Quarterly Investment Review

Cleary Wealth Management Quarterly Investment Review

December 2009


Market Summary –

December Quarter Markets continued their „recovery‟ during the December quarter exhibiting an apparent disdain for risk. The S&P 500 finished the year at 1,115.10, a gain of 5.4% for the quarter and up a whopping 64% from the lows of March 2009 amidst the worst moments of the credit crises. For the calendar year, the US market logged a reasonably impressive 25.2% positive return which stands in stark contrast to the -11.01% loss in the first quarter of the year when rampant fear abounded. Europe and Asia also recovered in tandem with the US.

The UK FTSE, either by coincidence or correlation, was up an identical 5.4% for the quarter and 22.05% for the year while Japan also rose 19% for the year. The Chinese market, which didn‟t reach new lows in March 2009 was up a staggering 78% in the calendar year and 90% from their October lows. In total, the MSCI World rose 27% (in USD).

Apart from concluding that geographical diversification is surely dead, the main message as 2009 drew to a close was “Wot me worry” to quote a certain MAD magazine figurehead. In fact markets are now barely 20% below their all-time highs reached in May 2007 amidst the aftermath of the (still recent) Global Financial Crisis.

How to reconcile these two facts? Plainly, the world situation is much improved from the depths of despair following the Lehman Brothers bankruptcy in Sept 2008. While Governments and Central banks clearly made numerous policy errors, they somehow managed to get two important policy aspects right: they kept credit markets from freezing completely and they then jump-started the economy with unprecedented levels of fiscal stimulus. As such, most economies are forecasted to have grown in 2009 and will improve again in 2010.

Share markets also exhibited sharply lower volatility in the second half of the year with the best market measure of volatility (the Chicago Board of Exchange VIX index) ending the year at around 20, significantly down from the panics of Oct 08 and March 09 when it touched above 80. It is now not much higher than the nonsensical calm of the 2003 – 2007 period. Credit spreads on corporate and emerging market debts also narrowed signifying increased risk appetites by global investors. In fact, you could argue that the markets have almost returned to normal. Indeed the fourth quarter was marked by the eerie sensation that no piece of news would cause the market to break lower.

Bad news was either ignored by the markets or spun as „good‟ news. Corporate profitability, particularly in the banking sector, was up strongly year on year. In fact, the year saw focus shift from how to save banks to how to stop bankers from being lynched by the public for rewarding themselves massive bonuses following near record profits for the year.

Ultimately, the string of strong performance from global markets and other risk assets is partially explained by the recovery of global economies from the near death experiences in late 2008 / early 2009. Perhaps more importantly however investors soon realised that cash rates were now effectively zero and unlikely to change in the near future as Central Banks affirmed and reaffirmed their intention to maintain stimulatory levels of monetary policy. This is being underwritten by Bernanke, a self-confessed Depression scholar, underwriting a global policy of quantitative easing and ultra low interest rate leading to a weaker US$.

 If investors wanted a return, they needed to take on some risk. New Zealand and Australia sharemarkets followed the global trends with both recording positive quarters (3.3% and 3.7% respectively) and calendar years (18.9% and 36.9%). Both currencies were also very strong throughout the year. The kiwi maintained a strong rise throughout the year starting at circa $0.54c v the US$ and ending nearer $0.74c. Such strength is the function of the tripartite of higher local interest rates, improving commodity prices and increased risk appetites‟ from global investors. With all three of these factors unlikely to abate in the near term, it is possible that the kiwi will continue to ride high for a period.

However, over the medium / longer term, it would seem a fall is inevitable. Our credit rating is under stress from deteriorating Govt and private balance sheets. Furthermore, everyone in the world seems to be short US$ and when everyone is on one side of a trade, a reversal becomes increasingly likely. Lastly, Goldman Sachs recently came out with their top 5 trades for 2010 and number 2 was for the kiwi to fall against the pound. If you need overseas currency, now would be a good time to grab some. In line with the recovering economy and markets generally, commodities were very strong throughout the year albeit relatively flat for the fourth quarter.

Crude oil basically spent the year rising in price charging up from an impossibly low US$40 a barrel to finish the year at $74. Gold bugs were in the ascendance all year as they continued to note the ongoing debasement of fiat paper currencies globally. Gold smashed through the US$1000 an ounce price point finishing the year at US$1100, up over 35% for the year.

Even commodities that NZ exports did well with global dairy prices showing strong gains, particularly in the second half of the year. By no means are the problems behind us however and it is almost certain that there is more pain to come. The roots of the GFC was a massive global credit bubble which led to record levels of private debt being assumed relative to income and GDP. The Total US Debt as a % of GDP reached 369.7% at the end of Q3 2009. The previous high was 299.8% in 1933 and we all know how that ended.

The average balance on a US adult‟s credit card is in excess of $16,000. Unfortunately, a lot of that debt is unsecured or borrowed against assets which are now worth less than cost of the debt. To rectify that situation and with selling assets not an option, borrowers must retrench spending and increase their savings to pay down debt levels or they must default. If they increase savings, economies will suffer from lower expenditure (the so called “Paradox of Thrift” problem). If they default, a second surge of banking related problems awaits us.

The process of de-leveraging is ugly and painful and will take many years, if not decades to resolve. Governments around the world have taken the necessary step of transferring or assuming some of that private debt but that merely shifts the burden. This itself causes problems which we will examine below.

The other major piece of news during the quarter was the massive if not unexpected disappointment of the Copenhagen climate talks. Global warming is an undoubted fact but its impact and timeframe are uncertain to say the least. Unfortunately, it‟s a global problem which therefore requires a global solution. What Copenhagen proved, beyond doubt, is the national Governments, answerable to local electorates, are manifestly unable to act for the common good.

The New Zealand solution of “yes we will set targets but won‟t achieve them unless everyone else does” is a great example. Global warming is a nightmarishly thorny problem for diplomats to solve because of the myriad impacts across numerous industries with every country having a distinct set of circumstances and influential lobbyists asking for their sector to be treated as a “special case”. It‟s the perfect example of the tragedy of the commons. Why should New Zealand farmers be forced to produce less milk when they can‟t be certain that a Chinese industrialist will likewise sacrifice production?

 When you have 187 nation states all playing a version of the Game Theory classic “Prisoner‟s Dilemma”, it inevitably leads to everyone spending the maximum time in jail. The negotiation deadlock is amplified by the thorny issue of developed versus developing countries with the latter quite reasonably asking why they should be denied a rich world standard of living and help to fix a problem of the developed world‟s making.

Lastly, the necessary framework of a decision quite materially infringes on national sovereignty. When China won‟t even agree to have numbers included in a meaningless post conference statement, the hope of ever having independent teams of auditors verifying that China is meeting their agreed quota targets seems forlorn indeed. The bright spots, while dim, did illustrate some progress is being made. That global warming is indeed occurring and that humans are responsible was agreed by all present which is, of itself, a major advance. Furthermore, we are starting to see powerful forces beginning to align with the environmentalist cause. Religious groups are increasingly seizing upon this issue reasoning that we are not doing enough to save a world of God‟s creation.

The other major group starting to assist environmentalists is, perhaps surprisingly, businesses. Part of this is simply a desire for regulatory certainty when it comes to making long term investment decisions, particularly in the energy sector. But also we are seeing groups of companies like insurance firms reasoning that the economic cost of avoiding sustained global warming is likely to be significantly less than the clean-up afterwards.