Market recovery – where to next?

December 9, 2009 – 08:57

It’s different, but it’s not Doomsday has been avoided. Not only is the market recovery well underway, it is actually following a rather ‘normal’ recovery pattern. History shows us that during periods of immense disruption, investment markets tend to rally ahead of economic recovery. The current recovery cycle has proved to be no exception. Figure 1 shows that the turning point for equities occurred relatively early in the economic downturn and sharemarkets in major economies that haven’t convincingly emerged from recession, such as the US, are up by as much as 62 per cent. This early mover trend is part of the reason that a very bad year of investment returns are more often than not followed by a period of very good returns. Figure 2 shows that while the downturn of 2008 was more pronounced than any other, the market correction of 2009 is following a typical recovery pattern that has occurred over the past century.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Risk on, risk off
A more unusual aspect of our current recovery is its ‘risk on, risk off’ nature. During the height of the Global Financial Crisis (GFC) almost all markets fell simultaneously as investors sought to exit any form of risk.

Yet the first phase of the rally – from March to September – was driven by riskier stocks. Depressed markets meant that valuations were very cheap, which boosted returns to the most volatile stocks in every region of the world as shown by figure 3 below.

  We are now transitioning to a new phase of the recovery, which is likely to involve a shift from ‘macro to micro’, where it will become increasingly hard for a company’s share price to rise simply because the market is rising. During this next stage of recovery, after-shocks such as the Dubai World debt concerns will continue to ripple through the global financial system, but most will not represent a new systemic risk.

Earnings now need to do the heavy lifting Generally speaking, sharemarkets are trading at reasonable valuations – they are no longer cheap relative to the current expected level of earnings growth.

This means that for sharemarkets to rise further, company earnings need to increase more than currently expected. The good news is that earning revisions are starting to turn positive, which is a typical occurrence during this stage of the recovery cycle.

What does this mean for investors?
The first stage of the market recovery saw global sharemarkets rise spectacularly, almost without a pause. This is typical of the first stage of a market rally, but not the next.

During this next phase, research will become increasingly important. Winners will include companies that deliver solid earningsimprovements, while stocks that disappoint on this front will be punished. This next stage will encompass difficulties, but offers strong return potential. Emergency measures will continue to be wound back – the Reserve Bank of Australia’s (RBA) recent rate rise is another example of this occurring – as global economic markets are turning around. Over the longer term sharemarkets tend to track economic growth and company earnings
and both of these factors are on the upswing.

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What does the rising $A mean for investment markets?

December 9, 2009 – 08:39

A bumpy ride
The $A has been through a bumpy ride over the past 18 months. After reaching a high of US97.48c in June last year, the $A fell to as low as US61.01c in November 2008, before turning and soaring to a high of US93.38c in
November this year – that’s a 53 per cent increase within 12 months. This fall and subsequent rise has been the
sharpest reversal in the $A since it was floated in 1983, as shown by figure 1 below, and has raised the possibility that the $A may reach parity with the $US in the near future.

 Figure 1
The $A is rising strongly relative to all major currencies, not just the $US. According to the Reserve Bank of Australia’s (RBA) Trade Weighted Index, which measures the $A against the average of our trading partners, the
$A increased by 40 per cent over the same period.

The rise was 40 per cent against the Pound Sterling, 46 per cent against the Japanese Yen, and even 26 per cent against the relatively strong Euro.

What’s driving the $A?
The short-term influences on $A currency movements can vary rapidly, but are typically a mixture of four key factors: interest rate differentials with other economies; economic and employment growth; inflation, and the
strength of commodity prices.

At present, all of these drivers are aligned for the Australian economy, creating considerable positive momentum for the $A. In particular, stronger than expected economic recovery and early signs of inflationary pressures point to further increases in Australian interest rates, well before other economies begin their rate rises.

The rise in commodity prices is largely being fuelled by strong growth in China, which shows no signs of abating in the near term.

How much higher is the $A likely to go?
Parity with the $US cannot be ruled out, but no trend lasts forever, especially when markets still need to revert to a more stable, equilibrium state.

A clear example that markets have not yet reverted to an equilibrium level is the historically low interest rates of the major overseas economies. An official rate of close to zero in the US is abnormal and cannot be
sustained over the longer term. When growth re-emerges in the US and rates begin to increase, the $A may come under some downward pressure.

What is fair value?
Determining the ‘correct’ value of a company share is difficult enough, but a currency has no absolute value. It represents an exchange rate relative to other currencies. Over long periods of time, the comparative buying power of currencies, measured by Purchase Power Parity (PPP), is a guide to fair value. The slightly tongue in cheek version – the Economist magazine’s Big Mac Index – looks at the relative price of a Big Mac in 120 different currencies. Recent calculations indicate an implied PPP Big Mac rate slightly above parity against the $US.

Obviously this is a very narrow measure as fast food prices don’t reflect all of the variables of the broader economy. Other more conventional models of PPP indicate that the $A has less room to move. What this means for investors The RBA recently indicated that the rise in the $A is in line with economic fundamentals, and is showing no interest in intervening. In  contrast, the central banks of other resource based economies such as Canada and New Zealand have flagged their rising currency as a potential concern and may take actions to limit
further gains.

The $A ranks in the top 10 most actively traded currencies in the world. It generally trades freely, without intervention and is therefore able to act as a stabiliser as relative demand changes. This means that large swings in the value of the $A can be expected to be an ongoing feature. Generally speaking, a rising $A benefits
importers and disadvantages exporters, but it is too simplistic to extend this logic to company earnings.
Many Australian companies have developed sophisticated approaches to managing currency risks and some have natural offsets in their cost and revenue structures. Returns to Australian investors in overseas asset portfolios are clearly impacted by currency changes.

An increasing $A reduces the value of unhedged offshore investments, which has been the case for many portfolios since March this year. On the flip side, the falling $A helped cushion some of the losses during the Global Financial Crisis (GFC). From October 2007 through to March 2009, the fall in the global sharemarket was not nearly as severe in $A terms compared to local currency.

Over the longer term, exposure to international sharemarkets and different currencies provides diversification benefits and this can help smooth out the ride.

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Does diversification still work?

August 18, 2009 – 08:51
Diversification: A portfolio strategy designed to
reduce exposure to risk by combining a variety of
investments, which are unlikely to all move in the
same way.

Diversification: A portfolio strategy designed to reduce exposure to risk by combining a variety of investments, which are unlikely to all move in the same way.

Diversifying drivers of return

Diversification is a risk minimisation strategy. In its simplest form, diversification is commonly understood as ‘not putting all your eggs in one basket’. The idea being that you can minimise potential losses by spreading risk across different asset classes, sectors and countries.

If risk is defined as not getting the return you are expecting, at a strategy level, diversification is about diversifying the drivers of potential return as well as specific risk factors such as company, industry, market, economy or country.

This is where correlations become important. High correlations are okay in positive markets, but when an asset class return is poor, correlations ideally need to be low, so that other asset classes can smooth out returns.

Equities versus fixed interest

The most basic portfolio diversification strategy is to diversify between equities and fixed interest. Equities offer greater potential returns than fixed interest, but this ‘reward’ carries more risk.

The theory behind this portfolio construction is based on the premise that returns on equities and fixed interest investments often have low or even negative correlation.

This theory largely stacks up. For example, Figure 1 reveals that the correlation of returns between Australian equities and Australian government bonds over the past 18 years has generally moved in a moderate range, providing a good degree of diversification.

An often surprising observation is that these correlations are far from stable. Since 1990, the rolling 12 month correlation of returns for Australian equities versus Australian government bonds has ranged from -0.8 to +0.9. As long as the outcome is less than +1.0, there is value in diversifying, but this data shows that the value of this diversification varies significantly over time.

When markets are stressed

Stressed market conditions are usually due to a specific risk factor becoming dominant. The experience of 2008 has shown that an over-riding factor – a global credit crisis – can cause many asset class returns to move in the same direction and reduce the benefits of diversification.

During this period, access to credit was almost completely cut off, placing the global financial system under significant stress. The dominant factor was risk aversion. Traditional diversification was of little help, since it largely involves diversifying among risks. In this case, the only way out was to exit risk.

Looking back to other times when markets were stressed, a similar pattern emerges. For example, Figure 1 shows that the correlation between Australian equities and Australian government bonds was unusually high during the 1994 bond market crash and again in1998 following the Asian Financial Crisis, Russia’s debt default and the Long Term Capital Management crisis.

In 2004 correlations again rose, but this time the market rally meant both equities and bonds rose in value. Here, the dominant factor was the unwinding of stress related to the tech wreck.

So does diversification work?

Diversification has been described as the only free lunch in the market because of the potential to reduce risk without reducing investment returns.

The rationale behind this saying is that poorly diversified portfolios are not efficient – they contain diversifiable risks for which investors are not compensated.

In other words, if diversification isn’t a free lunch, not diversifying can make the lunch very expensive.

At the individual securities level, diversification certainly helps reduce the impact of poor outcomes. This market cycle has, again, thrown up many examples of unfortunate investors who lost everything by investing all of their assets in a failed enterprise.

In contrast, a well diversified portfolio of assets means that even the complete failure of some assets will not mean catastrophic permanent loss.

The lessons of 2008 are not new. Diversification is less effective during periods of market stress or distortion. But overall, even taking these periods into account, the split between fixed interest and equities is a meaningful diversifier, and over time can help smooth returns.

For example, in 2008 Government bonds rose in value as sharemarkets fell. Conversely, non-government bonds fell in value as they became more positively correlated with corporate stress.

What does this mean for investors?

The events of 2008 caused markets to distort in all sorts of ways. As investment markets adjust and continue to evolve, diversifying the drivers of returns, not just asset classes, will become increasingly important.

Well-diversified portfolios will need to continue to seek new dimensions of diversification, which draw on factors such as the potentially uneven re-emergence of economic growth and allow for the inclusion of alternative asset classes.

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Investing in a world of government debt

August 18, 2009 – 08:28

Governments around the world are driving recovery with aggressive economic policies, creating both opportunities and threats for investment markets. For this Point of View, AXA’s National Development Manager – Investments Carmel McKenzie put some of the key questions raised by advisers to AXA’s Chief Investment Officer Mark Dutton.

Carmel: In your view, are the looming government debt levels problematic?

Mark: Policy makers around the world have intervened harder and faster than at any other time in history to stabilise the financial system and attack the forces of global recession.

As a result, global government actions will lead to a substantial increase in the level of public debt. For example, Australia’s net public debt is set to increase from a modest 4 per cent of Gross Domestic Product (GDP) to almost 14 per cent of GDP by 2014. However, this pales into insignificance when looking at the world’s largest economies. Net public debt is set to reach 80 per cent of GDP in the US and UK, while Japan is already there, with its net debt likely to exceed 130 per cent of GDP in five years time.

Yes, this level of borrowing is a problem. Government debt levels for some countries,  including the US, UK and Japan are unprecedented, and most governments have not outlined credible exit strategies.  And this is what’s worrying credit agencies and the market.

Carmel: What does this mean for the outlook?

Mark: Credit agencies have already begun to issue warnings about the sustainability of public debt levels. These warnings hit home in May, when Standard and Poor’s (S&P) issued a negative outlook for the UK’s prized AAA credit rating.

While there is no doubt that radical strategies were required to address the Global Financial Crisis, the price to pay will be an increased drag on economic performance of major debtor nations. In the long run, the risk of higher inflation will also re-emerge.

Despite the magnitude of the funding requirements, the US AAA rating is not under immediate threat, and will remain the global benchmark for the foreseeable future.

Carmel: What is the likely impact on investment markets? And what are the opportunities?

Mark: Clearly, we will see a major increase in the volume of government bonds on issue. OECD countries are set to issue about $US2.5 trillion of government bonds by the end of 2010 – the equivalent of 4 per cent of global GDP.

This issuance will change the structure of fixed income markets. As issuers compete for capital, we can expect to see markets differentiate further between issuers, creating new opportunities to improve yields and add value through active management of bond portfolios.

The key is to not chase higher yields without understanding the associated risks. For bonds, the risks are more volatility as the market wrestles with a surge in supply, credit rating dangers, and the reemergence of inflation.

Carmel: What other risks do investors need to be aware of?

Mark: Investors need to be aware that large increases in government issuance will change the composition and duration of bond market indices, and that this has significant implications for investment strategies.

For example, figure 1 reveals that by 2011 government bonds are set to comprise almost two thirds of the UBS Australian Bond Index and the corporate bond sector will shrink to about one third of this index.

This index is commonly used as a proxy for fixed interest investment strategies in Australia, meaning that issuers are effectively deciding the investment strategy. The duration of the index will increase right at the time when investors should be concerned about increasing duration.

Carmel: What about sharemarkets?

Mark: Increased bond issuance should not be an immediate concern for sharemarkets, as this is the flip side of economic stimulus policies. Some good news for equity investors is that they are now effectively being ‘paid’ to be patient, as dividend yields (based on last reported dividends) are higher than interest rate yields, as shown by figure 2.

Cash rates have fallen a long way over the past year. Sharemarkets are better placed to generate real income growth over the longer term. For example, even if takes five years for the Australian sharemarket to return to its previous high, this equates to an average annual return of 11 per cent (plus dividends). This is far higher than the current return from cash.

Global diversification will become increasingly important as countries and regions will emerge from recession at different times, with varying levels of debt to manage. As growth re-emerges, the beneficiaries will be unevenly spread and this will generate greater opportunities for ‘active’ managers than in recent years.

Mark: Policy makers around the world have intervened harder and faster than at any other time in history to stabilise the financial system and
attack the forces of global recession.
As a result, global government actions will lead to a
substantial increase in the level of public debt. For
example, Australia’s net public debt is set to
increase from a modest 4 per cent of Gross
Domestic Product (GDP) to almost 14 per cent of
GDP by 2014. However, this pales into
insignificance when looking at the world’s largest
economies. Net public debt is set to reach 80 per
cent of GDP in the US and UK, while Japan is
already there, with its net debt likely to exceed 130
per cent of GDP in five years time.
Yes, this level of borrowing is a problem.
Government debt levels for some countries,
including the US, UK and Japan are
unprecedented, and most governments have not
outlined credible exit strategies. And this is what’s
worrying credit agencies and the market
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De-leveraging has set in

August 18, 2009 – 07:57
What this means for the economy and financial
markets
This is no ordinary downturn and recovery is
unlikely to be quick. Too much debt is at the heart
of the problem and the process of de-leveraging
(shifting from too much borrowing, to debt
reduction) will largely determine the depth and
duration of the global recession.
In Australia, our debt has risen from 78 per cent of
Gross Domestic Product (GDP) during the early
1990s to 165 per cent by 2008. In line with this
trend, Australian household debt relative to income
has risen strongly, as shown in display 1 below.
Display 1 – Household debt as a percentage of
household income
0
20
40
60
80
100
120
140
160
180
77 80 83 86 89 92 95 98 01 04 07
(%)
Total Housing
Source: Reserve Bank of Australia. Data from March 1977 to
December 2008
The de-leveraging process is causing significant
structural change in the economy. It’s unlikely that
we will see a normal cyclical downturn followed by
a smooth upswing.
Banks need to rebuild balance sheets after a binge
of excessive leveraging. And this is no small feat,
given that during the boom period, bank leverage is
estimated to have exceeded 30 times, compared to
the 10 times leverage that economic research
suggests is optimal. This will limit the flow of
available credit in the economy.
Companies are also likely to take further action to
rebuild balance sheets, including asset sales,
capital raisings and lowering dividends.
Widespread cost-cutting on this front will inevitably
lead to further job losses and slower economic
growth.
But it is not all doom and gloom. Australia’s fiscal
position at the onset of the global financial crisis
was relatively strong, thanks to a long period of
government surpluses and the federal government
debt reduction program. In contrast, the US
entered the global financial crisis with a high level
of government debt. This gives Australian policy
makers somewhat more capacity to further
stimulate the economy, without the debt to GDP
ratio moving to the extreme highs of the US.
To date the Australian government has announced
two stimulus packages totalling $52 billion,
including cash payments, tax breaks and spending
on infrastructure. The Reserve Bank of Australia
(RBA) has decreased interest rates by 4 per cent
since September last year, bringing the official
cash rate to a low of 3 per cent

What this means for the economy and financial markets

This is no ordinary downturn and recovery is unlikely to be quick. Too much debt is at the heart of the problem and the process of de-leveraging (shifting from too much borrowing, to debt reduction) will largely determine the depth and duration of the global recession.

In Australia, our debt has risen from 78 per cent of  Gross Domestic Product (GDP) during the early 1990s to 165 per cent by 2008.  In line with this trend, Australian household debt relative to income has risen strongly, as shown in display 1 below.

Household debt as a percentage of household income

The de-leveraging process is causing significant structural change in the economy. It’s unlikely that we will see a normal cyclical downturn followed by a smooth upswing.

Banks need to rebuild balance sheets after a binge of excessive leveraging. And this is no small feat, given that during the boom period, bank leverage is estimated to have exceeded 30 times, compared to the 10 times leverage that economic research suggests is optimal. This will limit the flow of available credit in the economy.

Companies are also likely to take further action to rebuild balance sheets, including asset sales, capital raisings and lowering dividends. Widespread cost-cutting on this front will inevitably lead to further job losses and slower economic growth.

But it is not all doom and gloom. Australia’s fiscal position at the onset of the global financial crisis was relatively strong, thanks to a long period of government surpluses and the federal government debt reduction program. In contrast, the US entered the global financial crisis with a high level of government debt. This gives Australian policy makers somewhat more capacity to further stimulate the economy, without the debt to GDP ratio moving to the extreme highs of the US.

To date the Australian government has announced two stimulus packages totalling $52 billion, including cash payments, tax breaks and spending on infrastructure. The Reserve Bank of Australia (RBA) has decreased interest rates by 4 per cent since September last year, bringing the official cash rate to a low of 3 per cent.

There is a danger that this positive impact may be offset by the dramatic increase in ‘precautionary savings’ that has been driven by falling levels of wealth and increased anxiety about the economic outlook coupled with rising unemployment. The RBA estimates that household net worth has fallen by 14 per cent since last year.

However, there are signs that Australian household de-leveraging may already be at a relatively advanced stage. The household savings rate has been increasing since 2002 and is currently at 8.5 per cent as shown in display 2 – a level not seen for 20 years.

display2

In line with this trend, the use of credit to finance consumption has also declined markedly, having already retreated back to early 1990 levels, as shown in display 3.

One of the keys to recovery is generating a rise in average income, and it is here that Australian monetary policy may prove to be particularly effective. In contrast to the other nations, a large portion of official interest rate cuts has been passed on to households, and variable interest rates are now almost at an historic low.

Given that the vast majority of Australian household debt comprises owner occupier housing (totalling 59 per cent of total debt in September 2008) these cuts translate to a significant amount of cash flow relief. For example, the RBA estimates that the 3.75 per cent reduction in official interest rates from September 2008 to March 2009 has reduced debt servicing levels by approximately 5 per cent of household disposable income.1

What this means for investors

Financial markets should begin to stabilise once the de-leveraging process nears an end. In households at least, there is increasing evidence that the major part of the adjustment process may have already taken place.

As further adjustments take place, sharemarket volatility should begin to stabilise. More and more investors will look towards equity markets to grow long-term wealth as cash savings alone won’t allow households to meet their retirement needs.

The decision to hold cash over long-term growth assets is already becoming expensive. At 6.2 per cent, the dividend yield for the Australian sharemarket is now higher than the average 4 per cent return investors can receive from cash. If we allow for franking credits, this return is even higher.

While valuing the sharemarket is incredibly difficult in this environment, some indicators are emerging that earnings are holding up better than expected. For example, of the 25 per cent of companies in the US S&P 500 index that have reported earnings so far, 63.8 per cent have positive earnings surprises, and 6.9 per cent have zero per cent earnings surprises.

Over the next few months, market observers will continue to closely monitor the commitment of policy makers to support ongoing stimulus. Sharemarkets are likely to react positively to ongoing signs of that commitment.

Importantly the markets typically act as a leading indictor, bottoming out well before the underlying economy has recovered.

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Opportunities and threats in distortions

August 17, 2009 – 11:33

“Stability is unstable”
Hyman Minsky, US Economist

This insight captures the warning that when unusually calm conditions continue for a long time, distortions are likely to arise, which must ultimately correct.

Between 2003 and 2007, stable and positive conditions set up the distortions which triggered many of the challenges we now face. These included over-optimism, increased speculation and excessive borrowing.

An unspoken corollary to this insight is that instability is also unstable. Right now, powerful forces are at play to bring distorted markets back to a more stable equilibrium. In simple terms, things can’t stay out of whack for too long.

The highest risks are often present when investors become complacent, while the best opportunities frequently occur when investors are most risk averse. We now appear to face such opportunities.

Who moved my model?

Sitting behind our long run view of the world is a set of expectations about risk and return. We often model these expectations using a standard Normal Distribution of probabilities. This model assigns very low probabilities to returns which are a long way from the average.

According to some commentators referencing this model, we have just experienced 4 or even 6 standard deviation events – an occurrence that statistically speaking should only take place once every two and a half million years!

In practice, it is unlikely that we have experienced such a rare event. A more plausible explanation is that the model has changed, and our long-term expectations for risk and return have become distorted. The good news is this means the expected returns from forward looking ‘models’ are likely to be skewed, with a higher probability of positive outcomes.

This tendency to return to more sustainable equilibrium levels is the basis for a ‘mean reversion’ theory. Like a giant stretched rubber band, recent distortions have created powerful forces that should ultimately cause markets to pull back to more stable states.

Sharemarket volatility above sustainable levels

The extreme events of 2008 caused markets to distort in all sorts of ways. When some markets, particularly credit markets, almost completely ceased to function during the later part of 2008, sharemarkets around the world experienced historic levels of volatility.

The VIX volatility index – a key indicator of market expectations of near term volatility conveyed by the S&P 500 stock index option prices – is high when it reaches around 30. Values below 20 generally correspond to more ‘normal’ times in the market. As shown in figure 1, in November last year the VIX volatility index rose to 81, its highest level on record.

Figure 1 - Volatility Index

Investors can derive some comfort from the observation that volatility is also subject to mean reversion. As volatility reverts back to more normal levels, there is scope for prices to rise on risk based assets, such as shares. The good news is that volatility has already fallen from recent highs.
The Australian sharemarket is currently priced lower than its equilibrium growth trend, as shown in figure 2. Reversion to its long-term growth trend provides considerable upside potential. In fact, a full correction would imply a rise of more than 60 per cent on the All Ordinaries Price Index, with dividends adding to further upside returns.

Figure 2 - The Australian sharemarket

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Inflation and deflation tug of war – what this means for investors

June 19, 2009 – 09:25

Deflationary forces at work
The credit crisis has caused the global economy to change so rapidly that concerns have now risen about the risk of  wide-spread deflation – a situation typically defined as a persistent decline  general price levels. While it might be tempting to think that falling prices could be good for consumers, deflation on a large scale would be a horrendous outcome.

When deflation grips early in a recovery cycle, it can reduce the effectiveness of policy measures to kick start the economy. This is particularly the case for monetary policy because it becomes impossible to drive real interest rates below zero. Sustained deflation creates a destructive cycle for which there is no automatic correction process. It causes the cost of debt servicing to increase in real terms, reduces pricing power for companies and drives asset values lower. This process can bankrupt businesses or even countries.

Credit squeezes create deflationary conditions. Credit is the engine of the economy and when it seizes, economic growth, commodity and asset prices plummet. Deflationary forces are unleashed by the subsequent collapse in global demand, de-leveraging (unwinding of unsustainable debt), rising unemployment and pressure to reduce unwanted inventories. The G7 nations – US, Canada, UK, France, Italy, Germany and Japan – are showing signs of deflation. Inflation across the G7 countries has decreased from 1.2 per cent in 2008 to negative 0.2 per cent in 2009. While the US, Canada, Germany and Japan account for most of this decline, inflation levels for the other G7 countries are well below minimum target levels, which most central banks see as inflation rates of 1 to 3 per cent.Untitled-32

Inflationary pressures likely to rise over the longer term

Governments and Central Banks across the globe have implemented multiple policy measures to revive credit markets, stimulate an economic recovery and reduce the threat of deflation. These measures include significant reductions in interest rates, injections of large amounts of liquidity into the system through quantitative easing, in conjunction with fiscal stimulus packages amounting to 1.7 per cent of global Gross Domestic Product (GDP).

The sheer magnitude of these initiatives means that sustained deflation is likely to be avoided in the G7 countries, with the exception of Japan.1 But in the bid to reflate the economy, there is some danger that stimulus measures will overshoot, and cause inflation to rise when credit markets return to ‘normal’.

What this means for investors Deflation is bad news for equity investments. In this environment it becomes difficult for profits to be sustained because companies loose pricing power, demand falls, and debt levels increase in real terms. While most sectors would be adversely affected by deflation, companies with low levels of debt that are likely to benefit from policy measures to reflate the economy would become more in favour. An outlook of sustained deflation would mean that assets with fixed nominal yields, such as bonds, or other fixed rate assets appear more attractive than shares. Over the past six months, concerns about deflation, coupled with risk aversion, has driven investors into the Government bond market, forcing prices higher and therefore yields lower. However, as we have previously argued, government bonds are not as safe as they appear. The current 3.3 per cent yield on 10 year US government bonds is unusually low and unlikely to be sustained in the long term.

Large issuance of government bonds to fund stimulus measures in major global economies are adding to the pressure for yields to rise. When yields reach a more ‘normal’ level of around 6 per cent, the loss to investors could be more than 15 per cent. Policy makers have started to recognise that stimulus  easures have swung the future risk from deflation to higher inflation. Consequently, we are already seeing an increase in the demand for inflation-linked bonds. For example, Chinese authorities have recently asked the US government to increase issuance of inflation indexed US treasury bonds, of which China  held 24 per cent of current issuance. This suggests that Chinese authorities expect long-term inflation to trend up and believe pricing for treasuries is not sustainable.

The global credit crisis has shown us that our economic environment can change remarkably quickly. The unprecedented magnitude of current global stimulus is likely to prevent an entrenched deflationary environment. But there is the danger that these measures could overshoot and inflation could emerge more quickly than anticipated. These trends highlight the importance for investors to maintain exposure in growth assets, such as equities, to generate a real return above inflation over the longer-term.

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Deleveraging underway

June 18, 2009 – 15:15

What this means for the economy and financial markets

This is no ordinary downturn and recovery is unlikely to be quick. Too much debt is at the heart of the problem and the process of de-leveraging (shifting from too much borrowing, to debt reduction) will largely determine the depth and duration of the global recession.

In Australia, our debt has risen from 78 per cent of Gross Domestic Product (GDP) during the early 1990s to 165 per cent by 2008. In line with this trend, Australian household debt relative to income has risen strongly, as shown in display 1 below.

Display 1 – Household debt as a percentage of household incomeHousehold debt as a percentage of household income

The de-leveraging process is causing significant structural change in the economy. It’s unlikely that we will see a normal cyclical downturn followed by a smooth upswing. Banks need to rebuild balance sheets after a binge of excessive leveraging. And this is no small feat, given that during the boom period, bank leverage is estimated to have exceeded 30 times, compared to the 10 times leverage that economic research suggests is optimal. This will limit the flow of available credit in the economy. Companies are also likely to take further action to rebuild balance sheets, including asset sales, capital raisings and lowering dividends. Widespread cost-cutting on this front will inevitably lead to further job losses and slower economic growth.

But it is not all doom and gloom. Australia’s fiscal position at the onset of the global financial crisis was relatively strong, thanks to a long period of government surpluses and the federal government debt reduction program. In contrast, the US entered the global financial crisis with a high level of government debt. This gives Australian policy makers somewhat more capacity to further stimulate the economy, without the debt to GDP ratio moving to the extreme highs of the US. To date the Australian government has announced two stimulus packages totalling $52 billion, including cash payments, tax breaks and spending on infrastructure. The Reserve Bank of Australia (RBA) has decreased interest rates by 4 per cent since September last year, bringing the official cash rate to a low of 3 per cent.

Display 2 – Household savings rate has sky rocketed

Household savings rate has sky rocketed

Display 3 – Personal credit growth has declined sharply

Personal credit growth has declined sharply

One of the keys to recovery is generating a rise in average income, and it is here that Australian monetary policy may prove to be particularly effective. In contrast to the other nations, a large portion of official interest rate cuts has been passed on to households, and variable interest rates are now almost at an historic low. Given that the vast majority of Australian household debt comprises owner occupier housing (totalling 59 per cent of total debt in September 2008) these cuts translate to a significant amount of cash flow relief. For example, the RBA estimates that the 3.75 per cent reduction in official interest rates from September 2008 to March 2009 has reduced debt servicing levels by approximately 5 per cent of household disposable income.1 What this means for investors Financial markets should begin to stabilise once the de-leveraging process nears an end. In households at least, there is increasing evidence that the major part of the adjustment process may have already taken place. As further adjustments take place, sharemarket volatility should begin to stabilise. More and more investors will look towards equity markets to grow long-term wealth as cash savings alone won’t allow households to meet their retirement needs.

The decision to hold cash over long-term growth assets is already becoming expensive. At 6.2 per cent, the dividend yield for the Australian sharemarket is now higher than the average 4 per cent return investors can receive from cash. If we allow for franking credits, this return is even higher. While valuing the sharemarket is incredibly difficult in this environment, some indicators are emerging that earnings are holding up better than expected. For example, of the 25 per cent of companies in the US S&P 500 index that have reported earnings so far, 63.8 per cent have positive earnings surprises, and 6.9 per cent have zero per cent earnings surprises. Over the next few months, market observers will continue to closely monitor the commitment of policy makers to support ongoing stimulus. Sharemarkets are likely to react positively to ongoing signs of that commitment. Importantly the markets typically act as a leading indictor, bottoming out well before the underlying economy has recovered.

By AXA Australia | Posted in Uncategorized | Tagged , , , , , | Leave a Comment

Don’t rely on the crystal ball

January 21, 2009 – 10:47

Rolling out the predictions
The crystal ball is being polished up. After predicting that the Australian sharemarket would reach as high as 7000 in 2008, experts are already tipping that the Australian sharemarket will rise somewhere in the range of 13 per cent to more than 40 per cent in the year ahead.

While it’s true that current valuations provide plenty of room for markets to rally, investors who base strategic decisions on these kinds of predictions increase their risk – the track record on getting this right is very poor.

Lessons from history

2008 was an unusually tough year for investors.The credit crisis and massive deleveraging that took place led to unprecedented levels of market volatility and market returns that were among the worst on record. The global sharemarket finished the year down by 25 per cent in Australian dollars.

The US sharemarket fell by 38 per cent and the Australian sharemarket experienced its worst annual result on record (including the 1987 crash) with the market dropping by 41 per cent.

Over the past 100 years, there have been 10 occasions where the sharemarket has fallen by over 20 per cent and it has taken an average of 22 months for the market to reach new highs. Yet in the midst of each major downturn, it was unclear how long it would last or how it would be resolved. And it looked like a very bad time to invest.

Sharemarket recoveries are typically quick, with the exception of The Great Depression

Sharemarket recovery

Traps in making decisions – using price as a signal to invest

Anxiety about the way in which markets behaved in 2008 is understandable. The volatility was real – almost 4 times the historical average for the US market and 13 times the historical average for the Australian market.

Research shows that in times of increased uncertainty investors tend to place too much emphasis on price as a signal to invest. However, the magnitude of recent sharemarket falls is not a measure of value, but the outcome of the price that the sellers accept in a market that has poor liquidity and limited buying interest.

This was the case in 2008, with hedge funds accelerating the de-leveraging in financial markets and investors pulling money out of mutual funds and favouring cash accounts. In the month of October alone, US mutual funds suffered net outflows of US$126 billion.

The result is some extra ordinary investment opportunities for those who are willing and able to see past the current issues. Equity prices have now fallen to levels which allows for a recession and substantial declines in profit growth. For example, the current price/earnings (P/E) ratio for the Australian sharemarket is around 9 times, while the average P/E ratio for the Australian market over the past 30 years is close to15 times. The markets have effectively factored in an earnings decline of almost 40 per cent.

News reports over coming quarters will sound very negative as companies report their declining earnings and poor outlook. For those who have done the homework, this is not news, and is more than compensated for by the low prices that have now been reached.

The extremes of recent events heighten the risk that investors who wait for the price signal will invest at the wrong time – reinforcing the losing strategy of buying high and selling low. Research undertaken by the US firm DALBAR Inc. which looked at investor behaviour over a 20 year period found that the average US share investor achieved a return of 4.3 per cent per annum even though the funds they invested in returned 11.8 per cent per annum. Mistiming the market created extra risk and meant that these investors did not receive the full potential of their investment.2008 - an extraordinary year

Opportunities in bond markets

Current market dislocations have also created investment opportunities for bonds. Credit markets are yet to begin to operate normally, meaning that prices (or yields) are out of line. The unusually high yields on corporate bonds will provide either an attractive return to maturity or a large capital gain if markets revert to fair value prior to maturity. Conversely, government guaranteed bonds are now so expensive that returns  will be well below long-term investor requirements, and may generate a capital loss as yields rise again in the future.

Cash is a poor investment strategy

In 2008, safety became synonymous with cash. In 2009, the decision to hold cash over long-term growth assets is already becoming increasingly expensive. At 7 per cent, the dividend yield for the Australian sharemarket is now higher than the average 4 per cent return investors can receive from term deposits. If we take franking credits into account, the effective dividend rate is nearly double most prospective cash returns.

Confidence in the future

Trying to time a market recovery is fraught with danger. While we can be confident that markets will recover, we can’t rely on crystal ball predictions to tell us when the current abnormal markets will return to normal. Using sharemarket predictions and price as a signal to invest leads to poor investment decisions that increase risk. A more reliable strategy is to focus on having a quality investment portfolio that is well positioned for potential gains when markets re-assess asset values in the future. When that occurs, strong returns are likely to come from markets that are currently distressed.

By AXA Australia | Posted in Uncategorized | Tagged , , , , | Leave a Comment