Interact
Member access
Follow
Browse
SuperInvestor TV
ยป Global Investment Outlook
Date published: 12/06/2011
Global Investment Outlook – June 2011
For the last two years, global investment markets have been supported by a massive flood of liquidity. This has been driven by the US Federal Reserve under its “Quantitative Easing (QE)” programs ($2+ trillion of long-term bond purchases and counting), and emulated by central banks around the world. This liquidity injection has kept real interest rates below the rate of inflation and maintained a flow of funds into growth assets.
The real economy however, as measured by GDP, has not yet responded in kind to this massive flow of funds.
The best estimates for US GDP growth are between 2-3% for the coming year. This growth forecast could be jeopardized if business and consumer confidence levels do not continue to improve, however there are encouraging signs that business investment and employment levels are starting to turn around.
Taking you back to those mind numbing days of “Economics 101”, GDP is driven by Consumer spending, plus Government spending plus, Investment spending, plus net eXports (i.e. GDP = C + G + I +(nX).
While net exports have responded to the falling US dollar (US goods are now relatively cheap for overseas purchasers), Consumer spending (70% of US GDP) and Investment spending (10% of US GDP) still seem to be languishing as consumers and businesses (including the banks) hoard cash to reduce their loans and “batten down the hatches” in the midst of an uncertain economy. The relatively high US unemployment rate (around 8-9%) is also an anchor on a consumer spending turnaround. As for the US Government, they are on a path to reduced spending in the wake of persistent fiscal deficits and rising Government debt levels.
In short, a return to strong global economic growth will only come as confidence is fully restored, the business sector starts investing and hiring, and the US consumer start spending and investing.
Why such a focus on the US, given we live in Australia?
In very simple terms, the sheer size of the US economy drives most of the global demand for goods and services, which fuels exports from Europe & Asia, which in turn fuels predominantly commodity and other exports from Australia. Now while Australia has its own internal economic demand, much of our wealth of late has been created on the back of the commodity boom causing income levels and GDP to rise.
Table 1 - Country GDP Rankings
Investor sentiment – a bearish view
With the real economy taking some time to show sustainable signs of growth, and the US Federal Reserve’s second Quantitative Easing program (QE II) coming to a close in June, there has been much short-term speculation and concern that investment markets will take a turn for the worst unless a third QE program is announced.
Adding to the currently “bearish” view, the US hit its $14 Trillion congress-mandated debt ceiling on May 17. This has fuelled concerns that if congress does not agree to an increase of the debt ceiling level, the US Government may default on its payment commitments. This issue needs to be sorted out in the US Congress by August 2nd (likely resulting in an agreed increase to the debt ceiling in exchange for agreed spending cut measures by the US Government) and has contributed to the current market and currency volatility.
And finally, concerns over the economies and debt funding ability of Ireland, Greece, and Portugal (plus some concern over Italy and Spain) are also weighing on the minds of investors.
The Australian share market – investor reaction
Despite Australia’s relatively strong employment levels, bank stability, and reasonably strong housing sector, our market as represented by the All Ordinaries Index, has pulled back from April highs reaching the 4,970 level, to 4,600 – 4,700.
Other short term issues have been the negative economic impacts of the Queensland floods, and some softening in export demand due to the tsunami disaster in Japan.
It would also not be unreasonable to speculate that a large part of the market reaction has been driven by sales of commodity and risk-based assets by global hedge fund managers who often operate on leverage (large amounts of borrowed money – at low rates from the US& amp; Japan) and who pull the sales trigger at the first sign of trouble or take advantage of market manipulation.
As long term investors …
… making prudent investment decisions in the midst of negative investor sentiment can be hard, but often far more profitable than adding to your portfolio in the midst of optimism and selling when times seem bad. To cut through the noise of pessimism, we need to focus on the fundamental factors that will impact the performance of our investments (capital value and income generation) over the long term.
The bond market is stable, despite the level of US debt
There have been a number of reports suggesting that if the Fed stops its QE program, there will be no-one left to purchase the remaining bonds over concern about the US meeting its future interest payments. To put the US debt level in perspective, Japan which has been supported by the bond market with an uncertain economy over the last decade, has a debt to GDP ratio of 200%, whereas the US is at 100% debt to GDP.
In actual fact, market (non Us Fed purchased) demand for long term US bonds has been rising over the last year. This is in part recognition of a slow down in global growth (flight to the safety of bonds), but is also a signal of confidence in the ability of the US to meet its future debt obligations. This step-up in demand also provides confidence that the bond market is deep enough to absorb the closing of the US Fed’s QE II program (where the Fed effectively purchases excess bond submissions). In other words, the market is now displaying enough confidence to step-in as the Fed steps-out.
So it seems US debt levels are viewed as moderate-to-high rather than terminal. The US also has the advantage of being the world’s largest economy and reserve currency.
Make no mistake about it, the US must address the trend of its rising debt levels and take measures to meet its fiscal obligations over the coming decade (especially its long term social security, and medicare/medicade obligations), however the bond market will continue to support the US as long as it can meet its interest payments.
Shares, property and commodities; an inflation hedge, with a gold hedge on the falling US dollar
While we don’t think it is likely the US will default on its debt obligations, we do see a slow economic recovery process with continued downward pressure on the US dollar.
Negative inflation adjusted bond rates and a low US currency looks like the key strategy to push the US into a sustainable growth pattern and this will continue to expand the global money supply. Therefore, in the long-term, inflation-hedged investments will be important. That means investing in stocks, property and commodities.
Australia should remain a preferred investment destination as long as the Australian Government supports an attractive investment environment (some risk here with the current Government keen on introducing mining taxes, carbon taxes, flood levies, and more stringent foreign investment rules).
We also continue to believe that maintaining exposure to precious metals is prudent to protect our client’s portfolios from further US dollar devaluation and global economic uncertainty (e.g. European Debt Crisis).
High quality, large cap stocks are relatively cheap – here, and in the US
The balance sheets and operating performance of the leading companies in Australia and the US are strong. In the US, the relative pricing (e.g. the P/E ratios) of companies such as Microsoft, Cisco, Pfizer, J&J have never been cheaper. High-quality large-cap stocks that pay a relatively stable dividend north of 4% to 5%, in politically stable and innovative countries like the US will always attract investment funds; especially when alternative investment options like bonds yield returns less than inflation.
While some will say, owning that asset class for the last 10 years has been a very painful experience, today, the attractiveness of this sector is simple – earnings have grown strongly over the last 10 years, while price to earnings ratios have declined dramatically.
The relative asset prices in the US, along with our strong AUD to USD dollar purchasing strength theme, is why we introduced exposure to US based listed investments into the portfolio last year. The idea is to accumulate US assets (and other US denominated assets) while they are cheap and our dollar (AUD) is strong, with the view of gaining the dual upside of asset appreciation and more favourable investment income currency conversion with a rise in the USD against the AUD in years to come.
We note that it may take some time before the USD makes a comeback (years, not months) so we view US based investments as a long term investment play. [We are currently putting together a platform to enable clients to gain more direct exposure to US and other overseas assets.]
Global energy and resources demand
The ongoing global demand for energy is undeniable due to global population growth statistics and the urbanisation of major population groups in developing economies such as China and India. Developing economies as a group are estimated to grow at an average rate of 6.5% in 2011.
Australia’s strategic position to high-energy-demand growth countries bodes well for our local and overseas energy investments.
Most economic research houses are also of the view that demand for infrastructure and base commodities will continue to at least 2020, however will be subject to much more volatility given the ebbs and flows of inventory levels, constructions booms and busts, and government monetary policy (e.g. expansion and contraction of the money supply).
This is why we prefer an exposure to diversified-commodity focused companies over a single-commodity focus. Other companies to benefit from long-term resources demand will be companies providing engineering, infrastructure, maintenance and mining related services that support the mining industry.
The Eurozone will sort out it’s issues
Europe is not expected to be a major drag on global growth. The sovereign debt issues are mainly related to the smaller European countries and are being supported by the European Central Bank. The most important economies of France, Germany, and the UK seem to be staging reasonable recoveries.
We expect a drawn out muddle through scenario in Europe over the coming couple of years, while the combined economies of the US and developing nations (a combined 70% of GDP) should help drag the Eurozone forward.
Australian Residential Property
On the residential property front, there is reasonable justification for the view that we are likely to see a pullback in housing prices (this is already occurring in a number of suburbs) or a stagnation in prices for the short term due to:
- The comparative pace of “housing price” growth to the growth in “household income levels” and “interest rates” over the last few years;
- Changes to foreign investment rules, and a strong AUD, dampening some foreign investor support; and
- The winding up of the First Home Owner’s Boost.
Also in support of this view, recent bank results and government statistics are showing signs of stress in missed loan payments (these appear to be concentrated among first home buyers ) and in the number of small business insolvencies. This is combined with a historically low reported number of home loan approvals in March, and lower than expected employment growth figures in May. Already there has been a noticeable trend towards delinquencies on home loans.
We doubt the Reserve Bank will raise rates any time soon, especially in light of the short term economic headwinds from the recent QLD flood and Japanese tsunami disasters. In fact we would not rule out a rate cut if lending and employment figures do not show continuing signs of improvement from here. We also notice the banks at the moment are offering fixed interest rate specials, perhaps in an attempt to lock in rates as a hedge against future rate cuts.
Longer term however, a growing Australian economy means growing household income levels, and continued net migration will likely lead to tightening rental markets (shortage of dwelling supply) providing a back-drop for sustained long-term housing price growth.
There are various reports from noted global investors and economic research houses that the Australian housing market is significantly over-valued. While the market has become heated at times, and it is always prudent to be wary of comparable asset value (i.e. there is a price for everything), we believe these commentators often miss some fundamental diffferences between our housing market and other markets overseas – especially the US market.
The key difference between the Australian housing market and the US housing market is that we have:
- Strong prudential regulation with a focus on loan-serviceability;
- An on-balance-sheet approach to credit creation, as opposed to the ‘we originate the loan and then package and sell the loan to investors’ approach in the US (handball the risk approach); and
- Low loan delinquency levels that are the envy of the world (largely as a result of the first two points, and also because of our prudent credit rating system – we can’t just walk away from a mortgage we can’t pay).
The risk to housing price growth in the medium term will be a rapid escalation in interest rates by the RBA to fight off inflationary pressures, a rise in unemployment levels, and/or a sustained fall in net migration. None of these scenarios are likely in our view.
Time to add to our portfolios
The market has been trading in a tight band between the All Ord’s Index levels of 4,500 and 5,000 for the last two years.
Chart 1 - All Ords Index
With the recent pullback in the share market, and signs now that there is buying support at current pricing levels, we believe it is an opportune time to add to our quality portfolio of recommended share investments.
We also believe that the residential property market will present pockets of good buying opportunities over the coming 12 months.
For more information, or to discuss your specific situation, please contact me directly.
Robert Palma
Eden Wealth Management and Eden Tax Accounting
Now that you have read this, what do you think? Do you have other ideas? Please share you views with other members (eg by blog or discussion form) and/or request professional member(s) to contact you directly.
