With the earnings season now in progress, the past week was full of important corporate announcements that have impacted share performance. This week we discuss the News Corporation earnings report, significant profit downgrades from Myer and AGL Energy, a favourable result from JB Hi-Fi, a new CEO for Asciano and a strong rally for QBE Insurance following news that it will acquire the renewal rights to US insurer Balboa.

News Corporation’s Q2 earnings report was close to expectations and management confirmed that the company is on track to deliver on its full year earnings guidance. In terms of operational highlights, the television segment performed very strongly, underpinned by advertising growth in excess of 20%. Cable network negotiations are also driving strong revenue growth. The weakest segments were publishing and films but this was widely expected.

Myer provided the market with a trading update which revealed a 3.5% fall in sales in the six months ending 29 January 2011. Like-for-like sales declined 5.2% in the same period. This was much weaker than expected and will negatively impact net profit for FY11. Comments from management suggest a competitive retail environment (including consumers purchasing from offshore due to the strong $A), coupled with weaker consumer demand, particularly following the January flooding, were the main reasons for the sales decline. In November 2010, Myer’s guidance suggested growth in net profit after tax (NPAT) in
FY11 of between 5% and 10%. This has now been revised down significantly with Myer forecasting a fall in NPAT of up to 5%.

In stark contrast to Myer, JB Hi-Fi announced a record half year net profit of $87.9 for the six months to end December 2010. Sales rose 8.3% over the period and the company will pay a fully franked interim dividend of 48.0 cents per share. Thirteen new stores were opened in Australia and New Zealand over the period and there are plans to open another 5 in the second half. JB Hi-Fi seems to be addressing the challenge of on-line retailing which is affecting many traditional retail businesses like Myer. The company’s online sales rose 35% over the half year and were up 49% in December. Although sales guidance was
downgraded slightly, the overall result was favourable and defies the weaker trend being experienced by many companies in the retail sector.

AGL Energy announced that recent severe weather events, including the Queensland floods, extreme heat in New South Wales, Victoria and South Australia, and Cyclone Yasi, are expected to reduce forecast underlying NPAT in FY11 by between $30 and $35 million. AGL’s previous forecast for NPAT in FY11 was between $450 million and $480 million. This range has now been revised down to between $415 million and $440 million.

Asciano announced the appointment of John Mullen to succeed Peter Rowsthorn as the company’s new managing director and chief executive officer. Mr Mullen has extensive experience in transport and logistics as he was previously the CEO of DHL Express. He will formally commence as Asciano’s CEO on 14 February 2011.

QBE Insurance performed very strongly on Friday (+7%) following the announcement that it had acquired the renewal rights to US insurer Balboa for a consideration of $700 million. Balboa is currently owned by Bank of America and this attractively structured deal is part of an initial 10-year distribution agreement. Both the purchase price and deal structure are extremely attractive for QBE. Balboa is a very profitable business and it makes good commercial sense for QBE to purchase this US asset at a time when the Australian dollar is trading close to parity with the US dollar. QBE also announced a forecast NPAT for calendar year 2010 that was in line with analysts’ expectations.

Global markets

Major equity markets rallied convincingly as purchasing managers’ surveys from the US, Europe and Asia pointed to accelerating manufacturing and services output. The S&P 500 advanced two per cent to just over 13,000, and the FTSE 100 almost two per cent, closing three points below 6,000. The Nikkei 225 moved up 1.8%, despite corporate releases suggesting Japanese exporters remain hampered by the strength of the yen.

While the equity bull-market that began at the end of August 2010 shows little sign of abating, investors continue to shun ‘core’ bonds forcing yields up, and US ten-year yields hit a nine-month high last week. In the UK, where rising domestic prices are of particular concern, government bond yields rose for a fifth consecutive week, and sterling spiked as high as $1.62, in anticipation of bank base-rate rises in 2011.

The price of copper crossed $10,000 a tonne (or 434 cents a pound), while oil spiked to $103 a barrel midweek on uncertainty over developments in Egypt and the Middle East more generally, before closing a shade below the $100 mark.

Global equities

In a busy week for energy majors, ExxonMobil, the world’s largest company by market capitalisation, registered a near record 53% increase in Q4 net revenue, buoyed by rising oil prices. In the UK, BP announced a full-year loss of $4.9bn – it’s first in nearly twenty years, as the energy giant digested a $41bn charge relating to last year’s Gulf of Mexico disaster – and also the return of dividend payments, which have been suspended for three consecutive quarters. Anglo-Dutch rival Shell shed 3.3% despite reporting a near doubling of 2010 profits to $18.6bn. Elsewhere, GlaxoSmithKline rallied 3.5%, notwithstanding a slump in full-year profits from £8.7bn to £4.5bn, as the UK-based pharma giant announced a £2bn share buy-back programme. US corporate earnings for the final quarter of 2010 have generally surpassed forecasts – and companies as varied as Time Warner, UPS, Dow Chemical, Kellogg and fashion retailer Gap all saw their shares boosted as their revenues exceeded expectations
Over in Asia, Nippon Steel and Sumitomo Metal, two of Japan’s largest steelmakers, unveiled a $24.5bn merger aimed at cutting costs and matching the competitiveness of fast-growing emerging market rivals – while Baidu, China’s largest internetsearch, beat forecasts with a doubling of Q4 net revenue.

Sweden’s government is to sell its 6.3% in Nordea, the Nordic region’s largest bank, in a deal that would raise around $3bn – while LVMH, the world’s largest luxury goods company, reported 2010 sales up 19% to €20.3bn, boosted by rapid growth in Asian markets, and China in particular.

Global bonds

Ben Bernanke on Thursday restated the Federal Reserve’s commitment to a second round of asset purchases, or quantitative easing, which generally supports bond prices. Nonetheless, prices of US government bonds, or Treasuries, slid sharply as the Fed Chairman also voiced concern about the scale of the US budget deficit – which is forecast to hit a mammoth $1,480bn this year, or 10% of GDP. As a result, ten-year yields advanced a chunky 32 basis points to 3.65%.

UK ten-year yields marched up 17 basis points to 3.82% as investors continue to fret about the medium-term outlook for inflation, which could rise to four per cent during 2011. German ten-year yields also increased, although by a less marked 11 basis points to 3.26%, as the European Central Bank considers its response to Eurozone inflation now running at an annualised 2.4% – well above its target of ‘below but close’ to two per cent.

In a relatively quiet week for peripheral bonds, Spain issued €3.5bn of three- and five-year securities in a poorly subscribed auction, raising less than its €4bn target. Nonetheless, benchmark Spanish ten-year yields dropped from 5.51% to 5.16% as Madrid continues to insist the country is not in the same category as other highly indebted Eurozone nations such as Ireland and Portugal.

Mark Burgess, incoming Chief Investment Officer at Threadneedle, looks ahead to 2011: “Our central case for 2011 is one of reasonable global growth led by emerging markets. Against this backdrop world equity markets look good value, particularly against government bonds. In addition, many companies have strong, healthy balance sheets and are sitting on large cash piles, having held back on investment during the recession. We expect corporates globally to start to use this cash to increase capex, raise dividends, buy-back stock or undertake merger and acquisition activity. We believe that emerging markets will continue to grow and outperform the rest of the world, helping to fuel demand for consumer goods and commodities.

“At the same time we must be mindful of the risks to this scenario. The credit crisis elicited a range of untested policy responses and we are yet to see the full consequences of these policies. The banking sector globally needs to continue to raise capital, which will restrain credit expansion and hence economic growth. In emerging markets there is the potential for growth to turn into a bubble and inflation to become a risk. Globally, markets remain fragile and any major shocks could cause volatility.

“This volatility should create opportunities for nimble, experienced investors with a proven ability to look through short-term noise and indentify long-term winners.”

INVESTMENT THEMES FOR 2011

Policy responses to remain a key driver of markets

Growing economic divergences highlight critical global imbalances that require intervention. The Eurozone is in crisis, China is tightening policy and the actions of developed markets threaten to spark currency wars. These issues all demand that policymakers adopt appropriate measures in a timely manner, yet policy response remains the single most difficult risk to assess. We believe that the ride will be bumpy but that policymakers will eventually arrive at the right place, allowing supportive fundamentals and ample liquidity to support asset prices.

• The European Central Bank must act urgently, as it has been reactive and fallen behind the curve in protecting the Eurozone. The ECB should recognise that policy must support the weaker economies and not simply be tuned to the mantra of “one size fits all”. This will necessitate a policy that is far too easy for stronger members, but the viability of the monetary union is at stake. We believe the ECB is likely to adopt some combination of lower rates, below-market rate loans to troubled economies, liquidity provisions and outright bond purchases.
• As QE becomes a more prevalent policy tool it is certain to evoke fears of competitive currency devaluation. There will likely be growing calls for capital controls in many developing economies reluctant to see an unwanted surge of liquidity into their economies. Such steps should not undermine the global growth story, but will likely stoke higher volatility across markets.
• China’s deflationary boom is turning inflationary, representing a paradigm shift in the economy at the heart of global imbalances. The ability of Chinese policymakers to tighten policy without rattling investors will require more skill than in past cycles.
• Ongoing de-leveraging continues to unleash powerful deflationary forces, which should allow developed economies to sustain modest growth whilst pursuing reflationary policies.

QE consequences

Quantitative easing has unleashed a wave of liquidity that must find a home. At the same time, it has stirred strong opposition in some quarters.

• QE2 is explicitly targeting asset prices and liquidity is likely to find its way into the areas offering the best value and potential returns. Currently this means higher risk assets such as equities. This is one of the reasons why we remain overweight in equities versus bonds.
• Specifically, emerging market equities and bonds are likely to be well supported. We may be in the early stages of a bubble in these assets.
• Subsequent waves of QE will become increasingly difficult to defend on the world stage. This could tip the current phase of currency devaluation into full-blown protectionism. Stocks with significant overseas earnings could suffer in this scenario (this is not our central case).

“Emerging market exposure is a consensus trade, but it can continue to reap rewards throughout 2011. It doesn’t make sense to stand in the way of this tide of liquidity.” Sarah Arkle, Chief Investment Officer (Vice Chairman from Jan 2011)

Stock picks: Sun Hung Kai, Barrick Gold

Untested policies

The credit crisis elicited a range of innovative and untested policy responses. This is likely to lead to ongoing volatility, rotation and unforeseen consequences.

• An important skill in 2011 will be the ability to look through short-term volatility to see the longer-term pricing anomalies.
• Ongoing uncertainty means that it will be more important than ever to be aware of risks in portfolios and ensure that all risks are understood and intended.
• Active management and stock picking are likely to add significant value in 2011.

“We are in completely uncharted waters here. Investors expecting a reversion to mean may be disappointed.” Jim Cielinski, Head of Fixed Income

The haves and the have-nots

Two-speed economies are developing at a global (emerging vs developed world), European (core vs periphery) and US level (skilled vs unskilled workforce). These distortions create socio-political tensions but also provide opportunities in a number of sectors.

• US unemployment remains high but in certain sectors, wage bargaining power is evident. When analysing companies, we will be emphasising their ability to retain talented staff without instigating wage inflation.
• With interest rates at all-time lows and QE2 targeting higher asset prices, employed, asset-rich consumers with mortgages should feel wealthier in 2011. This will support high-end consumer discretionary stocks.
• European banks with exposure to the periphery have been de-rated significantly. This creates the scope for a sharp rally if solvency fears are addressed decisively by the ECB. We remain underweight but continue to monitor the sector closely.

“You can’t take someone that was laying bricks on a building site in 2007 and put them into Google’s product development team. Specialist skills are in short supply and will be rewarded in 2011.” Cormac Weldon, Head of US Equities

Stock picks: Tiffany, Polo Ralph Lauren

The search for yield

We believe that inflation is not a risk in the developed world and that interest rates will be kept at historic lows in these markets. As such, government bond yields are unlikely to rise significantly and investors will seek income in higher-yielding areas.

• Emerging market and corporate bond valuations remain attractive relative to their improving fundamentals. We continue to favour these bonds over government issues in fixed income.
• Income stocks are likely to be in favour in equities. Moreover, companies that are reinstating or raising their dividends are likely to be re-rated.

“Why would I lend money to the UK government at 3.5% when I can get 5.1% with the prospect of dividend and capital growth from AstraZeneca?” Leigh Harrison, Head of Equities

Stock picks: AstraZeneca, Vodafone, BT

The emerging market consumer

Emerging markets will continue to produce superior growth in 2011 and growing wealth among consumers in these markets will support demand in a number of areas.

• We continue to invest in luxury goods stocks in Europe, where robust earnings growth has seen multiples decline despite rising share prices.
• More recently, we have expanded this theme into European premium auto stocks, eg BMW, where the valuation is attractive relative to its Asian joint venture partners.
• Banks in under-penetrated markets such as Indonesia and India are likely to attract capital as investors follow through the consumer theme.

“Luxury goods stocks were the first beneficiaries of growing emerging market wealth. The developing consumer credit cycle will create bigger ticket opportunities as this theme matures.” William Davies, Head of European Equities

Stock picks: BMW, Bank Rakyat

The return of capex

Companies have been very cautious in their investment plans in this cycle, preferring to maintain high levels of cash. Corporate balance sheets are strengthening and capital expenditure to depreciation ratios are at all time lows. We believe this trend will change in 2011.

• Improving economic confidence and high commodity prices are likely to drive increased capex in the extractive industries. Industrial stocks will be among the key beneficiaries.
• The replacement of ageing IT infrastructure at a wide range of companies will support earnings in the software and hardware sub-sectors.

“Mining equipment companies have been buffeted by changes in economic sentiment in 2010. They are attractively valued and there is scope for significant upgrades to earnings.” Simon Brazier, Co-Head of UK Equities

Stock picks: IMI, Komatsu

Mergers and acquisitions

Cash balances are high, valuations are attractive and companies will crystallise value in the market by undertaking earnings-enhancing corporate activity such as m&a. Meanwhile, private equity companies are under pressure to invest. Emerging market corporates are also likely to take advantage of currency strength to acquire footholds in companies in the developed world. This, together with share buy-backs, will drive a significant phase of m&a.

• Companies with unique assets, superior growth or access to proprietary technology will be among the main takeover targets.
• Management quality and valuation may not always be key drivers: small and mid-caps are likely to attract interest despite full relative valuations.
• Companies deploying cash in shareholder-friendly ways are likely to outperform as investors become more focused on the efficient use of capital.

“2011 could be the year when a household western name gets taken over by an emerging market rival.” Jeremy Podger, Head of Global Equities

Stock picks: Mid-cap resources, industrial companies

Commodity prices will remain underpinned

The outlook for commodity prices is positive, given the recovery in the world economy and the dominance of resource-hungry emerging markets in the global growth profile.

• Commodity-rich nations will continue to witness capital inflows, further strengthening FX positions and credit worthiness. This should support equity valuations and further spread tightening in fixed income.
• Companies using more expensive raw materials in their production processes will witness margin pressures.
• Rising commodity prices could be a source of inflationary pressure.

“Our growth forecasts imply additional demand of around 1.5m to 2m barrels of oil per day in 2011. If it becomes apparent that OPEC does not have sufficient spare capacity to meet this demand, the oil price could move sharply higher.” David Donora, Head of Commodities

• Mark Burgess becomes Chief Investment Officer from Jan 2011, when current CIO Sarah Arkle moves into her role as Vice Chairman.

Headline developments of the past week

• Worries about Europe’s debt problems and tightening in China were again key issues for investors over the last week, and had the effect of initially pushing share markets down ahead of a reversal later on as some of the fears receded. Europe seems to be moving pretty quickly this time to try and limit the contagion from Ireland to other European countries – in fact, a bailout package for Ireland from the IMF and European Union looks imminent.
• Concerns about an aggressive tightening in China receded a bit after Chinese authorities announced a range of administrative measures to curb inflation. These involved measures to boost the supply of key foodstuffs, subsidies for low income households, temporary price controls on necessities and a crackdown on speculation. While the merits of price controls can be debated, to the extent that China is relying on targeted administrative measures to control inflation it may help take pressure of blunter less targeted measures such as interest rate hikes. However, Friday’s hike in the banks’ required reserve ratio – the fifth this year – highlighted that macro tightening is still on the agenda. The increase in the reserve ratio is necessary to mop up the increase in the money supply being generated by the current account surplus and the managed exchange rate. We still anticipate a few interest rate hikes and a further increase in the banks’ required reserve ratio going forward, but remain of the view that they will not be aggressive enough to crunch the Chinese economy.

Major global economic releases and implications

• US economic data over the last week was all over the place. Housing starts, weekly mortgage applications and a survey of home builders were all soft – but at least still seem consistent with housing activity having found some sort of bottom. Industrial production was flat and manufacturing surveys were mixed – weaker in the New York region but much stronger in the Philadelphia region. Clearly positive though were weekly jobless claims essentially sustaining the sharp fall seen in the previous week, a fall in mortgage delinquencies in the September quarter and a better than expected rise in a leading index for October. Producer and consumer price inflation both came in on the soft side. In fact, core consumer prices have now been flat for three months in a row and the annual rate was the lowest level every recorded (with data back to 1957). Quite clearly all of this provides support for the Fed’s commencement of QE2 – mixed economic indicators suggest that growth is still too low for comfort and inflation is verging on deflation. It is now more than 18 months since the Fed started QE1 and yet there is no sign of the hyperinflation that many were predicting when it was first announced.
• Meanwhile, a forceful defence of the Fed’s latest round of quantitative easing (QE2) by Ben Bernanke provided confidence that the Fed will not be abandoning it, as investors might have been starting to fear given the heavy criticism it has attracted in both the US and globally since first announced.
• In Japan, the big surprise was a rise in annualised GDP in the September quarter of 3.9% driven mostly by strong consumer spending. However, it is hard to see this pace being sustained as consumer spending falls back and the strong Yen constrains exports.
• The pressure from rising food prices on inflation was also evident in Korea which raised its short term interest rate for the second time since the GFC to 2.5%. Further rate hikes are likely next year.  Meanwhile, GDP growth remained strong in Taiwan and Singapore in the September quarter with both growing around 10% year on year, underlining the continued strength in Asia.

Australian economic releases and implications

• In Australia two things stand out from the minutes from the last Reserve Bank Board meeting and a speech by Deputy Governor Ric Battellino. The first is that the RBA does not see any urgency to raise interest rates again: the November move itself was finely balanced; the over and above rate hikes from the banks were probably more than the RBA expected; housing has slowed and consumers remain cautious; and we have seen a renewed intensification of worries about sovereign debt in Europe. However, the second point is that the RBA still retains an inclination to raise interest rates further. This is clearly evident in Ric Battellino’s comments that the challenge going forward will be to manage the economy in a way that contains inflation in the face of the large amount of money likely to flow into the economy in the next few years as a result of the mining boom and that over the medium term inflation is more likely to rise than fall. So putting it all together while we don’t see the next rate hike coming until February at the earliest, in a year’s time the cash rate is likely to have increased to around 5.5%.
• Over the last week though, Australian economic data provided a messy picture. On the one hand car sales and skilled job vacancies came in on the soft side but on the other wages growth on the RBA’s preferred measure showed further signs of acceleration.

Major market moves

• Global share markets had a roller coaster week, initially falling sharply before recovering some lost ground as a bailout for Ireland seemed to be nearing, worries about an aggressive tightening in China receded a bit, economic data and profit news came in better than expected, the successful General Motors IPO helped boost confidence and Fed Chairman Bernanke provided a strong commitment to quantitative easing. While Asian and Australian shares fell over the week, US shares were flat and Japanese and European shares actually rose. Japanese shares now seem to be benefitting from the weaker Yen.
• It was a similarly rough ride for commodity prices and the Australian dollar with initial sharp falls giving way to some recovery as global growth concerns receded a notch.
• It’s interesting to note that despite the gyrations in growth trades such as share markets over the past week bond yields have moved higher. While this may reflect traders unwinding excessively long positions built up through the mid year growth scare and in anticipation of QE2 it is also consistent with a greater degree of confidence in the global growth outlook.

What to watch in the week ahead?

• In the US, October home sales data are likely to slip back a notch after strong gains in September, September quarter GDP growth is likely to be revised up slightly from the 2% annualised pace initially reported and durable goods orders are likely to have remained solid in October. The minutes from the last Fed meeting may also shed some more light on the thinking behind the Fed’s adoption of another round of quantitative easing.
• Various European business conditions surveys for November will be watched to see how well Europe is holding up.
• In Australia, data on construction spending and business investment will help firm up estimates for September quarter GDP growth to be released on 1st December. Capex spending is likely to show a decent rebound after a fall in the June quarter and capex plans are likely to remain strong. Meanwhile, RBA Governor Glenn Stevens’ testimony before a Parliamentary committee on Friday will be watched closely for more clues regarding the interest rate outlook.

Outlook for markets

• After strong gains since late August, shares were vulnerable to a correction, which we have certainly seen over the last two weeks. While it’s too early to say whether we have seen the bottom or not, we continue to expect solid gains in shares into year end and through next year. Shares are cheap, particularly relative to government bonds, the risk of a double dip back into recession appears to have receded, the global liquidity backdrop is highly favourable underpinned by QE2 in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. In the past week we have seen BHP announce a resumption of share buybacks and Nike increase its dividend payout.
• Notwithstanding normal bumps along the way, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia continue to trend up, and commodity prices resume their rising trend. It’s likely that the $A will settle around $US1.10 in the year ahead.
• Deflation worries, along with central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

Key points

• Share markets and related trades such as commodity prices and commodity currencies have fallen over the last two weeks, partly triggered by worries about the impact of Chinese tightening and the re-emergence of sovereign debt problems in Europe.
• However, this is likely to be a correction in an ongoing cyclical recovery in shares: the global recovery looks like it is continuing, shares are still cheap, the liquidity backdrop for shares is positive and a cashed up corporate sector is likely to lead to increased capital being returned to shareholders.

Introduction

After solid gains from early July lows into early November, shares and related trades such as commodity prices and the Australian dollar have fallen sharply, as renewed worries about sovereign debt in Europe and more pressure to tighten in China have led to renewed worries about the global growth outlook. Our assessment is that this is just another correction in an ongoing cyclical recovery in shares. This note looks at why, and what the key threats might be.

Cyclical dynamics remain positive

After the strong gains in recent months, growth trades such as shares and commodities had become overbought and due for a correction. This is what we have seen over the last week or so with worries about another round of sovereign debt problems in Europe and more tightening in China being the main triggers. This could have a bit further to run.

However, the broad cyclical back drop for growth trades such as shares and commodities remains positive.

First, shares are still cheap. Price to earnings multiples are well below long term averages. For example, the price to earnings ratio for Australian shares based on one year forward consensus earnings is 12.5 times against a long term average of 14.6 times. The grossed up dividend yield from shares at 5.3% is about the same as the 10 year bond yield meaning shares require only modest capital growth to provide a much better return than bonds. Forward price to earnings multiples on global shares are also around 12.4% times, which is well below longer term averages.

Source: Bloomberg, AMP Capital Investors

Second, there is reason to have greater confidence in the continuation of the global recovery. After falling around mid year, business conditions indicators appear to have stabilised in most major countries, with the exception of Japan. In fact, in the US, Europe and China they have turned back up after falling around mid year.

Source: Bloomberg, AMP Capital Investors

In the US, strength in the corporate sector appears to be driving a pick up in employment and capital spending, housing indicators appear to have found a floor and retail sales growth has been surprising on the upside. In Europe, strength in Germany and other northern European countries has offset weakness in debt impaired countries, Japan’s economic growth has actually surprised on the upside and China has had anything but the hard landing feared earlier this year.

Third, we are now seeing more monetary easing with another round of quantitative easing in the US (QE2) and a mini version of the same in Japan. This in turn is being transmitted into several emerging countries to the extent they have intervened to resist an appreciation of their currencies as a result of capital inflows from the US and in so doing are effectively boosting their own money supplies. Putting the criticisms of QE2 aside, a key objective of quantitative easing is to boost asset prices – as this will increase the net wealth of households and hence help consumer spending. To the extent the extra liquidity has to go somewhere, there is a good chance some of it will go into shares achieving its aims in this regard. This was certainly evident from QE1 last year.

On the liquidity front it’s also worth noting that over the last few years a wall of money has gone into bond funds. This could reverse at some time pushing up bond yields and resulting into a greater flow of funds into equities.

Source: US Investment Company Institute, AMP Capital Investors

Fourth, the corporate sector is cashed up. This is evident in surging profits at a time when business investment is coming off a low base. As a result the corporate sectors in the US and Australia are now net lenders, i.e. generating more cash than they are investing (see the next chart for Australia). This points to a further pick up in M&A activity, dividends and share buybacks going forward.

Source: Thomson Financial, AMP Capital Investors

This is clearly evident in Australia where takeover activity is building. Eg, no sooner has BHP had its Potash takeover knocked back than it is restarting share buybacks. M&A, increased dividends, share buybacks all have the same affect, i.e. putting cash into the hands of shareholders.

Finally, there are a number of cyclical dynamics which are positive for shares. The seasonal pattern in share markets is such that the next six months, i.e. November through May, is normally the strongest period for share markets reflecting the ending of tax loss selling for US mutual funds and new year optimism (see the next chart). We are also coming into the third year of the US presidential election cycle which is normally the strongest with an average annual gain of 19.4% pa since 1927.

So for all these reasons we think the cyclical recovery in shares has further to run.

Source: Thomson Financial, AMP Capital Investors

Potential threats

But what are the potential threats? There are several risks worth keeping on eye on:

• Ireland and Portugal have seen their bond yields rise to new highs and the size of the problem in Greece is still increasing, raising concerns about another European sovereign debt crisis. This is certainly a risk. However, several considerations suggest the impact may be lower than seen earlier this year as Europeans are now more aware of the dangers of delaying and backstops are in place: the European Central Bank can resume its purchases of bonds and troubled countries can tap the European Financial Stability Facility.
• In China, worries about policy tightening crunching the economy have returned after surging food prices pushed inflation up. However, t’s hard to see Chinese authorities getting too aggressive as non-food inflation is just 1.6%, economic activity indicators have cooled from earlier this year and Chinese shares remain cheap. That said, it may be a source of short term jitters.
• Bond yields in advanced countries are running well below long term sustainable levels and are at risk if some of the record capital flows of recent years reverse, perhaps in response to a run of stronger economic data, much like in 1994. The risk of this may be low now but is worth keeping an eye on next year.
• Similarly, the $US could stage a rebound on the back of stronger US data, making life tougher for US companies, commodity prices and commodity currencies like the $A. Apart from the current bounce from oversold levels, a sustained rebound in the $US looks unlikely given the additional quantitative easing in the US. It’s also possible that to the extent a stronger $US reflects stronger US and hence stronger global growth it may actually be positive for risk trades such as shares and commodity prices.
• Finally, the problems with mortgage foreclosures in the US could turn into another banking crisis. This seems unlikely but its worth watching out for any renewed leg down in US house prices and pressure on banks to repurchase mortgages from securitized trusts.

Conclusion

The latest set back in shares reminds us that the global recovery remains fragile. However, there are good reasons to believe it is just a correction in the continuing cyclical recovery that got underway in March last year.

]]>

Key points

• Share markets and related trades such as commodity prices and commodity currencies have fallen over the last two weeks, partly triggered by worries about the impact of Chinese tightening and the re-emergence of sovereign debt problems in Europe.
• However, this is likely to be a correction in an ongoing cyclical recovery in shares: the global recovery looks like it is continuing, shares are still cheap, the liquidity backdrop for shares is positive and a cashed up corporate sector is likely to lead to increased capital being returned to shareholders.

Introduction

After solid gains from early July lows into early November, shares and related trades such as commodity prices and the Australian dollar have fallen sharply, as renewed worries about sovereign debt in Europe and more pressure to tighten in China have led to renewed worries about the global growth outlook. Our assessment is that this is just another correction in an ongoing cyclical recovery in shares. This note looks at why, and what the key threats might be.

Cyclical dynamics remain positive

After the strong gains in recent months, growth trades such as shares and commodities had become overbought and due for a correction. This is what we have seen over the last week or so with worries about another round of sovereign debt problems in Europe and more tightening in China being the main triggers. This could have a bit further to run.

However, the broad cyclical back drop for growth trades such as shares and commodities remains positive.

First, shares are still cheap. Price to earnings multiples are well below long term averages. For example, the price to earnings ratio for Australian shares based on one year forward consensus earnings is 12.5 times against a long term average of 14.6 times. The grossed up dividend yield from shares at 5.3% is about the same as the 10 year bond yield meaning shares require only modest capital growth to provide a much better return than bonds. Forward price to earnings multiples on global shares are also around 12.4% times, which is well below longer term averages.

Source: Bloomberg, AMP Capital Investors

Second, there is reason to have greater confidence in the continuation of the global recovery. After falling around mid year, business conditions indicators appear to have stabilised in most major countries, with the exception of Japan. In fact, in the US, Europe and China they have turned back up after falling around mid year.

Source: Bloomberg, AMP Capital Investors

In the US, strength in the corporate sector appears to be driving a pick up in employment and capital spending, housing indicators appear to have found a floor and retail sales growth has been surprising on the upside. In Europe, strength in Germany and other northern European countries has offset weakness in debt impaired countries, Japan’s economic growth has actually surprised on the upside and China has had anything but the hard landing feared earlier this year.

Third, we are now seeing more monetary easing with another round of quantitative easing in the US (QE2) and a mini version of the same in Japan. This in turn is being transmitted into several emerging countries to the extent they have intervened to resist an appreciation of their currencies as a result of capital inflows from the US and in so doing are effectively boosting their own money supplies. Putting the criticisms of QE2 aside, a key objective of quantitative easing is to boost asset prices – as this will increase the net wealth of households and hence help consumer spending. To the extent the extra liquidity has to go somewhere, there is a good chance some of it will go into shares achieving its aims in this regard. This was certainly evident from QE1 last year.

On the liquidity front it’s also worth noting that over the last few years a wall of money has gone into bond funds. This could reverse at some time pushing up bond yields and resulting into a greater flow of funds into equities.

Source: US Investment Company Institute, AMP Capital Investors

Fourth, the corporate sector is cashed up. This is evident in surging profits at a time when business investment is coming off a low base. As a result the corporate sectors in the US and Australia are now net lenders, i.e. generating more cash than they are investing (see the next chart for Australia). This points to a further pick up in M&A activity, dividends and share buybacks going forward.

Source: Thomson Financial, AMP Capital Investors

This is clearly evident in Australia where takeover activity is building. Eg, no sooner has BHP had its Potash takeover knocked back than it is restarting share buybacks. M&A, increased dividends, share buybacks all have the same affect, i.e. putting cash into the hands of shareholders.

Finally, there are a number of cyclical dynamics which are positive for shares. The seasonal pattern in share markets is such that the next six months, i.e. November through May, is normally the strongest period for share markets reflecting the ending of tax loss selling for US mutual funds and new year optimism (see the next chart). We are also coming into the third year of the US presidential election cycle which is normally the strongest with an average annual gain of 19.4% pa since 1927.

So for all these reasons we think the cyclical recovery in shares has further to run.

Source: Thomson Financial, AMP Capital Investors

Potential threats

But what are the potential threats? There are several risks worth keeping on eye on:

• Ireland and Portugal have seen their bond yields rise to new highs and the size of the problem in Greece is still increasing, raising concerns about another European sovereign debt crisis. This is certainly a risk. However, several considerations suggest the impact may be lower than seen earlier this year as Europeans are now more aware of the dangers of delaying and backstops are in place: the European Central Bank can resume its purchases of bonds and troubled countries can tap the European Financial Stability Facility.
• In China, worries about policy tightening crunching the economy have returned after surging food prices pushed inflation up. However, t’s hard to see Chinese authorities getting too aggressive as non-food inflation is just 1.6%, economic activity indicators have cooled from earlier this year and Chinese shares remain cheap. That said, it may be a source of short term jitters.
• Bond yields in advanced countries are running well below long term sustainable levels and are at risk if some of the record capital flows of recent years reverse, perhaps in response to a run of stronger economic data, much like in 1994. The risk of this may be low now but is worth keeping an eye on next year.
• Similarly, the $US could stage a rebound on the back of stronger US data, making life tougher for US companies, commodity prices and commodity currencies like the $A. Apart from the current bounce from oversold levels, a sustained rebound in the $US looks unlikely given the additional quantitative easing in the US. It’s also possible that to the extent a stronger $US reflects stronger US and hence stronger global growth it may actually be positive for risk trades such as shares and commodity prices.
• Finally, the problems with mortgage foreclosures in the US could turn into another banking crisis. This seems unlikely but its worth watching out for any renewed leg down in US house prices and pressure on banks to repurchase mortgages from securitized trusts.

Conclusion

The latest set back in shares reminds us that the global recovery remains fragile. However, there are good reasons to believe it is just a correction in the continuing cyclical recovery that got underway in March last year.

The post Cyclical recovery in shares remains on track, albeit bumpy appeared first on AdviserVoice.

Headline developments of the past week

• The contrast in global central banks was stark over the past week with those in weak countries such as the US, Japan and Europe leaving monetary conditions very easy and in the US actually easing further via more quantitative easing, whereas those in strong countries such as India and Australia actually raising interest rates. The move to QE2 in the US will result in a further huge boost to global liquidity which is positive for shares, particularly in emerging countries, and commodity prices and will reinforce the ongoing fall in the $US against commodity currencies such as the Australian dollar and emerging country currencies.
• The big event of the last week was of course the US Federal Reserve’s announcement of another round of quantitative easing (QE2), choosing to purchase an additional $US600bn of US Treasury bonds by the end of June next year with further moves subject to economic conditions. Will it work or will it just boost inflation? The claim by some that inflation will take off is nonsense. This will only be an issue once broad measures of money supply and credit pick up and capacity utilisation returns to normal but we have a long way to go to reach that point. The more substantive argument against QE2 is that the basic problem in the US is a lack of demand for credit. However, doing nothing is not an option. QE1 in 2008-09 does appear to have boosted the US economy. Moreover, QE2 could help the continuing US recovery by keeping borrowing costs low, boosting asset prices and hence having a positive wealth effect, keeping inflationary expectations positive and maintaining downwards pressure on the $US. The first three are likely to help support spending and a lower $US should help US exporters. With bond yields and the $US substantially lower and US shares up 17% or so since QE2 was first mooted in late August, it appears to have already had a positive effect.
• The US mid-term Congressional elections saw the Republicans regain control of the House of Representatives but fall short of control of the Senate. Republican control of the House of Representatives should help blunt some of the less business friendly policies that were emanating from the President Obama. More importantly, it may be good for the US if it leads to a more pragmatic and centrist approach from President Obama, much as occurred with President Clinton after the 1994 mid-term elections.
• In Australia, the Reserve Bank decided to act on its often stated tightening bias and raised the official cash rate by another 0.25% taking it to 4.75%. The Reserve Bank’s expectation that inflation will rise over the next few years points to further tightening ahead. However, the additional tightening that has flowed from the $A pushing through parity and bank moves to raise lending rates by more than the RBA rate increase suggest the next move probably won’t come until February and that the peak will be lower than otherwise would have been the case. Within a year’s time the cash rate is likely to have increased to around 5.5%.
• The RBA’s Quarterly Statement on Monetary Policy only served to reinforce its ongoing tightening bias. While inflation forecasts for this year were revised down, growth forecasts were revised up and the RBA still sees underlying inflation heading up to the top of its target range through the second half of next year as the boost to national income from high commodity prices pushes the economy up against capacity constraints.
• After a two week consolidation since first hitting parity, the $A broke decisively through the parity level against the $US on the back of the RBA’s rate hike and the Fed’s announcement of QE2. While gyrations in the $A will remain significant, the continuing strength in Australia’s terms of trade, further tightening in Australian monetary policy and an ongoing downtrend in the $US are likely to see the $A push up to around $US1.10 in the year ahead. Above parity for the $A will become part of the landscape, so get used to it!

Major global economic releases and implications

• US economic data was positive suggesting that the soft patch in growth may have ended and that, combined with QE2, the risk of a double dip back into recession has faded significantly. Both the ISM manufacturing and non-manufacturing conditions indicators rose in October, factory orders rose more than expected in September, weekly new mortgage applications rose further and most importantly payroll employment rose solidly in October led by 159,000 new private sector jobs.
• US profit reports remained very strong, consistent with continuing strength in productivity in the September quarter, and providing solid support for capex, employment and M&A activity going forward.
• European manufacturing conditions indicators rose in October with Germany remaining pretty solid.
• A further rise in Chinese manufacturing conditions indicators (or PMIs) and continuing strength in services sectors PMIs in October highlights the ongoing strength in the Chinese economy and points to a further tapping of the policy brakes in the months ahead. I have just spent the last week in China and have to say that there are no signs of the Chinese hard landing that was much feared earlier this year, let alone the bust that the China sceptics are always raving on about.

Australian economic releases and implications

• Australian economic data was mixed with a rise in indicators of manufacturing and services sector conditions, continued moderate growth in retail sales but flat house prices and another slide in building approvals. Quite clearly the 20% surge in house prices from the March quarter 2009 has now run its course and with affordability around record lows and set to worsen as mortgage rates rise further, house prices are likely to be flat to maybe even down slightly over the year ahead. However, the continuing undersupply highlighted by the latest fall in building approvals should provide a solid floor under house prices.

Major market moves

• Global shares are surging higher on a positive cocktail of better than expected global economic data and earnings news, the US announcement of QE2 and optimism that the Republican victories in US elections will lead to more business friendly policies. The surge in optimism has pushed US shares to new recovery highs and Australian shares decisively above the range they have been stuck in for a month with both markets up 3% over the last week. Asian shares which are likely to be key beneficiaries of the global liquidity boost flowing from QE2 were up even more with Hong Kong shares up 7.7% and Chinese shares up 5.1%.
• News of the increased supply of US dollars pushed the $US lower and this along with greater economic optimism pushed other growth trades such as commodity prices and the $A decisively higher.

What to watch in the week ahead?

• In the week ahead, the focus is likely to be on Chinese economic data for October. Activity indicators are expected to show ongoing solid, but not overheating growth. Housing indicators are likely to be soft. Higher food prices are likely to boost inflation to around 4%. However, this may well be the peak and benign non-food inflation and increasingly well balanced growth is likely to ensure that further policy tightening remains gradual and targeted.
• In Australia, employment data for October, due Thursday, is likely to show another decent gain in jobs and a fall in unemployment to 5%. Data for job ads are likely to remain solid, but Westpac’s consumer confidence index is likely to have fallen as a result on the latest rate hike and housing finance data for September is likely to have remained soft. The Government’s mid year economic and fiscal review is likely to see upside revisions to near term growth forecasts and a downwards revision to near term inflation forecasts.
• The G20 leaders’ summit is likely to provide nothing more than the usual hot air about commitments to market determined exchange rates and international cooperation. It may see more pressure on China to speed up the pace of Renminbi revaluation, but is unlikely to result in anything significant.

Outlook for markets

• Having undergone a consolidation in recent weeks, shares have now decisively broken out on the upside with further solid gains likely into year end and through next year. The global liquidity backdrop is getting even more favourable for shares underpinned by QE2 in the US, the soft patch in global growth appears to be over resulting in a return to investor confidence, the corporate sector is cashed up and this is likely to result in a further pickup in M&A activity, and shares remain very cheap relative to government bonds. Emerging market and Asian shares are likely to continue to outperform, but the key direction setting US share market is also likely to post solid gains. The average gain in US shares post mid-term elections has been 27% over the subsequent 12 months and we are now coming into the third year of the US presidential election cycle which is normally the strongest with an average post war gain of 18% pa. Against this backdrop, the Australian ASX200 share index is on track to push above the 5000 level by year end.
• After a period of consolidation since first hitting parity a few weeks ago the Australian dollar has broken decisively above it, and notwithstanding normal bumps along the way, looks to be heading even higher thanks to a falling US dollar, rising interest rates in Australia and high commodity prices. It is likely to settle around $US1.10 in the year ahead.
• Deflation worries, along with central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

“Print, baby, print” echoes the chorus of economists, investors and currency speculators worldwide. The strong possibility the US will create more money out of thin air has led to a significant depreciation of the US dollar and an appreciation of asset prices, including equities and bonds.

Investors do not seem to be concerned by the fact that money is not really being printed. It appears to matter even less that all that occurs when quantitative easing takes place is that banks sell the Federal Reserve treasuries and receive cash (in the form of a credit on the Feds’ balance sheet) in return for the hope they will lend the extra money out.

Importantly, none of this new money actually buys anything – not gold, shares, or even Australian dollars. Investors buying these assets are mostly speculators expecting a debasement of the US dollar or an increase in risk appetite.

What is most interesting, however, is that banks are not short of cash to lend. Excess cash on US bank balance sheets is over one trillion dollars. The real problem is that borrowers – scarred by weak demand, no employment growth and increasing regulation – just don’t feel the need to borrow to invest. Consumers have learnt the long-forgotten virtue of thrift in conjunction with a decline in the value of their collateral. Hence the problem of too much cash and not enough borrowers is unlikely to be solved by injecting liquidity. It appears this is a route chosen when all other alternatives are exhausted.

The US economy will march to its own rhythm and not be significantly swayed by the odd purchase of treasuries by the Federal Reserve. The bigger issue is whether investors should sell assets that have most recently been inflated, or buy more in the expectation it will continue.

Only time will tell, but our view is that purchasing assets in the hope that central bank policy actions will steer a complex series of economic events is fraught with danger.

It is true that equities currently represent fair to good value and a long term investment at these prices will likely be well rewarded. However, it would be foolish not to acknowledge a sense of short term euphoria that is liable to produce some level of disappointment in the near future. When the excitement of the second round of quantitative easing in the US fades, perhaps so will the froth in these outperforming assets.

For domestic investors, the surge in the Australian dollar has been of tremendous interest. We note with a healthy dose of cynicism that the higher the Australian dollar rises, so too do the forecasts of where it will go. Concepts of overvaluation seem to be discarded in favour of a belief in a new world where China is king, the US and Europe are declining empires and the Australian dollar is a proxy for the changing of the guards. The euphoria surrounding the local currency evokes the myopic views towards dotcom versus old economy stocks a decade ago.

At the moment, the market does not appear to be pricing in any risks to the Australian dollar.  However, any wobble or sneeze in the global economy – or the mere hint of a slowdown in China – will be met with a significant and sudden currency reversal.

It should not be forgotten that the pillars of local strength are the Australian property market and Chinese growth. The former is regarded as one of the world’s most overvalued markets while the latter is, by many accounts, overheating. Both countries are raising interest rates, which is never good for economic growth or property prices.

If for no other reason than risk management, investors should be taking advantage of the strong currency and purchasing assets globally.

The big picture

• Here’s a scary thought – 2010 is almost over, with just over two months to go to the end of the year. So it is opportune to see where Australia stands in the global rankings of shares, currencies and interest rates.
• One of the interesting findings is that the Australian sharemarket is amongst the laggards, not the leaders. Of the 72 global sharemarkets monitored, the Australian sharemarket is in 57th place, with the All Ordinaries just over three per cent down from the start of the year.
• The best performer is Sri Lanka, with shares up 94 per cent, followed by Estonia (up 59 per cent) and Lithuania (up 46 per cent). Asian sharemarkets have done well with both Indonesia and the Philippines up over 40 per cent and Thailand up 34 per cent. And of the major markets, the German Dax is up 10 per cent, the US Dow Jones is up almost seven per cent and Hong Kong has gained six per cent.
• At the other end of the scale the Greek sharemarket has slumped 28 per cent, followed by Cyprus and Slovakia. But it’s also worth noting that the Japanese sharemarket is down 11 per cent with China down 8.5 per cent.
• The relative weakness of our sharemarket will surprise some, especially as it has occurred at a time of a stronger Aussie dollar. Of 120 currencies monitored, the Australian dollar is the 8th strongest this year against the greenback. The Aussie dollar is currently up almost eight per cent against the US dollar, after being up by over 11 per cent at one point.
• The strongest currency is the Japanese yen, up almost 12 per cent in 2010 followed by the Thai baht, Mongolian tugrik and Icelandic krona (all up around 10 per cent). The other end of the list is dominated by African nations – Ethiopia, Uganda and Tanzania, but the Euro has also fallen against the US dollar over the year, down by around four per cent. Over 2010 the US dollar index is largely unchanged – a result that will surprise many given the perception that the greenback has been weak. Rather it has risen and retreated over the year.
• In terms of interest rates, Australia will end 2010 with the highest rates of any industrialised economy. The Economist magazine has data on 58 countries across the globe and Australia’s 3-month rate of 4.78 per cent is the 14th highest in the world, just behind Iceland and Hungary. Still, if the IMF’s listing of “advanced nations” is chosen instead, then Australia’s interest rates are the second highest, behind Iceland. Whichever way you cut it, Australia’s interest rates have more in common with those of developing nations.

The week ahead

• Will Murphy’s Law rule in the coming week? In October economists tipped a rate hike and it didn’t happen. For November, most have gone cold on a rate hike, so does that mean the Reserve Bank will spring a surprise?
• If the Reserve Bank does lift rates it will be a very big surprise. No matter how you cut the inflation data, there are no price pressures to be found. Rather, retailers are coping with deflation – falling prices. Add in the contraction in manufacturing and services sectors, the fact that no one is borrowing and the high Aussie dollar and there is no reason why the Reserve Bank would have to lift rates – even if it used its best pair of binoculars to gauge the future.
• In terms of the economic data, the Bureau of Statistics releases its house price index on Monday together with the Performance of Manufacturing index and October’s monthly inflation gauge. On Wednesday the Performance of Services index and building approvals are issued. Retail trade and international trade data are released on Thursday with the Reserve Bank’s Statement on Monetary Policy slated for Friday.
• It’s worth pointing out that the TD Securities/Melbourne Institute monthly inflation gauge has had a good track record. Not only was it ‘spot on’ with its forecast of the September quarter consumer price index, but past predictions have also been accurate. So the October data is worth watching closely.
• Of the other data, building approvals probably only partially rebounded by 2 per cent during September after the 4.7 per cent slump in August. And we expect that consumers are starting to spend a bit more, although it’s clear from the data that they are very selective. Retail trade probably rose 0.7 per cent in September after a 0.3 per cent lift in August with poor weather restraining seasonal purchases.
• The Statement on Monetary Policy will clearly be pivotal for the direction of interest rates. If the Reserve Bank trims its inflation forecast then rate hikes will be off the agenda until 2011.
• In the US, there will be three events that dominate attention over the week. The first is the midterm elections on Tuesday. Then the focus will turn to the Federal Reserve meeting to be held over Tuesday and Wednesday. And the third focal point will be Friday’s employment (non-farm payrolls) data.
• In terms of the mid-term elections, pundits expect the Democrats to lose seats – it just depends on how many and whether the Democrats also lose control of the Senate. Some investors believe that if control of the presidency and Congress is in different hands this would actually be a positive result – it may lead to fewer changes over the next two years and thus more investor certainty.
• Turning to the Federal Reserve meeting, the Fed would like to cut rates, but unfortunately the zero limit has been reached. (No matter how many times you say it, it’s still a remarkable situation.) So to give the economy a boost, the Federal Reserve is planning another batch of quantitative easing – in effect printing money. Arguably cutting payroll taxes would be more effective, but that gets us back to the political inertia.
• And then there is the employment data. At this early point economists expect private sector payrolls to rise by 80,000, a small improvement on the 64,000 lift in jobs in September. Job gains are still insufficient to trim the jobless queue, but that is largely because businesses are not confident enough to hire.
• Other data to watch over the week includes personal income, construction spending and the ISM manufacturing index on Monday. On Wednesday the ADP employment index and ISM services index are due together with factory orders and car sales.

Sharemarket

• We haven’t changed our end-year forecast for the Aussie sharemarket for around three months. For most of that period it has been more likely that we would have to trim our projection, but just in the past few weeks, our fabled 4,800 point target has moved into sight. We are actually still quite comfortable with our view, but it’s worth pointing out that the sharemarket rally can be traced back to August 27 when Federal Reserve chief Ben Bernanke vowed to do what it takes to restore economic growth. Bernanke said: “The committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly.”
• Global sharemarkets will be on edge in the coming week when investors put Ben Bernanke’s words to the test. The speculation is that the Federal Reserve won’t undertake ‘shock and awe’ stimulus measures, rather it will opt for modest purchases of bonds. But it is the statement that many will be watching. Businesses don’t have the confidence to use their hoards of cash to invest and employ staff. Economists may debate whether another round of quantitative easing is necessary, but it is the words and confidence effects that are generated rather than the action itself that are now important.

Interest rates, currencies & commodities

• Ahead of the last Reserve Bank Board meeting, financial markets reckoned there was a 74 per cent chance of the Reserve Bank lifting rates. In the end it didn’t happen. Current market pricing suggests a 20 per cent chance of a rate hike. It’s clear that investors have gone cold on the idea of a rate hike, just like the majority of economists.

• Strong returns by listed property companies during the month were mainly driven by positive momentum in most global equity markets.
• The prospect of further quantitative easing in the US would be beneficial to property companies. Asset valuations would improve because the lower risk-free rate tends to cause capitalisation rates to have adownward bias.
• We continue to hold a positive bias to the North American and Asia-Pacific regions and a cautious stance towards property companies in Europe, which we expect to continue to lag despite the outperformance during the September quarter.

Market Review

Strong returns were generated by property companies during the quarter in virtually all major geographies. European property companies generated the highest total returns, up more than 18%, based in part on the positive response to bank stress tests in July followed by Basel III pronouncements in September, both of which were deemed to be less stringent than expected. Property companies have benefited from lower bond yields, which have improved the yield spread versus fixed-income alternatives as well as improving earnings prospects.

Macro-economic news continues to drive sentiment

Macro-economic news continues to confound investors who are seeking smooth, sustainable trends. Economic releases have been inconsistent as they appear to vacillate. As an example, US existing home sales plunged 27% in July from a month earlier to an 11-year low as demand was pushed forward from the anticipated expiration of the first-time home buyer’s tax credit, only to rebound 7.6% in August to a seasonally adjusted annual rate of 4.13 million sales.

While up nicely from the 3.84 million annualized rate in July, this remains 19 percent below the 5.10 million-unit pace in August 2009 (so good news at first glance turns out to be mixed).

One clear theme for the quarter, however, was the consistently benign nature of the review of European banks. European bank stress tests, released on July 23, were less stringent than expected as only seven of the 91 banks tested failed. Separately, the Basel III rules announced in September were more accommodating than expected as banks will have the better part of a decade to meet the new requirements. This measure has provided relief for European banks as well as industries deemed to be capital users, including property companies. Equities rallied globally on this news.

Language from the US Federal Reserve Bank (the Fed) in September indicating that it’s open to further quantitative easing also contributed to the rally during the quarter. Taken with economic growth in the Asia-Pacific (ex-Japan) region which remains robust, the case for a continued global economic recovery appears to remain intact.

The implications of potential quantitative easing

Probably the most important recent event during the quarter was the change in language from the Fed’s rate-setting Federal Open Market Committee. The Committee in its September statement made it clear that further quantitative easing is a possibility as it stated that it “is prepared to provide additional accommodation if needed to support the economic recovery.”

As background, quantitative easing has typically been in the form of the Fed expanding its balance sheet by purchasing Treasuries and potentially mortgage-backed securities in the market in an effort to reduce these “reference rates” for a variety of fixed income instruments.

The ultimate goal is to reduce the cost of private sector borrowing in order to spur economic growth. The impact on real estate companies is generally very positive both with respect to asset valuations as well as cash flow.

Asset valuations are improved since a lower risk-free rate tends to cause capitalisation rates to have a downward bias, which causes the value of an in-place cash flow to rise.

Cap rates decrease since investors are able to afford to pay more for a given level of earnings while maintaining the same spread to the cost of capital (which has gone down because debt costs have come down and possibly the cost of equity, too).

Cash flows tend to improve as the cost of borrowing becomes cheaper.

External growth (acquisitions/development) also tends to pencil out more easily as the overall cost of capital goes down.

Taken together or even separately, quantitative easing is clearly very beneficial to real estate companies.

While the Fed has not engaged in another round of quantitative easing, it has made it clear that it is ready and able to engage if and when needed. This would be positive for real estate stocks.

Low rates and high spreads improved real estate valuations

Talk of quantitative easing and fears of recession are likely to keep interest rates low in the near term. As stated previously, yield spreads for real estate companies versus fixed-income alternatives remain attractive. Even with the rally in real estate stocks in September, implied cap rates generally represent significant positive spreads to local bond yields.

For investors who expect a continuation of low yields and low returns, it is logical that real estate values have been going up and may continue to do so. In the US, the implied real estate yield on REITs is 6.5%, which implies a spread at the end of September of 90 basis points to the 5.6% yield on Baa corporate bonds (the longest duration corporate bond composite of 25-30 year paper). This remains above the
average spread, which according to data compiled by Green Street Advisors has averaged 80 basis points since 1994.

Green Street Advisors has also estimated that commercial property values in the US have risen by 25% in the last 12 months and almost 30% from the trough values in May 2009. Values are still more than 20% below the peak levels reached in late 2007.

Other markets have followed a similar trend. The following table shows real estate yields (i.e., cap rates) implied by current REIT pricing around the world, as well as the NAV premium or discount, which reflects our estimate of implied pricing versus prevailing private market valuations for comparable real estate portfolios. We currently estimate that global listed property stocks trade, on a market cap weighted average basis, at a 3% discount to private market real estate values.

Third quarter earnings season is upon us

Third quarter earnings reports should evidence continued improvement as we expect many of the themes seen during 2Q10 to continue to play out:

1. improving property fundamentals;
2. wide-open access to debt and equity capital at competitive costs;
3. increasing transaction volumes and;
4. firming property transaction yields.

If anything, we expect the “new news” to be that yields have room to compress further as a result of bond yields, which have headed lower over the past few months and the Fed which has made it clear that it would like to keep yields low over the foreseeable future.

Property companies will continue to be able to reduce their cost of capital via a lower cost of debt as refinancing improves the prospects for positive spread investing. We expect low yields to continue to underpin property values.

OUTLOOK

Improving fundamentals portend positive earnings growth in 2011

We believe real estate companies will be able to deliver modest growth in earnings in the current environment. We look for a global weighted average growth rate for property company earnings of 7% in 2011. In the meantime, the unusually wide spreads between real estate yields and bond yields suggest that real estate assets are still attractively valued. If yields remain low, then real estate values if anything are likely to improve.

The path forward

We continue to retain the view we had at the beginning of the year, but with a few caveats. We continue to hold a positive bias to the North American and Asia-Pacific regions and a cautious stance towards property companies in Europe, which we expect to continue to lag despite the outperformance during the quarter.

By property type, we remain overweight sectors which stand to benefit from an economic recovery, including the shorter lease length hotel and apartment sectors as well as certain office markets in the Asia Pacific region. We remain underweight property types which react more slowly to economic recovery including healthcare and most office markets in North America and Europe.

Our outlook remains predicated on the assumption of gradual but steady global economic growth.

• There is no doubt that there is only one game in town – one ‘hot button’ issue, if you like – and that’s quantitative easing. In essence the term refers to the printing of more money; but as you would expect economists ‘poohpooh’ that kind of simplification saying that it is more complicated than that. But with interest rates in the US effectively at zero and concerns that the economic recovery is at risk of stalling, many of the US Federal Reserve members believe that another round of quantitative easing – or QE2 – may be necessary.
• In the first round of QE, the Federal Reserve bought US$1.7 trillion of mortgage-backed securities and Treasuries. Now Federal Reserve policymakers say that another round of QE may be necessary “before long” – they are just working out how much will be needed and how they should explain what’s going on. Of course the Fed didn’t actually say it like that; it said they “wanted to consider further the most effective framework for calibrating and communicating any additional steps to provide such stimulus.”
• As mentioned, economists don’t like to use the term “printing money” to describe quantitative easing. They prefer to say that the Federal Reserve is making use of its balance sheet to apply more stimulus to the economy. But when you buy securities from financial institutions in exchange for cash, that cash has to come from somewhere.
• How did the Fed get to this situation? Well it’s largely because it has fired all their traditional bullets. That is, interest rates are near zero – the range for the federal funds rate is between zero and 0.25 per cent. If the Fed believes the economy requires more assistance to get going, there is not much else it can do.
• Note that Federal Reserve chief, Ben Bernanke, has done a lot of research on the Great Depression and is determined that the economy avoids going down that path. Bernanke famously goes by the title “Helicopter Ben”, after a speech he gave in 2002 where he said that deflation (falling prices) should be avoided at all costs even if it required the government to drop money from a helicopter to get people spending.
• Will it work? The problem is that you can put dollars in people’s pockets but that doesn’t mean they have to spend. Corporate America is already sitting on US$2 trillion of cash (in a US$14 trillion economy) but they aren’t confident to employ or invest. Companies want certainty – that is, if they do start to do business again, that the rug won’t be pulled from under them. In other words, that policy won’t go from ‘loose’ to ‘tight’ too quickly.
• What are the risks? One risk is that it doesn’t work, undermining confidence. But there is another risk – it works too well – that all that extra money in the system creates inflation. With inflation near 1 per cent currently, that is not a risk. Of course all those extra US dollars in the system reduce the value of the currency and that means other currencies like the Australian dollar go up. Our currency strategists believe that is just a matter of time before the Aussie dollar hits parity with the greenback, and a key reason is QE.

The week ahead

• The Reserve Bank seems to hog the spotlight most weeks and the situation is no different in the week ahead. The Reserve Bank releases minutes of the last Board meeting on Tuesday, and given the brevity of the statement released immediately after the meeting, analysts will be scouring the latest document more closely than normal.
• The interest rate announcement gave few insights into the Reserve Bank’s thinking on the Australian economy, especially key issues like the tight job market, consumer spending and the housing market. If the Reserve Bank believes that the economy is patchy, with inflation likely to remain in the 2-3 per cent target band, then it won’t be in a rush to change policy settings.
• In terms of economic data, there are no ‘top shelf’ items on the calendar. Car sales figures are released on Monday with skilled vacancies, private sector wealth and imports on Wednesday. Reserve Bank Head of Financial Stability Department, Luci Ellis, is a panel discussant at the Finsia Annual Financial Services Conference on Wednesday. And data on export and import prices is released on Friday.
• Car sales have proved quite healthy with more than a million vehicles sold in the past year. But a key influence has been last year’s tax break with deliveries of vehicles still trickling in. Car dealers were telling clients late last year that deliveries could take up to a year for custom vehicles. But low car prices are also an attraction for budding buyers, with lower tariffs and the firmer dollar the key influences.
• The data on private wealth will probably show some stabilisation with lower share prices offsetting higher home prices. Wealth is at record highs, highlighting the good position of household balance sheets.
• In the US, a consistent flow of indicators awaits investors over the coming week. On Monday industrial production figures are released together with capital inflows data and the NAHB index. Housing starts are slated for Tuesday, the Federal Reserve Beige Book is issued on Wednesday, while both the Philadelphia Fed index and leading indicator report are released on Thursday.
• Industrial production probably lifted by 0.2 per cent in September, confirming that the economic expansion is continuing, but at a more modest pace. But housing starts probably eased for the first time in three months with activity showing further signs of settling just below a 600,000 annual rate. And the leading index probably lifted by 0.3 per cent in September, matching the gain in August.
• There will be plenty of interest in the views of Federal Reserve officials in the coming week with no fewer than 10 speeches scheduled by Fed governors or regional presidents.
• But arguably more important than the bevy of US figures to be released over the week is the latest monthly batch of Chinese data. On Wednesday China will release indicators covering production, retail spending and inflation, together with the economic growth estimates for the September quarter.

Sharemarket

• The US earnings (profit reporting) season truly takes centre-stage in the coming week with a ‘who’s who’ of Corporate America set to deliver results. Amongst those reporting on Monday are Citigroup, Apple and IBM. On Tuesday, Bank of America, Coca-Cola, Goldman Sachs, and Yahoo! are slated to report. Earnings results out on Wednesday include those from Boeing, Wells Fargo and E*Trade. On Thursday, AT&T, Caterpillar, McDonalds, Morgan Stanley, Amazon.com and American Express issue profit results. And a small group of 15 companies issue results on Friday including Verizon.

Interest rates, currencies & commodities

• The Aussie dollar bottomed in early June (June 7) when it fell to US81.50 cents. Since that time the Aussie dollar has risen by around 21 per cent. Clearly these stellar gains in such a short period of time have caused many to question whether the rally is sustainable. That is, how much of the Aussie dollar gain is due to weakness of the US dollar, and how much reflects fundamentals such as higher commodity prices.
• Unfortunately there is no fool-proof way to work it out. Certainly one of the best ways to assess the changes is to look at commodity prices in both US dollar terms and currency-neutral SDR terms. Since the start of June the Commonwealth Bank commodity index has risen by just over 11 per cent in SDR terms while lifting around 20 per cent in US dollar terms. It’s also worth pointing out that the US dollar index, which broadly measures the strength of the greenback, has lifted by around 13 per cent over the same period.
• These figures suggest that around half of the Aussie dollar gains can be attributed to commodity prices and the other half to US dollar weakness. But when the US dollar is falling, commodities become cheaper in local currency terms for buyers in Europe and Asia. So some of the gain in commodity prices would reflect greater short-term demand for a cheaper product. At the same time, the perception that Aussie interest rates are likely to rise in coming months and our strong economy would also be factors driving the Aussie dollar higher.
• All that we can say with certainty is that while there is indeed a fundamental basis to the Aussie dollar’s gains, a healthy component of the rise reflects a weak US dollar. That point is important when you consider that commodity prices have only risen by 1 per cent over the period since early June.