March Newsletter 2010

One year on and the recovery is intact

The end of February caps around 12 months of the recovery in financial markets.  Our sharemarket reached its low point on March 6 last year and since then the recovery has been as good as we could have hoped for.

The problems in January surrounding Greece have diminished slightly but concerns still do exist.  The positive is that the Greek Government and the European Union are working on a solution.

China and the US are trading verbal blows over the value of the Chinese currency and management of their economies.  Each is looking to improve their own position.  If China is to allow its currency to appreciate, then the price of its exports will increase.  Obviously this is not appealing to them.

The current concerns

Economic news continues to be prominent in the media.  Keep in mind that a comment like ‘things are going well' is not going to make headlines.  To feature, the story needs to be a little out of the ordinary.  To use an analogy, no-one in the media will report how many planes landed safely.  However a near miss or an accident is out of the ordinary and will be reported.

In relation to financial news, talk of a ‘double dip recession' is seen as newsworthy.  Experts love to be the one to predict these events.  A double dip simply means that those economies that suffered a recession will again suffer one soon after the original recession.  In the case of Australia, we technically didn't have a recession, but a double dip would still see conditions deteriorate.

This is unlikely here as our economic conditions are good and improving.  This is why the Reserve Bank has and will continue to raise interest rates.  It would take an external shock - problems overseas for our economy to suffer.

Let's look at some of the possible challenges.

Sovereign debt

Greece remains the main issue.  The reality is that Greece represents only 3% of the European Union economy and even in the worst case, on its own it is not be a big problem.  The real concern is the flow on effect and the question of who is next.

It appears that the problems facing Greece are in the process of a serious attempt at being resolved.  However we are not there yet and this is a problem that will not go away with Greece or other bigger countries.

The problem with Sovereign debt is that unless it can be reigned in, it will serve as a significant drag on economic growth.  The general view is that if the debt is too high then it will grow at a rate that is faster than it can be repaid.  The chart below shows the current and projected position of major overseas countries.

Source: Morgan Stanley, 2008 Data

This is one reason why the US is keen to keep their interest rates low.  If rates rise, the cost of the borrowing rises.  It will be a very difficult balancing act to keep rates low without letting inflation get out of control.  As we know, the main lever to control inflation is to increase interest rates.

If economies aren't growing strongly, it is unlikely that companies will be growing at an exciting rate, so share prices will struggle to add much value.  However this scenario does not mean we should not invest in those countries at all.  Japan has endured a similar fate to that described above for over a decade, yet one of the key managers that we use, Platinum, has enjoyed much success and part of this has been due to the inclusion of carefully selected Japanese stocks.

Australia's debt is a little higher than we would like but it should reduce next year to an acceptable level.  We are well supported by exporting so much to Asia rather than those countries that are struggling under the weight of debt.  Our company's profits have recovered well and the outlook is far better now.  Overall we are positioned more favourably than many overseas economies.  The only concern is housing prices.

Our house prices are very expensive compared to our income and our household debt is also very high compared to our income.  Despite this, prices continue to rise. Of course this fuels the myth that property prices, particularly houses never go down.  I say myth because it is absolute rubbish.  Overseas countries have suffered massive falls in the price of residential housing even to the extent that people walk away and hand the keys back to the bank.  We have had periods of falls but it is true that they have not been anywhere near the severity of those overseas.

Despite this our prices do continue to rise and we have very strong demand for housing based on our growing population. Logic says that the price growth cannot continue.  Rising interest rates will either dampen demand or restrict household spending or a combination of both.

China applying the brakes

As covered last month, the Chinese Government is attempting to slow the rate of growth of their economy.

This is a good thing as the aim is to avoid the boom/bust cycle and to enjoy a longer period of economic growth, albeit at a lower rate.

Again sensibly, the Chinese are focusing on reducing reliance on exports and more on domestic demand to support their economy.

These measures make sense but do carry risks.  If the rate of economic growth slows too much it will be very unsettling for many as there is significant reliance on China as a key driver of the world economy.  We only have to look locally to see that Australia has placed many of its eggs in the China and Asia baskets.

What can we expect?

The theme remains that of improving conditions, slow growth in many developing overseas nations, emerging markets leading the way and Australia situated very well.  Sharemarket returns will be much harder to come by now that the initial recovery has occurred.  Correct positioning into asset classes and sub classes will be more important.  Stockpicking and timing will be even more difficult in this environment.  Expect bad periods when losses will be suffered, but there will be a recovery from these.

The days of cash being the best place to have money have passed and returns from Bank accounts and many Term Deposits are poor, particularly after tax.  Of course if capital preservation is your only priority then cash is the place for you.

There is still value in growth assets despite the risks.