Dr Shane Oliver – Head of Investment Strategy and Chief Economist at AMP Capital comments on recent market developments for the week ending 23 May and provides an outlook to the future.

Oil prices continued to soar, reaching over $US135.00 a barrel at one stage on an unexpected fall in US oil stockpiles, intensifying worries about whether supply will keep up with demand and as speculators continue to pile in on the back of ever higher oil price forecasts. With the surge in oil prices starting to look increasingly like a speculative mania further increases are likely in the short term as more and more speculative capital is sucked into the vortex created by rising prices. $US150 a barrel is now just a few weeks trading away. And beyond the speculative frenzy now underway our assessment is that the long term trend will remain up as supply struggles to keep up with demand with the result being that $US300 a barrel is not inconceivable on a five year horizon. However, at some point over the next six months the oil price is likely to fall back sharply, maybe to around $US100 a barrel as the rise in the oil price itself is now starting to lead to weaker world economic growth and this will adversely impact oil demand and as speculative positions are unwound. The recent surge in oil prices has pushed world spending on oil relative to global GDP to near 8%, which is above the level reached just before the global and Australian economic slump of the early 1980s. See chart below.

The surge in the oil price is tightening the screws on Australian households with capital city petrol prices breaking above $1.60 a litre and the weekly petrol bill for a typical Australian family pushing above $70. See chart below.

The surging petrol bill along with rising mortgage stress and low consumer confidence is likely to ensure pretty weak consumer spending over the year ahead, even with the tax cuts. The strengthening $A has shielded motorists from the global oil price surge but only partially – so far this year the world oil price is up 36% in $US but the $A is up only 10%.

The Australian dollar continued its ascent hitting its highest level since February 1983 at one point on the back of strong commodity prices, raised expectations of another interest rate hike in Australia and a weak $US. The $A has doubled from its 2001 low of $US0.48 but remains well below the $US2.40 it started last century at. See chart below.

However, with Australia’s terms of trade (ie, the ratio of export to import prices) at its highest level since the early 1950s further gains in the $A are likely, with parity against the $US likely to be reached pretty soon. See chart below.

Cutting petrol excise is not a solution to rising oil and petrol prices as it would simply encourage more petrol usage. Australia could get the petrol price back to near $1 a litre if it wanted to simply by eliminating all petrol taxes but Australian petrol prices are already about the fourth lowest in the OECD, behind Mexico, the US and Canada solely because the tax imposed on petrol is relatively low in Australia. More importantly, cutting or eliminating petrol taxes would mute the price signal being sent by rising petrol prices that it is a finite resource and that we need to cut back on its use. Rather the best way to help households cope with rising petrol prices is via income tax cuts & these are already underway.

Major global economic releases and implications
• The US Federal Reserve upgraded its inflation forecasts but downgraded its growth expectations, adding to worries about stagflation. The minutes from the Fed’s last interest rate setting meeting basically indicated that it thinks it may have done enough and would like to leave rates on hold at its next meeting in June. We see further rate hikes ahead in the US but this will probably require clear evidence that inflationary pressures are easing. US economic data was mixed with the second monthly rise in a row in the Conference Board’s leading index and jobless claims remaining well below recession levels, but data for weekly retail sales, mortgage applications and house prices were all weak. Producer prices rose by more than expected, adding to inflation worries.

• The Bank of Japan left interest rates on hold as expected with the new BoJ Governor saying the economy is softening.

• German business conditions improved slightly in May according to the IFO survey, but the survey still points to a moderate softening in growth ahead and euro-zone industrial orders fell sharply in March.

Australian economic releases and implications
• In Australia, the minutes from the Reserve Bank’s interest rate setting meeting confirmed that interest rates are on hold for now, but the revelation that the Bank seriously considered raising interest rates again highlights that the risks for rates are all on the upside and that if growth in domestic demand doesn’t continue to slow or wages accelerate then rates will go up again. We see interest rates remaining on hold, but put the risk of another rate hike at 40%.

• Australian economic data was generally soft. Despite the Budget and the lack of a rate high early this month, consumer confidence rose only slightly in May and remains very weak. Car sales fell slightly in April and the HIA/Commonwealth Bank’s measure of housing affordability fell to a new record low in the March quarter as interest rates continued to rise.

Major market moves
• Global share markets fell on worries about the impact of the rising oil price on economic growth and earnings, indications from the Fed that may not current interest rates again and some soft earnings results.

• Australian shares fell on the back of the weak lead from global shares, falls in financials on the back of a profit warning from Macquarie, QBE walking away from its tilt at IAG and worries about another interest rate hike and the rising $A.

• While oil and gold prices rose, copper prices fell on weaker Chinese imports and a rise in stockpiles.

Outlook for markets
• After significant gains from the lows in March, share markets now appear to have hit an air pocket. Our view is that a further fall back is likely in the short term. Shares simply rose too far too fast over the last two months, the May to October period is often difficult for shares and the full economic fallout from the US housing slump, credit crunch and surging oil prices is yet to be seen. Inflation worries also have the potential to upset share markets in the short term. Australian shares are also yet to see the full fallout from the rise in local interest rates and the strong $A. As a result shares could fall 5% or more from current levels.

• However, while we are likely to see further weakness and turbulence over the next few months, shares globally, in Asia and in Australia are likely to hold above their March lows. We continue to see shares moving higher into yearend. Despite the recent rally, share valuations remain attractive, the monetary easing in the US has provided a significant boost to global liquidity some of which will find its way into shares and investors will start anticipating stronger global economic conditions in 2009.

• It is usually the case that the seeds for the next investment bubble are sown in the demise of the last one. For example, the monetary stimulus in the aftermath of the tech wreck led to the US housing bubble. The monetary easing we are now seeing is likely to set up another bubble but this time it is likely to generally be in energy, commodities and resources plays. Of course this may already be commencing in the case of oil.

• Global bonds offer very poor returns on a one-year perspective. Australian bonds provide much higher yields and the prospect of better returns, particularly as the RBA moves in the direction of cutting rates some time in the next year.

• The recent breakout in the $A above $US0.96 to new 25 year highs suggests that a run up to parity is likely some time in the next few weeks or months. While it will probably be a volatile ride, Australia’s strong terms of trade, high interest rates and ongoing weakness in the $US are certainly supportive of further gains in the $A. The last time Australia’s terms of trade was this strong, which was back in the early 1950s, one Australian dollar bought $US1.12.

Brendan Gallagher

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Recent market turbulence has been testing for even the most skilled investment managers. Different managers employ different strategies to deal with the unexpected. In this issue we feature two of the more successful managers that make up the list of investments that are included in the portfolio recommendations we make. Both the managers are share investors but they operate in very different ways to each other and to the other managers in our recommended portfolios.

Ausbil Australian Active Equity Fund
This fund has been a consistent performer over many years now. Over the past seven years (to 30 April 2008) it has provided a return of 13.98% per annum, exceeding its benchmark, the ASX 300 Accumulation Index by 1.78% per annum.

Ausbil has a top down / bottom up, neutral investment style with a comprehensive and well developed investment process. That is, Ausbil looks at the bigger economic issues first to identify the sectors and trends that are favourable for investment(i.e. top down). They then carry out detailed research at the company level to identify the stocks to be included in the portfolio (i.e. bottom up) in creating the portfolio with a style neutral approach (i.e. not skewed to a growth or value style but seeking to benefit from both styles according to prevailing market conditions). The manager seeks companies with a focus on short term (12 month) earnings drivers (e.g. Strong earnings profiles, defined strategies for earnings growth and quality management).

The fund has recently benefited from its overweight position in the Material and Utilities sectors and also its underweight position in Consumer Staples. Its overweight positions in BHP BiIliton, RIO Tinto and AGL Energy have provided strong lifts in returns in recent months. In addition, its zero exposure to ANZ Bank has helped it avoid ANZ’s fall following the above average write downs after the Opes Prime and Lift Capital collapses.

Ausbil expects that resource company earnings will be better insulated from current market issues due to the strength in underlying commodity markets.

Platinum International Fund
Platinum’s International Fund is a fund that performs well in falling markets. The manager has a strong track record of taking contrarian positions and performing well at times when other managers are struggling. This has led to strong outperformance over time.

Platinum is an Australian based fund manager that invests in 50-100 international stocks that they believe are undervalued by the market. Platinum also short sells shares that it considers to be over-valued. This ‘long-short’ investing can work particularly well during period of strong market volatility when shares are oversold or over bought and their share price overshoots its true underlying value. However the process relies upon good research and sound judgement to be successful. The experience of the Platinum team is important in this regard.

This fund most recently has received good results from its Japanese holdings. The three largest banks; Mitsubishi UFJ, Sumitomo Mitsui and Mizuho, increasing by more than 30%. Platinum typically targets out-of-favour stocks and in their opinion, the Japanese market stands out as neglected. Platinum successfully avoided exposure to the financial stocks and other hot areas in recent times. Some protection was derived from short selling specific market indices including US small companies, the German market, the Indian market and other emerging markets. The fund no longer holds Indian shares avoiding recent falls in that market, having enjoyed strong returns and taking gains from this region over a long period.

For the 12 months to the end of April, the benchmark MSCI World (ex Australia Net $A)) suffered a fall of 14.08%. In contrast, the Platinum International fell by a modest 6.61%. Over the past 5 years the fund has returned 10.26% per annum compared to its benchmark of 5.86%, a substantial addition of value for investors.

These funds add significant value to the portfolios that we recommend blending with managers of different styles and lifting portfolio performances at times when market conditions may not suite the style of other managers in the portfolio. This is a key benefit of diversity in portfolio construction.

Brendan Gallagher

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From a budget that featured few surprises, we summarise below some of the key changes that we consider may relate to our clients.

Proposed changes to personal tax rates

Extension of low income tax offset
The government has announced an extension of the low income tax offset entitlement in line with the changes to personal marginal tax rates. The proposed changes are effective from 1/7/08:

Impact on Senior Australian Tax Offset (SATO) recipients
Senior Australians who qualify (based on age, income and other eligibility criteria) for SATO, will not have an income tax liability unless their taxable income exceeds the following levels:

Medicare levy surcharge thresholds
Effective 1/7/08 existing annual Medicare levy surcharge thresholds of $50,000 for a single person and $100,000 for a couple or family will be increased to $100,000 and $150,000 respectively. These thresholds determine the income level at which the Medicare levy surcharge of 1% will apply to those taxpayers who do not hold private hospital insurance.

Dependant rebates and tax off sets
From 1/7/08, those earning more than $150,000 will not be entitled to claim the Dependent Spouse, Housekeeper, Child-Housekeeper, Invalid Relative and Parent/Parent-in-law tax offsets. From 1 July 2009, the definition of ‘income’ for these offsets will be amended to include certain salary sacrifice arrangements for superannuation, reportable fringe benefits and net financial investment and rental property losses.

Fringe benefits tax
From 13/5/08 employee arrangements for jointly owned investment assets and meal cards will no longer be concessional taxed. Also the FBT exemption for laptop computers, personal digital assistants, briefcases, and tools of trade will be limited to one of each item per year. They must be used primarily for work-related purposes and provided directly to the employee by the employer. Employees will no longer be able to claim depreciation on the item.

Capital protected borrowings
From 13/5/08 the benchmark interest rate in the capital protected borrowing rules will be lowered to the Reserve Bank of Australia’s indicator variable rate for standard housing loans. Interest expenses on a capital protected borrowing in excess of this level will be treated as the cost of capital protection and are not deductible if deemed to be capital in nature.

Employee share schemes
From 1/7/08 taxpayers who receive employee shares or rights, above the $1,000 exemption, who wish to be assessed under the ‘taxed-upfront’ concession must include the value of the discount in their tax return for the year the shares or rights were acquired. Otherwise they will be taken to have chosen to be taxed under the ’tax-deferred’ option. Taxpayers will not be permitted to change their election in the year of disposal in order to gain more favourable tax treatment.

First Home savers accounts
From 1/10/08, eligible individuals can open an FHSA if they are over 18 and under 65, have not previously purchased or built a first home in which to live, do not have nor have previously had a FHSA and provide their tax file number to the provider.

The contributions must be after tax and are only limited to a balance cap of $75,000 (indexed). The government will make an additional 17cents in the dollar contribution up to a maximum of $850 p.m. Once th4e cap is reached future investment earnings will continue to be credited to the account. Contributions to the FHSA can be made by any party (such as parents or employers).

Contributions will enter the FHSA tax free and earnings will be taxed at 15%. Withdrawals will be permitted when at least $1,000 has been contributed over at least four years and will be tax-free when used for a first home. If circumstances change the balance can be transferred into a super account

Andrew Condell

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