Kreston marker update week ending Friday 4th December 2009

Kreston ANZ

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News

News 2009

Kreston Dormers

Kreston Dormers Financial Services Pty Ltd

Please find below and attached our 'Weekly Market Update'.

We are continuing to get feedback and suggestions for improvement on the report, so if you have any suggestions please let us know

If you would like to discuss this email in more detail, please contact your financial adviser, Mark Johnson or Nick Pike on 1800 064 959.

Market Summary

The market more than recovered last week’s falls with the ASX 200 2.8% stronger. All sectors recovered last week’s losses except Property. Materials and Energy were the strongest performers.

	Friday	Week	%
All Ordinaries	4,748	128	2.8
S&P / ASX 200	4,732	133	2.9
Property Index	855	6	0.7
Utilities Index	4,195	34	0.8
Financials Index	4,656	166	3.7
Materials Index	12,469	427	3.5
Energy Index	15,950	406	2.6

Overseas, the US S&P 500 fell 1.0% while the UK’s FTSE was 2.3% stronger following the rebound from the Dubai news. In Asia saw the Nikkei rise 8.0% after the government announced further stimulatory measures and Hong Kong’s Hang Seng rose 1.5%.

In Australia the government’s ETS legislation was defeated and the RBA raised interest rates. Overseas Dubai World gave some welcome clarity to its debt problem. The feature section discusses the history of gold investing and that the price of gold has not risen in 2009.

Overseas News

Last Friday’s Dubai ‘crisis’ only lasted a day as markets reacted positively to Abu Dhabi’s announcement that they would be backing Dubai’s local and foreign banks. This week Dubai World stated that ‘only’ $26 billion of its $59 billion debt required restructuring. The markets breathed a sigh of relief and more than recovered Friday’s 3% fall.

Most of our local banks and companies such as Leightons and Hastie Group were quick to release details of their limited exposure to Dubai.

The US Federal Reserve (the US central bank) stated ‘economic conditions had improved modestly in November’. Consumer spending in 8 out of 12 districts increased.

In contrast US labour markets (employment) and commercial property have remained weak. This is a typical trend after a recession as unemployment tends to rise and commercial property prices continue to fall until well after a recession has ended. These two factors are related in that demand for commercial property is driven by the need to ‘house’ workers whereas if unemployment is rising there is less need for space to house workers. Unemployment will continue rising until GDP growth increases above the rate the population is growing (more than 2% p.a. in Australia) which will occur for some time despite the US recession having ended.

The Association of American Railroads reported the highest freight numbers for the year in the week ended 21 November 2009, up 2.1% from the previous week. The reason why we track this pretty obscure statistic is that it is a good indicator of the health of the US economy (also Warren Buffet follows it closely).

Bank of America (‘BOA’) announced it would repay $US45 billion of the government bail out (TARP) funds it received in 2008. The funds will come from reduced dividends, asset sales and the issue of new equity. European banks are also being asked for plans to repay government support.

Australian News

The Emissions Trading Scheme (ETS) proposed by the government was rejected by the Senate this week. From a business perspective the uncertainty is a big negative. For example, it is difficult to see any investment in energy industry (e.g. electricity) until the issue is resolved.

As expected, the Reserve Bank of Australia raised official interest rates by 0.25% to 3.75% which is the third month in a row there has been a 0.25% rise.

Westpac raised the ire of mortgage holders by increasing their variable rate mortgage rate by 0.45% to 6.76% rather than just passing on the 0.25% rise. NAB responded on Thursday by only raising rates by 0.25%. They are able to do that as their mortgage loan book is much smaller than Westpac’s.

There has been some conjecture that Westpac may be sending a message to regulators and the government that the cost of increased regulation (and there will be increased regulation) will be passed onto the consumer. Westpac’s move is a function of decreased competition in the banking sector.

In keeping with the trend of supermarkets owning hardware stores, Metcash (MTS) launched a bid for 50.1% of Mitre 10 with potential to move to 100%. The business models of each provide a reasonably good fit in that Mitre 10 is currently owned by its 400+ store owners. Metcash currently markets and distributes food and consumer goods to owner occupied stores under the IGA , Campbells Cash and Carry and Australian Liquor Markets brands

Going by the Wesfarmers owned Bunnings results, hardware provides much more attractive margins than grocery items. Given increased competition from Woolworths recently announced hardware rollout, the buyout is probably a ‘must do’ for Mitre 10 and an opportunity for Metcash.

Gold

We have been frequently asked of late about why the price of gold has been rising and what it means to investors. This week we discuss the history of gold, why investors invest in gold and also point out that the price of gold has not risen in 2009.

Gold – a store of wealth
Gold is used as an alternative to holding currency or bank notes or a ‘store of wealth’. That is, it can be used to purchase foods or services in the future which is the same function as dollar notes, pound sterling, chinese yuan etc.

When stored by a country to back its currency, it is called the gold reserves or a ‘gold standard’.

The rationale for a gold standard is that if a person buys or holds a country’s currency they can be comfortable that the currency will retain its value, or can buy the same goods or services at a later date, as the country has enough gold to buy the currency back at the current rate if required. This is in contrast with most countries today, where the holder of the currency is taking a view that the country’s economy is sufficiently strong to be able to repay the holder of the currency when required.

It is worth reviewing the history of ‘gold standards’ as it helps understand why gold is viewed as a safe ‘store of wealth’.

A ‘store of wealth’ – some history
Gold has been used as a ‘store of wealth’ for many centuries with the Chinese apparently using it as gold standard to back its currency as early as 9 AD.

Later, the Spaniards built an empire and its wealth within Europe on the conquest of South America and the gold repatriated to Spain. Unfortunately, the Spaniards focussed their entire economy on the gold trade rather than producing other goods and services. The Spanish borrowed heavily against their gold reserves and future gold production.

The Dutch put paid to the Spanish economy when they commenced issuing paper money. Dutch companies started to issue ‘promises to pay’ or bonds to finance their trade. These were not backed by gold but by the strength of the companies. Their promise to honour the bond was viewed as better investment than lending money to Spain or buying gold that did not actually produce anything. This was an early failure of the gold standard.

In the intervening years, European governments in particular tied the amount of money or currency issued to the amount of gold held in reserve. While stabilising the currency it also reduced the ability of companies to invest, as there was less money to invest. This was a factor in the stronger growth in the US over that period, which was tied less to the gold standard than Europe. In 1924 John Maynard Keynes called the gold standard a ‘barbarous relic’ due to this drag on economic growth.

Any one interested in the topic should read ‘The Ascent of Money’ by Niall Ferguson.

Post World War II (WW II) : The Bretton Woods Gold Standard
After WW II a Gold Standard was established under the Bretton Woods Agreements, whereby countries fixed their exchange rates to the $US and the US in turn tied its exchange rate to a fixed price of gold. The purpose was to provide some stability to exchange rates and the international banking system after the tumultuous times of the Second World War. The hyperinflation in Germany prior to WWII was firmly in the minds of the governments.

The Bretton Woods gold standard lasted until 1971 when the US cut the $US exchange rate to gold. i.e. it floated the $US with a view to making exporters more competitive. At the time the US was struggling with a recession and the Vietnam War.

Since that time, the $US has been used as a reserve currency rather than gold as it is seen as a ‘safe haven’ in times of turmoil due to the strength of the US economy (despite its recent weakness).

So what makes gold valuable
The answer is simply, ‘Nothing really’.

It is a rare commodity (only 161,000 tons has ever been mined which would just fill 2 olympic sized swimming pools). But that doesn’t make it valuable.

It has very little industrial use except electronics and dentistry. The biggest use is jewellery which accounts for 2/3 of annual demand (India for example buys about 25% of the worlds gold production mainly for jewellery). In that respect it is a lot like diamonds in that it is considered a good thing to own because it is rare but is not really productive (although my wife disagrees).

So we can conclude that the reason it is valuable is that it is has a long history of being considered valuable. There has always been a market for gold and probably always will be despite there being little economic use to underpin its value.

Why do people buy gold
Traditionally gold is used as a hedge against inflation and a hedge against periods of extreme instability (economically and/or politically).

Considering gold as a hedge against inflation, the International Monetary Fund stated that ‘…. spot gold price - experiences higher returns when inflation rises.’ (Inflation Hedging for Long Term Investors April 2009). The reason gold and other commodities prices outperform during periods of inflation is that they are physical things. If there are more dollars due to inflation but the same amount of gold, it will cost more dollars to buy that same amount of gold.

However in the same report, the IMF stated that the inflation hedge does not last and ‘at some point the hedging properties of commodities diminishes’.

Gold is also viewed as ‘safe haven’ in times of economic or political volatility. An extreme example would be a country at risk of being invaded. Investors will not want to hold the currency as a potential invader may disregard the currency i.e. it becomes worthless in buying goods or services. However, gold can be transported out of the country and sold elsewhere or hoarded for future use.

So why has gold been strong lately ?
The graphs attached show the value of an ounce of gold over the past 5 years, firstly in $US and secondly in $AUD.

In the first graph attached we can see that the gold price rose rapidly from 2005 to 2006 as inflation concerns rose. Another significant jump occurred in late 2007 as the Global Financial Crisis commenced and economies rapidly deteriorated.

Finally in late 2008 US interest rates and the USD started to fall. Usually the $USD is viewed as a safe haven or the ‘reserve currency’ but as investors expected it to fall they needed another place to hold their wealth. Money flowed to commodities including gold and thus you can buy more $USD with the same amount of gold (or buy less gold with the same amount of $USD). This has pushed the price of gold over $US 1,200 an ounce.

The chart attached is revealing in that it shows the importance of currency. Contrary to what most people believe, the price of an ounce of gold in AUD is the same as it was at the beginning of 2009.

We can conclude from the attached charts that while buying gold at the beginning of 2009 in the US was a very good investment decision, over that same period it has been a poor investment in Australia.

Simplistically, over 2009 the gold has not produced anything i.e. there is no cash flow via dividends or interest from the asset. It does not produce cash as a company might have and in Australian terms you are left with exactly the same asset at the end of the year as the start.

On the other hand gold was a good investment in both countries (or currencies) during the extreme volatility of 2008 when other assets were falling in value. You had the same asset at the end of the year as at the beginning of 2008.

A lesson from the above is that gold is a good investment in some circumstances, usually where there is a threat of inflation and/or periods of extreme volatility.

Gold returns over the long term The chart attached shows the real value of gold over the very long term. ‘Real value’ means the price has been adjusted (reduced) to take account of inflation.

The big spikes (including the current spike since 2000) have corresponded with periods of inflation concerns with 1982, in particular, a time of concern.

However over the longer term the real value of gold has not risen and after periods of volatility reverts to a real value well below $US 1,000.

This strengthens our conclusion above, that gold is a good investment as a hedge during periods of extreme volatility but over the (very) long term there is little if no return from holding gold.

Where is the gold price going ?
Generally, rapidly rising prices for any asset result in significant adjustments when the reason for the rise starts to wane. The latest rise in the gold price has been due to investors buying commodities to hedge against the fall in the $US. This will not last in the long term. As discussed in previous updates, once the markets concludes that the US Federal Reserve is likely to raise interest rates, money will flow back into the US and out of commodities. The $US will rise and gold and other commodity prices will fall.

The $64 billion question is ‘when ?’. Unfortunately I don’t know.

Investing in Gold
There are a number of ways to invest in gold :

  •  Gold bullion – The Western Australian Mint provides this service to investors

  •  Gold bullion through a company intermediary. ETFS Metal Securities Australia Ltd (GOLD) allows investors to own and trade physical gold bullion through a listed security traded on the ASX. You receive a share that is backed by 1/10 of an ounce of gold.

  •  Gold index funds (GoldLink Growth Plus, GoldLink Income Plus).

  •  Maturity Date. Having a maturity date provides some ‘certainty’ to an investor that they will be repaid. Consequently, the risk is lower for those hybrids with a Mandatory Maturity Date. As a general rule the shorter the term to maturity the less the risk.

  •  Gold miners. In Australia the 2 major listed gold producers are Newcrest Mining (NCM) and Lihir Gold (LGL). However, the company’s hedging strategies need to be considered. For example, much of Newcrest production is hedged, thus the recent gold price has had limited effect on the price. There are many smaller gold explorers in Australia.

Conclusion

Gold is a good hedge in very volatile times but the investment proposition becomes much weaker over other investment periods.

The recent rise in the gold price in $US has created considerable investor interest but there has been no rise in the price of gold in $AUD over 2009.

Investors should be very clear as to why they are investing in gold. If used as a hedge against future volatility or inflation, gold investment like other commodities can be a good hedge. If used to gain a trading exposure to a rise in the gold price – you are speculating. Goldman Sachs will beat you at that game every time.