Con Michalakis: A looming problem you can't price in

What challenges plague the mind of a CIO? SPACs and cryptos? An equity markets hangover? Or perhaps something more sinister and complex? We sat down with the chief investment officer for Statewide Super, Con Michalakis to find out the biggest challenges facing markets right now. 

Looking beyond COVID-19, markets are going to have to work a lot harder to meet the returns of the past year and Michalakis takes us through what the future economic growth will look like. Some we can hedge against, others are priced in, but there is one concern on the horizon that is keeping him up at night. 

The South Australia-based Michalakis is outstandingly bright, and not only for having studied a combination of mathematical science and financial strategy at the University of Adelaide, the University of London and also the Saïd Business School at the University of Oxford. Since 2008, he's overseen the investment strategy for nearly $11 billion in FUM at Statewide Super, which has won several awards and accolades for its strong financial performance over the years.

Source: Supplied. 

In addition to all this, those who know Michalakis, or have heard him in full-flight talking markets, knows he doesn't shy away from delivering his strong opinions in technicolour. 

Markets turned up to 11

I couldn't resist asking Michalakis for his thoughts on cryptocurrencies, SPACs and the recent popularisation of riskier financial innovations in markets today. 

"The FOMO factor (the fear of missing out) is as bad as I've seen … This is just bad behaviour, the gamification," he said

"I know it's fun to watch rockets, or YOLO to the moon but this speculative excess will not end well ... SPACs and crypto, on a scale of ten, is 11 out of 10 for speculative excess," he said. 

A SPAC, for the uninitiated, is a Special Purpose Acquisition Company, and they are usually used as pre-IPO holding companies during capital raising phases. 

"At Statewide, some of our hedge funds use the SPAC arbitrage to make money. Some of our later-stage venture capital may benefit from SPACs," he concedes. 

In the right place, at the right time, they are a useful financial tool. But he's not alone in his concerns that their usage is blown out of proportion. Fidelity International reported in March that SPACs had raised an average of $1 billion per day so far this year. 

And going forward it will be a lot harder to find value

Michalakis has a "healthy scepticism" in the current market, but that doesn't deter his expectation to find value hidden in a tougher market. "You just have to expect that it's going to be lower - it's not going to be the 40-50% returns".

"Equity markets have had an incredible run. The economic cycle is going to grow strongly for the next, hopefully, 12 to 18 months, but I think equity markets have factored in a lot of that growth," said Michalakis.  

The excess liquidity in markets has meant that we could be in for a "bit of a hangover" going forward, he told us. First of all, there is no question in his mind that higher interest rates and inflation are coming. While this may be tough on equity markets in the short term, he believes it will be better for the economy overall with a long-awaited lift in wage growth and lower unemployment.

"The easy money has been made and going on from here will be a better economy, but maybe a slightly harder market," he said. 

A lesson in less trading, more investing

So how do you set your portfolio for tougher conditions ahead? 

"Being a pension fund (we focus on) being invested, being diversified and at the margin adjusting," he said.  

The key adjustments at the margin are being made for value over growth, credit opportunities and big economies opening up, but Michalakis doesn't believe in overtrading or trying to "leap onto themes or trends". 

"The idea that you can frequently churn your portfolio to suit changing themes and ideas, that's not us," he said, wishing luck to those who want to trade that way. 

His motto is less trading, more investing. For example, knowing the border reopening trade is not far away he doesn't want to trade travel stocks, he wants to buy the whole airport. While his case study is perhaps more indicative of the purchasing power of super funds, the underlying message is one that resonates, whether it's applied to other real assets or credit opportunities: buy the instrument and hold it, he said. 

The #1 issue facing Aussie markets is China

An unexpectedly serious pall cast over the conversation when we turned to discuss the biggest issues facing the market over the next five years. The future of Australia's relationship with China is looking very grim.

"Well, that's probably the biggest thing as an Australian we should be worried about, since Coronavirus," said Michalakis.

Ongoing geopolitical tension between Australia and China has been the backdrop of the past year and hit a fever pitch in the past few weeks. Beyond trade wars - which are harmful enough - are all-out territory wars over Taiwan and the South China Sea. Right now, there really is very little understanding of how big this threat could become because we're at a tipping point. 

Michalakis draws on Graham Allison's "The Thucydides Trap" which was coined to describe US-China relations back in 2017, and still has its place today. The theory posits that when one superpower rises up to displace another, fear makes war inevitable.

"It happens in cyberwar, it happens in trade war, I just hope it doesn't manifest in geographical South China Sea war," he said.

"That's a pretty dark world," said Michalakis.

It is the problem that, in his role as CIO, keeps him up at night. For a man who is used to being able to cut through the noise, talk straight and tackle problems head-on - this one is perplexing and concerning.

"Markets are complacent about it because markets can't price this. How do you hedge for that?" he said.

There's a lot of sinister news about a war in the neighbouring region. Our political leaders are using hyperbole like the "drums of war" and our Minister for Defence Peter Dutton said a war between China and Taiwan is not out of the question. Even today, China announced it would be indefinitely suspending participation in the China-Australia Strategic Economic Dialogue.

Sectors like commodities, materials, energy sit at the forefront of a war-like scenario, but it would be more widespread than any sector-specific problem.

"I think if there was anything in the region, it would be like what happened in other wars. You can see markets falling aggressively and barriers going up. It would be pretty nasty," said Michalakis. 

Michalakis said the ripples are being felt in Adelaide, South Australia. Education is South Australia's primary export, second only to its wine industry. Both are heavily reliant on good relations with China and have soured of late. It's not a comfortable place to be.

"If I look at my home state, there are at least 6000 to 8000 international students that are not here. They pay between $40,000 - $50,000 a year into the universities. They bring their parents. They spend money here, he said.

"You can feel it in the city of Adelaide, you can feel it," he said. 

Conclusion

So, how do you solve an unsolvable problem? Time, perhaps. Collecting hay, while the sun shines? There is any number of platitudes to soothe the anxious investor. But it's the job of the top investor to be aware of the challenges of tomorrow without missing out on the opportunities of today. 

Over the next two to three years, we're looking at strong economic growth - firstly continued growth in capital markets, followed by the return of labour market strength. 

"A booming economy means unemployment goes down, and hopefully wage growth goes up.  It means people who are working can earn a living, pay off their debts, get on with their lives. That's what we want," said Michalakis. 

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