We’re already more than three weeks into the New Year and from an investment point of view it’s a case of so far, so good.
The S&P/ASX 200 has chalked up an impressive gain of 5.3% and the major U.S. stock indices are around 4% higher. While our base case is for a muddle-through year rather than sparkling returns, it’s certainly an encouraging start.
But before we officially consign 2011 to history, it’s worth examining the table to the left because some interesting trends emerged last year which could shape what happens in 2012.
The first point to note is that the poor performance of the overall market disguises some quite remarkable variations among the sub-indices. As you can see, the S&P/ASX 20 Leaders index – which is dominated by big financial institutions and resources companies – declined by 9.2% while the small and mid-cap indices fell by almost twice as much.
It’s a similar story with the industry sectors. The telecommunications index rallied nearly 30%; the mining, energy and IT sectors slid roughly 20%. Listed property securities, large industrials and banks were somewhere in between.
While the range of returns is striking, the flow of money into defensive assets is no great surprise. When investors are cautious, you would expect them to be tempted by Telstra (TLS)’s 8% fully franked yield. And in a world of uncertainty, industrial stocks like AGL Energy (AGK), Envestra (ENV), Spark Infrastructure (SKI), Coca-Cola Amatil (CCL) and Wesfarmers (WES) seem reassuringly safe.
The question now is whether term deposits and safe haven stocks will outperform again in 2012. The answer really depends on three things.
The first is how long financial markets will take to recuperate. If you think the recovery could be years away, then perhaps it makes sense to wait until there are more unequivocal signs of economic sunshine.
But consider this: the current bear market is already 51 months old. That’s fairly long in the tooth by historical standards. In the past two bear markets, share prices started to rebound after about 62 months (see the chart below). If you’re quick and alert, you might be able to buy back in before the rally begins in earnest but it’s a gamble.
When the 1974 and 1987 bear markets ended, the All Ordinaries index rallied 39% in the subsequent twelve months. That’s about seven year’s worth of term deposit returns so it’s clearly important to be in on the ground floor when the elevator starts going up.
The second issue is the U.S. economy. We all know that Europe, Japan and the U.K are in dire straits and that China, India and Russia are still motoring along strongly.
What’s not so clear is where the U.S. fits in. At this stage, the consensus is that the American economy is on the mend which is why the Dow Jones Industrial Average is close to a four-year high.
If the U.S. can continue to recover – and we think it will – it dramatically tips the scales in favour of a global economic rebound. In US$ terms, Europe, Japan and the U.K. are collectively about the same size as the U.S., China, India and Russia. As long as the latter group can keep their economies bubbling along, it should be sufficient for world share markets to move higher.
The third issue is interest rates. Ever wondered why people would buy U.S. Treasury bonds at 2-3% when the U.S. inflation rate is 3.5%? At first glance, it seems crazy: what kind of chump invests in an asset with a negative real return? One of the reasons is that 3% is actually a killer rate when viewed against the official cash rate of 0.08%.
This became apparent to us the other day when we noticed an advertisement on the CNN website urging online users to ‘learn more about high-yield savings.’
Clicking on the link took us to the American Express Bank home page where lucky savers were offered the chance to make their money work at 0.90% per annum! According to the comparison data, that’s a pretty tempting rate. Other online accounts like ING Direct are only yielding 0.80% per annum.
For those with a longer time horizon, AMEX was also offering a special 36-month term deposit rate of 1.40% per annum. Interested?
These rates are at least 2% below the U.S. inflation rate and are exerting some powerful pressure on consumer and investor behaviour.
For a start, you can understand why U.S. retail sales are so strong – up 6.0% in the year to December versus just 3.1% in Australia. Why would Americans bother to save with interest rates that low?
You can also see why U.S. investors are still piling into Treasury bonds. A bond yield of 2% to 3% looks miserly in Australia but might not seem too bad if you’re a risk-averse U.S. retiree.
And finally, low interest rates are encouraging people back into equities. The average dividend yield on the Dow Jones industrial stocks is currently 2.52%. For utility stocks, it’s 3.94%.
When investors are focused on capital preservation rather than capital return, they will put up with near-zero interest rates. However the bear market is now four years old and you can’t let your purchasing power dwindle away forever.
All in all, we think this will probably be the last year of the bear market. While we’re not expecting glowing returns in 2012, you can already sense change in the air. Yes, Europe is an on-going disaster, which is regrettable for them, but it’s unlikely to derail the positive trends in other markets.