Investment insights
Perpetual Investments houseviewThe 2007 – 2008 financial year was one of the most difficult for investors for decades. Global and Australian shares, listed property trusts and many fixed income investments suffered major declines. |
Performance by asset classAustralian equities |
What caused the correction?
The distinct change in investor sentiment, and the resulting sell off really began around the end of June 2007. A sharp decline in US house prices was matched by rising defaults on ‘sub-prime’ mortgages and the investment instruments backed by them. The impact on credit markets was severe, with yield spreads blowing out and credit flows drying up. The combination of a slowing US economy, surging oil prices, increasing inflation and cost of debt, proved a lethal combination for most investment markets. From a company perspective, the hardest hit during the sell off were the highly leveraged and the poorer quality businesses with hidden debt or opaque balance sheets.
How is Perpetual positioned?
Throughout the turmoil of the past year we have continued to stick to our investment principles – in stocks, focusing on quality businesses with sustainable earnings, strong balance sheets and resilience to tougher economic conditions; in fixed income, focusing on the real underlying risks for the return generated, liquidity and quality of security. We believe it is these quality principles that will continue to protect and reward our investors through the difficult period ahead, as the market increasingly focuses on business and economic fundamentals. We also believe that the current environment offers some very good long term investments at some of the best valuations seen in many years.
It is in times like these that astute investors and advisers can position their portfolios for sustainable long-term growth in value and income.
Australian equities
Year in review
Despite the strong Australian economy, the S&P/ASX Accumulation 300 Index declined 16% over 2007/08. The domestic market was initially impacted by the turmoil in global credit markets in August 2007 and when the situation stabilised, increased economic uncertainty and softening growth, combined with a 55% rise in oil prices in the second half of the year drove stocks lower. Accordingly, companies with high borrowings or high exposure to consumer spending were heavily sold, whereas companies in the energy sector performed well. Although investor sentiment is weak, in several cases stock prices have declined by significantly more than expected earnings.
Market outlook
There is no doubt that for the industrial market, there is considerable risk of earnings downgrades. The extensive falls in June show that the market has re-rated the valuation multiples of many industrial companies. Since the market decline started, most actual downgrades have occurred within the financials and property sectors but this most recent re-rating suggests that the market is anticipating further earnings downgrades across the industrial market. Investors will be focused on the level of downgrades leading up to the results announcements in August. The actual results and outlook comments from companies will have a significant influence on market sentiment in the near term. With interest rates set to stay high for the foreseeable future, investors will be hoping that inflationary pressures start to ease. If this does occur, it will provide some positive support for the market.
Portfolio positions
We continue to hold overweight positions in a several resource stocks in which we believe there is value. However we continue to avoid the more speculative part of the resources market and focus our attention on the larger more diversified businesses as well as a few other high quality coal and iron ore stocks, all of which are very strong cash generating businesses. In the industrials sector, we have been selectively adding to positions in the financials where valuations have been compelling. We are also seeing opportunities in the retail and consumer space where some very good quality names have been sold off aggressively.
The slowing economy and higher interest rates rightly signal pressure on earnings for these companies for the financial year 2009, but as longer term investors we are seeing some attractive entry points for companies with higher dividend yields and lower valuation measures than the overall market. In addition, our quality measures of high return on equity, low debt and high interest cover, highlights companies that are well placed to withstand economic and financial market stresses. Return to top
Global shares
Year in review
Global shares (as measured by the MSCI World (ex-Australia) Accumulation Index) declined 21% in 2007/08 in Australian dollar terms. Sharemarkets across the world were driven lower by the US credit market turmoil, higher oil prices, rising inflation and softening global growth, which weakened investor sentiment and prompted sharemarket declines across all regions.
Although many of these woes were centered in the US economy, its sharemarket (-13%) outperformed Europe (-23%) and Japan (-24%) as investors sought the perceived safety of US dollar assets and companies with proven business models. Risk-wary investors seem increasingly attracted to these ‘quality’ stocks and this is expected to continue over the medium term.
Market outlook
Oil prices, interest rates and inflation continue to dominate discussion on the global economic outlook. Commentators are very gloomy. Indeed, there are certain ominous parallels with the 1970s: a major foreign war on which the US is spending billions; a commodity price shock; and the import of stimulative US monetary policy to emerging economies by means of currency pegs to the US dollar. Food and utility price inflation threatens social stability in emerging economies, which in turn is encouraging their policy-makers to take a timid stance. Indonesia, the Philippines and India, for example, all have negative real interest rates. Rather than raising rates sharply, Asian countries might instead choose to end their currency links to the dollar altogether. The results for the US could include a currency crash and even higher domestic inflation.
The interest rate outlook changed during June. Following the release of meeting minutes and comments from Fed governors, the market got the message that the Fed's next move will be to raise rates, most likely beginning in the fourth quarter. The ECB also signalled that it will increase interest rates at its July meeting.
In such a risky environment, equity investors are looking to valuations for some comfort. Earlier in the year we warned that the market was operating on overly optimistic earnings expectations. These have certainly declined since and analysts now expect S&P500 earnings to drop 11% year-on-year in the second quarter. If that assumption is correct, it will be the first time that they have fallen in four successive quarters since the recession of the early ‘90s. For the financial sector, expectations now assume earnings will collapse, dividends will be cut, book values are wrong and published capital ratios misleading.
In spite of this, there is a lingering faith in a ‘V-shaped’ recovery, with forecasts generally expecting an early earnings rebound. Excluding the financial sector, analysts expect year-on-year growth in S&P500 earnings of about 14 % in each of the next two quarters. This still appears optimistic given the stagflationary threat. Belt-tightening by consumers and businesses means that companies will struggle to pass on higher raw materials costs, which can only serve to undermine margins.
Portfolio positions
We still believe the market has not properly reflected the divergent earnings prospects of different companies. We continue to focus on companies with stable and defensive earnings profiles and reasonable growth prospects. A strong balance sheet is a particularly valuable feature at a time when the corporate sector is being forced to de-leverage. The well-below average gearing in the portfolio should be of benefit as markets go through a very prolonged and painful period of adjustment. Return to top
Property
Year in review
Listed property markets around the world declined sharply in the wake of the US sub-prime housing crisis which increased the cost of debt and led to a sizable slowdown in the US economy. The S&P/ASX 300 Listed Property Trust Accumulation Index declined 38% over as initially high valuations were punctured by subsequently revised distributions. The sector was also characterised by several highly publicised cases of financial stress, such as Centro Properties Group and the Rubicon vehicles, which further weakened investor sentiment. However, several stocks appear to have been oversold and the sector is beginning to see increased corporate activity.
Market outlook
The environment for listed property markets has been challenging. Debt has been hard to find and is expensive. However, the fundamental characteristics of the Australian property market remain firm. We also note an increasing number of overseas investors attempting to acquire interests in direct property. In a precursor to further activity we note the recent moves by Lend Lease on the FKP Property group and Babcock and Brown Communities Group.
Portfolio positions
While a source of volatility, the uncertainty surrounding the current turmoil engulfing US credit markets may also create some investment opportunities for astute property managers.
The portfolio remains focused on quality trusts with high yields, good internal rates of return and distribution growth.
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Fixed income
Year in review
As has been the case globally, conditions in the domestic bond market were volatile in 2007-08, with yields rising in response to movements in global bonds and also expectations of more rate hikes by the Reserve Bank of Australia. Corporate bond yields relative to government bonds increased dramatically with consequent falls in the price of illiquid credit investments. This was in response to the US sub-prime market turmoil, the slowing global economy, rising inflation and the more fragile state of the global banking sector, which prompted investors to demand additional returns for risk. Short duration credit securities are attracting increased investor attention given their high running yield, particularly in higher rated securities.
Market outlook
We remain cautious about further volatility in the credit markets. The most pertinent risks at the moment are the possibility of more fundamental cracks appearing in the form of deteriorating corporate earnings and ongoing asset value writedowns. Banks, brokers and monoline insurers remain the potential source of weakness in the market as they diverge from the rest of the market. Cash bond spreads remain more stable, with commitments to a calendar of new issues poised to pick up should sentiment firm up.
As fear of systemic risk dissipates further there should be a return to fundamental themes driving asset values. We expect dispersion in credit quality between individual issuers to increase going forward creating more investment opportunities.
Portfolio positions
We strategically further reduced exposure to offshore banks and financials that we identified as lacking transparency or highly exposed to the US mortgage market, preferring the local banking sector which showed better relative value and stronger fundamentals. We maintained our disciplined strategy to only buy high quality, relatively short-dated paper with very attractive running yields. We continue to favour financials on valuation grounds, the ongoing equity re-capitalisation story and the prospect of regulatory support in the event it is required. The battle between cheap valuations and credit concerns will ensure volatility remains in the credit market albeit within a range over the coming weeks.
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Mortgages
Year in review
The credit crunch stemming from the US sub-prime loans issue has dramatically changed investor sentiment and the competitive landscape for commercial loans. Following years of cheap, easy debt, compressed credit spreads and wafer-thin risk premiums, the sentiment and competitive forces in the commercial lending market have undergone dramatic transformation.
Securitised debt instruments have suffered major falls in value, new debt issues have dried up, many non-bank lenders have withdrawn from the market, risk premiums have greatly increased and lending criteria has tightened.
In many ways the market has reverted to more rational behaviour that suits a traditional conservative lender such as Perpetual.
Market outlook
Due to the above changes we expect the commercial mortgage loan supply to be subdued for some time.
At the same time, overall demand for property loans has also receded, with global and Australian economic growth slowing, higher interest rates, and lower consumer and investor confidence, and the LPT sector licking its wounds.
However, we believe the ‘real’ property market fundamentals remain solid in terms of vacancies and the supply stream, and the previous irrational undercutting of risk premiums will not be returning any time soon.
Portfolio positions
Prior to the credit crunch we maintained our long-standing lending criteria and LVRs at 66.67%, which resulted in us holding high levels of cash in our funds. We have maintained our low default and arrears levels and are well positioned to selectively lend with confidence, while maintaining rigorous loan security.
This means we can look forward to rewarding our investors with regular income based on attractive risk premiums and reflecting the higher interest rate environment. Return to top
