The new reality - portfolio construction in a post GFC world

30 August 2010

Stemming from numerous client queries regarding the 4 corners program aired on Monday this week where a Global Financial Crisis (GFC) mark 2 was predicted, I have spent quite a bit of time over the last week thinking about the current state of investment markets and where they are likely to go over the next twelve months, five and ten years.

We are currently in a situation where most of the developed world’s growth prospects are undoubtedly crippled by a critical combination of spiralling national debt levels combined with high unemployment. The US and UK are prime examples of economies where unsustainable spending over a long period of time has brought them to a crunch point in history. National Governments have had to bail out reckless financial systems in both these counties (as well as most of Europe) in order to avoid a complete meltdown of the financial system (GFC mark 1). The result is these Nation’s balance sheets themselves are now at breaking point.  The prospect of a major developed nation defaulting on their debts is making the investment world nervous as there are no prospects of an intergalactic bailout fund arriving to save the day if this were to occur (unlike the ECB bail out of the Greeks).

 I believe (along with the majority of economists) that it is unlikely this catastrophic event will occur for a number of reasons. One of these reasons, the investment markets have not yet fully grasped or priced in. There is a power shift well underway. History tells us that every hundred years or so a new super power arises to replace the previous mega power. China is rising faster than any power has ever before in history.  If America sneezed the world used to catch a cold. America just caught pneumonia and China barely cleared its throat. There is a growing divide (and decoupling) between the submerging world and emerging world. The former is debt laden and will have to spend less and save more. The latter (China, S.E Asia, India, Brazil) is cashed up and ready to start enjoying the fruits of a growing middle class and rapid economic growth.

The doom and gloom in the Western press sells papers and is a reasonable reflection of growth prospects for the US and other Western economies but it is far from the global story.

Please consider the following facts:

In the next 10 years China will have at least an additional 200  million middle class consumers. Not far short of the entire population of the United States. They all want to buy goods and consume. This figure does not include India, Brazil, Russia or the rest of South East Asia who are also developing rapidly.

GDP growth in China is showing no signs of abating and is running at rates in excess of 8% per annum.

China’s domestic consumption is also growing rapidly. It is no longer so reliant on US and European consumers buying their goods as some people think. Rising wage levels in China and an appreciating Renminbi are reducing China’s competitive manufacturing advantage anyway. It is domestic consumption that is rapidly picking up the slack.

In terms of constructing portfolios I have come to the following conclusions:

	It is time to reduce the exposure to the index in International funds. It no longer makes sense to own 70% exposure to the submerging world and 30% emerging markets. This is a recipe for anaemic returns for at least the next decade.
	There are still very good companies listed in the well regulated Western markets that will grow strongly over the next 10 years but they are those that are exposed to growth opportunities in the emerging world. We need invest in ways that try to exploit these opportunities rather than buy the whole market.
	Australia is rapidly decoupling from America and Europe. While we still take our lead from these markets the long term trend shows correlation has been reducing for quite a while and this will continue. Our major trading partners are now China, India. Korea and Japan. The US makes up less than 5% of our export market and is shrinking.
	The resources boom has a long way to run. Demand for commodities will remain extraordinarily strong.  Supply will influence price with more coming on line from 2012 but for the next 18 months at least we should see very solid returns from the commodities sector as China has run down inventories stockpiled during the GFC.
	Commodities will drive the Australian economy over the next few years putting pressure on wages, inflation and ultimately interest rates. The consequences for an already inflated residential housing market need to be considered in this light. It is not the time for aggressive increases in residential property exposure.
	Volatility of markets will continue to be high for quite some time. As the transition from the West to East (submerging to emerging markets) continues markets will be volatile. China’s pace of growth combined with geo political issues will ensure it will encounter plenty of challenges that cause volatility but these will be overcome due to fiscal strength and cultural willingness.
	Australian equities are currently undervalued relative to profitability (earnings) on a long term basis, so combined with a favourable location in the world and gas, coal and iron ore deposits should provide a good hedge against inflation and a solid return over the next decade.
	Australian Term deposit rates are becoming increasingly attractive again and Australian (and some Asian) fixed interest (sovereign bonds) are looking increasing attractive homes for defensive money.
	We will continue to avoid low yielding US and European bonds which traditionally formed a key part of a portfolio as low interest rates provide poor income and almost no ability for any capital appreciation.

As we conduct portfolio reviews over the next few months I will discuss individually with you how we will incorporate these concepts into your portfolios. Feel free however to call should you have any questions.

Jason Bragger CFP DipFP BSC BA
Director - Dolfinwise
(07) 3831 5990