May 2012 Review Comments
Written by Tony Gray   
Friday, 11 May 2012 17:16

Portfolio Valuation & Comment

As anticipated, the Reserve Bank of Australia cut the overnight cash rate in early May.  The 0.5% cut was larger than expected by most, although the move by banks to cut their mortgage rates by a lesser 0.35% was not a surprise – in fact the RBA would have factored this in when deciding on the larger cut.

The reduction in term deposit rates has been perhaps 0.3% across short and mid-dated terms, as the banks continue to compete for deposits and switch funding away from wholesale markets and especially Europe.

This switch in funding, low growth in lending across the economy and higher domestic savings is steadily making Australia’s financial position more secure – more than compensating for the rapid rise in government debt.

On the negative side, total Australian private sector and government debt levels are only just off record levels (relative to the GDP) and our economy is likely to go through a protracted deleveraging process.  This will likely keep economic growth low for an extended period, with a risk of recession if base metal prices fall or if the decline in residential property prices becomes entrenched.

Referring back to the October 2011 portfolio comment, I outlined then the need for interest rates to decline and for unemployment to be rising as confirmation of our position in the economic cycle.  With three interest rate cuts totalling 1.0% in the last 6 months, we are clearly further along the downward section of the cycle (falling interest rates, declining or negative economic activity and falling sharemarkets).

Australian Shares

The million dollar question is ‘are we close enough to a cyclical low to buy shares’?  Right now my view is ‘probably not’ – but we’re a lot closer than we were 6 months ago.  Our position is to treat any meaningful sell-off in the market as an opportunity to switch some cash or maturing fixed interest into shares.

I recommend avoiding or holding only a minor exposure to mining stocks and mining service companies on the basis that there is a rising probability that China is destined for a hard landing – seeing lower prices and volumes than the markets currently anticipate.  Throw in the low yields, fixed cost base and capital intensive nature of the sector and these are not investments to ‘brave out’ when cycling down.

I’m also more cautious on the major banking stocks.  Share prices have risen, such that yields are significantly lower than 6 months ago – despite very little change in earnings.  I recommend lightening large individual holdings or where banks represent an overly large portion of the portfolio.  Some substitution into smaller banking groups, such as Bendigo Bank or MyState Limited might be considered – where much higher dividend yields provide some compensation for the risk of holding bank stocks.  Bank stocks are generally very good yielding companies to own – except in recessionary periods and right now this cannot be ruled out.

The remaining 30% of the market is a real mixture and our hunting ground if prices do fall further in the short-term.  Presently these stocks are generally trading at long-run average price to earnings multiples of 14 to 15 times.  On the one hand lower interest rates tend to support higher than normal valuations, but on the other a discount should apply due to the low growth outlook and higher than normal risks.

Listed Property

Listed property trusts have rallied as interest rates have fallen and are now much closer to asset backing – although with much lower debt than most unlisted trusts.  We’re not adding to this sector at present – nor are we selling.

International Shares & $US

International shares are dropping at present due to renewed concerns about the stability of the Eurozone and the Australian dollar is easing, although still above parity with the $US at the time of writing.  We continue to advocate a regular dollar cost averaging approach to build exposure to international shares.

Also consider holding some $US in the portfolio via the locally listed USD exchange traded fund – this provides a hedge against a falling $A.  There is no income generated, so this is a short to medium term alternative to holding an Australian cash reserve.  The intention is to sell down USD on any meaningful fall in the $A.

Our view is that the Australian dollar will fall sharply if the overseas economic picture deteriorates.  This will likely be accompanied by a fall in local shares and listed property.

Cash & Fixed Interest

Unfortunately interest rates have declined as feared, and ANZ are cutting the rate on their V2+ account to 4.35% tomorrow (the 11th of May).

Further declines in cash interest rates are probable, although far from certain.  Term deposit rates are acceptable and extending the term of deposits is still recommended.

We are becoming very wary of Australian government bonds - interest rates are now at 60 year lows.  It is very much a case of international investors buying Australian debt due to (1) higher interest rates than in their home countries, and (2) due to the AAA credit rating.

Further falls in bond yields will boost returns in the short-term, but the greater risk is that a future rise will lead to capital losses.  As rates fall it becomes harder to generate high sustainable returns and the risk and magnitude of loss rises.  We have not yet pulled the pin on existing bond holdings – waiting for the next RBA rate cut.

The Budget

The federal government continues to chop and change the taxation system and superannuation.  The party that had the foresight to introduce superannuation in the 1980’s now has cut back on contribution limits to such an extent that it will not be the main investment vehicle of choice for young and middle aged investors.

The government is ‘only’ borrowing $120 million a day for the current financial year – down from around $135 million per day last financial year!  The 2012/13 budget surplus is (again) predicated on an optimistic rise in economic activity and a circa 12% jump in taxation revenue. 

There is no provision for an economic slowdown in the numbers and no productive reform occurring.  I don’t consider taking more from those who save and giving to those who do not as ‘reform’.

From a planning perspective the following is relevant:

* Concessional superannuation contributions (i.e. where a tax deduction is claimed) will be capped at $25,000 from 1 July – despite Minister Shorten’s promise that a $50,000 cap would apply for those with less than $500,000 in superannuation.
* The indexation of contribution limits has been frozen for a further 2 years.
* Those earning over $300,000 (including fringe benefits and superannuation contributions) will pay 30% tax on Concessional Contributions to superannuation instead of 15%.
* Minimum super pension payments will remain at 75% of the standard rate for 2012/13 (i.e. 3.0% until age 65 and then 3.75% until age 75).
* Marginal tax rates will change on 1 July, with the tax free threshold rising to $18,200, but with marginal rates rising up to the $80,000 threshold.  Bracket creep is returning as a traditional government trick of lifting the tax burden.

End of Financial Year

We are endeavouring to complete end of financial year reviews this month. Please make contact if you have any specific queries or concerns. 

Although happy to receive referrals, I am not acting for new clients until July as May and June will be busy months - as we check contribution and pension action has occurred and the current year tax position is considered.

As always, if there is a material change in your position or goals, or if you have any investment or planning queries or concerns, please contact me. 

Best wishes,

A.W. (Tony) Gray BCom, LLB, Dip FP, GDipAppFin, CFP, FFin
Principal, TG Financial

Please treat the above comments as General Advice, with no action to occur until we have considered with reference to your financial position, needs and goals.



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