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Quarterly investment report
December quarter 2008
The environment
The December quarter began in the immediate aftermath of a period in which a wide range of major policy initiatives were unveiled to prevent the collapse of the global financial system. A number of additional policy initiatives were implemented during the course of the December quarter. These took the form of capital injections into private companies, major stimulatory fiscal packages and a significant easing of monetary policy. To date, these policy initiatives have been successful in terms of maintaining the viability of the global financial system and fostering the first signs of a thawing in credit markets. However, the global economy remains in very poor shape.
The December quarter saw a major deterioration in the global economic growth outlook. After economic growth in the major economies contracted in the September quarter, the rate of this deterioration intensified in the December quarter. As a result, many analysts now predict that the current global economic downturn will be the most severe since World War II. In the US, the labor market has deteriorated rapidly, with employment levels in 2008 falling by the most since 1945. Furthermore, the unemployment rate has risen to 7.2%, the highest level since the early 1990s recession. Added to this, the housing market continues to contract with no real signs of bottoming. US housing prices are now almost 20% below their levels of a year ago.
Other developed economies are also in recession, with real GDP contracting in the major European countries, the UK, Japan and New Zealand. The Chinese economy continues to grow, albeit at a reduced pace, with industrial production growth slowing to 5.4% in the year ending November from 8.2% a month earlier. In Australia, economic growth has also slowed significantly, albeit not to the same extent as in other major developed countries. Real GDP rose by a marginal 0.1% in the September quarter, buoyed by solid growth in the farm sector. However, non-farm economic growth contracted and latest data suggest economic growth remains very weak, particularly in the housing sector.
The December quarter also saw a major decline in inflationary expectations, due to the sharp deterioration in economic activity and a large fall in commodity prices, particularly oil. In the US, inflation declined from over 5% in August 2008 to 1.1% by November. In Europe, inflation has declined to 1.6%, which is below the European Central Bank’s 2% inflation target. In Australia, inflationary pressures are also falling, although this has yet to show up in the official quarterly statistics. The decline in inflation has allowed policy makers a free reign to invoke a major easing of monetary policy. In the US, official short–term interest rates were lowered to a range of 0%-0.25% in December. Rates in Japan have been reduced to just 0.1%, while in the UK, short rates have been cut to 1.5%, the lowest level since the Bank of England was established in 1694. In Australia, short rates have declined from a peak of 7.25% in early September to 4.25% and are expected to be lowered further in coming months.
Financial market performance
Within this environment, equity markets declined dramatically in the December quarter, with global equities hedged into Australian Dollars falling by 21%. A sizeable fall in the value of the Australian Dollar meant that global equities in unhedged terms contracted by just 11%. Amongst the important markets, returns were uniformly poor. The worst declines were recorded by India (down 26%), the US (down 23%), Japan (down 21%), China (down 21%), France (down 20%), Hong Kong (down 20%) and Germany (down 18%). In the UK, the magnitude of the equity market fall was limited to 10%.
The Australian equity market did not escape the carnage, falling by 19%, with industrial and resource stocks both declining by the same magnitude as the overall market. Resource shares were buffeted by a major reduction in commodity prices, particularly oil, which fell by 61%. Metal prices also experienced dramatic weakness, with copper down 55%, aluminum 40% and nickel 31%. Gold prices went against this trend, achieving a marginal gain of 1%. Large capitalisation stocks again outperformed small capitalisation stocks, with the Small Ordinaries Index falling by 29%. Although all sectors experienced declines, sector performance dispersion was again significant. The worst performing sectors were property trusts (down 33%), consumer discretionary (down 25%), industrials (down 23%) and energy and financials (both down 21%). The best performing sectors were the more defensive utilities (down 5%), healthcare (down 6%) and telecoms (down 9%).
In the December quarter, government bond markets continued to benefit from a ‘flight to quality’ and reductions in short-term interest rates. This resulted in global government bonds achieving a very strong return of just under 7%. At the same time, the return from a composite basket of global fixed interest securities which includes government bonds as well as investment grade corporate bonds and structured securities returned just under 5%. Meanwhile, the return from a composite basket of Australian fixed interest securities was just over 6%. The rise in global bond markets in the December quarter was propelled by a significant reduction in government bond yields. In the US, 10 year government bond yields fell by 1.6% to 2.2%. Yields declined by 1.1% to 3.0% in Europe, by 1.4% to 3.0% in the UK, by 0.3% to 1.2% in Japan and by 1.4% to 4.0% in Australia. Credit spreads (over government bond yields) continued to rise over the quarter due to the deteriorating economic outlook.
The Australian Dollar experienced a very weak quarter, hurt by both the large decrease in commodity prices and heightened investor risk aversion. Reflecting this, the Australian Dollar fell by 24% against the Yen and 11% against both the US Dollar and Euro. However the Pound was even weaker, with the Australian Dollar appreciating by 9% against it. On a trade weighted index basis, the Australian Dollar fell by 12%.
PSS performance
Given the bleak economic and financial market backdrop, the majority of ARIA options recorded negative returns in the December quarter. Cash was the only option to achieve positive returns.
For the year ending December 2008, option performance was dominated by the very large declines experienced in equity markets. Single digit negative returns were recorded by the default option.
PSS performance for both the December quarter of 2008 and one year to the end of December 2008 is provided in the following table.
PSS option performance—periods ending December 2008*
| PSS option | 3 months (%) |
1 year (%) |
|---|---|---|
| Default fund | -9.9 | -18.4 |
| Cash fund | 1.4 | 6.3 |
* These figures are after fees and tax
Alison Tarditi
Chief Investment Officer
16 January 2009