October 2012 Review Comments
Written by Tony Gray   
Wednesday, 10 October 2012 12:41

Portfolio Valuation & Comment

Interest Rates & Markets

Unfortunately interest rates still appear to be sliding lower over time.  The swap market for 3 year and 10 year Commonwealth Government bonds implies a yield of 2.35% and 2.97% respectively.  This sits below the Reserve Bank’s overnight cash rate of 3.25% following last week’s quarter percentage point cut.

I say ‘unfortunately’ as ordinarily lower long-term rates compared to short-term rates are a predictor for recession.  Further, it suggests that over time at-call and term deposit rates will continue to decline.  This becomes an issue for those relying on income to meet pension payments and living expenses.

The protracted decline in interest rates in other developed economies and the risk to income levels of lower interest rates is the key reason we have been consistently advocating holding longer dated term deposits within the fixed interest component of portfolios.  This remains the case today, even while yields of only slightly above 5.0% for 5 year terms apply – these are still attractive rates relative to inflation and bond markets. 

In review conversations I have been painting a picture of what lower interest rates might mean over the next 12 months and the behaviour of the stockmarket.  Essentially the story is that as term deposits mature (most investors who don’t seek advice tend to keep deposits short-dated – typically 3 to 12 months) that they will seek out higher yielding shares and property.  In other words, as rates fall the value of shares and property (not residential) rise.  This could make for very difficult investment decisions in 2013 if underinvested in growth assets or holding too much cash or short dated fixed interest.

This is the current situation in the United States, where stock markets are relatively high as a zero interest rate policy has been locked in by the Federal Reserve for the next three years.  Listed property in the US also trades at a premium to asset backing as investors chase yield.

We have the benefit of seeing how international investors have behaved as interest rates have been cut in their economies and hence we continue to advocate applying some cash reserves to boosting exposure to growth assets.

Currency Wars

Major world economies are fighting it out to keep their currencies weak against competitors.  The US is now ‘creating’ $40 billion a month to buy their own debt.  This is ostensibly to keep interest rates low, but is also aimed at keeping the $US weak against the Euro and other trading partners.

This followed Europe’s expansion of money supply through the various leveraging instruments to buy new debt issues from the likes of Spain.

Meanwhile, as Europeans shipped money into Switzerland as a safe haven, this was pushing up the Swiss Franc and impacting on the competitiveness of that country – so they are now printing francs to buy Euros and weaken the franc...

Meanwhile the $A trades at a much higher level than can be judged against past indicators – such as the fall in commodity prices, which would see the currency at around 90 US cents (instead of $1.02 presently).  Comparisons to the Trade Weighted Index would see the $A even lower.

The reason seems to be the demand for Australian debt by the rest of the world – our interest rates remain relatively high given our AAA credit rating.

My view is that this is all temporary – as the high $A, weakening budgetary position of the Commonwealth Government, slower economy and lower commodity prices will result in more debt issuance by government and a lower Australian dollar.

This means we continue to advocate diversification into international equities.

Inflation & Gold

The huge increase in the amount of paper (electronic) money in the world compared to the size of economies must ultimately result in inflation in our opinion.  It may be a little while before it leaks out of the financial system in a way that is captured by the CPI (consumer price index), but we’re likely to see spikes in the prices of a range of assets due to ‘cheap’ money.

Governments are dealing with today’s debt and deficit issues by creating an inflationary time bomb.  For this reason we are actively seeking exposure to infrastructure and assets that provide some protection against inflation (by stint of their compounding cash-flows).

We also think there is a possibility that the gold price has a massive run higher.  With limited new supply and the value of gold relative to paper money now very low, the conditions are ideal for a price spike.  If the experience of the 1970’s is repeated, then a move to $8,000 per ounce is not out of the question!  This figure is based on the twenty fold increase in the gold price through the 1970’s – a historic guide of how big the last great gold bubble was.

With no yield on offer and a rally merely being a possibility, we are recommending only low gold or gold stock exposures, but we do see a place for a holding in most portfolios.  There is always the ‘risk’ that governments balance budgets, get debt levels under control and that sustainable growth is achieved!

Specific Investment Notes

Macquarie Group (MQG)

We have started recommending Macquarie Group as a higher risk/return stock for portfolios.  It has been about 8 years since this stock was generally recommended for additions to portfolios and in the last cycle we sold far too early (but still more than double the current share price).

Sure investment banking and bankers are on the nose.  Yes, capital markets are weak and the wealth management/broking division is losing money – but Macquarie Bank and the global asset and leasing business are ticking along.  The real attraction for this stock is the $323 billion funds under management – which includes enough infrastructure to rank them as the number one private manager globally.

My belief is that through the cycle the value of infrastructure held by Macquarie Group and the fees on managing that infrastructure will be very strong.  We are seeing the likes of the Future Fund bidding for Australian Infrastructure Fund and the Canadian pension funds bought out Connect East last year.  There is global appetite for long-term cash-flow compounding assets.

Macquarie Group is yielding ~ 5.0% unfranked but is trading at a premium of only ~3% to book value and until recently was buying back shares to cancel – signalling the board’s confidence.

The stock could quite easily fall back to ~$24 from the present ~$29 level on the next bout of ‘bad’ market news – but accepting this volatility, we feel the longer-term potential is strong.

Floating Rate Notes

There have been a number of offerings in recent months to shareholders to buy unsecured debt; including National Bank, Commonwealth Bank and Bendigo Bank notes.  We generally recommend avoiding the new issues as the longer terms mean investors are accepting a risk closer to equity (share) holders, with lower yields and without the upside.

This stated, there are some existing notes listed that offer shorter time frames and more certainty of return.  We can review the details of note issues of interest and there are a handful we are prepared to recommend to supplement deposit portfolios.

SCA Property Group

Woolworths are distributing 69 existing supermarkets or shopping centres into a new trust and distributing to shareholders 1 unit for every 5 shares held.  We are seeking more detail on turnover rent thresholds before forming an opinion.

Please contact me with any queries in relation to your portfolio, markets or planning.

Best wishes,

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

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


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