September Market Commentary

10 Oct September Market Commentary

Monthly Economic & Investment Market Commentary

September 2012

We are going to draw on a couple of research reports for our monthly discussion, including the latest World Economic Outlook from the International Monetary Fund (IMF), the World Bank’s East Asia and Pacific Data Monitor and also a speech from Australia’s Treasury Secretary Martin Parkinson. In broad terms the IMF now expects that growth in developed markets will be 1.5% (down from 1.8%) and for emerging and developing countries to grow at 5.6% (down from 5.8%). Weakness in the former is seen to be a continuing drag on growth in emerging and developing countries, increasing the importance of robust domestic demand for those economies.

Our commentary starts with the two regions of most concern, Europe and the United States, where the IMF notes that “Worries about the ability of European policymakers to control the euro crisis and worries about the failure to date of U.S. policymakers to agree on a fiscal plan surely play an important role, but one that is hard to nail down.”¹

EUROPE

Luxembourg’s Prime Minister will chair the now active European Stability Mechanism (ESM), and declared that the €500 billion bailout fund “marks a historic milestone in shaping the future of monetary union”, however Spain is still yet to formally request assistance. The Chief Economist at the IMF took heart from the fact that “Most of these pieces are falling into place, and if the complex puzzle can be rapidly completed, one can reasonably hope that the worst might be behind us.”

To the extent that it is this uncertainty that is contributing to the current slowdown, then it stands to reason that alleviating it may lead to outcomes that are better than currently forecast. However, it is worth reiterating, that what we are looking forward to is not having a disastrous disintegration of Europe, and whilst that is of course welcome, even in that more optimistic scenario the outlook for economic growth still looks anaemic at best.

The IMF sees growth in the euro area contracting by 0.5% in 2012 and then increasing by 0.25% in 2013. The report also notes that this forecast assumes that efforts at managing the crisis are successful and ultimately lead to deeper fiscal integration and a full-fledged banking union.

On balance, we agree with the IMF conclusions that at least in the short term the risks to the downside outweigh those to the upside, and hence we will continue to be comfortable not having direct exposure to Europe in the International Equities investments in your portfolio.

UNITED STATES

There are no great surprises from the IMF when it comes to the USA: “Growth in the United States has been sluggish, and job creation has weakened. The recovery is expected to remain tepid, given a weaker global environment and significant domestic policy uncertainty, including about the fiscal cliff.” ¹

They go on to estimate the impact of the different components of the Fiscal Cliff, as shown in the attached chart. Clearly an impact equivalent to more than 4% of GDP in 2013 would be a terrible outcome, for an economy that is struggling to grow at around 1.5% per annum.

It would seem that there may be differing views about how this situation will be handled between Washington and Wall Street. One expert commentator summed it up as “never underestimate Wall Street’s ability to overestimate Washington”² before going on to say that the odds of hitting the cliff are better than 50/50.

The more optimistic scenario is that going over the cliff would provide a catalyst for a serious compromise from both sides, and that as the full impact of the spending cuts and tax rate increases doesn’t immediately come into effect on January 1, that such a deal early next year could still avert a recession.

The Americans are now down to about a month or so before about half of them will vote to decide who will be the next President, as well as which party will control the House of Representatives and the Senate. A surge for Mitt Romney following a lacklustre effort from President Obama in the first of three debates has tightened the race, though the most likely outcome still appears to be that President Obama will be given a second term.

Assuming this happens, what is more difficult to predict is the reaction of Republicans. On the one hand it may be that more moderate influences come to ascendancy in the party, increasing the likelihood of compromise, on the other it is entirely possible that the parties move further apart, and what the IMF calls the “urgent policy priorities… to avoid excessive fiscal contraction‟ continue to be used as bargaining chips in a game of political brinkmanship.

ASIA AND EMERGING MARKETS

We note the IMF comments that economies in these regions have been impacted by declining exports to the weaker developed nations, but take some comfort from comments in the World Bank report³ that domestic demand has been relatively robust. The report is prepared for the East Asia and Pacific (EAP) region, which includes China, Indonesia, Korea, Malaysia, the Philippines and Thailand among others.

Across the region, it will continue to be important for these economies to increase the contribution to growth from domestic demand, which will help to offset the impact from slower rates of growth, and hence lower export demand, from developed economies.

The World Bank says that these countries are well placed to deal with this situation, noting that: “Most countries have current account surpluses or only modest deficits and most hold high levels of international reserves compared to international payment obligations.”

They go on to note that the banking system is well capitalised, and that non-performing loans are relatively low.

At right the historical and expected growth for developing countries is shown in blue, compared to the developed countries in orange, with the average for the world in red.

AUSTRALIA

The performance of the local share market still lags many of its global developed market peers, where in some cases the pre financial crisis highs are within reach. In September the S&P500 index that tracks the US market got to within 7% of its peak, whilst our recent rally to 4,500 in the ASX200 still leaves us some 27% below the peak set at 6,850.

It is worth remembering that all other things being equal, lower prices now generally mean higher future returns, and high current prices often mean lower future returns. Of course, all other things are just about never equal, so what does the future look like for the Australian economy? Are we about to face the end of the mining boom and a dire outlook as has been predicted?

Treasury Secretary Martin Parkinson gave a speech⁴ in which he argued that the term ‘mining boom’ itself is too simplistic, in that we have all become accustomed to a boom being followed by a bust. Rather, he argues that we should think of the impact to our economy from the growth in emerging Asian economies as being in three waves, only the first of which is likely to conclude in the near future.

That initial phase involves high commodity prices, such as we have seen in recent years, where elevated demand exists and has not yet been met by increased supply. In the last few years we have had the benefit of what he describes as ‘windfall gains’ from these higher commodity prices, supporting our economy that has now gone more than 20 years without a recession. Whilst lower than recent peaks, particularly for iron ore, he expects that our economy will see sustained higher terms of trade (export prices / import prices), and that the mining sector will “rise from 5 per cent of gross value added in the early 2000s, to in the order of 10 – 12 per cent in the decades to come.”

The second stage, which he argues is just beginning, is the increase in supply as a result of the recent years of investment to increase capacity for our key commodities. Companies will of course have to ensure that any future investment is carefully considered, and that appropriate rates of return are available before proceeding. We have seen evidence that such consideration is indeed being undertaken, leading in some cases to notable delays or mothballing of more marginal projects.

ASSET CLASS VALUATIONS

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).

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.