E-news September 2011
Up and Down Again!
Do you get a sense of déjà vu? Global equity markets have been all over the place - again. However, there are some differences - this time around the credit markets are continuing to function. During the worst of the global financial crisis, in 2008 and 2009, confidence in the global credit system evaporated – corporate lending spreads (the amount of extra interest a company has to pay above the Reserve Bank rate to compensate for its perceived higher level of risk) blew out to previously unimaginable levels, banks refused to lend to each other, and global trade plummeted as trade finance dried up.
Equity markets are now responding to what are two concerns. Firstly, fear of a good old-fashioned growth recession in developed economies; and secondly, a question of competency, as markets evaluate the ability of policymakers in Europe and the United States to deal with their respective fiscal challenges.
Global economic growth to slow
On the growth front, indications are that growth slowed in the US and Western Europe during the June quarter, with both manufacturing and consumer demand slowing. The causes were several, for example a higher oil price affecting consumer spending in the US and austerity measures curtailing consumer spending, whilst the Japanese tsunami caused shortages of certain production inputs that triggered manufacturing delays. Business surveys indicate the global manufacturing downturn intensified during July.
The problem now is that this growth slowdown may well be exacerbated by the fiscal imbroglio in the US. The US debt ceiling agreement, as it stands, makes for a restrictive fiscal environment in 2012, with the result that market economists are lowering growth forecasts. The US can fix its fiscal problem anytime it wants to by either cutting entitlements or raising taxes, or both. Politically they will wait until forced. Remember Winston Churchill’s wry comment: "You can always rely on the Americans to do the right thing... after they've exhausted all the alternatives."
In Europe, the fiscal restraint required of several of the deeply indebted countries similarly will be a constraint on growth. The implication for northern hemisphere equity markets is that earnings forecasts will have to come down.
Australia should remain resilient
Australia appears better placed than most developed countries to deal with financial challenges. While a synchronised slowdown in developed economies would no doubt put pressure on commodity prices, demand from China and other EM countries should continue to underpin demand for our commodity exports. Australian unemployment is 4.9% versus the US at 9.1% and our public finances are the envy of most other developed nations. Australia has a very strong domestic banking sector and the economy has much greater leverage to China than it does to the US (25% of Australian exports go to China whilst only 4% go to the US). Furthermore, the Australian government and the Reserve Bank have a well-stocked armoury of policy responses available to spur the economy, in the form of fiscal and monetary stimulus respectively – as was the case during the worst of 2008 and 2009. The Reserve Bank has ample scope to cut interest rates and provide liquidity support for banks if necessary. There is also space to delay the return to surplus given the low level of government net debt.
Our equity market will no doubt be correlated to international markets, but perhaps to a lesser degree than during the last crisis. With the growth supports described above, the risk to earnings forecasts will not be as great, balance sheets have been strengthened both via capital raisings and lengthening of debt maturities, and our banking system remains one of the strongest in the world.
Outlook
No doubt there remains a risk that the global banking system will be tested again. The ultimate resolution of the European sovereign debt predicament may well turn out to be similar to comparable crises during the 20th century – bond holders and lenders will have to take a “haircut” on their loans. In other words, lenders may not get all their capital back or may have to accept a lower rate of return on the money lent. As a result, many of Europe’s banks may well need re-capitalising. However, the precedent of government sponsored bank rescues and market based recapitalisations during 2008 and 2009 gives some confidence that equity markets will not approach the nadir of the earlier crisis.
Current concerns will no doubt prolong the uncertainty in the share markets. That being said, it is strange indeed that investors believe that the right response to a US credit rating downgrade and to European political ineptitude is to indiscriminately dump global and Australian shares that mostly have never had stronger balance sheets, higher sustainable dividend yields, or a lower true risk of financial failure. According to a new report from Moody’s Investors Service, U.S. companies are sitting on a cash hoard of US$1.24 trillion, which should lead to more capital spending, shareholder distributions, and mergers and acquisitions. Furthermore, 160 of the companies in the S&P500 will pay higher dividend yields than the yield on a US 10 Year Treasury.
The bottom line is: Don't panic. This is not 2008 and many companies are now in much healthier shape than they were when Lehman Brothers collapsed. Yes, there will be unnervingly wild days on the share market. Yes, there are reasons to be cautious as we consider a weaker economic outlook for the rest of the year, but that should not necessarily lead investors to sell in haste. Markets are often volatile and that this is part of the process. Investments should be made for the long term. All the trading over the last month has added significant trading and tax costs for many investors and very little return for most of them. For those that have put long term investment strategies in place, this short term volatility should not detract from that longer term goal. At times like these it is important to remember the benefits of portfolio diversification and of sticking to your investment strategy.
Emerging Markets
With the slowdown in the developed markets of Europe, the US and Japan, more and more attention is being given to the emerging markets as the future growth engine of the global economy. Emerging markets are nations in the process of rapid growth and industrialisation and are defined as economies with low to middle per capita income. Currently, there are 28 emerging markets in the world, constituting approximately 80% of the global population and representing about 25% of the world's economy. These countries include Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.
What makes them different?
Emerging markets have four major characteristics. First, the Asian and Latin American markets are regional economic powerhouses with large populations, large resource bases and large home markets which can spur development in the countries around them. Second, they are transitional societies that are undertaking domestic economic and political reforms. They have adopted more open door policies to replace their previous state interventionist policies which had failed to produce sustainable economic growth. Third, they are the world's fastest growing economies, contributing a great deal to the growth of world trade as they become more significant buyers of goods and services than the industrialised countries. Fourth, they are increasingly active participants in the world's major political, economic, and social affairs.
In their effort to create a market economy and to ensure sustainable development, emerging markets still face big challenges that come from fundamental problems associated with their traditional economic and political systems. A serious problem that emerging countries have to confront is controlling corruption, which often impedes the development process. An even more challenging task for these countries is to undertake structural reforms with their financial, legal and political systems, so as to provide a disciplined and stable economy that is relatively free of political disturbances and interference.
Why invest in Emerging Markets?
Most emerging markets stories revolve around commodities, infrastructure, exports and currency issues. Emerging markets are usually perceived as producers of manufactured goods (e.g. China) or as commodity suppliers (e.g. Brazil and Russia), with incomes too low or savings rates too high to have a meaningful impact on global consumption. However, emerging markets have now become major consumers, particularly the huge markets of China and India, outstripping the US in their share of global consumption.
Emerging economies are far less dependent on the developed world for growth than they were a few years ago. Strong demand from within their own growing economies, and trade with other growing emerging market countries (particularly China and India), make these economies much more self-sufficient. In recent years, the emerging economies have been growing 4% to 5% faster than the developed economies and are now the drivers of global growth, taking over from the US, and are set to contribute 70-75% of global growth.
Demographics are an important attraction for emerging markets. Household size, family structures, urbanisation, age structure, etc. drive consumer expenditure patterns. The relative wealth of the emerging markets’ populations is increasing. As incomes rise, households have considerably more spending power over and above simply putting food on the table and a roof over their head. Emerging market populations have much better demographic characteristics than their developed country peers, which have aging and shrinking populations, are downsizing their homes, and are already highly urbanised.
Economic fundamentals such as current account/fiscal balances and government debt levels are generally in better shape in the emerging world than in the developed markets. While the developed world has increased its indebtedness, debt levels in the emerging markets are comparatively low and savings ratios are high. Emerging market banks have had fewer problems because of their relatively conservative lending policies and their economies generally do not face the prospect of a prolonged recovery period, as the developed economies work through the deleveraging process.
The three largest emerging consumer markets are China, Brazil and India. These markets currently are, or are about to become, trillion dollar growth markets. China and India will be the two main players, given their vast populations. The Chinese development story is well documented. Its consumer market has been growing by 8% a year for the past decade. Indian incomes are projected to grow three-fold over the next 15 years, elevating India to become the world’s fifth largest consumer market by 2025. Despite often being overlooked, Latin America is close on the Asian countries’ heels. For a long time the perceived wisdom was that Latin America offered investors little apart from commodities, boom/bust cycles, defaults and political uncertainty. However, things have changed and Latin America, particularly Brazil, now has a rapidly growing consumer market.
The chart below tells the story. Not much seemed to happen between 1994 and 2004. Then in 2004, things really began to take off. The GFC hit the emerging markets hard, with fears that their economies would not weather the storm and there was a flight of capital. However, they proved to be resilient and have enjoyed a strong recovery. The past year has been lacklustre, on the back of concerns that China’s economy may be slowing.
Not without risk
Investments in emerging markets come with much greater risk due to political instability, domestic infrastructure problems, currency volatility and limited equity opportunities. Emerging markets remain significantly more volatile compared to the developed markets in the US, UK, Europe and Japan. While volatility within the emerging markets has indeed diminished significantly during the past decade after the wild gyrations in the 1990s, investors should still be aware of the additional risk that this higher volatility will have on their portfolios.
Emerging markets generally do not have the level of market efficiency and the same standards in accounting and securities regulation as the developed economies. This creates a lack of transparency and additional risk for investors. Although emerging markets will typically have a physical financial infrastructure including banks, a stock exchange and a unified currency, local stock exchanges may not offer fully liquid markets for outside investors.
An emerging market economy will have to weigh local political and social factors as it attempts to open up its economy to the world. This creates sovereign risk. Citizens who are accustomed to being protected from the outside world can often be distrustful of foreign investment and may be opposed to having foreigners own parts of the local economy. Panic and speculation are also more common. The 1997 Asian crisis, during which international capital flows into these countries actually began to reverse themselves, is a good example of how emerging markets can be high-risk investment opportunities.
The process of ‘emergence’ may be difficult and fraught at times. Countries emerging from one way of life to another, from the agrarian to the urban, will encounter stresses and strains along the way. It should not be forgotten that significant numbers of their citizens remain poor or vulnerable. In developing countries even small economic dislocations can provoke substantial challenges. When jobs are lost, where corruption flourishes, when remittances are cut off and when food prices soar, social tensions will worsen. This is particularly true where income disparities are large and there are still sizeable pockets of poverty.
Although emerging economies may be able to look forward to brighter opportunities and offer new areas of investment for foreign and developed economies, investors need to be fully aware of the risks. Inevitably there will be bumps along the way. We believe there is a case for including emerging markets within a diversified portfolio for growth-oriented investors. Emerging markets are important to the future growth of world trade and global financial stability, and they are becoming important players in global politics. They are determined to undertake domestic reforms to support sustainable economic growth. If they can maintain political stability and succeed with their structural reforms, their future is promising.
The Dollar in 2016
Forecasting the comparative value of the Australian dollar is fraught with difficulty and never so much as now when there are conflicting forces pushing the A$ in different directions.
The recent strength of the A$ has been driven largely by a weaker US$, rising commodity prices and Australia’s relatively high interest rates. The current weakness in the US$ stems mainly from the US Federal Reserve’s quantitative easing program and lack of urgency to raise interest rates at a time when other central banks, including the European Central bank, are beginning to raise their interest rates. Further contributing to US$ weakness is greater consumer confidence globally, especially in Asia, which has reduced demand for the US$ as a safe haven currency.
The industrialisation of China and other emerging markets has been a key driver of higher commodity prices in recent years. Australia as a net exporter of commodities has benefitted greatly from this by way of a rise in our terms of trade. At the same time, our higher interest rates compared to those in the US and Europe has made Australia an increasingly attractive place to invest, providing further support for the A$.
The asset consultant Russell Investments recently surveyed 40 Australian fund managers for their views and asked what they believed the value of the A$ would be against the US$ in five years’ time. The majority of fund managers believed the A$ would fall from its current level of around US$1.09 to between US$0.80 and US$0.90 cents. Not a single manager expected the currency to be trading above US$1.10 by mid 2016.
The Russell Investments survey shows that fund managers view the A$ at current levels as unsustainable over the medium term. The question is what will be the catalyst for a lower A$ over the next five years? Perhaps the biggest factor is a potential slowdown in China, where officials continue to try and strike a balance between strong economic growth and rising inflation. A slowdown in Chinese growth would impact our terms of trade and put pressure on the A$. Other factors include increased risk aversion triggered by Europe’s continuing sovereign debt woes, and a delay by the RBA in raising interest rates due to weakness in the non-mining sector of our economy.
What is particularly interesting in the Russell Investments survey is the range of views – anywhere from US$0.80 up to US$1.10. This wide dispersion highlights the risk of making big bets on a single exchange rate prediction. We prefer not to play the forecasting game and instead prefer to adopt a partial currency hedging strategy. A consistent 50% hedge effectively reduces volatility in portfolios, at lower cost, and, on average (when compared to more active approaches) adds value.
On a lighter note, the Economist’s Big Mac Index, an always amusing guide to whether currencies are at their “correct” level, indicates the A$ is overvalued by 22%, or by 12% after adjusting for GDP per person. (The Index is based on the theory of purchasing-power parity, the notion that in the long run, exchange rates should move towards the rate that would equalise the prices of identical goods and services around the world. The Big Mac is identical anywhere in the world and, all else being equal, should cost the same worldwide. In fact, a Big Mac costs US$4.94 in Australia vs. US$4.07 in the USA). Some fund managers would seem to broadly agree with the Big Mac Index, others are more bearish. We will have to wait and see who the better forecaster is. In the meantime, it seems now is the time to take your overseas holidays.
Dividends: Targeting Equities for Income
A common goal of many investors is to achieve a steady, reliable income stream. While fixed interest and cash based investments are traditional instruments for achieving consistent income flow, other asset classes such as equities, which comprise a significant proportion of many portfolios, should not be overlooked.
Most profitable companies pay a portion of their profits to shareholders each year as dividends. Dividends provide income in much the same way an interest rate security pays interest, however a major difference is that unlike interest, a dividend payment can be varied or withheld by a company if business conditions deteriorate. For this reason, dividends have the potential to be more volatile than the income streams of other asset classes.
In Australia, most established successful companies have tended to pay regular dividends which have increased as their profits have risen. In less profitable years, company directors may elect to utilise past earnings to maintain dividends at a relatively consistent level. Where a portfolio is to be structured with the aim of maximising dividend income, it may therefore be useful to check back through the company's history to see if it has a long track record of reasonably reliable dividends. With careful selection of dividend paying stocks, the risk of income volatility can be greatly reduced.
Where an equity portfolio is constructed to provide a suitable level of diversification across high quality companies, there will be greater potential for the total dividend payments to increase from year to year as companies generate profit growth. Dividends may therefore have a significant advantage over other forms of income in an inflationary environment, as they allow the investor to maintain the real value of their income stream over time.
Another important characteristic of dividends is their tax-effectiveness. The dividend imputation system eliminates the double taxation of company profits, as Australian resident shareholders receiving dividends are entitled to a credit for tax already paid by the company.
In contrast, interest payments are fully taxable at an investor’s marginal rate with no associated concessions.
While equities may form an important component of an income-oriented portfolio, it should be remembered that the principle of diversification among different asset classes remains a crucial factor in minimising overall portfolio risk.
By way of example, consider the annual interest on $100,000 invested in bank bills compared to the dividends from a $100,000 investment in Woolworths (WOW) shares on 1 July 1994. As can be seen in the graph above, the share investment has provided an attractive growing dividend stream. Other benefits of investing in shares include potential capital growth and franking credits.
The Global Financial Crisis saw the rates offered on term deposits hit all time highs relative to the cash rate, as Australian banks looked to diversify their loan funding sources beyond frozen or expensive global capital markets and competed fiercely for local investors.
Funding sources are now returning to normal, which is resulting in the major banks reducing the interest rates on term deposits.
Falling term deposit rates and the recent share market weakness makes the current yields on offer from blue chip stocks very attractive.
The table below highlights the forecast dividend yields on offer.
Surging Price of Gold
19 Sep 2011
The price of gold has soared over the past six years, with the price of the yellow metal rising 4.4 times since January 2005.
Unlike the gold boom of the late 1970s – which was triggered by an extended period of high inflation and driven by small mum-and-dad investors – this one has been driven most emphatically by professional investors with deep pockets.
Like the boom that went before it, this gold boom has split the investment community down the middle. Gold bulls are predicting that the gold price will keep edging higher as faith in paper currencies continues to dwindle and supply fails to keep up with demand.
Gold bears say that they have seen it all before and that it won’t be long before the price of gold returns to the long-run marginal cost of production, which is at least 50 percent below the current price of just under US$1,900 an ounce.
On the gold bulls’ side of the argument, there is no doubt that there are many grounds for concern about the value of paper money in general and the US dollar in particular. Governments in the United States and Europe are running huge budget deficits and monetary policy from the Federal Reserve in the United States is extremely loose.
The rise and rise of China has also added spice to the pro-gold argument. One of the many causes of the strong performance of gold over the past year has been consumer purchases of gold in China, where the growing middle class is putting away small gold bars as protection against uncertainty. If China’s demand for gold does keep rising, the current gold price may be with us for some time.
Despite the sharp surge in the gold price, share prices of gold companies have lagged.
Newcrest Mining (NCM)
Newcrest Mining is a world class gold mining and exploration company. Strong growth has seen the company become the third largest gold company in the world. NCM has low operating costs, large reserves, and proven operational and exploration capability.
Around half of NCM’s assets are Australian based with low sovereign risk. The company has four major gold mining centres of Telfer in Western Australia, Cadia Valley in New South Wales, Lihir Island in PNG, and Halmahera Island in Indonesia.
NCM expects to grow gold output from 2.70Moz to 2.78-2.93Moz in FY12, while copper production is expected to increase from 75,600t to 75-85,000t. The majority of the uplift will come from the Cadia Valley and Lihir. Cash costs are expected to be unchanged at around A$500/oz.
NCM expects to increase gold output from 2.70Moz in FY11 to 3.4-3.6Moz in FY14 and 4.0Moz in FY16. Cash costs are expected to fall by around 20% to US$320-400/oz by FY16. If the gold price remains around current levels, the company will generate significant profits.
Have You Considered Hybrids?
19 Sep 2011
New Issue - ANZ Convertible Preference Shares 3
Hybrids earn their name from the fact that they possess some characteristics of a listed share and some characteristics of a fixed interest type investment. Most hybrids are listed on the Australian Stock Exchange and can be bought and sold like any other listed investment.
They pay interest on a regular basis (either half yearly or quarterly) and are usually a lower risk investment than shares. With the recent fall in interest rates offered on Term Deposit, investors are looking for alternatives to boost their income.
Hybrid securities are an increasingly popular method of achieving fixed interest exposure, however it is important that you understand how they work and the potential risks.
Hybrids are not immune to the volatility in credit and equity markets, with most hybrid issues falling in value during the Global Financial Crisis (GFC). The weakness was due to a widening in credit spreads, i.e. the return above the risk free rate. The uncertainty in credit markets meant that investors required a higher return for the same level of risk. For investors buying the securities, this meant they offered a lower price. As the risks in credit markets reduced, the security prices returned to around pre-GFC levels.
ANZ Bank (ANZ) recently announced the issue of a new hybrid called Convertible Preference Shares 3 (CPS3).
CPS3 will mandatorily convert into ordinary shares on 1 September 2019 (subject to certain conditions being satisfied). ANZ also has the opportunity to elect for an optional exchange on 1 September 2017 – this could result in the shares being converted in six years rather eight.
CPS3 will pay a margin of 3.30% over the 180 day bank bill swap rate (currently 4.63%). This equates to a gross yield of 7.73% to 7.93%. The interest rate will be reset semi-annually at the time of the dividend payment.
ANZ is seeking to raise $750m from this offer with the ability to issue more or less depending on market demand.
The CPS3 structure is similar to recent bank issues. The main difference from recent issues is that ANZ must convert CPS3 into ordinary shares if its common equity ratio falls below 5.125%.
Investors will receive no more than the maximum conversion number of shares if this common equity ratio was to be breached and consequently may receive less than $101.01 (there is a 1% discount on conversion) of ordinary shares in ANZ.
The ANZ share price would need to fall by more than 50% for shareholders to start losing capital. While this loss absorption clause does represent an additional risk, the probability of this happening is minimal.
CPS3 is expected to list on the Australian Stock Exchange on 29 September 2011.
CPS3 offer an attractive yield and may be suitable for diversified portfolios. If you would like further information about CPS3, please contact your adviser.