Yield and the real world outlook

Economic Overview

After the euphoric rise in equity markets in the 2013 financial year, it would seem logical to expect that we would now be witnessing clear signs of a strong global economic recovery.

But, alas, there is not much of an economic recovery happening and, on reflection, it seems markets in 2013 got a little ahead of themselves. Then again, markets were responding to historically low interest rates and the so-called quest for yield.

Equity market returns in the March quarter were somewhat disappointing. Even with the predictable end of quarter rally (or window dressing), the Australian market barely registered a positive return in the March quarter. In fact, over the quarter, most of the index return was from dividends.

Overseas markets, in the main, produced less-than-stellar results as well. Noteworthy were the large falls in the Japanese stockmarket, down about 9%, and the Hong Kong market, which retreated by 5%. In the US, the broad market index was marginally positive, but in Europe the major indices in Germany and the UK were respectively flat and down 2.2%.

Click to enlarge

In my view, markets are reflecting the developed world’s struggle to generate solid economic recovery. The indicators of industrial activity across all major economies, including China, suggest that output growth is slowing. The long-awaited economic recovery in Europe is still struggling to take root. In particular, German industrial activity growth is measuring at a meek annualised rate of less than 2%. The recent upheaval in Crimea and the Ukraine has led to economic sanctions being levied upon Russia that could cause a recession in the ninth-largest economy in the world. Russia has effectively been expelled from the G8, which has now become the G7.

At this point I reiterate my message that economic growth for the developed world remains remarkably lacklustre, despite massive fiscal and monetary support. Markets have been buoyed by these policies and interest rate settings have placed a floor under equities markets.

It is important to now note that interest rates have probably reached a cyclical low point. Therefore, if equity markets are to lift from here, as suggested by some, this will need to follow a solid lift in corporate profits. That, in turn, will be a consequence of a sustained higher level of economic growth. At this point, that condition is not readily apparent.

Click to enlarge

Predictions for equity markets

Investors are constantly bombarded with predictions for the “end-of-year target” for the Australian sharemarket. In the main, these predictions are made by commission agents seeking to generate buying activity. Their modus operandi is to scare investors into believing that they will miss out on the market boom that lies ahead, just beyond the horizon.

However, predicting that the price (measured by the index) of equity markets will rise over time is actually not a bold prediction; that is what markets have always done over long periods. However, a focus on a short period, like the next nine months, is pure speculation, particularly so if it is not based on some assessment of value. A couple of points need to be understood when forecasting the direction of equity markets in Australia.

Firstly, over time, the Australian equity market’s value has and will continue to steadily rise. This is a function of solid recurring economic growth generated from population growth and the flow of equity capital into Australian companies. This equity capital is retained by companies from profits and/or raised via new issues. Value is derived as a multiple of equity; this is a function of the return on that equity. With more equity and a growing economy, profits will rise over time. The question that most commentators ignore is the rate of return on capital; unfortunately, for the last five years, Australian companies have generated relatively poor returns using this metric. That is why the market today is at the level it was in April 2006.

Secondly, there are large macroeconomic environmental issues that drive the direction of markets. The two biggest macro issues for Australia today are the direction in the prices of our major export commodities and the trading value of our currency. Over the first quarter of this year, the Australian equity market has largely ignored a sharp decline in the price of iron ore and a lift in the exchange rate. These factors are negative for the major mining companies that are so crucial for generating earnings and capital investment.

It follows that the most likely market outcomes are as follows: continuing weakness in commodity prices, continuing increases in the unemployment rate, and a steady decline in capital investment activity.

It is remarkable that many forecasters expect the Australian equity market to lift towards 5800 or 6000 by year end. They predict an economy whose growth is checked, but maintain their view that these issues do not affect the short-term trajectory of the market. In doing so, they exhibit a “buy-side” bias that has been stoked by a long period of extremely supportive monetary policy.

My point is simple: market predictions made by commission agents are inherently flawed and will usually be vastly optimistic. It is far better to base a prediction on fundamental valuations that properly reflect the economic environment.

For the record, my view is that the Australian equity market is highly unlikely to lift above 5800 by year end. However, should the Australian dollar suffer a sharp devaluation, independent of a decline in commodity export prices, then our market could quickly rise. A currency level of US$0.75 cents would see our market lift, but that could be a precursor to major inflationary issues and sharply higher interest rates in 2015. The market, in such circumstances, would be in dangerous territory.

In contrast, should the currency revalue back to parity without a substantial lift in export prices, our market would likely retreat below 5000 points. A higher $A would be bad news for Australian corporate profits, with the most dynamic of Australian companies being most affected.

If the above is confusing, then welcome to the real world. There is nothing easy about investing, and the current economic climate is both difficult to predict and subject to constant change. Those who blandly predict a rise in market prices, without stating the context for those forecasts, or including their assumptions for the currency, commodity prices, interest rates, and so on, are not actually trying to help you – rather they are either trying to scare you or sell to you.

Apart from the political manoeuvrings in Ukraine, the key recent international economic development has been the decision by the US Federal Reserve (the Fed) to reduce its monthly level of asset purchases. At the March meeting, the Fed reduced (tapered) monthly purchases to $US55 billion. The forward guidance suggests that the US economy will be QE free by October or November this year, and by mid-2015 the Fed will begin to lift cash rates.

None of the above surprised markets, but the Fed has made no public announcement as to what it intends to do with its $2.5 trillion US bond holding and its $1.5 trillion ownership of mortgage-backed securities. These will be crucial decisions because the ultimate focus of Fed policy is to ensure that the cost of debt across the US remains at very low levels. I expect that the Fed will be a long-term owner of US government debt.

Conclusions

The world economy is experiencing a period of slow economic recovery. It is not a normal strong recovery, such as we would expect following a sharp economic downturn. The economic settings in major offshore economies obviously have a large influence upon the Australian economy. This is seen in an elevated currency and very low interest rate settings. It is the level of the Australian dollar, in particular, and commodity prices in general that will determine the overall outlook for Australian interest rates.

I anticipate the Australian dollar is heading down and that it will be lower in a few years’ time. However, its short-term trajectory is unpredictable – in some respects it has become a plaything of international central banks. This view that the $A will weaken in the medium and long term is strengthened by my expectation that commodity export prices are drifting lower and are still currently elevated when compared to historic prices.

The above macroeconomic view, coupled with a lack of value apparent in the market, suggests that a conservative portfolio positioning remains the most prudent course of action at present. As such, I remain of the view that exercising patience is critical and will ultimately assist in achieving sound long-term investment returns. As has been noted previously, I continue to patiently and diligently focused on the goal of doubling your capital every seven years.

John Abernethy is the Chief Investment Officer at Clime Asset Management. Clime offer excellent performing growth and income portfolios through its individually managed accounts service. To find out more, or to request a review of your share portfolio, call Clime on 1300 788 568 or visit www.clime.com.au.

Clime Growth Portfolio Statistics

Return since June 30, 2013: 8.11%

Returns since Inception (April 19, 2012): 27.14%

Average Yield: 5.85%

Start Value: $141,128.64

Current Value: $152,570.44

Dividends accrued since June 30, 2013: $5,049.21