• Home
• Log in
• Search
• Join now

• Home
• Markets
• Asset Allocation
• Portfolios
• Products
• Parameters
• Journal
• Conference
• Tools

This final DIRECTINVESTING Special Edition for 2005 looks ahead with some excitement to the possibilities in 2006. We examine key leading indicators of economic and investment strength around the world for 2006, and ask how the US will fare as it confronts some fundamental problems (and find that it is shaping to be one of the better value markets in which to invest). And we profile an innovative investment opportunity that allows Australian investors to access shares in Warren Buffett's legendary Berkshire Hathaway investment company.

Understandably, investors who lost money by succumbing to the asset consultants' mantra to be 'target weighted' to international equities during the early 2000s find it hard to get excited about the prospects of making money offshore. Certainly, the conventional relative value wisdom used to spruik international funds leaves a lot to be desired - for example, Australia is sitting towards the bottom of these tables, largely because of the huge run that our stock market indices have experienced in the last couple of years.

But if we base international investing simply on perceived cheapness or value, we will miss some of the most exciting investment opportunities available in 2006. To spot these opportunities, we should "start at the top" so to speak, by looking at the global macro-economic conditions driving massive economic growth in key markets like the US, China, and India, and many of the other emerging market nations. By doing so, we can quickly see that there many ideal settings available in international equity markets - and we can also see areas about which investors should be concerned.

The challenge - where do we invest now?

Following years of disappointing returns for investors using Australian-based international equity funds, many are now overweight Australian shares and underweight international equities. And many advisers and their clients have enjoyed some of the best returns for many years by adopting this approach.

However, this position is now under pressure as the Australian share market approaches full value. Most advisers we speak with are using Platinum as an international fund manager – buoyed by its ability to short markets as well as its excellent track record. But apart from this fund, and those of a few emerging boutiques, there is not a lot of certainty or optimism about international investing.

But there is a growing awareness of the need to think about re-entering or increasing exposure to international markets. Figure 1 provides some context.

Source: Consensus Economics, Courtesy of BT Economics, November 2005

The reality is that it's not all doom and gloom in the international markets, despite the predictions of the tabloid media and hedge funds with short positions in place. The global bears have been filling the airwaves during the last half of 2005 with bad news stories, mainly focusing on the idea that global growth is slowing, either because of increasing costs flowing from rising commodity and energy prices, or the prospects of rising inflation (which we are led to believe will drive interest rates higher, depressing equity markets) or, if you believe the end of the world scenarios, because the US is going to collapse under the weight of its twin deficits (budget and current account).

Rational analysis of economic data presents a somewhat different picture.

Certainly, key markets like France and Germany are undercooked, with inefficient labour market practices and high cost structures leading to low employment, industrial unrest and low growth.

In contrast, developed nations like the US are moving forward, confounding the cynics. This phenomenon has been appraised by Ben Bernanke, the new Chairman of the US Fed Reserve, with an incisive analysis of the causes of the massive US current account deficit. This analysis provides a far more benign picture than has commonly been endorsed by economic orthodoxy. Bernanke's alternative view of the US twin deficits (for example, they are being driven not so much by US excess as by Asian central bank buying of $US) are contained in his original paper (click HERE >). If correct, the likelihood of sustained US and hence global economic growth is higher than commonly expected. Of course, this will flow through to higher equity prices in key international markets including Australia, but interest rates may not be far behind (except to the extent that global economic efficiency moderates them – more on this below).

The US twin deficit - not such a bogeyman?

One of 2005's great bogeymen (or is it bogey people?) has been widespread concern about the size of the US current account deficit, which at $US666 billion and representing 5.75% US GDP, is at an all time high. Conventional wisdom (for this, read the prophecies of Australia's major fund managers and asset consultants) has it that this level of current account deficit is unsustainable and will eventually lead to a massive contraction in the US economy, when and if foreign lenders move their cash to safer havens. Since the US is the world's largest economy, financial collapse in the US would undoubtedly have severe consequences for us all.

The thesis that Bernanke defends in his paper is that US current account deficits have been funded by a rapidly growing pool of savings in emerging market nations, which are buying the $US to shore up their own currencies against possible capital outflows in times of domestic economic crisis. That is, on Bernanke's view, the funding of the US current account deficit isn't so much arising because it has to, but rather because emerging nations want to invest in the US. Important economies like China are amongst these nations. Bernanke puts his position thus:

"In response to these crises, emerging market nations either chose or were forced into new strategies for managing international capital flows. In general, these strategies involved shifting from being net importers of financial capital to being net exporters, in some cases very large net exporters. For example, in response to instability of capital flows and the exchange rate, some East Asian countries, such as Korea and Thailand, began to build up large quantities of foreign-exchange reserves and continued to do so even after the constraints imposed by the halt to capital inflows from global financial markets were relaxed.

Countries in the region that had escaped the worst effects of the crisis but remained concerned about future crises, notably China, also built up reserves. These 'war chests' of foreign reserves have been used as a buffer against potential capital outflows. In practice, these countries (use their foreign exchange reserves) to buy US Treasury securities and other assets...

Another factor that has contributed to the swing toward current-account surplus among the non-industrialised nations in the past few years is the sharp rise in oil prices.  The current account surpluses of oil exporters, notably in the Middle East but also in countries such as Russia, Nigeria, and Venezuela, have risen as oil revenues have surged. For example...  the collective current account surplus of the Middle East and Africa rose more than $115 billion between 1996 and 2004.

In short, events since the mid-1990s have led to a large change in the collective current account position of the developing world, implying that many developing and emerging market countries are now large net lenders rather than net borrowers on international financial markets."

This interesting analysis deserves careful consideration by every investor in Australian or international stocks and bonds. As with markets everywhere, investor's oscillate between exuberance and despair, often overshooting the mark. In the case of the US, are we guilty of the same, this time favouring the pessimistic case more than is rationally justified? The implications for world growth of a strong and stable US are profound and need to be factored in to any investment analysis.

China is the engine of growth for the 21st century

Australians were shocked by images of riots in the French capital this year, caused by unemployed North African émigrés protesting against their joblessness, and general economic malaise. With French unemployment running at around 10%, no one should be surprised to see violent mobs. And since the same phenomenon exists in other tired economies in the first world, what we should also be concerned about are the prospects for investors into those economies.

With massive economic growth underway in the fast growing economies of China and India, it is time for Australian investors to think about investment prospects in these regions – either investing directly, or indirectly through companies that profit from trade in the region, or into the commodities that these economies are buying as part of their modernisation.

As Figure 2 shows, by mid century, China is predicted to have overtaken the US as the leading economy in the world by around 2040. The US will hold second place, with India a close third. But have a look at the prospects for the likes of Japan and Germany...

Figure 2: GDP Growth 2000 - 2050

Source: Goldman Sachs, courtesy of Schroders

China's growth story is very different to the cyclical growth of some of the other nations that are modernising. Countries that are only equipped to grow by exporting to developed nations are only as strong as the economic fortunes of their trading partners. China is experiencing a far more profound economic change, driven by urbanisation and industrialisation as several hundred million individuals migrate from regional areas to China's cities. As Figure 3 shows, this industrialisation is driving the consumption of massive quantities of raw materials, and the strength of this process is leading some commentators to suggest that Chinese growth is driving an economic supercycle which may last for decades. As BT Chief Economist Dr Chris Caton said in November "The Chinese growth story has decades left to run."

Figure 3: China's share of world commodity demand

Source: Credit Suisse Asset Management

What about rising oil and commodity prices?

In recent months, the Reserve Bank of Australia has let the inflation genie take a peek out of the bottle, especially in a statement in October that rising interest rates may be needed to quell oil and resource price led inflation. This comes at the same time as US market worries about inflation are on the increase, with US rates currently at 3.75% and some concern that they could go as far as 5% with employment and wages rising in step with GDP growth. These inflationary fears are rekindling the pessimism about the Australian and US equity markets that were at the forefront of bearish sentiments in mid to late 2003.

What will rising oil and commodity prices mean for Aussie stock prices?

The answer, according to RBA Deputy Governor Glenn Stevens, may not be a rosy picture for Aussie investors. In a speech made in October 2005, Stevens commented that "the issue before us in the next year or two is whether the world and Australian economies can adapt to higher energy and resource prices without a significant bout of inflation." The speech highlighted that the RBA will be looking closely at inflationary evidence in forthcoming data.

Although oil prices have moderated from their post Hurricane Katrina and Rita highs (prices have already fallen from $US70.85 on 30 August to $US57.00 in mid November 2005), it remains unlikely that global energy and resource prices will decline substantially while China and the emerging markets continue their drive to modernisation. China has accounted for 38% of the growth in demand for oil in the last four years, and as we saw above, Chinese demand for key commodities is unlikely to abate in the foreseeable future.

What about gold?

As the great Australian icon Norman May used to say, the economic news for the past few months has been all about "Gold, Gold, Gold". Sure, Nugget May was talking about our Aussie Olympic athletes, but in the context of the market, there is definitely some important guidance here for investors. Gold appreciates in value as inflation rises because it is seen as a hedge against falling currencies and rising prices. And, off the back of the rising oil prices, we're seeing an additional stimulus to US inflationary fears (as well as the double whammy, where rising oil prices drive up Middle Eastern revenues, which in turn buys more gold.

However, a sensible consensus seems to be that US near-term inflationary fears are probably a bit overdone, with structural settings like rising rates likely to dampen the medium-term inflationary pressures. That said, the US is clearly coming out of the deflationary spiral experienced after the Tech wreck in 2000 and terrorist attacks of September 11, so upwards pressure on inflation is to be expected.

Fairly static gold production is also fuelling gold price rises. On the demand side, it is those two new engines of economic growth, China and India, that are driving demand for gold. India values giving gold as part of the Hindu wedding ceremony, and China's new riches and liberated market are allowing Chinese to buy bullion with far more freedom than traditionally enjoyed. And, as noted above, Middle Eastern investors are increasingly pushing into gold as a store of wealth.

This has contributed to the spot gold price rising above $US500/oz. While there are a number of good Aussie gold stocks around, the increasing trend for investors is to look at physical gold as a way of locking in clean exposure to gold, and this can be done via the facilities provided by the Perth Mint. There is also a listed investment company that plays the gold market, as well as an ETF (ASX Code: GOLD) and a number of structured products that provide exposure to gold. And, for those who want some guidance on portfolio construction, we have seen at least one of the major Australian research houses extolling its view that an explicit allocation to gold of up to 5% of the total portfolio, may be a good diversifier for the coming part of the cycle.

International investing

Emerging markets have been out of favour with mainstream investors since the series of financial shocks in the late 1990s that culminated with the default by Russia on its sovereign bonds in 1997. What's changed since then, to bring emerging market investing back into favour (with a number of new products being released this year that provide exposure to emerging markets)?

As Figure 4 below shows, emerging market debt has been providing solid returns since the late 1990s, outperforming major asset classes like US equities and bonds. Behind this performance are two inter-related factors, commodity production and increasing fiscal prudence, both of which feature prominently in the analysis of changing global investment conditions identified by US Fed chairman Bernanke in the paper discussed above.

Emerging market debt has been providing extremely strong returns in its own right since the late 1990s, driven primarily by the huge growth in export revenue from the majority of those emerging markets that are commodity and energy producers. These exports have led to substantial national balance sheet repair which has reduced the obviously very high levels of risk observed in emerging market debt in the 1990s. This balance sheet repair has been noticed by a range of bodies including Standard and Poor's, IMF, and the US Fed Reserve.

Figure 4: Comparative returns, emerging market debt

Source: Schroder Investment Management, December 2005

So which assets make sense for 2006?

For 2006, then, Australian share investors will face an anxious few months as they watch and wait for evidence of rising inflation and the likely adverse impact on Australian share prices. As rates rise, so too do relative bond values and, with this, stock values and prices inevitably decline. If this comes to pass, watch as defensive stocks begin to rally - again! In the expectation of rising prices and values for defensive stocks, it may pay to start to move pre-emptively back into this sector.

For investors poised to look again at offshore markets, there are some excellent opportunities available. In doing so, investors should look to add both diversification and growth to their portfolios:

• International markets are showing signs of renewed vigour, but investors should be focused on markets which are clearly growing like the US, China, and India;

• Australia will still be an attractive place to invest, but beware of stocks that aren't in growth mode, and do focus on stocks that have exposure to key offshore markets like China, India and the US;

• Commodity, energy and gold prices are likely to remain high for the foreseeable future – and buying exposure to these assets may be an alternative way to obtain exposure to markets like China and India that investors (and even asset managers) find it difficult to invest in directly;

• Watch out for rising inflation, but be aware of the downward price pressure that cheap imports from places like China – these are having the effect of keeping inflation in check for now, even though economic activity and consumer spending is rising.
  

2006 is set to be another rewarding year - of course, only time will tell by how much!

Warren E. Buffett's investment company, Berkshire Hathaway Inc. (BRK), has achieved this amazing growth over the past 40 years. Now, the Global Masters Fund offers the prospect (but not the guarantee) of superior returns in the future, by investing up to 80% of its assets in Berkshire Hathaway Class A Stock.

As an illustration of Berkshire Hathaway Inc.’s past results, a $US10,000 investment in Berkshire Hathaway Stock in 1965 is now worth about $US50,000,000.

However, a single Berkshire Hathaway Inc. Class A Stock is currently valued at over $US80,000, placing them well out of reach of most investors looking for high growth, blue chip investments... until now.

The Global Masters Fund (GMF) will invest in Berkshire Hathaway A stock and other high quality assets, to make these assets available to Australian investors. GMF is a soon-to-be listed investment company. Its strategy is long-term capital appreciation through investment in global investments with a history of high returns

• The portfolio includes Berkshire Hathaway Inc. A Stock (up to 80% of assets). The balance will be in global bonds and cash;

• It features asset and multi-currency diversification with the fixed interest investments being hedged back to $A;

• There is one free stapled option per share and an annual buy-back offer at NAV less 5%;

• The offer is for 60 million stapled securities with unlimited oversubscriptions;

• The minimum individual investment is $A5,000 and thereafter, multiples of $A1,000;

• The annual MER is a maximum of 0.85% (plus GST) reducing to 0.65%. An investment with a value of $A5,000 will therefore attract an MER of no more than $42.50 (plus GST) per annum;

• There is a 1% upfront commission to the adviser – there is no trail commission;

• Margin lending facilities are available via Leveraged Equities and BT. For further details, please refer to the GMF website (click HERE>);

• The close date for the fund is 9 February, 2006;

• The fund has a Five Star Rating from research house, InvestorWeb Limited.
  

The Manager Growth Equities Corporation Limited (GEC) is a specialist manager founded in 2002. It is totally independent of any large group. GEC develops, markets and manages Exchange Traded Funds (ETFs) and other managed investments.

LIC Innovations  To address the issue of LICs trading at a discount, for the first three years, the company will arrange an annual off-market offer to buy back shares from investors wishing to sell at NAV less 5% (limited to 10% of share capital in any one twelve month period). At listing, the NAV will be $A0.97, plus a two-year option, stapled for the first year. GMF will review the Manager every five years to ensure that it maintains peak performance.

For more information
Email kathleen@tepana.com or bianca@gecetf.com.au
Phone Kathleen Tepana +61 2 9388 8369
View the Prospectus click HERE >

© 2005 DIRECTINVESTING, Brillient Pty Ltd, ABN 77 098 429 335.
All rights reserved. Refer Terms & Conditions of Use.