October Review Comments
Written by Tony Gray   
Tuesday, 13 October 2009 11:05
The Economic/Interest Rate Cycle

The decision by the Reserve Bank of Australia to increase official cash interest rates from 3.00% to 3.25% has been long anticipated, with most commentators expecting a rise prior to Christmas.

Theoretically, higher interest rates tend to depress the value of ‘growth’ investments – as the current value of future earnings (cashflow) falls and cash and fixed interest returns become relatively more attractive.  However, in reality we tend to see growth linked assets (shares and property) continue to rise as interest rates initially rise.  This is since earnings upgrades on the back of a stronger economy (as evident through the need for higher interest rates to contain inflation) overwhelm the negative valuation impact of higher interest rates.

Whilst it is possible that the Reserve Bank has acted too early, it is more likely in my opinion that we will see further interest rate rises and continued increases in local share and property values.  A neutral setting for monetary policy is widely seen as between 5.0% and 5.5% - suggesting we will see quite a number of rate rises through 2010 – even if the economy is growing only slowly.

It remains a possibility that the continuing trade and money flow imbalances and the possibility of further write-downs of bad debts by US and European banks will see another down-cycle to the global financial crisis (and sharemarkets).  This is becoming more doubtful as savings rates have improved, credit markets are beginning to operate more normally and governments have been unwilling to allow large corporate failures to threaten the financial system (failure is not an option).

The absence of a large increase in unemployment is further evidence of the local economy’s strength and we are likely to see further upward revisions to earnings – including the banks, where bad debt provisions are likely to begin falling during 2010 – assisting profit growth.

Cash & Fixed Interest

Holding cash in preference to bonds is recommended in a rising interest rate environment.  Exposure to floating rate notes and maintaining a rolling maturity strategy for term deposits is recommended.  I recommend against holding bonds, especially with longer duration, as values are likely to fall further as interest rates increase.

International Shares

The Australian dollar continues to rise and rise – with the attraction of a stronger local economy and higher interest rates dragging in international investment.  This has taken the shine off the return from international shares, but with portfolios generally well underweight the sector this represents an opportunity.  As the dollar continues to strengthen it becomes cheaper to buy overseas assets.

Europe, including the UK and the US still have major banking system issues, with losses not being realised.  However, the weakness in their currencies is assisting with the competitiveness of many companies, so these regions should not be ignored.

Asia and especially China have been very strong but are not cheap in terms of current earnings.  Long-term returns from the region are still expected to be attractive.

The outperformance added by the Platinum Asset Management team has become more apparent than ever through the down-turn – more than compensating for the management fees incurred.  We are tending to introduce regional and industry specific Platinum funds to portfolios to diversify away from the highly concentrated Australian sharemarket.

Listed Property

Now that interest rates are rising, I expect that the worst of non-residential property sector falls has ended and there is improved scope for the discount to asset backing to narrow further.  Bargains are no longer apparent, but risks have also declined.  Additional investment in the sector is recommended for portfolios with low allocations (relative to the Investment Strategy).

Australian Shares

We are seeing rotation amongst various sectors, so value is available on a regular basis as we acquire temporarily out of favour blue chip stocks and some non-core stocks.

The market can be characterised as representing ‘fair value’ – which tends to translate to relatively healthy total returns.  Evidence of improved earnings is required to justify higher prices in the short-term.  I still expect at some point the sharp recovery in prices will morph into a sideways trading range.

The rising Australian dollar is likely to see exporters, companies with overseas operations and import competitors struggle in terms of profit growth, although inflows from overseas investors may well push share prices higher.

Last Updated on Wednesday, 28 October 2009 10:42
 

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