Investment market update - September 2012

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September 2012

UniSuper's Chief Investment Officer, John Pearce, provides a market update for UniSuper members.

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Returns are for periods to 31 August 2012 and are after fund taxes and investment expenses, but gross of account based fees. They are soft crediting rates. Final crediting rates will be available later in the month and may be different. Past performance is not an indication of future performance.

The solid start to the financial year has continued in August on the basis that no news equals good news, particularly with respect to Europe. The Balanced option returned approximately 1.8%* for August, which brings financial year to date returns to approximately 3.2%*. The standout performer over the past two months has been the Australian Equity Income option which has returned approximately 8.3%*, reflecting the ongoing popularity of high yielding stocks such as the Australian banks, Telstra, Woolworths, and the like.


* These returns are for the accumulation options and are after fund taxes and investment expenses, but gross of account based fees. They are soft crediting rates. Final crediting rates will be available later in the month and may be different. Visit our Options and performance page for performance information on all investment options.

September has kicked off to a nervous start, although not due to the typical European woes. The main source of concern is now a raft of Chinese statistics indicating that the slowdown in the Chinese economy could be greater than previously forecast. A slowdown in China has detrimental implications for Australia, and the sharp fall in iron ore prices is the most obvious impact to date. Iron ore prices peaked at around USD $190 per tonne in February 2011, and now trade at USD $90 per tonne. The marginal cost of production for many Chinese producers is about $120 per tonne, so the fall to current levels has taken many analysts by surprise.

It is clear that a number of State-owned Chinese iron ore miners and steel producers have maintained production, despite the losses incurred. This irrational behaviour has resulted in a global glut of iron ore and steel. With inventories at historically high levels and demand slowing, further price weakness could be expected in the short term. A number of commentators have been quick to announce the “end of the boom”, and whether one agrees or not, it’s clear that the fall in commodity prices is having a dramatic impact. For example, we have seen:

  • Steep declines in the share price of many resource companies, particularly non-diversified companies such as Fortescue (which has seen its share price halve in the past few months).

  • Many resource projects put on hold, the most significant being BHP’s Olympic Dam expansion in South Australia.

  • Warnings from the treasurer Wayne Swan that the fall in commodity prices will impact the budget. While we can expect the politicians to sugar-coat the message, the reality is there is no way the fiscal position of the Australian Government is returning to surplus any time soon.

Historically, a fall in commodity prices would be cushioned by a commensurate fall in in the Australian dollar. However, things seem to be different this time around, and the following attempts to shed some light on the reasons why. 

The Australian Dollar: the world’s newest safe haven?

Ten years ago one Australian dollar (AUD) bought approximately 55 US cents. Historically, the AUD had the reputation as a ‘commodity currency’ prone to bouts of sharp declines in the wake of falling commodity prices. However, if we leave aside the short period during the financial crisis when investors rushed to the safety of US dollars, the last decade has witnessed a relentless rise in the AUD. This of course has been driven by China’s emergence as a world economic power, and her voracious appetite for commodities. 

Recently, the seemingly stable relationship between commodity prices and the AUD has been broken and the accompanying graph (A) illustrates the point.

The break in the nexus between the currency and our terms of trade has been met with a growing school of thought that the currency is overvalued, creating major problems for our exporters, particularly those without pricing power. Various factors have contributed to the strength of the currency, with the chief ones discussed below.

graphA

High domestic interest rates

The accompanying graph (B) shows the large difference in official rates between Australia compared to those of Europe and the USA. With limited room to move on fiscal policy the central banks of the USA and Europe have shouldered the responsibility for stimulating growth via loose monetary policy.

Through various means, including lower official cash rates and quantitative easing (which is effectively printing money), they have kept the price of money extremely low and the supply of money extremely high. Consequently, their respective currencies have come under selling pressure.

While central banks will typically argue they want to maintain strong and stable currencies, their actions have undoubtedly lead to weak and volatile currencies. By contrast, the RBA has been much slower to reduce rates based on a view that Australia’s economy is in better shape.

GraphB

Australia’s AAA status

Australia is now just one of seven developed nations with a government credit rating of AAA and stable outlook from the three major rating agencies. Incredibly, if we look at the ratings in aggregate, Australia now has a stronger rating than countries like Japan, the USA, and even Germany!
 
Even Paul Keating must be suitably impressed that Australia has managed to transform itself from a ‘banana republic’ (to use his infamous expression) to a safe haven status in a few decades. 
 
Of course, in a volatile world, a safe haven attracts capital and that’s exactly what we’ve seen. There has been a significant increase in funds allocated to Australian bonds among central banks, sovereign wealth funds, and even large multi national corporations such as Apple and Google. According to a recent survey conducted by RBS, 80% of central banks are seeking to increase their allocations to AUD holdings. Global reserve holdings are now so immense that a 1% additional allocation of foreign reserves into AUDs translates into 8% of Australia’s GDP.

GraphC

UniSuper’s currency hedging framework

A high AUD hurts our export industry as it reduces its competitiveness. For Australian investors, a rising AUD also hurts because it diminishes the value of offshore investments in AUD terms. For example, since 2000 the US stock market has returned about 25% in USD terms. However, for an unhedged Australian investor the rise in the AUD would have more than wiped out these gains. One school of thought is that, in an efficient market, currency movements and equity prices should adjust so that returns are eventually brought into line. However, when currency markets are being driven by ‘non-financial’ participants such as central banks, equilibrium could take a very long time indeed.

GraphD

UniSuper takes the view (unlike some other investors) that currency is not an asset class, but rather a risk to be managed. Our currency hedging framework prescribes different minimum hedge ratios for different asset classes. While the full detail is beyond the scope of this paper, the key tenets of the framework are:

  1. For asset classes in which the price volatility of the asset is far less than currency volatility, the hedge ratio will be as close to 100% as practicable. For example, our global fixed interest portfolio will be close to fully hedged at all times. 

  2. For assets which exhibit price volatility commensurate with currency volatility (such as global listed equities) a dynamic hedge ratio is employed. The ratio will be influenced by a number of factors, chief of which will be the level at which the currency is trading relative to its historical average. For example, if the AUD fell to historical lows of around USD 55 cents, the framework would dictate a hedge ratio of close to 100%. Given the AUD is currently trading at levels that are high by historical standards, the hedge ratio is well below 50%. Of course, there is no scientifically correct answer, so the actual ratio is subject to management discretion.

Past performance is not an indicator of future performance. This information is of a general nature only and may include 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 7 September 2012.