Published on 21/10/2009

It is hard to believe that only 12 months ago the world was literally on the cusp of what literally could have been the second Great Depression.

Overview - Australian economy

It is hard to believe that only 12 months ago the world was literally on the cusp of what literally could have been the second Great Depression. In recent months, business and consumer confidence has improved beyond measure, the sharemarket has roared back to life and a ‘business as usual’ mentality has returned. In this update we thought it might be appropriate to remove ourselves from the emotion and consider whether the economic fundamentals have really improved as dramatically as markets would suggest.

A cursory look at the economic data would indeed suggest that the fundamentals seem much improved. Firstly, the rebound in business and consumer confidence is nothing short of extraordinary. Remember, these tend to be leading indicators of future growth. The Business Confidence Index is at the highest level since 2003 (after the end of the Iraq war) while the consumer confidence reading is the highest since July 2007 (pre-financial crisis).

In addition, building approvals have improved markedly and private new capital expenditure, an indicator that businesses remain confident about future orders, was stronger than expected, (up by 3.3% in the June quarter).

In addition, job advertisements have finally begun to rise which should stem the rise in unemployment and personal credit has also shown signs of improvement.

Nevertheless there are still some indicators that remain lucklustre. Business credit remains weak, as do car sales. Both indicators though are likely to improve in coming months should sentiment continue to remain robust.

Key Risks

The data suggests, unequivocally, that the Australian economy is in a recovery phase. While clearly this is good news, it must be said that a number of dangerous imbalances exist both internationally (which we will discuss later) and domestically. In our view the key imbalance on the domestic front remains the asset price bubble that continues to buoy the Australian housing market.

While the financial crisis taught the corporate sector harsh lessons about financial responsibility - forcing it to deleverage due to the inability to access credit - the same cannot be necessarily said for the over-indebted household sector. The rapid easing of monetary policy coupled with the various fiscal stimulus measures most probably prevented a collapse in housing prices that otherwise appeared imminent. Moreover, not only did the measures prevent a collapse but the ill conceived¹ first home buyer’s grants have actually worked to reignite parts of the residential property market. The core asset price problem has not been resolved, merely deferred.

On any measure, Australian housing prices are among the most expensive in the world. This continues to present a very high future risk to the over-indebted homeowner. Housing prices have already fallen sharply in the United States and parts of Europe. Should unemployment and interest rates rise sharply in future years (as may be likely at the onset of the next recession, whenever that may be) a similar fall in Australian property prices appears likely. The catastrophic outcomes of such an event are already well known. A percentage² of unemployed homeowners would be forced to default on their mortgages. Houses would be sold at values that would not cover the outstanding loan. Banks would incur huge losses and some inevitably would fail. As property values fall, consumption would too as equity diminishes. Corporate profits would follow and growth would grind to a halt. Remember, this is not some nightmare scenario, it is exactly what has happened already in the US and parts of Europe.

Conclusion

With business and consumer confidence improving, the prospects for positive growth in the short term for the Australian economy remain promising. While corporate balance sheets are much improved as a result of the deleveraging reprocess, the housing price bubble remains a significant concern for, not only the over-indebted homeowner, but the broader economy. Until this bubble deflates we recommend individuals exercise caution when borrowing against equity in their homes to fund future consumption.

¹ In our view the policy was ill conceived because it increased demand for housing, which placed more upward pressure on prices. Increasing the supply of dwellings (e.g. building affordable housing) would have been a much better use of funds as it would at least go some way to addressing the demand/supply imbalance and, at the same time, create additional jobs for builders and tradesmen.
² Refer to graph of non performing home loans. The American experience shows that you don’t need to have a large percentage of impaired loans to cause untold damage on the financial system.

Overview - International economy

The extraordinary stimulus provided by governments and central banks around the world have finally gained some traction and have helped stabilise the global economy. Nowhere is this more evident than on credit markets where spreads now show some semblance of normality.

While growth in China continues to exceed expectations, courtesy of measures that have induced strong domestic demand, there are also some signs of growth emerging in the United States but these remain tentative for now and it must be said the situation remains extremely fragile.

From a macro sense, the erosion of household wealth brought about by the potent mix of falling house prices, falling stocks prices and rising unemployment was always going to lead to a decline in consumer spending (in the United States, consumer spending accounts for around 70% of GDP and so the importance of this sector cannot be understated). To address this problem, Governments set about adding liquidity and reducing interest rates to encourage lending, together with unprecedented levels of government spending.

With industrial production and business confidence beginning to improve in the United States, you could be forgiven for thinking that the worst is over. Yet the reality is that the situation remains extremely fragile. Most of the improvement has been stimulus driven. The health care sector has benefitted from the Government’s plan to extend health care to the masses. The auto sector has benefited from the ‘Cash for Clunkers’ program, the financial sector has benefitted from the low interest rates and Government contractors have benefited from the infrastructure programs. All of these policies have been positive for the US economy and in the short term we may see further growth as inventory de-stocking is reversed. But ultimately these effects are all stimulus driven and are unsustainable.

The reality is that the fundamental cause of the current crisis needs to be fixed before a sustainable growth path can be assured. Make no mistake that this repair process is happening but it was never going to be fixed overnight. The banking sector has started the deleveraging process but this is not yet complete and systemic risks remain while equity levels remain low. Outside the financial sector, the corporate sector is in reasonably good shape but the consumer is little advanced and so they must continue with the deleveraging process before they can start to spend again in a sustainable fashion. Without equity in the family home, low interest rates, designed to entice the consumer into spending once more, may have little effect. Meanwhile, unemployment continues to trend higher and, at the same time, Government debt has soared.

So, while the consumer is undertaking the painful and prolonged process of deleveraging to restore their own balance sheets, the irony is that the government has tried to fix the problem by borrowing even more money. This of course, has created a new, and highly dangerous, imbalance in the economy. Budget deficits must be funded in some way shape or form. If policymakers try to rein in the deficit by reducing spending and increasing taxes then they risk undermining any recovery. On the other hand, if policymakers continue to maintain large deficits and provide liquidity then the prospect of higher inflation and (hence) higher interest rates may also counteract growth. In addition, there is now little room to manoeuvre should another shockwave hit the economy broadside. Where is the money going to come from next time to fund future stimulus measures?

All of this may sound overly bearish. In the short term we actually remain confident that a recovery is emerging in the global economy - but we expect growth to remain very weak indeed. In the medium term our concern focuses on how Central Banks and Governments are going to extricate the liquidity in the system without causing another recession. Therein lies an enormous challenge to policymakers.

Overview - Australian equities

Over the quarter ending 30 September 2009, the ASX 200 Accumulation Index rose by 21.50%.

The Australian sharemarket rallied strongly over the quarter. Gains were relatively broadbased. Financials benefited as fears of further bad debts in the banking sector were allayed by a strengthening economy. Cyclical also benefitted as investors appetite for risk increased on the prospect of a recovery.

Valuation Update

With our fair value indicator for the ASX 200 as at 30 June 2011 sitting around 5,000 points, the market has now factored in all the expected earnings growth for 2009/10 and around 70% of the expected growth during the 2011 financial year. The market is forward looking so this is not abnormal but given the inherent volatility in earnings forecasts, the market has perhaps run marginally ahead of where it rationally should be.

Outlook

With the sharemarket already pricing in a moderate economic recovery, we would have to argue that the rapid gains made in the last 6 months are unlikely to continue. Indeed the prospect of a minor correction in the sharemarket looms large should the recovery not unfold as expected. Encouragingly, the balance sheet repair process is well advanced (but not complete) in corporate Australia which means that the underlying fundamentals of the average company are in much better shape than at the height of the market in 2007. This improvement should provide the framework for a sustainable recovery.

Nevertheless, we remain concerned about the potential impact that the imbalances mentioned in our economic commentary may have on the sharemarket. While the corporate sector is much improved, the consumer remains vulnerable to a severe downturn in the housing market should the housing bubble burst. In the near term, we view this risk as low but, unless it slowly deflates over time, remains a potent risk nonetheless. Internationally we do not believe the strong gains on numerous offshore sharemarkets are justified given the much weaker economic fundamentals abroad. The risk of a correction on these sharemarkets would inevitably impact upon our own sharemarket. For these reasons we believe it is prudent to exercise some caution in the near term, at least until signs of a sustainable economic recovery in the US and Europe become indisputable.

Overview - International equities

The MSCI World (ex Australia) Index rose by 7.18% over the quarter.

Outlook

Global sharemarkets have rallied by over 50% since their lows in early March as tentative signs of an economic recovery began to emerge. In the United States, 73% of the S&P 500 companies that reported earnings in the June quarter exceeded analyst expectations. This does not justify the rally - earnings for the S&P 500 were still down 27% on the prior year. As the market is now factoring in growth more typical of a mid cycle recovery phase, we would have to suggest that global markets are overvalued. We say this on the proviso that markets are forward looking and should the global economic recovery gather more strength, it may be entirely justified in time. In the meantime we would argue that the economic headwinds (including weak consumer spending, a housing market that is still not showing any real signs of recovery, high unemployment and an enormous Government debt) remain uncomfortably strong.

Conclusion

We remain wary of the recent recovery on global sharemarkets given that economic fundamentals remain both weak and uncertain. As a result, we recommend an underweight exposure to international equities over the next quarter.

Overview - Australian real estate investment trusts (listed property)

The Australian Real Estate Investment Trust (A-REIT) sector rose by 30.45% over the quarter ending 30 September 2009.

Strong gains were experienced over the quarter on renewed investor confidence, partly buoyed by the improvement in economic conditions and partly by the reopening of debt markets in the sector (Westfield completed a US$2 billion debt issue in August ; ING Industrial refinanced a $1.63billion facility with a banking syndicate; and Macquarie Countrywide issued $265million of commercial mortgage backed securities). The reopening of debt markets obviates the need to raise capital by dilutive capital raisings at discounts to market value and so marks a critical turning point for the sector.

Fundamentally, the large amount of capital raisings to reduce debt over the last 18-24 months has dramatically improved balance sheets in many instances. Further, the move back to basis where property trusts generate passive rental income has also helped to reduce the risks attached to operating income. Nevertheless there is still a number of trusts with look-through gearing levels that remain relatively high. These trusts may need to raise more capital and/or sell assets before we reconsider those as potential investments. While further falls in asset prices in overseas markets cannot be ruled out, we believe that asset prices in the Australian market may start to stabilise as the economic situation improves.

Conclusion

We believe selective value remains in the A-REIT sector as some trusts that have deleveraged sufficiently remain at attractive discounts to their purported net asset value. As commercial property prices stabilize, the potential for further gains in the sector are likely.

Overview - fixed interest and cash

Fixed interest returned 1.76% over the quarter ending 30 September while cash returned 0.80%.

Despite more hawkish comments by the Reserve Bank of Australia (RBA), which would suggest that the cash rate is more likely to increase at some stage in the next six months, bonds rose over the quarter outperforming cash.

Outlook

Longer dated bond yields have risen sharply since the start of the year on the expectation that the stimulus measures will ultimately prove inflationary. This may well prove to be the case but, at the present time, inflation remains well contained. The inflation rate for the year ending 30 June of 1.50% remains well within the RBA target range of 2-3%p.a. Nevertheless consumer price index data is backward looking and so the RBA, when assessing the appropriateness of the current cash rate, needs to consider inflationary expectations. Clearly if the RBA is considering changing its neutral bias to one of tightening then it believes inflationary expectations are rising. This is a valid estimation should aggregate demand continue to improve as expected. The global recovery, however, remains somewhat more fragile than domestic conditions suggest. This may temper inflationary expectations until this uncertainty begins to dissipate.

Conclusion

We recommend a marginal overweight exposure to cash and marginal underweight exposure to fixed interest.