Kreston marker update week ending Friday 13th November 2009

Kreston ANZ

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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 had a strong week with the S&P/ASX 200 up 3.2%. All sectors rose with Property and Materials each 5% stronger.

	Friday	Week	%
All Ordinaries	4,726	169	3.7
S&P / ASX 200	4,713	147	3.2
Property Index	893	48	5.7
Utilities Index	4,167	43	1.0
Financials Index	4,718	125	2.7
Materials Index	11,729	566	5.1
Energy Index	15,896	311	2.0

Overseas, the US S&P 500 had a good week, rising 2% despite a fall of 0.9% on Thursday night. The UK FTSE was 2.9% stronger. In Asia the Nikkei was flat for the week and Hong Kong’s Hang Seng was the outperformer, up 4.3%.

There are some significant differences emerging in the share market recoveries. The Hang Seng has risen 86.6% from its March lows compared to the Nikkei’s rise of only 35.4% over that period. The US has been a strong performer with the S&P 500 up 59.4% since March while markets in other developed economies such as Australia have risen around 50%. ASIC have flagged they may protect existing shareholders in future capital raisings and AMP made a takeover proposal for rival Axa. Overseas China continues to release strong economic results and business confidence increases.

Our feature section defines and discusses the Carry Trade and whether this may be a risk to share markets and other asset prices.

Overseas News

China’s industrial output rose 16.1% in October when compared to October 2008. Steel production rose 42%, coal production was up 21.1% and copper production was 28.4% stronger.

As exports have not risen by these amounts there are concerns that there is a build up in inventories. Offsetting this concern to some extent is that much of China’s stimulatory package has been directed at internal infrastructure projects and consumption has also been rising.

McKinsey & Co released the results of an October 2009 survey of CEO’s across the world and stated ‘For the first time in a year, a majority of respondents—51 percent—say economic conditions in their countries are better now than they were in September 2008’.

As you would expect, executives in Asia are the most optimistic and those in Europe the least optimistic.

The key concern of the CEO’s surveyed was consumers continuing to buy their products while government regulation was the second greatest concern.

Australian News

The Australian Securities & Investments Commission (ASIC) has stated they are considering law reform over capital raisings where existing shareholders are not offered the same opportunity as institutional shareholders.

A good example of ASIC’s concerns was the recent NAB Share Purchase Plan that scaled back acceptances to around 30% of applications from existing shareholders.

Shares in capital raisings are usually offered at significant discounts to attract new investors. This means that unless existing shareholders are offered shares at prices and volumes consistent with the new shareholders, they are in fact reducing the percentage of future profits they will participate in (their shareholding is diluted).

In the case of the NAB offer the new shares were offered at $21.50 whereas the price had risen well above this level by the time the existing shareholders were offered new shares. Existing shareholders ‘missed out’ due to the scale back.

Another ‘odd’ part of the existing laws is that shareholders can only participate in up to $15,000 each year in Share Purchase Plans for an individual company. It is difficult to understand who this law is attempting to protect as those shareholders who bought NAB in the earlier Share Purchase Plan at $20.00 could only apply for $5,000 in the second offer despite the second offer being very attractive for existing shareholders.

Existing shareholders should be protected in these circumstances. Requiring companies to approach existing shareholders first or on equal terms as new shareholders might make it more difficult for companies to ‘get away’ capital raisings quickly but protecting shareholders rights should be paramount.

The consolidation trend in financial services continues as AMP announced they intended to make a joint $8 billion bid (with Axa’s biggest shareholder Axa SA) for wealth management company Axa Pacific Holdings. AMP is interested in Axa’s Australian operations. The proposal was promptly rejected by Axa on the basis that it was underpriced. We expect a higher offer.

Goldman Sachs JB Were upgraded their expectations for 2009/10 domestic grain production by 4.2% from 35.8 million tonnes to 37.3 million tonnes. The main increases were in WA and SA while NSW fell from previous forecasts. Prices however are being negatively impacted by the strong AUD although a recent small uptick in prices has been attributed to a slow harvest in North America.

I had the opportunity to drive from Horsham in Western Victoria to Albury in South East NSW two weeks ago. The countryside looked in good shape with maturing wheat crops a major factor.

While the Australian unemployment rate rose from 5.7% in September to 5.8% per cent in October, the result is a positive for the recovering strength of the economy. Most of the job growth however was part time rather than full time. Nevertheless this is a ‘solid’ result in the circumstances but increases the likelihood of a rate rise in December and almost certainly in January.

The 'Carry Trade'

There has been quite a deal of discussion in the media of late around the impact of the ‘carry trade’ on rising share markets and other assets such as commodities.

What is the Carry Trade ?

‘A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.’ (Investopedia.com.au).

An example over the past decade or so has been the Japanese Yen and Australian dollar carry trade. Interest rates in Japan over that period have been at times close to 0% whereas in Australia our rates have been much higher.

In a carry trade, the Japanese investor borrows yen perhaps for as little as 2% (or uses his/her own money) converts the funds to $AUD and buys an Australian bond with the $AUD. If the Australian bond is paying say 5% the investor gains 3%.

The big risk to the investor is that the currency may fluctuate. For example, if the Yen rises against the $AUD it will be more expensive for the investor to buy back the same number of Yen to pay back the loan.

This approach to investing becomes very risky when the borrowings are high relative to the amount invested. Large speculative investors are typically very highly geared and if there is enough of this type of investment, it can push up the price of the $AUD and the assets purchased in Australia.

Is the carry trade a problem – Nouriel Roubini ?

New York University professor Nouriel Roubini recently warned that investors worldwide are borrowing USD (US Dollars) and buying other assets including shares and commodities. He contends that this is being brought about by the very low 0% to 0.25% official interest rates currently in place in the US. Thus ‘carry trade’ investors are able to borrow at very low interest rates and convert the money to higher yielding assets.

Roubini has stated that this may be, or at least has the potential for, creating a ‘bubble’. His concerns specifically relate to :
   - rising share markets in emerging countries,
   - some currencies have risen too far relative to the USD, and
   - the rise in the oil price is not justified.

His contention is that the when the borrowing to undertake the trades is unwound it will destabilise the financial system.

However, he doesn’t see this happening for 2 years or so and also does not see the share market returning to March 2009 lows at least in the short term.

There is a lack of firm data

There is no doubt that some of the rises in the share markets, commodities and possibly even real estate is being driven by the USD ‘carry trade’ i.e. borrowing USD and investing in non-denominated USD assets (in Australia and other countries). There is always an element of speculation in market movements but the question is ‘How big is the carry trade impact?’ in pushing up current prices.

Given the lack of numbers backing Roubini’s argument the materiality of the carry trade impact at this point would have to remain in the realm of conjecture. In fact there is probably no way of measuring the ‘carry trade’ impact.

Where is the money coming from ?

I would also ask who is lending the money to allow the leverage to occur? The banks in the US (and other countries) have tightened lending dramatically over the past 2 years. This is evidenced by the record amounts of money the US banks have deposited with the US Central bank (Federal Reserve) i.e. they are not lending the money to customers.

Asset prices have risen

To accept Roubini’s proposition you would also need to accept that there is a bubble in asset prices.

Share market and company P/E's (at least in Australia) are around fair value as the recovery in earnings continues. While the markets have risen 50%+ around the world from March 2009 lows, we have precedents for these sorts of rises (1987 and 1974) after severe bear markets. Chinese markets are the standouts having risen over 80% and might suggest they are overpriced. However, countering this view are the high Chinese GDP growth rates of 8%+ providing an underlying economic justification for the rise in China’s markets.

Commodity prices are certainly at high levels historically but this can be explained by inventory replenishment and the extra demand from the industrialisation of developing economies (e.g. India, China) (refer graph below).

Oil is a common destination for speculators, but it seems to have reached a plateau at around the $US80 per barrel mark which is not too far from historic and projected averages . Please click here to view the chart.

So at present there is not a lot of evidence to support the view that a bubble is forming unless you are of the view that the China and emerging markets growth stories are overdone.

The USD will rebound

As discussed in previous updates the USD has fallen significantly against other currencies due to the very low interest rates in the US. At some stage the difference will reduce between say Australian and US interest rates as the US economy recovers. (A survey in the Wall Street Journal predicted US interest rates to start rising in September 2010)

Six months or so before this occurs, money will flow back to the USD from other currencies and the USD will rise against other currencies. This in turn may put downward pressure on share markets and other asset prices in non-US destinations.

However, it is not clear that this flow will have significant impact in non-US markets. For example, a recovering US economy is good for the rest of the world (and therefore non-US companies and commodity prices).

How good have Roubini’s predictions been ?

Roubini, has been very good at predicting economic trends but has been poor at predicting share market movements.

The media usually refers to Roubini’s accurate prediction of the Credit Crisis we experienced over the past two years. He has also been accurate in predicting when the US economy would begin growing again (late 2009/early 2010).

However, he misjudged the March 2009 rally on share markets when he described it as a ‘dead cat’ bounce and warned investors about investing into the rally.

It ‘goes to show’ how difficult it is to make economic predictions and then ‘convert’ these to expected changes in the share market. Investors such as Warren Buffet and Bill Gross from Pimco appear more adept at that.

Conclusion

The very low US interest rates are supporting the carry trade at present but we don’t see evidence of asset price bubbles at this point.

Carry trade speculative investments will have positively impacted share markets and commodity prices over the past 8 months and that part of the rise may be at risk once US interest rates start rising.

However, there has been a stream of consistently good economic news which has underpinned the recovery in share markets and commodities. While this is occurring and confidence continues to rise there is a good foundation forming under share market and commodity prices that will reduce the effects of an unwinding of the USD carry trade.