Quarterly investment report

March quarter 2008

The environment

The March quarter of 2008 will long be remembered as the period in which the global liquidity crisis, borne of a recognition that risk was inappropriately priced, brought the US financial system to the brink of a systemic breakdown and sent the US economy into recession.

The early part of the quarter saw material debt-related loss write-downs by a number of large banks; an associated tightening of credit standards for household and corporate borrowers; and concerns over the financial viability of companies (monoline insurers such as AMBAC Financial and MBIA) that provide guarantees on various municipal bonds and mortgage-related structured investments. This raised concerns about the stability of the US financial system. These concerns came to a head in March when the imminent collapse of Bear Sterns, a large US investment bank, resulted in the US Central Bank, the Federal Reserve, organising a bail-out package which involved it providing the finance for JP Morgan, another large US investment bank, to purchase Bear Sterns and honor its commitments to other financial institutions.

The March quarter was also notable for the US economy sliding into recession. Further deterioration in the housing market, together with weakness in manufacturing, retail sales, construction, employment and the services sector, suggest that the US will record negative growth in the March quarter. The response by policy makers has been significant. A stimulatory US fiscal policy was quickly put together, major Central Banks co-ordinated liquidity injections in an attempt to smooth the efficient working of the global financial system and a major easing of US short-term interest rates saw the Fed Funds rate lowered from 4.25% to 2.25% in the March quarter.  Short-term interest rates were also lowered in the UK and Canada during the same period.

Economic growth in other countries has, to date, been less affected by the global liquidity crisis. In Europe and the UK, growth has slowed somewhat, but inflationary pressures remain an issue for policy makers. In Australia, the early part of the quarter was characterized by continued robust economic growth and an admission by the Reserve Bank that inflation would remain above its target range until 2010. This culminated in two official short-term interest rate increases from 6.75% to 7.25%. In addition, major banks raised mortgage lending rates by more than the increase in official rates due to an increase in the cost of their funding. Towards the end of the quarter early evidence emerged that the pace of economic growth may be beginning to slow.

Financial market performance

Against this backdrop, global equity markets experienced major declines, with global equities, hedged into Australian Dollars, falling by around 12%. A small increase in the value of the Australian Dollar meant that global equities in unhedged terms fell by a slightly larger 12.5%. Few markets escaped the carnage (although a number of “frontier” markets, particularly in the Middle East and South America managed to rise), with the best return amongst the major developed markets achieved by Canada (down 3.5%). The US declined by 10%, the UK by 12%, Japan by 18%, Hong Kong by 18% and Germany by 19%. The Chinese market fell by 34%, but it had risen by over 200% in the 12 months ending October 2007.

The magnitude of the decline in Australian equities (down 14.5%) was slightly greater than that experienced by its global counterparts, although Resource stocks (down 6.6%) fared far better than industrial stocks (down 17.5%), which were dragged lower by a large decline in financial stocks. At the same time, large capitalisation stocks modestly outperformed small capitalisation stocks. The strong relative performance of Resource stocks reflected a large increase in commodity prices, as evidenced by base metal prices rising by 20%, gold by 10% and oil by 6%. Sector performance dispersion was large, with Financial stocks declining by 22%, Consumer Discretionary by 21%, Listed Property Trusts by 19% and Utilities by 16%. This contrasted with a decline of 3% in Energy stocks, 6% in Materials and Telecoms and 8% in Healthcare.

Amidst the carnage within equity markets, global bonds performed strongly, rising by 3.4%. This contrasted with a more modest return of 2.2% from Australian bonds and 1.8% from cash. The strong return from fixed interest markets reflected both the safe haven status of government bonds in a time of financial market distress and the attempt by policy makers to stimulate economic growth by lowering the level of official short term interest rates. Nowhere was this more evident than in the US, where 3 year government bond yields fell by 1.5% to a level of 1.6% and 10 year government bond yields declined by 0.6% to 3.4%. Government bond yields tended to also fall in other countries, assisted by the easing in monetary policy in the UK and Canada.

In Australia, government bond yields also declined despite two hikes in official short-term interest rates. This occurrence can be explained by both the safe haven status of government bonds and the high correlation between global government bond yields, which resulted in Australian yields being dragged lower by declining global government bond yields.  The decline in Australian government bond yields was particularly pronounced at the short end of the yield curve, where 3 year yields fell by 0.8% to 6.1%. This resulted in a significant change in the slope of the yield curve, which by the end of the quarter was flat between the 3 and 10 year segment. By the end of the quarter the market was also anticipating that the next move in official shirt-term interest rates would be down.

The experience of government bonds was very different to that of non-government bonds in the March quarter. This reflected a major widening in the spread (over government bond yields) of all corporate, asset backed and structured securities. As the global liquidity crisis deepened and expanded, investors became very reluctant to hold anything other than government securities. Consequently, all non-government securities experienced a significant increase in their yield to maturity, irrespective of their credit worthiness. By the end of the quarter, the spread on many non-government securities was at levels that had never been experienced historically. In this way, the occurrence of a major global recession has been priced into the price of these securities.        

The Australian Dollar experienced mixed fortunes in the March quarter, experiencing an increase of over 4% against both the US Dollar and Pound, but a decline of 7% against the Yen and 3.5% against the Euro. Given that Australian official short-term interest rates were raised twice and commodity prices increased strongly, the inability of the Australian Dollar to strengthen against the Yen and Euro suggested a global investor preference for the most liquid, major currencies during a time of financial market stress. The decline of the US Dollar reflected its status at the epicenter of the global financial-sector crisis, the weakness of its economy and the major decline in the level of its official short-term interest rates. The Pound was negatively impacted by a softening in economic growth and a decline in official short-term interest rates.   

ARIA performance

ARIA option performance ending March 2008*

* these figures are after fees and tax

Over the year to date, ARIA’s default funds rank in the first quartile across relevant peer-groups.