(MONDAY 9TH JANUARY- 07:01 - JAMES GERRISH)... 2012 is shaping up as a massive year for investors with a number of complex and interrelated issues likely to play out in the first half.
At the moment, Europe is center stage and unfortunately, it looks like they'll hog the lime light for the next few months at least. Not until we get decisive political leadership with the ECB stepping in as lender of last resort will there be any sustained period of risk appetite from investors.
In the US, the data is actually improving with unemployment ticking lower, Consumer Confidence bottoming and monetary policy remaining pretty loose.
Its also worth remembering the US Presidential election is due on the 6th November. Looking back in time tells us that since 1942, the stock market has never found a new low in the 4th year of a Presidents term. Its most often bottomed in the 2nd year while the 1st year of the cycle also corresponds with a number of market lows (that was 2009 when the mkt bottomed). Since 1926, the S&P 500 has returned an average of 11% during an election year and out of 21 election years, investors have lost money in only four - so history is offering 'some' cause for optimism.
Also on our radar is China and although growth data from the region remains fairly upbeat, the pace of growth will slow in 2012 which will have a negative impact on Australian exports - as we've seen last week with a contraction in our Terms Of Trade.
Throughout 2011, Chinese authorities have been working hard to manage growth and curtail rising property prices. Data thus far shows its working pretty well and although we'll continue to hear a chorus of China doomsayers, the controlled nature of their economy provides a greater ability for the leadership to manage drivers for growth, and we fully expect that China will continue to expand in excess of 7.5% PA.
The Nikkei Newspaper actually came out over the weekend suggesting that Chinese officials will lower their base case scenario for growth going forward to 7%, down from the 8% we've seen over the past few years. Its important to note this is a base case outcome and traditionally we've seen the economy grow at higher levels than their stated base case. That suggests Chinese officials are targeting about 8% growth and although that sounds impressive anything sub 7% would be considered a recession for that economy, so we need to be conscious of that.
The near term outlook for a lot of Australian companies is linked to the news flow coming from China and there is a lot of it out this week. Last year we saw the material stocks under perform the All Ords index by about 10%, Copper was off by 20% in the year and the broader suite of base metals were under pressure - highlighting the concerns that local investors have about the rate of growth in China and the impact of a European recession on Chinese exports.
If we do see Chinese data stabilize, the US continue to improve as recent data has shown and god for bid, European leaders put together a longer term plan for the region, it will be these risk assets that lead an impressive market rally that history shows, can be well in excess of +30% in a year. That's probably some way off yet (my readings on longer term price cycles suggests this move will come in the second half of the year) but history does show moves like this will happen after periods of intense volatility.
From an investors point of view, we retain our bias at the start of the year for the following portfolio structure:
- Hold a selection of boring, high yield securities >7% that offset a lot of growth potential with a higher degree of earnings certainty. By this we mean securities that pay a high yield now with the understanding that the income will probably stay static for the next few years. These can include stocks and hybrid style investments.
- Complement this with an array of stocks that pay decent yields >4% now, but have strong trends in earnings and an underlying driver that will see those earnings continue to rise. This should filter through to growth in dividends over time.
- Combine options in the portfolio to smooth returns and take advantage of volatility. When we use options, we're primarily sellers of options (not buyers), with options being used to reduce risk, rather than adding risk to the portfolio.
- Consider using interest rate securities such as Hybrids to further reduce volatility and increase income.
- Be active rather than passive in the market. The set and forget approach is dead and active management will be key in 2012 & beyond.
EUROPE
Stock markets in Europe finished mostly lower in 2011
FTSE 100 - Down -1.58%
French CAC - Down -15.39%
German DAX - Down -12.81
Euro v USD - Down marginally
** Figures above show the 12 month return as at 8th January - Source Bloomberg
Despite a lot of noise to the contrary, I don't believe the Eurozone will 'break up' and the shared currency will stay in tact for the foreseeable future at least. Because of this, the Euro will be under pressure from economic weakness in countries like Spain, Portugal, Italy and Ireland but the weakness will benefit export led nations such as Germany - which will ultimately provide the backstop (through the ECB) for the regions debt woes.
Although the new head of the ECB Mario Draghi has been adamant that the Central Bank won't be the 'lender of last resort' his track record of cutting rates + increasing liquidity as soon as he took over, highlights his bias for easing policy and the next step would be some form of Quantitative Easing (similar to what happened in the US).
I'd also suggest a greater level of fiscal integration in the Eurozone with the introduction of Euro Bonds to ease funding pressures on weaker nations.
These steps may be some way off - or they might be rolled out next week however one would have to assume, we're closer to getting some type of coordinated, centralized action from leaders than we were six months ago. I think the situation in Europe is improving behind the scenes and although it will remain volatile, I believe sanity will prevail.
I do say this with some degree of trepidation and obvious nervousness given the likely impact on markets if Europe implodes - which is always a possibility but i don't think it's the most probable outcome.
One aspect that is likely to keep markets under pressure near term is the refinancing program for a lot of these struggling European nations. Italy kicks this process off in February with the country needing to refinance 200 billion Euros before April. (Its got total debt of 1.9 trillion Euros). Spain, Portugal, etc will follow suit.
My own view is that the market can't have a sustained rally until we see that these nations can refinance debt and it seems that it will take some type of involvement by the ECB to provide the confidence needed in the market, which in turn will put down ward pressure on bond yields.
Looking at the chart below, we see the FTSE 100 has now broken above the 200 day moving average (Orange line) and buyers are tipping into the market at higher prices each time there is a pullback. It is at a critical juncture at the moment given there is a chance of a double top and subsequent resistant level around 5750 but the chart looks better than most.
The German Dax looks similar to the chart of the Aussie market. It seems that equity investors are pricing future pain in Germany (and Australia for that matter) given they were more resilient throughout the GFC and continue to provide a backstop for peripheral Europe.
From a technical standpoint the DAX is trading in a contracting range with higher lows and lower highs. The nature of this pattern doesn't give us a lot of evidence to suggest which way the market will break - only that its likely to break either way with a high degree of force.
Meanwhile the French CAC has a similar chart to the German market which shows some indecision amongst investors.
The US of A
The US stock market finished higher in 2011.
Dow Jones - Up +5.5%
S&P 500 - Up +0.5%
Nasdaq - Down 0.04%
US Dollar Index - up +13.65%
** Figures above show the 12 month return as at 8th January - Source Bloomberg
On Friday night we saw data that showed +200,000 jobs were added in the US in December and although this number has obvious seasonal factors within it (ie 27,000 part time retail jobs were added + jobs in logistics for the seasonal spike in activity) the trend is heading in the right direction at least.
We're seeing this theme play out in other metrics we look at including US manufacturing data and consumer confidence (and in turn business confidence) that seem to have have bottomed. Consumer confidence is actually an important print to consider given the historical correlation between a low in this data set and a strong equity market rally which we spoke of (probably prematurely) at the end of last year.
Debt is obviously the big elephant in the room in the US and the graph below highlights the trend of increasing Government debt v deleveraging of households. This theme thus far has had a big (negative) impact on the US services sector (70% of US economy) and I would anticipate that the trend of lower household debt will mean the recovery continues at a slower pace.
This also has implications for stock valuations given that previous assessments were calculated in an environment where consumers were more highly leveraged If we take out the leverage, spending capacity contracts and asset prices come back to meet the market, therefore creating the new norm around valuations. I guess what I'm saying here is that looking at historical valuations should be done so with a degree of caution because the operating environment has changed.
On the whole, we think that the US is actually in pretty good shape relative to other countries. Debt is massive and political imbalances are glaringly obvious, but stimulus has been positive and it seems Benanke and Co are happy to prime the pumps again if conditions warrant it.
As we said earlier, monetary policy is as loose as it gets and is likely to stay that way for a while (as confirmed by the Fed Treasurer) and history points to a positive year courtesy of the Presidential cycle.
Looking at the Charts, we see the US market as shown by the DOW JONES looks pretty strong. Its broken above the 200 Day Moving Average, its now above its last trading range and we see buyers getting interested at higher levels each time there is a pullback. It looks like the healthiest market by far from a price action perspective so we've got to give that some respect for now.
CHINA
The Chinese market fell sharply in 2011 and this put added pressure on our local market.
Shanghai Shenzhen CSI 300 Index - Down -26.67%
Will they or won't they...have a hard landing that is?
This is the biggest question from an Australian/Commodity perspective that needs an answer this year. To be honest - I don't know what the outcome will be and this ads additional risk to the markets.
If we look at the data prints from China, so far it seems the Chinese leadership are doing a pretty good job of curbing inflation and capping growth at a more sustainable level. Talking to people who visit the country regularly, on the whole their personal experiences are supportive of the data we're seeing.
We also listen to the global commodity producers such as BHP, RIO and Vale and take on board what they say about the demand for their products - and at this stage, they remain upbeat about the health of their customers.
We can look at China's track record of managing global market volatility/crisis and see that they have maintained incredible growth for sustained periods of time, through changing global trends... yet the market is still very skeptical of the Chinese story.
That's why we've seen the Chinese equity market fall nearly 27% this year - that's why Copper is off 20% in the last 12 months and it also explains the underperformnace of the Australian market v the US in 2011.
The fact is, no one really has an intricate understanding of how China's economy is positioned yet it seems we're ready to sell the China story first and ask questions later. I guess that's why BHP has such a big discount applied to its future earnings.
What ever the case, China's importance to the Australian economy can not be understated. This was highlighted this year when the RBA announced they'd be opening an office in Shanghai to gain a more hands on feel for the economy. Perhaps this will give the RBA a better insight into the region and will enable them to act preemptively if China does come unstuck.
As it stands, Australia is supplying China with a significant amount of raw materials to fuel their expansion. The numbers are phenomenal and that trend is more likely to continue than falter.
Yes, there certainly will be some impact from a European recession and if the US slips backwards that would have further implication for Chinese exports, but China has massive currency reserves, is a controlled economy where leaders have more responsive levers to pull, plus they have a changing domestic demographic with the emergence of the middle class or Chuppy as Charlie Aiken likes to call them (Chinese Yuppy).
So, although I think China will continue to slow, and this will have a negative impact for Australian commodities short term, the long term drivers of growth remain and until we see those dynamics change, we can't get too bearish on our big Asian neighbor.
In saying all of this, one question that does trouble me a little is the challenge facing an economy that is hot in some parts and cooling in others. Yes, the Government has to tools available to re inflate prices if things start to come back too hard but how they support some parts whilst dampening others will be critical.
Property prices for instance are still at elevated levels and the government wants to avoid a bubble, yet they want to continue to support manufacturing given the slowing demand coming out of Europe. An interesting conundrum!
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AUSTRALIA
The Australian Equity market had a tough year in 2011 dropping -14.6%.
So how do the global factors we've discussed above impact an Australian investor who is trying to grow wealth and provide income for retirement?
Equity market volatility has been significant and because of the uncertainties outlined above, that trend will continue for the first few months in 2011 at least. So firstly, to invest in the equity markets we need to be realistic about what to expect. You'll have periods of concern followed by periods of elation. They'll be wins and losses but if you apply a structure and be active, and initially have a greater focus on income, you'll be in the market when the big upside move does come as history suggests it will.
Clearly, the two big Questions short term for Australia is the resolution in Europe and growth expectations for China. Unfortunately, we can only monitor each situation and make fluid assessments as the data becomes available.
We presented our suggested portfolio structure above that has served us well in 2011. We retain that view for the first half of 2012 unless conditions change significantly.
James Gerrish
