This article appeared in the January 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
JON REILLY considers the outlook for Europe, the US, China and Australia in 2013. His view: local shares should still be a significant part of portfolios, but understand the risks of higher-yielding investments that rallied last year.
By Jon Reilly, Implemented Portfolios
We can look back on a strong close to 2012 for most investment markets, particularly shares, although we must acknowledge that the imbalances that led to the GFC remain with us.
We often hear that markets don't like uncertainty, but must acknowledge that investors have shown a much greater capacity to absorb uncertainty in recent times.
There are a number of things we can have a reasonably high level of confidence about, including that interest rates here and in other developed economies are likely to remain at historically low levels.
Also, inflation continues to be benign despite the dire predictions of those who objected to the wide range of liquidity measures (monetary policy) implemented by central banks. In the United States, particularly, we know directly from the Federal Reserve that the extraordinary low interest rates will continue in 2014 and probably beyond.
Low yields on defensive investments have pushed investors into seeking a higher return in riskier asset classes. In this environment it is more important than ever to understand the valuation process, to determine if future returns are likely to compensate for the risk being assumed.
The arithmetic on a government bond is straightforward. Currently the 10-year Commonwealth Government Bond in Australia is paying a little more than 3 per cent, which is up from the low of July 2012 set at 2.68 per cent. If you hold the bond to maturity and there is no default, you know that your annual return will be a little more than 3 per cent. This is much lower than current bank term deposit rates, which come with a government guarantee for investments of up to $250,000.
This also assumes that you hold the individual bond to maturity, but what is more likely is that you own these investments in a managed fund that targets a particular duration for its bond portfolio. Even in passive investment structures such as index funds and exchange-traded funds, there is buying and selling of bonds to provide a relatively steady maturity. What makes bonds even less appealing in the current environment is the prospect of capital losses being triggered on selling should interest rates rise from these historically low levels.
The first criteria when constructing the defensive side of your portfolio should be to ensure the investments you select will provide defensive characteristics when required to do so. Investors who have bank term deposit maturities coming up, having previously secured much higher rates, need to determine what represents an acceptable return in a structurally lower interest rate environment. In these circumstances and in general, investors should be especially careful not to discount the risks attached to higher-yielding investments.
With an appropriate defensive foundation to their portfolio, investors can start to consider investments that promise higher returns but carry higher risk. Below we briefly consider each of the major economic regions and highlight some of the issues that will probably have an impact on their shares markets.
Undeniable progress was made in 2012 by the Europeans towards resolution of the problems of dealing with deeply indebted members of the EU. In a speech in London before the Olympics, European Central Bank president Mario Draghi said it was prepared to do whatever it took to preserve the common currency, and tellingly said: "Believe me, it will be enough." More recently the Greeks satisfied the conditions for the next stage of their bailout and are now in a position where most of their debt is held in the official sector. As a result of concessions on the interest rates and repayment schedules, Greece now has a manageable ratio of interest payments to GDP.
The point is not that the outlook for 2013 and beyond looks bright for the Greeks or indeed for most of Europe, but rather that they are continuing to deal with their problems. More importantly, the prospect of a disorderly breakup of the euro now looks unlikely. On this basis, and looking over the long term, the forecast starts to look more attractive, though this will require a genuine long-term investment and the ability to withstand periods of significant volatility. A patient and incremental approach to building exposure is likely to provide the best outcomes in this instance.
After the US election, attention quickly turned to attempts to reach a compromise that would avert the so-called fiscal cliff. The term refers to the automatic spending cuts and reversion to higher tax rates that would come into effect at the start of 2013, as a direct result of the failure of a 2011 bipartisan committee to agree on a package of, you guessed it, spending cuts and tax reforms.
As mentioned, the US has very low interest rates, currently just 1.6 per cent on 10-year bonds, which means it has time to address the problems, though not unlimited time. There are undoubtedly some encouraging signs in the US economy: the housing market looks to have bottomed, alleviating what was a significant headwind, and the unemployment rate continues to trend lower. However, the prospects for a long-term sustainable recovery will depend on legislators in Washington being able to enact the required reforms to address long-term imbalances.
At this point there is little evidence to suggest that is a likely outcome, particularly as the next round of the debate about raising the US debt ceiling gets under way in the early months of 2013. What is clear is that the current trajectory of the US economy is not sustainable over the long term, and that spending will have to be lower and taxes higher, both of which will slow the economy from already sub-trend growth rates.
Given this outlook, and corporate profits that are already at their highest level compared to GDP since the 1940s, the future long-term returns from US equities may be underwhelming.
The Chinese recently had a leadership transition, but this once-in-a-decade transfer was completed smoothly and the new leadership team is expected to persist with the objectives of the current Five-Year Plan. The focus will continue to be on not just the level of growth, but very much on the quality of growth. For the first time, a clear objective has been set to double per-capita income between 2010 and 2020 for both urban and rural residents.
Over much of the past decade, income growth lagged broader economic growth, especially given the huge investment-driven stimulus program enacted in response to the GFC. In annual terms, doubling over 10 years implies a growth rate of 7 per cent per annum, a level already exceeded in 2011 and 2012, so this should be a realistic target for the world's second-largest economy. In recent years there has been reason for some confidence that the Chinese will be able to achieve their desired outcomes of rebalancing the economy towards domestic consumption, while reducing reliance on fixed asset investment and export markets.
The new leadership of Xi Jinping and Li Keqiang is expected to provide a steady hand on the Chinese economy, leading to very solid, if not spectacular, growth over the next decade. We should not forget that the Chinese retain considerable capacity to address problems such as non-performing loans along this growth path, and that from current low prices, long-term returns continue to look attractive.
The fundamentals of Australia's economy remain largely supportive. The Reserve Bank has now cut official interest rates by 1.75 per cent in the current easing cycle that began in late 2011, and mortgagees, who are mainly borrowing at variable rates, see most of that assistance relatively quickly. Our labour market remains robust, with the most recent data showing the unemployment rate had fallen to 5.2 per cent, and annual GDP growth came in at 3.1 per cent for the year ending September 2012.
However, we too are not without our imbalances and in particular we have a transition to the next phase of the mining boom to navigate in the next couple of years. On the latest figures there are committed investments totalling $268 billion in the resources and energy sector, much of which is directed towards the LNG sector. Elsewhere in the economy, Australian households have been paying down debt and increasing their savings rate for the past few years, and the banks have decreased their reliance on offshore funding.
The banking regulator, APRA, recently provided some detail on the latest stress-testing it undertook on the major banks. The stress scenario included a sharp 5 per cent contraction in GDP, the unemployment rate rising to 12 per cent, home prices falling 35 per cent and commercial property prices falling by 40 per cent, along with global credit markets being unavailable for six months. APRA emphasised that this was in no way considered a likely outcome, but nevertheless concluded that none of the major banks would require a public bailout or breach minimum capital requirements.
We do, of course, have our own version of federal and state political dysfunction, but are fortunate at this stage not to have the magnitude of problems that politicians in Europe and the United States need to contend with. Returns from Australian shares, including the benefits of dividend imputation, should mean this asset class has a significant allocation in your portfolio.
About the author
Jon Reilly is Chief Investment Officer of Implemented Portfolios, a leading portfolio construction and investment management company.
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