Review your equities comfort level

PORTFOLIO POINT: With an imminent deal in Europe set to spur markets, and changes on the deposit front under way, it’s time to review your overall strategy.

The next month or two will see the emergence of some very important developments in both our sharemarket and our deposit markets. It requires a review of your investment strategies.

This week we saw a clear sign of the international share buying forces building up in anticipation of what Alan Kohler outlined in Wednesday’s Eureka Report.

I want to take that Kohler report a step further and combine it with other events we see happening around the world. Accordingly, I think it is a time to recall what level of equity you are comfortable with and make sure that you do in fact have that comfort level of equity. 

Many people have taken their equity below their comfort zone for good reason. There is clearly the prospect of a further rise in sharemarkets. Nothing is certain, but given the changes taking place around the globe you do need to set your equity at your comfort levels.

Why the change? First, in the last set of European conferences the dominance shifted from Germany to Italy. In any conference where there is confrontation, the dominant player is the one that can and will walk away. And, in Europe, that person is now Italian Prime Minister Mario Monti, because Italy can leave the euro and not only survive, but prosper.

He is combining with the head of the European Central Bank, Mario Draghi, to ambush German Chancellor Angela Merkel and sideline the Bundesbank, Germany’s central bank.

There are deep rumblings in Germany, but if the Monti-Draghi plan continues to develop momentum there is going to be a European solution that will probably involve the purchase of large amounts of bonds by the ECB and conceivably the cancellation of some of those bonds. There will be a requirement to alter labor practices in Spain and Italy. That means it will be easier to hire people and fire people. Right now, the rigid labor practices in Spain and Italy are boosting unemployment because people simply can’t afford to hire people.

Monti understands better than most leaders in Europe that the only way out of the European problem is via corporate health, and that’s good for sharemarkets. At the moment European shares are undervalued, and if the world believes that the euro is not going to collapse then European shares will drive world markets.

I am still a long-term doubter as to whether you can get a solution that accommodates the different European cost structures, and I think it is possible that some countries may leave the euro, particularly Greece. But as long as Spain and Italy are in the core, then the euro will not collapse.

Longer term there will need to be a much greater integration of the financial policies of the various countries to try and minimise the differences, which will not be easy and will lead to further crisis. But that’s in the longer term.

If, as markets believe, Europe can get through this, then there will be some very interesting side effects and changes taking place which we need consider. One is that the wholesale overseas markets for Australian banks will remain open. Perhaps the most dramatic single development that took place this week was the decision by UBS to take advantage of what are currently lower wholesale borrowing rates on the global market to fund a raid on NAB term deposits.

UBS is saying to its wholesale clients that UBS will offer loans secured against NAB deposits (via UBank, the NAB’s internet bank) and at a six-month fixed loan rate of, say, 4.42% per annum. You then invest that loan plus your deposit (10% of the total deal) in NAB (UBank) six-month term deposits at 5.06%.

The rate differential means you end up with a return of just over 12.4% on your 10% deposit outlay. If that UBS arbitrage offer gains momentum, then Australian banks will be forced to reduce their deposit rates and that will affect the investment strategies of a large number of investors who have their money invested in that area.

As of this morning UBank had held its deposit rates. Quite rightly Australian banks have been using bank deposits to lessen their dependence on overseas money because they fear what will happen with the euro. But if the Monti and Draghi solution comes to pass, the overseas banking markets may not collapse and the arbitrage between the two will force Australian deposit rates down. So your second strategy is to make sure you try to lock in for at least 12 months that part of your portfolio that has deposits. (I realise maturity dates can make this difficult).

Having said that, the current bond rates in the US and in the stable parts of Europe are ridiculously low and, over time, that will change. So the cost of wholesale money may rise, but that is down the track. 

The third major development that arose this week was the fact that we are looking at an enormous amount of global gas. The technology that can extract gas from coal and from shale means that the globe now has very large reserves of energy. And that energy is emerging from the US, Australia, China and Africa, and will probably also emerge from Europe.

Whether we like it or not, that means there will be much lower-priced gas around the world in the next decade. Australia is stupidly trying to build three massive LNG plants in Gladstone, Queensland, at the same time, which involves an enormous but rushed piping exercise to extract the gas from the coal-gas fields nearby.

The end result is going to be a scramble for gas supplies to meet contracts and much higher construction costs than were necessary.

ASX-listed energy group Santos is probably the best placed in all the players in that area because it can get gas from Moomba in South Australia, and so it can reduce its participation in the scramble. But I fear Gladstone is not going to be a happy hunting ground for profit in coming years because higher construction and gas extraction costs will come up against prices that may be less than was first hoped for.

This avalanche of cheap gas is going to change the global investment scene, which will foster a flurry of construction later in the decade. We are going to use gas in ways the globe has rarely used it before. This may make coal vulnerable. In time we’ll develop economic alternative energy sources, but in the meantime gas is going to be our path to carbon reduction on a global scale and there will be opportunities emerging that we haven’t thought of.

Meanwhile, the market sees the slow US recovery as the path to QE3, and Europe’s problems as the path to a Monti-Draghi solution rather than a further austerity led Bundesbank solution. At the same time, China is not letting its economy bound ahead in a way that would really cause a big rise in demand for Australian commodities.

But under the Monti-Draghi solution, the threat of a major collapse could be averted. And that would be extremely good news for the sharemarket.