MADISON INVESTMENT COMMITTEE Investment Market & Portfolio Update 4 November 2010

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1 Investment market & portfolio update 4 November 2010 The big event last week (and the biggest for some time) was not the US mid term election (which changes little in practice for the investment markets) but rather the two day meeting of the US Federal Reserve Board s Open Market Committee. Since the beginning of this year, the Fed has executed a complete U turn on monetary policy. It has shifted its policy position from one at the start of the year, of raising the bank discount rate (from 0.5% p.a. to 0.75% p.a.) and talking about how and when to bring the monetary stimulus to a halt, to a position in August of placing a minimum of $US2 trillion on the assets it would hold following large scale purchases from the banks, to now indicating that it will buy a further $US 600 billion of treasury bonds and high grade mortgage securities from the commercial banks. This activity is called Large Scale Asset Purchases (LSAP). It is equivalent to printing money and is euphemistically referred to as Quantitative Easing. Last week s decision is the second round of QE that the US has decided to engage in hence it has been called QE2. Some commentators fully expect that we will eventually see QE3, QE4... and so on. We quote the FOMC s announcement in full as it is a succinct and clear statement of why they believe they needed to take this action: Statement issued by Federal Open Market Committee of the Federal Reserve Board of Governors 3 November 2010 Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in non-residential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow. To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. Page 1

2 Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen. Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy. The reality is that the Fed has no other policy options. The main question is whether pumping more cash into the commercial banks will actually stimulate the US economy at all, let alone sufficiently to bring down unemployment. It appears that the first program of creating $US 1.7 trillion of money and using it to buy assets from the banks, together with slashing interest rates to near zero, helped stabilise the economy and prevent more serious unemployment, but the recovery is still anaemic. Now that interest rates are almost zero, they can no longer be cut. Well established indicators such as the Taylor rule (which indicates the size of interest rate movements needed, based on the gap between the actual GDP and potential GDP together with the relativity of actual inflation to the Fed target of 2% p.a. to 3% p.a.) are indicating that interest rates would now need to be cut by a further 6% p.a. It has been estimated that LSAPs of $500 billion are equivalent to a rate cut of about 1% p.a. Hence the announced $US600 billion of LSAP should provide the stimulus that a rate cut of 1.2% p.a. would provide, if it works (see below for comment on this). Even if it works, it is a long way short of the stimulus needed (equivalent to a 6% p. a. rate cut). QE2 may not work to create much stimulus as it depends on two factors: o The banks wanting to lend the cash o Consumers and businesses wanting to borrow to spend or invest rather than reducing their debt levels. It is not hard to see how the cash could just sit on the balance sheets of the banks, largely unused for a long time, but providing the basis of a future surge in spending and inflation. In the medium to longer term, the disruptive effects of increased inflation could be severe and need to be kept in mind. The thirty year bull market in fixed interest is over. The key beneficiaries of the announced policy are Wall Street in general and major listed banks in particular. Both are key constituencies of the Federal Reserve. The US equity market expected to see at least $US500 billion of QE from the Fed and they have not been let down. Much of the buoyancy in US share prices in recent weeks has come from anticipation of this announcement. This buoyancy continued in the first two days after the announcement but is starting to falter a little. Meanwhile the creation of extra US dollars has added to the weakness of the US Dollar exchange rate, boosting the US dollar gold price, the oil price and the AUD/USD exchange rate to above $1.00. The weakening of the USD may in fact be one of the main objectives in spite of US Treasury Secretary Geithner s protestations that he is committed to a strong US Dollar. Page 2

3 The USD weakness adds to the tensions in the currency markets and to relations with China, Japan and Europe. We expect China to continue to resist pressure to appreciate its currency against the USD. We also expect Japan to take action to stem the rise of the Yen. The European Central Bank will be hamstrung by tensions between Germany and the other major EU economies and the Euro may strengthen more than is good for the struggling economies of Europe (i.e. those outside Germany) As we reported recently, the economic outlook has changed little in recent weeks with the most likely outcome for the major economies of the US and Europe looking like a slower than usual recovery rather than a slide into outright recession. We are now very slightly more optimistic (or less pessimistic) than we were about the prospect of avoiding a double dip recession and achieving slow growth. A slow recovery is still a poor outcome with unemployment remaining high in the USA and Europe, undermining consumer and business confidence. We do not see that the QE2 announcement changes the reality apart from boosting confidence (by too much we believe) in the US equity market. The equity markets have taken this as a major indicator that stock prices should benefit and have run up markedly on the strength of this in the last month. The bond markets have also responded positively but for the more direct reason that there will be more new money bidding up bond prices, pushing yields to new lows. There is now a clear divergence of views between the bond markets, which expect growth and inflation to be slower and the equity markets which are banking on the new money that is being manufactured creating renewed stimulus in corporate earnings. Both cannot be right and the odds favour the bond markets being closer to the eventual truth. Chinese real GDP growth is still strong but has continued to moderate slightly over the last three quarters, from 11.9% p.a. to 10.3% p.a. to 9.6% p.a., under the influence of tightening Chinese policy settings such as the recent decision to raise official interest rates (by +0.25% p.a. ) for the first time in three years. Meanwhile Chinese trade continues to boom with foreign exchange reserves climbing to $US2.65 trillion, the largest of any country. The impact on prices of key Australian exports to China remains very beneficial. In Europe, unemployment rose surprisingly in the latest month, from 10.0% to 10.1% notwithstanding the strength of the German economy which has unemployment at only 6.7%. Germany is gaining market share of exports to Brazil, Russia, India and China (the so called BRIC countries) at the expense of France, Britain and Italy. It now makes up 36% of all European exports to BRIC versus a combined 25% for the other three countries mentioned. As we reported last time, the International Monetary Fund has reduced its forecast for world economic growth in 2010 and More recently the OECD (made up of the major rich countries) has indicated that it does not expect the OECD output gap to close until (the output gap is the difference between the actual GDP and the GDP that would be produced if the economies were running at full potential. The OECD says that Page 3

4 unemployment in the EU and Japan will fall only slowly, if at all, in spite of the demographic trend which is reducing the number of people of working age. In a separate study, Jorgensen and Viu, two US based economists, estimated that demographic changes reducing the growth of the labour force will reduce the real GDP growth of the G7 countries (the largest 7 economies in the world) from an average of +2.1% p.a. in the period to +1.4% p.a. in the next ten years. Meanwhile in the shorter term, OECD consumers are expected to cut consumption by the equivalent of 7% of GDP over the next year, following a similar cut back last year, as they seek to reduce their debts. In Australia, the AUD will continue to strengthen as long as we have relatively high interest rates (by world standards) and strong terms of trade, pushed by high commodity prices and export volumes. This will hurt much of the economy outside the minerals sector but will also help hold down inflation and hence domestic interest rates. This week s increase in the RBA cash rate from 4.50% p.a. to 4.75% p.a. indicates that this argument in favour of restrained rate increases will not always hold. The rise in the AUD versus the USD in particular has blunted the returns on international assets held by Australian domiciled investors, even though the US and other stock markets have had significant recent gains when measured in their own currencies (see table 1 below). We take currency valuation into account when comparing current market levels to long term fair value; however we do not predicate investment allocation decisions on short term forecasts of currency movements. We think currency exchange rates are simply too hard to predict, given the lack of transparency in and the magnitude of the forces driving foreign exchange markets. Even though the valuation indicators for some equity markets are very encouraging, as shown in Table 2 below, the degree of uncertainty is particularly high. This relates not only to the outlook for economic activity but also to the possible responses of financial markets to issues such as quantitative easing. The degree of correlation between different markets is very high, indicating a tendency to herding behaviour which is greater than usual with the attendant prospect of exaggerated movements in either direction. Overall we think it is still a time for caution and remaining underweight in Australian and International equities, much more underweight in property and fixed interest and overweight in cash and bank term deposits. This is reflected in our descriptions of the possible investment market scenarios as well as our portfolio recommendations (where we are indicating no change from the stance set out in our last update) Page 4

5 Where are we now? Table 1: Market movements over the 2010/2011 financial year Market indicator Level at 30 June 2010 Level at 4 November 2010 Movement over the course of the financial year S&P ASX % Resources % AREIT % USA: S&P % UK: FTSE % Germany: DAX % Japan: Nikkei % China: Hang Seng % USD/AUD % YEN/AUD % EUR/AUD % GBP/AUD % Aus: 90 day bank bill Aus: 10 year govt bond US: Federal Reserve funds rate US: 10 year govt bond Gold USD/ounce % Oil USD/barrel (WTI) % Copper US cents per lb % The Australian stock market is up significantly over the opening months of the current financial year, with much of the gain coming in the last several weeks. This reflects strength in the two strongest sectors of the economy: mining and banking. As indicated in the valuation tables below, the prices of Australian stocks, as measured by the ASX 200, are close to long term fair value. Page 5

6 US, British and Chinese stock markets have risen more strongly than the Australian market, when measured in their own currencies, but they have been much less rewarding in Australian dollar terms due to the strong rise in the AUD versus the USD and the GB pound. The US and British stock market prices are significantly below long term Fair value. Movements in the Japanese and European stock markets have been less pronounced over the financial year to date, as have their currencies versus the AUD so that the net result for Australian based investors has been fairly modest. Table2: Comparison of current market prices versus long term fair value assessments under three key scenarios. Date 03-November-2010 Scenario BASE CASE UPSIDE CASE ASSUMPTIONS DOWNSIDE CASE Current bond yield multiplied by Current EPS changed by % -20.0% EPS growth rate changed by % -1.0% Country Ratio of current market value to long term fair value Required long term return from stocks if priced at fair value Ratio of current market value to long term fair value Required long term return from stocks if priced at fair value Ratio of current market value to long term fair value Required long term return from stocks if priced at fair value % % p.a. % % p.a. % % p.a. USA 72% 7.7% 66% 8.3% 60% 7.2% Canada 86% 8.0% 79% 8.6% 73% 7.4% Japan 71% 5.9% 60% 6.1% 65% 5.8% Britain 94% 8.3% 87% 8.9% 86% 7.6% Germany 69% 7.6% 63% 8.1% 61% 7.0% France 94% 7.9% 86% 8.4% 86% 7.3% Italy 103% 8.9% 97% 9.7% 95% 8.1% Australia 104% 10.2% 101% 11.2% 93% 9.2% Brazil 127% 14.2% 124% 15.4% 124% 12.9% Russia 96% 13.3% 92% 14.3% 96% 12.2% India 319% 16.3% 315% 18.0% 319% 14.7% China 85% 11.0% 79% 11.6% 78% 10.4% The base case assessment has been based on current bond yields, earnings per share and PE ratios, as well as moderate assumptions for growth in earnings per share over the next ten years. What may happen next? Possible scenarios Given the extreme level of volatility in both the equity and fixed interest markets we need to consider a number of scenarios of what may happen over the next one to three years. It is important to recognise that we need to use scenarios because even our best assessments are so uncertain and there is a significant likelihood that our recommended portfolio strategies will turn out to be wrong if left unchanged in the face of market developments. Page 6

7 Base case (40% probability) The USA avoids a return to recession but has very slow growth (sub 2% p.a.) over the next five years. This means that unemployment will stay high, adversely impacting consumer spending which is a mainstay of the US economy. Japan continues in recession well into 2011and Europe (outside of Germany) re enters recession in Under the influence of the flood of new money being created by central banks, inflation in developed countries picks up into the 3% p.a. to 5% p.a. range from 2011 onwards but does not get out of control. This has the beneficial effect of reducing real interest rates and the real burden of debt. Australian cash and short term interest rates increase modestly with the RBA cash rate rising to above 5% p.a. by the end of the first quarter of Bond yields up by +0.25% p.a. over the course of the rest of FY2010/2011 and up between +0.5% p.a. and +1.5% p.a. by the end of FY2011/2012. Commercial property values do not recover their 2007 values till 2013 or later. Earnings per share for the ASX 200 grow moderately over the next 5 years with the exception of the major resource companies which achieve more rapid growth in the next two years and beyond. ASX and US stock markets recover their 2007 high by late The markets are prone to further falls of 10% to 20% during the course of the 2010 and the 2011 financial years. The Australian dollar continues to swing in a wider than normal range of between USD 0.80 and USD 1.10, adding more short term volatility to returns on international assets. Upside case (10% probability) Worldwide growth stronger than expected due to consumers and businesses recovering in confidence as governments generally handle the gradual withdrawal of the stimulus exceptionally well. US unemployment drops below 9% by late 2011, Europe avoids a relapse into recession, Japan recovers more quickly and Chinese growth slows only minimally. Inflation in developed countries picks up into the 3% p.a. to 5% p.a. range from 2012 onwards but does not get out of control, even though it is at the higher end of the range most of the time. Australian cash and short term interest rates increase more significantly over the course of to combat re emerging inflation risk. Bond yields up by +0.5% p.a. to +1.0% p.a. by the end of FY 2010/2011 and by up to +3.0% p.a. by the end of Commercial property values recover their 2007 values by Earnings per share growth for the ASX 200 are faster than expected over the next 5 years. ASX and US stock markets recover their 2007 high by late 2011 or early The Australian dollar continues to swing in a wider than normal range, adding more short term volatility to returns on international assets. Page 7

8 Downside case (30% probability) Recession re emerges in the USA and Europe in 2011 and proves to be a worldwide double dip event and lasts till 2012 or later, threatening a recession in Australia. Inflation is contained by recession and slips into deflation for up to 5 years, ranging between 2% p.a. and +1% p.a. Australian cash and short term interest rates down by 1.0% p.a. from current levels over 2011 and by further 1.0% p.a. in 2012 as the world moves into recession and the RBA cuts rates to stimulate the economy. Bond yields down by 0.5% p.a. by the end of FY 2010/2011 and a further 1.0% p.a. in FY 2011/2012. Commercial property values recover their 2007 level in 2016 or later. Earnings per share growth for the ASX 200 are negative in and slower by 2% p.a. for the next 5 years. ASX and US stock markets bottom some time in 2011 between 20% and 30% below current levels and recover their 2007 high by 2015 or later. The Australian dollar continues to swing in a wider than normal range, adding more short term volatility to returns on international assets. The other 20% of possibilities we simply do not know about. They include a range of unknown unknowns. What to do next: implications for investment portfolio strategy Focussing on the base case scenario with some regard to the downside scenario and less regard to the upside scenario, our recommended underweighting to Australian and International equities should be reduced in periods of market weakness over the next few months. This means increasing the allocation to equities during periods of significant market dips. For example, reduce the current underweight to Australian equities by one third if the ASX 200 falls below 4500, by a further one third at 4200 and eliminate the underweight at 4000 or below. Cash and term deposits are currently more appealing investments than government bonds. Government bond yields are more likely to rise than fall worldwide over the next 1 to 3 years which will cause a corresponding fall in capital values. Government fixed interest is therefore less attractive than cash or term deposits over the next twelve months. Fixed interest with credit risk still requires caution unless it is short dated or variable rate and issued by an AA rated entity. Commercial property in the US and Europe is still prone to major downward revaluation although in Australia we may be getting closer to the bottom. Unlisted property investments should be confined to brand new portfolios being built from acquisitions from distressed sellers or comprising long term leases to tenants of unquestioned quality. In this climate of market instability generally avoid investment products that are not clearly transparent in terms of how they work and what they charge. In general avoid hedge funds and structured products. Page 8

9 Recommended portfolio weightings The following table sets out portfolio allocation guidance in terms of positioning relative to long term benchmark or strategic asset allocations. We have expressed them in terms of percentages of the long term benchmark or strategic allocations. In summary, the recommended portfolio strategies take account of all three scenarios outlined above. The recommended portfolio weightings have a significant amount of cash which is both precautionary and available for the opportunity for deployment into growth assets depending on how the scenarios unfold. The situation requires fairly constant review and attention. Asset class Risky assets Target Portfolio weighting relative to long term (5 10 year) target weight as a % of long term strategic or benchmark weighting Australian equities 65% for portfolios 1,2& 3; 73% for portfolio 4; and 83% for portfolio 5 International equities 65% for portfolios 1,2& 3; 73% for portfolio 4; and 83% for portfolio 5 Property Fixed interest Tier 2 50% with a bias to unlisted assets on a very selective basis with total returns above 10% p.a. 30% in AA rated issuers only Defensive assets Fixed interest Tier 1 Cash 50% with a bias towards bank term deposits Balance of the portfolio Page 9

10 Investment of new cash flow We recommend that new regular cash flows in or out of the portfolio are invested in order to achieve the target allocations recommended above. Large one off cash flows should be invested over a period of six months to achieve the same result. Gearing to invest For some investors borrowing to invest will still be worthwhile provided that: o o o There is a strong prospect the return on the investments assets bought with the borrowed funds will outperform the cost of borrowing on an after tax basis over the term of the loan (although it is increasingly difficult to find such investments given the rising costs of loan funds); and The investor has a very high tolerance for short term risks and fluctuations in asset prices whose effects will be magnified in any geared investment (the tolerance to such fluctuations may be enhanced by the presence of a capital guarantee or protection mechanism which ensures that the amount of the loan to be repaid is no more than the value of the assets being financed: and Geared investments are not made into asset classes where the recommended allocation is less than 100% of the long term benchmark, unless the individual asset offers the prospect of significantly better returns relative to the rest of the asset class. This document and its contents are general in nature and do not constitute or convey personal advice. It has been prepared without consideration of anyone s financial situation, needs or financial objectives. Formal advice should be sought before acting on the areas discussed. This document is a private communication and is not intended for public circulation other than to authorised representatives of the Madison Financial Group and their clients. The authors and distributors of this document accept no liability for any loss or damage suffered by any person as a result of that person, or any other person, placing any reliance on the contents of this document. Page 10