9 August 2011

Last night’s developments…

The downward movement in Asian share prices that investors witnessed yesterday spread to European and North American markets overnight. Initially market sentiment in the northern hemisphere was better than expected, as the European Central Bank continued its buying of stressed Spanish and Italian bonds. However, the market mood dampened when German Chancellor Merkel stated that the EFSF rescue package, which is too small to bail out either Italy or Spain, would not be expanded. This sentiment was reinforced after Standard and Poor’s stated that US debt could be further downgraded in the next 6 to 24 months and lowered its senior issuer ratings for Fannie Mae and Freddie Mac.

With the stresses in European government balance sheets well known and with the recent US downgrade, these price declines in northern hemisphere markets was expected (see Chart). The great irony is that since the announced US debt downgrade, both the US dollar and US bond prices have risen against most of their international peers. That is, investors are so concerned about US ability to fund its debt, that its bonds have been one of the few asset classes (along with gold) to rise in recent days.

Chart 1: Northern Hemisphere markets have led the declines since end-July 2011

Some people are calling for a double-dip

Concerns are rife at the moment that the world is not only heading into a double-dip recession, but a double dip GFC. At this stage, sentiment seems to be more hysteria than anything else. Although markets are experiencing their worst decline since the 2008/09 GFC, the economic conditions are not supportive of GFC round two. Sure the S&P/ASX All Ordinaries Index is down 20% from its April 2011 high, but the global economy is not weak like it was in 2008. At that time there were many factors at play including a decline in global nominal GDP for the first time since WW2, the real economy had declined for four straight quarters, the US ISM manufacturing survey was reading between 35 and 40, around 5 million Americans had lost their jobs, Chinese economic growth was at a decade-low of 6% and global and Australian corporate earnings were in free-fall. None of these factors are at play today. GDP while subdued is not declining, US manufacturing is still expanding and is around 51, US employment is still growing, global industrial production is expanding and Chinese growth as still around 10%. Most importantly, the US profit reporting season was very good and Australian earnings are continuing to grow.

The global financial crisis was an event centred on fears that the global banking sector had become insolvent due to bad loans and a freeze in funding markets. Some banks did indeed fail, but most were saved and this time around, US banks will not become insolvent in response a US debt downgrade. Some European banks are more exposed to trends in Europe, but Deusche Bank, for example, has sold over 90% of its Italian bond holdings over the past six months and other banks have also undoubtedly been reducing this risk too. That doesn't mean that all the work is done and we just have to wait for the hysteria to end. Much work by global authorities needs to be done.

The US Congress needs to agree to find more Budget savings to prevent an escalation of markets expecting further downgrades. The European authorities need to increase the size of the EFSF rescue package to stabilise fears that Europe is on the verge of a calamitous financial event. The ECB also needs to accelerate its bond repurchase program for struggling economies and those governments need to make more spending cuts in the medium to long-term (so as to stabilise their government debt situation, but not at the expense of a near-term recession). The RBA needs to confirm that, despite rising inflation, they have moved to a neutral policy stance (at least) and are prepared to cut rates, if things deteriorate further. The Australian Government needs to announce that if things deteriorate further they will not be making big spending cuts to bring the Budget into surplus in 2012/13.

Announcements like these will go some way to stabilise market sentiment and would demonstrate that the authorities are considering the problem and are taking steps to get ahead of it, instead of just reacting to it. This should prevent a dangerous negative feedback loop from developing, where a weakening economic outlook, declining asset prices and escalating government stress all intensify and become self-fulfilling.

What does it mean for our portfolios?

Equities:

• Perpetual never loses focus on investing in sound companies, with quality businesses, a strong balance sheet and a history of recurring earnings. Quality companies like these have consistently outperformed during periods of market stress.
  • Perpetual constantly looks for value in the market and buying opportunities, often present during markets like these.
• Investors using a Perpetual managed fund should take comfort in a robust risk managed investment process, designed for both up and down markets.
  • Perpetual has a history of outperforming in down markets.

Credit Funds:

• The fixed income exposures we manage for clients are largely invested in Australia. We predominantly lend to Australian Governments, good quality Australian companies and Australian home-owners.
  • Australian borrowers have generally had lower cumulative default rates than its global peers - having exposure to Australian dollar denominated assets mean much lower volatility in the cash we can distribute and, most importantly, it is a market that we know very well.
  • We invest primarily in short dated securities that provide better certainty on the return of capital and have no exposure to US sovereign debt and little exposure to sub-investment grade debt.
• We remain highly cautious in managing our clients' funds.
  • Our credit funds currently have a credit score of -1 as part of our credit outlook. The score of -1 largely reflects high oil prices and weak equity markets, and manufacturing and credit growth and more credit rating upgrades to downgrades prevent us from a more bearish outlook.
  • Australian credit spreads have remained firm against the backdrop of global volatility highlighting the continuing value of high grade credit as a diversifier to equities and an attractive source of returns.
•  There will be a fair degree of volatility associated with current conditions and the quality of underlying assets will be important for preserving capital. The ability to take advantage of emerging value opportunities through active management is very useful also.
  • There is still good value in Australian asset backed securities and local banks, and the running yield on our flagship Perpetual Diversified Income Fund is still about 2% above the cash rate. Given the modest weighted average life (the average length of the lending in the portfolio), there is a reasonable degree of visibility to this outcome over the medium term.

Disclaimer

This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for financial advisers only. It is general information only and is not intended to provide you with financial advice. The views expressed are the opinion of the author at the time of writing and do not constitute a recommendation to act. Any information referenced is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital.  Past performance is not indicative of future performance.  for financial advisers only. It is general information only and is not intended to provide you with financial advice. The views expressed are the opinion of the author at the time of writing and do not constitute a recommendation to act. Any information referenced is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital.  Past performance is not indicative of future performance.