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Look overseas, but with care

PSI |  18 November 2013  |  Portfolio


SMSF investors greatly prefer investing in local stocks with high dividend yields. They have not looked aborad to any great extent. It is easier for them to understand the companies and there is a favourable tax treatment on dividend yields. But with the $A high and some signs of recovery in overseas economies,, it has led to a lack of diversification. The cost of that narrowness has been traked in today's AFR which notes that there are concerns about the high valuations on Australia’s banks, which now account for about 30 per cent of the S&P/ASX 200. Rapidly rising property prices also represent a danger, including to the banks, which are heavily exposed to the domestic property market.
The AFR says:

"The Australian dollar now trades at US94¢, well ahead of the Reserve Bank of Australia’s target of US85¢. If the central bank is successful in achieving its goal, the currency effect on an overseas portfolio would be profound.

This time last year the $A traded at $US1.05. Its fall over the past 12 months has added about 10 percentage points to the returns of Australian investors in overseas shares.

Since October last year, the S&P/ASX 200 Index has gained 20.1 per cent, the US S&P500 chalked up a 24.2 per cent return and the Euro Stoxx 50 is up 22.4 per cent.

According to the latest Mercer Investment Surveys, the median long-only Aussie shares manager returned 28.8 per cent in the year to October, an impressive achievement that would suggest fund managers are actually adding value. (One explanation for the outperformance may be that professional fund managers were more adept at avoiding the materials sector, which shrank 0.4 per cent in the past year.) But the median long only overseas shares manager, by contrast, delivered a whopping 39.3 per cent in $A terms."

It does suggest a need for diversification. But if SMSF investors do look overseas, it is not without its risks. It is far more likely that the $A will fall rather than rise, but the global economy is fragile. The Financial Times points out that the talk is now of secular stagnation, a term coined by American Keynesian Alvin Hansen in the late 1930s:

"In a nutshell, the argument is that the equilibrium real rate of interest in the global economy has been significantly negative (around -2 to -3 per cent) since at least the mid 2000s, while the actual real rate (at least on bonds) has consistently been much higher than this, despite the efforts of the central banks to reduce it [1].

The alleged consequence of the fact that the actual real rate is above the equilibrium is that there has been a prolonged period of under-investment in the developed economies, with GDP falling further and further behind its underlying long run potential. In a largely unsuccessful effort to close the gap, the central banks have created asset price bubbles (technology stocks in the late 1990s, housing in the mid 2000s and possibly credit today), since this has been the only means available to boost demand."

There is no doubt that America's large corporations are under investing; they are extremely cashed up, which is one reason why their valuations are so high. And they are not likely to start investing when the economic growth indicators are so sluggish. The FT argues there are three implications:

"The problem of under-performance of GDP will last for a very long time, and will not solve itself through flexibility in prices and interest rates, which is what happens in classical economic models (rapidly), and in new Keynesian models (more slowly). The reason for this is presumably that the zero lower bound prevents nominal interest rates from falling, and also prevents prices and wages from adjusting downwards. Therefore none of the normal forces for restoring equilibrium apply.

A second implication is that the normal route through which monetary policy works, by bringing forward consumption from the future into the present, is unlikely to be successful. If the secular stagnationists are right, there will still be a shortage of demand when the future comes around, so there will be a need for ever-greater injections of monetary stimulus (presumably through quantitative easing) in order to avoid an ever-worsening recession.

A third implication is that calls for fiscal action are bound to intensify. Following the Summers speech, Ben Bernanke commented that secular stagnation was unlikely to occur, because there would always be capital projects with a positive rate of return that would be undertaken by the public sector. These projects could be financed by raising public debt at zero or negative real rates of interest, so the debt would be sustainable and the net worth of the government would actually improve. Therefore, in a rational world, public investment would always be used to end the secular stagnation."

The latest evidence on secular stagnation is reflected in the graph below:

Conclusion? Investors should look overseas, but the environment will be shaky. The greatest growth may come from developing markets where investments are riskier and direct share investment should be undertaken with extreme care and much research (indexes are a lower risk option). It is likely that the $A will eventually fall, giving investors a big return, but the stock markets of the developed world are likely to be under pressure for some time.


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