The Federal Election – what does it mean for the markets?

 

The Liberal- National Party coalition had a clear win in Saturday’s Federal election in the House of Representatives, though the picture in the Senate is much more murky. While some hope that the new Government will result in a share market rally before Christmas, my view is that the result was well anticipated and will have limited impact. More important will be global developments, such as growth in China and the US, developments in Europe, the Middle East, etc.

 

Increased Superannuation contribution cap – for some

 

The legislation that increases the concessional contribution cap in 2013-14 for persons age 60 and above (age 59 as at 1 July 2013) was passed before the election. This helps those with the ability to utilise the increased cap. The increase to $35,000 will apply to persons age 50 and above (age 49 as at 1 July 2014) next financial year.

 

What is happening in the Australian housing market?

 

Most Australians are interested in what’s happening in the residential property market because they either own or aspire to own property, be it a place to live in or an investment property. Recent statistics and anecdotal reports indicate that property prices have been rising in most markets, particularly in Sydney, driven by limited supply and low interest rates. This is not that surprising with Term Deposit rates now mostly below 4% and with residential mortgages available below 5%.

 

MLC have just published a report which may be of interest:  What’s the outlook for Australia’s housing market?

 

I continue to suggest that diversification in your asset portfolio is important to reduce risk so before  deciding to buy more residential property I think it’s worth noting the view of the report’s author that  ‘Australian investors should carefully consider the extent to which residential housing dominates their wealth.’ As the expression goes, don’t put all your eggs in one basket. And if you do decide to buy residential property, ensure you have done your research first. Don’t be seduced by property salesmen masquerading as financial advisers.

 

Term Deposit Rates are still falling – what to do?

 

Until recently many investors have been content to place a significant proportion of their investments in bank Term Deposits as they were paying rates well above inflation and offered very high security. However, as interest rates in Australia have come down significantly the attraction of Term Deposits has reduced as it is increasing difficult to get even 4% which is only modestly above inflation, particularly after tax is taken into account.

 

It is not sensible to chase yield by taking too much risk, particularly in products you may not fully understand. The lure of higher rates is how many investors were lured into Westpoint, Estate Mortgage, Australian Capital Reserve, Fincorp, Banksia Securities, etc, all of which failed and lead to large losses for investors. Last year The Australian reported that “more than one-third of all companies in the nation’s high-risk $8 billion debenture market have collapsed since the Australian Securities & Investments Commission launched a crackdown on the sector in the lead-up to the global financial crisis”. While I certainly would not put the various hybrid and subordinated issues by the banks in the same category, many professional investors don’t believe retail investors are being fairly compensated for the additional risk in these recent issues. As regulator ASIC has said:

  • § “Hybrid securities are complex products. Even experienced investors will struggle to understand the risks in trading them. If you don’t fully understand how they work you should not invest”. ASIC’s SmartMoney website
  • § “We think retail investors too often see the household name and they see something as secure and reliable without looking at the underlying product and the risks associated with it”. ASIC Commissioner Peter Kell
  • § “Investors need to understand the conditions of these offers, such as the terms and conditions that allow the issuer to exit the deal or suspend interest payments, and long term maturity dates of several decades. We want to ensure consumers are fully informed before they invest”. ASIC Chairman Greg Medcraft

 

Security of capital is a paramount concern for many investors, particularly retirees, so it is better to accept we are currently in a world of lower returns and it can be dangerous to chase higher returns if the risk is either unknown or out of line with your financial circumstances and your ability and willingness to take risk.  It is worthwhile checking between the banks to get the best deposit rates available, but if you are considering moving into higher risk debt securities or high yielding shares ensure you fully understand the additional risk you are taking.

 

Are high yielding shares the best approach for equity investors?

 

With Cash & Term Deposit rates at record low levels many investors have sought the alternative of high yielding shares, like the banks. Fund Manager Don Hamson from Plato has noted that “we have seen significant outperformance of many high yield stocks in the most recent bull market which commenced around the end of May 2012. However, we have also seen many low yielding stocks, like CSL and much of the Health Care sector, also perform very strongly. Overall, the whole market has rallied strongly since May 2012 reflecting lower interest rates, with the official RBA cash rates hitting all time lows. We believe much of the out performance of high yielding stocks like the banks and Telstra has been due to a correction from previously very cheap levels”.

 

My view is that continuing to simply chase high yielding stocks is likely to lead to under-performance and many of the better opportunities may lie with stocks with greater growth potential.  Over the past decade an investment in BHP gave a significantly higher return than an investment in Telstra, highlighting that it’s not as simple as identifying today’s high yielding stocks.

 

Emerging Markets: a repeat of the 1998 crisis starting?

 

July was the third consecutive month of negative performance for emerging markets, such as India, Indonesia, Turkey & Brazil. Meanwhile, the S&P 500 rose 4.95% (USD) to make new all-time highs. Fund manager GaveKal has commented that the sustained de-rating of many of the emerging markets means that, on any number of measures, the valuation gap between emerging market equities and the US is now approaching levels usually associated with a serious crisis. Behind this aggressive de-rating are a number of factors, including:

  • The fear that earnings (which have grown much more slowly than share prices over the past year) will disappoint on the back of the China slowdown and the yen devaluation.
  • The fact that, since the beginning of the year, economic data in emerging markets have tended to underwhelm, while those in developed markets (the US, Japan and the UK, for example) have positively surprised beaten-down expectations.
  • Political unrest in Turkey, Brazil, Egypt, and, of course, Syria.
  • An oil price that has remained stubbornly high, even as other commodities fell.

 

 

The optimistic view is that the recent sell-off in emerging markets stocks is an opportunity to increase exposure on the cheap. To put things in perspective, “since 1998, the MSCI Emerging Markets Index has had a total return of 200 percent (according to Index Universe). That’s 13 percent or so annually. In fact, had you reinvested your dividends over that period, you would be looking at a total return in excess of 300 percent”.

 

The pessimistic view is that, while emerging markets are rightly discounting a growth slowdown, developed markets are not, probably because of the excess liquidity created by central banks.  When the US Fed reduces its huge bond buying program and/or if growth in developed markets is unable to build on the recent momentum, then the valuation gap might close not through a re-rating of emerging market equities, but a de-rating of developed markets.

I lean to the optimistic side but recognise the potential danger that further deterioration in emerging markets would have for developed economies, particularly those like Australia which are reliant on capital inflows and exports to developing countries, in particular China. Ambrose Evans-Pritchard at the London Telegraph recently wrote that:

“This has the makings of a grave policy error: a repeat of the dramatic events in the autumn of 1998 at best; a full-blown debacle and a slide into a second leg of the Long Slump at worst. Emerging markets are now big enough to drag down the global economy. As Indonesia, India, Ukraine, Brazil, Turkey, Venezuela, South Africa, Russia, Thailand and Kazakhstan try to shore up their currencies, the effect is ricocheting back into the advanced world in higher borrowing costs. Back in 1998 the developed world was twice as big as the developing world. Today that ratio is about even. We all know what a crisis for the markets 1998 was.”

The appropriate course for most investors is caution – maintain the asset allocation that is appropriate for you – until it is clearer how events will unfold. Right now nothing looks outstandingly cheap so there’s no strong case to rush into Property, Term Deposits or Shares. My preference for share investors is to stick with high quality companies that should prosper in all market conditions.

This newsletter is not advice and provides information only. It does not take account of your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision. 

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