RBA Rate Rise tomorrow? Odds on

Australian Government Bond Yields - 29 Jan 2010

Source: Bloomberg

The RBA Cash rate is currently at 3.75% and with government backed 30 day bank bills at 4.12% and the recent tender of 23 March 2010 Treasury Notes fetching a yield of ~3.96% the financial markets are pretty much expecting a 25bps increase.

Whilst the sharemarkets have had the jitters whereby the ASX200 has dropped in excess of 6% this year, it is only government bond with a maturity greater than 1 year whose yields have dropped. The shorter term rates haven't dropped much at all as the market continue to believe that 2010 will be a year of rising RBA rates.

As for the chart above...it doesn't really reflect too much of what I've said and actually contradicts the 3 month rates I quoted earlier...my only comment is...what's going on with Bloomberg such that it quotes 3 month Treasury Notes at 3.75%??? Might be best to double check rates from different sources before accepting them.

Jon Stewart talks Obama vs Bankers

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Obama Takes On Bankers
www.thedailyshow.com
Daily Show Full Episodes Political Humor Health Care Crisis

S&P500 vs Inflation vs PE Ratio over 97 years

The above chart shows the 10 year performance of the S&P500 (blue bars) versus the 10 year average annual inflation (red bars) versus the Shiller PE Ratio at the start of each decade (green bars). There are several notable observations...

• The worst performance was during the 1930s when the US experienced a deflationary environment and PE ratio started very high
• The second worse performance occurred 2000-2009 when PE Ratios started through the roof (> 40) and contracted
  
• Other poor performances typically related to high inflation (1913-1919; 1970-1979) and/or PE ratio contraction (1940-1949)
  

So what do we start 2010-2019 with? A very high Shiller PE Ratio (~20.1), third highest to the start of the Great Depression and Tech Wreck/GFC decades. And, an outlook for inflation that is relatively low due to the very high unemployment that is expected to stay around for some time. The US economy has just seen an economic bounce largely on the back of inventories that are being built back up but this is not a sustainable growth driver and certainly from a sharemarket perspective not a justification for a high PE.

Whislt the US Economy recivers for decent sharemarket returns there needs to be some stronger growth drivers and what these drivers will be is a little unclear.

The return of lifetime annuities!??!

I just read that the Henry Review is likely to suggest that superannuation can be exchanged for guaranteed lifetime income like lifetime annuities. Strangely, it can be done already by purchasing a lifetime annuity with superannuation money. The problem with the current situation is that there are no lifetime annuities left on the market....Comminsure and not much else.

Hopefully this initiative re-opens competition for this outstanding product, except, instead of the current situation, hopefully the new products are priced appropriately. Yields for lifetime and long term anunities have a long way to go to be attractive.

Interest Rates...relatively stable but a minor dip at the long end

Source: Reserve Bank of Australia

The government bond yield curve certainly expects another 50bps in RBA hikes this year with bonds yielding in the second half of this year trading around 4.3% to 4.4%. But since the start  of the year the yields in longer term bonds have declined a little...this indicates a slight drop in confidence of the Australian economy this year.

As has been widely published, the Australian economy has performed relatively well compared to other developed nations around the world and this is largely thanks to the strong links of the Asian developing economies and their continued hunger for our commodities. With China starting to tighten its credit belt a little there is no cause for alarm, but complacency is not appropriate.

In a week or two, the half yearly reporting season begins and after a few months of relative lack of volatility, I'm sure reporting season may well change that. With US, Japan, and much of Europe in a little economic disarray, the risks still exist, so it should be another interesting year for investors.

Active managers smash passive managers in 2009

Yesterday Morningstar released their investment performance league tables for each of the major asset classes for the Australian market. For almost every asset class in 2009, a higher proportion of active manager outperformed the index funds, like Vanguard, than underperformed.

Vanguard's 1 year performance rankings for each asset class are...

• Australian Shares - 55th out of 99
• International Shares (Unhedged) - 55th out of 77
• International Shares (Hedged) - 10th out of 16
• Australian Fixed Interest - 27th out of 30
• International Fixed Interest (Hedged) - 18th out of 20
• Australian Property - 21st out of 34
• International Property - 10th (Hedged) and 24th (Unhedged) out of 27

Now these performance rankings by Vanguard are pretty bad as they are expected to perform around the middle of rankings, but a couple of things need to be kept in mind. Firstly, risk was rewarded in 2009 with significant growth in small cap equities and credit securities...the index funds are biased away from these and more conservative in nature and the performance tables are not adjusted for these risks. Secondly, these league tables always have a survivorship bias towards the winning funds...funds all around the world as well as in Australia disappeared during 2008 and 2009.

After the disaster of 2008 there was an enormous shift towards passive managers after numerous active managers fell over. Given the outperformance by active managers in the Morningstar league tables, will we see a shift out of passive and back into active in 2010?

John Stewart on Wall Street Bonuses

I found this video one of my favourite blogs....www.calculatedrisk.com .

"The only people who have recovered from the financial meltdown are the ones who caused the financial meltdown"...John Stewart 

Click here.

Economist Magazine says Australian housing overvalued by 50%!!!

I started reading this week's Economist mag yesterday and the lead article is about the asset bubbles that are appearing all around the world thanks to low interest rates. Article can be found here for subscribers.

In terms of housing the article suggested that the US is at fair value, whilst Britain is 30% overvalued, and Australia, Spain, and Hong Kong are 50% overvalued based on the current level of rental yields. Commodities were mentioed as being overvalued and as with my last post, so too are Emergin Markets.

"Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. Something has to give"

I guess I'm off to a bearish start to the day today.

Why shouldn't I invest in China?

There's an excellent article in the 12 Jan Financial Times on investing in emerging markets...found here. The basic message is that there is no correlation between GDP Growth and stockmarket performance, in fact its slightly negative if anything, so be wary when investing in emerging markets.

According to Professor Jay Rittner of the University of Florida,

"Countries with high-growth potential do not offer good investment opportunities unless valuations are low"

Another interesting point made was that in fast growing economies, the companies that end up winning the race may not even be known yet.

"In the 1950s there were more than 100 motorbike companies. The market leader was driven out of business by the cut-throat pricing of a flaky upstart called Honda"

The conclusion in terms of value is that the biggest emerging economy of them all, China, is in a current bubble and valuations are far from low, in both equities and real estate, where valuation metrics are above what Japan was at its peak in 1990. What is frightening with regards to China's valuations, is that twenty years after Japan's peak, its equity market is still trading around 70% lower.

Bottom line, be careful of investing in Emerging Markets and secondly, don't forget Australia's current reliance on China as any bust could be catastrophic for both our economy and markets.

Current thoughts on some investing risks and themes

We have seen numerous investment trends come and sometimes go over the last X number of years whether it be technology, commerical property, Buffettology, CDOs, high yield, hedge funds, mortgage funds, etc, but at the end of the day a balance of the key investment risks wins through....i.e. the risks relating to equity, liquidity, interest rates, credit, currency, and inflation.

These are my current thoughts on these risks and some investment themes...

• Liquidity Risk - forgotten for many years (particularly by the MTAA Super fund, and mortgage investors...remember Estate Mortgage???) but it still exists...forget chasing returns and having liquidity at the same time!!! Know what liquidity you need and hold CASH...not the so-called liquid Asian High Yield securities Basis Capital used for liquidity or even Enhanced Cash funds...CASH in a bank or pure Cash Management Trust that get's it returns from 11am, government securities, and bank bills.
• Equity Risk...guess what? equity risk doesn't just turn up in...equities! It can also be found in corporate bonds, hybrids, hedge funds, property securities, and many others...it is essential to understand the true equity risk a portfolio has and don't push some of that risk into the more conservative asset classes like fixed interest. Equity risk can be scary, is required for growth, and shouldn't substitute for anything else...like...an inflation hedge!...investing in equities is often a poor hedge to inflation as the 1970s showed...high inflation is not good for equity performance at all
• Interest Rate Risk...too many have ignored this one...but it can work in your favour in a crisis and can provide some portfolio stability...stockbrokers should try them some day...the whole "everything correlates to one in a crisis" is absolute rubbish...during the global financial crisis, those who diversified their portfolio with pure interest rate risk (i.e. little to no credit risk) from boring government bonds or conservative bond funds received double digit returns from this risk. During a crisis, investors run to quality and boring government bonds are just that...why don't retail investors want to invest in quality???
• Credit risk...in times of crisis this is highly correlated with equty risk...as a result when building portfolios ensure your credit securities do not result in overweighting the exposure to equity risks. However, always keep in mind that credit securities have a negatively skewed return distribution...limited upside with massive downside...so why not just invest in equities instead and leave the fixed interest to boring governemnt bonds???
• Currency risks...what's the Australian dollar going to do? Answer...absolutely no idea. So what to do? Being unhedged was favourable during the GFC as Yen carry trades returned to Japan and the flight to safety went to the US (yep....good ol' Australian currency wasn't considered that safe!). So perhaps unhedged is the go...however, the reverse was true in the recovery...market timing is very very difficult so if you don't know, and I don't, perhaps 50% hedged, and 50% unhedged is the go for global share allocations. Its difficult to invest in international bonds without being hedged to the Australian dollar...I guess if you want ot investin bonds for their safety and income then currency risk removes the safety aspect and perhapd hedged is best.
• Inflation risks...this is my favourite...bonds are best during deflation but the only investment that (hopefully) guarantees strong performance during high inflation is INFLATION LINKED BONDS!!! Governments around the world, including Australia, are issuing more...woohoo!...let's get on board and reduce inflation risk from our portfolios. Life companies issue inflation linked annuities also...let's look at them as well.
• Commodities can also can be a good inflation hedge also but they certainly carry a few other risks but are worthy considerations as they provide diversification with other asset classes. The only thing with commodities is...they mostly supply and demand driven!...there's not really much added value there, so...good luck with picking supply and demand!!!
• Hedge Funds...these guys carry equity risk and/or credit risk...when markets crash...SO DO Hedge funds...the marketing myth of positive returns in any market has been exposed by the GFC and there's two other things...its very very difficult to get your money out and their fees are so big that they have to take on significant risk to get the return...but at the end of the day if you don't know how a fund invests you don't know the risks so...don't invest in hedge funds!
• Emerging Markets...all the rage because of their economic growth...guess what...there is no evidence that shows high returns from countries displaying high economic growth. If Emerging markets aren't in a bubble today...they probably will be tomorrow...so proceed with caution. 
• Mortgage funds...they're gone for a long time
• Australian economy...had an amazing run and is the leading economy in the developed world but keep this in mind...we're basically a hole in the ground and reliant upon commodities. If the emerging economies falter and decide to stop buying our commodities then look out Australia...things may not be so rosy...just keep it in mind...and stop being so complacent about the Australian economy...I know you are so stop it!
• Property...I think I need a new Post for this one! Stay tuned

Perhaps House Prices are a bit high in Austraila?

It appears there is a breakdown in the relationship between unemployment and house prices. I hazard a guess that its due to the low home loan interest rates we currently have (see my previous post) but given it appears the Reserve Bank looks like increasing rates further this year, for how long will this breakdown last?...probably not too long...my guess....house price growth is unlikely to be sustained and the property purchaser needs to be careful.

Low Interest Rates for some but not all

Source:RBA

The above chart shows the changes in interest rates since the start of 1997 for 3 different bank loans...

1. Credit Card Interest Rates
2. Personal Loan Variable Interest rates
3. Home Loan Standard variable interest rates

Now, over the past 18 months we have all heard about ow the banks have not been passing on all of the RBA interest rates cuts and passing on even more than the RBA's interest rate increases. This piece of information relates to the Standard Variable home loan rates which as the green line shows, as at the end of November, is at roughly the lowest levels since the beginning of the chart in 1997.

Unfortunately for those stuck in the debt trap of the personal loan or credit card, interest rates continue to be historically high...despite lower Reserve Bank rates, credit card and personal loan rates were lower just over 2 years ago and were never higher from the start of the chart in 1997!!! No wonder the rich get richer and the poor get poorer.

Common Sense view on Diversification

On December 30, Robert Jaeger wrote an excellent piece on diversification for the Financial Times (article can be found here) that palces a bit of common sense around portfolio construction as it probably should be. As he mentions...

In the good old days, asset allocation revolved around three main asset classes: stocks, for long term growth; bonds, for income and safety; and cash, for liquidity

 ...unfortunately recent years saw this simple asset allocation rule forgotten. He goes on to say...

cash and plain-vanilla bonds were disdained as “drags on performance”. The equity portfolio evolved to include everything from developed to frontier markets. The bond portfolio evolved to include an alphabet soup of complex products that investors didn’t fully understand. And the new category of “alternative assets” (private equity, hedge funds, timber, et al), many of which are illiquid, seemed to offer a way to enhance diversification without giving up returns.

As we all should know by now (although many are still in denial), these so-called diversifiers failed to diversify during the global financial crisis and we ended up holding portfolios that are illiquid (motrgage trusts, fund of hedge funds, and hybrid property funds) and we have dissatisfied clients.

Now I do believe that investment simplicity reined supreme in 2009  and I hope it continues into 2010. Happy New Year to all!

US New Home Sales Drop...a long way from a strong economy

I think it was last week that the market rose because sales of existing homes significantly increased so there were thoughts around an economy looking better. Unfortunately, overnight the latest report regarding new home sales was that of a fall. Guess what? New homes is a far stronger indicator of the strength of an economy than existing homes...the US is a long way away from a strong looking economy. With unemployment still enormous and monetary policy at the end of its limits (i.e. the nil interest bound), banks like Citi struggling, perhaps another US stimulus package is needed???

The last 12 months....Australian Government Bond Yields

Certainly an interesting 12 months has transpired in financial markets. The above chart shows the movement in the AUstralian Government Bond yield curve and this time last year the sever downward slope indicated the market was expecting the Reserve Bank to drop interest rates to below 3% during 2009. Clearly that didn't happen but there was a rapid decline down to 3% which was maintained until the last few months.

The yield curve was incredibly steep at 22 Jun 09 indicating an expected strong economic bounceback, however over the last six months the longer term yields have dropped suggesting the economic outlook has subdued a little. What we are left with is still a strong upward looking curve which is a good sign for economic prospects and the market appears to expect continued interest rate rises by the Reserve Bank. However, with a one year government bond yield of approximately 4.25% the expectations of the level of interest rate increases appears to have diminished a little so there's no guarantee of a rate rise in February but a good chance of a 25bps increase in March or April.

Pension Portfolio Construction

A couple of weeks ago I presented to a large group of financial planners a Case Study on constructing a portfolio for a pension drawdown situation. The case study required an annual drawdown of around 10% of the portfolio balance which given dividend yields, current interest rates, and low expected return potential meant the portfolio situation was going to require some type of capital drawdown. To make things a little more difficult the hypothetical investor was classified as a 'middle of the road' risk type...or "balanced" investor.

So how should we construct such a portfolio? I would say most financial planners would typically set aside two to three years of drawdown into cash and invest the remaining assets into a balanced type portfolio or maybe a diversified portfolio with a little more risk given the cash allocation. A second common solution is simply to invest the whole lot into a balanced portfolio and draw down across all asset classes so as to maintain the Strategic Asset Allocation that matches the balanced risk profiile. The problem with both of these solutions is that they are quite inefficient due to the possibility of being forced to sell equity positions within three years to fund cash flow.

My proposed solution, put forward for the purposes of discussion, was to firstly satisfy the investor's cashflow needs with a minimum of five year Nil RCV (i.e. expires at end of term with a zero balance) annuity and with the remaining funds invested in a high growth equities only portfolio that will hopefully grow sufficiently to replace the annuity at maturity. To me, having a minimum of a five year timeframe for an equities portfolio is a lot better than between not much and three years which is largely the current practice. It may not be the perfect solution but satisfying a client's cashflow needs for at least the next five years is very attractive to most investors and a lot easier to manage.

The response I received from the audience was quite disappointing and could be summed up by two themes...

1. Thoughts that the strategy is non-compliant, and
2. Existing systems made recommended such a combination difficult

In terms of non-compliance the audience felt that because the asset allocation shifted to 100% High Growth portfolio at the end of the annuity term that it was non-compliant. This is completely false. An investors asset allocation changes every day and there is absolutely nothing in legislation that suggests rebalancing must occur or that an investor's asset allocation must meet the corresponding Strategic Asset Allocation over time. Once again, what the proposed solution provides is a satisfied client in terms of cashflow for at least the next fiveyears from an annuity and a second portfolio that is designed for growth over that same period so as to, hopefully, continue to provide income for a lot longer. This strategy is completely compliant and first and foremost meets the client's needs. If the client has concerns then it doesn't matter what the risk profile of the client is these concerns must be addressed but that is a separate issue.

The second point disappointed me most. Whilst Nil RCV annuities are not currently available in master trusts or wrap platforms that is once again quite irrelevant to the client's needs. If existing systems don't quite make it easy for paraplanning or ongoing reporting then tough luck...if its the best solution for the client then a bit of additional work for the client's benefit should be considered...in fact perhaps it is justification to charge additional fees.

My general observation in recent years of the methods of portfolio construction for the retail investor in this country is that portfolios are designed to firstly be compliant within business rules and secondly to match client's needs and unfortuantely the thoughts around compliance get a little bit carried away. Client needs must always come first and if they are met and all risks and fees are disclosed and the client is still happy then there will never be a problem. Throw in some ongoign communication and needs reviews and if the strategy still applies then it should be happy days.

Consumer Alert - be wary of Omega Watches

I hope I don't use this forum for my consumer complaints too often, but I have to vent my frustration regarding my Omega Seamaster watch. Despite being a fairly expensive piece of equipment, it was losing around 5 minutes per month so after missing one too many trains I decided to return it to the shop where I purchased it.

As expected they sent it away and advised it would take "around 4 weeks"...its almost 8 weeks now and yesterday I was advised that "it is in the final stage of 'quality control' and should be ready by the end of next week, which is Xmas after which we close so it should be ready in the New Year"...mmm...10 weeks after a promise of 4...boy do I hope it keeps better time.

Fees in Perspective

From 1 November 1980 to 31 October 2009, a total of 29 years, an investment in bank bills would have yielded a total return of 1,257% which is an annual return of 9.41%...many banks provide this type of return for their customers and as we have found out in the last year or so, the Australian government is happy to protect your deposits when times are tough so the risk is very low and bank bill type returns are achievable for all of us.

Compare this to the return of the All Ordinaries Index....which is the best proxy of the broader market as it encapsulates on average around 500 of the top Australian companies...which returned 1,996%...better than bank bills...however...the annualised return is only 11.06%. This annual return represents a risk premium of only 1.65%pa.

For the average punter, access to managed funds is typically done via master trusts or wrap platforms, and guess what....their total annual product fees (which include administration, fund manager, and advice fees) are typically around 1.9%pa for an investment in an Australian Shares fund. Therefore, if you made an investment into the Australian sharemarket at the start of 1980, (which opened with around a 50% first 12 months return), you would have underperformed bank bills by paying the fees that current platforms charge adn most importantly with more risk!

No wonder the Cooper review and government will insist on fees being less than 1%pa.

A Simple 2009 Review and Outlook piece for clients

The year 2009 has turned out to be a significant turnaround year for the global economy and sharemarkets. At the start of the year, the word depression was mentioned often as many economists, investment professionals and politicians thought entering the world’s second great depression was a potential reality. Thankfully, around March 2009, “green shoots” of the global economy started to appear and whilst they haven’t blossomed into anything too beautiful, we have at least witnessed the emergence of many other “green shoots” that have improved conditions in credit markets, share markets, and in the US some positive signs in their housing market.

Sharemarkets bounce...
For investors in sharemarkets, the year 2008 was one they would rather forget and this continued into the first quarter of 2009 where the S&P/ASX200 index bottomed at the start of March. This was the lowest level for the sharemarket since 2003 but despite a lot of paper talk of the market potentially going lower, as is often the case, when the news out of the sharemarket is at its worst prices start to rise. Although the news continued to be bad it wasn’t as bad as expected and between March and October the S&P/ASX200 increased by almost 60%...an astonishing rebound.

The same was true for global shares despite the US, Japan, and Europe’s economic woes that continue today. For the global share investor, returns were also strong double digits. Unfortunately, for the unhedged investor, which is most of us, the strength of the Australian dollar reduced investors global sharemarket gains and many may well see negative performance for the 2009 calendar year.

Bonds subdued...
The economic “green shoots” that contributed to the increase in sharemarkets from March of this year also contributed to increases in interest rates. Unfortunately for the bond investor, an increase in interest rates results in the decline in the value of bonds. For the local bond investor the strength of the Australian economy resulted in some of the strongest interest rate rises in the world and overall returns for Australian bond investors may well be flat. Global bond investors have fared a little better as the overseas economies have struggled significantly more than in Australia and interest rate movement has been minimal to negative. As a result global bond investors may see annual returns between five and ten percent.

Economic Landscape...
The Australian economy has certainly fared very well compared to the US, Europe, and Japan and this is largely due to three main factors:

1. Strength of our banking system which is significantly more conservative than some of the largest banks in the world
2. Strength in our commodity export sector and geographci position close to Asia. This has provided the ability to leverage from the significant growth in China
3. Strength of our government’s balance sheet who in the good times had budget surpluses allowing these savings to be used for the tough times that turned out to be the global financial crisis

Looking forward it is near impossible to know how investment markets will perform but indications are that overall the global economy will be slow as global households continue to reduce debt and high levels of unemployment (which are expected to still rise) provide a drag on consumer spending. Whilst the global economy is improving there remain significant risks as evidenced by the default in its debt payments by Dubai World. Credit markets are far from normal and this is a strong indication that full recovery is a long way off yet.

In Australia, markets have priced in further increases in interest rates by the Reserve Bank with another 0.5% of rises expected by March or April 2010. Rising interest rates is a sign of strong economic conditions so with a bit of luck if there are no further economic shocks there is a stronger sharemarket into the first half of 2010. Given the volatility of sharemarkets this is far from a sure thing but on the positive side, we are coming from the worst global economic conditions since the Great Depression and we are still a long way off our sharemarket highs which were reached in November 2007.

Dubai World Default

Early signs in the US are that the Dubai World default may not really mean too much. Sure US Stocks fell by more than 1%...which isn't too uncommon nowadays...but conversely, US Bond Yields are up suggesting there isn't too much "rush to quality". Time will tell but I'd suggest this is quite a tame reaction.

Nouriel Roubini, famed GFC forecaster, apparently believes this may be the first of more sovereign defults...if so, then that's a different kettle of fish. But at this stage...the US markets aren't convinced.

Best Pie Chart Ever!

Got this Fox News chart from flowingdata.com...possibly a little tragic but I can laugh at this all day.

FPA toughen education rules for financial planners

The front page of the Australian Financial Review today talks of the toughening of education standards the FPA requires from 2015 (I'd rather they start now)...anyway...apparently the FPA expect financial planners to be tertiary qualified, pass a national examination, accreditation process, and from next year complete compulsory ethics training.

I think higher education standards for financial planners in this country is long overdue so well done to the FPA.

The irony in this is that it wasn't that long ago that FPA Australia was handing out CFP status to anyone that called themselves a financial planner...the old CFP from a cornflakes packet accreditation.

I can hear the planners now...more compliance, more education requirements, changing our business model away from commissions...looks like fee for service might look very expensive.

Krugman says US Fed's Cash Rate ideally should be minus 6.7%

My favourite Nobel Prize Winning economist's article can be found here…This is quite an astounding conclusion but not too far fetched given the evidence. What really concerns me is that whilst the US Cash Rate ideally should be much lower, our Reserve Bank and (judging by the Yield Curve) our markets envisage significant cash rate hikes over the next 12 months….mmm…do you think we Australians are being just a little optimistic about our growth potential or expectations given the clearly disastrous economy of the US (& Japan,  UK, Euro zone etc)?

State of the US Economy

For a fascinating outlook for the US Economy and property sectors, Federal Reserve of San Francisco's Janet Yellen's 10 November speech is a must read. Access it here.

Australia's unemployment creeps back to 5.8%

With the government downgrading its June 2010 unemployment expectation to 6.75% it appears we will be creeping there slowly given we have been around 5.8% for much of the last 6 months. This is largely thanks to a drift from full time to part time employment and of course the downside is that on average we are working much less and therefore earning less.

The number of unemployed persons in Australia is now 669,000 (increasing by 34.3% over the last 12 months) and this is the highest since late 2001. From an Australian perspective, we must be thankful thta we are no where near the horrific unemployment levels of the US at 10.2%...things must be very tough there with small signs of recovery but most economists believe that US recovery will exclude employment growth.