Current State of Play

In times like these we should remind ourselves of the hurdles that are currently before us.

In a speech delivered by Glen Stevens, Governor of the Reserve Bank of Australia yesterday we can see what factors are in play at the moment, locally and abroad. These factors are worth considering when weighing up how you measure risk and return.

From an international perspective allot has been made of the Greek problems and more recently the rumors that other parts of Europe may have problems that are worse than expected. England has commented on its 'not so rosy' financial position with a new Government taking the reigns, and Hungary has come out with 2 comments about its financial position in as many days. Also the weakness of the Euro means global growth will be slower - and while its easy to be confused about the many headlines that are available, more generally the overall story highlights the fact that the world is looking for negative news. The World Bank, to top it off, warned this morning of a double dip recession if debt wasn’t brought under control.

This is important because sentiment has clearly turned down of late, and expectations about the near future that were looking slightly better, have evaporated. In the US we have varying degrees of news – non-farm payrolls and employment growth, housing and construction numbers have been mixed to say the least.

Profits and company results have not excited and expectations going forward are sanguine. As equity markets are always looking forward, this change in outlook has seen the equity markets crumble - and all the while the Dow Jones falls, one of the biggest natural disasters in US history looms for the economy in the form of the BP and Mexican Gulf oil spill.

The old adage - 'sell in May and go away' never looked better!

China has seemed to be chugging along nicely, however we have stories about the need for them to contain inflationary pressures internally, with a close eye on the housing sector. Also continued pressure on their currency, the Yuan at time where China is the worlds Banker.

If China were to slow more than expected you would have to wonder who might pick up he slack. Who will keeping what little light there is in global growth outlook, shining?

China has single handedly taken the global economic growth 'reins' over and its importance in the health of the global economy we have today cannot be underestimated. The question remains, is it enough going forward - can they continue to carry the weight of the rest of the world?

While Australia is in a good fiscal position, we have to be thinking about the 'well' of stimulus money that has pump primed our economic fortunes for the last two years running dry. This year spending will exceed revenue by $58 billion dollars - an all time high. It simply can’t continue - and the budget position dictates it wont.

The national accounts have demonstrated that without the Government spending hand over fist, the economy would have contracted - and with business and consumer confidence levels falling you have to wonder - who will pick up that slack?

It’s also important to consider the only other sector that has provided a base line of growth, the Mining sector. They have had the 'boat rocked' by a new tax that nobody understands, and won’t be legislated until after the election. At the very least, regardless of your politics, some level of doubt will be cast over future investment and growth of the sector going forward.

If this vital section of the economy does contract - only slightly, it is not what we need when the consumer and business sectors are looking fragile at best.

We also have the uncertainty surrounding the political landscape - who knows if international investors will take comfort or caution from the election that’s coming. Australia has taken on the surprise mantle of a 'safe haven' due to its strength through the GFC - the question becomes could this confidence be shaded?

Lastly - the world has not addressed its appetite for debt at all. Countries that are 'intrinsically broke' have borrowed more money - hence the countries that were owed money originally - are now owed more. Global Debt is not a story that’s close to running its course.

Countries unable to repay originally are now in a worse position - having borrowed more. Countries owed that money lent them more, all on a loose promises to address internal imbalances and promises to restructure the economies that are 'broken' to start with.

'Band aid' solutions surrounding economic management and hollow statements about the ability to overcome the debt and the interest burden, cant be extinguished with higher overall levels of debt. These bailout 'solutions' were more about stopping a wave of global 'no-confidence' than actually fixing the problem.

In Australia revised figures show we are looking at $90 billion dollars debt - that’s approximately $5000 for every man woman and child - it makes the stimulus cheque of $900 dollars look small. But in countries where the starting position was deficit - the picture is significantly different - some countries are running debt in well in excess of GDP.

Also Important to this debate is the overall levels of Interest rates. Australia compared to the rest of the world has some of the highest rates (in the developed world). We have seen six consecutive rate rises to stifle parts of the economy that seemed to be to 'hot', we can see now its worked - maybe too well.

Retail sales, construction, and housing to name a few, all look set for a breather.

Aussie families have had their back pockets lightened significantly because of the levels of debt we carry, and the Interest rate rises here. Simply put, collectively we don't have the capacity to spend or reasonably borrow anymore.

Near 'zero' official rates available everywhere else don't look like being tightened anytime soon, Ben Bernake (Chief US Fed Reserve) commented only on Monday he doesn't see rates going up anytime soon - a sure sign officials are not convinced momentum within their economy can be sustained if rates were not kept at all time lows. This leaves them no room to cut rates at all.

Given then the recovery in Europe and the US is not looking as reliable, China is looking to slow itself down, and locally no more Government spending together with business and the consumer taking a break - the pressure on rates being lifted near term seems to have abated.

Its looking like a perfect storm - and while we can deliberate endlessly about the possibilities above - facts remain that the gloss has been all but wiped off the outlook for the remainder of this year and into next.

How to move forward -

With the current yield curve pricing in so much tightening - you could reasonable argue the back end of the curve still offers value. With official rates at 4.5% and a 3year TD in the 6.5 -7% range, the curve still offers value.

Even with the recent rally - running yield is your friend - especially if it’s guaranteed. The Financial Claims Scheme ($1M deposits) still has over 12 months to run.

The 1-year rate over 6.25% deserves attention, as does the Floating rate TD products being offered around 100 over BBSW rolling quarterly.

While its not all doom and gloom - it’s important at times like these to have your eyes on strategies that protect capital.

Government Guarantees are as good as it gets. And in a global sense our sovereign risk in right up there.

We encourage all our clients to consider closely the relationship between risk and return, especially anomalies that might exist between similar rated organisations.

Every dollar after your first $1million invested reverts back to the underlying credit quality of the ADI concerned.

Unrated institutions (credit unions, banks, building societies) obviously fund themselves differently - given they don’t rely on a guarantee to go to professional wholesale markets - and this is where comfort from the Guarantee is derived. The basic strategy we have been recommending of multiple $1million deposits - cherry picking rates if you like - is still a sound and opportunistic way of improving the credit quality and returns available, and one we will continue to advocate.

In the near term I would encourage all our clients to pay special attention the structure of their books and as always we would welcome any questions you might have about how to best get appropriate risk weighted value in the market.