For most of the past five years there have been industry executives prepared to predict an end to the bull market in Australian equities. In 2008 they appear to have, finally, been proved right.
Perennial Growth portfolio manager Lee Mickelborough believes that the status quo has finally been upset.
“The air has certainly come out of the bubble,” said Mickelborough. “Particularly in the highly leveraged areas and in externally managed structures. We’re also talking about a property sector that has previously outperformed even a bull equities market, and it has suddenly been brought into focus as well.
“These are all areas that have come back to the pack now,” he said.
Though pointing out that he is not a subscriber to broad perspectives on the current domestic equities market, Australian Super chief investment officer Mark Delaney admitted that the Australian financial environment had shifted dramatically.
“When analysing the domestic marketplace, Australian Super is looking to evaluate on the basis of risks, earning prospects and valuations,” he said. “However, there is little doubt that in the last six to eight months there has been a material change in the financial environment, originally sourced from the US and spreading throughout the world.”
Delaney said 2008 would undoubtedly be a tough year for most super funds and that he expected most to report returns that were barely positive over the first six months.
“The environment that the industry is coming out of was one in which we had big numbers,” he said. “And by that I mean returns in the order of 17 per cent throughout 2004, 2005, 2006, and 2007. But towards the back-end of that period, everyone was saying that more modest returns were just over the horizon.
“And they’re surely here now,” added Delaney, “With January and February returns already shaping up as negative.”
But it isn’t all bad news for domestic equities according to Mickelborough, with the silver lining to a volatile market being medium term opportunities for those funds selective and patient enough to take advantage.
“Everyone is feeling the pain now, particularly with the banks and lower risk areas being affected,” he said. “But it’s important to realise that despite what is happening now, the warning shots for this volatility were fired as far back as August last year. Smart funds and investors will have made preparations.
“And that is the other side of the coin,” continued Mickelborough. “There are now opportunities presenting themselves, so there’s no reason for long-term institutional investors like super funds to be panicking.”
Perhaps not surprisingly, Mickelborough’s advice that funds and investors remain both patient and calm throughout current market volatility is not unique. Super investment is, after all, a long-term game. Yet not all funds are looking to place themselves in a position to take advantage of the shorter-term opportunities.
The chief executive officer of industry fund HESTA, Anne-Marie Corboy, chooses instead to focus on the reality of market cycles and the benefits to be gained from diversification.
“HESTA’s investment strategy of diversification is determined to take account of market cycles,” she said.
“Our exposure to both the Australian and international share markets is not as high as it is for some of our competitors,” Corboy continued. “So while the current market volatility is affecting our portfolio in the same way as it is affecting others, we would expect our members will continue to experience long-term benefits from our investment strategy.”
For Mickelborough, moving forward is about funds and investors being conscious of long-term average returns for domestic equities and being wary of those stocks he’d put in the mismanagement category.
“In the current environment, many of the stocks we’ve seen flounder have done so on the basis of mismanagement,” he said. “They’ll point to the credit crunch as the reason for their woes, but if that’s their excuse, then we’re talking about buy short and lend long strategies and mismanagement overall.
“Investors have now got to be looking at long-term averages of 8 to 10 per cent when they had previously been doing 20s for up to two and three years.” he said. “That has to be kept in mind.”
Delaney said rationalising zero or negative returns this year compared with what was Australian Super’s best ever return last year was difficult but necessary.
“Markets often go from very strong to very weak,” he said. “It’s like a cold change through Melbourne, we are set to see the market go from very hot to very cold before normalising. And despite the fluctuation, we must stick to those important factors — risks, earning prospects, valuations — even as we overlay more medium term perspectives.”
Unfortunately, though an increasingly volatile equities market presents enough challenges for super funds, that rocky ride is not the only risk on that radar.
According to Mickelborough, much hinges on the interest rate policy of the Reserve Bank of Australia.
“That’s the real issue for the market,” he said. “Whether a tightening of interest rates spills over to consumer Australia.
“At the moment, the economy is holding up well,” continued Mickelborough. “And on a calendar year basis, the equities market should finish positive too. But the number one risk to that is the interest rate policy of the Reserve Bank. If they make a mistake, then the market will be lower by year-end.”
In the meantime, during the severe panic correction that the domestic equities market finds itself in at the moment, Delaney said Australian Super would be looking for opportunities, just as Mickelborough suggested many funds would.
“When the Australian equities environment started changing during the second half of last year, Australian Super made the decision to no longer allocate cash towards the domestic market,” said Delaney. “Despite the strong rallies towards the end of the year, we continued that trend through to the new year with a view to having cash available.
“What that has meant,” continued Delaney, “Is that now, within a panicked and volatile market, we have the wherewithal to take advantage of any opportunities that may emerge”.
And there is good reason to believe that the opportunities pointed to by Mickelborough and sought by Delaney will, at some point, present themselves, with particular sectors of the Australian economy still performing well.
“Some sectors of the economy, resources and infrastructure in particular, are managing to do well in spite of what is going on around them,” said Mickelborough. “Though they’ve still come back to returns that are single digit.
“However, the companies we’re talking about in these sectors have growth in their order books, so the profits will come,” he continued. “They’re profits that aren’t coming back quickly, but they will be there.”
But the strength of Australian resources and even the risk of Reserve Bank interest rate policies aside, there is little doubt that the biggest risk to domestic equities would be a further downturn in the US economy. The impact of the sub-prime mortgage crisis in particular would seem to be proof enough.
However, for Delaney, the premise that the fates of the Australian and US equities markets are so closely intertwined is too simplistic.
“The Australian market has materially outperformed the US and global equities markets since 2000,” he said. “As things stand, the Australian market has suffered, but a large chunk of that suffering can be attributed to the financial sector, which has had significant poor performance.
“Our economy is very different to that of the US,” added Delaney. “We have different stocks and different underlying fundamentals, so if you take things as they currently stand, and take out the financials, then the market really hasn’t done so badly, especially when you look at resources.”
Mickelborough’s view of ties between the US and Australian equities markets echo Delaney’s.
“Well, it’s the old story isn’t it,” he said. “When the US sneezes, the whole world gets a cold.
“But in this case it isn’t quite true,” continued Mickelborough. “Australian metals are still getting good prices. Long-term growth dynamics in China remain good. So while the US may be heading towards a recession, copper has been heading back towards its highs. And with strong demand coming from China and India, independent of the US, that trend is set to continue.”
In terms of sub-prime mortgage, Mickelborough said he had seen very little in the way of related losses for the Australian financial system.
“Instead, the sub-prime crisis highlighted mismanagement more than anything else,” he said. “We were seeing a lot of credit upgrades without the underlying support being in place and that’s where most of the trouble came from. Fortunately, the Australian system hasn’t been overly exposed to those sorts of issues.”
Moving forward, Delaney said that much would revolve around the health of the Australian economy and the performance of financial institutions.
“The outlook for earnings will have a large say in how the economy goes,” he said. “But within Australia, the financials make up 30 per cent of the market, so performance in that area will continue to be a key factor.”
For Mickelborough, 2008 will be about financial system stability.
“The biggest risk to the market at the moment has to be the policies of the Reserve Bank,” he said. “But there is still a healthy dividend yield to be had, so if funds keep a cool head and buy in the right sectors, they should come out of this more than okay.”
