Let’s look at the global position…


Google Maps view of Australia

i don’t know about you but at this time of the year i don’t sleep all that much. A financial planner looks at the end of the financial year as a one-way farm gate – if you don’t get all of your clients’ assets and details through that gate then there are opportunities that are irretrievably lost. This means relying on systems, institutions, processes, paper trails, notes, phone calls, emails and faxes and faxes and faxes. Oh, and did i mention faxes? It seems that modern technology is quite a long way ahead of legal authorities and institutional capabilities – there are still a lot of large businesses in the financial world that cannot easily access email contact. Believe it or not!

Of course, just as big a reason for not sleeping much is the bleak realisation that no matter what you do, there are going to be issues and activities that didn’t make the deadline – like a couple of errant sheep from a large flock. They could be caused by any number of reasons but a financial planner knows that they will spend the first week of the new financial year trying to sort those out – arguing with large institutions, trying to get the people/businesses involved to fix their mistakes or help get those errant sheep over the fence. Not all planners will have those issues but planners with a very wide scope of dealings will, and WSP does not restrict itself to vanilla (if we wanted to do that, we’d all go join a bank planning network and fit into their sales paradigm).

So why am i sharing this little peek into the private life of a financial planner?

Because on being awake in the wee hours of the morning, i have watched the US market fall over 3%, and it occurs to me that the Australian market will fall a similar amount (sharemarkets are very, very global) and that many people will see that as simply another layer of doubt about the future and its impact on them. So i thought an (at this stage) brief email to cover my impressions of all this, may be of assistance.

So, what is going on?

Simply put, we are seeing the ongoing playing out of an extended period of global deflation.

World growth leading up to 2007 was in “ramp-up” mode. That is, Governments, institutions, industries and individuals were arranging affairs to deal with what appeared to be a period of extended ‘above trend’ growth. Companies (car makers were a glaring example of this) invested heavily in plant and equipment to allow them to meet anticipated demand. Utilities invested heavily in capital and equipment to allow them to deliver basic infrastructure into this increasing demand (brought about by a geometrically rising global population and an historic level of movement from rural to urban living in developing countries).

There have been large imbalances across the world, as countries borrowed to mee these objectives and deficits/surpluses became unwieldy. Asset bubbles emerged in pockets across the world, predominantly in real estate but also in areas such as infrastructure and in these currency/deficit positions. Greater risks were required to be taken to earn equivalent to historic returns. The ‘free market’ mantra was adopted by many law-makers, unleashing a drive for increased credit funded partially by these bubbles.

The bursting of the United States housing bubble, was a primary trigger to a reassessment of these imbalances. The reassessment of risk led to a devaluation of any given stream of income to the point where values of many assets plummeted. The combined values of world property markets and sharemarkets (remembering that in developed countries, sharemarkets are worth around one third of what residential property markets are, so falls in property values have very large impacts on overall economies and the individuals within them) fell by figures measured in thousands of thousands of millions of dollars (measured by any currency terms which you may think in). Suddenly, “trillions” became a word used by adult laypersons, instead of being a fantasy figure used by children in games of one-upmanship.

The precise amount of money that evaporated doesn’t really matter. What matters is that an amount of money equivalent to many times the combined value of every single asset in Australia simply disappeared from the global economy in that reassessment of risk.

This means that there is less money around to pay for assets and income streams, meaning lower values. This means there is less credit available to rollover any existing debt. This means there is surplus capacity in plant and equipment, which in turn means supply is greater than demand, leading to lower prices.

And in amongst all of this is a growing global population that needs more food (protein especially), more energy (electricity, power for heating/cooling/industrial applications) and more space, while at the same time becoming more educated on better lifestyles and environmental limits – and therefore demanding that all this be achieved with less impact on the earths’ resources.

So we have a global trend of deflationary asset values, combined with an inflationary basic cost of living.

In other words, there is a global mismatch between the needs of the human race and the allocation of resources within it in terms of meeting those needs.

How do we end up in this level of discussion when talking about the level of the Australian sharemarket on the 30th of June 2010? We end up here because these large global trends don’t necessarily mean that all is doom and gloom. It does mean that we are in a period of readjustment that is likely to be extended. Such periods traditionally are accompanied by social unrest and war (let’s hope that any such issues are located outside our borders). These aren’t doomsday predictions, they are a statement of potential outcomes. It is not all doom and gloom because the central bankers of the world (as opposed to the legislators and political leaders) are vividly aware of the outcomes and have – to date – been highly (and unusually) coordinated in their responses. Mr Bernanke over in the United States, we are told, is a student of the Great Depression, and very aware of the potential for Governments to legislate an economy into very bad outcomes. And so the US has been in a state of “easy money” since the onset of the Global Financial Crisis. That is, they have made money available to their key banks (pretty much for free) in an effort to support the banks to enable them to continue the bulk of their lending. In other words, they have become the lender of last resort for the world’s largest economy. This does little for jobs in the short/medium term but it does help to rebuild confidence and in the long run that impacts on valuations and activity that stimulates growth. Most major countries around the world embarked on similar measures. This helped to create a strong rebound from the depths of the GFC, which saw sharemarkets around the world lift from their very low levels of 2008/09.

Historically minded folk will be aware that the recessions which moved to to be considered Depressions (really just periods of negative growth bigger than ‘normal’ drops) were generally made worse by a combination of : governments increasing taxes to try to meet higher deficits; governments introducing trade restrictions to try to protect their industries/economy; reductions in spending by governments (which is important because in times when the private sector is strapped for credit/cash, it is the government sector that has the ability to hire and build and invest and keep economic activity moving).

For a while it looked as though governments would continue this coordinated action, and that economic activity would continue to grow. If not back to pre-GFC levels then at least back to levels that were required by a growing demographic. Interest rates were being kept low and governments were spending ‘stimulus’ money to do what they have been told by economic theorists/historians is required to keep the world turning.

However, in the last few months many countries have been winding back their stimulatory efforts, and instead beginning to focus on bringing deficits into line. This may have been precipitated by the position of Iceland/Ireland/Greece but their example has focused a lot of politicians on trying to keep their particular piece of turf away from those horrible outcomes. And so Germany, Spain, the UK and others have moved on to drastically cut government spending – without necessarily waiting to make sure that their private sectors are operating at sustainable levels yet (Germany stands out as a country that is fussing about these issues even while the government rakes in huge income from the rest of the world’s efforts owing to the reduction in the value of the Euro and Germany’s position as the largest exporter in the world).

This is exactly what the US (and many economists) did not want to happen. It will reduce the ability of those countries to meet their ongoing debt, potentially leading to devastating economic conditions for large sections of the population. You only have to consider Ireland’s position to see just what horrible outcomes await those who pay too much attention to austerity measures.

And so we are in a position where large pools of money (from the cheap central bank interest rates) is washing around the world, trying to speculate on short term returns (because those pushing the buttons know that the cheap money will eventually stop and so they cannot take too many long positions in a ‘net’ sense), and trying to bet on where the ‘true temporary deficits’ are in the world are (ie, places where there is very high sustainable demand that can underpin growing values/income, and that is supported by an ability to pay).

And so we have the example of Caterpillar (one of the world’s largest manufacturers of heavy industrial machinery) growing its earnings by around 25%, while the price of the shares (which are part of the Dow index) falls by over 5% last night. We have Chinese authorities trying to coordinate a stimulatory programme to keep their export markets and stimulate their domestic economy while at the same time trying to prick any bubbles that will inevitably arise from such a policy (ie, trying to stop property bubbles while still growing property development to house and provide for incredibly large population shifts). This in turn, leads to global mining companies being valued down on the potential for China to reduce its intake of minerals and its consumption of commodities (iron ore, coal, oil, copper, aluminium etc).

And so we come down to Australia’s sharemarket. We have benefitted in amongst all of this by our small size (our needs for capital aren’t too taxing in the global scheme of events, our mineral wealth and our strong banking system. Ironically, that strong banking system is helped by the ongoing inability of governments at all levels to deal with our property market issues (ie, supply in the face of an increasing natural birth rate and immigration is not being increased sufficiently to copy with demand). Therefore, our property market prices have reached the equivalent of a bubble (on relative asset terms/income to capital terms/price to income terms etc, etc) but the bubble has not popped and, with legislative care, may even make it through the next few years in a state of mild price changes rather than a large fall.

Australians are happier owning property than investing into the companies that operate the country. Therefore, we have high levels of home ownership and a situation whereby the average investor owns a rental property and complains about foreigners taking the bulk of the profits from our mineral wealth. It also means that house prices are maintained through a commonly held set of assumptions, which suggest that property operates outside of normal asset changes. There are dangerous commonly held myths about residential property in Australia, and we would be foolish to look upon the rest of the world as being somehow ‘less’ than us or that our market will be completely isolated from the bubble-bursts that have occured overseas. As a country, we also have around one third of our sharemarket owned by foreigners, who view us in a different light to how we see ourselves. Therefore, there is a lot of money in markets that will act contrary to what we consider to be logic. This is highlighted when looking at our currency and its relative values, and in the way that our market slavishly follows global markets, even when the supposed ‘trigger events’ are not directly impacting on our industries or major companies.

And so our sharemarket will move according to global money flows, almost regardless of the ‘you beaut’ position that our politicians keep crowing about. Our banks still obtain around half of their annual cash needs from overseas, so our credit markets are also subject to the global position.

However, all is still not doom and gloom. Our sharemarket is currently valued at around 11 times its expected earnings. This is equivalent to the position AFTER the 1987 sharemarket crash. This is not indicative of the best positioned developed economy in the world nor is it indicative of the impacts of likely scenarios on the relative values of our major companies. At these levels, the earnings of the major companies could drop by around 10% and still the valuations would be below our markets’ long term average. And this in the face of expectations for growth in earnings which are very positive (around 19% for resources and ~14% overall).

So how do you develop a strategy in amongst all of this? WSP is a small firm but the marvels of the modern world have brought previously central-bank levels of data and analysis into the common domain, and from this deluge of input we seek to remove some of the noise from the world and focus on the key issues.

And this is the purpose of my note. To suggest that the daily ructions of markets are just that. To suggest that more than ever, the focus of an individual must be on their position and how they will prepare themselves for protection of their family and assets, and how they will grow their position with any spare capital or income at their disposal. The issues of today are large in economic terms but that is simply a matter of scale. The basics have not altered.

The end result? Most likely a need for more focus on your own position, more regularly.


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