Why the equities road makes sense

PORTFOLIO POINT: The latest economic stimulatory actions in the US and Europe have set a more positive tone for equities, and our banks are heading back to the offshore bond market.

It’s not often after I publish a Eureka commentary that I become nervous and wonder if I have misled my readers – particularly when I suggest they lift their equity exposure.

So let me take you back into the background of my commentary on the dramatic announcement by the chief of the European Central Bank, Mario Draghi, just over a week ago.

I started working just after 5am and studied what he said and some of the early commentaries that had been made. My conclusion was different to most others. I believed that the moves would stimulate the sharemarket, but more particularly would enable Australian banks to borrow offshore much more easily, so making it less urgent for them to replace offshore borrowing with local term deposits.

In turn this would mean that they could pass on more of the Reserve Bank interest rate reductions and a lot of the pressure would be taken off the banking system.

Accordingly I concluded that we would have lower Australian interest rates and now was the time to lock in either high-income equity investments or longer-term term deposits.

And there was also a very good chance that China was about to stimulate more substantially than before. 

In the days that followed bank shares fell and I felt very alone and concerned that I misled you. But then the Commonwealth Bank came up with its gigantic overseas bond issue and it was clear that it was now possible to raise much more money overseas than it had been in the past. And it was likely that this environment would continue because of the threat of a European meltdown had been greatly reduced.

Yesterday that threat was further reduced by the decision of the German constitutional court to allow the Germans to support the bailout programs. 

Accordingly we began to see bank shares edge up. At the same time, the expected China stimulus is via more investment in construction projects, which is seeing iron ore prices rise. I advised Eureka readers not to go overboard in equities because there are still risks, but it was reasonable to take your equity up to the levels with which you are comfortable. Those levels may be lower than many financial planners recommend. I followed my advice and increased my equity exposure.

Then last night we received the long-awaited QE3.

Share and commodity markets have now basically received two of the three stimulus’s that were expected and China is well on the way, except that clearly there are deep leadership issues at present.

As we look forward there is clearly the possibility of more European turmoil and it’s possible Greece will leave the euro. But markets have, for the most part, adjusted to a Greek exit.

The next hazard comes from the US. Obama and Romney are engaged in a neck and neck struggle, so neither is likely to have a sweeping mandate.

When a winner is decided the biggest issue the President will face will be the so called “fiscal cliff”. The US legislature has passed acts that require $1.2 trillion in expenditure cuts and an end to the Bush tax cuts. It will send the US into recession unless reversed in the first two or three months of the new President.

Back home, during the week I did some early research on the state of the Australian economy and in particular the fact that unemployment has not increased when there has been such a widespread level of retrenchment.

I think what is happening is that large amounts of the retrenched people are in white collar middle class areas. They never before had to go to Centrelink and are not looking forward to the process. In any event they have substantial retrenchment benefits, which would prevent them accessing Centrelink. They often class themselves as consultants or some other title and claim they actually have work to do. What they are really doing is looking for part or full-time work. That process is delaying the impact of the retrenchments into unemployment figures. But this money is going to run out.

Moreover the rise in unemployment will have a large percentage of middle-income Australia in its ranks. This is a relatively rare phenomena. If I am right, in the months that are ahead or early next year we are going to see unemployment go above 6%. And when that happens interest rates in Australia will fall and could fall quite steeply. So I am repeating the advice of last week.

It is also clear that governments around the world, but particularly in Australia, are discovering that they simply can’t maintain the level of expenditure that they have become used to. They can try to increase taxes but that is quite difficult, and really the only way out is to lower staff numbers and again this hits the middle class. Queensland Premier Campbell Newman has been the most aggressive of our state premiers but the same thing is happening in Victoria and New South Wales. 

And it is going to have to happen in Canberra. This process will add to the impetus for  lower interest rates. 

In the mining sector the remarks of BHP chairman Jacque Nasser are important. He pointed out that coal was in abundance around the world. And he could have added in steaming coal there is now going to be great competition with gas and in metallurgical coal (used in steelmaking). Mozambique will be a major player with a much lower cost operations. The outlook for Australian coal is not good.  The Queensland Premier is new in the office and didn’t understand this, but in fairness to him he was under enormous pressure because of his budget deficit.

The iron ore outlook is looking better and it is clear that China has become frightened of how deep its economy fell, and accordingly is going for investment in new infrastructure projects like subways and bridges etc. That will increase demand for iron ore and, as a result, the iron ore price has recovered somewhat. But there is still a lot of capacity and we do have a continuing depressed Europe and a similar albeit better situation in the US, assuming we avoid the fiscal cliff.