E-news December 2011
Living with Volatility
The past six months have been extremely volatile in investment markets. Some would say they have been reminiscent of the Global Financial Crisis (GFC), particularly in early August this year when markets experienced wild price swings on a day-to-day basis.
The catalysts for this higher volatility have been well documented:
- The long term nature of deleveraging and the price it is extracting from the global economy;
- Fears of another global recession with clear signs of weaker growth in the US and Europe;
- On-going financial instability and insolvency problems in Europe given the heightened risk of a Greek debt default, a dithering European political response, and some European banks requiring emergency ECB overnight funding;
- Expectations that the US Federal Reserve would implement more policy easing in September but with equity investors ultimately being disappointed with the yield curve flattening strategy chosen by the Fed;
- US retail investors choosing to withdraw from markets completely, until the outlook becomes clearer - August was the first month since September 2008 that there was a net outflow from US equity, bond and cash funds. The same pattern is evident in Australia as investors favour term deposits, despite declining yields.
However, we are nowhere near the pre-GFC levels of market volatility of 5%pa and it may be that market volatility at levels around 10%-15% is to be expected for the foreseeable future.
It’s all about Deleveraging
We are moving into an uncertain world which is putting stresses and strains on economies and financial institutions. The developed world is in a period of deleveraging which is likely to impact markets for a considerable period of time. This is because the amount of leverage in the global economy is huge and was accumulated over a long period of time (at least the last 20 years). So unwinding the leverage cannot take place overnight. A recent study by McKinsey indicated that 6-7 years was a reasonable expectation of how long it might take. One only has to look at the experience of Japan after its speculative real estate bubble burst in the early 1990s to see just how long deleveraging can take. In the decade following the bust, Japan experienced seven calendar years of sub-2% growth and the Japanese share market fell by 65%!
While the US real estate bubble was nowhere near as large as Japan’s, unwinding the leverage in the US economy will still take time. The current deleveraging cycle started with the GFC in 2008 when the US government stepped in to bail out ailing financial institutions that had lent far too much money to the US housing market. At that time, government assistance helped US banks and corporates to start deleveraging but, in reality, the problem was simply passed to the US government that purchased much of the debt. In addition, US government spending rose significantly under the Bush Administration and taxes were cut, so the US government is now so indebted that it needs to do its own deleveraging to avoid an unsustainable fiscal position in years to come.
Similarly in Europe, the current bout of uncertainty over sovereign debt levels and the insolvency of the banking system have their roots in the explosion of leverage that took place after the creation of the Euro in early 1999. European authorities (the ECB and national governments in the core) are now being called upon to bail out European banks and insolvent peripheral countries or face the prospect that some may default or be forced to exit the monetary union.
Deleveraging has a price
The other aspect of deleveraging that markets must deal with is the cost – in this case, the contractionary effect it is having on the global economy. Reducing debt to more sustainable levels requires a period of austerity, lower government spending (and the flow-on into the provision and employment in all government services), higher taxes, reduced consumption and increased household saving. All this is clearly evident in Europe and the US at present and are likely to continue for some time.
These themes are not conducive to stability, confidence and strong economic growth.
A prolonged period of slower earnings growth may be looming for the major developed economies. Global earnings forecasts are already being downgraded for FY12 in response to all these developments.
Recent Announcements from the Federal Government
Recently, the Federal Government released its Mid-Year Economic and Fiscal Outlook (MYEFO). Generally, this would not include any significant announcements which may impact your financial planning, however given the impact that Global events appear to be having on the Federal budget and the government’s desire to honour its commitment to return the budget to surplus, this year’s outlook is an exception to the rule.
On the upside:
- The age limit for receipt of superannuation guarantee contributions will be abolished from 1st July 2013. This means that, regardless of age, any employed individual will generally be eligible for the mandated employer contributions into their superannuation fund.
- The 25% reduction in the minimum payment from Account Based Pensions will continue throughout 2012/13.
On the down side:
- Various initiatives announced in previous Federal Budgets have been deferred. For example, the 50% discount on interest income will not commence until the 2013/14 financial year (originally this was to commence from the 2011/12 financial year). In addition the introduction of standard work deductions have also been deferred to 2013/14.
- Indexation of the superannuation contribution caps will not occur until 2014/15 at the earliest.
- The superannuation co-contribution will reduce to a maximum payment of $500 with its availability also being restricted
- The baby bonus will reduce to $5,000 for children born after 1st September 2012 with indexation of the payment being frozen until the 2015/16 financial year.
While some of these announcements are positive, the majority restrict an individual’s ability to contribute to superannuation and access various tax concessions.
If you have any questions relating to your personal circumstances please contact your adviser.
The Power of Compounding
Albert Einstein described compound interest as the “greatest mathematical discovery of all time”. For a person who made several significant discoveries in science, this statement highlights the power of compounding – that is the ability to generate long-term returns on not only the original sum invested, but earnings generated along the way.
In essence, if you put your money in an investment that delivers a return – and then reinvest those earnings as you receive them - the snowball effect can be quite significant over the long term. This is particularly true for retirement savings, where principal is allowed to grow for many years in the concessionally taxed superannuation environment.
Compounding is the ideal ‘Get Rich Slowly’ scheme. All that is needed is an initial sum to invest and the patience to allow the effect of compounding to take hold. The effect of compounding can be enhanced by making additional investments along the way.
For example, let’s assume you have $100,000 in your bank account and decide to put it into an investment with a net 5% annual return. Over the space of the first year, you earn $5,000 on your investment, giving you a total of $105,000. If you leave those earnings alone, rather than pull them out to spend, the second year would deliver another $5,250, or 5% on both the original $100,000 and the $5,000 gain. Your two-year total: $110,250 and climbing.
At time passes, the effect of compounding becomes more pronounced as more earnings are generated and that 5% return is applied to a larger balance. In fact after 20 years in our example, the investment would have grown nearly three-fold to more than $265,000.
Twenty Years Without Stumbling
Australia recently reached an economic milestone. At the end of June, the Australian economy marked two decades without a recession. A report released in September by the Australian Bureau of Statistics showed that Australia’s economy grew 1.2% in the June quarter, to give 1.4% growth for the financial year. This was the 20th consecutive year the economy has grown, for our last recession ended in the June quarter of 1991.1
The “recession we had to have” seems a distant memory now, and since then we have forged ahead without serious pain while many other countries have stumbled.
This record for uninterrupted growth highlights how well Australia is placed to cope with the challenges besetting the global economy, including the lack of investor confidence in Europe that has undermined global share markets in recent weeks. While the woes in Europe and the US have dented business and consumer confidence in Australia, our economy shines in comparison with much of the developed world. Unemployment is 5.1%, which is more or less regarded as full employment. Inflation is within – albeit just within – the Reserve Bank’s 2% to 3% target range. Consumer prices advanced 2.9% in the year to June.
The terms of trade (the prices we get for our exports compared to imports) have surged by 36% in the past two years and are at their highest level since records began in the 1870s. Our high dollar means, in effect, that we have all had a pay rise – we can afford more imports or overseas trips – even if the strong dollar makes life tougher for exporters. Even with a high currency diminishing the value of foreign-sourced revenue, our companies are posting solid earnings and have strong balance sheets.
There are no reasons to be especially gloomy about Australia’s economy in coming years. The Reserve Bank, unlike many of its peers, has the ability to cut interest rates to revive the economy, if required, as it is beginning to do again with two recent rate cuts. The Australian cash rate is now at 4.25% whereas in Europe, Japan and the US the cash rates are 1.5%, effectively zero and close to zero respectively.
Our financial system appears sound. Our banks avoided the excesses of their global peers and are among the highest rated in the world. Our government debt is low as a proportion of GDP, being at a ratio of 22% compared with, say, 225% for Japan, about 80% for Germany and about 60% for the US.
Most importantly of all, Australia is benefiting from the rises of China and India that are expanding at annual paces of about 9% and 8% respectively. While returns from the stock markets of these countries have been mediocre, Australia is benefitting as the industrialisation of these giants is boosting the prices of our commodity and food exports while bolstering sales in volume terms. Businesses have committed to long-term investment plans to ensure Australia has the capacity to meet the heightened demand from India and China.
That should not be construed as assuming that there will be no bumps on the way. With Europe struggling to find its way out of its insolvency crisis and the US seemly on a ‘muddle through’ course to gradual revival, there will be times when confidence falters and the economy slows.
Australia has economic challenges such as a perennial current-account deficit, high foreign debt, hefty consumer debt and an overvalued property market. But with all its advantages, there is no reason why Australia’s economy can’t extend its growth run for a while yet.
Source: Fidelity