Which investments were the winners over the past 10 Years?
Russell Investments recently released the 2013 version of their Long-term Investing Report. Click here if you are interested in reading it. It highlights two key themes over the past 10 and 20 years up to the end of 2012. They are:
- Falling bond yields in Australia and globally
- Strong economic growth in Australia, driven by the resources sector.
No surprises there, though some other interesting conclusions include:
- Australian shares outperformed overseas shares in most years, but not in 2012
- Both pre-tax and after-tax, Australian shares outperformed Australian residential property by over 2% p.a. over the decade, though shares are more volatile.
- The AUD doubled in value over the 10 years
- The impact of tax continues to be lower for Australian shares, due to dividend imputation, and for Australian residential property due to the tax deductibility of expenses, including interest, as compared with other investments, including Cash and Term Deposits. Returns on defensive assets are primarily taxed as income without any concessions.
- Lower taxation means that investment returns are higher for most investors on an after-tax basis if owned via Super rather than personally.
- The 0.5% increase in the Medicare level from 1 July 2013 to help fund the disability care scheme and the prospect of higher personal tax rates in coming years will make it more attractive to invest via Super rather than directly.
Which investments were the winners over the past Year?
Numerous markets were buoyed by momentum and massive Central Bank stimulus, which has enticed investors out of low risk assets. The 2012/13 financial year was overwhelmingly positive for global equities with strong gains in Japan (51.9%), Germany (24.0%) and the US (17.9%). The Chinese market was the odd one out with the Shanghai Composite Index down 11.1% over the year.
Extremely low global interest rates encouraged investors into high yielding investments such as high yielding equities (in Australia, Telstra and the big 4 banks), driving up their prices. At the same time, the outlook for China moderated which put downward pressure on resources and particularly small resources companies leveraged to the commodity cycle. This resulted in very wide divergences in sector returns. Over the year, the ASX 100 Accumulation index increased 24.5% compared to a decline of 5.3% for the Small Ordinaries Accumulation index. Health care & Telecoms were both up around 40% but large-cap resources (BHP, RIO, etc) finished the year down 3.3% and small-cap resources declined 47.8%.
Reasons to be positive
The global economy is improving, perhaps faster than many acknowledge, and the most accommodative monetary policies in history have gained some traction, most notably in the world’s largest economy, the US. The US stock market is at an all time high and housing prices have increased significantly in the past year. Even the Japanese economy seems to be improving on the back of a much weaker yen. While there has been some slowing in China, it is worth noting that a 1% increase in the growth rate in America and Japan makes up for a lot of slowing in China. The emerging Asian economies, including Indonesia, should continue on their remarkable rise as will those in Africa and Latin America.
So what are the risks?
The biggest risk to the world economy and investors everywhere, including Australia, is that the US recovery gains too much momentum leading to large and rapid increases in interest rates as the market anticipates and reacts to a rapid exit from so called quantitative easing the US Fed. Quantitative easing is the Fed buying US government and mortgage-backed bonds and other securities. US treasuries, which have fallen dramatically over the past 20 years, could be expected to rise sharply if the Fed starts selling rather than buying. An increase in the 10 Year US Treasury bond from the current 2.6% to around 5% over the next year or two would not surprise but a larger increase would be disruptive. Large rises in US rates would lead to significant increases in interest rates worldwide and potentially some large falls in equities and some currencies, possibly including the AUD.
A large and unexpected slowdown in China or a credit crisis would also be bad for most investors, including in Australia, though there is no sign of that more extreme outcome happening at present.
Should we be concerned about China?
For much of the past five years China has been doing the heavy lifting in the global economy and now the burden is being shared more equally.
In China, we have seen further confirmation that the economy has slowed to around 7% growth. The new administration appears to have decided they must reduce credit growth, which has grown very rapidly over the past 5 years However, it appears that they will look to ensure that a 7% level of growth is defended.
Is Europe on the road to recovery?
European recovery is far from assured in my view despite the calm at present. The European banking system remains weak and further deleveraging is inevitable, but the ECB, under the skilful guidance of Mario Draghi, appears to have successfully taken the dissolution of the euro scenario off the table. Unfortunately there remain many problems, as recently outlined by commentator Jonathan Pain.
First, joblessness continues to spread. The overall unemployment rate (12%) has yet to peak, led by an alarming lack of jobs among the young (24% joblessness in the euro zone as a whole, with highs of 59% and 56% in Greece and Spain, respectively).
Second, adjustment fatigue is widespread and becoming more acute. Long-struggling European citizens – especially the long-term unemployed – have yet to gain any sustained benefit from the austerity measures to which they have been subjected. And the result is not just general disappointment and worrisome social unrest. In the last few weeks, political stability in Greece and Portugal has been threatened as governments struggle with declining credibility and a rising popular backlash.
Third, bailout fatigue is apparent. Citizens in the stronger European economies, like Germany, are increasingly unwilling to provide financial support to their struggling neighbours. Their elected representatives will find it hard to ignore growing resentment of repeated diversion of national tax revenues, which has yielded only disappointing outcomes. Meanwhile, high levels of past exposure and weakening creditor coordination are undermining the availability of external funding for the weaker countries.
Finally, little credit is available to the private sector. While Europe has succeeded in stabilizing its sovereign-bond markets, at least for now, financial intermediation for small and medium-size enterprises remains highly disrupted. With most credit pipelines already partly blocked, the shortage of corporate credit will become more severe as regulators finally force banks to increase capital and shrink balance sheets to less risky levels.
All of this adds up to a sad reality for Europe. Despite hopeful blips in an economic indicator here and there, too many countries lack both immediate growth and longer-term growth engines. Reforms are regularly resisted. As a result, debt overhangs will remain problematic. Personally I expect that some of the debts of Greece and others will have to be effectively written off in the next few years. I will also be surprised if the Euro doesn’t weaken further at some point.
Is the US really recovering?
Despite the on-going political stalemate that seems to have become the norm in the US, there is little doubt that the US economy is recovering. Corporate profits are generally strong, the equity market is at an all-time high (unlike Australia’s stock market) and house prices have risen quite significantly over the past year. The boom in shale gas has given some impetus to manufacturing, in particular.
While debt and deficits remain an issue, who can remember the dreaded fiscal cliff deadline?
What should Australian investors be doing?
We always argue that a diversified portfolio is best for most investors because no-one truly knows which assets will perform best over the next year. Who was predicting a year ago that unhedged international equities would return 30-40%? To see how much returns from different types of assets vary from year to year see the attached table which covers the last 20 years.
However, there are a few things that I think are clear:
- Staying in Cash and Term Deposits is safe but guarantees low returns, particularly after tax and inflation are taken into account. Cash and Term Deposit rates are likely to remain low with few banks offering even 4% except for long term maturities.
- Now is not a good time for investors to lock into long term bonds or Term Deposits as rates must go back towards more “normal” rates at some point. For borrowers, locking in to long borrowings at today’s rates, such as some companies are doing, probably carries limited risk.
- Australian and global shares aren’t cheap on any traditional valuation basis so it’s unlikely we will see the big rises we saw in 2012-13 in the coming 12 months, though as markets aren’t always rational it can’t be completely ruled out.
- The low interest rates available to borrowers are likely to encourage strong demand for residential housing, particularly by investors in the sub $1 million category. Low supply growth, low borrowing costs and low returns on most alternative investments are enticing investors despite the fact that Australian housing is very expensive, relative to incomes, in any global comparison.
- There is more likelihood of the AUD falling from its current value of US 93 cents than it rising back to parity or above, particularly as the US recovers and given the Australian RBA has indicated a preference for a lower AUD. In this environment unhedged offshore investments are likely to outperform their currency hedged equivalents.
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.