Back to Basics Portfolio Construction

My latest draft article submitted for publication in IFA can be found here. In an nutshell, one of the problems with asset allocation portfolio construction in recent years is the increase in the number of asset classes promising diversification benefits...hasn't quite turned out that way. Secondly, we've seen equity-like risk creeping into the fixed interest and even cash asset classes which have created a few problems in recent times. Thirdly, dealing with rising inflation in retail investment portfolios has traditionally been dealt with via an equities exposure...this is prone to failure as equities can be a very poor hedge to inflation...inflation linked bonds and real assets (not stapled property securities) have proven to be the best inflation hedge.

Understanding total portfolio risks is essential to good portfolio construction and knowing how much market risk (including the possibly hidden equity-like risks) and liquidity risks to name a couple will remove more of the hidden surprises while all markets continue to be volatile.

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.

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.

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

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!

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.

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.

Macquarie is the only gutsy fund manager

Macquarie have a series of managed funds whereby they guarantee the index return, for whichever asset class, to the investor with an ongoing MER of zero. This series of funds is called their true index series. What Macquarie is saying and doing is that they have the ability to outperform the index after costs and they make money from whatever outperformance they can generate. The investor is effectively taking on counterparty risk of Macquarie.

There are so many fund managers out there who claim that their method of active management is the best, will outperform by x% or whatever...my challenge to them is to put their money where their mouth is just like Macquarie has. If their active management method style is so good, then give me a guaranteed return of their index (say ASX200 Accumulation Index) plus 10bps (no point matching Macquarie..may as well better them) and watch the money flow in. Active managers struggle to outperform the index over the long term but for those managers that reckon they're so good....this challenge will guarantee outperformance of the index every year...as long as they stay solvent.

Economic Growth does not mean High Equity Returns

One of the more frequent queries I receive is from planners who want to invest their client's funds into high economic growth countries of India, China, and emerging markets. My response is fairly standard in that I wonder why they believe that would provide their clients and the response is typically along the lines of "their growth potential is greater than the rest of the world".

Last week, one of my favourite bloggers, Buttonwood (The Economist), provided commentary on this phenomenon, titled "The Growth Illusion". I know I'm doubling up and perhaps you can read it yourself but in essence, "the faster an economy grows does not mean the faster corporate profits grow and therefore the investor receives higher returns". A study performed performed by Dimson, Marsh and Staunton (they're a few academics involved in the production of Credit Suisse's Global Investment Returns Yearbook this year), showed that there was in fact a "negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting"...so no go there.

A second study showed that the better returns from 1990 to 2005 did not come from the highest growth economies. And a third study showed "no statistical link between one year GDP growth rate and the next year's investment returns".

Another study by Paul Marson of Lombard Odier, showed there is no correlation between GDP Growth and Stockmarket returns of Emerging Markets.

The most likely reasons for all of this rests with a few reasons stated in the Buttonwood blog...

• the potential is already recognised and factored into prices so that they are bid up to very high levels
• the stock market does not represent a country's economy and vice versa
• "growth is siphoned off by insiders at the risk of shareholders"

The best recent example I can think of is China. It may have had one of the best growth rates in 2008 but the sharemarket still crashed by 70%. With all of this good news flowing through for the month of August China's stockmarket was still down 20% (albeit up by 70% beforehand). Maybe investing in a growth economy will produce the good or maybe it won't, but as the first point above alludes to...everyone knows this so why wouldn't it already be priced in?

Bond Fund Correlations

The above chart shows the 6 month daily correlation between Hedged Global Shares and four Australian bond funds...

• Tyndall Australian Bond
• UBS International Bond
• Macquarie Diversified Fixed Interest
• Principal Global Strategic Income Fund

Each fund is different. Tyndall is invested in high grade Australian bonds, UBS International in high grade global bonds, Macquarie is 60% Australian bonds, 40% global and also takes on some investment grade credit risks, and Principal's fund invests in high yielding securities including hybrids, asset backed securities, junk bonds, as well as some conservative bonds. All global exposures are hedged to Australian dollars.

What this chart demonstrates is the increasing correlation between Principal and hedged international shares from mid 2007, the start of the credit crunch. Basically, diversification benefits did not really exist for the high yielding investment.

However for the other funds, which had conservative bonds as a high proportion, their low correlation with hedge international shares shows their diverisifcation benefits in tact.

So a simple conclusion is...whilst high yielding investment may giove you the opportunity for higher returns, don't think they will provide diversification benefits if sharemarkets tank. With a weak outlook for shares, so too is the outlook for companies to pay their debt so the price of low-grade credit can fall significantly also. A final point, which is often overlooked...bonds have limited upside...at maturity the most you will ever receive is the face value...that's it.

Yield Curve looking Good...is it too good?

As the above chart shows, the Australian government yield curve has been steepening ever since the end of last year. This yield curve is a good indicator of the future strength of the AUstralian economy. As it shows, during June of 2008 the curve was negative (i.e. sloping downwards) and worst case scenario, is that a negative yield curve signals potential recession as there is no premium for long term rates like you would expect. Right now, 5 August, the curve is incredible steep with current interest rates at 3% and 5 year government bonds yielding around 5.5%. This curve indicates there is only one direction for rates to go and that is up...and that is only likely to occur if the economy is strong.

There is no doubt the outlook for the Australian economy and global economy) has improved in recent months, but the speed of the improvement, whether sharemarkets or the strengthening of the above yield curve, has been startling. Whilst yields aren't what they used to be, has this rapid improvement been to fast, so is there a short term opportunity for bonds? If not, then can this yield curve get steeper?

Another blow for active managers

Following the APRA report from a few weeks ago, late last week Standard and Poors published a paper that wasn't too flattering of the active side of the Australian funds management industry. The paper can be found here.

Their analysis had the following conclusions:

• Over 5 years, the benchmarks outperformed the majority of active managers
• ASX/S&P200 index outperformed two-thirds of active Australian general equity funds
• UBS Composite 0+ Bond index outperformed more than 97% of actively managed bond funds over the last 5 years
• Between 10% to 30% of all funds have disappeared over the last 5 years

A fascinating, but unsurprising result of which most in fund research or academia have known for a long time. The most surprising result is that it has come from Standard and Poors who are potentially damaging their own business (albeit in a very small way) by suggesting that active management, on average, fails.

I guess Standard and Poors will be suggesting that it requires their skill to pick the best managers!!!

Mutual Fund Theorem - Ignored by most financial advisers

According to John Campbell, Professor of Finance at Harvard, “academic finance has had a remarkable impact on many financial services. Yet, financial planners offering portfolio advice to long-term investors have received curiously little guidance from academic financial economists”.

A case in point is the Mutual Fund Theorem, which was developed by Nobel Laureate, James Tobin in 1958. The mutual fund theorem is a very simple approach to investing based around Harry Markowitz’s efficient frontier framework suggesting that all investors should hold only one portfolio of risky assets. This one portfolio can then be adjusted for the conservative investor by adding risk free assets (or cash), or can be geared for the aggressive investor.

Figure 1 shows the efficient frontier and the Capital Market Line (CML) which is drawn from the expected return of Cash through the tangent of the efficient frontier (represented by the Optimal Portfolio). Whilst it is not a perfect representation of reality, it demonstrates the possibilities that:

• By adding cash (or a risk free asset) to the optimal portfolio (which contains bonds, equities, etc) it is possible to achieve a high return for less risk than a portfolio of bonds…this is the benefit of diversification


• Gearing the optimal portfolio has the ability to achieve a high risk-adjust return than a portfolio of 100% equities. Most of the high growth portfolios include only equities (which clearly may be less efficient than a geared diversified (or optimal) portfolio)

Whilst most if not all financial planners and advisers are aware of the Markowitz efficient frontier and the derivation of the optimal portfolio (i.e. the portfolio with the highest expected return per unit risk), the use of this very simple part of modern portfolio theory has seldom been put into practice. Financial planners throughout the world typically look to personalise portfolios for individual clients based on their risk profile, income and growth needs and most likely looking to build portfolios that are on the efficient frontier. As Figure 1 shows, in theory this may not be the most efficient approach and is potentially creating unnecessary work that adds little to no value in terms of what matters to investors the most, investment returns.

From a practical financial planning perspective, adding cash or gearing an “optimal portfolio” certainly makes things a lot simpler.

Now whilst every investment professional in the world attempts to design an optimal portfolio within their constrained investment universe, we all know that it is impossible, but of course, it doesn’t stop us from trying. For the retail investor the optimal portfolio is often regarded as the “balanced” portfolio, which has a diversified allocation across all available asset classes whether equities, bonds, real assets, etc.

So to really keep portfolio construction simple, recommend the “balanced” fund for the balanced investor and add cash for the more conservative investors and gear into the balanced fund for the growth and high growth investor.

Some of the challenges with implementation include, choosing the optimal portfolio; the limitations of implementation in various investment vehicles such as superannuation where gearing may be difficult; or simply getting cost effective gearing.

Overall, this theorem should provide some food for thought next time a portfolio is constructed and some questions to ask before building the next “tailored” portfolio could be…can a geared diversified portfolio be more efficient than 100% equities or should the client really be out of equities just because they are conservative? At the very least, the Mutual Fund Theorem demonstrates the best method to manage risk is diversification and diversification across all asset classes should be considered irrespective of the investor’s risk profile.

A simple economic/financial update for some planners

Over the past few months the global economy has seen the emergence of “green shoots”. As implied, there are indications that the global economy may be turning a corner. Like turning around a super tanker, turning around the global economy will take a long time and these signs aren’t so much an improvement but indicate a slowdown in the deterioration of the global economy. For example, in the US only 345,000 jobs were lost during May which is around half the average monthly decline of the previous six months. US Unemployment is still increasing but not at the rate it previously was.

Other positives include the gradual decline in the cost of credit (remember the Global Financial Crisis started as a credit crisis), stabilising financial markets, perceived future demand resulting in increasing commodity prices (Oil increased by 48% in USD terms over the past 3 months), and improving consumer confidence.

In Australia, our unemployment stands at 5.7% and the Australian Bureau of Statistics announced that we avoided a technical recession to the quarter ending March 2009 with positive real GDP Growth of 0.4% thanks to declining imports.

For the Australian sharemarket investor, returns for the 3 months ending May 2009 have been spectacular with the broad All Ordinaries Accumulation index increasing by a little more than 17%. Overseas sharemarkets also provided strong returns and the major sharemarket indices of the US, UK, and Japan increased by 25%, 15% and 25% respectively. With the Australian dollar appreciating over the same 3 months against the US Dollar, Pound, and Yen, by 25%, 11%, and 22% only the hedged international investor experienced the strong international gains as the strength of the Aussie dollar most of these returns.

The perceived improvement in the global economy combined with large budget deficits all around the world including here in Australia, government bond yields increased substantially. This means that investment returns for the bond investor were relatively weak (as high interest rates mean lower bond prices). The UBS Composite Bond index had a slightly negative return of -0.6% for the 3 months to May 31, and the global fixed interest index, JP Morgan Broad WGBI (AUD) Hedged Index, returned only 0.43%.

Whilst the short term sharemarket gains indicate positive signs for both the Global and Australian economy, there are still significant signs of weakness. Unemployment both here and overseas is still increasing which will continue to dampen demand and force households into increased savings instead of spending. Business investment is weak and companies continue to struggle, as evidenced with the recent collapse of General Motors and Chrysler in the US, and two of the largest agribusiness companies in Australia, Timbercorp and Great Southern. The last few months have shown the risks of being out of the sharemarket when everything appears to be at their worst. For investors, sticking to a portfolio with the risk profile designed to help achieve financial goals is essential.

Australia's Steep Yield Curve

An incredible steepening of the yield curve has occurred throughout 2009. As can be seen the latest 10 year bond yield isn't too far from where it was in the middle of 2008. This yield curve tells us several things about the state of current markets and economy...

• the market is starting to think that the next RBA move will be an increase in interest rates and not a drop...the 3 month yield is only 2.95% versus the 3% cash rate and longer term yields are above 3%
  
• The steep normal looking yield curve is typically a sign that Australia's economy is looking up and this steepening has increased throughout the year in line with increasingly positive news
  
• The sharp increase in steepness has happened so quickly....does this mean that bonds are oversold?

Overall this is a good looking positive yield curve despite global economic news continuing to be mixed. We are still in the 'green shoots' phase of a global economic recovery so this steep yield curve looks to be a relatively attractive buying opportunity to me.

The safest investment strategy

I have just read an article by Zvi Bodie, who has authroed a few university investment texts, and he reminds us of a simple but unfortunately forgotten or ignored concept...

"Matching is the safest investment strategy for achieving a specific goal. To eliminate the risk of falling short of an investment goal at a specific future date, the investor needs to match the maturity of his investments to the date of his goal, with target dated, inflation protected investments" like inflation linked bonds.

Government Inflation linked bonds is the only true risk free investment...does anyone actually realise this fact???

Market Valuation Update

Source: RBA

The rise in global sharemarkets in the last 2 months has seen the PE Ratio increase from its bottom at around 10 to around 12 to 13. As the above chart shows this ratio valuation level is not too different to the average PE Ratio in the 1970s and for Australia, the 1970s and 1980s.

With the global adn local economy still forecast to shrink in 2009, company profits expected to drop significantly, the current PE ratio still does not look cheap and significant downside risks remain on valuation alone.

Risks of Direct Equity Portfolios

This week my latest education article was published in IFA magazine. Basically it summarises the amount of additional downside risk a direct equities portfolio with a small number of stocks takes on compared to portfolio with a large number of stocks. There is myth that concentrated stock portfolios are more likely to outperform managed funds, an index, or a larger stock portfolio. This myth appears every bear market and must be exposed for what it is...rubbish.

If you can’t get the magazine, never mind as the article can be found by clicking on the following link... http://tinyurl.com/dmq7da

Economic Outlook

At the time of writing, sharemarkets around the world have experienced one of their strongest six week rallies in history. The push to get the ball rolling was the $1trillion Geitner package that was designed to remove toxic assets from balance sheets. The G20 meeting of world leadersproduced one of the more productive outcomes in recent times and all of this was followed by surprised quarterly profit announcements from some of the biggest American banks in Goldman Sachs, and Citigroup. Whilst the newspapers and various commentators are calling the bottom of the market, there appears to be little evidence suggesting that things are looking up for the economy. The grim reality is that the major economic statistics released in recent weeks have been terrible.

Globally, the International Monetary Fund is predicting the first global GDP contraction since the great depression and that advanced economies will experience deflation during 2009. Deflation is where prices decrease and is just as concerning as high inflation as Japan in the 1990s will attest. For example if prices are declining then consumers are less inclined to spend as prices will be lower tomorrow. This obviously leads to lower profits, less jobs, less spending and the vicious cycle continues. Industrial production around the world is at record lows, credit is still expensive, andthe banks are still writing off enormous assets. Many of the leading economists in the US believe the $1trillion Geitner package is insufficient and should be more in the order of $4trillion otherwise the only hope for the US banks is nationalisation...but in the land of the free nationalisation of a bank is sacriligious.

In Australia, recent months have seen unemployment rapidly increase from just around 4.5% towards the end of 2008 to 5.4% at the end of February 2009. The federal government was forecasting unemployment to peak around 7% by mid 2010 and there is little doubt this figure will be revised upwards in the current budget. Whilst Australia is not technically in a recession (i.e. two consecutive quarters of negative growth) it is just a matter of weeks before a recession in Australia is confirmed. In fact, even before the GDP figures are released Kevin Rudd has announced that “it is inevitable that Australia is dragged into recession".

The Australian government starting responding to the threats of recession several months ago by announcing their $42billion Nation Building and Jobs Plan, with around $30billion of this to be spent on infrastructure over the next few years. Compared to the rest of the world, the federal government has been very active in attempts to re-accelerate economic growth.

The first Tuesday in March saw the Reserve Bank decrease their cash rates by 0.25% to 3%, which again, compared to the rest of the world is one of the largest and most rapid of interest rate reductions. Unfortunately, whilst bank cash accounts reduced interest rates the same cannot be said for home loans where only a small proportion of the rate cut was passed onto borrowers. In longer term interest rate markets we have seen government bond yields increase substantially in recent weeks. This increase is due to the government required capital raisings to fund their future debt and once again this is not helping those that wish to fix their home loan interest rates. Commonwealth bank announced that they are increasing their fixed rate for all mortgages with terms greater than 1 year.

The outlook for interest rates are further reductions. The Australian government bond maturing in September this year currently trades on a yield of 2.77% indicating at least one and most likely two reductions of 0.25% over the next few months.

Chart 1

The outlook for equity markets both here and overseas continues to be one of volatility. Whilst valuations (as defined by the PE Ratio) continues to be at low levels (Chart 1), the expected decline in earnings (Chart 2) and lack of earnings guidance from companies both in Australia and around the world provides significant uncertainty of potential. As chart 2 shows future earnings expectations are to be below 2005/06 and 2006/07 levels.

Chart 2

With low cash rates, volatile equity and bond markets, and continued economic uncertainty, diversification of investment portfolios is essential. Compared to the rest of the world the Australian economy is better positioned to withstand the slowdown. The government has one of the lowest debt levels in the world and the Reserve Bank still has significant room to move on interest rates. These factors provide opportunity to add further stimulus to our economy to provide jobs and economic growth. Whilst Australia is probably already in recession these factors suggest the slowdown won’t be as bad here as in the rest of the world.

Is the market cheap?

The above chart is a couple of weeks old now but is showing the market PE ratio to be around 11 (so its probably 12 now). As the chart shows this is a PE ratio that was pretty much the average throughout the 70s and early 80s. Now a PE of 11 is an earnings yield of 9% and if we expect negative growth of say 1% then we're left with an 8% earnings yield over the next 12 months. With the government bond yield at around 3% is 5% really a sufficient risk premium? With BBB rated corporate bonds with an average credit spread of at least 5% I'm not really sure the current PE ratio really stacks up as attractive given the incredible headwinds Australian companies are facing...many may say the market's cheap and maybe a PE of 11 (or 12) is cheap...but not yet.

Don't be deceived with low valuations

The lcaol sharemarket continues to show some very low PE Ratios and very high dividend yields which look terribly attractive. As the following chart shows, looks can be very misleading while analysts continue to sharply downgrade forecast earnings.

Traps of Capital Protected Investments

Capital protected investments are getting more and more popular in these economically uncertain times. There are quite a few varieties of capital protected products and on the surface many of them look very attractive however most come with a few hidden traps. This article doesn't explain all of the traps but a few of the more common ones.

Some examples include:

• 100% protection and 100% exposure to growth of the S&P/ASX200 index...this is a very common structure where the protection comes from the purchase of a zero coupon bond and the index exposure comes from the purchase of a call option. The trap is that the exposure is only capital growth and excludes any franked dividends that the S&P/ASX200 may pay. The current dividend yield of the S&P/ASX200 index is around 7.2% and if we assume a significant drop to 5% dividends over the next 12 months plus some franking then this is a hefty price to pay for the pleasure of capital protection.
• 100% capital protection and 100% exposure to both growth and dividends of an underlying index or managed fund...this particular capital protected product uses an insurance method commonly called CPPI (Constant Proportion Portfolio Insurance) or Dynamic Threshold Management. Basically, if the underlying index or managed fund drops below a certain price, it is sold and low risk bonds are purchased to ensure the capital is protected. There are two traps with this method. Trap One...in very volatile markets and low interest rate environments this method is prone to failure. This is because a sudden drop in the price of the underlying may not given the protection manager sufficient time to sell at the right price to ensure protection. This leads to counterparty risk so ensuring the provider can pay up is essential. Trap Two...this method is inefficient as growth assets are sold when low and bought back when prices are high. This seriously dilutes the final return.
• 100% Protected Index Linked Deferred Purchase Agreement...there are a few products available at the moment where for a deposit of around $5,000 to $7,000 an investor can obtain a 100% protected exposure to $50,000 in an index such as the S&P/ASX200 with a cap on the upside of between 20% and 30%. There are several traps with this product…
  Trap One…the same as point 1 above applies, that is, the index exposure excludes dividends. Trap Two…the payment is in fact an insurance premium payment and not an installment or actual investment so like any insurance payment it is a cost that is immediately lost. Trap Three…the price. The investor is actually purchasing an "At the money" call option plus selling an "Out of the Money" call option with a strike price 20%-30% above the current index price. Using option pricing methods such as Black & Scholes at current volatility levels this structure should cost around 5%-7% at most but the actual cost is 10%-14% (($5,000 to $7,000)/$50,000)...quite a hefty profit for the product provider and quite a high return required (without dividends) just to get the premium back.

Unfortunately, due to their complexity capital protected investments lack a lot of pricing transparency and in these volatile times cost a lot of money. Always keep in mind that capital protected products are unlikely to replicate sharemarket returns and are expected to provide a diluted return. Due to these factors it is typically more efficient to invest into a balanced portfolio of numerous asset classes.

Government Bonds and interest rate movement

The above government bond yield curve shows how the yields have changed across the different terms from early February to today (before the RBA's decision). The 1 year yield is still around 2.60% indicating the market expects the RBA to drop rates to around 2.5% by July 2009 but the interesting part is how the yields have increased from maturities of 2 years and above. With the Australian government's fiscal stimulus packages and expected capital raising from bond issues, the market is demanding a higher premium from the government and yields have increased by around 0.50% to 0.75% for all longer term government debt issues.

From an investment perspective this increase in yield over the last 2 months would have dampened bond returns significantly. But with the economy still deteriorating perhaps the yield curve movement is a little overdone and maybe now there's a buying opportunity???

Deflation...how to invest?

Source: IMF

The above chart shows the IMF's global inflation forecasts and they don't look pretty. They are forecasting that advanced economies might by in a position of deflation similar to what Japan experienced in the 1990s. Many would argue that deflation is just as or almost as bad as high inflation. Deflation is simply the decline in prices and what this means is that if you as a consumer believe that prices will be cheaper tomorrow then you will not spend today and save your money. Not spending means lower revenue today, therefore costs need to be cut, jobs are lost, followed by less spending and the vicious cycle continues.

From an investment perspective, the above-mentioned vicious cycle results in declining profits which is therefore a negative for equities, credit, and as it often leads to near zero interest rates is not particularly good for cash either. The one asset class that is a good place to be in times of deflation are high grade bonds. Because inflation is the bond investor's enemy, deflation is their friend. As interest rates, prices, and profits decrease during the deflationary cycle, high grade bond investors receive a fixed interest rate that doesn't lose its purchasing power but actually increases it.

So whilst, governmet bonds had an incredible run in the 2008 calendar year, with deflation looking like a possibility in 2009 perhaps now is not the time to discount their value in a diversified portfolio.

Investment Thought for the Day

With the reporting season before us, an uncertain economic outlook both globally and locally, investing in Australian Shares today is fraught with danger. If seeking equity risks, irrespective of attractive valuations, I believe dollar cost averaging is the only way to go.

Asset Class Views

Cash

• Expectations are quite strong that short term interest rates will drop quite rapidly due to slowing global and Australian economy

Australian Fixed Interest

• General expectations are that investors will continue to move from equities to bonds and cash due to a current environment of risk aversion.
• Downside risks are that bond prices are at historic highs

Global Fixed Interest

• Underweight positions are primarily value driven whereby global bond yields are at extremely low levels.
• ING have an overweight position due to their belief there will be continued risk aversion and that the global economy will continue to be weak, thereby placing downward pressure on longer term yields

Australian & Global Listed Property

• Despite attractive valuations, there is expected to be continued high volatility
• Primary risks relate to property trusts continued struggle managing debt levels combined with declining asset values

Australian Shares

• Similar story to listed property whereby valuation metrics, like PE’s, look very attractive and are at historic lows.
• Downside risks relate to uncertainty around a lack of clarity around corporate earnings (reporting season commences in February) and the declining strength of the Australian economy.

Global Shares

• Once again, valuation metrics, such as the PE Ratio, appear quite attractive.
• With many of the major developed countries in recession, future company earnings are extremely uncertain thereby providing weak guidance for determining value

Alternative Assets

• The positives of alternative strategies relate to their diversification potential and the flexibility of many of their investment strategies.
• Unfortunately, the Madoff scandal combined with the weakest hedge fund returns in history have resulted in large worldwide redemptions and the suspension of numerous funds.

Currency

• The Australian dollar has been quite volatile over the past 6 months and has declined by around one-third versus the US Dollar and this has provided a boost for unhedged international investors.
• Currently the Australian dollar is trading around US66c which is 10% below its long time average of US73c. Whilst downside risks still exist for the AUD, they have diminished significantly given the massive expenditure announcements of the US and other overseas governments.