This commentary is a summary of key events since 30 June 2011, with a focus on those events and forecasts that may impact on AvSuper’s investment returns.
Special 10 August 2011 Investment Update
What a month August has been! No doubt you have seen the huge drops in the equities market recently. In this month’s investment update we provide you with a special edition with a bit more information than our usual investment updates. In the last two weeks the recent events in the markets have been sparked by a few major issues:
- Tensions within the U.S. Government over a deal to raise the “debt ceiling”, which may prevent a U.S. default, but the budget cuts and austerity commitments may come at a significant cost to economic growth. Things were exacerbated by the recent downgrading of the USA debt from AAA to AA+, by which Standard & Poors have insightfully highlighted the lack of a clear plan for dealing with the long term debt position, rather than the actual level of debt as it now stands; and
- A widening of the European sovereign debt concerns to include the large Italian and Spanish economies.
Markets in general
Equity markets sold off heavily over the period from 31 July to 8 August, with share prices now below mid-2010 levels. Ten-year bond yields have fallen substantially over recent weeks and by around 1% in Australia and the US since the end of December. Credit markets have sold off to some extent as well.
Last week, the RBA revised its forecast 2011 growth rate from 4.25% to 3.25% but also increased its growth forecast for 2012 from 4.25% to 4.50%. Other than mining, most sectors of the Australian economy are under pressure from lacklustre retail spending, higher wage costs and the impact of the high level of the AUD. Retail sales growth to 30 June was the lowest for 50 years while household savings rate is at its highest in 25 years at 11.5%. Commodity prices have been falling in response to lower global growth expectations and the ‘flight to safety’ effect. Australian Government bond yields have fallen dramatically as investors seek ‘safe havens’ given the US credit rating downgrade and European debt problems – 70% of Commonwealth bonds are now held by offshore investors. The AUD has fallen around 5.5% from last week’s peak of just under USD1.11.
The US reached agreement to raise the debt ceiling by US$2.4tn in return for spending cuts of the same magnitude. However, there was little agreement on a plan for addressing the longer term problem of US$115tn of unfunded long-term government liabilities. This was the main cause cited by Standard & Poor’s downgrading the US credit rate. Their June quarter GDP growth figure was lower than expected at 1.3% (annualised) and the March quarter GDP growth was 0.4% (annualised). This data, combined with a string of recent poor data releases, spooked markets that a ‘double dip’ recession could be on the cards. However, non-farm payroll data released on Friday was above expectations (but not at a rate high enough that, if sustained, would make a serious dent in the 9.1% unemployment rate).The ISM’s Manufacturing Index fell to its weakest level in two years and the Services Index fell to its lowest level since February 2010, but both remain above 50, implying growth above long-term trend levels. Standard & Poor’s lowered its US sovereign credit rating from AAA to AA+. While Moody’s and Fitch retainedr top rating for the US, Moody’s placed the US on ‘negative watch’.
Italian and Spanish 10-year Government bond yields rose above 6%. The European Central Bank (ECB) kept interest rates on hold and took two main decisions. First, it reactivated its Securities Market Programme, buying distressed Portuguese and Irish bonds on-market after an 18-week break. Second, it announced new liquidity measures for liquidity starved banks. However, markets were spooked by Jean Claude Trichet’s (head of ECB) admission that it was not a unanimous decision and that the ECB’s on-market bond purchases did not cover Italian and Spanish bonds.
Looking ahead and our assessment
The main risks in the global economy have not changed, and can be broadly summarised as follows:
- The slowdown in US growth worsens and the ‘soft patch’ becomes a recession
- European debt problems, and in particular Italy and Spain which are “too big to fail, too big to save” and have banks holding much of the balance sheets in their home government’s bonds. Other Eurozone country banks are also exposed to sovereign bond holdings in these countries as well as the bonds of Greece, Portugal and Ireland.
- There is less government/central bank firepower compared to the 2008 GFC – although arguably there is more capital in the global financial system, especially in the US.
- Outcomes are very much tied to political agreement/implementation, which is a major concern to markets given the divided US Government and the need to coordinate 17 countries in the Eurozone.
Is there any good news in all this? Yes, there are some potential positives in terms of the current position and valuations:
- Australian growth is linked to Asia/China which is both a positive and of course a risk. Australia also has a lot of scope to stimulate if necessary, with cash rates at 4.75% and a very low level of government debt (7.2% of GDP) and a fairly small budget deficit.
- Shares are cheap for those willing to buy, and the earnings from Australian shares are 13.5 times higher than historical earnings -and similar patterns are taking place in the US market at 13.2x historical earnings (20% below 50-year average).
- The northern hemisphere earnings season was solid to strong with 75% of S&P500 companies exceeding earnings expectations. The corporate sector appears to be in overall good health after several years of cost cutting.
- Compared to the 2008 GFC everything is already down – equity valuations, bond yields, housing prices (offshore), consumer confidence, etc – and so has less scope to fall.
Investors should continue to expect volatility in markets, as much uncertainty prevails in the world economy. However, we reinforce the longer-term approach taken toward the management of your money, and the Fund continues to be managed prudently against this context. We remain cognisant of short term risks, but also of longer term opportunities such a market presents to our members. We trust you find this information useful in understanding how your AvSuper investment is performing and welcome your feedback on how we can improve the information we provide to you.