December 2011, Newsletter

November market update

 
John Pearce - UniSuper Chief Investment Officer
 

Dear Member,

I am providing this update with the uneasy feeling that by the time you read it most of it will seem out of date, such is the volatile state of financial markets.

After experiencing a healthy rally in October, the markets were relatively benign for the early weeks in November, only to be in the grips of a perfect storm later in the month. In the spate of one week we had:

• A blowout in the bond yields of various European countries, the most concerning being that of Italy’s – a country that is simply “too big to bail”  
• Another stalemate between Republicans and Democrats regarding the composition of spending cuts / tax increases in the US, and
• Some worrying data out of China suggesting that the economic slowdown may be a bit harder than the market is wishing for; in particular a lead manufacturing index of 48 (a reading under 50 denotes a contraction in manufacturing).

Of least concern is the stalemate between Republicans and Democrats, which appears to be another bout of political posturing, with both parties having one eye on solving problems and the other on the presidential elections. In relation to China, all vital signs such as credit growth, retail consumption, fixed asset investment, etc points to a (desired) soft landing. Which brings us back to Europe where the problems are large, and the crisis is current.

Providing a detailed analysis of the European situation is beyond the scope of this update; in any case there is no shortage of information on the subject. By way of summary, the root of the problem is the large fiscal deficits in the so-called “GIIPS” countries (a much more politically correct acronym than “PIGS”). Of course, these problems can only be solved over the long term with the right mix of micro and macro policies, including very unpopular austerity measures. However, the crisis is now as a number of the debtor countries need to re-finance their existing debt. As the market sells the bonds of the debtor countries, the higher interest costs add further pressure to their fiscal positions, and expectations of default inevitably rise. The contagion spreads to the banking system and lending between banks starts to freeze (as per the GFC). The fear in debt markets quickly spreads to equity markets and hence the sell off witnessed in November. The current turmoil is therefore not a new “sovereign debt” crisis, it’s actually a continuation of the original GFC, manifesting in a slightly different way. While countries, rather than banks, are getting most of the bad publicity, the reality is that it’s all linked to the same problem. 

A solution essentially involves the stronger countries such as Germany and France providing enough liquidity for the debtor countries to refinance their debt. This of course doesn’t resolve the long-term problem, but it does buy some time in which their fiscal positions can be improved. It is my view that a solution will be found simply because the cost of not finding one would be a disastrous; it won’t be recession, it will be depression. In other words, the German and French will have to rescue the situation, as much to save themselves as the rest of Europe.  

Unfortunately, Europe has overshadowed some positive surprises from the US, or maybe we should say less negative surprises. After six months of growing at less than 1%, the US is expanding at around a 2-3% pace in the second half of 2011. The main contributor to US GDP in the September quarter was personal spending, notwithstanding that the US consumer is dealing with 9.5% unemployment, and a persistent housing crisis that has led to 25% of homeowners with negative equity in their house. The positive surprise in US October retail sales, despite depressed levels of consumer confidence and sluggish wage growth, is evidence that the US consumer is intact.

The resilient consumer has also been partly responsible for the strong revenue growth of S&P 500 companies (see chart below). A continuation of this trend should help sustain elevated profit margins.

Apart from showing the bounce in sales and nominal GDP, what strikes me about the chart is how “normal” the recovery in sales has been post the recession. Some of our members would be aware of a thesis postulated by the Mohamed El-Erian (CEO of PIMCO) that the world has fundamentally changed, the recovery from the great recession will be long and painful, and persistent volatility represents the “new normal”. Given recent market behaviour, his thesis seems to be gaining traction among a broad audience. However, the chart suggests that the recovery in sales is following a very similar post-recession pattern to that which we have seen over the past few decades. There is something distinctly “old normal” about it.

Bank Deposits V Bank Shares (and the friendly wager)

As is always the case during times of extreme market stress, since the GFC, we have seen the rise in popularity of income type products such as bank term deposits (“TDs”). Note that for the purposes of this discussion, we can consider TDs as equivalent to cash. Given the strength of Australian banks, our relatively high interest rates, and the poor performance of stock markets, many investors have done quite well by simply rolling their TDs. However, past performance is not necessarily a guide to future performance so the question is whether a bank TD is still a good investment compared to equities. In addressing this question, I would like to add a bit of colour by letting you in on a friendly wager I had last year with John Goodwin, who is a Senior Financial Planner in our Sydney office.   

Over a couple of Christmas drinks (December 2010), John and I debated the merits of investing in Commonwealth Bank (CBA) TDs, or their shares. John is always thinking of the interests of his clients, many of whom are retirees, and therefore quite rightly places enormous value on “peace of mind”. He was therefore strongly in favour of TDs. This is a very important point because if the volatility of shares causes one to lose sleep then the investment decision should be quite straightforward – stay in cash; a good sleep is more important than a few extra dollars. However, a few restless nights are part and parcel of being an investment professional, so I favoured CBA shares, based on what the numbers were (and still are) telling me.   

Of course, the debate ended in a friendly wager and we agreed that the investment time frame would be three years, so there are another two years to run. I will let the reader be the judge as to who will win, but this is how things currently stand:  

3 Month TD rates
1 Jan 2011	5.60%
1 April	5.80%
1 July	6.00%
1 Oct	5.50%
2011 Return	5.70%

On January 1 the CBA share price was $50.77 and at time of writing was $47.00, a disappointing drop of 7.4%. However, during the year, two dividends totalling $3.20 were received, which equates to an income yield of 6.30%. Furthermore, the dividends were fully franked so the total yield (for a retiree on a zero tax rate) is 9.01%. Therefore, total return on the CBA shares if the shares were sold at current market prices would be 1.61%, which does not compare favourably with the TD return of 5.70%. It seems that John is well in front on the wager at this stage. However, before he counts his winnings he needs to keep in mind:

1. The investment period is for three years so the capital loss is a “paper loss” at this stage, and yet to be realized. If the fundamentals of a company are still intact, then share price volatility should only concern day traders – not long term investors. Anyone who doesn’t need the cash doesn’t need to realise the loss.
2. If current market expectations prove to be accurate, TD rates will be falling, and the fall could be large. The market expects the cash rate to be around 3% in 12 months’ time, which implies that the TD rate could possibly be around 3.5%!
3. At $47 the current yield (including franking) of CBA shares is about 10% which should provide support for the share price, particularly given the low rates on offer in the bond market. In fact, if Australia avoids a recession, there is every reason to expect that the CBA could increase its dividends as it has a long track record of doing so. Over the last 20 years, the CBA has only reduced its dividend on one occasion, and that was by 14% in 2008. This was followed by a 27% increase in 2009.

On the other hand, it is possible for Australia to experience a recession, and it is possible for CBA to cut dividends, in which case the share price is likely to fall further. However, on the balance of probabilities, I am taking comfort from the fact that the current dividend yield provides enough of a buffer to favour the shares over the TDs. In fact I’m hoping to double the wager.

Of course, John will also point out that during the year, the CBA share price fell to as low as $42.93. While this may not equate to a realised capital loss, it equates to lost sleep, and you can’t put a value on that. On that point we agree. 

This information is of a general nature only and includes general advice. It has been prepared without taking into account your individual objectives, financial situation or needs. UniSuper’s investment strategies will not necessarily be appropriate for other investors.  Before making any decision in relation to your UniSuper membership, you should consider your personal circumstances, the relevant product disclosure statement for your membership category and whether to consult a licensed financial adviser. This information is current as at 2 December 2011 and is based on our understanding of legislation at that date. Information is subject to change. Issued by UniSuper Management Pty Ltd on behalf of UniSuper Limited, the trustee of UniSuper.