January Market Commentary

January Market Commentary

Monthly Economic & Investment Market Commentary

January 2013

Given the equity market rally and the more buoyant mood that is apparent in 2013 in investment markets generally, it is interesting to see how quickly those that seek to provide interpretations of the very short term change their commentary. In reality, many of the pundits that make regular appearances in the financial media seem to reach the same conclusion no matter the underlying circumstances. There are pundits that are known to be unfailingly optimistic, just as there are those that can be relied upon to foretell the next crisis which is always just around the corner. There is a saying that if you are going to make a forecast you should predict either the level or the timeframe, but never both.

The process of producing financial media is far removed from the responsibilities we have to be a safe steward of your investment portfolio, and we of course share with you regularly our forecasts for the returns of the major asset classes. When we do so it is always over the long term forecast period we use, which affords much higher confidence than trying to predict market moves over shorter periods.

In simple terms our assessment for each asset class comes down to what income investors will receive, how quickly profit will grow and how much people will be prepared to pay to share in those future profits. If we use shares as an example, what is the current dividend (including tax credits), at what rate will companies be able to grow their earnings, and what valuation (P/E ratio) will investors apply. As you would expect these long term estimates are generally quite stable from month to month, however what does change in shorter periods is the price. To illustrate this we use the Asset Class Valuations table which is provided at the end of each of these monthly commentaries.

The rise in both Australian and International Equities, particularly Developed Markets, means our forecast returns are lower than they were a month ago despite the underlying earnings assumptions remaining steady. What is important is to assess the relative forecasts between asset classes and also to compare each individual forecast return to the return on a risk free investment like term deposits.

When annual returns are forecast to be at least 5% better than the risk free return, an asset class is in the Cheap valuation range, and in contrast when we expect average annual returns to be less than risk free returns the asset class has become Overpriced. This spectrum extends both higher and lower, as well as encompassing the Fair Value and Fully Priced ranges.


As we usually do in the monthly commentary we will consider the major economic regions of the world in this discussion, but this month will focus on the policies and actions of the central banks and the outlook for official interest rates. Some have suggested that the real sign that we have returned to a more normal economy will be when central bankers have returned to their former anonymity. If that really is the measure then we have some way to go.


A stark example we have of such support was the emergency interest rate cuts following the onset of the Global Financial Crisis. Here we show official interest rates in the United States as set by the Federal Reserve, starting in 2007 and continuing to present, where interest rates have now been very close to zero for more than four years. The problem the Fed has is that the economy continued to remain weak and interest rates can’t be cut any further.

The answer was a series of extraordinary policy measures, collectively known as QE or quantitative easing, that allowed the central bank to provide even greater liquidity to the US economy. In an unprecedented step, the bank has in the past said that it will continue with these policies for at least the next couple of years and more recently they have been explicit about continuing these policies until target unemployment and inflation rates were met, which most agree are at least several years away.

What this means for investors in the United States is that you will be earning close to nothing on your savings if they are held in traditional safe investments such as bonds and money market funds. Those that seek a return above nothing are hence compelled to assume more risk in their portfolio, and to put a greater proportion of their money into investments like shares. These central bank policies have certainly distorted investment markets, and will continue to do so in the short to medium term.

To be able to service growing government debt the authorities need to keep interest rates low, which results in financial repression of people relying on their savings for income. The likelihood is that this will mean more money is attracted to shares, despite the fact that corporate earnings are at post war highs compared to GDP. Thinking back to our forecasting method, how quickly would you assume that corporate earnings continue to grow from the highest levels seen in more than half a century? Or is it in fact more likely that these earnings will revert lower to long term trend levels? If it is the latter, then there will be a negative contribution to future returns, and once again high prices will lead to low future returns.


The situation in Europe has some similarities, but also some very significant differences, the most important of which is that troubled nations that have adopted the Euro have by definition relinquished the right to issue debt in their own currency. In addition to maintaining interest rates at very low levels, the ECB has also applied its own version of additional support, only with different acronyms. Two versions of LTRO (long term refinancing operations) followed up with some OMT (outright monetary transactions) have been successful in assuring investors that disintegration in Europe is now unlikely. These two policies ensure liquidity is available to banks and that doubts about solvency in European banks are allayed for the time being.

There are certainly ongoing risks that remain in Europe, as one analyst has described it “the success of 2012 was to end the acute phase of the crisis, but its chronic features persist.”1 Interest rates have often been described as a blunt instrument, and this is especially the case in Europe where the economic outlook varies markedly from some stronger northern countries compared with Spain where the economy continued to contract late last year and unemployment has just exceeded 26%. The same analyst above argues that real change is yet to come in Europe and that the more manageable chronic phase of the crisis is more likely to be when this change occurs. We will monitor developments closely, but will do so from the side line for the time being.

The United Kingdom has appointed a new Governor of the Bank of England and for the first time in the more than three centuries since it was established has appointed someone from outside Britain to the role. The current Governor of the Bank of Canada Mark Carney will assume the position in July, bringing with him a strong reputation for the role he played in guiding Canada’s economy during the financial crisis. Carney has already indicated that interest rates would remain low until growth returns strongly, or until the economy has achieved “escape velocity,”2 which seems some way off amidst the current talk of a potential triple dip recession for the UK.


We have here a similar chart3 to the US version shown above, in this case showing the RBA Cash Rate and the 90 Day Bank Bill rate covering both the pre and post GFC periods. Clearly we also had an emergency response to the financial crisis which saw interest rates of 7.25% in 2008 cut by 4% in the six months to February 2009.

We were however fortunate to see a subsequent recovery in our economy that not only allowed the RBA to pause at 3% but to actually raise rates back up to 4.75% during the recovery phase. So, far from reaching the lower bound and having to resort to extraordinary additional supportive policies, the RBA still has room to move on interest rates if it deems that the economy requires that additional support.

At its most recent meeting it determined that that wasn’t required at this time:

“During 2012, there was a significant easing in monetary policy. Though the full impact of this will still take further time to become apparent, there are signs that the easier conditions are having some of the expected effects: the demand for some categories of consumer durables has picked up; housing prices have moved higher; there are early indications of a pick-up in dwelling construction; and savers are starting to shift portfolios towards assets offering higher expected returns.”4

We have long held the view that in addition to several inherent advantages in the Australian economy, such as demand for our resources and our proximity to growing economies in Asia, that our central bank retained greater capacity to address short term weakness more effectively than most other developed economies. We continue to maintain that view, and whilst with the recent strength in Australian equity markets valuations are not as attractive as they were in the middle of the last year, they still compare favourably to the US and most other Developed Markets economies.


The table below shows our long term (10 year) expected returns from four asset classes; Australian shares (represented by All Ordinaries index), international shares (S&P 500), Emerging Markets (represented by the FTSE Emerging Markets Index) and listed property (ASX 200 Property). The four valuation ranges, represented by the different colours, are determined by comparing the return we forecast, to a risk free rate of return (Term Deposit rate).

1. G Frieda, Chronic Europe – Project Syndicate. 29-Jan-13.
2. S Kennedy & J Ryan, Carney Says Policy Must Achieve “Escape Velocity‟ – Bloomberg. 28-Jan-13.
3. RBA Chart Pack. 6-Feb-13.
4. Glenn Stevens, Statement on Monetary Policy – RBA. 5-Feb-13.


DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (ABN 76 821 231 362 Corporate Authorised Representative of CHPW Financial Pty Ltd AFSL 280201) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial planning) for suitability in respect of their unique circumstances.

About Reuben Zelwer


Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.