Quarterly Outlook Q3 2014
Prime Minister of Japan
Shinzo Abe
Prime Minister of India
narendra modi
Indonesian President
JOKO ‘JOKOWI’ widodo
Asia’s new reformers
investment outlook for Q3 2014
Dear Reader,
All asset classes have performed well over
the past 12 months. The current investment
environment is extraordinary. Ten year bond
yields traded below 3% in Spain and Italy;
the European Central Bank cut its headline
rate to minus 0.1%; yet world equities
markets soared over 20% and junk bonds
now pay less than 6%.
Against this unusual backdrop, Stanford
Brown’s inherently conservative portfolios
have performed extremely well. We will
never chase momentum or hot stocks
just for a short term gain, as we are often
reminded of Warren Buffet’s wise words;
“To finish first, you must first finish”.
Read on to find out our predictions for
“When the music stops…
things will be complicated.
But as long as the music is
playing, you’ve got to get up
and dance.”
global economies, politics and asset class
Chuck Prince, ex-CEO of Citigroup
Jonathan Hoyle
valuations.
Happy reading!
Chief Investment Officer, Stanford Brown
Disclaimer
Any advice contained in this newsletter is general advice only and does not take into consideration the reader’s personal
circumstances. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to
you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances. When
considering a financial product please consider the Product Disclosure Statement. Genesys and its representatives receive fees and
brokerage from the provision of financial advice or placement of financial products.
Genesys Wealth Advisers Limited ABN 20 060 778 216 AFSL No.232686
Page 2 | Quarterly Commentary Q3
Executive Summary
• All asset classes have performed well over the past 12 months. This is a highly unusual
state of affairs. It won’t last.
• The Fed’s third program of Quantitative Easing will end in October. Interest rates are
likely to start rising six months afterwards. This does not foretell the end of the equity bull
market.
• The Bank of England is likely to be the first major central bank to raise rates. However,
monetary conditions will be eased in Europe, China and Japan. On balance, financial
markets will still benefit from net stimulus. Long live the carry trade.
• Global growth is likely to accelerate in the second half of 2014, led by China, Japan and
the US.
• In contrast, Europe remains mired in economic stagnation. Living standards have been
falling for six years. They will continue to do so for the foreseeable future. The decision to
install Jean-Claude Juncker as the European Union’s Chief Executive confirms a Continent
in denial.
• Asia’s most populous democracies (India, Japan and Indonesia) have elected a crop of
reform-minded leaders. This is good for Asia and good for Australia.
• The US would love to run a foreign policy of ‘splendid isolation’, but events on the Russian
border and in the Middle East are overrunning them. Having finally extricated itself from
two disastrous wars in Iraq and Afghanistan, America finds itself in a similar position to
Godfather, Michael Corleone; ‘just when I thought I was out, they pull me back in’. • With the notable exception of the US, global equity markets offer reasonable value. This is
particularly the case for Australian equities. In any case, the alternatives (property, bonds
and cash) are poor.
Quarterly Commentary Q3 | Page 3
Geopolitical tensions on the rise
President Obama’s recent speech at the US Military Academy at West Point
sought to raise the bar for military action.
‘Here’s my bottom line: America must always lead on
the world stage. If we don’t, no one else will…But
US military action cannot be the only – or even the
primary – component of leadership in every instance.
Just because we have the best hammer does not
mean that every problem is a nail’.
Given events in Ukraine and Iraq, the President’s
definition of a ‘nail’ in relation to the US military
‘hammer’ becomes of paramount importance.
How does this fit with Thomas Jefferson’s warning
that the United States should pursue ‘peace,
commerce, and honest friendship with all nations;
entangling alliances with none.’?
In Ukraine, a pro-Russian government was replaced
by a pro-Western one, the Russians took control of
Crimea and provided support for pro-Russian groups
in the east of Ukraine. The Russian strategy is to use
energy, finance and covert relationships to undermine
the Ukraine leadership. The US is faced with a plethora
of poor options. Intervention is impossible as this is
Russia’s backyard. Its only option is to provide support
for the border countries, notably Romania and Poland.
Net, Ukraine is not a nail.
Iraq consists of three major groups; Sunnis, Shias
and Kurds (see map). The US left Iraq in the hands of
the Shia government of Nouri al-Maliki, which failed
to integrate the Sunnis or Kurds. As a result, tensions
rose leading to the evolution of a particularly violent
Al-Qaeda spin-off, The Islamic State (ISIS). Their stated
aim is the restoration of the Islamic Caliphate that died
in the rubble of the Ottoman Empire following the end
of the First World War.
As in Ukraine, it is not clear that the US has an
overriding interest in Iraq. Given the fiasco of the
2003 Iraq invasion, future ground operations are
unthinkable. The US is left with a single viable
strategy; accept what exists – a tripartite Iraq – and
Page 4 | Quarterly Commentary Q3
allow internal hostilities to fight each other rather than
the US.
There has been much media speculation as to the
impact on the oil market should The Islamic State
make further gains in Iraq. The reality (as is often the
case) is less threatening. Iraqi oil exports amount
to 2.3 million barrels a day compared to global
production of 91.7 mbd. However, most of Iraq’s oil
is concentrated in the much better protected Shia
south; US shale oil production grows each month;
and OPEC has more than enough spare capacity to
meet any Iraqi shortfall.
We conclude that the US will limit itself to wars that
are in the national interest or those that can be won;
neither Ukraine nor Iraq fit the bill. This is not a new
strategy for the US, a country that has vacillated
from pretending it is immune to the world to
believing it can shape it. Barack Obama and future US
Presidents are likely to heed Jefferson’s warnings and
‘unentangle’ where possible. Whilst Iraq and Ukraine
make for dramatic headlines, and are tragic situations
for those involved, neither has the scope to derail the
global economy.
ASIA’S NEW REFORM-MINDED LEADERS
Three decades ago, India’s GDP per head was the same as China’s. It is
now less than a quarter of the size.
Three decades ago, India’s GDP (a measure of
economic output) per head was the same as China’s.
It is now less than a quarter of the size. Decades
of corruption, incompetence and bureaucracy have
held the gigantic Indian economy back. Now, for the
first time ever, India has a strong government whose
priority is growth. Narendra Modi, who leads the BJP
party, was elected in May in a landslide victory on the
promise to make India’s economy work.
Since independence in 1947, India has been mostly
ruled by the Congress party, a Nehru-Gandhi fiefdom
with a rotten economic agenda. However, Mr. Modi, a
tea-seller’s son, was elected with an outright majority
with a mandate for reform. He needs to clean out the
banks, cut extravagant subsidies, widen the tax base
and sort out the government’s desperate finances.
It’s a tough job. We wish him every success; Indian
growth would be great for not only Indians but also
for Australia.
Over in Indonesia, the authorities are still counting
the results of the recent election. We sincerely
hope the winner turns out to be Joko Widodo, the
GDP Growth of China, India & US indexed to 1980
unassuming and popular governor of Jakarta.
Mr. Widodo, also known as ‘Jokowi’ has cemented
a reputation as a pragmatic reformer, and most
importantly, is seen as a different beast altogether
from Indonesia’s usual assortment of corrupt,
venal and aloof politicians.
And in Tokyo, it is now 18 months since Japan
embarked upon a program designed to reinvigorate
its economy under Prime Minister Shinzo Abe,
which has become known as ‘Abenomics’. His policy
response to Japan’s two lost decades has been
characterised by ‘The Three Arrows’; fiscal stimulus
(cutting taxes), monetary stimulus (money printing)
and supply side economic reforms (cutting red tape).
The aim has been to boost inflation and GDP growth
to 2%; it might not seem too ambitious, but Japan
has experienced neither outcome since the late
1980s.
All three have been elected amidst optimism for the
future. Though expectations are high, it will be hard
for this trio to underperform their predecessors. Good
luck to Messrs Jokowi, Abe and Modi!
Indian growth
would be great
for not only
Indians but also
for Australia.
Quarterly Commentary Q3 | Page 5
Japan’s Awakening
During Japan’s Meiji restoration, which began in 1868, a group of reformist
individuals completely reshaped the Japanese economy in the space of just
one decade.
Central Bank Assets – percent of nominal GDP
During Japan’s Meiji restoration, which began in
1868, a group of reformist individuals completely
reshaped the Japanese economy in the space of
just one decade. This oft-told tale has left a perennial
optimism amongst the Japanese that they too can
change direction, despite over 20 years of economic
stagnation.
Following election in 2012, Shinzo Abe fired the first
two arrows of ‘Abenomics’; a huge fiscal stimulus
program and a massive bout of central bank money
printing (QE). In fact, the Bank of Japan’s QE program
is of such magnitude that it is equivalent to twice that
being run by the Federal Reserve. It is a gamble of
epic proportions (see Chart #1).
His approval rating soared, the stock market ignited
and the yen sank. Following nearly a decade of
almost uninterrupted deflation, prices are rising once
again (see Chart #2).
Source: J.P. Morgan Global Economic Research, J.P. Morgan Asset Management
Chart #1
However, cutting taxes and printing money is easy;
the third arrow was always going to be a much
tougher job. Mr. Abe is now back for his third and
hardest arrow; supply side reforms - opening up
the economy to foreigners, deregulating business,
cutting corporate taxes and hacking away at Japan’s
huge bureaucracy. Vested interests have hampered
all previous attempts at reform, but the outlook this
time is much rosier. There are three reasons for such
optimism.
Firstly, in a similar way to Brits in the late 1970s when
the rubbish was piling up in the streets, the country
has reached a point where most Japanese realise
that some sort of reform is essential. Second, Japan’s
demographics are truly awful; no population is ageing
faster, fertility rates are well below replacement level
and immigration is non-existent. There is a growing
Page 6 | Quarterly Commentary Q3
recognition that Japan’s aged care and medical bills
will soon go unpaid. And finally, there is the rise and
rise of China. Voters understand the need for Japan
to stand up for itself. That has led to some ugly
nationalist photo opportunities (Mr. Abe’s appearance
at the Yasukuni shrine in particular), but it makes
reform seem all the more urgent.
Why does reform matter? Japan is the world’s third
largest economy and takes 16% of all Australia’s
exports. Mr. Abe likes to quote Shoin Yoshida, the
man who inspired the Meiji’s reformers: ‘once
a man’s will is set, he can triumph through any
obstacle.’ But the heavy lifting has only just begun.
Mr. Abe needs to stay focused on reform and avoid
being sidetracked by nationalism and hijacked by the
vested interests of the Japanese bureaucracy.
In fact, the Bank of Japan’s QE
program is of such magnitude that
it is equivalent to twice that being
run by the Federal Reserve. It is a
gamble of epic proportions.
Inflation and Japanese Government Bond Yields
Year-over-year % change for inflation
Source: Bank of Japan, OECD, IMF, FactSet, J.P. Morgan Asset Management
Chart #2
Quarterly Commentary Q3 | Page 7
US - the end of QE and the first rate hike
Since the start of the Great Recession of 2008/09, the world’s central
bankers have responded with gusto by pumping the almost dead patient
with monetary stimulus.
Major DM Central banks will have injected around
~USD 8bn by the end of this year
Source: Haver Analytics, Deutsche Bank Reserve
Chart #1
Bank of England interest rates, 1694-2010
Source: Bank of England
Chart #2
First, interest rates were cut; in most cases to zero,
and in some even to negative rates! Then the printing
presses fired up to purchase government bonds from
governments facing yawning budget deficits. To the
end of this year, a total of $12 trillion will have been
printed by the world’s central bankers – a staggering
sum (see Chart #1). The consequences of this
monetary largesse are yet to be known. And finally
central bankers proudly announced to the markets
that rates would stay low for long – a policy which
became known as ‘forward guidance’. In short, it’s
been a wonderful time to be a central banker. Move
aside Bono, Messrs Draghi, Yellen, Bernanke, Carney
and Kuroda are the real rock stars of today!
That said, the glory days for some are drawing to a
close. It is highly likely that the Bank of England will
become the first of the world’s significant central
banks to raise rates – probably before the year is out.
This is hardly going to cripple the UK economy as
rates have never been lower in the Bank’s 300 year
history (see Chart #2).
Over in the US the picture is similar. The Fed
has officially announced that its third program of
quantitative easing (QE) will end at its October
meeting. Fed boss, Janet Yellen, has also signaled
that the first rate hike is likely to follow six months
after. The Fed has placed three conditions on when
it will raise rates; unemployment is below 6.5% (it
is currently 6.1%); inflation is likely to exceed 2.5%
(currently 2%); and long term inflation expectations
are rising. Below we take a look at each of these key
metrics.
Inflation has been subdued for a long time despite
the Fed’s balance sheet expanding to over $4.4
trillion. However, since the end of last year, inflation
has stopped falling and is now rising. The reason is
that surplus capacity is dwindling. This is a pattern
that is quite consistent at this late stage of an
economic recovery (see Chart #3).
Page 8 | Quarterly Commentary Q3
Inflation: PCE Inflation
As at May 31, 2014
Source: BEA Haver Analytics, seasonally adjusted
Chart #3
Inflation: Change in Average hourly earnings, year over year
As at June 30, 2014
Source: Standard & Poor’s, U.S. Trasury, FactSet, J.P. Morgan Asset Management
Chart #4
We believe that the Fed will
tolerate inflation that exceeds its
key target of 2.5% in the short
term because the outlook for long
term inflation is subdued and there
is still so little wage growth (see
Chart #4).
However, the unemployment rate,
which peaked at 10% in 2009, has
fallen all the way back to 6.1%,
only slightly above the Fed’s
estimate of ‘full employment’. In
May of this year, the US economy
finally created back all the jobs
lost during the Great Recession
of 2007-2009. Whilst there is little
sign yet of wage escalation, some
industries are at full capacity (see
Chart #5, over page).
So what does a rising interest rate
environment mean for investors?
Is it time to bail out of stocks
which have served us so well for
the past five years? The answer is
no for two reasons. First, is that
whilst rates are likely to rise from
the middle of 2015, the Fed will
err on the side of caution and lift
rates very cautiously in case they
plunge the still fragile economy
back into recession. Second, even
though the Fed is likely to reverse
course and apply the monetary
brakes next year, most other major
central banks are planning to keep
the printing presses running at full
capacity. Europe, Japan and China,
in particular will be strong net
Quarterly Commentary Q3 | Page 9
US - the end of QE and the first rate hike – continued
Civilian Unemployment Rate Seasonally adjusted
contributors to global liquidity, supporting the prices
of shares and property.
In any case, rising rates do not necessarily signal
falling equity prices. The JPMorgan study below
actually reveals that rising rates from low levels
correlate with a strong equity market. It is only when
rates rise from higher levels (above 5%) that equities
tend to decline (see Chart #6).
A study from research group Capital Economics
examining the seven rate hike cycles since 1970, has
shown that on average the S&P 500 rose by almost
9% in the eight months leading up to the Fed’s first
rate hike and continued to rise a further 11% in the
subsequent 21 months.
Source: BLS, FactSet, J.P. Morgan Asset Management
Chart #5
Correlations between weekly stock returns and interest rate movements
Weekly S&P 500 return, 50-year treasury yield, rolling 2-year correlation, May 1963 - Jun 2014
Source: Standard & Poor’s, U.S. Treasurey, FactSet, J.P. Morgan Asset Management
Chart #6
Page 10 | Quarterly Commentary Q3
europe – Rage, rage against the dying of the light
Europe is plagued with the curse of deflation. Long term bond rates have come down to just 3% in Italy and
Spain despite their mountainous debt piles and chronic budget deficits; in Germany bond yields are heading to
1%. The chart below shows the aggregate rate of inflation in Europe; inflation in the Med countries has turned
to deflation.
So whilst Europe is no longer in perpetual crisis mode, the spectre of deflation dominates decision making.
The ECB tried in May to stimulate the economy by introducing a negative interest rate of 0.1%, effectively
penalising banks for holding cash on its balance sheet. It will be some time before we know the results of
this rather blunt attempt to force banks to lend out money to the broader economy.
However, growth in Europe remains non-existent. It is for these reasons that we stick with our January call
that the ECB will embark upon a quantitative easing program similar to the one the Fed is winding down.
The Germans are the last obstacle and even their relatively strong economy is faltering.
Though there are some signs of promise – reduced labour costs in the Med countries, a promising new Italian
Prime Minister and a healthier UK economy – they are far outweighed by the economic malaise that has
pervaded Europe since the onset of the Great Recession. Whilst sad for Europeans, the ECB’s imminent
QE program will be a boon for Australian-based investors.
‘Do not go gentle into
that good night,
Old age should burn
and rave at close of
day;
Rage, rage against the
dying of the light.’
Inflation has weakened in the Eurozone and in the US in
the last 2 years and is below central bank target
Dylan Thomas
Note: Inflation target = 2% for Fed, and close to but below 2% for ECB
Source: Haver Analytics, Deutsche Bank Reserve
Quarterly Commentary Q3 | Page 11
summary
The recovery following the Great Recession has been very weak, especially
in Europe which remains below pre-crisis levels.
%GDP growth vs pre-crisis peak (up to Q1 2014)
Note: (*) From 1973, 1981, 1990, 2001 recessions
Source: Haver Analytics, Deutsche Bank Reserve
Too much debt was
the cause of the
Great Recession, so
how’s the process of
debt reduction faring?
Page 12 | Quarterly Commentary Q3
Even in the US, which has
experienced the strongest bounce
since the dark days of 2009, the
expansion has been the weakest
since 1945 and GDP is just 6%
above its pre-crisis peak despite
near zero interest rates and money
printing on an unprecedented
scale.
There are several explanations for
the weakness. First, due to horrific
budget deficits, most economies
have had to cut spending and
increase taxes. This has halved
budget deficits since 2009 but
has acted like a ball and chain
on economic growth. Second,
faced with great economic
uncertainty, households have
chosen not to spend and to repair
their own balance sheets – an
understandable response to their
reckless governments. And third,
the European sovereign debt crisis
has reduced risk appetite.
Too much debt was the cause of
the Great Recession, so how’s
the process of debt reduction
faring? This study, shown below
by Hoisington Management,
indicates that the process has yet
to begin. In fact, in most countries
debt has been actually increasing.
Deleveraging has only really begun
in Germany and the US. It’s going
to be a long and arduous journey
with many bumps along the way.
As in Japan, the West has relied
far too much on their central
banks to do the heavy lifting. It is
now time for brave politicians to
take on the vested interests and
push through desperately needed
supply side reforms. Europe,
in particular, must open up its
corrupt and sclerotic economies.
Here’s some ideas for Europe’s
new chief executive to mull over;
cut income taxes for the less
well-off, cut corporate taxes,
encourage foreign investment,
take an axe to corporate
welfare (especially the wasteful
agricultural subsidies) and
allow entrepreneurs to flourish
by arranging a bonfire of the
regulations.
Investors too, are overly reliant
on central banks for propping
up the prices of their homes
and their share portfolios. When
liquidity does eventually pull
back, there will surely be a repricing lower of all risk assets.
However, we continue to believe
that day is some way off. A riskaverse investor who decided
(understandably) to de-risk their
portfolio by moving to cash would
now be 25% worse off in just
the past two years. The dangers
of being out of the market for
prolonged periods are just as real
as the risks inherent within it.
Europe, in
particular, must
open up its corrupt
and sclerotic
economies.
Total Private and Public Debt as a % of GDP Major Countries (annual)
2008
2013
Japan
604.9%
656.8%
U.S.
357.2%
346.1%
Australia
325.1%
325.7%
Eurozone
412.9%
462.6%
United Kingdom
500.6%
544.4%
Canada
244.2%
286.3%
China
320.0%
420.0%
Weighted Average
402.7%
435.6%
Source: Bank of Japan, Cabinet Office, Statistics Canada, Federal Reserve, Bureau of Economic Analysis, Office for
National Statistics of U.K., Statistical Office of the European Communities, Reserve bank of Australia
Good luck!
Quarterly Commentary Q3 | Page 13
stanford brown portfolios
CONSERVATIVE
Strategic Asset Allocation
30/70
Current Asset Allocation
35/65
International Shares
10%
9%
Property & Infrastructure
5%
7%
Alternative Growth
0%
4%
Alternative Defensive
0%
6%
Conservative Debt
60%
54%
Cash & Term Deposits
10%
5%
MODERATELY CONSERVATIVE
Strategic Asset Allocation
50/50
Current Asset Allocation
55/45
Australian Shares
26%
28%
Three decades ago, India’s GDP per head was the same as
China’s.
It is now less 15%
than a quarter of the size.
Australian Shares
15%
International Shares
17%
16%
Property & Infrastructure
7%
6%
Alternative Growth
0%
5%
Alternative Defensive
0%
5%
Conservative Debt
43%
38%
Cash & Term Deposits
7%
2%
BALANCED
Strategic Asset Allocation
65/35
Current Asset Allocation
70/30
Australian Shares
34%
36%
International Shares
23%
22%
Property & Infrastructure
8%
7%
Alternative Growth
0%
5%
Alternative Defensive
0%
4%
Conservative Debt
30%
24%
Cash & Term Deposits
5%
2%
GROWTH
Strategic Asset Allocation
80/20
Current Asset Allocation
85/15
Australian Shares
42%
45%
International Shares
29%
28%
Property & Infrastructure
9%
7%
Alternative Growth
0%
5%
Alternative Defensive
0%
4%
Conservative Debt
18%
9%
Cash & Term Deposits
2%
2%
Alternatives have been split into investments that exhibit Growth and Defensive qualities, though the line is
grey. Alternatives include High Yield Debt, Long/Short Equity, Macro, CTAs, Private Equity, Commodities and
Hedge Funds.
Page 14 | Quarterly Commentary Q3
historic asset class returns
Asset Class Returns – to 31 Jun 2014
3 months
1 year
5 years
0.9%
17.4%
11.2%
-2.3%
13.1%
3.4%
MSCI World Index (unhedged)
3.0%
20.4%
11.5%
MSCI World Index AUD ($A hedged)
5.2%
24.9%
18.0%
MSCI Emerging Markets Index
4.7%
10.9%
5.9%
S&P 500 Index
5.2%
24.6%
18.9%
S&P/Citigroup Global REIT Index ($A hedged)
8.0%
15.8%
22.7%
S&P Global Infrastructure ($A hedged)
8.0%
28.5%
15.5%
CRB/Reuters Commodities Index
1.2%
11.8%
4.3%
ML High Yield Index ($A hedged)
3.5%
14.9%
17.9%
Gold (USD)
3.4%
7.5%
7.4%
Credit Suisse Tremont Hedge Fund Index
0.4%
6.0%
7.7%
UBSA Composite Bonds (‘Defensive’ Bonds)
3.1%
6.1%
6.9%
ASX 200 Accumulation
ASX Small-Cap Ords
Quarterly Commentary Q3 | Page 15
Portfolio comments
Are We There Yet?
The bull market is now more
than five years old. The S&P
500 has nearly tripled from
its low of 666 in March
2009, though European
and Asian markets have
not rallied to anything like
the same extent. Warnings
of corrections and crashes
abound. So are we there
yet? Is it time to batten
down the hatches and
prepare for a cold winter?
Chart #1
A cursory glance at the S&P
500 would suggest that now is
probably not the best entry point
ever. Would you buy this market?
(see Chart #1)
However, context is everything.
Viewed over a longer time horizon,
it can be seen that the current five
year bull market has signaled the
end of a long, icy bear market that
began in 2000 (see Chart #2).
Chart #2
Chart #3
Chart #3
Page 16 | Quarterly Commentary Q3
And the graph at left (Chart #3)
neatly highlights that bull markets
tend to be long lasting and of
significant magnitude (blue bars)
compared to short, shallow bear
markets (red bars). The economic
risks of missing out on a bull
market are significant.
Whilst it may be painful to buy a
stock market that has tripled in
value (why didn’t we load up the
truck five years ago!), timing is
a mug’s game. All that matters
is valuations. Valuations tell us
nothing about the direction a
market is headed in the short term
(under three years) but they do act
as a reliable guide over the longer
term. This is why Stanford Brown
publishes 10 year asset class
forecast returns rather than 1 year
forecasts. We have no idea about
the latter, but can be far more
confident in predicting the former.
So what do valuations tell us about
future returns?
Despite the very strong rally of
the past five years, the US stock
market is trading just above fair
value when compared to its 25
year average. The study below
by JPMorgan compares current
equity valuations to their historical
averages on a range of measures
including Price to Earnings
(PE ratio), the Schiller PE (this
compares prices to an average of
the past 10 years earnings), the
Dividend Yield, the Price to Book
and the Price to Cash Flow ratios.
On nearly all metrics the US equity
market trades in line with its long
term average (see Chart #4).
However. And there is one major
however. All this is fine provided
the current level of corporate
earnings are sustainable. The
chart below shows the dramatic
recovery in corporate profitability
since the depths of the GFC
in 2009; earnings have now
exceeded their 2007 peak and the
operating margin of the S&P 500
sits at all-time highs. Those (like
us) who believe that profit margins
mean revert over time fear for
the sustainability of these stellar
profits and margins (see Chart #5). Chart #4
Chart #5
Despite still trading well below its
2007 peak, the Australian equity
market trades at similar valuations
to the US; the forward Price
Chart #6
Quarterly Commentary Q3 | Page 17
Portfolio comments – continued
Earnings ratio of the ASX 200 is
a touch under 15x – certainly no
bargain (see Chart #6).
So why do we remain more
optimistic on the outlook for
Australian equities? There are
a number of critical differences
between the US and Australia
– all in our favour as domestic
investors.
Chart #7
Firstly, the anaemic recovery in
Australian corporate profitability
is in direct contrast with the US.
Profit margins here are about
average and profitability is below
its long term trend. This leaves
plenty of scope for positive
earnings surprises.
Since the GFC, companies have
reduced gearing and hunkered
down. We are optimistic about
the long term growth outlook
of corporate Australia, mainly
because we know that corporate
earnings mean revert over the long
term. Merely growing at trend will
produce double digit returns for
shareholders.
Chart #8
Chart #9
Page 18 | Quarterly Commentary Q3
Second, is the benefits of franking
credits and high dividend payout
ratios. Total dividend yields are
approximately 5.5% in Australia
compared with about 2% in the
US. This contrasts very favourably
with the ever dwindling yields
available on bank term deposits
and online savings accounts.
Historically, your money has
earned twice as much in the bank
as in shares (see Chart #7). These
are unusual times indeed.
Third, is the bullish effect of
de-equitisation. This refers to the
fact that the Australian equity
market is actually shrinking in
size at a time of huge demand
from superannuation funds. The
market is declining in size due
to companies buying back their
shares and delisting from the
stock market. The Credit Suisse
research shown below indicates
this process of de-equitisation will
be significant (see Chart #8).
And finally, there is almost no
euphoria about stocks in Australia
(in direct contrast to the US).
Perhaps too many horror stories
related to margin loans have
entered the public consciousness.
The graph from ANZ Economics
(Chart #9) quite clearly shows that
this equity bull market, in contrast
to the last one of 2002-2007,
has been characterized by a total
absence of leveraged buying (blue
line). Where are our animal spirits?
All of this makes us nervous of
the US but far more comfortable
with Australia, and in fact with just
about every other international
stock market. Our 10 year annual
return forecasts are shown in
Table #1 at top right.
With the exception of the US and
India, stock markets across the
rest of the world are expected to
show strong returns for investors.
We have one source of concern
though. We believe that a
consequence of the world’s
central banks eagerness to rush
to the aid of stock investors every
time the market has wobbled,
has inculcated a sense of
complacency and even invincibility.
Investing in the stock market is
increasingly being regarded as a
Table #1
Chart #10
one-way bet. This has caused all
financial assets to become much
less volatile. The cost of protecting
your portfolio from a dramatic
downwards move in the market
has plummeted to rock bottom
levels (see Chart #10 above). It might not seem like it at the
time but volatility is a good thing.
It is the reason that holders of
equities have returned so much
more than investors in ‘safe’
assets like bonds and term
deposits. Don’t fear volatility;
fear its absence.
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