September Review Comments
Written by Tony Gray   
Monday, 28 September 2009 11:36

The Economic Cycle / Asset Class Outlook

It appears that we are in the ‘early expansion’ phase of the economic cycle – where shares outperform and bonds underperform.  Generally at this stage it pays to maintain a relatively high allocation to Australian shares, relative to your investment strategy range.  One point of difference in this recovery is how rapidly commodity prices have recovered – normally prices for metals and energy would rise much later in the expansion, after economic growth is well entrenched and interest rates had risen.  This might mean that metals and energy have the potential to run on sharply for an extended period, or it may mean that we are in for a pull-back before we enter the ‘middle expansion’ phase?

Given the severity of the down-turn, my expectation is that the sharemarket will enter a consolidation phase where prices range sideways for an extended period – since psychologically investors will not be as optimistic in pricing future earnings - put another way, investors are more risk averse.  If the sharemarket behaves as it did in the first half of the 1990’s, then we may well see rises or falls of perhaps 20% and the opportunity to buy or sell stock at extremes every 6 to 12 months.  For this reason, where allocations to Australian shares are approaching the upper end of the investment strategy allocation, I recommend taking some gains and adding to cash reserves.

With rising interest rates, there is no rush to lock in interest rates through term deposits, although continuing a rolling maturity and reinvestment policy is recommended for those where the defensive fixed interest asset class forms a larger part of the investment strategy.  Credit spreads are high but narrowing and now should prove to be a good opportunity to add floating rate note exposure – where the interest rate is a premium to bank bill rates.  An example is the Commonwealth Bank Perls V offer currently in the process of floating – where a 3.40% premium to bank bill rates is attractive.  By comparison, when National Australia Bank released the first major floating rate note issue in the late 1990’s it was at a premium of only 1.25%.

Major listed property trusts generally remain good value in my opinion, with discounts to written down net tangible asset backing sufficient to absorb further falls in non-residential property values.  Distributions have been cut, such that they are fully funded out of rental cash-flow and the median level of gearing is now relatively low at the circa 30% level.  Despite the cut in distributions, yields are still in the vicinity of 7% to 8% for most trusts – with the exception of Westfield Group, which needs to fall back in price to justify a purchase in my opinion.
The higher Australian dollar has reduced the currency risk from adding international exposure and generally most portfolios are underweight this asset class.  I recommend allocating funds to this sector.


There are many parallels with the Chinese economy now and Japan in the late 1980’s.  The high savings rate, investment in infrastructure, strong economic growth and a large proportion of the economy tied to the level of exports.  Similarly, the Chinese are now on a buying spree in terms of international assets – primarily energy and metals.  Back in the 1980’s it was the Japanese purchase of Australian coal assets and the Gold Coast.
After the 1987 stockmarket crash, Japanese shares were barely affected and both shares and property raced ever higher until late 1989.  The Japanese sharemarket briefly had a capitalisation larger than that of the United States markets and the square mile of the Emperor’s palace in Tokyo was reputedly worth more than Canada!  For the next 13 years the bust that followed saw more than 80% of the stockmarket’s capitalisation evaporate.  The huge non-performing loans in the banking sector, deflation and long-term declines in property values ‘road blocked’ the economy.

The Chinese sharemarket (Shanghai Composite) has more than doubled from late 2008 lows but is still 40% off 2007 peaks.  Property prices have been rising sharply and artificially low interest rates have encouraged speculation.  Whilst there is a risk this all ends badly in the short-term, my feeling is that we will see a bubble develop in the Chinese economy and asset prices over the next few years.
A bubble in the Chinese economy could be very positive for Australia, with the mining and energy sectors likely to be key beneficiaries and indirectly boost our whole economy.  It is too early to fear a Chinese ‘bust’, but the higher asset prices race higher the worse the hangover that will ensue.

Many portfolios have an adequate energy exposure but are underweight mining stocks.  I think it is worthwhile considering further mining stock investment in the medium term – if the lower income yields fit within portfolio goals.

Last Updated on Wednesday, 28 October 2009 10:43

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