Investment Review March 2010

An Investment Review prepared by Grant Cleary and Neville Giles of Cleary Wealth Management

Market Summary – March Quarter Global markets continued to climb higher in the first quarter of 2010 carrying on the recovery from the near death experience of the Global Financial Crisis (hereafter to be known as the “GFC” it seems). The S&P 500 was up 4.9% in the quarter finishing the quarter at 1169.43. The US market is now up an astonishing 73.5% since its March 2009 lows. Apparently the entire world is a rosy and benign place. Other global markets followed in lock step demonstrating the absolute fallacy of geographical spread as a means of diversification. European markets all rose with the UK FTSE up an identical 4.9% (can you spell „highly correlated‟?) while Asia was not much different with the Japanese Nikkei 225 rising by 5.1% over the quarter. Overall, our model portfolio saw three successive monthly gains, climbing +0.73% in January, +0.44% in February and a strong +3.06% in March for a quarterly performance gain of +4.27%. In fact during the quarter, only 3 of the 17 investments in the model portfolio were negative showing the breadth of the market advance over multiple asset classes. We almost get concerned when our investments, chosen for their low correlation to each other, all move in the same direction! So what was driving the markets? The honest answer is we simply don‟t know. Markets are made up of people, people are irrational, ergo markets are irrational. Markets were relatively quiescent over the quarter with very few days up or down more than 1% (this contrasts quite noticeably with some of the trading days subsequent to the end of the quarter). There were certainly pockets of good news around with corporate earnings coming through relatively strongly in year on year comparisons although we should remember that the year on year comparisons are with Q1 2009 which was the weakest earnings quarter in living memory. Leading the market charge were cyclical stocks (those most exposed to the level of economic activity) who greatly outperformed their more defensive counterparts. Across most sectors, earnings were being driven more from cost cutting rather than strong sales. This is particularly important looking forward as much of the strength in the latter half of 2009 / early 2010 was simply the restocking of depleted inventories. Markets will now be looking for stronger revenue growth from businesses in order to justify valuations which are now tending to the expensive side of fair value. Overall, the market is certainly not expensive relative to companies‟ ability to generate free cash flow; but it is also not the screaming buy it was halfway through 2009. Closer to home the New Zealand and Australian sharemarkets followed global counterparts higher. The Australian ASX All Ords was up 5.7% for the quarter led higher by strong performances from the banks and mining stocks. New Zealand was also up albeit by a smaller amount of only 1.2%. In terms of the currency, the NZ dollar was a mixed bag showing strength against the pound and the Euro in light of the economic problems afflicting the UK and Greece, but was down against the US dollar, Japanese yen and Australian dollar although some of that weakness has dissipated since the quarter end.
The bond markets were little changed over the quarter with US 30 year treasuries ending about where they started the quarter. However this quiescence disguised some of the powerful underlying mechanics. In fact bond prices resemble a tug of war with the relative small movements disguising the massive powerful forces exerting their heft on the underlying
indicator. Weighing heavily on yields is the possibility of deflation in the future across the developed world as well as the risk of further economic upheavals. This downward pressure is being assisted by the US Federal Reserve which has pledged to maintain low rates for an extended period. Conversely, we have the probability of inflation in the emerging world. Such a dichotomy is unprecedented. Aligned against these quite powerful deflationary forces are three equally powerful considerations. Firstly the US Federal Reserve stopped their programme of Quantitative Easing whereby they purchased long dated US Bonds in order to try and keep yields low. Secondly, foreign buyers, in particular the Chinese, have started to desert the Treasury buying auctions leading to less demand and thus higher yields needed to attract buyers. Last and certainly not least is the fact that the US continues to run a gigantic budget deficit (US$220 billion in the month of February alone!) and needs to issue a lot of bonds to finance this deficit. As with any product, if there is an increase in supply, the relevant price will go down. Yields move inversely to the price of bonds and so bond prices really have only one place to go, and that is down. The United States, as we have detailed in previous quarterlies, has massive problems with its government deficit over the medium to long term and we would estimate that bond yields will likely continue to creep higher which results in a capital loss for bond investors. On current projections, in less than 10 years, 93% of US tax revenues will go to pay social security, Medicare, Medicaid and interest costs on national debt. This implies virtually no money left over for defense, homeland security, welfare, education and the other essential functions of federal Government. Events will go on until they can‟t and at some point the US must address its massive structural federal deficit. But the US is still rated a AAA credit risk by Standard & Poors. It sure doesn‟t look riskless to us. Its seems the market agrees. One of the highlights of the quarter was that yields on Berkshire Hathaway debt (Warren Buffett‟s trading entity) started trading at a yield LOWER than that of US Government bonds. US Treasuries are meant to be the ultimate risk free asset with every asset trading at a positive spread over Treasuries reflecting their additional underlying risk. But the market assessment during the quarter was that Warren Buffett was more likely to repay you than the US Government! Given that Warren doesn‟t have the power to tax you, that‟s quite an indictment on the budget problems of the world‟s largest debtor. So while, there was certainly cause for satisfaction for investors‟ portfolios, the sad fact is that we are not out of the woods yet. There are multiple serious issues yet to play out and all of them could potentially lead to weakness in asset prices during the rest of the years. We are not bears, but are certainly not bullish about the prospects of the wider market at this point. Effective diversification remains the most valuable tool in an investors armoury. The issues we see impacting the markets in the coming quarters include the following:
Govt Debt – as detailed in greater depth in our last quarterly, there is a bubble in Government debt forming. A huge quantity of debt is or will be issued over the next few years as Governments globally have taken on a lot of borrowing to effect the recovery and provide economic stimulus. This comes at a particularly bad time with the baby boomers set to start retiring over the next few years which will inevitably worsen the structural budget deficits of developed countries.
The problem is twofold. Firstly, bond yields inevitably must rise to attract more buyers to the government debt markets. The US alone will need to issue $2.6 trillion dollars of debt this year, up around 42% on last year. Higher interest rates on Government debt flow through to the broader economy and are generally bad for most economic activity as debt is harder to service and investment is discouraged. Secondly, the chances of a sovereign debt default are rapidly increasing. Greece is nearly there now with Portugal and Spain not far behind. Germany cannot really allow Greece to fail as its banks own a large part of the debt as part of their equity base. However, the Germans are starting to baulk at the cost of the bailout particularly when the line of countries with their hand out seems to be growing weekly. Other non-European Governments have also pursued aggressive fiscal stimulus policies where it‟s far from certain that they can service the debt which has resulted. While any sovereign bond default would be destabilising on the markets generally, this would be particularly disastrous if it was a Euro market. Commercial Real Estate – the problems with commercial real estate are just starting to be felt now. Real estate is an unusual asset in that the timeframes for impacts of economic upheaval are much longer. Rent is usually the last expenditure a failing business will stop paying and it can therefore take a while before economic weakness filters down to commercial property. While it is a slow moving train, its influence is considerable as banks are usually heavily exposed to the commercial property market. Across the United States, there are now wide swathes of commercial and retail properties which are unlet and whose values have plummeted. Around 70% of all leveraged commercially real estate in the United States is now in negative equity and the majority of this debt is held by the regional US banks. All things being equal, a rise in bond yields causes a fall in property valuations as the rental stream from the property is worth less. So as bond yields inevitably rise from their multi-generational lows, we would expect further deterioration in the balance sheet positions of these banks. There have been 68 bank failures in the United States already in 2010 as at beginning of May. With a lot of the debt used to fund commercial property purchases now falling due in increasing amounts, we expect this problem to worsen and further constrain the economic recovery as credit is withdrawn from the market.
Chinese Property Bubble — we are growing increasingly concerned about the unsustainable bubble in Chinese property prices, with the position illustrated in the graph below. This is a direct function of the fixed exchange rate the Chinese government operates. In the face of a massive current account surplus, the Government must continue to print more Chinese Yuan in order to ensure the rate stays fixed against the US dollar. This causes massive monetary stimulus which finds its way into the various asset markets. The Chinese are trying to treat the symptoms not the cause of the problem through the introduction of new or higher taxes on real estate sales, and possibly a property tax, in order to cool down a booming property market now widely being described as a bubble (prices up well over 10% from a year ago). Revaluing the Yuan is the most practicable method to prevent rampant speculation but they seem curiously reluctant to act in their own interests. However, their hand is likely to be forced. A collapse in the property sector would be massively destabilising socially with most of the population now dabbling in property speculation. We are hearing anecdotal stories of Chinese house maids owning multiple investment properties which sounds awfully similar to shoe shine boys buying stocks in the 1920‟s. Again, something that cannot go on forever inevitably won‟t.