capital formation, and larger than the UK and France individually.

That capex is the largest physical commodity bid ever assembled inside eight income statements. These are not two separate trades. They are the two sides of the same equation.

The Magnificent 7 is the bid for molecules, electrons, copper, water, gallium, and concrete. The Munificent 7 — ExxonMobil, Chevron, ConocoPhillips, Shell, TotalEnergies, BP, and Equinor — are the offer.

At $105 Brent they generate a 15.5% FCF yield (hence Munificent). The Magnificent 7 generates closer to 1.5%. That's the asymmetry! At $105 oil for 2026: Munificent 7 — 15.5% FCF yield, 7x PE. Magnificent 7 — 1.5% FCF yield, 28x PE. At consensus, the Munificent 7 still yield 12%. The bottleneck is energy and commodities. Theory says capital flows to stocks with improving ROIC.

The price of one cannot move without repricing the other.

This is one way to hedge your portfolio against the earnings bubble forming in the US tech sector and the potential looming recession in Australia.

Investing is all about assessing probabilities

No one knows the future. So it comes down to weighing up risk and reward. That is, it’s all about assessing probabilities.

When the market is good value and the economic environment is benign, you should be all in. When the market is expensive relative to economic conditions (that is, a poor risk/reward environment) you should increase cash levels.

The 32% cash weighting in the portfolio is a large position. I would encourage you to see it not as a comment on near-term market direction, but as a statement on the poor probabilities investors face right now, given that the poor economic outlook is at odds with what the market is pricing in.

Which brings me to bond yields…

The Aussie 10-year yield hit 5.15% recently, the highest level in 15 years. That’s partly because of concern about Iran and energy prices, and partly (or mostly!) because of concern about out-of-control government spending that the budget did nothing to address.

Yields are now back below 5%. Last week’s jump in the unemployment rate and the impact of the budget now has the bond market pricing in an economic slowdown.

So we have a slowing economy and a ‘risk-free rate’ around 4.9%. The ASX200, on a forward PE of around 18-20 times, equates to an earnings yield of 5% - 5.6%.

That’s a very thin margin for equities over bonds. You can justify it in a high-growth environment. But not when productivity is in the toilet and the economy is being increasingly run as a socialist experiment.

Passive investors are in for very poor ‘risk-adjusted’ returns over the next 5 years.

A lot of this poor value is explained by the banks, given their large index weighting. Here are the forward PE multiples the Big Four trade on…

Commonwealth Bank – 24x
Westpac – 16.8x
ANZ – 14x
NAB – 15.8x

Throw in other ‘housing exposed’ large index weights and you can see where the risk lies:

Macquarie Bank – 18.6x
Wesfarmers – 27.2x
REA Group – 31x

If housing is turning down and property speculation is over, the banks are heading towards single-digit PEs. Maybe that happens in 2027, but the message is: stay away.

Quality is important, but the price you pay is more important.

Focus on income

My strategy for the portfolio here is to ensure we have a decent income stream while the risk/reward trade-off remains poor.

Since its inception in December 2024, our portfolio has generated an annualised income return of 5.23% (not including franking credits). With a capital gain of 16.36%, that’s a total annualised return of 21.26% since inception (as at 19 May).

In the next few years, I expect capital gains to be much harder to achieve. That annualised capital gain will come down.

But the income reinvested in the portfolio gives us the opportunity to deploy into higher-return investments when the opportunity arises. This is what helps the compounding process. And it's especially valuable in bear markets.

That’s because, in bear markets, investors put a higher value on dollars paid out in the form of a dividend than on dollars retained for future growth. That’s not to say you shouldn’t invest in growth companies (provided the price is attractive). Rather, you should skew your portfolio towards income.

For a passive investor buying the market, the ASX200 dividend yield is around 3.1%, well below its long-term average of around 4.1%. During the bear market lows of 2022 and 2023, the ASX200 yield reached 4.9% and 4.8%.

If we’re facing recessionary conditions, dividends are unlikely to increase much over the next year or two. That suggests a fall in the index is required to increase the market dividend yield (when prices fall, yields rise).

That should provide us with good opportunities down the track.

No one likes to be negative. When my kids complain about something, I tell them to stop whinging and focus on the positives.

But we have to be realistic and accept some hard truths. This budget has knocked household confidence, which was already poor. It has increased the probability that property prices will fall, and could fall much further than consensus thinking.

That in turn could lead to a recession and higher unemployment.

The upside is that if things play out this way, we will have some exceptional investment opportunities to take advantage of. But as always, you’ll need to be patient and take the long view. We’re investing for decades, not months.

What’s coming won’t be easy. But having that long-term mindset will make all the difference.

*This is an edited version of a note sent to clients on 19 May

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