An update from Perpetual - 23 September 2011

Recent developments – economic data has dissapointed and announced policy measures have failed to inspire confidence.

• Since the last update in mid-September, global economic prospects have deteriorated in response to the same themes that have been around now for a while - stress in the European financial system and fears of an advanced economy recession. However, these themes now appear to be spreading and sapping market confidence at a time when investors are questioning if the world’s two largest economies (the US and Europe) have any significant policy ammunition left.

Table 1: Sharemarket performance (%)

• Asian and Asia-related markets (including Australia and Canada) have continued to outperform during the volatility, whereas the stress centres have underperformed, with Italy and France recording the two largest declines over the past week (see Table 1).
• Given the growing stresses, this remains a confidence game more than anything else and there has to date been significant policy coordination failures across Europe, where they are still struggling to agree on what the problem is and therefore what can be done to address deteriorating sentiment. What is clear is that the French banks missed the opportunity to strengthen their balance sheets in 2010, when market prices were considerably higher than now.
• The US Federal Reserve announced a plan to flatten the yield curve yesterday morning by selling short-dated US Government bonds and using the funds to buy long-dated US Government bonds. The Fed hopes this will enable US households to refinance their mortgage onto cheaper interest rates and stimulate spending. This approach has been dubbed ‘Operation Twist’ by market participants. However, the market remains unconvinced this will work, as the US and European problem is not the price of money, but rather the weak economic growth emanating from household deleveraging, which has, or will be joined by forced government deleveraging.
• On a bright note, Greece does appear to have done enough to qualify for its next tranche of bailout funds. However, the market’s focus has broadened to now include the larger European economies and investors are using any negative news as a trigger to sell down risk assets. There is now renewed attention on Italy (which is the third biggest economy in the Eurozone and the third biggest bond market in the world (after the US and Japan)) as its funding costs have increased recently (given the rise in bond yields) and it was officially downgraded one notch to ‘A’ by Standard and Poor’s. Moodys will be reviewing their decision on Italy over the next month.
• The direct impact of the northern hemisphere debt situations on Australian exports should be minimal as the US and Europe represent only 8% of our total exports, whereas around two thirds of exports are directed to developing Asian economies, which are forecast to grow at 8% in 2012 by the International Monetary Fund.
• It is too early to judge how Australia will be impacted by the unfolding events offshore. Fortunately, the RBA (and most of our Asian trading partners) has plenty of policy ammunition left and can rapidly unleash this support, as required. Two consecutive monthly increases in the unemployment rate, a downward statistical revision to estimates of underlying inflation and the global situation all have markets expecting the RBA to cut rates (by a total of 1.5%) with the expectation that this process will begin soon.
• However, the RBA has hinted that this view is overly optimistic and the RBA’s September Board meeting minutes, along with recent comments by Deputy Governor Battellino and Assistant Governor Lowe, provide cause for a pause for the time being. Indeed the RBA will most likely not waste its policy ammunition until there is a very large trigger point, such as rapidly rising financial system stress in Europe. In these situations it is the direction and size of the rate cut that is key for investor confidence, not the level of the interest rate itself, and the impact of any previous rate cut would be totally lost after such an event begins.
• From an investment perspective, these global developments highlight the importance of balance sheets and not investing in a company without understanding its finances. That is probably the easiest and by far the best form of risk management. In every downturn, the companies with the weakest balance sheets fall the farthest.
• At the same time, we continue to search for stocks which generate good surplus cashflow and provide investors with good yields and potential income growth and which are attractively valued.
• These themes will be discussed in depth in the September edition of Perpetual Perspective, which will be dispatched next week.

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IMPORTANT NOTE: This document has been prepared by Perpetual Investment Management Limited ABN 18 000 866 535, an Australian Financial Services Licensee, Licence Number 234426, a subsidiary of Perpetual Limited. It is general information only and is not intended to provide you with financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.