News & Commentary

Market Review - July 2009

A welcome global stock market rally in the final four months of the year was not enough to salvage an extremely difficult financial year 2009. Since the 6 March trough, the Australian share market rose by 27.3% through June 30, and the US share market by 34.9% in local currency terms. Despite that, the Australian share market suffered the worst performance in the last 27 financial years to end up with a total return of -20.3%; the US share market returned -27.1% in local currency terms, and overall world share markets excluding Australia, returned -28.4% on a currency hedged basis and -16.2% on an unhedged basis.

As a result, diversified investors ended up with a very disappointing result for the year. Although high quality bond investments performed well (the UBS Australian Composite Bond Index was up 10.8% for the year and international government bonds were up 11.5%), the benchmark of a diversified growth portfolio with a mix of 70% growth assets and 30% defensive assets returned -12.6% (pre-tax) and -11.0% post-tax for a superannuation investor. Following a poor 2008 result, the recent two-year period would represent a roughly 1 in 25 chance based on the experience of the last 30 years – highly unusual.

Strange Days
As unusual as the results were, the events leading to the share market declines were even more peculiar. Millions of words have been written about the unfolding of the global financial crisis (GFC) and many excellent books will be devoted to post-mortems in future years. Rather than delve into that fascinating past here, let me focus more on the stage we are currently in and whether we can be optimistic that the worst has passed. In other words, let me address the question of why the markets have rallied more recently and whether the much discussed “Green Shoots” of recovery are real or illusory.

The economies of major world markets are continuing to face major challenges. First quarter economic growth showed promising signs after following a fourth quarter 2008 which was among the worst on record. Unemployment levels – as good a proxy for economic troubles as any – in the US have reached 9.4% – up from about 5% when the GFC began. Unemployment has increased around the globe with the UK at 7.1%, Europe at 9.2% and Japan at 5.0%. In Australia, unemployment has increased to 5.7% from 4% last year. Forecasts for unemployment show further increases ahead.

However, this crisis began and has been deeply rooted in the global financial sector, moving into the real economy through restricting flows of credit. The International Monetary Fund described the crisis as “importantly a crisis of confidence.” In the worst days of the GFC there was almost a complete loss of confidence in the financial system, with banks and other major financial institutions deeply concerned about the risk of doing business with other counterparties, particularly after Lehman Brothers was allowed to go bankrupt on 15 September 2008. The drop in confidence was indicated by the rise in interbank borrowing costs, the loss of liquidity in fixed income and currency markets, the volatility indexes, and the cost or availability of credit to corporations.

So, while it is difficult to see the green shoots of economic recovery, I do think we should take heart from the clear improvement in financial market conditions which form a background for improving confidence. After all, financial markets look forward and anticipate events in the real economy, albeit not always correctly or accurately. The following table provides a partial list of positive signs:

These indicators suggest a movement back towards normality, although a fair distance remains to be covered. Governments around the world and here at home have played an important role in improving confidence in the system. The extensive interventions in the US and European economies to preserve the banking system have gone a long way. The guarantees of bank deposits and borrowings by the Rudd Government have been well-aligned with this global coordinated action to preserve the integrity of the system in the face of huge challenges. Actions by central banks to create liquidity by lowering interest rates and purchasing troubled assets have been effective at forestalling even worse outcomes. And expansive fiscal policy has been enacted to create demand from the government sector in the context of decreased consumer and business demand.

It will definitely take some time for a return to a solid growth global economy. This morass will not be easily exited. But the indicators are hopefully correct in suggesting that a better economic future lies ahead. (Of course, that does not necessarily mean that a strong share market performance lies ahead, especially given the rally we’ve recently had. However, past history would say that the recent rally is fairly typical of post-bear market recoveries and that returns over a five year period should be reasonable).

Australia in the Global Crisis
It’s useful to take a look at how Australia did in the crisis, as Australian assets naturally tend to dominate local investors’ portfolios. In fact, superannuation and managed funds data suggest that the typical diversified portfolio has 70% invested in Australian assets and 30% in overseas assets. In terms of the share market results, it’s fair to say Australia’s fall from the November 2007 market high was dramatic. But given it had risen further before the fall, it actually held up relatively well. The following table tells the story. Over a five year horizon, Australia has done remarkably well comparatively.

There are a couple of key factors behind the Australian story. First to note is the dominant importance of the commodity cycle. Our share market soared until November 2007 on the incredible improvement in our export prospects based on rising demand and prices for commodities. Resources as a share of the ASX 300 increased from 16% in June 2004 to 27% in November 2007. However, when commodity prices collapsed in July 2008, so did our share market and the Australian dollar plummeted.

As resources stocks currently make up 31% of the local share market, the impact of an about-face in commodity demand and prices has a dramatic impact on the overall market. Similarly, when commodity prices reversed direction again in early 2009, the positive impact was substantial. Secondly, the finance sector and particularly the big four banks have long been a substantial component of our market – some 31% in November 2007. While the secondary players in the sector have been “roughed up” by the markets, the Big Four banks have not been immune but have done remarkably well by world standards. Their exposure to the GFC was less direct, not through large holdings of toxic US subprime mortgages, but through the increased costs of borrowing offshore to finance local lending. And those costs were mostly passed through to local clients. Accordingly, the major four banks have suffered average declines of 20% since November 2007, – much better than banks overseas which lost 50 to 75% – a nice defence for the Australian share market.

The listed property sector by contrast has been severely hurt through the crisis. Their borrowing costs have increased, credit availability has decreased dramatically and many have found themselves overgeared. The real estate investment sector has been hit hard – a total return of -42.1% over financial 2009 and -63.2% since November 2007. The problems in property trusts were not a uniquely Australian phenomenon; global REITs were down -43.9% on a hedged basis over the last year.

One of the saving graces of the Australian share market has been the ability to raise fresh capital in rights issues and other secondary offerings. Over the last year Australian companies and property trusts have raised $90 billion, a much higher percentage of market capitalisation than for most other markets around the world. This has helped our companies reduce leverage on their balance sheets and deal with the disappearing supplies of credit.

In some ways then, market-wise and economically, Australia has held up better than other developed economies. Our ties to Asian economies, our strong banks, and strong fiscal, monetary and regulatory position have stood us in good stead. But the factors above also indicate why we need to diversify our portfolios beyond Australian shores.

Our stock market base is narrow, so heavily dependent on just a couple of industries, and we are tied so inextricably to the commodity price cycle, that we just must diversify offshore to reduce our overall risk exposure.