November Review Comments
Written by Tony Gray   
Friday, 13 November 2009 14:46

Overseas Economic/Market Comment

The budgetary deficit situation of many developed governments, especially in the UK and US, is chronic.  Tax revenue is well below expenditure even before allowing for massive borrowing programmes for stimulus spending.  There is no choice but for governments to increase tax and cut expenditure over time and this is likely to restrain economic growth – and consequently the rate of consumer spending and company profit growth.

Apart from deficits, existing and near term government borrowing levels are dangerously high.  Japan’s position through the 1990’s highlights the danger to an economy of high government debt levels, ongoing budget deficits and the failure of very low interest rates and government spending to stimulate.  Unfortunately it appears much of the industrialised world is now facing Japan’s predicament.

International sharemarkets appear expensive on 2010 forward earnings multiples (at around 19 times MSCI estimates) and the pricing of cyclical stocks is especially high relative to defensive stocks (1.6 times compared to an average of 0.95 times).  It seems most markets are pricing in a strong recovery in profits during 2010 and 2011.  If this profit recovery disappoints or fails to materialise, then a global correction in sharemarkets is possible – although lows are unlikely to be close to March 2009 levels.

Weaker global sharemarkets may well see Australian shares fall significantly as international investors pull money out – most likely to repay ‘carry trades’ funded from overseas borrowings at very low interest rates.  This would also be accompanied by a falling Australian dollar.

Despite the above comments, I am optimistic that the Australian economy will benefit from the continued shift to Asia as the growth engine of the world.  Australia’s trade with China and Japan combined is something in the order of 4 times larger than with the United States – and trending higher – although Japanese trade has weakened during 2009.  Our government budget deficit is only cyclical at this point – partly since we have low levels of government debt and consequently do not suffer a large interest cost burden.

The ‘mini’ correction from late October to the first week of November saw an 8% fall from the peak to the low for the Australian sharemarket and more than half of the losses recovered in just three trading days.  It is unclear at this point if a larger correction will occur prior to Christmas or not?  Based only on the Australian economy and company valuations, I am inclined to feel that the local market is ‘fair value’ and that returns from this point will be reasonable.

Cash & Fixed Interest

In light of the rise in interest rates and available term deposit rates, I generally recommend locking some funds away for a 1 and/or 2 year time frame if fixed interest forms part of your investment mix.  The best guaranteed rates we can find at the moment are 6.00% for a 12 month deposit and 6.30% for a 24 month deposit (for amounts <$50,000).  Whilst cash rates are expected to rise through 2010, they are unlikely (in my opinion) to rise to a point where actual cash interest income averages more than the 12 month or 24 month term interest rates.

Listed Property

Our position on listed trusts is unchanged, with further scope to add holdings at moderate discounts to asset backing and generally low levels of gearing.  Declines in property values in Australia appear to be easing.
Whilst distribution yields of 5% to 7% p.a. (partly tax deferred) are unexciting for many of the larger trusts, this is based on a payout ratio of around 70% of net rental income.  Once trusts have stopped applying surplus cash-flow to debt reduction, pay-out ratios are likely to return to 100% (as is normal for a trust).  Hence the income range is likely to be 7% to 10% p.a. within a couple of years – before allowing for inflation linked rises in rents.

I remain positive on Dexus Property Group (DXS) for office and industrial property, GPT Group (GPT) for Australian shopping centre exposure with some office, industrial and hotel exposure.  Westfield Group need to trade in the lower $11 range to justify a purchase at this time.  Other trusts to consider include Macquarie Countrywide (MCW), ING Office Fund (IOF) and Commonwealth Property Office Fund (CPA).

International Shares

The rising Australian dollar continues to take the urgency out of making additional international investment – plus the fact that overseas markets appear expensive (Asia, US and Europe).  Since the Australian dollar now appears highly correlated with overseas sharemarkets, the risks from market falls is reduced for existing investments.  Unhedged (currency) exposure is recommended presently.

Australian Shares

The mini correction and updates from annual general meetings has revealed a range of stocks that represent decent value at current prices.  Since most portfolios have a relatively high weighting to Australian shares following earlier investment and the market rise, we are more inclined to lighten or exit certain holdings to make way for new stock and perhaps rebuild cash reserves.

The major banks reported generally healthy results and have been confident enough to claim the peak of the bad debt cycle has passed – although banks are already priced for growth.  I see MyState Limited as offering value in the financial sector (non-core), with the ability to cut costs and obtain merger synergies with Tasmanian Perpetual Trustees likely to generate profit growth over the next 2 to 3 years.  The company has a market capitalisation of $180 million and is not yet represented in any indices – although this is likely to change and bring the company to the attention of fund managers.

Other stocks of interest include QBE Insurance (QBE), Caltex (CTX), IMF Limited (IMF) and WDS Limited (WDS).  The latter two companies may not be known to investors, providing litigation funding and coal seam gas drilling and pipeline services respectively.

Gold

A sector that is returning as an asset class in its own right is gold.  The structural deficits of the US and large parts of Europe and high levels of government debt and trade deficits indicate that long-term these currencies will decline.  This and growing unease with the US financial position and status as global reserve currency mean that gold is attracting new investment.  Mine supply is unable to cope with increased demand and this situation could see a very significant rise in the gold price from already record levels.  India’s purchase of 200 tonnes of gold from the International Monetary Fund has highlighted the shift in sentiment at all investor levels.

Returns from physical gold have in fact not been particularly strong for Australian investors in the last couple of years, with the rising Australian dollar offsetting $US gold price rises.  The greatest leverage is through ownership of gold miners.  Unfortunately most large gold stocks are already priced at high levels relative to earnings – which may be justified if price rises occur, but entails higher risk.  As such, a smaller allocation to junior gold companies either in production or coming into production may be contemplated.  This will not suit conservative investors or some investment strategies.

Summary

We are concerned about the broader economic picture internationally but while individual investment opportunities remain, we are not uncomfortable with continued investment across the asset classes.  Despite assessing the Australian sharemarket as ‘fair value’ – which normally generates healthy total returns our focus is shifting to reducing the impact of a correction at the possible expense of not fully participating in further short-term rises.

Please treat the above comments as General Advice, with no action to occur until we have considered with reference to your financial position, needs and goals.

 

Portfolio Management


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